President’s Advisory Panel on
Federal Tax Reform
Integration of Corporate and Individual
Income Taxes
Alvin Warren
Harvard Law School
May 12, 2005
Two Questions to be Addressed:
1. Why should corporate and individual
income taxes be integrated?
2. How can it be done?
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Why should corporate and individual income taxes be
integrated? Two components to the answer:
A. Taxable corporate income distributed to taxable
shareholders is taxed twice, once when earned by the
corporation and again when received by shareholders
as a dividend.
This “double taxation” can create incentives for:
- individuals to invest outside of corporations,
- corporations to issue debt, rather than equity
(because interest, but not dividends, are deductible),
- retention, rather than distribution, of corporate
earnings (depending on the relationship of corporate
and shareholder tax rates), and
- distribution of earnings as capital gains, rather than
dividends (particularly if taxed at different rates). 3
B. On the other hand, not all corporate income is subject
to double taxation:
Some is taxed once at the investor level (e.g., corporate
earnings distributed as interest to taxable lenders).
Some is taxed once at the company level (e.g.,
corporate earnings distributed as dividends to exempt or
foreign shareholders).
Some is taxed at neither the company nor the investor
level (e.g., corporate earnings distributed as interest to
exempt or foreign lenders).
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Goal of integration:
Corporate income should be taxed once,
but only once, to reduce tax-induced distortions.
Three methods:
- Shareholder credit for corporate taxes paid
- Shareholder exclusion for dividends received
- Corporate deduction for dividends paid
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Shareholder Credit for Corporate Taxes Paid
Basic idea: Shareholder receives credit for corporate
taxes paid with respect to earnings distributed as a
dividend.
Result: Corporate earnings are taxed to shareholders at
their individual rates, so corporate tax becomes simply a
withholding tax.
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Shareholder Credit Example
Corporation earns $200, pays $60 in corporate taxes (at
30%), and distributes the remaining $140 equally to
shareholders A and B, whose tax rates are 25% and 35%.
Corporate income $200
Corporate tax
60
Cash dividend
140
Shareholders
Shareholder cash dividend
Shareholder taxable income
Preliminary shareholder tax
Tax credit
Final shareholder tax
Net shareholder cash
A
B
$ 70 $ 70
100 100
25
35
(30) (30)
( 5)
5
75
65
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Shareholder Exclusion for Dividends
Basic idea: Shareholder excludes dividends already taxed
at the corporate level.
Result: Corporate earnings are taxed at the corporate rate,
rather than the individual investor’s rate.
Example:
Corporation again earns $200, pays $60 in corporate taxes
(at 30%), and distributes the remaining $140 equally to
shareholders A and B, whose tax rates are 25% and 35%.
Dividends are excluded from shareholder taxable income,
so each shareholder receives cash of $70, reflecting the
corporate tax rate of 30%.
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Corporate Deduction for Dividends
Basic idea: Corporation deducts dividends paid to
shareholders.
Result: Corporate income ultimately taxed at
shareholder tax rates, as under a shareholder tax credit.
Caveat: Without a withholding tax, the deduction method
automatically extends the benefit of integration to taxexempt and foreign shareholders. Coupling a deduction
with withholding essentially reproduces the shareholdercredit method.
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Some Integration Tax Policy Issues
Distribution of untaxed corporate income: How can a
shareholder credit or exclusion be limited to income
taxed at the corporate level?
International investment: Should the benefits of
integration be extended to foreign investment or foreign
investors?
Tax-exempt investors: Should the benefits of integration
be extended to tax-exempt investors?
Conformity with debt: How closely should the integration
method be aligned to the treatment of debt to prevent
distortions?
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Recent Developments
United States
In 2003, the tax rate on dividends was conformed to the
preferential tax rate on capital gains.
- This is a partial step toward dividend exclusion,
which was originally proposed by the President.
- As enacted, the lower shareholder rate applies
even if income was not subject to corporate tax.
European Union
Several important trading partners of the U.S. have recently
replaced their longstanding shareholder-credit integration
systems with a partial exclusion for dividends, in order to
avoid judicial decisions prohibiting discrimination against
investment involving other E.U. countries.
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Conclusions
1. The basic idea of integrating individual and corporate
income taxes is that corporate income should be taxed
once, but only once, to reduce economic distortions.
2. The principal design question raised by integration is
whether corporate income should ultimately be taxed at
shareholder or corporate rates. The first answer would
suggest a shareholder credit, the second a shareholder
exclusion.
3. Under either approach, the shareholder credit or
exclusion should be available only for income that was
actually taxed at the corporate level.
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Appendix
A few additional thoughts on a some issues of tax policy
and legislative design that would be implicated by
integration of the individual and corporate income taxes in
the U.S.:
1. Partial dividend exclusion in the E.U. would not be
incompatible with a shareholder credit in the U.S. The
previous E.U. credit systems discriminated against
international income, but such discrimination is not a
necessary feature of shareholder-credit integration.
2. Discrimination against outgoing investment under a
shareholder credit could be avoided by passing through
the foreign tax credit or partially exempting foreign income
from shareholder taxation.
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3. Limiting shareholder credits or exclusions to income
taxed at the corporate level could be accomplished by (a) a
withholding tax on dividends paid out of untaxed income or
(b) requiring corporations to notify shareholders of whether
corporate tax had been paid with respect to the dividend.
The former puts an additional burden on corporations, but
is much simpler for shareholders, who can treat all
dividends identically.
4. The tax burden on investment income flowing to tax
exempts could either be left unchanged under integration
(such as by making shareholder credits nonrefundable) or
modified (as by setting an explicit tax rate against which
credits could be taken).
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These and many other issues of tax policy and legislative
design are considered in two in-depth studies of
integration for the U.S.:
U.S. Department of the Treasury, Integration of the Individual and
Corporate Tax Systems: Taxing Business Income Income Once (1992)
Alvin C. Warren, Jr., Integration of Individual and Corporate Income
Taxes (American Law Institute, 1993)
Those two studies are reprinted in:
Michael J. Graetz and Alvin C. Warren, Jr., Integration of the U.S.
Corporate and Individual Income Taxes: The Treasury Department and
American Law Institute Reports (Tax Analysts, 1998)
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