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OFFICIAL OTP FILES RETURN TO ROOM 4040

A Treasury Tax Study ...

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,�.­

.... 

THE ·POSTWAR 

._ CORPORATION TAX 

STRUCTURE 

), 

,, :I­ TREASURY DEPARTMENT • Division of Tax Research * ��

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!HI POSTWAR CORPORATION TAX STRUCTURE • 

.}} 

• 

:By- Richard B. Goode 

'l'REASURY DEPAR~ ... 

Division of Tax Reaearch 

• 
.On~ of the ms,Jor issues ot postwar t2.X polic1 concerns 

the position at the corporation tn the tu atructure. The 

corporation income tu has been widely critjcized on ground• 

ot alleged inequity and undesirable economic effect•. The 

purpose of this report 1• to examine criticiama of the corporation income tax and the arguments in· its favor, and to 

anal7ze proposals for tundementall7 r~visinc it. The report 

advances no poliey recommendation, but discusses conaidera~ 

tiona important to the formulation of auch recommendations. 

!rhe report was prepared in the Business Tax Section ot 

the Diviaton ·of Tax Research by Mr.:Richard Goode.under the 

supervision of Mr. Gordon Keith. In tta preparation, use 

waa made ot research memoranda prepared by other members or 

former members of the Division staff including Mr. Car:, Brown, 

Misa Nanc7 Dunlap, Mr. Cheeter Hir1ch, Mr. Merton Miller, 

Mr. J:veret Straus. and Mr. Hallkell Wald. 

Louia Shere 

Acting Director of Tu Res~arcb 

December 6. 1946 

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2. 

THI POSTWAR CORPORATION TAX STRUCTUll 

Table of Contents 

Page 

Summa.ry• • • •, • • • • • • � • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • � •• •••i - V ,••

• I • Cri ticisma of the present corpo�ation income tax 

and arguments in ita favor••••••••••••••••••••·••••�•••••••• 1 

A.•• Introduction ••••••••••••••••••••••••••••••••••••••••• .-

...•• 1 

B.••Effect o� the corporation income tex on••

commodity prices and wage rates•··•••••••••••••••••••••••• 2 

1.••·Prices••••••••••••••••••••••••••••••••••••••••••••••••• 2·. Wage rates ••••• � .•.•••••••••• •• ••••••••••• •• ••••.•••••••

c. Analysis of criticisms of the present .••

corporation income tax•••••••••••••••••••�•••••••••••••••• 4 

1. Equity arguments against the corp ·• ora.te t·•

ax ••••••••••••• 4

a.••Double taxation ••••••••••••••••••••• �.••••••••••••• 4 

(1)•• Combined impact of corporate and••

individue.l taxes on corporate profits ••• ••••• 5 

(2)•• Effect of corporate tax on prices and ;•• yields of various kinda of assets•••••••••••• ·7

b.••Regressi vi ty ••••••••••••••••••••••••••••••·•••••• ••• g

�onomic arguments aga.inst the corporate tax•• ••• •• •••• 9

a.••Effects on 1ndividll81 security purc•hases•••••••••.•• 9- -b. Effect on-business incentives to invest •••••••••••• '10 

(1) Prem1um_£or risk taking ••••••••• � ••••••••••• 10· 

(2)' Minimum return••••·••••••••••••••••••••••••• 11 

'(3) Rel:I.Ction of management•••••••••••••••••••••• 12 

(4) ·•Non-corporate investment ••••••••••••• � •••• ·•••• 121

(5) Necessity o! comparing effects of••

corporate tax and other taxes•••••••••••••• 12 

c. Effect on-methods of corporate 

financing - debt versus equit7••••••••••••••••• 13 

d. Effects on form of business-organization •••••••••. 13 

e• Significance of shifting••••••••••••••••••••••••• 14 

• 
••• 

Table of Contents - 2 

Page 

D. Analysis o~ argument~ in favor of 

the present corporation income tax•••••••••••••••••••••• 15 . . ' . 

/, 

l. Equity arguments in favor of the corporate tax••••••• 15 f: 

,, a. Special privilege as a basis of corporate 

taxation••••••••••••••• ~·• ••••••••••••.. •.. ~ ••••• 15 ill 

b. Progressive character•••-••••••••••••••••••••••••• 15 

c. Economic distinction between corporations 

and stockholders••••••••••••••••••·•••••••••••••• 16 

d. SignificB-nce of shifting••••••••••••••••••••••••• 17 

2. Economic arguments in favor of the corpor1tte tax••••• 17 

a. I,npact on consumption and savings••••• ~ •••• ~ ••••• 17 

b. Impact on invea tment •• ••••• ~ •••••••••'•••••••••••• 19 

c. Significance of shifting•••••••••••••••••••·•••••• 19 

II. Prob_lema encountered in adopting a_ new method . of taxing corporate profita.·•••••••••••••••••••••• •.••••••••• , 20 

A. -Prevention of individual tax avoidance 

through corporate undiatributedprofita................. 20 

B. Windfall gains to stockholders and 

,. ·effect on stock prices•••••·••••••••••••••••••••••••.•••• 21 

C. Timing of tax adjustments in relation to their 

effects on commodity pricea,and investment•••~•••••-••••• _23 

1. Commodit7 prices••••••••·••••• ~ ••••••• ~ ••••,•.• • • •••• • • • 23 

2. Investment•••••••••••••• ;, •••••.••••••••••• • • •••••••• • • 23 

III.· Methods of coordinating individual and 

corporate tax on corpor~te profits•••••••••••••••••••••••••• 23 \ I , 

A. El1minat1on'of corporate income tex and_ 

,adoption of full taxation of capital _gains••••••••.••.•• 23 

.1•. Rationale••• •·• •••• • ••• ~ •••••••••••••••••••••••••~ •••• • 24 

2. Tax avoidance and postponement••••••••••••••••••••~•• 24 

3. Discrimination among taxpayers••••••••••••••••••✓.• 26 

4. General economic ef:f'ecto •••••••••••·•• • •• • • • •••••• • • •• 27 

5. Evaluatl.on••• ~ ••••~ ••••·~ ••• ~ •·• •••••••••••••••••••••••• 27 '· 
Table of Contents - 3 

Page· 

:a. Cur:rent taxation,of ·all corporate profits at 

rates applicable to individual shareholder,............. 27 

Partnerahip method••••.••••••••••••••••••.•••••••••••. 27 

a. Rationale•••••••••••••••.-.••••••••••••••·••••••••••· 30, , b. Technical and administrative feature••••••••••••• 30 ! (1) Allocation of income·among•tockholders••••• 30 

(2) .Special, types of income, deductione, · ·. 

and credita•••••••••••••.•••• ~.~ •••••••••••• 31 

(3) AdJustmenta of corporate income of 

prior 7eara•• ~•••••••••••~••• ..••·•••••••••• 31 

(4) AdJuatment ot baaia of atock•••••••••••••••• 32 

c. Area.of applicabilit7••••••••••••••• ~ •••••••.-•••• 32 

d. ··. Compulsoey or optional partnership treatment••••• 33: 

e. Partnerahip method with final accounting 

a~ time of transfer of shares••••••••••••••••••• 

t. E'f'aluation•••••••••••••••••••••••• ~ •••••••••••••• 

(l) l!lquit7 conaiderationa.~ ••••••••••••••••••••• 

·(2) Economic considerations•••••••••••••••••••• ~ 

(3) Administrative conaiderationa••••••••••••••• 

2. Collection of tax from corporation·exactl.7 

equivalent to individual tax if profits 

distributed. •••••••••.;;.~............................ ·35 

.a. Use in United-Kingdom end Australia•••••••••••••• 36 

b. . Evaluation••••••••••••·•••••.•••••••.-.••.·.·.~ ••••• ~. 36 

o. Ad,Justment. for diatributed profits at the 

corporate levei - eredit for divi~ends paid••••••••••.. 37 · 

1. Rationale•••• ~ ••••••••.•••••••••••·• •••••• • ••·••••• ~ ••• 

2. Reliet for small corporation••••••••••••••••••••••••• 

a. Added versu1 vanishing presumptive 

dividends-paid allowance•••••••••••••••••••••••• 4o 

b. · Size of' preaumpt'ive dividende•paid 

alfowance••• ~ ••••••••••••••••••••••••••••.••••••• 41 

J ••.. Dividends paid in exceSB of available income•• ••••••• 42 

4 Treatment of special ty:pes of income••••••• ; •••• .-•••• 43 

·a; Intercorporate dividends.;•••••••••••••••••••••••· . ·~ lilvaluation......................·•••••••••••••••••••••• 

a. lquit7-considerations••••••••••••••.'~ •• ~ •••; •••••. ,1+4

• b. Economic considerations••••••••••••••••••• ·• •••• .; • 45 

c. Administrs.tive considerations•••••••••••••• ~.•••• 46 

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Table of Contents - 4 

.Page 

D. AclJu1tment at the individual level tor . corporate tax on d11tributed income•••••••• ~ •• ~••••••••• 46 

1. Yithholding tax approach•••.~ •• ~ ••; ••••• •••••• •• ·• • • • • 46 

a. Bational••••••·•·•·••~••••••••••·••••····•••••••• 46 

b. Illustration.-••••••••••••••••• · ••• ~ ••••••••••••••• 47 

c. Rate of vltbholding•••••••••••••••••••••••••••••• 48 

cl. Withholding ln excess of individual tu••••••.••• 48 _•• Method• of vithho141ng•••••••••-.;••••••••••••••••• 48 

(1) ,tJnltorm mark-up ot cash diTidenda 

to reflect amount withheld•••••••••• ~ •••••• 49 

(a) Dividend• on preferred stock••••••••••• 49_ 

(b) DiT14ends not paid from current 

tullt taxable income•••-••••••••••••••• 50 

('l) Earnings and profits accumulated 

.prior to adoption of plaJi•••••••• 50 

(2) Earnlnge and profitsaccum.ulated 

aubaequent to adoption of plan••• 50 

(c) . DlTidend.1 paid from income partlall.7 :. 

or vholl7 tax•uempt•••••••••••••••••• 51 

(d) Dividends paid from capital•• ~ ••••••••• 52 

(e) Intercorporate dividend•••••••••·•••••• 52 

(f') Relief for small corporatlon••••••••••• 52 

(2~ · lxact allocation of' vi thholdlng 

wt th reports to· stockholdere••••••••·••••••• 53 

t. Relation of withholding to ta:ration of capital · gains and· losses realized on stock••-. ••••••••••• 54 

g. Evaluation••••••••••·•••••••••••••·•••••••••~•••• 56 

( 1) Equtt7 conai'derationa••••••••••• , •••••••.•.•• 56 

(2) .Economic considerations•••••••·••••••••• ••••• 57 

(3) AdminiatratiTe condderations.......; .~.••••. 58 

Dividenda-received•credit approach••••••• ~ ••••• ~ ·• • • •• 58 

a. Rat.lona.le•••••• ~~•••••••• •.••••••••••••'• ••••,,,.•••• ••·•· 58. 

b. Implicit rate ·structure._•••.-•••••-•••·•••• ~ •••••••• 5~ 

c. Possible modifications of' the dividends• 

received-credit s7atem~ •••••..•·• ••. ~. ~ •••• ~ •.••• 61 

d. Evaluation•••••••• ••••••·••••••••••• . -~ •. ~ ; .• ~ ..•·•.• 61 

(1) Equit7 conaiderationa••••••·•••••• • • •••••••• • 61. 

(2) · Economic conelderation•••••••••••••••••••••• 61 

(3) AdminbtratiTe con1ideration1...•••• • ••••••• 62 

Partial exclusion of' dividends received 

from indivfdual ta:rable income••••••• ~ ••••;.••••••••• 

a. ,Rationale•••••••••••••••••••-••• ~ ••••••.·•••·••••,~. 

b. Implicit rate structur•••••·••••••••••••••••••~••• 

c. Evaluation.••••••.••••• •• •••••·.••••.~•.•~ •••• ~ ••••• 
· Table of Contenta - 5 

Page 

_I. Summaey compar1eon of method of coordination and 

estimates of re,•enue 7ield of illuatrative. plan.·••••••. · 64 .. 

Appendiz A - Collection• from Corporation Income and lxceae- 1 · 

Profit• Tsxes, Individual Income Tuea, and 

Total Internal Revenue, 1lacal .Years 1925-1945 ....... ,. 70 . . ' - ' ' 

Appendix B - Progreaeivlt7 of a nat•rate Corporate Income . 

Tax on Distributed }>rot'its••••• ••••·••••••••••••••••• ._ 71 

Appendiz C - Nev Domestic Corporate Security Iaaue1_b7 Types, · . . ' 

1921-1945••• ' ~ ••••••••••••;........................... t6 I ' ' 

Appendix D - Bet Savinga'ot'Corporatlona and Individuals,· · 

1929-1945~ •••••••••••••••••••••·••• · •••••••••·•••••••••• ' 79 

J'ol:lowtng · Page 

Chart 1 - Total ·_Tu on Corporate Prof'ita Under Preent Plan.••••••• 6 ' 

Chart 2 .. Total '!ax on CorpoNJ.te· Prott ts Under Dhidenda- . 

Paid .Credit Plan ••• ••• •• ~ •••••·• ••••••• ~.•••• •••••••• •••. 4o ' . . 

Chart 3 - -Tot·a1' Tax on. Oorpora-te Profits Under Withholding 4S Plan•••••••• ••••• ••·• •••. •••••••• •·• • • • • • • • •••·• •• •. • • • • • . ~ • • 

Ohart.4 • Total Tax on Corporate Prof'ite Under Divtdends-

-.Becetved Credit Plan•••••••• ~ ••••••••••• ~.•• ••-.• •• .-•.•;•• 58 

Ohart 5 - Total Tax on Corporate Profit Under Dividends 

Jtl:cluaion Plan •••• ~••••••••••••••••••••••••••••••••••••• 62

Chart 6-_ Total .Tax on Corpo;ate Profit Under 11Ye Plana 

Compared with Partnership Treat~ent••••••••••••••••••••• 66 

• 
DI POSTWAR.CORPORATION TAX STRUCTURE 

SUMMARY 

I. Criticisms' of the present corporB.tion income tax 

and arguments i~ its favor 

... A. Introduction 

·Critics of the present corporate income tax argue that it is inequitable and economicall.7 undesirable. Defenders of the tu either deny these 

charges or find compen,sating advantages in the 'tax. The purpose of this 

report is to examine criticisms of the corporation income tu and arguments 

in its favor and to analyze proposals for fundamentally revising it. The 

report advances no policy recommendations but discusses considerations important to the formulation of such recommendations. . ' 

B. Effect of the corporation income tax on 

commodity prices and wage rates 

The effect ·of:the corporate income ta.:r: on commodity prices and ~age 

rates is of vital importance in the debate as to the merits of the tax. 

Unfort'Une.tely, there ia no general agreement as to whether'the te.x rests on 

corporations and.stockholders or ia shifted to consumers and wage earners. 

On the basis of usual price theory, many economists argue that a net income 

tax ha.a no eftect on prices or ·wages. Many others, however, doubt the 

applicability of this reasoning to the present corporate. tax. :Business 

opinion.is divided, but in two extensive surveys a ls~ge majorit1 of businessmen re1:1ponding believed that the corporate tax cannot be paSBed along 

in the form of higher prices. :IDven if the corporate tax has in the past 

pushed up prices and held down wages, it does not necessarily follow that 

1ts reduction would automatically reverse these effects. '·, 

C. Analysis of criticisms of the present 

corporation income tax 

On. grounds of equity the corporate tax is critiched as double taxe,:.. 

tion of dividend income and as an impersoM.1 tax1not adjusted to the incomes ot stockholders. These criticisms depend on the assumption that the 

tax is not shifted to prices or wages., If it is shifted, there is no 

double te.xation, but the tax ia regressive ·1n the same wa,y as e. sales te.x 

or peyroll tax. 

The chief economic argument advanced against the corporate tax is that 

• it reduces'both ability and willingness of corporations to invest. The tax 

1s held to reduce investment ability by limiting ca1)1tal availe.ble from 

security sales and ~rem retained earnings. It is also held to reduce incentives to invest, especially in rislcy' enterpriees. If it were alwaye 

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posaible to deduct loues on unsuccessful investments- from other taxable 

inco�e, the corporate income tax would not reduce the reward for risk talting in relation'to the net amount risked. Although perfect loss offsets 

are not possible nov (and c,m hardly be made so), existing opportunities. 

for loas.offae�s mitigate the effects of. the tax on incentives. Regardless of rhk •tthe·tax may in some circumstances reduce &nticipated returns . 

below the minimum necessary to induce investment. The corporate tax 

appears likely to·reetrict invest�ent, but to �bat extent is highly uncer- r 

tain. Alternative truces would also directly or indirectly deter some 

investment. . Double taxation of dividend income, but not of interest income, is ' 

held to encourage corporations to .borrow rather than to float stocks.· Excessive fixed debts may agg�avate economic instability. 

D.ttAnal1sis of arguments in favor oftt

the present corporation income tax ·tt

The traditional,Justlfication fo� special truces on corporations is 

that a public charter gives them special p�ivilegea and economic advantages. But the whole privilege theory ot taxation baa been challenged. 

Moreover, it has been argued that, since all who wish may incorporate at 

little eXpenae, a corporate charter can have little economic value. 

Some supporters of the present corporate tax system deny the validity 

of the double-taxation charge against it. They contend that there is a · · 

realistic legal and economic distinction between corporations and their 

stockholders and that separate taxation is Ju�tified. 

The chief economic argument advanced in favor of the present corporate tax is that it reduces consumption less and savings more than would 

feasible alternative taxes. Dividends ar·e heavily concentrated in relatively high-income groups, in the hands of individuals who ha.bituall� save 

large percentages ot their incomes •. It appears that the corporate tax, if 

not shifted, is in the aggregate a broadly progressive tax, which h less 

burdensome.totconsumption than many other te:JCes. The corporat� tax, however, is likely to be less progressive than the individual income tax. 

The fact that the corporation tax falls lightl7 on consumption is nn·advanta&e on the aHwnp.tion that· maintenance of enough total demand to 

assure a high level ot income and emplo)'ment will be an important iong•runtt · · economic problem. 

·11. Problems encountered in adopting a new methodtt

of taxing corporate profits 

Few critics would recommend simple eli�ina.tion of the corporate incomet1 tax without any further change. · It is generally agreed that some 

�rovision must be made to prevent individual tax avoidance ·on income re- tained in· corporations.· Most plans for corporate tax reform are·a.ttempts 

' to reduce inequitlity· of taxation of corpora.t,e pro:fi ts and other kirids of 

in�ome. -This involves reduction of both overtua.tion and undertaxation. 
) 

iii - ' 

• 

" 

• 

An incidental �roblem of corporate tax adjustment is to minimize. 

windfall gains·to stockholders and the likelihood of-setting off' a speculative stock market boom. For this purpose, it bas been suggested tbs.t 

any tax adjustment be spread over a nu.'!!ber of years. 

III.ooMethods of coordinating individual andoo . I 

corporate tax on corporate profitsoo

A.oo Elimination of corporate income true andoo

·oadoption of full t�tion of ca.pi tal gainsoo

·oOne approach to taxation of corpor'ate profits would be to eliminateoo

entirely the corporate tax an� to rely on taxation of' realized capital

gains at regular individual rates to prevent tax'avoidance with respect to 

undistributed·corporate profit■• A capital gain or loss would �e realized 

whenever an asset was tra.nsf'erred by sale, gift, or bequest. Some method 

of ave�aging individual income for tax purposes woul� be required. 

This approach would completely eliminate "double taxation" of diatributed corporate profits. :But. undiet.ributed corporate profits would be 

taxed lees heavil7 than other income. Undistributed profit• not reflected 

in the value ot stock at the time of a transfer would not be taxed. Stock_i.; 

holders would have the opportunity of postp·oning ,throughout life a tax on 

'their share of; undistributed profi t1, and. this would discriminate against , other forms ot' saving. The capital-gains approach would favor corporate 

saving and internall7 financed investment as compared with consumption and 

non-corporate saving and investment. Thia would be likel� to bring eco-� 

nomic disadvantages as' well as inequities. 

!. Current taxation'of all corEorate profits at 

ratesepplicable to individual shareholders_-· 

Comp let� integration of indi vidua.l and corporate taxes could be 

achieved by- determining tax liabilit7 on corporate profits without regard 

to the legal distinction between corporation• and.stockholders. The partnership method, for example, would tax stockholders currently at their 

regule.r personal tax rates on both distribu�ed and undhtributed profits. 

This approach would completely eliminate double taxation; individual tax 

postpoonement; ·and ·tax discrimination· against equity financing. It might 

or might not,· on balance,' increase incentives to invest. The partnership 

method would p_r9bably be administrativel7_ feasible for corporations Yi th 

simple capital structures and a relatively small number of stockholders. 

:SU.toit probably would not be,feaaible for· large corporations with compli-:­

cated.capital structures and·a large number of shareholders., A plan similar to the partnership method would be to tax each corporation at the 

average rate its shareholders would pay- on dividends ;if all profits were

distributed. This plan would present the same administrative difficulties 

as the partnership method. 

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c. AdJustment tor distributed profits at the 

co;ryorate level -- credit for dividends wd 

Another approach to coordination would be to·gtve corporation• a tax 

credit or deduction from taxable income for dividends paid.. This· approach 

would keep a t~ on undistributed prof'ita but would reduce or eliminate 

the corporate tax on distributed profits•. In recognition o~ the'probleme 

of financing small business. some moderate amount of ·retained profits 

might be taxed as it diatributed. .Dividends paid in exceas of current in- come could be applied against income of· past or future 7e"1"s. · ' 

. -This di't"idends-pat.d..:credit approach could completel7 or p!.rtiall7 

eliminate "double taxation,• remove or lessen tax discrimination against· 

equity financing, and reduce,the weight of taxation on corporate profits. 

Tax reduction at the corporate level might stimulate corporate investment 

and help co'?,D,teract U1' effort of management to shift the corporate tax b7 

increasing commodit7 prices and reducin& wages. The 'approach would present some administrative difticultiea but no insuperable' ones. 

l). MJustment at the individual level for 

CO_!l)orate taz on distributed income 

1.. Wiihholdlng.tu approach 

Another.. approach to coordination would be to treat part or all of the 

ta: paid by corporations aa a withholding_ tax on dividend income.• Individuals would include in taxable income cash dividends· received plus wtthholding tu on them and . would get credit tor the ta: witbheld b7 the corporation. The vitbholdix,g tax would apply to all corporate prottta. but 

stockholders would get credit ·currentl7 onl7 tor the withholding on the. 

part of profits paid out in dividend.a.. If'. ·withholding a:ceeded a stockholder•• tax liabilit7. he would get a refund. 

' ' ' 

!rhe vithholding approach could eliminate or.reduce •double taxation" · ot distributed corporate profita, reduce individual tax postponement on 

·undistributed proflts, an4 leaaen tax discrimination against equity financing. It migh~ ~timulate ,individual securit7 purchases. The withholding 

approach might have a lesa favorable effect on corporations• incentives to 

invest than an: ad,Justment at the .corporate level, and 1 t would be leas 

likel7 to counteract aDT effort of management to pass on the corporate tax 

through higher pricea or l~ver wages. A refined withholding method would 

present some rather serious aclm1n1strat1ve probleme. · 

2.· Dividends-recei•ed-credit.approach 

Another approach to coordination would be to·exempt dividends from a 

substantial individual normal or flra,-bracket·tax rate or to give stock~ 

holders an equivalent tax credit. Thia approach would give no relief to 

stockholders not aubJect to individual income tax. It would offer conaid- .. erable benefits to high-income stockholders, since in effect a part of the • • • ✓ I • - • 

ii 
C 

\ 

' : •_.•~ 

- V -

corporation's tax payment would be applied to their personal tax liabili-. 

ties but wo,1ld not be included in their taxable income. At the extreme 1 t 

would tax distributed profits at lower rates than other kinds of income. 

Thus, the plan would offer an inducement to wealthy individuals to buy

stocks. It would do little to counteract possible undesirable effects of 

the eorporate tax on management policies as to investment, prices, and 

wages. The dividends-received-credit approach would be administrativel7 

simple. 

3 •. , Partial exclusion of dividends rece.i ve'd 

' from individual. taxable income 

Still.another adjustment would be to exclude a part of dividends from 

ind.1 vi dual taxable income and tax the remainder at regula.r individual 

rs:tes. This plan would result in a distribution of tax benefi ta somewhat 

similar to that-under the dividends-received-credit method. It also would 

giTe no relief to stockholders not subject to individual income tax but 

would offer even greateroadvantages.to wealthy'stockholdere. The equity 

and economic effects and administrative ·features of the dividendexclusion approach ,,ould in general resemble those of the dividendsreceived-credi t method. 

·oE. Summary comparison of methods of coordination andoo

estimates of revenue yield of illustrative plane 

Complete �qualit7 of taxation of distributed corporate profits and 

other kinas of income could be achieved by any of four basic approaches. 

These are: (1) elimination of the corporate income tax. while relying on 

the capital gaine ·tax to reach undistributed profits; (2) taxation of 

•tockholders as if theY were partners; (3) elimination of the corporateoo

tax on distributed prof! ts but not on undistributed profits; (4) adJustment of the individual tax of stockholders 'to take account of the tax paidoo

by the corporation. :But only the partnership approach or some variationoo

of it could tax undistributed corporate profits in exactly the same way asoo

other kinds of income. Specific versions of the third and fourth basicoo

apprott.ches �Y. aim at reducing inequalities of taxation of.� corporate profi te and other kinds of inco·me rather than at complete eq_uali ty of taxation.oo

Starting from approximately the present relation between corporate and in-'oo

dividual tu rates, all approaches to coordination of individual and corporate taxes would be likely to result in some loss of revenue. Generally.oo

the more nearly "complete" the·coordination or integration, the greater·oo

vouldoe the loss of revenue.oo

\, 
" 

.. 

.. 

THI POSTWAR CORPORATION TAX STRUCTURE 

I.tt Criticisms of the present corporation income taxtt

and arguments in its favortt

A.ttIntroductiontt

� There are maJor ditferencea of �pinion aa to postwar taxation of cor:­

porate income. Many desire radical change• in the present a79tem. Others 

wish no basic revision. Not all those who favor ulUmate elimination of 

the corporate tax would recommend this step immediately. Moreover, many 

who approve the present t7Pe of corporate tax favor lover rates and other 

modification•• 

Argument• egainat the present corporate income tax hold that it 1a 

inequitable and economically undesirable. !he equity argument moat often 

streeeed ii that the corporation income tax, together with the individual 

income tax, reeulta ln double taxation of distributed corporate profits. 

The corporation-tax ia aleo alleged to discriminate with especial severity 

against low-income etockholdera. 

Economic arguments hold that the corporate tax decreases willingness 

of individuals to.buy securities and th�• limits capital available to corporations. Furthermore. it 1e contended that the corporate tax reduces 

the ablli t1 and villinpeaa of management to inveat and take risks. Another line ot argument against the corporate income tax 11 that it raises 

prices and lovers wages. Moreover, it ia held that the corporate tax encourages corporation• to borrow rather than to float new equit7 securities 

and that thia may accentuate economic downswings. Some fear that the tax 

mq discourage uae·of the corporate form, which they belieTe to be an· 

-especially efficient type of busineae organization.tt

Defenders of the present method of taxing corporations and stockholders either deny charge• brought b71critics or find compensating advantages 

in the corporation income tu. As to equit7, they hold that special privilege, and benefit• of incorporation warrant special taxation. Th97 argue 

that the corporate tax, broadly viewed, ia a desirable progressive element 

in the revenue qatem. Some supporters of the corporate tax doubt the 

realism or importance of the double-taxation criticism againat the present 

s7stem. 

On economic grounds, advocates ot the corporate tax argue that it baa 

the merit of falling lightly on consumption. These supporters of the corporate income tax are convinced that feaaible alternative sources of revenue·woμld be almost certain to burden consumption more heavily. The7 believe. - that national income ,md emploJment vill be higher· if .a given amount 

of revenue i• raiaed from the corporate tax than from likely alternative 

taxes. It ia alao argued that a significant portion of corporate profits 

ia economic surplus, unneceH&17 to vigorous functioning of the economy. 

Taxation of such surplus 1a regarded as a desirable source of revenue. 
- 2 -

Still others, w1 thout denying validity to criticisms of the tax. 

think the corporation income tax is such an important revenue source that 

it tl'U.at be caintained. !/ In the opinion of these observers, future revenue requirements will be so great that no established major tax can 

safely be abandoned or reduced more than in proportion to other tax cuts. 

They contend that the public will be unwilling to tolerate subotantial reduction of truces on corporate profits while other taxes are maintained 

well above their prewar levels. 

The following discuosion will exanine criticisms of the corporate ta.x 

and argw::1ents in its favor and then analyze proposals for fundamentally 

revising it. No attempt will be made to advance definite po~icy recommendations, but considerations relevant to formulation of such recommenda- tions will appear. Y · 

B. Effect of the corporation incomo tax on 

commoditz prices and wage rates 

Validity of most criticisms of the corporation income tax as well as 

of most argu:'llents in its behalf depends on an assu,rpti.on about where the 

tax actually comes to rest. Clearly, tha 11 double-taxation" argument, for 

example, implies that the corporation ta.x remains to a considerable extent 

where it is imposed -- on profits (a.nd hence on stockholders). On the 

other hand, another complaint against the corporate tax is based on the 

opposite belief that a significant part of it is passed on to consumers 

and wage earners through price and wage adjustments. Other argu..~ents 

against and in favor of the tax depend also, if less obviously, on one or 

the other opinion about who really pays it. 

Unfortunately. this crucial question cannot be definitely answered. 

There are differences of opinion among businessmen and among economists, 

and no statistical evidence is available. Nevertheless, it seems advisable to review briefly the possible effects of the corporation income tax 

on commodity prices and wage rates. 

If the corporation tax either raises co'Tlmodity prices or depresses 

wages it is said to be shifted. There are two possible kinds of explanations of shifting. The simpler concept, apparently referred to by most 

businesamen, is that producers faced with a. profits tax will deliberEitely 

g See Appendix A for a tabulation of revenue collections from corporate 

income and excess-profits taxes, individual income taxes, and tota.l 

internal revenue during the fiscal years 1925-1945. In appraising 

these figures, it should be remembered that a part of the revenue collected from corporate taxes merely replaces revenue which would otherwise be collected under the indivi~ual income tax.· 

Special incentive tax plans -- taxes on hoarding, deductions for investment, accele.rated depreciation, and the like -- will not be 

discussed. 
.. 

" 

.. 

- 3 -

decide to increase prices or reduce wages in order to protect their net 

returns. The other version of shifting, usually favored by economists, is 

that shifting is effected through unplanned oper�tion of market forces. 

According to this latter view, a tex may result in higher prices if it 

brings about a curtailment of supply. Similarly,_ a ts,x may·lower·ewages if' 

it reduces possible returns to business from employing labor. Normal 

business behavior may result in shifting, even though there is no conscious attempt to pass on the tax • 

1.ee Pricesee

Business opinion is divided. Spokesm�n for business often assert 

that the tax is shifted. However,.�n the two occasions when a sizable 

number of American businessmen were questioned, a la.rge maJori ty of those 

who expressed a definite opinion · sa1d tha.t the corporate tax cannot be 

passed along in th� form of higher prices.!/ The reason most frequently' 

cited for this opinion was that the force of competition and general market ·condietions set prices and do not allow the tax to be added. The 

minority of respondents who expressed the opinion that the tax increases 

prices regarded- it as a cost which must be covered by prices. 

Economists ha.Te usually held that a tax on net profits does notdirectly affect prices or wages, although some have challenged this view.

The opinion that a.profits tax does not stimulate a price rise is based 

fundamentally ·on the conviction that the tax is not in the economic sense 

a cost of production. Under competitive conditions, prices ·are supposedto be set by market forces beyond the control of individual firms. In 

cases of monopoly. prices are presumed in any case to be set-at the most 

profitable level inethe light of deman� and costs.e _ee

Economists have usually argued that the objective of all producers 

can be assumed to be maximum profits. They contend that any firm -­ whether in a competitive, monopolistic, or mixed market -- which has set 

its price and output most advantageously before a tax is imposed on true 

profits, will-find the tax no reason for ·changing either price or output. 

It is argued that the tax will reduce the amount of profits which can be 

retained, but' that it will still be advantageous to have the maximum obtainable profits before tax. Maximum profits before tax, it is held, •will 

yield maximum net income after subtraction of tax. 

But some part of the "net income" subject to Federal corporation income tax is actually a return necessary in the long run to induce continued oper�tion end ex:pension. This necessary return IDB.7 be regarded, from 

the social point of view, as a coat of production. If it is reduced, 

y National Industrial Conferen�e :Soard, The Shifting a,nd Effects of the 

Federal Corporation Income Tax, Vol. 1 (New York, 1928), pp. 153-155; . National Industrial.Conference Boe.rd,'Effects of Taxes Upon Corporate Policy (Nev York, 1943), PP• 57-58.
- 4 -

investment and production will be restricted. Because of the consequent 

decrease in suppl7 it may be argued that pricea will be forced up. The 

extent of the price movement would be _influenced by general economic conditions and urgency of demand for particular commodities. 

Even if the corporate tax restrict• investment and ultimately reduces 

production. a general price rise does not necessarily follow. A significant decrease in investment. not compensated for by more consumption, 

mean a decline in national income and consumer demand. A declining 

national income makes a fall of prices more likely than an increase. 

ertheless, some prices mq increase while othere decline. 

will 

NevThe outcome of the discussion -1. by no means clear and definite. It 

does seem. on the strength of testimony�of businessmen and economists, 

that an immediate and significant increase in prices can hardly be e:Rpected after adoption or increase of a corporate tax. Over the long run, 

d.evelopments are less clear. It 1• difficult to demonstrate that a corporate income tax will induce a significant increase in the general level ofee

prices even over a long period of time. Nevertheless. it is hard to proveee

that the tax will have no effect on price1.

The practical problem for postwar tax pollc7 is not the one Just discussed. The problem is, would elimination or reduction of the corpora,te 

tax lead to a price decline! It seems unlikely that a general fall in 

prices would follow immediately e.nd automaticall7 •. Such an adJuatment 

would probably have to be forced b7 competition or threat of competition. 

Its extent and timing would depend on market conditions. The attitude of 

businessmen would also be important. 

2.eeWage ratesee

The effect of the corporate tax on wage rates ls even more difficult 

to ascertain. It may well be that vigorous le,bor unions could capture a 

significant share of profits freed.by lower corporate taxee. :But profits 

and the corporate income tax in relation to the we&e bill vsrr widely :from 

firm to firm. Hence, a wage increase which would.absorb a reduction of 

the tax would "hs,ve to differ grea tl7 among firms. Any uniform wage increase in an industry or area, unless restricted to the tax reduction of 

the leaet profitable firm, would in some cases exceed the tex cut and in 

others :f'all short of it. A uniform wa&e · increase, representing an increase in·the costs of all firms, might well lead to a price increase. 

C.eeAnalysis of criticism& of the presentee

corporation income taxee / 

1.eeEquity arguments against the corporate taxee

a.ee Double tautionee

If the·corporation incom� _tax is not passed on in higher prices or 
� 

- 5 -

\ 

lower wages, it reduces profits ave.Hable for dividends. Dividend� mq ·

not immediately be reduced by the. full amount of the tax, but ownership

claims of stockholders will be decreased. Since dividends received by individua,ls are subject to regular-individual income tax rates, combined 

operation of corporation and individual income taxes appears to result in 

double taxation. 

(1)ee Combined impact of corporate andee

individual truces on corporate profitsee

Before considering further the implications of the double-taxation 

criticism of the present corporate tax system, it may be desirable to examine more carefully the mechanics of the system. The corporation income 

tax applies to corporate profits as a whole. The individual income tax,

of course, applies only to dividends paid to taxable stockholders. It 

does not apply to the portion of .corporate profits taken by the corporate 

tax. For this reason, the total tax rate on distributed profits cannot be 

obtained by simply adding together the corporate and individual tax rates. 

For-example, if the corporate_ tax rate were 4o percent!} and the individual tax rate of the stockholder were 20 percent, the total tax on corporate profits would not be 60 percent btit would be 52 percent (4o-percent 

·corporate tax on the whole profits plus 20-percent individual tax on theee

6o percent of·profits left after the corporate tax). Furthermore, the individual tax does not apply to profits so long as they are retained by theee

corporation and not paid out in dividends.ee

Chart 1 shows how the corporate and individual income tSJtes combine 

to make up the total tax on corporate profi ta, assuming for illustra.tion . a 4()..percent corporate tax.· The total te.x is the aggregate of corporate 

and individual taxes on a dollar of profits earned tor a share of stock 

owned by any given stockholder. In the two panels at the top of the cha.rt, 

the.corporate tax is shown on the left-band scale, the individual tax on 

the middle scale, and the total tax on the right-hand scale.· 

The first panel (upp�r left) of Chart 1 shows the total tax on corporate profits on the assumption that the corporation retains none of its 

proftts but pays all of them out in dividends and taxes. The corporate 

tax of 40 percent. shown·on the left-hand sea.le, leaves 6o percent of . total profits to be paid out in dividends. 

Y The4o-percent corporate tax rate and the individual tax rates mentioned here and elsewhere in the text are intended solely for purposes 

ot illustration. The illustrations were developed when the combined 

corporate normal tax and surtax was 40 percent. The illustrations 

have not been-revised with the reduction of the corporate tax rate to 

3g percent in the Revenue ·Act of 1945, partly because of the convenience of dealing with even numbers obtained by use of a .l�O-percent 

rate. No,recommendation is implied as to proper rates for either the 

corporate or individual tax. 
- 6 -

The dividends are in turn subject to individua.1 income tax in the 

h8nds of stockholders at different rates, which depend on the income and 

·personal circumstances of the individual. • range of individual tax ratestt

from O up to 100 percent is shown for the sake of illustration, withouttt

implying that a 10()-percent top rate is likell' or desirable. As haett

already been pointed out, these individual rates apply only.to the portionof profits paid out in dividends. This is shown on the chart by the plac- ing of the individual tax scale.tt

The total tax on corporate profits, stated as n percent of total 

profits. can be read from the right-rumd· scale of the first panel of the -• chart. The total tax ranges from 4o percent, when dividends are paid to a 

stockholder not subject to individual income tSJC, to a theoretical maximum 

of 100 percent, when the. stockholder is assumed. to be subJect to a 100- pereent individual tax rate. For example, in the case of a stockholder 

subject to a tax rate of 20 percent, the total tax, shown on the righthand scale directly opposite that individual rate, is found to be 52 

percent. 

The second panel of Chart 1 (upper right) illustrates th� effect of

retained profits on the total tax. In this panel, the assumption is that 

the corporation retains 30 percent of its total profits and pays 30 percent out in dividen4s. The fact that the retained profits are not currently subject to individual income tax is indicated on the chart by the 

shrinkage of the individual rate scale. Although the individual tax rates 

still range from O to 100 percent, the range as a percentage of total corporate profits has been cut _in half. It will be found that eveey individual tax rate above O on the middle scale falls opposite a lower total rate 

on the right-hand scale than in the first panel. For example, opposite 

20-percent individual rate the total rate is 46 percent rather than the 

52 percent shown in the first panel. 

The third (lo�er left) panel of Chart 1 generalizes the illustration 

of the principles shown in the upper half of the chart. This panel shows

the total tax on corporate profits for any assumption as to: (1) the in� 

dividual tax rate ��plicable to the stockholder and (2) the percentage of 

·ttprofits ·retained by the corporation. (On the assumption of a 4o-percenttt

corporate 'tax, the most a corporation could retain would be 6o percent oftt

its total profits.) Use of the third panel is illustrated in the fourthtt

(lower right) panel. The shrinkage of the individual income tax base as

profits are retained by corporations ia shown by the slope of the varioustt

individual-tax-rate lines downward to the right•. For example, the 20-

percent individual-rate line is opposite 52 percent total tax (on thett

right) when no profits are retained by the corporation; .opposite �6 percent total tax -when 30 percent of profits a.re retained by the corporation;tt

e.nd it comes together with the other lines at 4o percent total tax whentt

6o percent of profits are retained by the corporation. With 6o percent oftt

profits retained by the corporation, no dividends are paid to become subJect to individual true, - e.nd the 4o-percent c.or:porate tax is the only tax.tt _tt
Profits - 100"' -----------------------

70'4 

.. @ 

.. 00 

40 @ 80'4 

ro... 60"' 

::i Sub/tl<I lo lh• rot• of Ind/rid- 60 ~•ullillf """" 1111/ Jncom• lox .. !!O'II, .. rotol • applyln1 fo any •0'4 rax 

,, I flr•n $fO&khokl_, :,0,, so" I 

I 

I 

--~-

~ 

• 

' .. 

------------------------

------------------------------------------------

�----------------.100% 

1------160"4 

1------150"4 

------140% 

------110"4 

Chart I 

TOTAL TAX ON CORPORATE PROFITS UNDER PRESENT PLAN 

40% CORPORATE TAX 

Aggregate of corporation and individual income tax based on: · A. Varying percentages of profits retained by corporation.

B. Rate of individual income tax applying to any given stockholder .

.----------------------------------,1'---------------------------------- NO PROFITS RETAINED BY CORPORATION Individual Total Tax aa lnc ax Profits :;;:_r :ar! ��!fit, 

100% --------------------- -- 100%, -------,100% 

30% OF PROFITS RETAINED BY CORPORATION Individual . Total Tax a, lnc ax :;;:_r :ar! ��!fit, -------.100% 

90% 

-----90% ------190"4 

® 

Dividends-+ 

Subjt1cf lo fht1 rot11 of lndlvid· 60% .. uo/ /11comt1 fox opp/ylng to any givt1n ,tock/toldtlr 

--------180% 

60% @) 

Ru11/fing -•-Toto/-• 70"4 Tax 

------180"4 

--------·-------- 100% ------1 70% 

90,i, 

40% ----------------------- o....a-------140"4 

® 

Dividends-+ .. 20% 

10% 

0 

-----�30"4 -----..... 30"4 

Q) Q) 

� 40% --------1 20"4· �;!o;:x-� 40

'1. �� ------120"4 ;!o;:x-ro;

------110"4 

------------------------------------------- 0 0 -----------------------------------, --------- 0 0 

VARYING PERCENTAGES OF PROFITS RETAINED 

BY CORPORATION ILLUSTRATION 

For illustration of use. see -------•111111111o.. Individual Total Tax a, · Individual Total Tax a,

Income Tax . Income Tax 

RalH o�af! ��!fi;, Profits o�f! ��!fi;, Profits Rain 

100% 100% ·...---------------.100,-

40° 40"4 40"4 40"4 4 NONE 10% 20"4 30"4 40% 50%

RETAINED PROFITS 

NONE 10% 20"4 30"4 40% 50"4 RETAINED PROFITS

O Individual income tax rate 45%. Corpora20% lion Tax, � @ 20% of profits retained by corporation. 20% 

Q Total tax• 58% of corporate profits. \ 

10% 10% 

------------------------------------------------- 0 0 0 0 

8-648 Office of the Secretary of the Treasury, Division of Resea�ch and Statistics 
" 

c 

- 7 -

(2)eeEffect of corporate tax on prices andee

·yields of various kinds of assetsee

A number of adJustments of prices and yields of stocks and other 

assets are likely to diffuse and modify the original imps.ct of the corporate tax. When a corporate tax is first imposed or when rates are increased, the resulting decline in profits available for dividends will be 

-�ee reflected 'to a considerab1.e extent in prices of stocks. If there is no 

change in investors• standards for an adequate rate of return on securities, stockholders at the time when the tax is imposed will suffer capital 

losses or will fail to realize capital gains which otherwise would have 

accrued to them. Nev purchasers of stocks will take the tax into account, 

if they expect it to continue, and accordingly will offer less for stocks. 

If market adjustments were perfect, new purchasers would acquire stocks at 

prices fully discounting prospective corporate _taxes. These new purchasers would in effect escape the corporate tax in force when they bought 

their stock, if the tax were expected.to be continued indefinitely in the 

future. Old stockholders would have borne the tax once and for all. 

Actually, investors will in time change their standards for an adequate 

return, and securities markets are imperfect. Therefore, price adjustments will not be instantaneous nor complete. Nevertheless, imposition of 

a corporate tax can be expected to reduce the price of stocks below the 

level which otherwise would have prevailed. 

Price adjustments will not be confined to stocks, but will extend to 

other assets. When a corporate tax is first imposed some individuals will 

try to shift their investments from stocks to bonds and other assets, and 

some new investors who previously would have bought stocks will select 

bon.ds or other assets. Prices of bonds, real estate, and other assets 

will be bid up, and the fall of prices of stocks cushioned. Yields from 

all kinds of investments will suffer •. Conver�ely, the effect of a reduction in corporate tax will be likely to spread to_prices and yields of all 

kinds of investments and not be confined to stocks. 

It seems that in the long run, taking into account probable changes 

in the prices of assets, the corporate tax is more likely to result in 

general reduction of investment yields from all sources than in specific 

11double taxation" of dividend income. Similarly, reduction or repeal of 

the ·corporate tax would be.likely to bring about some general increase in 

investment yields. This reasoning is more clearly applicable to extensively traded securities listed on national'exchanges than to unlisted 

stock and other assets. Nevertheless, less readily marketable assets 

would probably be subject to much the same basic influences as_ listed 

securi tie a. 

To the extent that the tax is shifted to consumers and wage earners 

there· is no double ·taxation of dividend recipients. On this assumption, 

the corporate tax is no more a double ta:x: on shareholders than, say, excises on alcoholic beverages are "double taxes" on stockholders in breweries, wineries, and distilleries. 
.:. 8 -

b. Regreaaivitf 

It 1a contended ~hat the corporat·e tax, whether finallJ' borne b7'. consumers and workera or by stockholders, 11 regressive, or at beat proportional. If'. the corporation income ta:r: ie paaaed on to consumers in higher 

prices. it ia·regressive and inequitable in the same wq as a sales tax. 

A tu which raises prices atrikea low-income groups with greater weight 

than those with high incomea,,because low-income families mat spend a 

larger portion of their income~ on current consumption. lf the corporate . tu reduces wages it ia alao regressive, because vacee are in general a 

larger portion of low ~ncomea than of' high incomea. 

If the corporate tu reate on stockholders, it appears at firat sight 

to be proportional. The tax takes no account of differences in the income 

of stockholders of corporations. It reduces the amount of profit• available to corporations for- dividends, and to the extent that this cute · .. actual dividend payments it bring• about the same percent9&e reduction in 

dividends paid to all holders of a given stock. regardless of differences 

in their income.· Thia 11 held to be espec1al17 burdenaome to low-income 

atockholdera, in violation ot the principle of progreseiTe taxation. 

Moreover, a uniform reduction in corporate profits available tor dividends brings about a smaller reduction 1n the amount which a high-income 

stockholder could retain out of a dollar of corporate profits than in the 

amount which a lo~income atockholder-cou14 retain out of a dollar of 

profits. Thia 1s true because' the corporate ta:r:, when it reducea div.idenda, decreases the amount of peraonal income aubJect to the progressive 

rates of individual income tex~ If, in the absence of a corporation tax,. 

a well-to-do stockholder would have received additional dividends, they· 

would have been aubJect to a high rate of individual. income .tax•. A leas 

prosperous atoclcholder would have paid a: smaller. individual tu or perhaps 

·1101?,e at all. !( J'roa this point of view the corporate ta:r: appeara to be 

regressive. 

y :ror example, assume that the! corporation has profits of $1 per ·amμoe 

before ta:r:es • .&. 40-percent corporate tex will reduce earn1_ngs avail• 

e.ble for ciividends. to 601 per •hare·. Aeaume further that ato~olcler 

A ie subJect to a marginal individual tax rate of 50 percent, stock.;, 

holder :S to a marginal rate of 20 percent. If all earn1nge available . ·tor dividends are distributed, the combined corporate and individual 

tax on the $1 ot profits earned on A'• share of atock will be 701 (1K>¢ 

corporate tax plu• 30¢ individual tax). _'l'he combined tax on the $1 of 

·profits earned on B's share of stock will be 521J1K>¢ corporate tax 

plus 121 individual tax). If no corporate tax were imposed on distributed profits and as a reeult dividends paid b7' the X corporation 

were $1 par share instead of 601. the total tax on the fl· ot profits 

earned on A'•· share would be 5()¢.and on the $1 earned on B1 a share, 

20¢. 'l'hus, .the corporate tu increases.total taxea on·the $1 earned 

on A•• share by 20¢ (70,J as compared w1 th 50¢) and on the $1 earned on 

:B 1 a share b7' 32¢ (521 as . ~compared . w1 th 20¢). · I 

•-

.. 

... 
.. 

- 9 -

From still another point of view, the.first impression - that the 

corporate tax ie proportional - appears to be Justified. The v8l7ing 

amounts by which the corporate tax r.educes the poasible net yield of a 

sbare of stock tor stockholders in different income brackets represents . the ~a.me traction of the net yield which would be.possible if there were 

no corporate tax. The corporate tax reduces dividend income which could 

be retained by a stockholder after· individual income tax by the same percentage in eve1'7 income bracket.!/ Percentagewiae, the corporate. tax baa 

the same effect on· bqth gro11 dividend income and disposable dividend in- -come for all stockholders, whatever their individual income tax rate. 

The anaqais so far concerns the amount of corporate tax on a dollar 

of profits allocable to stockholders with different total incomes. It. 

take• no account of the var7{ng importance of dividends aa a portion of 

total income in different tndividual income claBSea •. When account ie 

taken of this last-mentioned factor, it is found that to the extent that 

the corporate tax reduces dividends it repreaenta, in the aggregate, a 

larger percentage ot income of high-income groups than ·of low. g/ On the 

basis of this fact, it ia sometimes said that the corporate tax, instead 

of being proportional or regressive, ia in a aenae a broadly progreaaive 

tax. Thia characterization of the ta:r: abstrs.cta from differences among 

individuals in the same income claas. The tax 1a not progressive in the 

sense that it falls haavil.7 on all high incomes and lightl.J' on all low in• 

comea. The refer.ence is ra:therto broad atatiatical aggregatesor 

averages. JI · 

2. · Economic arguments ya.inst the corporate tax 

. . a. Effecta on individual aecuritz purchaaea 

_!he corporate tax, if not shifted, probabl.7 resulta in a general reduction in investment 7ields. Thia reduction will be leas than proportional. to the tu: rate, and within a relevant range of ratea ma.y be rather 

small. But, any reduction in investment 7'.elda, however small, is likel.J' 

y In the example cite.d in ·the immediately preceding footnote, the 20-

cent increase -in total taxes on the $1 of profits earned on A1 a share 

of stock is 4o percent of the 50 cents which A could retain if,there 

were no corporate tax.· The 32-cent increase in the total tu: on the 

$1 earned on B's share is likewise 40 percent of the 80 centa.which B 

could retain if there were no corporate ta:r:•. The reduction in eveZ7 

income bracket would be the same l&O percent of potential disposable 

dividend income, 4o percent being the corporate tax rate. Thie abstracts from the fact that ma.ny stockholders fall in a lower surtax 

br.aket because dividend are·reduced b7 the corporate tax• 

g/_ See pp. 15-16 and Appendix B. · - JI For a further consideration of the signific8llce of this point, aee

P• 16. · 
... 

- 10--

to deter some individuals from buying securitiea. It is not easy to e�aluate the quantitative extent of this reaction or its economic importance.

One uncertainty relates to the extent of the flexibility of individual investors• standards for an adequate return. _Investors will probably revise 

downward their. standards in time,, but how fast or how far this revision 

will go canno·t be definitely known. Moreover• the economic significance

of �ecreaaed willingness of individuals to purchase securities will depend 

on the extent to which corporations need to raise capital by new security 

issues. The large part of corporate gross investmen, which is fine.need 

from internal sources will not be directly effected by a decrease in the 

market for securities. However, the corporate tax, if not shifted, will 

probably also restrict corporate net saving and reduce funds available 

from internal sources. 

b.ttEffect on business incentives to investtt

Of more direct economic importance is the possible effect of the corporation income tax on investment by corporations-in plant and equipment. 

(1)ttPremium for risk takingtt

A primary deterrent to investment is risk of loss of principal. If 

investment is to be attracted, the prospective return must be great enough 

to overcome fear of loss. While b7 no means all investment decisions are 

based on nicely calculated evaluations of riak and return, 'U8Ually the 

more hazardoue the undertaking, the greater mu.st be pros�ective gains in 

order to induce investment. That part of total prospective return required to compensate for possible loss of principal may be termed premium 

for risk taking. 

The corporate tax, by reducing profits which cen be retained on successful ventures, may cut into the necessary anticipated premium for risk 

taking. The exact effect of a reduction of this premium cannot be determined, since investment decisions depend on high17 subjective appraisals

of opportunities� Clearly, the result will be to restrain investment, to 

some indetertminate degree. 

The tax, however, does not always reduce the reward for risk taking, 

in relation to the amount which would be lost if the investment were unsuccessful. If losses are fully offset-against .other taxable income ·of 

current, past, or future years, the percenta&e return on the net amount at 

risk will not be affected by the tax. Under these conditions, government

shares both in gains of 'success and ;oases of failure.!/ 

y See A. P. Lerner, "Functional Finance and the Federal Debt," Social

Research, Vol. 10 (1943), pp. 45-46; Evae7 D. Domar and Richard A. 

Musgrave, nproportional Income Taxation and Risk Taking," guarterl7 

Journal of Economics,t_Vol. LVIII (194�). pp. 3ss-li22. 

"I 
. ... 

~ 11 -

· A 1'0-percent ~orporate tax will reduce a $100 retvn on an investment 

ot $1.000 to $60 after tax. ·But if the $1,000 tnTeatment were totall.T 

1oat and could be deducted from other taxable income, the concern•• taxe1 

would be n4uce4 $1too. fhua, the net amount actual.11 at riak would be . $6oo. S1xt1 dollars, the return after tu, would be 10 percent of the net 

amount r1eked.;.... .the aame percen\age return aa 1t there were no corporate 

tax. 

Uncler preaent law, however, -loaa ottaeta are not alwqa poaalble. 

Otten a firm doea not haTe aufticient income in the current yeaz to coTer 

fullT a loaa on an unncceeatul Tenture, and carqtorwarcla and carr,backa 

of loaeea are 11m1ted. Even . an unlim1 ted curytorward or c&rr7back would 

not assure full loaa offaeta tor tirma which neTer realized income equal 

to the amount·ot unsucceaaful inTea~menta. !J Bnertheleaa, exlating poaaibilitiea for offaetting lo•••• cona1derabl7 reduce the burden of the tax 

on riak talcing. Admittedl.7, .loaa otfaeta are more likely for large, established tirma vi th diTeraified actinties than for aull, new enterpr1aea 

with onl.7 a few llnea ot production. In thia reapect, the corporate tax\ . faTora large and vell-eatabliahed buaineasea. · J 

. ( ?) Minimum return 

, Regardleaa ot rialc, the proapect ot eome minimum return la nece1sa17 

to induce inTeatment •. Unleaa i11Veators· anticipate some gain g/ the7-vill 

not go to the trouble of inTestlng, enn though there ls little or no danger of losing their principal.. Possible lose offsets will not compensate 

tor red~tion of the minimum return. . 

Bo fixed limits can be aet to the minlnrwn anticipated return necessary to call torth inTeatment b7 corporations •. Tbat return la uauall.7 

aaaumed to be roughly equal to interest obt,t:nable on high-grade bond•• 

If a corporation cannot reaeonabl.T anticipate at least that rate of return 

from brveatment in plant and tq_ulpment, auch ln'f'e1tment la 11ke17 to be ,. unattractiTe. Aa haa alrea.q been 1uggested, hovner. the corporate tax 

!/ !o a llmi\ed extent atockholdera UT be.able to oftaet against other 

income capital loaaea reaultln& from a decline in the Talue of the uneuccea1tul corporation•• stock. Under present law, hoveTer, capital losaea can be oftset main17 against capttal gains and only to a Tel7' 

limited extent agaln1t.d1Tidend1 and other kinda ot income. 

·,Y The gain mq be a poaiti'f'e profit or a reduction of losaea which would. 

be auatained if the in'f'e1tment were not made. J'or example. a. firm mq 

find lt neceaaa.17 to purcha.ae certatn urgentl7 needed new equipment, 

even though no immediate profit la anticipated, 1n order to atq in 

bu1ine1a with the hoptfof later profit or more faTorable liqa:ldatipu. -· ' 
- 12 -

itself may reduce prevailing rates of return on bonds a.nd other assets and. 

thereby reduce alternative rates of return a.vailable to corporations and 

stockholders. The extent of the resulting reduction in the minimum return 

necessP..ry to induce corporate investment is the uncertain outcoil!,e of many 

influences. But whatever adjustments take place in the minimum return, it 

is clear in principle that the corporation ta.x_will always in some cases 

infringe upon that minimum return. It is not possible to say how important quantitatively this will be, but it seems probable that some new corporate investments, which would have been made if there had been no tax, 

will not be undertaken, however complete the opportunity for offsetting _ losses against taxable income. 

(3) Reaction of managementee

The foregoing discussion indicates that the corporation tax must be 

assumed in some cases to reduce the anticipated net return on invest�ent ·e

below the level ordinarily neceesa.ry to ·sti:nulate investment. Corporation 

managers may elect to pay all earnings out in dividends or to hold fund.a 

idle. Management may even choose gradual disinvestment by failing to replace �orn-out equipment or drawing down inventories. However,. current 

production with existing facilities may be expected to continue. In some 

cases, management may be m·ore interested in the power and prestige that go 

with large-scale opera.tions than in the exact size of' the net return on 

invested capital and may therefore continue to reinvest funds despite a 

low net return., 

It should be emphasized that these are merely qualitative statements. 

They indicate ·the character of the influence of a tax ori corporate profits 

but not the extent of that influence. The extent of the influence of the u true will depend on subjective evaluations of' futre prospects·, alternative 

opportunities, and many other unpredictable conditions. 

(4) Non-corporate investmentee

'If investment by corporations is diminished, unincorporated businesses may ta..�e advantage of som� opportunities foregone by corporations. 

Increased investment by partnerships and sole proprietorships may partly 

offset the decrease in corporate investment, but is unlikely to compensate 

fully for such a decrease. In the first place, corporate organization is 

highly advantageous in many fields; �n some practically essential; and in 

such areas non-corporate investment is unlikely to take up the gap left by 

a decline in investment by corporations. In the second place, a decline 

1n corporate investment will depress general economic conditions and will 

make investment opportunities less attractive. 

(5) Necessity of comparing effects ofee

corporate tax and other trucesee

The effect of the corporate tax is clearly to limit .investment to 

some un.�nown degree wh�n a situation in which there is no corporate tax 
- 13·..: 

... 

., 

ia compared with a situation in which a corporate tax is imposed.· It is 

more realistic, however, to compare effects ori. investment ot raising a 

given amount of revenue from a corporation income tax and of raising the 

same sum from another source. Alternative sources of revenue - individual income taxes, excise taxes, and other taxes -- also dlrect].J' or indirectly restrain investment. It would be easy to consider each tax in 

turn, to find detrimental effects, and to decide to discard it. The diffic'lilt problem is to ~ompare various measures end to determine the role of 

each in the· revenue system. 

c. Effect on methods of corporate 

financing - debt versus equity 

Another criticism of the corporation income tax is that it encourages 

financing by bonds and other borrowing in preference to stock issues. Interest paid is deductible from taxable income, but dividends paid are not. 

With a 40-peroent corporate tax rate, a compa!J7 must earn approximately $1.67 in order to pq $lcof-dividends out of current profits. To pay $1 

of interest 1t need earn only $1. · · 

. Thus the corporation tax may be one factor making debt f'inancin& 

attractive. Other reasons of equal or perhaps greater weight are a desire 

to avoid dilution of control of existing stockholders and an attempt to 

tap funds at the,disposal of insurance companies and similar institutions 

compelled by law and custom to prefer bonds. Actually. opportunity for 

floating bonds may not be open· to ma127 corporations. Rigid!ty of debt 

contracts·will deter ma.ey even when the opportunity exists. · 

To the extent that debt f'inancin& is stimulated, ability of corporations to withstand economic stress may be' impaired. Widespread defaults 

and bankruptcies, which might be induced by excessive fixed debt, would 

have unfavorable repercussions on the economy in a period of recession. 

Statistical data on debt and equity financintf over the past 25 7ears 

indicate no marked trend either toward or a.yq from long-term debt ftnanc- .· ing. !/ Of course, there is· no wq of knowing what means of financing · would have been used if there had been no corporate income tax. 

d. Effects on form of' business organization · 

The corporation income tax ls often said to place a special burden on. 

the corporate method.of doing business. This is held to discourage formation ot new corporations and to'leadto disinc~rporation of existing firms. 

Thus, social advantages of an efficient ~orm of organization may be lost. 

Some critics urge that the corporate income tax is inconsistent with a 

principle which they consider important -- that the tax system should not 

be a factor in choice of form o! business organization. 

!/ See Appendix C for data on new domestic corporate security hsues by 

types, 1921-1945. 
14 -

Undoubtedly, the corporation income tax, together with the individual 

inc~me tax, influences the form of business organization. The tax system, 

however, does not always decrease advantages of incorporation. Under some 

circumstances ~he tax system favors corporations; under other circumst~nces it fav-0rs unincorporated business. The way'the scales tip depends 

on rels,tive rates of corporate and individual income tax, size of business, 

income of owners, percent of profits retained b~ the business.and length 

of retention. For example, in some cases taxation of net busi~ess savings .. s.t corpors.te tax rates instead of 1n.d1vidua.l rates is highl7 advantageous. !/ In other ci:i,sea, esc~pe/frorn taxRtion of distributed income at 

the business level is a decisive advantage to ~incorporated firms. g/ 

e. Significance of shifting 

The possible unfavorable economic effects previousl.7 described are 

easiest to comprehend on the assumption that .the corporate tax is not 

shifted but rests on stockholders. In fact, these effects seem incompat-. 

ible with a successful, consciousl7 planned effort b7 business to compensate for the tax by higher prices or lower wages~ However, in another 

sense, the restrictive effect of the tax on investment might baa cause of 

"shifting" through automatic operation of market forces. This would not 

mean that corporations and their-stockholdere were completel7 freed of the 

tax. On the contrary, the fact that the tax rested.on them in the first 

instance would be what set the shifting process in motion. 

y Take, for example, a business with net profits of $60,000, owned in 

eque,l proportion• by five individuals, who wish to retain a.11 ava.11- able profits in the business to finAJ1ce·expansion. If the business 

were incorpor~ted, the tax on the retained profits would be, sq, 38 

perce~t, or $22,800. If the business were organized as a partnership, 

the tsx on retained profits might be higher or lower, depending on how 

much income the owners had from sources other than the business. If 

each of the owners were married with two dependent children and had 

$5,000 of net income from other sources, the total individual 1r.come 

tax (at 1946 rates) on the $60,000 of retained profita would be .' 

$19,520. · This would be approximately a 32.5-percent effective rate, 

as compared with a 38-percent corpprate rate. · In this case,· the cor~ 

porate form would be somewhat disadvantageous so far as te.xes for the 

current year alone are concerned. If, however, each of the owners had 

$15,000 of income in addition to the profits of the businesa, the 

total individual income tex on the retained profits would be $30,025 

or m·ore than 50 :percent, as compared with the 38-percent corporate 

rate. In the latter C8se, more retained profits would be available 

for financing the busineBB if it were incorporated than if it were a ., pertner~hip. But an offset against this ~rent advantage would be 

. I the probab1lit7 of a later individual tax on dividends pa.id from _tbe· 

retained earnings of the corporation or on capital gains attributable 

to retained earni~gi. , . . · g/ Under the present system the tax is always higher on distributed corporate profits than on -profits from an unincorporated enterprise. 
 

a.

- 15 -

If, however, the corporate tax·ia shifted to prices or wages, probably its most important·economic effect is to reduce consumption. Under 

conditions of actual or incipient deficiency of total demand, such a reduotion of consumption would make maintenance of a high level of national income and employment more difficult. It is also true .that a tax which reduce·s consump-tion has an indirect, but nonetheless severe, dampening 

effect on investment. If consumption is held down, market prospects will 

• � be worsened and many 1nv:estment plans will be prevent�d from ever coming 

_into being. 

• D. Analysia of arguments in favor of

the present corporation income tax

1.- Egu.it7 arguments in favor of the corporate tax 

Special privilege as a baeis of corporate

taxation

The traditional Justification for special taxation of corporations is 

that corporations'are given special privileges and economic advantages b7 

government. Corporations are held to be creatures of law which owe all_ 

their rights and powers to public grant. A number of economically important characteristics of corporations are often advanced as a basis for 

taxation. These include limited liability of stockholders, easy transfer 

of ownership, perpetual life, and consequent accesa to national capital 

markets. 

Two fundamental obJectiona have been raised against the privilege 

theory. -First, it is argued that powers granted corporations are in the 

public interest and should not be negated by taxation. Second, it 1• 

pointed out that incorporation.is now open to all on relatively easy terms 

and from this 1 t is deduced that an ordinsry corpors.te charter can have 

little distinct economic value� 

b •. Progreaaive character 

Defenders of the corporate tax contend that, broadly speaking, it 

adds to the progresaivity of the tax syetem. In the a&gregate, dividend• 

are a much larger fraction of high incomes than of low, and the greater 

part of dividends is received by people with relatively high incomes. 

Thus, if the corporate �ax reduces dividends, it reduces high incomes, in 

_the aggregate and on the aver9&9, by a greater percentage than it reduces 

low incomes. On the basis of thi� analysis, it is argued that the corporate income tax is a broadly progressive tax and that its use adds to the 

progressivity of the whole tax system. The same contention can be made if 

-the ultimate effect of the corporation income te,x is to reduce all prop- erty incomes and not merely dividends.

It is true that the corporate inco·me tax is broadly progr�saive, in 

the sense in which its advocates seem to be using the term.· However, even· 
.. 

- f6 -

within that frame of reference, neither the degree of progression nor the 

weight of the tax _is so great as might be supposed merely from inspection 

of the distribution of dividends among individUB,l income classes. The 

progressive rate structure of the individual income tax, to a considerable 

extent, offset, the significance of the fact that dividends are a larger, 

fraction of high incomes than of low. 

Assuming.the 1942 distribution of dividends and other income by individual income classes and a hyyothetical individual income•tax schedule 

(rates from 15 to 65 percent), it appears that in the aggregate a 4opercent corpors.te tax on distributed profits would be e4uivalent to additional effective rates on taxable individuals ranging from about 0.8 percent on those with net incfomes· below $4,000 to 7.5 percent on those above 

$200,000. '£/ 

The progression implicit in the corpor�te income tax is different and 

much less refined· ·than that of the individual income tax. Under a progressive individual income tax, the aim is �o tax high incomes more heavily than low, and to tax all persons in the same income bracket end in 

similar personal circumstances at the saoe rate •. The corporation tax does 

fall more heavily on the average on high-income groups, but it does not 

fall with equal weight on all persons in the same �ncome bracket and in 

similar personal circumstances. This is true because of the great differences in stock holdings among persons in the same income bracket. Some 

wealthy people own no stock and 'are not directly affected by the tax. Some 

people with low incomes-depend largely on dividends and hence are directly

affected by the corporate tax to a much greater extent than the avera.ge 

figures for their income level indicate. With present rate schedules, the 

individual income tax is more progressive than the corpora.te tax, more 

uniform among individue.la in the same income group, and hence by usual 

standards more equitable. 

c.eeEconomic distinct ion between corpora.ti on aee

and stockholdersee

Some defenders of the present corporation income tax deny significance �o the charge of double taxa.tion which is brought by the critics of 

the existing system. They assert that at present in ma.ny large corpo�ations the distinction between the corporation and its stockholders is more 

than a legal formality. They maintain that to disregard the so-called 

corporate fiction and to consider a corpors.tion as no more than an aggregation of individual stockholders overlooks an important aspect of the institution. In many instances stockholders have little control ·over corporate nolicies and receive a return which may not be responsive to moderate 

cha.ng�s in tax rates and annual profits. From these conditions the con­ clus�on is drawn that the �corpora.tion is, a going concern separate and 

distinct from its stockholders, with its own rights-and duties, and with 

separa.teetax-paying abi 11 ty. 

y See Appendix Band pp. s-9.

- ,. 
- 17 -

It there ie a baeia for drawing a realistic diatinctlon between a 

corporation and ita atockholclera, a aeparate corporate tax 11 more reaeon• 

able than would otherwise be the caae. The fact that some realistic diatinctlon can be drawn doe, not in 1taelf, hoveYer, argue for separate 

taxation ot corporations and their atoclcholdera, unleea one takea it' for 

granted, that a11 · economic entitie ahould be taxed. · The argument seems to 

be more· tn ·the· natu:re of a rebuttal of the charge of double taxation than 

an independent aupport tor the corporate income tax. 

' . 

d. Sip1t1cace of shitting 

• · The contention that t~ corporation income tax ia a broadly progres­

iYe tax la .baaed on the·beltet that the tu ia. not shifted to &111'· important eztent. It this ia not true, the maJor contention falls. The pr1T1- lege theo17 aeema ordinarily to be baaed on the same assumption as to 

incidence of the tax. , · · 

!l'he fact that the corporate.tax vaa shifted would not·neceasarilJ' be 

1ncona1atent with the ph11oao* Which holds that the corporation is a 

amtable· taxable ol,Ject,. dlatlnct from ita atock:holdere. It might be 

argued. that the tax le a proper coat of doing buaineH - a pqment for 

the coat of covermnent aenlcee to bue1neae in general and to corporations 

in particular. According to this approach, it voulc1 be fltting and normal 

that the tax in common with other coata should enter into determination ot 

prlcea, wages, and .all 1hare1 of ·111come. · 

2.. Economic argmnenta in favor ot the corporate tax 

a. Impact on consug;,tlon and aav:tya. 

· The chief economic argument in favor of the corporation income tu 

advanced 'b1 1ta eupportera ia that it reduces con8U11lption leas and aav1Dgs 

more than would tea1ible alternative aources of revenue. To the extent 

that the corporate tax reduces reta1nedprot1ta of corporations it talla 

entlrelJ" on cur,ent aavi11&1 and hasuo direct effect on current consumption. The part ot the tax which fall on individual dirldend recipients 

reduces both potential.conaumptioa and potential savings, but the reduc-

. tlon in potential con8Ullptlon. resulting from a ginn amount of revenue 1a 

relatively ••11 and the reduction ln potential aaY!J:Jga relatively great. 

!'hie conclu1ion· la baaed on the broadly progreaa1ve character of the tax 

and the·obaened fact that· families ln each succesaively higher income · group eave a -larger traction of their lncomea then do those w1 th lover in-

• comae~ The followi11& 41acuea1on relate aolel.7 to the net corporate tax 

on profit d11trtbuted to 1ndind\1al.a, aince there is more 41fference of 

opinion about thia part ot the tu: than about the part which falls on un- 41atribu.tad . profita. '!/. -

iJ See .Appendix D for. eetimatea ot corporate and 1ndh1.dual net savings,- . 1929-1945. . . . . 
- 18 -

In comparison with the corporate tax, excises and payroll taxes are 

probably regressive and hence probably fall more heaviiy on consumption. 

This is on the assumption that the corporate tax falls mainly on stock� 

holders 8:Jld that excisea, and payroll taxes fall ma.inly on consumers and 

workers in general. The individual income tax may be more or less progressive than· the corporate .. tax, depending on the rates and exemptions 

adopted. In any case, the progressivity of the individual tax will be 

more even and more uniform among individuals in similar circumstances. 

Whether the individual income tax will fall more or less heavily on consumption than the corporate income tex depends mainly on the relative progressivity of the particular tax structures under consideration. 

The fact that a tax falls heavily on savings and lightly on consumption is an economic argument-in its favor on the assumption that maintenance of enough total demand to assure high levels of employment and 

national income will be a matter of public concern in the future. To the 

extent that a tax reduces ·potential consumption it cuts down demand for 

the products of industry and agriculture. To the extent that a tax comes 

out of potential savings it does not directly reduce demand. It may, however, indirectly reduce the investment c�mponent of total demand by·irnpai� . ing the incentive to invest or by reducing funds available for investment. 

It is now widel7, but not universall7, a,;reed that under conditions likely , to prevail after the end-of-var tranai tion period it will be econ:omicall7 

advantageous to select taxes which result in a minimum of ·reduction in 

total demand, whether for consumption goods or for investment goods. 

The question as to whether lt is feasible to replace the· corporate 

tax without increasing-the tax burden on.consumption can be �esolved to a 

question as to whether the individual income tax could be increaaed to re-. 

place the corporate tax.!/ 

The increase in individual income tax necessa.J7 to duplicate the corporate tax would depend on the distribution of dividends by income classes 

and the individual income tax already in effect. Given these conditions, 

it is possible to estimate the adjustment in the individual. income tax 

necessary to achieve the same allocation of taxes by income classes as 

that resulting from the corporate tax on distributed profits. For illustration the following may be assumed: (1) 4o-percent corporate tax; (2) the 

1942 distribution of dividends by individual income classes; (3). hypothetical individua.1 income taxes at rates of 15 percent to 65 percent already 

in effect, with present exemptions. Under these conditions, the part of a. 

4o-percent corporate tax Qn pr·ofits distributed to individual income taxpayers would be roughly equivalent to additional individual surtax rates 

ranging from 2 percentage points on surtax incomes of less than $2,000 to 

7 percent9€;e points on all surtax income in excess of $8,000. g/ An 

!/ In this context "increasing" the individual income tax may mean only

that reductions in the tax otherwise feasible would no longer be so. 

y See Appendix B.
.. 

- 19 -

increase of individual income tax rates of this amount would replace the 

corporate income tax on profits distributed to stockholders subject to in-. 

dividual income tax from approximately the same individual income classes 

as the corporate tax now comes, if it is not shifted. The individual tax. 

of course, would not come from the same indirlduals, but it would come 

from the same· income clauea. Preeumabl7 1 t would have much the same·

effect on.consumption as the part of the corporate tax which it would replace. With individual income tax rates at the-outset higher than those 

assumed above, the corporate tax would be equivalent to a smaller additional individual tax. If individual income tax rates were lower at the 

outset,they would have to be raised more to replace the corporate tax on 

distributed profits. 

These comparisons rela,te only to the part of the corporate · tax imposed on profits distributed to persons already subject to individual income tax. They are based on the assumption that funds freed by remission 

of the corporate tax on distributed profits would be paid out as additional dividends., To the extent that the remitted tax was retained by 

corporations and dividends not increased, taxable individual income would 

not rise, ,and rnenue lost could not be replaced by the personal tax 

changes indicated. Moreover, the part of the corporate tax on profits 

distributed to non-taxable individuals and institutions. and foreign 

stockholders would have to be made up in some other way. 

b.ttImpact on investmenttt

As to investment, supporters of the corporate. tax raise doubts about 

the extent of any possible adverse effects of the tax. They believe that 

within fairly broad limits corporate investment is not highly sensitive to 

the tax rate. They argue that a large part of profits is not needed-to induce a satisfactory level of investment. 

It is undoubtedly true that some profits are higher. than necessary to 

induce adequate investment and production. It is equally certain that 

some expectation of profits is required to stimulate private investment. 

The corporation income tax strikes both socially necessary and unnecessary 

profits. 1 � 

c.tt Significance of shiftingtt

The economic arguments, like most·of the equity arguments, in behalf 

of the corporate inco�e tax rest on the assumption that the te.x strikes 

mainly corporations and investors rather than consumers and wage �arners. 

If this is not true, the economic effects of the tax are quite different 

from those attributed to it by its supporters. NevertheleH, it' is argu.­

able that the corporate tax compares favorably with alternative taxes, 

even if it 1a to a considerable extent ghifted. The same reasoning which 

maintains ·that the corporate tax is shifted could seemingly be extended to 

en,.importent portion of the individual income tax-as well as to_most othertt' 

fiscally productive levies. Thus a large part of the apparent adventages 
- 20 -

of one or the- other tax would be cancelled out. If this is the true state 

of affairs proponents of the corporation tax might well rest their case on 

the b�sis that the ts� is a relatively convenient wa:y of collecting 

revenue -- revenue which comes in part from consumers, in part from 

workers, in pa.;rt from stockholders, and in part from corpore,te hoards. 

II.tt Problems encountered in adopting a new methodtt

of taxing corpora.te profitstt

·1f the case against the present corporation income tax is found su.f�tt

ficiently persuasive to demand some basic change, new problems arise. 

These relate to possible incidental evils of individual tax avoidance and 

windfall gains and to timing of changes. 

. A. Prevention of individual tax avoidance 

through corporate undistributed profits 

Few critics would advocate simple eliminatfon of the corporation income tax without any further changes. If the tax were merely abolished 

outright, the corporate form would become a true-free haven for individual 

s�vings. By retaining profits the corporation could postpone indefinitely 

taxation of these earnings. If the retained earnings were rea.lized by 

s,tockholders in the form of capi ta.l gair:.s, they would be subject under 

present law to a prefe�entially.lov tax rate. If the owner died. without 

realizing the retained earnings as capital gains, under present law his 

heirs could do so without paying any income tax. Similar, but less extreme, results would ensue if the corporate tax were not abolished but 

simply reduced to a very low rate. 

Considerations of equity and economic policy require that any reform 

of the corporate tax include some method of preventing individua.l tax 

avoidance ·through use of the corporate entity. One relatively simple but 

drastic method of preventing use of the corporate machinery for tax avoidance would be to forestall corpor�te saving by prohibitory taxation. However, this Procrustean treatment might be as bad as, or worse than, the 

ills it would be designed to cure. Retained profits are� iegitima.te and 

important source of funds for contingencies and for expansion. 

In any corporate te.x reform some way must be found to minimize inequalities of taxetion of distributed and undistributed profits and of 

dividends and other income. There are four-basic epprosches: 

1.tt The corporation tax may be abolished and.full taxation of capital gains relied upon to prevent individual tax 

avoidance with respect to undistributed profits; 

2.ttThe corporate entity may be ignored in determiningtt

tax li�bilities and corporate profits may be texed as if stockholders were partners; 
- 21 -

3. The corporation may pay a tax on its profits with 

a reduction in that tax for distributions of profits, that 

is, for dividends p&id; 

4. .The corpore.tion may pay e. tax on all of its profi ta, 

and individuals may ·be given a tax adJuetment in relation to 

dividends received. 

A later section of this memorandum will discuss considere,tions o:f' 

equity, economic effects, and administration relating to specific versions 

of the four basic approaches to coordination of taxation of corporE1.te 

profits and other kinds of income. 

B. Windfall gains to stockholderR and 

effect on stock prices 

Decrease of the rate of taxation of corpor~te profits belov the level 

now anticipated by investors would be likely to bring windfall gains to 

stockholders at the time of the change. _Fundamentally, these windfalls 

would consist of an unexpected increase in the actual or potential income 

of stockholders. Another and more spectacular manifestation of the windfall• would be an increase in stock prices. Such a development might be 

induced either by drastic reduction of the present corporate tax .or by 

adoption of any method of coordination of individual and corporate taxation which lessened taxation of dividend income. 

It should be noted that a general adJustment at either the corporate 

or individual level with the objective of eliminating or reducing "double" 

taxation would result in a decrease in taxation of distributed profits. 

If corporations were granted a tax reduction when dividends were paid, 

they would be able to pay larger dividends out of a given amount of profits before taxes, or they would ha.Te larger undistributed profits after 

paying the same dividends. On the other hand, if individuals were given a 

tax credit for part or all of the tax paid by corporations on income distributed in dividends, most investors would get a lerger net yield. If 

the same amount of dividends were paid as before, all stockholders 

(whether or not subject to individual income tax) would gain. 

It is impossible to say just what rate of taxation of corporate profits is now anticipated by investors and reflected in present market prices 

of stocks. It seems reasonable to suppose, however. that market prices 

are, in general. based implicitly on the expecta.tion that corporate prof­

! ts, whether distributed or retained, will continue to bear a substantial 

tax in addition to regular personal income tax. 

It, in the postwar period., the additional tax on dividend income no 

longer· exiete or if it proves to be smaller than was expected, the current 

and anticipated yields of stocks at previous prices would rise sharply, 

Prices of stocks could be expected to be bid up until yields in relation 

to new prices were adJusted toward their previous levels. These 
- 22 -

developments would bring windfall gains to individuals ownixig stock. In 

some unknown number of cases, these windfalls would only make good losses 

suffered at all earlier date when the corporate tax was imposed or 

increased. · 

Sometimes it is suggested that the problem of wind.fall gains could be 

met by an increase in the tax rate on capital gains. This suggestion, 

however, focuses attention on one manifestation of windfall gains, rather 

than on the true windfall. Fundamentally, the windfall arising out of unexpected .reduction or repeal of the corporate tax would be an increase in 

the income of stockholders. This in turn would lead to a rise in stock 

prices. An increase in the capital-gains tax would merely decrease the 

possible net proceeds of sale of the stock with its anticipated stream of 

additional income. This would·not remove the real windfall gain to stockholders. The capital-gains tax would not apply to the additional income 

realized by stockholders before they transferred their stock, and the tax 

rate would doubtless be leas than 100 percent. Admittedly, an increase in 

the capital-gains tax would decrease windfall gains which otherwise would 

be realized. 

The apparent extent of wind.fall ga.ina and effects on stock prices 

would be influenced by the economic outlook at the time of reduction of 

the corporate tax. Tax reduction at·a time when corporate profits were 

falling might merely prevent a decline in dividend• and stock prices instead of causing an increase. Tax reduction when corporate profits were 

rising might appear to result in especially lexge windfall gains. 

The general character, if not the extent, of probable windfalls is 

easy to discern. More difficult to foresee vould be the economic and 

social consequences of a sharp upturn of the stock market, which might 

occur if the te.x adjustment were made in a time of prosperity. On the one 

hand, a rising market might generate a state of business optimism which 

would stimulate real investment and increased production. On the other 

hand, the upward movement might waste.its force in a cumulative speculative boom with undesirable consequences for the economy. 

Wind.falls to individuals and the likelihood of touching off a cumulaU ve speculative boom might be somewhat reduced by spreading tsx reductions or adjustments over several years. Security prices could be expected to adjust fully to a staggered decrease in corporate taxes, but a 

sudden impact might be avoided and secondary or cumulatiTe effects minimized.!} If the price increase were distributed over a period of years, 

benefits might be divided among more individuals. However, if a plan o! 

gradual reduction were definitely announced, the effect on security prices 

might be almost as great as _if it had been put into operation immediately. 

y The effects might be simile.r it corporate taxes were reduced at one 

stroke, but only after discussion over a period of years during which 

investors came to antiQ.ipate the ·reduction with a gra.dually increaeing 

degree of confidence. 
- 23 -

o. Timing of tax adJustmente in relation to their 

effects on commodity prices end investment 

1. Commodity prices 

Timing of corporate tax adJustments would also be important in relation to possible effects on commodity- prices. Reduction of taxes would be 

much less likely to be passed on to consumers in the form of lower prices 

in a seller• s market than in a bwer• a market. In a time of high demand, 

if price reductione were not made., busineu profits would rise rapidl7. 

If this development stimulated su;ceastul general wage demands by organ­

" ized labor, prices might move still higher. In a potentially inflationary 

si.tuation a cumula.tive upward spiral of both prices and wages could ensue. 

M~reover, corporate tax reductions or adJustments would be likely to invite increased pressure for other tax conceseions. which might be inappropriate under potentially inflationary conditions• 

. Price reductions would be more likely when a bcyer•a market prevailed. 

However, in such circumstances the outlo.ok for profits ma;r be so bad that 

a tax reduction will stimulate,less new investment than it would in times 

of ~eater consumer demand. 

2. Investment 

Profitability of investment depends fund.a.mentally on favorable market 

conditions. If the outlook for demand is already reasonably good, tax reductions may- have a considerable stimulating effect. On the ~ther hand, 

during a period of slack demand or depression, businessmen may see little 

opportunity for profitable investment, regardless of tax rates. Under 

these conditions, t8.X reductions may stimulate relatively little new · investment. 

Despite the apparen~ conflict between.timing requirements for induc• 

in.g price decreases and for stimulating investment there is no fundamental 

dilemma. On balance, tax reductions appear most desirable in times of low 

economic activity.or when a declt"ne threatens. The immediate stinm.lus to 

investment may be small, but ant response will be of the right kind. 

Under inflationary conditions caution is indicated in reducing corporate 

and othe~ taxes. In these circl1!!2stances JD81lY. kinds of investment, as well 

as.increased.consumption, may be undesirable. Profit opportunities are 

likely to appear good with a substantial corporate tax and still better 

without it• .. III. Methods of coordinating individual and 

CO!J2orate tax ~n co~orate profits 

, A. Elimination of corporate income true and 

adoption of :t:_ull taxation of capital gains 

One approach to trucation of corporate prof'ita would be to eliminate 
- 24 -

the corporate income tax entirel.1' and to rely on taxation o! capital gaina 

to prevent tax avoidance with respect to undistributed profits. Those who 

favor this approach would recommend Ml taxation of all realized capital 

Gains at the regular individual income tax rates and full deductibility of 

realized c~pital losses trom any other income. A gain or loss would be 

realized wherever an aaset was transferred by sale, gift, or devolution at 

death.!/ Full taxation of capital gains and full deductibility of capital losses are nearly alwqs linked with proposals for averaging of taxable income over a period of years: sometimes. over the whole life ot the 

taxpayer. For the sake of brevity, a syatem of the type described in this 

paraQaph will be referred to as the capital-gains approach. g/ 

l. Rationale 

The c~pital•gains approach is based on the idea that corporations as 

such should not be taxed. The objective of the approach is to tax.individual stockholders in the moat sat1sf~ctoey way. Advocates of the 

capital-gains approach ·seem to believe that stockholders have realized income, which can properly be taxed, only when they receive a dividend or 

transfer title to their shares at a gain. Although the economic power of 

stockholders may increase when the corporation retains profits, it may be 

argued that this is merely a caae of an increase in property value and 

that there is no more reason to consider such an "unrealized gain11 taxable 

income in the case of stock than in the case of any other asset. 

2. Tax avoidance and ~ostponement 

An .essential feature of the ca-pital-gaina approach 1s tba.t realized 

capital gains should be taxed at the same rates as dividends received and 

other forms of income. This is intended to prevent stockholders from 

avoiding taxes by realizing their return from their investment in the form 

of capital gains attributable to retained corporate profits rather than in 

the form of.dividends. The approach would be effective in taxing income 

actually withdrawn from the corporation, but full taxation of capital 

gains .and dividends received would leave some corporate profits untaxed. 

Not all profits retained by corporations are reflected in the market value 

of stock. Changes in stock prices appear to be determined by prospects of 

future profi ta and dividends rather than b7 changes in retained earntng·s. 

y Henry c. Simons, Personal Income Taxation (Chic9&01 University of 

Chicago Press, 1938), Chapters VII and IX; Willi~m Vickrey, "A 

Reasonable Undistributed Profits Tax," Taxes, The Tax Magazine, Vol. 23 

(February, 1945), PP• 123-127. Simona recommends against allowing a 

loss deduction to donors with respect to estimated losses on property 

transferred b7 gift. Op.cit•• P• 212. 

Proposals for regular-taxation of capital gains and full deductibilit7 

of capital losses raise issues of broader scope than the problem of 

preventing tax.avoidance on undistributed corporate profits. These 

broader questions will not be discussed in this memorandum. 

.. 
- 25 -

If market developments or technological cha?ige1 destro1 a corporation's 

prospects for :future profitable operation,, it1 stock ·m~ become worthle11, no matter how much pro:f'i ta it has retained in the past. Moreover, 

the tock of a aucceaeful corporation may be transferred at a low price · when the stock market in general is temporaril7 depres1ed. In the first 

case, the profits retained in earlier years vould neTer be taxed under the 

capital-gaina approach. In the latter ca.ae, the retained profita would 

not be taxed to the original stockholder, but might be taJCed to a suba.equent stockholder who acquired the stock when \he price wao low. 

One extensive stll.q of common stock price, indicated that over the 

period 1671 to 1938, on the average eveey $2.5() of earniD&• retained by 

corporations was associated with an increase of $1.80 in the market value 

of their stock.!/ Thua, over that whole period, on the average, more 

than one-fourth of retained corporate profit, did not find expression in 

the market price of stocks and could not have been reached by full taxation of capital gains. Diacrepa.ncies in the caae of individual companies 

and at particular timea were doubtlesa much creeter than for the 68-rear 

aver9&e. g/ 

A stockholder may enjoy important accretions of economic power and 

social prestige over a long period of time on the basis of ownership of 

stock in an expanding corporation without receiTing any large amount of 

dividends or "realizing• any c~pital gain. Be 11111' be in complete control 

of the policies and operations of the corporation. In the end, the value 

of the stock may disappear, and, under the capital-gains approach, the 

stockholder would entirely escape taxation on the income vhich gave rise 

to his earlier advantages. Whether such a situation 11183' properly be 

called tax avoidance is largely a matter of terminology. 

It may be argued that diecrepancies between the market value of stock 

and the amount invested in corporations are attributable mainl7 to defects 

in corporate accounting methods, and that the capi tal•gain1 !Dlthod would 

correct for these defects and give stockholder, the opportunity of averaging profits and losse1 over a long period of year,. Even if 'thi1 e:q,lanation of the discrepancies between market value of stock and investment or 

book value is accepted, it does not follow that atockholdera should be I 

y Alfred Cowles 3rd and associates, Common•1tock Indexes (~loomington, 

Indiana: Principia Press, 1939), p. 42. 

y In 7 years during the 18-year period 1921-1938 inclusive, the aggregate market value of the large groups of co,nmon 1toclc1 studied by the 

Cowles Commiaeion moved in the opposite direction from retained net 

earnings of the corporations which bad. 18~4 the stocks. In 4 tears 

when retained net earnlnga were podtiTe, the market Talue of th~ 

stocks decreaaed; in 3 years when retalne4 net earni13g1 were negative, 

the market nlue of the atocka increa ed. · In 8- of the remaining 11 

1eara, retained earninca were positive and atock 'price, roae; in 3 

7ear1 ret&1n.e4 earning, were.negatlTe and •t~ck price, fell. Derived 

from_!!!!. · 
.- 26 -

given the benefits of an extended period of averaging, which are not avail• 

-!lble to other classes of income recipients.!} 

Even if all retained corporate profits were ultimately subject to tax 

as delayed dividends or· capital gains, stockholders vould have a significant advanta.ge by reason of postponement of the tax. In the interval b&­

tween earning of profits b7 the corporation and technical realization by 

stockholders. the corporation would be able to use the retained profits in 

the interest of stockholders. It has been argued that -the advantages of 

such tax postponement could be neutralized by a repetitive annual tax on 

the accumulated retained earnings of corporations at a rate equal _to a 

proper interest charge on the postponed tax. g/ :But no one rate of taxation could actually neutralize the advantages of postponement for all taxpayers. i/ Moreover, changes in tax rates over time would destroy any 

putative. eq_ua.lization e,chieved by such a measure. If, however, no averaging or incomplete e.veraging of income for tax purposes were allowed, the 

prospect of raising one 1 s self into a high surtax bracket at the time of 

realizatfon of a capital gain attributable to retained corporate profits 

might deter stockholders in closely held corporations trom retaining profits in the corporation in order to postpone taxes. 

3. Discrimination among taxpayers 

The capital-gains approach to taxation of undistributed corporate 

profits would offer an i~portant advantage to stockholders as compared with 

other taxpayers. Owners of unincorporated businesses must pay taxes on 

their annual profits, regardless of whether the profits are withdrawn or 

retained in the business. Owners of incorporated businesses would be taxed 

only when they withdrew their'profits or disposed of their shares. An 

attempt to correct this discrimination by offertng unincorpora.ted business 

the option of being treated like corporations - that is, the option of not 

being truced on retained profits -- would open up avenues for tax avoidance 

and present difficult administrative problems. Moreover, the equity objection would not be met unless all texpayers were allowed an exemption for 

their savings: 'ljj If this were done, the income tax would be transformed 

y A number of unresolved problems connected with the possibility of extending averaging for tsx purposes to all income recipients and all 

tYPeS of income are now under study. · 

Vickrey, o~.cit. 

Because of imperfections in the capital market and differences in the 

discount rate among individuale and firms. 

If all persons in business, in either the corporate or non-corporate 

form, were allowed the option of paying no tax on their savings (retained profits), a grave discrimination would result against persons 

not in business but wishing to save in order to go into business. ,, 

There would be a further discrimination against persons choosing to 

provide for their :future by such techniques as annuities as compared 

with those choosing•to invest their. savings directly in busineBB 

enterprises. 
-- 27 -

into a spendings tax. A discussion· of·the merits of the spendings tax is 

outside the scope of thia memorandum. but it is safe to say that substitution of a spendings tax for the income tax would be a drastic solution to 

the problem of_double taxation of corporate profits. 

4.t· General economic effectstt

.. Failure to collect a current tax on corpor8.te retained profi te would 

free an important part of savings from taxation.!,/ -�his would mean that 

the tax system would have to fall more heavily on consumption and investment not.finenced out of retained corporate profitn than would otherwise

be the ca.se. It 1a likely that this would make maintenance of a high 

level of national income and employmen� more difficult. 

5.ttEvaluationtt

The capital-gains approach would, of course, entirely eliminate 

double taxation of distributed profits. It-would, however, result in a 

seriously defective method of texing undistributed corporate profits. The 

system would ope� the way for a great deal of individual tax p�stponement. 

It �ould result in inequitable diacrimination among taxpayers. One kind 

of saving would be free from current taxation, while other kinds of saving 

would continue.to be currently truced. By stimulating corporate savings 

and shifting the tax load to consumption and investment not .financed out 

of corporate savings, the plan would be likely to accentuate the problem 

of achieving aggregate demand a.dequate to maintain a. satisfactory level of 

national income and employment. 

!. Current taxation of all corporate profits at 

re.tes applicable to individual shareholders 

The most direct and thorough-going solution to the problem of coorM:­

nation of in·dividua.l and corporate tues would be to tax currently all 

corporate income, whether.dtistributed or not, at rates applic�ble to individual shareholders in the corporation. Dividends paid out of corporate 

profits previously taxed at the individua.l rates and capital gains traceable to.such.profits would not be subJect to individual income tax in the 

hands of the stockholder. Under such a syst�m distributed and undistributed profi ta and dividends and other income would always bear the se.me 

r&te of tax. The te.x might be formally imposed upon either stockholders 

or corporations. 

1.ttPartnership methodtt

One plan using this approach is the partnership method. No tax would ,. be levied on the corporation as such, but for tax purposes stockholders 

!f Appendix D gives figures on net savings of corporations, 1929-1945. Adoption of a tax plan such as that now under.discussion might well 

stimulate large increases in corporate savings •. 
- 28 -

vould be treated as if they were partners. Ea.ch etockholdor would be required to include in his taxable income his pro r8,te. share of corporate 

profits, both distributed and undistributed. Stockholders, hn.ving been 

truced currently on their share of undistributed corporate profito, would 

not be truced again if they later received dividends paid from profits 

accumulated while the partnership mothod vas in use. If the syutem were 

followed to its logical concluaion, the individUtil would alao be alloved to 

take account of his shnre of corpornte losses. Although the tax liability 

would rest on stockholders, corporations might be required in oomo circ'W:lstances to make an advance payn:ent on stockholders• liabilitiea. 

The partnership method MB been given a li~ited applicability by 

recent Federal tax law,!/ and it has been somewhat more widoly applied in 

the past. g/ A special committee of the National True Association 

Optional for personal service corpor8.tionu for excess-profits to.x, but 

not income tax, Internal Revenue Code, secs. 725, 391-396. The true 

partnership method n:ay be distinguished from the "consent-dividends" 

provision of the Code (sec. 28), which allows corporations a credit for 

dividends paid~ including in dividends that part of retained income 

upon which stockholders consent to be taxed as if actually received· in 

the form of dividends. This latter treatment is applicable for purposes of surtax on improper accumulation of surplus (sec. 102 (d)(2)); 

surtax on perGons.l holding cor::panieo (sec. 504 (a)); normal true and 

surtax on regulated investment companies (sec. 362 (b)). Under the 

consent-dividends provision, stockholders my elect to be taxed on any 

portion of undistributed profits which they choose and need not be 

taxed on their full share. Different stockholders ma.y consent to be 

ta.xod on different fractions of their share of profits. No provision 

is mado for allocation of corporate losses. Still snother variation of 

the approach which overlooks the formalities of separate legal existence of aorporation and stockholders 1B the requirement thnt U. s. 

stockholders include in their groos inco~e their pro ratn share of un- distributed Supplement P net income of foreign personal holding companies (Supplemont P, especially sec. 337). In the last-mentioned case 

thia requirement hns no effect on tar liability, if any, of the foreign 

personal holding coi:pany itself. · 

g/ The Civil War income tax levied no tax on ordinary industrial and mercantile corporations, and individual stockholders were subject to tax 

on their share of profita in such corpo,rations, whether dictributed or 

not. In the 1864 Act, however, banks, trust compa.nieo, savings institutions, insursnce companies, railroads, cruinls, turnpikeo, etc., and 

their stockholdars were not taxed in this way. In the ce.so of these 

corporations, which probably were then 1:1ore· important thnn industrial 

and mercantile corporations, the corporation was required to pay a tax 

on its profits (before deduction of interest in the case of the troneportation companiee, but apparently not before interest in the cane of 

the financial companies). Investors were not required to include in 

their taxable income undistributed profita, dividends, or interest from· 

LFootnote continued on page .22} 
- 29 -

'y such corporations, provided the income had been assessed for tax in the 

hands of the corpors.tion. The tex paid by these quasi-public corporations was 5 percent, while the tax imposed on individuals was graduated

from 5 percent up to 10 percent. (Sections 116-122, Act of June 30, 

1864, Public No. 148, 38th Cong., 1st seas., chap. 173, 13 Stat. 223.)o

In 1865 the law was amended to require stockholders in all kinds of 

corporations to include. in their taxable income their share of profits, 

whether distributed or �ot. Stockholders in the quasi-public corpora- . tions mentioned in connection with the Act of 1s6ij were spe�ifically 

required to include dividends received from such corporations in their 

tav�le income, but were·given a tax credit for the tax paid by the 

corporetion. (Act of March 3, 1865, 38th Cong., 2nd sess., chap. 78, 

13 Stat. 469·.) In the 1913 Act, stockholders were ms.de liable for 

"additionf!.l tax" (later ca.lled surtax) on their share of undistributed 

profits of corporations "formed or fraudulently availed of" for the · · 

purpose of accumulating profits to avoid surtax on stoc�Jlolders. The 

fact that the corporation was a "mere holding company• or that profits 

were accumulated beyond the reasonable needs of the business were to be 

taken as prims. fa.cie evidence of fraudulent purpose to esce�e tax. 

(Section II, A, Subdivision 2, Act of October 3, 1913, Public No. 16, 

63rd Cong., 1st sess., chap. 16, 38 Stat. 114. ). The 1918 Act elimi11 nated the term 11fraudo from the provision relating to d'orporations used 

to avoid surtax but continued mandatory �e.rtnership treatment for them, 

with the same standards for prima facieoevider.ce· of use to avoid surtax 

a.s were provided by the 1913 Act. {Sect'ion 220, Revenue Act of 1918,oo

Public No. 254, 65th Cong., 3rd sess., chap. 18, 4o Stat. 1057.) Inoo

1921. the House Ways and Means Committee felt that the decision of theoo

Supreme Court in the stock-dividend case, Eisner v. Macomber (252 U.S.oo

189), cast co'nsidere.ble doubt on the cons ti tutionali ty of the mandatoryoo

partnership method. (Report of House Ways and Means Co�ittee, Houseoo

Report No. 350, 67th Cong., 1st sess., pp. 12-13.) ·The Act of 1921·oo

substituted a ·gpecial surtax on corporations used for the purpose ofoo

avoiding surtax for the previous ir.andatory pa.rtnership method, but itoo

also provided thB,t if all stockholders Rgread the Commissioner mightoo

apply. the pa.rtnership method, in lieu of all taxes on such a corporation. (Section 220, Revenue'Act of 1921,Tublic No. 98, 67th Cong.,oo

ht sees.·, chap. 136, 42 Stat. 227.) It should be noted that the partnership option was open only to.corporations formed or used for theoo

purpose of avoiding surtu. Th.is anomaly was noticed and commentedoo / 

upon in the Senate debate on the 1921 Act, but the Senate rejected anoo

emendment to make the partnership option generally availa.ble.oo

(Congre!_.sio�al Rec�. Vol. 61, Part 7, p. 7483.) The optional partnership ·t�ee.�."Dent. for the one type of corporation was dropped in theoo

Revenue Act of 1924, in connection with a general tightening of theoo

·provisions ·with respect to use of corporations to avoid individual surtax. (Report of Senate Fine.nee· Committee, Senate Report No. 398, 68thoo

Cong., 1st seas; Section 220, Revenue Act of 1924. :Public lfo. 176. 68th

Cong., 1st sess.) The Sec·retary of the Treasury testified that only aoo

"very few" case, had been found in which corporations were formed oroo

used to avoid surtax. within the meaning of the Revenue Act of 1921.oo

(Senate Finp�ce Committee Hearin� on Revenue Act or 1924. p. 291.)
' 

ll. 

I 

rn 

40), P• -

I 

- 30 -

recommended in 1939 that the partnership method be "extended to the limits 

of its legal end administrative possibilities., Y 

a.ooRationaleoo

The partnership method is baaed on the idea that the corporation and · its stockholders are substantially an economic identity. It overlooks 

formalities of separate legal existence and regards income of a corpore,­

tion as income of its stockholders, whether paid out in dividends or retained. B7 implication, the partners�1p approach assumes that each individual stockholder ha.a a large degree of effective control over dividend 

policies ot the corporation, or at least that the stockholder's economic 

power increases in close relation to retained corporate earnings. 

b.oo Technica.l and administra.tive featuresoo

(1)ooAllocation of income among stockholdersoo

Administrative problems in allocating profits among stockholders would 

be serious, even_for corporations with simple capital structures. g/ 

Strict application of the partnership principle would require that a share 

of earnings or �oases be allocated to ever7 person who wae a stockholder 

a.t any ti me during the corpora.ti on' a taxable year. However, it might beoo

more expedient to limit allocation of undistributed profits to stockholders as of some· fixed date, sq. the end of the corporation's accountingoo

:period. At best, there would be millions of shareholdings to deal w1 th,oo

if the partnershipo_method were extended to all corporations. if For someoo

y "Final Report of the Committee of the National Tax Association on

Federal Taxation of Corporations, n Proceedings of the National Tax 

Aesocbtion, 1939·,. P• 555. Although the Committee was not certain that 

a constitutional amendment would be required to permit adoption of the 

partnership method, it believed that an amendment should be sought 

without delay if deemed necessary. The Committee believed that applica­ tion of the partnership method would be· administra ..tively feasible for a 

large number of corporations, perhaps for all but a few thousand. 

y The "partnership approach" presents almost insuperable administre.tive

problems if applied to other than closely-held corporations. If confined to corporations with few shareholders it might be feasible. A 

compulsory partnership approach would, however, eliminate to a large 

degree certain existing problems such as: (1) unreasonable compensation 

to shareholder officers; (2) improper accumulation of surplus (Section 

102); (3) interest paid vs. dividends; (4) personal holding companies; 

(5) personal service corporations.oo

The number of record shareholdings in Americen corporations as ofoo

December 31� 1937, has been estimated at 22 to 25 million.· Tempors.17oo

Ns.tional Economic Com:ni ttee Monograph No. 29, The Distribution ofoo

Ownershi in the 200 Lar est Nonfinancial Co orations (76th Cong.,oo

3rd sess., Senate Committ,e Print, 19 170.oo
- 31 -

giant corporations the list of stockholdings runs to hundreds of thousands. !f Moreover, many holdings of record are nominee holdings by 

brokers and others for a number of individual beneficial owners. 

. ' 

In the ca�e of corporations with more complicated capital structures, 

difficulties would be encountered in allocating retained earnings s.mong 

classes of stockholders. For example, profits retained in one year in excess of accumulated claims of preferred stockholders would presumably be 

allocated to holders of common stock. Yet in a later year these funds 

might be used to pay dividends on preferred stock. Correction of this 

situation would require reopening returns or adjusting current year's income for all stockholders of the earlier year. Complicationa would also 

arise in the case of intercorporate af'filis.tions. g/ 

(2)oo Special tzyes of income, deductions,oo

and creditsoo

Partially tax-exempt income, capital gains, charitable contributions, 

income and-profits taxes paid to foreign governments, and other items 

accorded special tax treatment would present difficulties. The partnership method in its purest form would require that ·these items be reported 

separately to stockholders and treated as. if they had accrued directly to 

them. However, a plan which failed.to trace. these items through to stockholders would be simpler, and might be acceptable. Even though the partnership approach intends to treat stockholders and the corporation as one 

for tax purposes, it does not seem feasible or necessary to trace all items 

Qf receipts and outleys through the corporate organization.· 

(3)ooAd.jus tments of corporate income ofoo

prioryeareoo

Strict adherence to the partnership principle .would co�el reopening

individual_ returns of all stockholders whenever profits reporte� for.an 

YTn� following are a f�w conspicuous examples of corporations with a 

large number of shareholders of record (at various recent dates): ·oo

American Telephone and Telegraph Company 651,711 

Cities Service Company 430,12s 

General Motors Corporation . 423,705. 

United States Steel Corporation 24o,641 

General Electric Company- . 235,742 " " Moody's Investors Serv'ice, Moody's·oManUA.ls of Investments, Americrui 

and Foreign, Industrial Securities,. 1945, and Public Utility 

Securities, 1944. ,. gJ For exam-_ple, Corporation X may hold shares in Corporation Y, 

Corporation! may holdcshares in Corporation!, and Corporation! may 

hold ahares in Corporation X. In such a· case, simultaneous equations

would be required· to determ'fne the equity of individual shareholders 

in the income of the various corporationso 
/ 

i 

- 32 -

earlier year were altered by audit, court decision, or ca.rrybacks. Nevertheless, in order to minimize administrative problems, rela.tively sma.11 

excesses or deficiencies of prior year income might be treated as adjustments of corporate income in the year in which-discovered. Individual returns would be reopened only in the event of ma.jor revisions of income of 

an earlier year. 

(4) Adjustment of basis of stocktt

The 'Philosophy of the partnership method would regard retained corporate profits as equivalent to additional investment by stockholders and 

would regard dividends in excess of current earnings as disinvestment. 

Accordingly, it would be.appropriate to adjust, for -purposes of capitalgains taxation, the basis of stock in corpore.tions taxed as partnerships 

to reflect the amount of undistributed income which had been taxed to the 

stockholders. The basis of stock would have to be increased by the amount 

of profits retained by the corporation in any year when it was subject to 

--partnership treatment.· The basis of stock would be decreas�d by the 

amount of any dividends paid in excess of current income, provided the excess was paid from taxable income accumulated while the corporation was 

subjec·t to partnership treatment. !/ 

c • .Area of applicability 

Both conceptual and p·ractical oonsiderat ions suggest the advisability

of limiting the area of applicability of the partnership method. 

The partnership approach would be appropriate and practicable for 

thousands of small corporations, probably the grea.t maJori ty or all corporations. y Such concerns a.re little more than chartered partnerships or I 

y" Some more or less arbitrary rule would be required to determine 

whether 11 11excesst dividende were paid from te.xable income accumulated 

while the corporation was subject to partnership treatment. Dividends 

in excess of current income might be conddered to be paid from: (a) 

any available ta.xable income acculfflllated during use of the partnership 

method, to the full extent of_ that income; (b) from the most recently 

accumulated income; (c) from the earliest accumulated incoMe. 

?J On the basis of a small sample of. co�orate· tax returns, it has been 

estimated that 70 percent of ·the non-financial corporations with

assets under $50,000 and 50 percent of those with Rssets between 

- $50,-000 and $250,000 are wholly own�d by three or fewer corporate

officers who are.also full-time workers in the corporation. Joseph L.tt

McConnell, "Corpor�te Earnings by Size of Firm," Survey of Currenttt

Business, May, 1945, p. 7. Corporations in.these size classes estimated by McConnell to be wholly owned by three or fewer officers constituted 55 percent of the total number of all non-financial corporations submitting balA.nce sheets in 1941. Statistics of Income fortt

1941, Part 2, Table 6.
- 33 -

proprietorships with limited liability. Typicall7, they are closely held 

and have no access to national capital markets. However, !or the relatively small number of large corporations with many stockholders, which do 

a large part of corporate business and realize a large portion of corporate profits, .the partnership concept would be artificial. Indi'vidual 

stockholders in most such cases have little actual control over maJor policies or day-to~day operations of the corporation. Stockholders usually 

have no legal clsim to earnings of a corporation until dividends are declared. Most individual stockholders in the giant-public corporations 

have no effective control over dividend policy. In such cases, the legal 

distinction between income of stockholders and income of the corporation 

has a large degree of economic reality. Even though the individual stockholder has no control over dividend policy. it may qe argued tha.t .retention of corporate profits increases the stockholder's economic power. In 

many cases, ho~ever, stock prices do not increase in close correspondence 

with growth of the corporation' 1 assets. y Even 1:f' stock prices did. reflect undistributed profits, it would be a departure from usual practice 

to· treat such unrealized gains as taxable income. 

Moreover, in the interest of administrative feasibility at leest the 

largest corporations with the longest lists of stockholders end the most 

complicated ca-pits.l structures would probably have to be excluded from 

partnership tree.tment. One reasonable standard would be to 8,pply the partnership method only to corporations wJth not more than some stated, fairly 

small number.of ·individual stockholders (and. no corporate stockholders), 

end with no more than one class of stock. A supplementary or alternative 

st&ndard might be size of the corporation (probably measured in terms of 

assets)~ · 

d. Compulsorr or optional partnersl;!p treatment 

The partnership method might be ma.de either compulsory or optional 

for corpor~.tions- meeting requirements for i te application. It should be 

recognized that the purposes which could be served by the partnership 

teohni~ue would differ, depending on whether it we~e mandatory or optional. 

Compulsory use of the method might have as one of its objectives preven- tion of use or the corporation as a means of postponing or avoiding individual income tex on investment income. An option to use the partnership 

method could not serve this purpose, but it could be regarded as a means 

of relieving double t~tion and of reducing inequalities in access to 

capital resources. 

.. e. Partnership method with final a.ccount1~ 

at time of transfer of shares 

• It would be possible to adopt in conjunction withthe :partnership 

- method the principle of final. accounting and a.djustment of tex lia.bilities 

-g--s-ee-~-.-2-5-.-------------------------~ 
- 34 -

with respect to undistributed profits at the time of transfer of stock. 

This awroach would be a compromise between the pure partnership method· 

and the capital-gains a.pproe.ch which was discussed above. Stockholders 

would be taxed each year on their share of undistributed profits, o.nd the 

basis of stock would be written up by the amount of the undistributed 

profits. At the time of transfer of stock by sale, gift, or bequest, a 

capital gain or loss would be realized. Any capital ga.in would be subJect 

to regular income tax rates, and any capital loss would be fully deductible from taxable income. Apparently, some rather liberal method of avere&ing income would be needed. 

The objective of thia approach would be to gain the advanteges of 

substantially current ta:xation of stock.holders on their sha.ra of undistributed profits without extreme pressure for exactness in ~urrent allocations. If it were certain that the tax.effects of under- or·overststements of current income of stockholders would be l~rgely corrected at the 

time of transfer of the stock. minor and unsystematic inaccuraci~e of current reporting would give less cause for.concern. If the income of stockholders were currently understated, it would be expected that this would 

be corrected by le.ter tax11tion of-a capital gain. If income were overstated, a later capital lose would be relied Upon to correct this. Under 

these conditions the margin of tolersnce for reopening returns of stockholders might justifiably be rather wide. 

One objection raised agaic$t the capital-gains approach may.also be, 

brought age.inst this variation of the partnership method. If changes in 

conditions C8Used a previously prof'i table corpore.tion to lose a ls.rge :part 

of its earning prospects. a capital loss would occur when stock was transferred, which might, if fully deductible, result in a refund of a large 

portion of the tp...x already paid on retained profits. The Sfl.me thing might 

take place if the stock were tre.nsferred at a time when the stock market 

·was temporarily depressed. As in the cese of the capital-gains appronch, 

the result would be equivalent to granting the stockholder a very long 

~eriod of averaging of income from his stockholdings. This would seem to 

be appropriate only if other income recipients were given eqtll!.l opportunities .for averaging taxable income. 

f'. Evaluation 

( 1) Equitz considera.tJ:~!:! 

The partnership method would eliminate any element of double taxation 

of dividend income in the area to which it was applicable. Stockholders 

would be taxed according to their personal circumstances at usu.al individual r~tes. · 

However. in some instances stockholders might be emba.rras'sed by taxation of income over which they did not have full control. The fact that 

the corporation had accumulated undistributed profits would not always 

give stockholders en i1r.mediate in.crease in resources with which to p8Y 

• 
- 35 -

• 

., 

• 

taxes. Even if the value of the individua.1e1 e shareholdings increased --- · 

promptly to reflect corporate accumulations, which would not always be the 

case, he could realize this increment only by disposing of some of hie 

securities and decreasing hie proportionate interest in the company. Furthermore, such opportunity at beat would be available only in the case of' - readily marke·te.ble stock. 

(2)eeEconomic considerationsee

The partnership approach would free management of the necessity of 

taking the corporation tax into account in its decisions. But the individual income tax would have to be taken into account more explicitly than at 

present, and it might in many cases prove more restrictive than the corporate tax. Since all income flowing from the corporation would-be subJect 

only to individual income tax imposed on its recipient, the tax premium on 

debt finMcing would be entirely eliminated. Moreover,_ the likelihood of 

a direct effort by management to shift the tax on corporate profits to 

prices or wages would be diminished. 

By freeing dividends from taxation at the corporate level, the partnership meth1>d might stimulate purchase of stocks by individuals and thus 

make outside financing of corporate expansion easier. On the other hand, 

individua.ls might hesitate to acquire shares in growing corporations likel.7 

to wish to retain a considerable part of their profits. 

·eUnder the partnership method corporations lacking access to nationalee

capital markets could retain larger net amounts of profits than under the 

present tax system. If, however, application of the partnership method 

increased stockhold�r preaaure,for dividend distributions, retention of 

earnings m.ight become more difficult. 

(3) Administrative considerationsee

Administra.tive difficulties of application of the partnership method 

to largo, publicl7 held corporations appear virtually insuperable. However, 

a simplified version of the method seems feasible if restricted to more 

-cloeel7 held corporations with relatively simple capital atructurea.ee

·e2. Collection of tax from corporation exactl7 eguinlentee

to individual tax if profits distributed 

An alternative version of the general approach which determines tax 

liability on undistributed p�ofits on an individual basis would•impose the 

tax upon the corporation rather than upon individual stockholders. Undistributed pro-f'i ts of each corpora.ti on would be allocated among ahare_holdera 

and individual income tax on the additional imputed income calculated sep8.ra.tely for each individual stockholder. The sum of these additional imputed lia.b111ties, which would be exactl7 equivalent to individual income 

tax which would have been due had all the corporation1 a profits been distributed, would then be·collected from the corporation. If 'dividends were

• 
.. 

q q q q 

( d ij ) 

9 9l 

b) 

� 

- 36 -

later declared from income which bad been so taxed, they would not be subject to inditvidual income tax. 

a.ttUse in United Kingdom and Australiatt

The United �ingdom and Australia e.pply this method to "private" corporationa which fsil to distribute a reasonable portion of their profits.!/ 

The procedure 1 s applicable in the United Kingdom to a company under control of not more than five persona and in Australia to atcompR.ny under control of not more than seven persons. In both Jurisdictions, a company is 

deemed to be a "private" company if it is not a subsidiary of a pubUc company or a company in which "the public 81'8 substantially interested" __ , 

that is, a company in which common shares.carrying 25 percent or more of 

the voting power are unconditionally held by the public and listed on a 

stock exchange. The test of reasonable distribution is left in the United 

Kingdom to be determined by the special commissioners f�r the Income Tax 

Acts, vi thin broad statutory limits. In Australia the statute requires 

distri lru.tion of the whole of dist_ributable · income of an investment company 

and for other companies the whole of dividends received from private companies plus two-thirds of other distributable income. 

Australia formerly applied this method to all corporations, whether 

public or private, which failed to make a reasonable distribution of profits •. However, a. Ro7al Commission on Taxation which sat in 1933 and 1934, 

recommended that consideration be given to restricting it to private companies,• g/ and this was later done. if 

b.ttEvaluationtt

This method would be essentially similar, in conception and operation, to the par.tnership treatment. It would place the CAsh drain of meeting tax 

liabilities attaching to undistributed profits on the corporation rather 

y In the United Kingdom the su.per-tax.lsurtaj under this provision is

"assessed upon • • • fthi/ member £stockholdeif in the n� of the company-" and, if the stockholder does not elect to pay the tax, it is payable by the company. In Australia it appears that the tax is assessed 

directly against the company. United Kingdom, Finance Act, 1922, sec. 

21; aee The Income Tax Act,- 1 18, and Finance Acts, Years 1 1 to 1 41 

Inclusive, with supplements Lon on: H. M. Stationery Office, 19 1, 

pa.rs.graph 547, pp. 255-259. Commonwealth of Australia, Income Tax 

Assessment Act of 1936, sec. 103-104; see Income Tax, Eqlanatory 

Handbook Showing the Difference Between the Income Tax Assessment Act 

1936 and the Income Tax Assessment Act 1 22-1 4 (Canberra, • Commonwealth Govt. Printer, 193 , p. 128 et passim. · 

Commonwealth of Australia, Royal Commission on Taxation, First Report, 

1933 (Canberra: Commonwealth Govt. Printer, 1933), P• 30. 

Income Tax Assessment Act of 1936, sec. 103-104. loc. cit. 

• 
.. 

.. 

- 37 -

than on stockholders. l'rom the administrative viewpoint, it.might.be easier .to collect the imputed tax from corporations the.n from individuals, 

but the chief administrative burden - allocating profits and computing 

individual liabilities - would be the same as under the partnership 

method. Moreo.ver, the plan would impose great compliance burdens on corporations, and would make advance planning by corporations extremely difficult.,/ · . . 

Economic implications of collecting a given tax from a corporation 

would differ somewhat from effects of collecting the same tax from stockhqlders. Investment decisions and price.and wage policy of mane&ement 

would be more likely to be affected by collection at the corporate level. 

Payment of the tex by corporations might restrict investment funds of corporations more than payment by individuals under the partnership method, 

but this is not certain. 

C.ooAdjustment for distributed profits at theoo

corporate level -- credit for dividends paidoo

AdJustment· for distributed profits at the corporate level would involve reduction of the corporate tax on account of dividend distributions. 

A tax would be imposed on corporate net income but a deduction :from taxable 

income or a t� cred.i t would be granted the corporation :fo_r_ dividends paid.· 

The principle of an e.dJustment in the corporate tex on account of 

dividend distributions is given a limited recognition by present Federal 

tax law. Dividends paid by.public utility corporations on preferred stock 

issued prior to October 1, 1942, are credited against surtax _net income', 

and are thus freed of the corpora.ta surtax. !/ 

The tax credit or deduction for dividends pa.id might be such that the 

corporate te.x would apply only to undlstributed profits, and distributed 

profits would be subJect only to the individual income tax. Alternatively, 

some corporate tax on distributed profits could be continued by allowing 

only a partial deduction or tax credit for .dividends paid. Whichever were . done, it would probably be advisable to allow a considerable period for 

carrying forward and/or backward l�sses and dividends paid in excess of 

current income. It might be desirable to allow a tax···-(:redit :for dividend.a 

paid in th,e corporation• s own stock or other certifics.t'e_s as well as for 

g In'ternal Revenue Code, sec. 15{a), sec. ?6(h); provided _b7 the Revenue 

Act of 1942, as amended • 

• 
• 

/ 

- 38 -

di v1denda paid in cash, provided the non-cash dividends were taxable to 

the �ecipient. y

The following-is an example of a specific version of the dividendopaid•credit approach which would reduce, but not eli•inate, the corporate 

tax on distributed profits. A 4o-percent tax might be levied on corporate 

.net income and a tax credit allowed equal to, say, one-fourth of dividonde 

paid from current income. g/ This.particular plan would reduce the corporate tax- on distributed profits to 20 percent. The tax on corporate income as a whole would range from 20 percent,. if all distributed, to 4o 

percent, if nothing were distributed. if• Any number of variations of this 

basic approach would be possible with different maximum rates, and tax 

credits or deductions. 

Under the undistributed profito tax of 1936, which was in some re­ ·y 

spects similar to the dividends-paid-credit plan, a two-1ear carryforwn.rd of dividends paid in excess of available income was allowed,

end dividends paid in stock and other property were conaidered distributions of corporate income so long as the dividends ve�e taxable to 

recipients. (Sec. 27, Revenue Act of 1936, Public No. 7140, 74th Con&.,

2nd seas., chap. 690, 49 Stat. 1648.) No carryforward or carey-back of 

operating loss was allowed in the original 1936 act, but a one-year· 

careyforward of net operating loss was added in 1938 for p�oses of 

the remnant of the undhtributed pro:f'it·s tax only. (Sec. 26(c), 

Revenue Act of 1938, Public No. 554, 75th'Cong., 3rd sess., chap. 289,

52 Stat. 447.) 

g/ The illustrative rates used in the text for this and other plans were 

developed when the combined corporate normal tax and surtax was 4o percent� The illustrations have not been revised with the reduction of 

the corporate tax rate to 3g percent in the Revenue Act of 1945, partl1

because of the convenience of dealing with the even.numbers appropriate 

fo� a 4o percent over-all corporate rate. The particular rates mentioned at various points in the text are intended solely to illustrate 

the operations of the plans; they imply no recommendation as to the 

proper rate structure. 

'JI To illustrate, suppose a corporation has profits of $100. The tentative ma.xicum tax of 4o percent would be $140. If no dividends were 

paid, no tax credit would be allowed, and $4o would be the final corporate tax liability. If, however, the corporation paid $24 of dividends, it wouid get a tex credit of one-fourth of this a.mount, or $6.

The final corporate tax would be $34 ($4o less $6 tax credit for dividends paid).. If the corporation paid $SO ot dividends, it would get a. 

tax credit of one-fourth of thie amount or $20, which would reduce its 

final tu to the ,minimum of $20. The maximum amount of dividends 

which could be paid r�om current income and still leave enough to meet 

the corporation's final tax liability would be $SO. Hence the greatest 

�ossible tax credit for dividends paid from curr�nt income would be 

$20, and the minimum tax $20, or 20 percent of income. 

' -
- 39 -

The operation of a dividends-paid-credit plan and tho tax load on cor-_ · 

porate profits under such a plan are fllustrated in Chart 2. This chart, 

which is drawn in·the same general vay as Chart 1, shows the total tax on 

corporate profits under the particular rate schedule mentioned in the preceding.paragraph. The chart shows how the total tnx vould-be ma.de up of: 

(1)ttthe corporate troc, which would VtWJ"_with the portion of profits paidtt

out in dividends by the corporation; and (2) the individual income tax ontt

distributed profits, which would depend on the sm.ount of dividends paidtt

out to taxable stockholders and the rate of tax to which theao dividendstt

would be subJect in the hands of individual stockholders. The chart shows

• all possible combinations of these factors and hence the entire range oftt

possible total tax load on corporate profit• under the illustrative dividends-paid-credit plan.tt

The first (upper left) panel of Chart 2 ahowo the total tax on the 

assumption that the corporation retains none of its profita but pays out 

all its current income in dividends end taxes. The total tax is determined 

by adding the corporate tax (20 percent in this case) and the individual 

tax. The chart is so constructed that the total tax corresponding with 

any given individual tax rate nppeara on the right-hand·acale directl7 

opposite that individual rate in the middle scale. 

The second (upper right) panel of the chart is the same as the first 

except that the corporation is assumed to retain 30 percent of its profits. 

These retained profits do not currentl7 come within the field of the individual income tax, as is indicated by the shrinkage of the individual 

rate scale. At the ea.me time, the corporate tax is reduced to 30 percent 

rather than to 20 percent, which partl7 compensates for the r�striction of 

the individual tax base. 

The third (lower left). panel of the chart generalizes the analysis 

illustrated in the first two panels. It shows the locus of all possible 

verticle lines of the type appearing in the first tvo panels. It is possible to read the total tax on corporatte,profits for any assumed combination of retained profits and individual tax rates. 

·tChart 2 cringe out the fact that the particular rate schedules usedtt

for illustration of this approach would not completel.7 eliminate double or 

additional taxation of distributed corporate profits. But it would be 

possible to select rates which would do so. 

1.ttRationalett

The purpose of granting a tax credit to corporations for dividends 

paid would be to reduce or eliminate double taxation 9f distributed prof­ • its. Distributed profits would be wholly or partially relieved of the 

corporate tax, in recognition of the fact that such profits are taxable 

income in the hands of stockholders. Undistributed profits, which would 

not. be currently subject-to tax in the hands of stockholders, would rems.in 

subject to th� full corporate income tax, in order to reduce poasibiliti�a 
- 4o -

for tax avoidance and postponement and to preven� revenue loss. The 

credit-for-dividends-paid approach would be less of a departure from the 

:present system than either the partnership or capital-gains approach, 

which have already been discussed. 

2.ttRelief for small co!"Porationstt

Although the credit-for-dividends-paid approach would not be intended 

as a penalty tax on undistributed profits, it would offer an inducement to 

distribute corporate earnings. !} The current tax load would be lighter 

on corporations that could conveniently pay out a large portion of their 

income than on those that needed to retain a considerable part of their 

profits. g/ Since many small and med.ium-aized corporations must rely on 

retained earnings as their primary source of additional capital, it might 

be considered desirable\to lessen the impact of the tax on such corpora-­

tions. Thia could be accomplished b7 treating some stated amount of retained income as if distributed. A "presumptive" ·dividends-paid -allowance 

would be gre.nted for tax purposes, and a limited amount of retained profits 

would be subJect to no more tax than distributed profits. 

Such a presumptive dividends-paid allowance would result in some inequality of· taxation of different parts of retained profits and would permit some postponement of individual taxation. The tax stimulus to distribute dividends would be lessened. The presumptive allowance, however, 

would be a valuable concession to small, growing companies and would prob- ably somewhat simplify compliance wit� the plan. 

a.ttAdded versus vanishing presumptivett

dividends-paid allowancett

The presumptive dividends-paid allowance could be an addition.to, actual dividends paid -- that is, the first $X of retained income could be 

treated as if distributed, regardless of the amount of income or dividends 

paid. Alternatively, the presumptive dividends-paid allowance could be 

restricted to the tirat $X of income available for dividends, with the 

y A penalty tax on undistributed corporate profits has been supported on 

the basis of a number of considerations. Arguments which have been 

advanced in favor of such a tax include the followiDg: (1)- It would 

compel corpora�ion mana&era to submit proJected new investments end 

expansions to the test of the capital market; (2) it would give stockholders an opportunity to diepoee of their share of corporate profits 

aa they please, rather than being forced to leave it in the corpora- tion; (3) it would curb excessive saving; (4) it would put a brake on 

arbitrary power of corporate management; (5) it would check the growth 

of giant corporations. 

g/ Given complete avera&ing of,corporate income and dividends and stable 

tax rates, the ultimate·te.x would be. the same on all prof'ita if they 

were finally distributed as dividends. 
l 

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.. 60%· 70% 

!SO%· 

90'1, I 

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80'1, I 

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"Total Ta• GI 

lnoome individual Toa:· •"'•••,.' eo,,orf.~a RatH 00'1, -- I 

·-· - SO% 

-- I 50% 

(D 

90% 

80'1, 

70'1, 

60% 

30'1, 

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-------------------------------------------------------------------------------------------------------I 

40"4 

40"4 

Chart 2 

TOTAL TAX ON CORPORATE PROFITS UNDER DIVIDENDS -PAID CREDIT PLAN 

40% MAXIMUM CORPORATE TAX, WITH 25% TAX CREDIT FOR DIVIDENDS PAID, 

RESULTING IN 20% MINIMUM �ORPORATE TAX. 

Aggregate of corporation and individual income tax /JaserJ on: 

. A. Varying percentages of profits retained /Jy corporation. 

8. Rate of individual income tax applying to any given stockholder.

.,

I 

r-------------------------------------------------------------------------------------------- NO PROFITS RETAINED BY CORPORATION· 30% OF PROFITS RETAINED BY CORPORATION I 

I Individual Toto I Tax· a, 

Income Tax "4 af Corp- Profits Ratn orate Profits 100"4 ----------------------- 100% ------,100% 

90% 

BO"lo 

70"4 

-----�90"4 

-------<80'4 

® 

Dividends .. eo% 

@ 

Ruulfing • Total .. 60"4

Tax 

40% 1-------150"4 

® 

Dividends .. 40% 

@

Subj•ct to th• 

.. r::r ,:�:n::1:; • 1

. :r:. :':1o::h:'J/., 

100% 

90"/o 

80"4 

70% 

ISO% 

40% 

------190'4 

-------<80'4 

70'4 

60"4 

@ 

"-•ulfln{I • Total .. TtlX 

1-------140"4 30"4 

20"4. 20"/o 

I0"4 

-----� !0'4 !0% 0 10"4 

-------------------------- o- -------l 20"4 ---,-----120"4 

'I © 30% ��::,,o;:/� _____..,. ,o"' l ------1 10"4 !

I ��;!o;:x-� t I t I I o -------------------------------------------- o o --------------------- ---:------------------ o � l I 

1----------------------------------------------------------.--------. ------------------------------1 , l- VARYING PERCENTAGES OF PROFITS RETAINED I , 

l BY CORPORATION ILLUSTRATION I 

I For 17/ustrotion of use. see -------------... I

1 I Individual 1otal Tax a, X · 'Individual . Total Tax aa IJ\Come Tax · � - Income Tax '4 of Cor,i•

its R_ate_• . - o�f! ��!fi,, s Rat 1 f f 11____________ ,

I 100,_Pro .,. -- ----------,I00'4 100,_P,_r_o _it...__-..- -11-

o_rat

_,T� I

ts .

.C, 

-t-=--i===�=�::;__=,,�r===r.i 50%-� 50.7% 

Maximum Maximum 

Corpora-• 40% 40"4 Corpora-•40'4 

lion Tax lion Tax (No divid,nds paid} (No dividsndspaid) 

..i,-.,:::::--t--;;-l-"==--+--+--��"4 

• Minimum _.___,___,,____.___,__--t� Minimum 

Corporq-• 20% "4 Corpora-•20'4 �-�-�--�----.._-��"'

lion Tax 10'4 20"4 !0"4 40"4 50"4 lion Tax NONE 10'4 20"4 !0"4 40"4 50"4

(No prolifs rafoinad) RETAINED PROFITS (No profits r•fain,d} RETAINED PROFITS 

t0"4 

20 % ond 40" du, /o lox 

cmlif of 2$3⁄4 of dlvldlnda pold. 8 20% of profits retained by corporation. 

0 ----------------------------------- -------------- 0 0 C, Toto/ fox• 50. 7% of corporation profits. --

Corporaf, fox vorl•• b1fw11n 10"4 0 Individual income fox rote 45%. 

o · 

Office of the Secretory of the Treasury, Division of Tax Research B-649 
- 4'.1 -

_proviso that the allowance should not exceed $X minus dividends actua.117 

paid. The former practice may �e termed an added presumption, .the latter 

a ve.nishill8 presumption. An added presumption could be, supported on the 

grounds that all firms should be allowed to retain a limited amount of 

profits on equa.117 favor�ble terms and that a cuahion should be provided . ·efor cases in which minor deficiencies·1n corporate income as originall7

reported were discovered after the tia; return had been filed. A vanishingee

presumption could be based on the view that a presumption is justifiableee

chiefly for corporations which cannot afford to distribute their profitsee

and that firms which ce.n distribute dividends.do not need special treatment.ee

The differences between an added and a vanishing presumptive 

dividends-paid allowance would.be most significant for medium-sized corporations. Veey small corporations would pay only the minimum tex with.·_· 

either kind of allowance, and very large corporations would probabl7 not 

be greatl7 affected by a modera.te-sized· allovance of either tn,e. Medium-· 

sized corporations would find that their dividend policy would significantly affect their tax bills.};/ 

b.ee Size of' presumptive dividends-paid

allowanceee

A presumptive dividends-paid allowe.x;ce of any fixed size, whether 

vanishing or additive, would exceed the requirements of man7 corporations. 

It unused presumptions were allowed to accumulate, a premium would.be 

/ placed on acquisition- of existing small companies for the sake of their 

accumulated unused presumptive dividends. The simplest safeguard would be 

to limit the presumptive allowance to the_ smaller of (1) ·some fixed amount 

or (2) the corporation's net income (minus the basic-tax on distributed 

profits if that were a feature of the plan). Such a limitation would, 

however, result in some discrimination against firms with widely tluotus.ting 1nco1!1e as compared with firms with stable income. 

y - An added presumptive allowance of, say, $50,000 would offer no tex inducement to pay out the last $50,000 of' income_ available for dividendsee

but would.offer a tax inducement to pay aD7 amount of dividends· shortee

of that. A vanishing presumptive allowance of $50,000 would. offer noee

tax inducement to P81' out the first $5(),000 of dividends, but wouldee

offer an inducement to pay out all income in excess of $50.000. Inee

the case of a corporAtion with $100,000 of income available for.dividends, a vanishing presumption would mean that the corporati�n•s taxee

would be the same whether it paid $50,000 in dividends .or no dividends..ee

but its tax would be reduced if it paid more than $50.000 in dividends.ee

Under an·added allowance, p91'Illent of any- amount of dividend& up toee

$50.000 would reduce the corporation's tax, but additional div�dendee

payments would not reduce the tax any further.· Fo� �11 corporationsee

that would be likely to pa:, out ·more than $50,000 of dividends withoutee

any tax inducement, the vanishing presumption would offer a greateree

incentiTe to pay additional dividends.ee
- 42 -

Choice ot size ot maximw:i allowable presumption depends on coverage 

desired. It is estimated tbat in the prewar year 1940 vanishing or added 

presumptions of various sizes would have reduced coverage as follows:!/ 

• • Execpted aZ

: Percent of . Percent of Presumption ..• :firms with: •

• Percent of • 

retained . : : net incom3 •

• 

net income , net income 

$ 100.000 

Vanishing 9~ 11i 25i 

Added 98~ / 25~ 35~

$ 50.000 

Vaniehing 9~ 1~ 19~ 

Added 9~ 17~ 2~ 

$ 25,000 

Vanishing g~ s~ 13i 

Added. 94~ 1~ l~ 

;g Or subject only to the minimum tax. 

One serious problem with a preswnptive dividends-paid allowance of 

8%lY' fixed Bise would be that it would offer a tax incentive to oplit up 

existing corporations and to organise new businecses, whenever posaible. 

as a number of.small corporations rather than one larger corporation. 

However. the inducement for "split-ups• would not be much different than 

under the present graduation of the corporate tax on net income• of leu 

than $50,000. · 

3. Dividends paid in o:cooa of available income 

If a corporation paid diyidends in excess of available income - net 

income minus the basic tax, if arq - these could be treated, in effect, 

as distribllti•ons of past or :tuture income. g/ Alternat1Tel7, the tax . could be computed separately for each 7ear witliout regard to dii,.tribuUon 

of other years. 1a1lure to carry oTer excess d.ist~ibutions, however, 

would make maintenance of a stable dividend policy more difficult. 

rJ Estimated from dat~ in Statistics of Income for 1940, Part 2, assuming 

that dividends paid under the plan would be the sa.me :percent of income 

available for dividends in each net income class as in 194o. 

g/ In some cases excesa dividend distributions would first be revealed 

after the end of the tax year in which pai~, when the income that a 

corporation originall.7 reported vas later decreased by audit or b7 a 

~areyback of net operating loss. 
- 43 -

The simplest procedure would be to allow distributions in excess of 

aTailable income to reduce the maximwn tax in future years. Thia could be · accomplished technically by carrying forward either excess distributions 

of dividends or credits in exceBB of the maxilllWll allowable in the current 

year. It woul_d be more in accord with the logic of dividend distributions . to regard excesa dividends as distributions of previoualy retained net income. Moreover, this treatment would make -the tax advantage of distributions certain, since it would.not depend on the possibility of-future 

accumulations of profits. A careyback would therefore provide a greater 

inducement for paying dividends in times of depreasion than-would a carryforward. Nevertheless, a carr7back of exceSB dividends would involve some · administrative problems·and would require granting of refunds of taxes 

·previously collected.. In the early years of the plan a careyback.might 

benefit fewer corporations than a carryforward. The careyback and ca.rryforward procedures might be combined, with excess distributions or credits 

applied first to prior years and any unexhausted balance carried forward. 

The issue between carryforwerda and carrybacks would concern mainl.7 

large corporations, provided a fairl7 generous presumptive dividends~paid 

allowance were a feature of the plan. The presumptive allowance would reduce the tax on small corporations to a minimum, whatever their dividend 

policy. Either a carr;rback or carryforward could adequately meet tru,· 

needs of a firm with.profits and dividends fluctuating above and below a 

reaaonabl7 atable level. A steadily declining firm that wished to pq out 

profit accumulated in earlier, more prosperous years would be benefited 

onl7 b;r a carryback. 

There would be little reason in principle for limiting the period of 

carryforward end/or carryback of exceaa diatributions of dividends or 

credits. However, considerations of administrative expediency would auggeat.  ome arbitraJ7 limit ot, sq, five or six years. The period should 

be.long enoi1&h to permit a reasonable degree of balancing of dividends and 

profits. · 

4. Treatment of special t7Pes of income 

a. Intercorporate dividends 

It dividends received from other corporations were fully included in 

corporate income, no problem would arise in connection with credit or deduction for dividends paid from this source_•. On the other hand, if intercorporate dividends received were wholly or partially excluded from the 

tax base for determination of maximum corporate tax. ·!/·no cred.1 t or de• 

duction should be given for dividends distributed from the part of this 

income excluded from the.base. 

y For purposes of corporate normal tax and surtax, present law allows a 

credit a.go.inst taxable income equal to 85 percent of dividends received from·domestic corporations subject to income tax, 'flith certain 

limitations. Internal Revenue Code, sec. 26(b). 
- 44 -

One solution would be to include the tull a.mount of dividends received in income for computation of tentative maximum tax and to allow 

against any minimum tax an appropri~te tax credit for dividends received. 

Alternatively, dividends received could be vholl~ or partially excluded 

from the base for the maximum tax and dividends paid eligible for credit 

reduced by an.equal a.mount. The latter solution vould completely or partially exempt intercorporate dividends from tax but vould grant no credit 

for dividends distributed from e~empt income.!/ It would be implicitly 

assumed that dividends were paid first from non-taxable dividends received 

and from other income only after non-taxable income was exhausted. The 

first approach (through use of a tax credit for dividends·receivod) could 

be adjusted either to free dividends received from all tax if distributed, 

or to leave a low minimum tax on intercorporate dividends even if not retained by the recipient. Income from intercorporate dividends would presumably be su.bJect to some tax if retained. g/ 

Similar problems would be encountered in dealing with other kinds of 

income not subject to regular taxation, such as partially and whollT·taxexempt interest. and excess of percentage depletion over cost depletion. 

Since these kinds of income presumably would not have been included in full 

in the base for the maximum corporate tax,. their distribution as dividends 

should not reduce the maximum tax in the same way as distribution of fu.117 

taxable income. Either of the two solutions mentioned for intercorporate 

dividends could be adopted. 

5. Evaluation 

a. Equity considera.tiono' 

Adjustment of the corporation tax for dividends distributed could 

completely free distributed profits from double taxation. Dividend income could be made taxable in the same w~ as other income, at raten applicable to indiTidual recipients. Undistributed profits would be subject 

to taxation at the corporate level so that individual tax postponement or 

avoidance through the corporate machinery would be reduced. Under this 

epproech. any desired degree of taxation of corporate income as such, without regard to- whether 1t was distributed or retained. could be achieve~ by 

varying the credit for dividends paid. 

y For example, if 85 percent.of dividends received were excluded from 

the bAse, as under present lav, dividends paid subject to credit would 

be reduced by 85 percent of the amount of dividends received. 

ror example, assuming a 4o--p~rcent maximum true on corporate income 

with a 25-percent tax credit for dividends paid. an add.iti~nal tax 

credit of 15 percent of intercorporate dividends received would wh~ll7 

exempt dividends received it paid out by the stoekhold.1~ corporation 

but subJect'them to a 25-pereent tax if retained.. 
- 45 -

Tho dividonda-paid-credit approach vould not completely equalize current ta~tion of distributed and undistributed profits. The corporate truc 

rate vould alvnya bo higher or lover on some parts of retained profits than 

tho combined individual and corporate t,u would be.if tho profltc v0re distributed. ~he extent of current undortaxation or overto.xation, cea1urcd by 

atrictly individual stnndn.rd.a, would dopend on tho rate structure adopted. 

For high-income atockholdero thore would be a te.x advantnge from retention 

of corporate profito, and such stockholdore might press for large retentions. 

Lov-income stockholders would suffer from ouch o. policy, aince their individual tnx liabilities vould be leuo on diotributod profits than the corporate 

tax on their share of undistributed :profito. · Tho approach might impose a 

burden on stockholders in corporations that, because of impaired ca.pita.l, are 

prevented by State lnvs from paying out their current inco~e in di?idends. 

b. Economic considerations 

An ndJustnent for dividend dhtributionc at the corporate level vould 

reduce taxes on all corporations except those which retained all their 

earnings. Such a reduction in taJtes paid by corporations would make man7 

invectment opportunities ceem more profitable and might lessen tox restr4ints on ma.nn&e~cnt decisions to invest.. 

The effect on individual decioions to purchase securities would be 

less direct, but insofar as the system permitted or r.timulated additional 

dividend payments it would make stock more attractive to many individuals. 

However, to the extent that the approach rnade retention of corporate profits leas usual, it might lessen the incentive that some high-income individuals now have to bw shares in corporations likely to retn.in a large 

portion of their earnings. These individuals would find it harder to take 

advantage of the opportunity of postponing taxes and perhaps of ultima.toly 

realizing lhe fruita of their investment in the form of a capital gain. - with consequent tax advnntn.geo under present lav. 

Retained earnings would still be subject ~o tax. but this would not 

noceasarily interfere seriousl7 with financing of corporate investment. 

If n presumptivo dividends~id allowsnco were granted. small corporations 

wo~ld be free_ to grow by use of retained earnings. Large corporations 

could pay neceusa.ry dividends at smaller coot. Although retained funds of 

larger corporations would bo lessoned as a result of the tax, such concerns can more often resort to tho capital market to finance attractive 

invest~ento. It seems likely, however, that an investment opportunity has 

to be more attractive to induce inTestment of funds to be secured from the 

capital market than to induce a corporation to invest retained earnings 

and other internal funds. Undoubtodl,7, there would be corporations that 

would be unable or unwilling to finance some investment under the dividendspaid-credit plan that they would be able nnd willing to finance if there 

were no corporate troc. 

Reduction of the tax paid by corporations would be ~ore likely to 

counterftCt o.ny dhposition of i::anagei:ent to try to paao on tho corporation 

tu by re.icing pricea or dopreodng vagoa than would an adjuutment granted 

to individual stockholders. 
- 46 -

If distributed profits were completely freed ot taxation at tho corpo• 

rate level, the tax incent1Te to debt financing would be eliminated. If 

some baaic tax were continued on all p~ofite, the pr•m• on debt financing 

would be reduced but not eliminatecl. 

c. Adminlatrat1Te conaiderationa 

Although some adm1n1atrat1ve problems would be met in a plan for ·coordination involving recognition of diatributed profits at the corporate 

level, these complicationa do not seem grave enough to be an important 

factor in evaluating the plan. 

]). Wuatm.ent at the individual level for ~ corporate tax on distributed income 

1. Withholding tax approach 

Om, approach to 9oordinating corporate and individual income taxes 

would be to collect a withholding tax from corporate prof,its. This withholding might be regarded as a pa.rt of the corporate income tax or aa 

merely an advance payment on tax liabilities ot stockholders. In either 

case the Withholding rate. would apply to both distributed and undistributed · profita. When d1Tidenda were distributed, indiTiduals would include in 

their taxable income• caah diTiden.de-received plus the withholding tu paid 

b;r the corporation• .After computing their indiTidual. income tax, etock:­

holdora would take credit tor the tu on their ·diTldenda withheld at the 

corporate level. The withholding approach to integration la often ca,.led ·the British qstem. !/ · 

a. Rationale 

'!he withholdiDg approach would attempt to reduce or eliminate double 

taxation of distributed proflta b7 applying part or all of the tu paid by 

the corporation with respect to such profits against the tu liabllit7 of 

atockholdera. This approach would be baaed on the idea that a tax formal.17 

paid b7 a corporation may be regarded as a tax paid by or on behalf of its 

stockholders.· On thia reasoning, it a corporation paid a withholdi?Jg tu 

on its profits, a atockholder should not be required to pa:, a tax on his 

dividends, unleae his individual tax liability exceeded the. amount already' 

paid by the corpnration with respect to the profits from which the ' · 

!) The Research Committee of the Committee for Economic DeTelopment has 

recommended a withholding plan tor the United Statea. (See their report, A Postwar Federal Tax Plan tor High !!Plozment, 1944.) Mr. 

George E. Barnes has proposed a dual corporation tax 171tem composed 

of (a) a baatc franchise tu similar to the present corporation income 

tax, and (b) an additional withholding tax that would be credited to · 

divldend-recipienta. (See hie article, "A Plan to Simplify Corporation 

Taxes,"· Exchange• Vol. V, September, 194\.) 

• 

.. 

.. 
dividends were paid. Similarl7, if the amount pa14: bJ the corporation exceeded the stockholder•• liabilit7,. he ahould &et a refund. Since the 

withholding tax paid by the corporation would be used to meet a portion of 

stockholders• tax liabilitiee, thia tax ahould be regarded as a part of 

stockholders• income. Stockholder, would be presumed to have r.eceivecl 

cash dividends· plus the vithholdin& tax attached to them. The withholding 

tax would appi7 not onl7 to profits currentl7 distributed but alao to un• 

distributed profita, in order to .Prevent excessive tax avoidance and postponement with respect to undietribu~ecl profit• 

b. Illuatration .. The operation of a particular withholding plan and the distribution 

of the tax load under it are illustrated in Chart 3. Thia chart is drawn 

in the same wa7 aa Charts 1 and 2, which were used to illustrate the present s7stem and the dividenda-paid•eredit approach. Chart J ahova the 

total tax on corporate profits under a plan that would impose a 20-percent 

basic corporate ·tax plus a 20-percent vithholding . tax, and that would 

credit the withholding tax to individual atockholdera at the rate of $1 

for each $3 of ca.eh d1Tidenda received. · The total tax on a dollar of prot- 1ta earned on a share of stock owned by aJ27 stockholder cu be read off 

the right-hand acale oppoeite the individual rate applicable to d1T1dend 

income of the stockholder~ · 

The easence of the vithhold.1128 approach is illustrated in Char.t 3 b3" 

the overlapping of the individual rate acale ud· the vithholding part of 

the corporate scale. Thia illustrates how part of the tax paid b7 the 

corporation vould be used to meet the individual atockholder 1s tax liabil- 1t:, and shows that the wi thholdin& tax 10 used would be included in the 

stockholder's taxable income. Only the w1~hhold1ng relating to dividends 

paid would be currentl.J' credited to stookholdera. In the first (upper . left) panel of the chart, where no profits are a88umed to be retained b7 

the corporation, all of the w1 thholding would be currentl7 ·credited to 

stockholders; but in the aecond panel. where 30 percent of profits are 

assumed to be retained b7 the corporation, onl:, half ot'the total withholding would be currently credited to atockholdere. For stockholders not eub-­

Ject to individual income tax or subJect to a rate of lees than 25 percent. 

all or part of the withholding related to dividends would be refunded. 

The lover halt of Chart 3 generalises the illustration given in the 

upper half. The slope of the bottom individual-rate line upward to the 

right illustrates how the amount ot withholding credit currentl71 available 

to stockholders would climiniah as the amount of profite 1 retained b7 the 

corporation increased. , But at the same time, stockholders• tax· 11abll1- ties would decrease, and the smaller withholding credit would still cover 

the first 25-percentage point of individual tu.liability on dividend 

income. · 
- 4g -

c. Rate of vithholding 

The rate of withholding on corporate income would be important for 

reasons of equity as well _as for protection of the revenues. To prevent 

any possibility of tax postponement or avoidance by individuals the rate 

would have to be equal to the highest individual tax bracket. To prevent 

reduction or tax revenue~ by retention of corporate profits, the withholding rate would need to be equal to the average individual tax rate applicable to dividend income. The maximum individUB.l tax re.te would probably 

be regarded as too severe. On the other hand, the minimum individual tax 

rate, which 1s often suggested, would permit a considerable eJnount of tax 

postponement by individuals. Well over half of total dividends receiTed 

by individuals are likely to be subject to more than the minirmm individual tax rate, assuming approximately present exemptions and a $2,000 beginning surtax bracket."!/ The withholding rate could be applied to all 

corporate profits or to the balance remaining after application of any 

corporate tax not considered withholding. 

d. Withholding in excess of individual tax 

Equity would require that individuals be given tax refunds if the tu 

withheld on their dividonda exceeded their individual tax liability. Thia 

would ce:use an administrative :problem, the exact extent of which would depend on the withholding rate in comparison with individual tax rates and 

exemption. Many individuals would be able to ac1just for overwithholding 

in connection with their estimates and current payments of tax, if the 

present individual system were continued. Mally others would have to depend on cash refunds. 

e. Methods of withholding 

Thia section mentions first a simple withholding method that would 

ca.11 for a. uniform mark-up of cash dividends to reflect vithholding at the 

corporate level. Then it discusses problems encountered with this method 

and presents relatively minor modifications of the method designed to meet 

some of these problems without significant loss of simplicity. ~inally, 

the section outlines an alternative withholding method that would require 

corporations to allocate oxa.ctly the amount wit}lheld to various dividend 

payments and to report this to dividend recipients. 

y In 1946 and 1941, 55 to 6o percent of dividends pa.id to individuals 

(and institutions treated as individurtls in national income estimates) 

were reported on individual tu returns with net income of $5,000 or 

more, making allowance for the part of income from fiduciaries estimated to be dividends. Most of these individuals presumably had surtax net income in excees of $2,000. ?Jany individuals with net incomes 

of less than $5,000 aleo had surtax net income in excess of $2.000. 
-----------------------

------------------------------- --------------

I 

Chart 3 

TOTAL TAX ON CORPORATE PROFITS UNDER WITHHOLDING PLAN 

·20% BASIC CORPORATE TAX PLUS 20% WITHHOLDING TAX CURRENTLY CREDITED 

TO STOCKHOLDERS AT RATE OF $1 FOR EACH $3 OF CASH DIVIDENDS. 

Aggregate of corporation and individual income fox based on: 

A. Varying percentages ofprofits retained by corporation. 

B. Rote of individual income tax applying to any given stockholder. 

,------------------·------------------------------ -------------------------------------------------,I 

NO PROFITS RETAINED BY CORPORATION 30% OF PROFITS RETAINED BY CORPORATION

lndlvlduol Total Tax as 

Profits I lnc~;;:,rox : 0:! ~~!fi~t 

IOO'r, 

I 

I ® I Dividends-.- I 

I 

I 

I 

I 

I 

I 

I 

I 

I 40o/o 

I 

I 

I 

I

I {Withholding , Et> I 

I 

ICD · 20% I 

: Basic I Corpora-~ 1 tion Tax I 

I 

I 

I 0 I 

100% 

40% 

WithholdingC::::, 

20'4 

'Basic 

Corpora•~ 

tionTox 

0 

60% @ 

SuJJj•cf lo lh• 1 

.. r::i,:~~"m":y/:; .. applying /o. any 

g1~11n •tockhold• 

I 

---.-----------------1· Cr1dll 

. Wllh't:Jdln9... 

----------------' ______! 

100% 

------190% 

------'80% 

-------l70'r, 

0 0 --------------------------- ------·---------· 0

100% ------100% 

90% 

BO% 

70% 

------<90% 

-------'80% 

@) Ruuh/111 .. To/11I ... 

TOK 

------140% 

_______, 30% 

------< 20-W, 

_______,,o<r. 

70% 60% 

@ 00% 60% Subj1cl lo flu ® 

Oiv,dends-. .. ~a;:,:~;"::"/:; • 1JpP/yl11g lo any 40% 

&0% g111•n •tockllold.r

c7:11--~ 

lfllh/lolditll 

10% 

~(- ithho/d~:: m oBasic 

Corpora-!:!} 

lion Tax 

Profils lnc~=,~~ax o~f! ~~!ft;. ,-..------------~•00"4 

~ 

40% 

Cnd/1 lo llloclrhold,n for 10"4

wllhho/dln1:$lfor- $:S . 

of,:a,11 dillithndo -

-------·----------------------------- 0

100% 

40% 

,20% 

Bos1't: 

Corpora- 12$ 

fionTOJI \ ,· 

0 

90% 

BO% 

""" """ 00% 

40% 

'°" 

20% 

10% 

oI 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I @) 60% 

R1111lllflg 

.. Tola/ llt Tox 

-------leO% 

_______,40% 

------<30% 

------<2011, 

------'101(, 

'-------------------------------------------------------------------------------------------· ---------~ I ' I 

VARYING PERCENTAGES OF PROFITS RETAINED I 

BY CORPORATION ILLUSTRATION I 

F~~i:~:.totlon of use, $66 ----T.·,·a,·,,·..•••....-,.... lndl•ldual Total Ta, •• ! 

Profits lnci:,~~ax o~f! ~~:fit, : 

-----------------,oo<r, I 

3⁄4 I

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

0 @

--i..~-="t="-""~""'"1"""'~"""'="1"eo<r.-~ 50.7% 

40% 

N..JOL<NEe::__IOL'Y,--20,,_;,___S_;_O'Y,--40"4..1-_ll_;O,,_..:,___j 20"4 

RETAINED PROFITS 

O Individual income toJt rate 45%. 

8 20% of profits retained by corporation. 

O rota! foJt,, 5a7% of corporation profits. 

101(, 

0 

-------~--------------------------------------·-----.Ji.-----·---------------------------------------------'------

Office of Iha Secretary of Iha Treasury, Division of Tax Rasaarch B-650 
- 49 -

(1)ooUniform mark-up of cash dividends

to ·reflect amount withheldoo

The simplest withholding method would require dividend recipients to 

increase tbei� cash dividends for tax purposea-b7 a uniform fraction to 

reflect the current rate of withholding at the corporate level.· Thu.a, if 

a 4o-percent corporate tax were regarded exclusively aa a vithhoiding tax, 

individual dividend recipients would include in their taxable income 

approximatel7 $1.67 tor each $1 of ca1h dividend• received. It only' half 

of a 40-percent_tax were regarded as a withholding tax, individuals would 

include approximatel7 $1.33 for each $1 of cash dividends.!/· After com­

, p�ti:ng their individual income tax liabilities on net income, including

full nominal dividends, individuals would apply the difference between .nominal and cash dividends as a tax credit, thus reducing their personal 

liabilities. Stockholders not subject to individual income tax would be 

allowed to claim a refund for corporate tax withheld on their dividend 

income. 

(a)ooDividends on preferred stockoo

Unless specifically so provided by legislation, dividends on preferred stock probabl7 would not be reduced by the withholding t� collected trom corporations. g/ If recipien�a of preferred dividends were 

given the same tax credit as holder& of common stock, the7 would get a 

windfall�_ In effect, preferred stockholders would be credited with, an4

receive a refund for, taxes actuall7 borne b7 common stockholders. Thia 

could be avoided only if corporations were apecifics.117 required to reduce 

contractual dividends on preferred stock b7 the amount of the withholding 

tax. iJ Mere denial of a withholding credit to preferred stockholders· 

would not meet the problem. Common stockholders, as residual claimants in 

the-corporation, wo�d typically bear the whole corporate tax. including 

1/ This system would be equivalent to a 20-percent tax on all corporate 

profits and·a 25-percent withholding tax on the bale.nee of corporate 

income after deduction of the basic tax. 

g/ This paragraph is written on the assumption that corporate i ncome 

after taxes would be large enough to cover preferred dividends. 

While this would not always be the case, ,the reasoning would be much 

the same so long as both common and preferred stockholders had a genuine equity in the corporation. 

if Unless the di vi'dends were paid from earnings and profits accumula·ted 

before adoption of the withholding plan., Preferred stockholders would_ in effect largely escape any basic corporate tax not treated as a 

withholding tax� Just as they are now protected from the present.corporate tu. 
.. 

- 50 -

the withholding tax, and would not be adequa.tel.7, recompensed b)" tho mark-up 

and credit ayatem deocribed in the preceding paragraph. y Another w,q ot 

meeting this problem would be to grant corpora ti one a credit for preferred 

� Tidenda paid in arri Ting at the w1 thholding t� base. Thi a would combine 

a general Withholding approach with some features of the d1T1dends-pa1d• 

credit ·appro�h discussed above. 

(b)oo Dividends not pid from currentoo

tul.17 taxable incomeoo

The aimple w1t�old1ng system described aboTe would be reaaonabl7 

•atlatactoey it dividend, were paid only from proflta that had all beenoo

aubJect to the same rate of vi thholding tax. Dividends paid from taxableoo

income of the current-year or a prior year when the withholding rate wasoo

the aame ae the current rate would present no problem •. However. dividendsoo

would often be paid in whole or in part from profit� that had not beenoo

full)" aubJect to the current withholding tax or that had borne a higheroo

rate. If such dividends were treated like those originating from currentoo

taxable income, stockholders would receive credit for more or for leas taxoo

'than had actually been paid on their behalf b7 the corporation. 

(1)ooEarnings and profits accumulatedoo

prior to adoption of planoo

Profi ta retained prior to adoption of the vi thholding plan would have 

been eubJect to a corporate tax but not to withholding. If dividends paid 

from thi1 source were treated as if the7 had been subject to withholding,

the result would be discrimination in favor of s�ockholders in corporations that had previously retained earnings as compared with stockholders 

in corporations that bad regularly diatributed the maJor part of proti ta. 

(2)ooEarnings and profit• aceumulatedoo

aubaeguent to adoption of planoo

If the withholding r&te were Yaried from year to year, many caaea ot 

under- or overstatement of-true withholding and of proper individual tax 

credit• would arise. g/ Presumably the vi thholcling rate would be geared 

to individual. income tax ratee and would need to be changed whenever 

'y Assume, for exampie: corporate profits $100; witiiho!ding tax $lio; preferred dividends $50: hence, available for common dividends $10. The 

withholding tax would have occasioned a $40 or SO-percent reduction in 

income available for common dividends, but the 67-Eercent mark-up would 

give common stockholders credit for a maximum of $6.70· of withholding. 

?} It the vi thhold1ng rate were held constant, the system could be 

arranged so that the basic corporate tax rate could be varied without 

complication. · This would be possible if the withholding rate were 

applied to profits remaining �tor deduction of the baai� tax, instead 

of to _total income • Thia method, ot course, would require a higher 

nominal rate ot vi thholding than a system that would simpl)" impose a 

corporate tax of X�percent and proTide that X-Y percentage points of 

the tax should be conaidered withholding. 
- 51 -

individual tax rates were altered. If rates fluctuated widely, this defect would eeem to be serious enough to require some refinement of the 

simple system already described. 

(c) DiTidenda paid from income partiallz 

or wholly tax-exempt 

J.f withholding were regarded as a. part of the corporR.te tax, a :problem would arise with respect to dividends paid from corporate income that 

is partially or wholly tax-exempt, or subJ~ct to a lower rate of tax than 

other kinds of income. This would include partially tax-exempt interest, 

wholly tax-exempt interest, excess of percentage depletion over cos~ depletion, and perhaps capital gains and other kinds of income. Unless an 

adjustment were made, the simple withholding method involving a uniform 

mark-up would give credit for more than the actual amount withheld on such 

income. !./ 

One solution would be to adjust the withholding rate upward on income 

not subject to the regular corporate tax rate, .so that the simple mark-up 

treatment could be applied to dividends pa.id from such income. For ex­

~le, the excess of percentage depletion over coat depletion might be exempt from the basic corporate tax but subject to a 25-percent withholding 

tax. This would permit a one-third mark-up of dividends paid from this 

income, as of other dividends under a plan ca.lling for a 2()-percent basic 

tax and a 20-percent withholding tax. g/ This solution, however, might 

not be considered· appropriate for dividends paid from wholly tax-exempt 

interest. · 

If withholding were regarded as an advance payment of stockholders• 

tax lia.bilities rather than a tax on the corporation, it might be possible 

!f"i'or example, partially tax-exempt•interest might be subje~t to a basic 

tax of 10 percent.and ordinary corporate income to a basic tax of 20 

percent, with an additional 20-percent tax on all corporate income, 

which would be treated as withholding. The corporation would thus paya 30-percent tax on partially tax-6xempt interest. Out of $100 of 

such income received by a corporation, stockholders might be paid cash 

dividends of $70. If stockholders applied the regular one-third mark:­

up, the cash dividends would be increased to $93.33 of tAXable income; 

stockholders would receive credit for $23.33 or withholding ($93.33 

taxable dividends minus $70 cash dividends). Yet the amount withheld 

on this $100 of corporate income would actually have been only $20. 

gJ Similarly, in the case of income subject to say one-half the basic 

corpore.te rate, e. 32.5-percent tax might b~ imposed, consisting of 10- percent basic tax and 22.5-percent withholding tax. This modification 

would make a one-third mark-up appropriate -- (100 percent - 32.5 percent)l-1/3 = 90 percent, which is 100 percent of partially tax-~xempt 

income minu~ the basic corporate tax of 10 ~ercent. 

( . 
- 52 -

to ignore distinctions among types of corporate income. Withholding might 

be applied at the same rate to all income from which dividende could be 

paid, including wholly end partially ta:z:-exempt interest and similar items, 

as well as ordinsry income. At present, wholl.7 tax-exempt interest, for 

example, is no~ subject to corporate tu:, but dividends paid from such interest are taxable income in the hands or stockholders. y The withhold.:. 

ing system would not impose a corporate tax on tax-exempt income, but it 

would require corporations to withhold in advance.a portion of stockhold-

.ers• presumed taxes on dividends that might be paid out of such income. 

This withholding plan would differ from. the present method of wi.thholding on salaries and wages in that no account would be taken of dividend recipients• personal exemptions. {However, 11' withholding exceeded 

the individual stockholder•• tax liability, he would receive a refund from 

the Trea.suey-. ) 

(d) Dividends paid from capital 

, 

Dividend~ paidtrom capital are now not taxable to stockholders and 

hence must now be segregated from other dividends. Under a withholding 

system, dividends :paid from capital would present no new problems. 

· (e) Intercorporate dividends 

Dividends received from other domestic corporations that had been 

subject to the withholding tax should be exempt !rom the withholding requirement in the hands of a stockholding corporation. It might also be 

considered desirable to exempt intercorporate dividends from any basic , 

corporation tax not treated as a withholding tax. It would probably be 

necessary to trace intercorporate dividends back through the different 

corporate layers to detel"!!line exactly how much had been withheld on .them, 

so that proper credit could be given-to individual stockholde~s who might 

receive dividends paid b7 the stockholding corporation out of the dividends that it had received from other corporations. This tracing would 

require some a.rbitrary rule as to the source from which dividends are paid. 

(f) Relief for small corporations 

If a lower tax were desired for-sm~ll corporations, the tax rate 

could be graduated. This would give rise to the same kind of complications at the individual level as would be associated with other kinds of 

corporate 1nc~me taxed at less than the stand.a.rd rate. A uniform percentage mark-up of dividends for tax purposes might #;lve stockholders in small 

corporations credit for more then the actual amount of withholding. This 

difficulty could be met in the sa~e way as the similar problem discussed 

in the preceding section -- by a higher withholding rate. In this case, 

there might be objection to such a solution because it would put a drain 

!) Regulations 111. sec. 29.115-3. 
- 53 - . 

on the cash resources of small corporations a.nd would result in overwithholding on the dividends of many stockholders in small corporations. 

Moreover, adherence to the simple mark-up system would greatly restrict 

the scope of possible graduation of the corporate rate scale. With a one-. 

third mark-up,, for ex.ample. the beginning corporate rate could not be less 

than 25 ·percent, and would have to be higher if some bade corporate tax · in addition to w1 thholding, were de~red for the smallest corporations. !f 

· {2) Exact allocation of withholding 

with reports to stockholders 

From the foregoing discussion it appears that some, but not all, of 

the problems encountered with the simplest version of the withholding 

approach could be met b7 relatively minor adJustments. However, there 

seems to be no satisfactory wa.7 of making sure in all cases that a uniform 

mark-up of cash dividends received by _individuals would result in an accurate statement of actual withholding on the protit1 trom which the dividends were paid. The most serious difficulties would arise in connection 

with dividends paid from earnings and profits accumulated prior to adop• 

tion of the plan, from wholly tax-exempt intereet, and from profits of 

prior 7ears when different rates of withholding were in effect. · 

A more refined method would be to require corporations to report to 

each stockholder and the :Bureau of Internal Revenue the precise amount 

withheld on aIIY' ca&h dividends paid. Stockholders would use this report 

rather-than a uniform mark-up in tiling their returns. 

Under this method, corporations would compute tax on thefr net,income 

in the usual way, or with the adjustments in withholding rates :previously 

mentioned tor certain tn,es of income. When dividends were paid they 

would allocate the withholding tax between distributed and undistributed 

profits. If dividends exceeded net income of the current 7ear, a last-1nf1ret-out rule or some other convention could be applied to determine the 

source from which the dividends were paid. Dividends would be applied 

first against income of the current year and· then against retained income 

of the immediately preceding year and so on back to earlier years. 

y With a one-third mark-u:p system the beginning corporate rate might be 

25 percent, which would all be withholding. Corporations in the_ next 

size group might be subject to a JO-percent rate. In this group a 

corporation would pay- $30 of tax on $100 of profits a.nd might then 

distribute $70 of ca.sh dividends. The cash dividends would be marked 

up to $93.33 for te.x purposes, an~ stockholders would get credit for 

$23.33 of withholding. The remaining $6.67 of tax peid by the corpo- .ration would be considered the basic corporation tax. It can be 

readil1 seen that such a system would leave little room fo.r variations 

in the basic tax and withholding tax paid by small corporations. 
- 54 -

Either of two ·rules could be adopted for dividends assumed to be paid 

from non-te.xable income or income subject to less than the standard corpor~te tax rate. Such income could be prorated between dividends end retained incooe e.nd each dividend assumed to be composed partly of ordinary 

income and partly of non-taxable inco~e. Alternatively, it could be 

assumed that dividends were 'P~,id first from non-taxable income of prior 

years up to the amount of that income and from taxable income of the current year on~ after non-taxable income of prior years was exhausted. 

Having determined the source of dividends paid, the corporation could 

determine the amount of te.x which had been withheld on the dividend. The 

cori::oration would report to each stockholder the caah dividend and the 

withholding tax allocable to it, and the sum of these two items would be 

the nominal dividend that would be included in the stockholder• s taxable 

income. Apparently these reports would have to be made at the close of 

the corporR.tion's tax year to all st-0ckholdera of record at dividend dates 

during the year. 

One technical difficulty under the method would arise from adjustments of prior-year corporate income due to audit, carrybacks, or court 

decision. A deficiency in corporate income would require an additional 

corporate te.x and additional withholding. But a reduction in corpornte 

net income originally reported would not necessarily warrant refund of a 

:pa.rt of the amount previously vi thheld. Stockholders might already have 

_received credit for the vithholding originally reported. Proba.bly refunds 

could properly be made to the corporation for excessiTe withholdi~ only 

if application of the last-in-first-out or similar rule showed that the 

income originally reported had not been distributed. 

The exact-allocation method would obviate difficulties of the uniform 

JnB.rk-up method related to dividends paid f'ro:n funds not subject to the full 

r~te of withholding. It would, however. occasion a ls.rge amount of paper 

work both for corporations and individual taxpayers. Difficulties of verifying and auditing individual returns would be greatly increased. The 

system might induce adoption of once-a-year dividend policies. 

f. Relation of withholding to taxation of cAnital 

gains and losses realized on stock 

It has been suggested that under 8: withholding pls.n an adjustment 

should be lll8.de in taxation of CRpi tal ga.int!I realized on stock, to take 

account of the fact that undistributed profits that may be responsible for 

a.t least a part of the capits.l gains have been subject to withholding. !/ 

The Justification for an ~dJustment ,would be similar to that under the 

y Harold !-!. Groves, Production, Jobs and Taxes (New York, 1944). pp. 46,:- 47. Groves has later reconsidered and withdrawn his earlier recommendation. See hie, Poatwar Ta:r:ation and Economic Progress (Nev York, 

1946), :P• x. 
- 55 -

partnership method., Under �he partnership method reteined earnings would 

be currently taxed to individual stockholders, and the basis of stock 

would be increased as if stocr.holders had made an additional investreent in 

the corporation. While tp.e withholding plan would not _go so far a.s the 

partnership pl:e.n, 1 t would collect a. tax. on retained earnings on behalf ot

stockholders.- . A stockholder may realize his share of retained earnings 

either by selling his stock at a gain or by receiving a dividend. Under 

the withholding method he would get a tax credit if he received a dividend 

but no credit if he realized a cepital gain. The result would appear to 

be a _discrimination against capital gains. 

Closer ·exe.mina.tion, however, suggests that the discrimins.tion e.gainst 

capital gAins might be less extreme than it would appear at fir�t sight. 

To some extent, stockholders who sold their stock would "cash in" on their 

share of withholding on retained profits in the form of higher prices for 

the stock. A share of stock in a corporation that had retained profits . would in effect carry with it a tax re�eipt for withholding on the retained profits. The hypothetical tax receipt would be redeemable when-· the 

retained -profits ·were paid cut in dividends. The :prices a.t which sto�k 

sold would reflect the v�.lue of withholding as well as retained profits. 

If investors expected that the retained profits would be �aid out soon, 

stock prices might include 1

almost the full amount of the withholding. In 

that event, the stockholder who sold his stock would get his share of 

withholding on retained profits as a part of his ca-pital gain. The stockholder who realized his share of earnings in the form of a dividend would 

get a tax credit for his share of withholding, and would include the 

credit in his taxable income. Full taxation of the seller's cepitnl gain 

would involve no discrimination against him as compared with the dividend 

recipient. In other cases, however, the mA.rket price of stock _would not 

reflect the full �Jllount of withholding, and sellers would not get the full 

benefit of withholding. If investors expected that a corporation would 

:postpone :paying out its retained earnings for several years, a. time discount would attach to the M.les price of withholding associated with 1 ts 

retained earnings. If investors anticipated that retained eernin·gs 

tt would

never be paid out .in dividends, the withholding related to them might add 

little or nothing to the market value of the corpore.tiont1 s stock.!} Full 

taxation of c-a-pital gains in the latter two· kinds of ce.ses would mean some 

discrimination • 

. Any discrimination against capital gains arising out of retained 

earnings would not be serious so long as capital gains are subject to the 

present comparatively low tax rate. Such discrimination would become 

worse, however, if the tax rate on capital·gains were to be raised toward 

that on ordinary income. Soma people, who believe tha.t·more effective 

taxation of capital gains is especially important, fear that discrimination a.gs.inst capital ge.ins might be used as an argument for _continuing the 

y The retained profits would still have a market velue, however, if investors thought tha.t the corport!l.tion would etirn a. return on them in 

the future. 
present low tax rate on capital gains. They consider this an objection to 

a withholding system or any other approach ·that would put a·ta.x on undistributed corporate profits and not adjust the basis of stock to take 

account of that te.x. y 

A satisfactory adjust:nent df the capital ga.ins true to take .account of 

previous withholding on retained corporate ea.rnings would be very difficult. An arrangement almost as elaborate as the full partnership method 

would be needed to determine exactly how much undistributed profits and 

withholding on them accrued on a share of stock while it was owned by any 

one person. When a stockholder sold his share, presumably he should get 

credit for withholding related to undiotributed profits accumulated while 

he held the stock. If so, a future holder should not be allowed to claim 

the same withholding when the retained profits were finally paid out in 

dividends. Yot a complicated system would be needed to grant withholding 

credit to the one stockholder and to deny it to the other. 

g. Evaluation 

(1) Equity considerations 

The withholding approach could eliminate every element of double taxation of dividend incoce. Corporate and individual taxation of distributed 

profits could be completely integrated by this method. At the same time, 

undistributed profits vould bo subject to taxation at the corporate level 

and individual tru:: postponement through corporate retention of earnings 

thereby reduced. 

The vi thholding approach, like a credit for corporations for dividend 

distributions, could not.completely equalize current tnxation of distributed and undistributed profits. The withholding rate on undistributed · 

profits would be lover than the marginal tax rate of sooe stockholders, 

higher than that of others. The result would be tax postponement in the 

first case and temporary overpcyment in the second case. Unless the withholding rate were higher than the first-bracket individual rate, there 

would probably be some tax postponement for the majority of retained profits, but not tor the majority of dividend recipients. 

The withholding approach could oo combined with any desired bacic true 

on corporations th~mselvee by treating only part of the corporate true as a 

withholding tax. 

The simplest withholding method, which would mRke no effort to determine the exa.ct source of dividend payments, would often grant too much or 

!/ Only the partnership approach and the so-called capital gains approach 

· would entirely avoid the problem. 
- 57 -

too little credit for withholding. A more refined method, which allocated 

withholding in a rather _precise (albeit arbitrary) wq to particular diTid.end p~enta, would be a great improvement from the standpoint of equity. 

(~) Economic considerations 

A withholding plan would be the most direct e.pproach to removal of .. tu: impediments to individual investment in stocks. Stockholders would 

not hove to rely on changes in corporate dividend :policy for .a larger net 

return. If cash dividends were maintained, any dividend recipient, whether 

~ or not subJectto personal income tax, would get~ larger yield after taxes. 

The withholding approach would not eliminate the corporate tax as a 

factor in management decisions. Corporations would pay as much in taxes 

as under a corporate tax of the present t;ype imposed at the same rate as 

the withholding tax. The effects of the tax on manage~ent decisions would 

depend to a great extent on how managers thought of the tax. To the ex­

.tent that they considered the withholding tax a coroora.te tex, rather than 

a tax on stockholders, they presumably would reac~ to it in mu.ch the sAme 

.w~ as to a corporate tax of the present t;vpe. They would consider the 

'Withholding tax a factor affecting the profitability of invea~ment and the 

length of time necessary to recover capital outl~s in risky fields. To 

the extent that managers -looked on the withholding tax as something that 

could be written off their books when dividends were paid, the effect of · the tax on investment decisions would be similar to that of a tax under a 

dividends•paid•credit plan. took~d at from this latter point of view. the 

withholding system would appear to be composed of two elements - a tax on. 

undistributed corporate profits and collection at source of individual 

taxes on dividends. 

A withholding tu would restrict the maximum amount of invest~ent 

funds availAble to a corporation from internal sources as much as the 

present type of tA.X or a tax under a dividends-paid-credit plan. If corporation managers looked forward to the opportunity of writing the withholding tax off their books when they distributed dividends, the withholding tax would offer mu.ch the sa~e incentive to pA,Y dividends.as a . dividends-paid-credit plan. A withholding-tax plan would leave corporations less funds to pay cash dividends than would a dividends-:i;mid-credit 

plan, but the tex credit to stockholders for withhol~ing together v.'-th ~efunds for overwithholding would probably make stockholders content with 

smaller c;:ash dividends. The withholding plan would probably ma..lte it 

easier for corporations to.obtain new outside e~'t,lity capital. bui it seems 

li~ely that profit prospects must be.better to induce corporations to 

raise and inTest ·such new funds ~han to· induce them to invest 1nt_erna.l 

funds. 

If management consciously tries to mark up prices and hold down wages 

to recoup the corporation income tax, ado~tion of a withholding plan wouli 

be less likely to change this than a. reduction of th_e present corporation 

income t,a or adoption of a divid~nds-paid-credit plan. 
- 5g -

(3) Administrative considerationsee

The withholding method in its simplest form would present no grave 

administrative difficulties. Admittedly, the plan would somewhat complicate the individual tax return, and refunds for overvlthholding might be a 

problem. A more refined and more equitable withholding method would result 1n rather serious administrative problems attributable mainly to 

efforts to trace various kinds of income through the corporation in order 

to determine how much withholding tax should be credited on particule,r

di�idend payments. 

2.eeDividends-received-credit &pProachee

Another variation of the general approach to coordination of corporate.and individual taxes through an adJustment at the individual level 

would be to allow stockholders a credit or exemption for dividends received. Dividends received would be exempt from normal tax or from the 

first bracket·ot the individual tax; or stockholders would be granted a 

tax credit equal to the amount of dividends received multiplied by the normal or !iret-bracket tax rate. Dividends would be subject to individual 

. surtax rates or rates in excess of the fi�st-bracket rate. Advocates of 

this approach usually contemplste a corporate tax rate equal to the individual �ormal ta.x or first-bracket rate, but it would be possible to have 

a higher corporate tax rate. The dividends-received-credit approach is 

similar to the plan used in the United States prior to 1936. y 

Chart 4 illustrates a pa,rticular dividend�-received-credit plan,

under which a 4o-percent corporate tax would be imposed and dividends received by individua.1 stockholders would be exempt from the first 20- percentage points of individual incom� tax. Like the charts illustrating 

the plans already discussed, Chart 4 shows how the corporate and individual truces combine to give the total tax on corporate profi,ts for a:ny given 

stockholder and any dividend policy. The effect of exempting dividends 

received from �he first 20-percentage points of the individual tax is 

shown in the chart by the dropping of the individual rate scale. For stockholders subject to more than a 20-percent tax rate on ordinary inco!ne, the 

personal income tax on dividends is always 20-percentage points less'than 

the tax on otller kinds of income. But the total tax on corporate profits 

is ·never lees than 4o ·percent, since the exemption meai1s nothing to stockholders who would not be tax�ble in any case. 

a.eeRationaleee

The dividends-received-credit approach resembles in some respects the 

withholding approach, but it ·differs from that ap�roach in certain other 

important ·respects. Advocates of the dividends-received-credit approach would Justify reducing the individual tax on dividend income on the 

y The dividends-received�credit approach _has been recom�ended by a 

Committe·e on Postwar· Tax Policy, under the chairmanship of Mr. Roswell 

Magill. See the report or the Committee, A Tax Program for a Solvent 

America (1945), pp. 98-103.
------------------------------------ 30% OF PROFITS RETAINED BY CORPORATION 

tndlviduol Total Tox GI 

lnc:;;:_raic !a1! ~~!fi;t 

® Oi11id11nds-+ 

® !00% 

Subj#r:I to lh• 903⁄4 --@- rat• 11f Ind/rid-- eo., Jhsulting

11,11 lwcom• lox .. 70% .. rotol • applying- ro a11y 60,, Tox gi~•" ,tcekl1<>ltllr' 5()"1,, -~--~~- 40% 

"°"' l!O.. 

-------110"4 

0 ,_ -- ---------- ---- - -----·---- --·---- 0 

·-------------------------

ILLUSTRATION 

I 

I 

I 

I 

I 

Chari 4 

TOTAL TAX ON CORPORATE PROFITS UNDER DIVIDENDS - RECEIVED CREDIT PLAN 

40% CORPORATE TAX; OIVIOENOS EXEMPT FROM FIRST 20% POINTS OF INOIVIOUAL TAX. 

Aggregate of corpora lion and individual income lox based on: 

A. Varying percentages ofprofits retained by corporation. 

8. Rote ofindividual income tax applying to any given stoc/rholder. 

I For 11/ustrotion of use. sell --------111!'-..........._llo I 

:

I o """"""-------------------------------------- o I 0 -·-····-·---·.,...-·------------------ ' ·-----· 0

·--------------------~-------J,____ ·---------------------------JI 

' 

~ 

I 

I NO PROFITS RETAINED BY CORPORATION 

r lndlvlduol Total Tox as I Profils Income Tax !a:! ~~!Ti;. I 100,;.--.,c---- Rollu ------,IOOT, 

i 

I 

I -------l90T, I 100"1.

I 

I 

I 90.. I -------l80T, I 

I 

I 

I 

I 

I ® I , Oividends-+ I 

I 

I 

l 

I 40.. 

-------150T, 

303⁄4 

! 

I 

I 

1· 

I 

I 

I 

I 

I 

I 

I 

I· 

I 

I

,------·-------------- ! 

60'4 

---~---1 10"4 

0 ----------------- ----- - ---- -- - -------------- ______ 0 ,____,__ 

I VARYING PERCENTAGES OF PROFITS RETAINED I BY CORPORATION , I 

1 lndlvldual Total Tax <H 

I Profits lni.~!1~:ox o~f: ~:!fl;. I 

I IOOT, 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

l 

I 

I 

I 

I 

l 

I 

l 

I 

I 

I 

: 

! 

'i•:, 

~~;:%:- ~ 

l

l 

-<l------'---------100,; 

------------- 9~ 

2 '-, 0'Y. : 1 1 : :

\\,. -+{0!~::,0 ~ ~~~r;~i:~n~~:. ~~ l \ . - i l points of lndiYiduol income ta:it. 

'~-~;__~!__~!__i~-~--1 30', 

NONE • IOT, : 20T, I 30% I , 40% ! : ' 50T, 30T, I NONE 10"4 20T, 30"4 40T, 50% 

RETAINEO PROFITS RETAINED PROFITS 

- 201. .~~;:o;:x-~ k'4<)0;>-a-----'~-----'------","7 20T,

0 lndi11i<luo/ incomo fox roto 45%. I 

I O 20% ofprofits n,toinod by corporotlon. 10"4 IDT, .9 Toto/ fox• 50% of corporation profits. I 

~ I tndlvlduol Total Tait 01 I lncomt To11 I Profits Rottt o~f~ ~~;fi;, I 100"4 

\ i \,,j_ 

'\OT, 

. ~o;,;de~d• tx•m~t from ,/,., 20% 

100"4 I 

I 

I 

I 

I 90"4 I 

I 

I 

I 

60T, I 

I 

l 

I 

I 70T, I 

I 

! 

I 

I 60"4 

9 

50"4-•50% 

40"4 

-----~I00T, 

-------,90T, 

-----760"4 

-------,70"4 

Office, of the Secretory of the Treasury, Division of Toi Research 8-651 

I 
·' - 59 -

gro,mda that the corporate tax should be considered a partial payment ot 

~he tax liability of dividend recipients. However, the dividenda-receivedcredit approach would not follow this logic to its conclusion. Like the 

w1 thholding approach, 1 t would in eft,ect ·appl.1' part or all of the corporate tsx to th~ liabilities of individual 1tockholdera, but. unlike the 

withholding approach, it would not include.the corporate tax in the tuable income of dividend recipients~ For discharge of personal tax liability, the dividenda•received-credit approach would operate as ~f stockhold• 

ers had actually paid the· corporate tax from their own 1nco1118; but "in 

assessing personal tax liability, the corporate tax would not be considered a part of s_tockholdera• income. Moreover., the dividends-receivedcredit approach would make no adJustment for corporate tax on dividends 

paid to stockholder• not_subJect to individual income tax. To be sure, 

there is onl7 one tax in·the,caee of dividends paid to non-tnable reciptenta, but the real significance of the double-taxation criticism of tho 

present corporate tax system is not that there are two different tuea but 

that dividends are taxed more heavily than other kinda of income. 

' b. Implicit rate structure 

. The net reault of the divid.ends-received-credi t approach. would be 

vastly different tax benefits for persona at different income levels. 

Und~r this approach, the total tu on profits earned for stockholders with 

incomes too small to be subject to individual income tax would remain as 

high as under the present system. At the other extreme, the total tax on 

corporate profits earned for high-income itockholdera would be less than 

the tax on other kinds of income. It no profits were retained. by the corporation, the total tax in the case of high-income stockholders would be 

less under the dividends-received-credit approach than if no corporate tax 

were 1:mposed and dividends were su.bJect onl7'to the regular individual income tax. · If, as is often proposed, the corporate tax rate and the individual norma.l tu or first-bracket rate were equal, the dividends-received- . credit plan would result in combined corporate and individual taxes lower · than the regular 1ndivi~ual tax alone in the case of all profits distributed to stockholders subject to more than the minimum individual tax rate.· 

:a,. its nature, the dividends-received-credit approach would not benefit · low-income stockholders, but it would offer substantial advantages to 

stockhold..ers "1th high incomes. 

The implicit rate structure under a particular dividende-receivedcred.1 t plan··1s illustrated in the following table. The table also shows 

for comparison the total tax under a super:ticiall:, similar withholding 

approach. The table shows the·total tax on·corporate profits for stockholders subJeet to different individual tax rates, on the assumption that 

the corporation retains none of the profits. Alternatively, the figures .. mq be rega;-ded as the total tax on the distributed portion of profit, 

including in distributed ~rofits the corporate tu relating to dividend.I 

¢~ . 
6o -

Stockholder's 

regμle.r 

individual 

ta:r rate 

Total tax!] :. 

~D::-i=-v~i~d=-e-n"".:d.~s---r-ec_e_i~v-e-d=----=---------

: credit plan : Withholding system 

:(40~ corporate tax; div-:(2~ baaic corporate 

:idends exempt from first: · tax plus 

: 20-percent9'e points of:20-;t withholding tax)

individual tax) ··-

o:t 4o~ 

20 4o· 2°' 36 

4o 52 52 

6o 64 6g 

80 76 84 

!/ This comparison assumes that under the withholding system 

·refunds would be made to individuals whose taJC was lower 

than the withholding rate and that cash dividends plus , 

- the amount withheld would be included in individual. taxs.ble income. 

The foregoing table brings out the characteristics of the dividends• 

received-credit approach. As compared with the wfthholding plan. the 

dividends-received-credit plan would impose a much higher tax in the case 

or low-income stockholders (who are subject to the lover individual tax 

rates); but in the case of high-income stockholders (who e.re subject to 

high individual tax rates), the total tax would be less under the dividend.sreceived-credit plan. As the table shows. the total tax would be lees in 

the case of upper-bracket stockholders than the individual t,u: alone, without any cor~orate tax at all. Under the particular version of the 

dividends-received-credit approach illustrated in the table, this lastmentioned peculiarity becomes evident only for very high individual tax 

rates, but under other versions of the approach it would be evident over a 

much ~ider range of individual tax rates. lf 

g The breaking point would be where the following equation was satisfied: 

. Rsi (l - Re)+ .Re= But+ Rsi, 

where R8 i is the average rate of individual surtax on dividend income: 

Rc is the corporate true rate; and Rni is the individual normal or 

first-bracket tax rate. - · • 

With a 4o-percent corporate rate and a 20-percent individual normal or first-bracket tax rate, the breaking point would be at a 50- percent a.verE1,ge individual surtax rate (70-percent aggregate regular 

individual rate) on dividend income. For higher individual rA.tes, the 

combined ta.x on distributed profits would be lower than the individual 

tax alone. For lower surtax· rates, the combined te.x ':Would be greater•. 

With equal cor:oorA.te and individual normal tu rates (Rc = ~ 1). the 

combined corporate and individual taxes would always be lower than the 

individual tax ~lone, if the stockholder were subject to surtox. 
- 61 -

c. Posuible modifications of the dividendsreceived-credit system 

Some of the anomalies of the dividenda-received-credit system_ would 

be eliminated if incij.viduals were required to include _the full value of 

di'V'idende (before deducting the corporate tax) in their aurtax income. 

With a 20-percent corporate tax and dividends exempt from an individua.l 

norme.l tax of 20 percent, ,stockholders would report for surtax purposes 

their C8sh dividends increased by- one-third. This modification would 

transform the system into a withholding tu approach. but without refunds .. for individuals not subject to personal income tax• 

Another possible modification of the dividends-received-credit - - approach that would eliminate the discrimination in favor of dividend income inherent in the unmodified plan would be to allow all tarpB7era to 

deduct the normru. te.x f'rom taxa.ble income in computing the surtax. - With 

respect to all taxable income except cash dividends and partially taxexempt interest·, the tu:pa.ver would be entitled to a. deduction f'or the 

normal trot paid. but on items of income on which no normal tax was imposed 

there would be no deduction. This method would have the undesirable 

effect of mtik:ing tax rates seem higher than they actua.117 vere. To raise 

any given amount of revenue. higher nominal surtax rates would be required 

than under the present system,. For example, a. normal tax rate of 20 percent plus a surtax rate of 50 percent would add up to a 6o-percent combined rate rather than 70 percent. Moreover, this modification ot the 

dividends-received-credit approach would still give no benefit to the 

stockholder with income too small to be subJect to the individual incoma 

tax. 

d. Evaluation 

(1) Equitr considerations 

The inequitable character of the implicit rate structure of the 

dividends-received-credit system would be its most serious disadvantage. 

The system would discriminate a.ga.inct low-income dividend recipients and 

in favor of high-income dividend recipients. - · 

The system would not completely eliminate double taxs.tion of distributed profits but it would reduce the· degree of double taxation. In the 

highest income bracket dividends might be taxed at lower rates than other 

kinds of income. In lower brackets distributed profits would still bear a 

higher tax than other income. 

(2) Economic considerations 

In common with other a.d,Justments e.t the individual level, the 

dividends-received-credit s7stem would leave the corporate tax as a possible factor in management decision~ as to investment and price and wage ✓ policies. · It would reduce. but not wholly eliminate, tax discrimination 
62 -

~ainst equity financing. It vould make investment in stock especially 

attractive to wes.lthy individuals. 

(3) Administra.tive consideretions 

The dividends-received-credit system would be easier to administer 

than the other methods of coordination that have been discussed in this 

report. Ad.ministra.tive simplicity would be the chief advantage of the 

dividends-received-credit approach. 

3. Partial exclusion of dividends received 

· from individual taxable income 

Still another adjustment at the individual level, somewhat related to 

the divi dends-received-credit approach. would be to exclude a pa.rt of dividends received from individual taxable income. For example, a 4o-percent 

corporation income tax.might be imposed and individual stockholders 

allowed to exclude from taxable income some stated frs.ction of dividends 

received.!} 

Chart 5 shows the total tax on corporate profits under a particular 

dividend-exclusion plan. which would provide for a 4o-percent corporate 

tl'!,X and exclusion from individual te.xable income of 4o percent of dividends received. This chart is drawn in the srune wey as the preceding ones. 

tTnder the plan illustrated the corporate tax would alvays be 40 :percent. 

but the individual tax would be influenced both by the dividend exclusion 

and the portion of profits retained by the corpornticn. The dividend exclusion. represented in the u~per half of the cha.rt by the shaded bar and 

in the lower half by the shaded ·area above the top individual-ra.te line, 

causes the individuel rate scale to contract. This 1 of course, greatly 

lessens the tax loed on dividends under any given individual rate schedule. 

a. Rationale 

The intent of the dividend-exclusion approach apparently would be to 

reduce the individual tax on dividends in recognition of the fact that 

corpora.te profits have been subject to a corpora.te tax. Exclusion of a 

portion of dividends received from taxable income would reduce the individual tax on them, but the reduction would bear little relation to the 

amount of tax already' paid by the corp9ration. Tbe reduction in individual tax would depend on the tax value of the exclusion from taxable income, 

which in turn would be governed by the top rate applicable to the stockholder's income. Although all corporate profits would have borne the same 

rete of corporate tax, the individual adjustment to take account of this 

A specific plan proposed: by a group of Y.innesota businesamen called il for .a 4o-percent corporate tax l!.nd exclusion of 4o percent of dividends received. See, Twin Cities Research :Bureau, Inc., Postwar Taxes, 

The Twin Cities Plan, Saint Paul, Minnesota (1944). 
------------

Chart 5 

TOTAL TAX ON -CORPORATE,iPROFITS UNDER DIVIDENDS EXCLUSION PLAN 

40% CORPOf:iATE TAX; INDIVIDUALS EXCLUDE 40% OF DIVIDENDS R~CEIVED FROM TAXABLE INCOME. 

Aggrsgote of corporation (JJ'ld indivldualinconie lax based on: 

A. Varying psrcentogs8 ofprofi/8 retoinsd bj corporofion. 

· B. Rote oflndividuo/income lox applying la ony givsn stockholder. 

@,,._,,,, .. Toi/II .. Ttlit 

' 

80 

70 

110 

50 

10 

I 

I. ... •-- ICOY. @ 

Dividends .. 

-< -80% 

@ ,.,,._ SII/Jju_l lolH ...... r::1::.:::•,"t; .. 50'JI, 11/IPlrllt, IO ,,,,, ,,,.,, stot;tllo/tW' 

-

so,i, 

20% 

10% 

,0 

@

_.a.::;::, .. Tllit 

© 

Corporo-.,.:,. 40,. ------120% llonTt11t "'+' 

------110% I --------- . ----- . ____ ... _,.._______________ 0 0 0 ------------ 0 

' . i 

VARYING PERCENTAGES OF PROFITS RETAINED l 

BY CORPORATION . For 11/ustration of use. see _________, 

Individual Tatal TGll a1 

Profits '"i::~o~ •~~fij, ·•---'-----------,1100% 

------------t9O% 

100% 

NONE IQ% 2°" 50% 40% 110% 

RETAINED PROFITS 

Corportl~ 

lionTox ~ 

0 --------------------------------------- 0 

. 

I 

._ I ____ ____o 

lndlv:u~LUSTRATION TotalT••·..----il 

Profits ln,=~a•. o~f: ~~:ftf, 100%-...---,.,---~~--------,1100% 

'40% 

-----------190% 

20% 50% 40% 110% 

,. 

RETAINED PROFITS 

O lndividl/QI income tox rote 45%. 

0 20% of profits retoined by corporation. 

0 TiJtol_tox• 50.8% of corporation profits. 

-------_------_---.----=== •~_-J ·--------------------- __ 

Office of the Sec~ry of the Treasury, Olvielon of Tax ReHorch 8-651? 

I 
- b3 -

tax would differ greatly among dividend recipients. Exclusion of 4o percent of dividends received from individual ta:rable income would not make a 

4();.percent corporate tu in any sense e~uivalent to a withholding tex, nor 

would.the plan be equivalent to a dividends-received-credit plan. 

b•. l!DP11c1t rate structure 

The dividend-exclusion approach would reduce the weight of taxation 

on corporate profits diatributed to stockholders subject to '.'Personal income tax. The_extent of this reduction would depend on the rate of taxation to which particular stockholders were subject. Stockholders not 

liable for individt1al income tax would receive no benefit; those subject 

to a high tax rate would receive a large benefit. The tax velue of the 

dividend exclusion would increase uniformly with the progression of the 

individU&l income tax. 

With a 4o-percent corporate tax and 4o-percent dividend excluaion. 

the combined individual and corporate taxes on distributed profit• would · never fall below 4o percent and would alwa7a increase as the re.te of tax 

on individual dividend recipients rose. However, in all cases where dividends, if distributed to individuals, would have been subje~t to a tax 

rate above 62.5 percent, this particular scheme would yield a smaller combined tax on distributed profits than would the individual income tax 

alone.!} · · 

. The effect ot the dividend-exclusion plan discussed above ia 1;1ustrated in the following table: 

• 

Stockholder's :Reduction in individual: Total tax 

individual tax rate on dividends: on 

tax rate : (percent8!9 points) distributed profits 

~ ~ 20 8 

4o 16 

6o 24 

80 32 

Y The breaking point would be where the following equation was satisfied: 

Ri lCl - D1) (1 - RJJ + RC= R1, 

where Riis the average rate of individual income tax on dividend income; Di" is the percent of dividends received excluded from individual. 

taxableincome; and Rc the corporate tax rate. 

' 
- 64 -

c. Evaluation 

With regard to equity, economic effects,, and administrative considerations, the dividend-exclusion approach would resembl~ the dividends- . received-cred~t approach. Both approaches would favor high-income stockholders as compared with those with low incomes, but the dividend-exclusion 

plan would go further in this direction. For this reason, the dividendexclusion approach would probably make stock even more attractive to 

wealthy investors than would the dividends-received-credit plan. 

E. SUmmarz comparison of methods of coordination and 

estimates of,revenue field of illustrative plans 

The objective of plans for coordinating corporate and individual 

ta:z:es is to reduce inequalities between total taxes on corporate profits 

and on other kinds of income. The problem of achieving equality of taxation has two sides. One side is elimination or reduction of "double taxation, 11 that is, keeping corporate profits from being taxed more heavily 

than other kinds of income. The other side is prevention or limitation of 

tax postponement and avoidance, that is, keeping corpore.te -profits from 

being taxed less tha.n other,kinds of income. 

The only wsy to a.ssure complete equality of taxation of all corporate 

profits and other kinds of income is to eliminate the corporate tax and to 

tax stockholder~ on their full share of corporate profits, withoμt regard 

to whether the profits are distributed or retained by the corporation. 

This may be called the partnership approach, since it disregards the cor-

• . porate entity for tax purposes and treats stockholders as partners. The 

partnership approach achieves complete equality of taxation by looking 

through the corporate entity ~d taxing ~rofits retained by the corporation in the same way as profits distributed to stockholders. No other 

approach to coordins.tion does this. Since corporations do not distribute 

all of their profits, all other approaches must :f'all short of co!ll!)lete 

e·quali ty of taxation of corporate profits and other income. 

The distributed part of corporate pro:f'i ts could be taxed at exactly 

the same ra.te·s as other kinds of income under any of the four basic 

a~~roaches to coordination discussed in this memorandum. These basic 

approaches.are; (1) the partnership approach, which would disregard the 

corporate entity for tax purposes and currently tax stockholders on thetr 

full share of corporate profits, whether distributed or retained; (2) the 

capital-gains approach, which would eliminate the corporate tax and tax 

stockholders on realized capital gains at regular individual rates; (3) 

the approach that would reduce the co~orate tax when profits were distributed as dividends; (4) the approach that would adjust stockholders• 

taxes to take account of the fact that corporations have paid taxes on 

profits from which dividends are distributed. 
- 65 - . 

Th~ 9art of corporate prc:f'its retained by corporationo could be taxed 

at exa.ctly the same rates as other kinds of income only- under the partnership approach. Under the three other basic approaches, totA.l taxes on 

corporate profits would be affected by the amo~t of profits.retained b1 

the corporation. Under some conditions undistributed profits would be 

taxed less· heavily than other kinds of income. Under other conditions un• 

distributed profits would be taxed more heavily.than other kinds of income. 

Some stockholders would gain at least a tempor8.l7' tax advantage by having 

their share of profits retained in.the corporation. Under the two, 

approaches that would require collection of a ~ax from corporations. other , taxpayers would suffer at least a. temporary- te.x disadvantage by having 

their share of te.xes retained in the corporation. One important problem 

in coordinating taxes on corporate profits ia how to minimize differences 

in taxation of corporate profits a.nd other kinda of income attributable to 

the fact that corporations retain part of their profits. 

All a:pproa,ches except the partnership of necessity fall short of complete equality of taxation ot retained profits a.nd other kinds of income. 

Moreover, specific versions of approaches that would levy a tax on the 

corporation may also depart from complete equality of taxation of distributed profits end other kinds of income, but such departures are a matter of 

deliberate choice. Advocates of these plans may wish to stop short of 

complete elimination of additional truces on corporate profits because of 

their appraisal of revenue needs a.nd their doubts about the complete Talid:­

ity of the case against the present corporate tax system. Among the . specific plans presented for illustrative purposes in this memorandum. the 

dividends-paid-credit plan, withholding.plan, dividends-received-credit 

plan, and dividend-exclusion plan, all retain some corporate tax on distributed-profits. Under these plans, distributed profits, as well as retained profits, would be taxed differently from other kinds.of income. 

Chart 6 com-oares, as methods of coordination, some of the specific 

plans discus_sed in this memorandum. To that end, the cha.rt compares the 

total tax on corpornte profits under specific versions of the present corporate tax system and four other plans vith the total tax under the partnership method. The partnership method is used as the stands.rd of complete 

coordination..- The cha.rt is intended to convey only 8. general impression 

of the distribution of total truces on corporate profits under the various 

plans. Emphasis ie on differences in treatment of profits earned for 

high- and low-income stockholders. Chart 6 is drawn on the assumption 

that the corporation retains none of its profits. Alterne.tively, the 

chart l'111'!.Y be thought of as relating to the part of profits that is distributed by' any corporation (including in distributed profits the corporate true relating to that part of profits). Differences among the plans 

shown in the chart relate onl7"t,o distributed profits. ~aeh of the five 

specific plans shown would impose a 4o-percent tax on retained corporate 

profits. 
· - 66 -

The top panels of Chart &are intended to explain the relation between the graphic methods used in this chart and in the first five charts. 

In the top-right and folloYing panels, the broken diagonal line represents 

the total tax on corpor~te profits under the partnership method, which is 

merely the individual tax alone. The solid diagonal line in each case is 

. the total tax (corporate and individual) under the -pA.rticule.r plu bei13g 

coarpared with the partnership method. The shaded area between the two 

diagonals is the difference between the individua.l tax under the partnership pls.n and the total tax under the particular plan under consideration. 

This difference is attributable entirel1 to the corporate tax. Where the 

solid line is above the broken line, the chart indicates that the plan 

under consideration would true distributed corporate profits more heavily 

than other kinds of income. Where the solid line falls below the dotted 

line in the two bottom panels. the plan would tax distributed eor-oorate 

profits less heavily than other kinds of income. By the ~tandard of complete coordination, the former is overtaxation or, broadly speaking, 

"double11 taxation; the latter, undertruc~.tion. 

It can be q_uickl)" seen from the chart that the additionAl tax under 

all five plans is highest on profits earned for low-income stockholders, 

who a.re subject to the low individual tax ra.tes shown toward the left end 

of the top scale in each panel. The gap between the two diagonal lines is 

widest here. Under the present system, the dividends-paid-credit plan, 

and the withholding plan, the gap between the diagonals gradually narrows 

at higher individual tax rates. and completely closes at the illustrative 

100-percent individual tax rate at the extreme right. This means that the 

corporate tax adds less to· the total ta.x on profits earned for high-income 

stockholders than on profits earned for low-income stoc~.holders. The' 

reason is simple. !Ugh-income stockholders, who are subject to high personal tu rates. would pay a high tax on their she.re of corporate profits 

even under the partnership method. In large part, profits taken by the 

corporate tax would otherwise have been taken by the individual tp..x. 

Under both the dividends-paid-credit plan s.nd the withholding plan, the 

net corporate tax:. depicted by the shaded area, is only half that under 

the present system. These two plans would go half wsy toward eliminating 

"double taxation" of distributed profits. 

Under the dividends-received-credit plan and the dividend..;excludon 

plan, the total tax on corporate profits would be less for high-income . stockholders then the individual tax alone under the partnership treatment. 

This is shown in Chart 6 by allowing the solid line to fall below the . 

dotted line toward the right. These two ~lens would go beyond complete 

elimination of double taxation. They would put dividend income o! wealthy 

stockholdere in a preferred position.· 

Chart 6 is .satisfactory for comparing the general distribution of the 

tax load under the plans illustrated. It brings out clearly differences 

in the relative treat~ent of high- and low-income stockholders. However, 

the illustrative plans a.re not strictly comparable, because they would 

yield different amounts of revenue. For this reason, the emct total tax 
---------------------

Chart 6 

TOTAL TAX ON CORPORATE PROFITS UNDER FIVE PLANS 

COMPARED WITH PARTNERSHIP TREATMENT 

Assuming no Profits Retained by Corporation 

PRESENT SYSTEM-40% CORPORATE TAX PARTNERSHIP T~tal Tax" Corporate Tax + lndivlduol Tax TREATMENT 

Total Tax • Individual lox CD As shown in Chart I. --------- ~ As shown for bdtfer comporison 

with Porfnership 7reofment lndividuat Individual Total Ta:it as Income Tax Income Tox 

Rates 

!00% 

90% 

80% 

0% 

Dividends • 

Profits 

"°"' 

30% 

20'Y. 

IO'Y. 

0 

• 

Rotes 

100% 

90o/o 

"""'· 

10% 

"""· "°"'· 

40%, 

IO'Y. 

0 

DIVIDENDS-PAID CREDIT PLAN 

40% Maximum corporate lox; 25% tax credit 

for dividends paid; 20% minimum corporate tax 

INDIVIDUAL INCOME tAX RATE$ 

o/..,, of Corporate INDIVIDUAL INCOME TAX RATES 

JI !00% Profits "- o ID% 20% 30%. 40% ~0% so,. 70% 80,C. 9Q<Y,. 100% i--r'--".,r--,~-,-------.~--,--,-~-,---,---.,. 

90% 

80% 

SO'Y. 

40%-----------40% 

30% 

'°" 

WITHHOLDING PLAN 

20% Basic corporate tax plus 

20% withholding tax 

INOI\IIOUAL INCOME TAX RATES 

0 10% 20% 30'fo 40% e,o,:,,. 60% 70% 80% 90% 100% 100-.. 

IO'll, 

/ 

A~ 

A. ~·"' ~"; 

/Ill• ~,J 

~ IJl"'UI' 

A !11ffi1it \jttv 

llflWJ llllll~ 

Al 1111111,hll 1 I 

rnir1 i~JW 

~~ )~~~~ I 

DIVIOENDS-RECEIVED CREDIT PLAN 

40% Corporate tax; dividends exempt 

from first 20% points of individual tax 

JNDIVJOUAL INCOME TAX RATES 

'°"' 

10% 2:0%- 30% 40'¥.. tl0% 60% 70% SQo/., 90,. IOO% 

.. 

0 IO% 20o/oc 30% 40% ~0% SO,. 7oo. 80o/o. 90% 100% , \00,-o 

90% 

,o... 

o.. i 

,. (f!Pr 

A JPV 

A iLU•' 

•

w-1," 

.-! 111ll 1w·· 

Al 111111 [lll" 

~ 111111 jjfl," 

~LY• 

I 

V 

DIVIDENDS EXCLUSION PLAN 

40% Corporate !ox: individuals exclude 

40% of dividends received from taxable income 

1NDIV10UAI.. INCOME TAX RATES 

IOO'o/. 0 !Oo/o 20% 30,. 40o/o ?,0%- SO% 70% 80"% 90% IOOo/6 

~ 80'4. f-~f-~-~--+--+--+--+--,,:mi'l#>ffl..l' 

" '°"' f----f-----i---i---i--t--t--ililffiWl....,9"--1 ~ 

"~ W'Y. f-----j--t-,---t-+--l::;;~~-f---j--t--! 

atri·5011, f--+-+::.al'rmltttttltlff.t::,_-+-+-+--1--1 

~ 

.~ 

e

;:.: 

II 40'Y. 

!01'. 

20% 

'°"' 

Office of -the Secretary of the Tre~aury, Division of Tax Research 8-656 
- 67 -

shown for any particular stockholder is not of great significance. The 

total tax shown :for the present· system, for example. is higher for most 

stockholders than under other plans, partly because the present type of 

plan_ shown in the chart would yield more revenue. · Although this does not 

affect the rel~ability of the general impression conveyed by the chart, 

the differences in revenue should be taken into account. 

,. Since revenue 7ield is an important consideration in appraising a tax 

plan, it is desirable to have some impression of the effect of the different plans· on revenue,. The following table gives estimates of the yield I of plans illustrat_ed in Chart 6. '!J The table shows separatel.7 the estimated corporate tax liability, the net individual tax on dividend income, 

and the resulting total yield of each or the plans. In estimating the individual tax liability on dividend income, the rates and exemptions of the 

Revenue Act of 1945 were used, and dividends were treated ae the last in• 

crement in individual income. All the estimates are based on assumed 

economic conditions con,istent with national income payments of abo~t $150 

billion. 

In makiDg the revenue estimates, it has been assumed that.net dividends paid by all domestic corporations, as a group, would be the same 

percentsse of corporate income available for dividends under all of the 

plans.. Under eac~ of the plans except the dividends-paid-credit plan, income available tor dividends would be net corporate income minus the corporate tax liabilit7. Under the dividends-paid-credlt plen, income &vailabie for dividends_, ta.ken to mean net corporate income minus the minimum corporate ta:ic, r~ther than net income after the actual fin~l corporate 

tax liability. Under this plan, corporations could reduce their ta:ices to 

the 20-pereent minimum by paying out all of their current income. Hence, 

all corporate income above tha minimum tax liability imq be said .to be 

available for dividends. 

The assumption e.s to dividend policy- implies larger cash dividends 

under the dividends-paid-credit plan than under the other plans. The 

amount of dividend• taxable to stockholders, how~ver, would be roughly the 

same under the witbholdicg plan and the dividends-paid-credit plan. The 

smaller cash "dividends paid under the w1 thholding plan would be marked u:p 

for purposes of the individual income tax. The assumption of diridend 

payments equal to a uniform percentage of available income was selected as 

unambiguous, although arbitrary. Some more or less arbitrary assumption • 

I • g The version of the dividends-received-credit plan used in the table 

differs slightly' from that illustrated in Chart 6~ In the plan shown 

in the table, dividends would be exempt from the first 19-percentage · 

points of individual tax. rather thnn the first 20-percentage points 

as shovn in the cha.rt. This modification was made because the beginning rate of individual tax under the Revenue Act of 1945 is 19 percent (combined normal tax and surtax. after deduction of the 5-Percent 

tax reduction provided by the Act). , 
- 68 -

Revenue Yield of Five Corporate Tax Plans !} 

(Billion, of dollara) 

: Income tax liability net of 

: - credits and refunds Plan· : : Corporate : lnd.1vidual tax 

: Total Y : tax : on dividends 3/ 

Present system 

(4~-corpora.te ta:x 2!J) s.6 2.0 

Dividends-paid-credit plan 

(~ maximum corporate tax; 

25~ tax credit !or net dividends paid. 2f; 2°-' minimum 

corporate tax§/) 6.4 

Withholding plan 

(2~ basic corporate tax plus - 2~ withholding tax 2/) 8.6 o.6 Jj 

DiTidends-received-credit plan 

(~ corporate tax 2!J; dividends exempt from tirat 19 

percentage points of individual tax) s.6 1.0 

Dividend-exclusion plan 

(4o~ corporate tax 4/; individuals exclude 4of ot dividenda .received from taxable 

income) s.6 1.1 

Source: Treasury Department, Division of Research and Statistica 

!J National income picyments assumed to be approximately $150 billion. 

Dividends paid under all plane assumed to be the same traction of income available for dividenda. (See text.) g/ The two following columns do not add to this total in some caeea because of rounding. 'J./ Viewing dividends as the last ir.crement in individual income; rates .. enacted by Revenue Act of 1945, with mod.1t1cationa of individual tax 

indicated in connection with each plan. 2!J Corporate tax credit~equal to 20 percent of partially tax-exempt in~ 

tereat also allowed. . . · 5J Corporate tex credit equal to 15 percent of partially- tax-exempt interest also allowed. 

§1_ ·:Baaed on corporate net income excluding partially tax-e-xempt interest. IJ After deducting $0.4 billion of refunds to stockholders tor overwitbholding. 
- 69 -

was necessary because there ie no experience on which to ba1e refined estimates. The particular assumption ueed may well understate ·the amount of 

dividends that would be paid under the alternative plans, as compared with 

the present system. Reduction of the degree o! •double taxation• o! distributed pror1,a might make wealtbT stockholders leas inclined to retain 

profits in the corporation to avoid 1ndiT1dual aurtaz. ~ dividend-paidcredit plan and the withhold1ng plan would be l1kel.7 to stimulate more · dividend p9J1Dents than the other plans. It seems likely that the psychological effect of the dividends-paid-credit plan would make that plan the 

most effective in stimulating dividend paJmenta. 

It..corporations would pa:, out the same fraction of income available 

tor dividends under the dividends-paid-credit plan and under a comparable 

withholding plan, both plans would alwqa yield the same total revenue. 

The yield would be divided clif:terentl7 between corporate and individual .­ taxea. but the total would be the same. Under the withholding approach a 

tax credit relating to dividends would be gi~en to stockholders. Under 

the dividends-paid-credit approach an equivalent taz credit would be given 

to corporations for distributing their profit• ~he total revenue would 

be the same. not only tor the particular illustrative rate structures used 

in thi• memorandum. but also tor~ other rate structures that bore the 

same relationship to each other. · 

All of the plans tor coordination ot the corporate and individual income taxes would yield smaller revenues than the present eyetem. The 

withholding plan and the dividends-paid-credit plan would yield less than 

the other illustrative plane, because they would go furtherest toward 

elimination ot 1 double taxation• of distributed profit• The smaller revenue loss under the dividends-rece1Ted-credit plan and the dividendexclusion plan 'WOUld be attributable mainl7 to the higher tax on dividends 

received by low-income stockholders• 

• 
- 70 -

APPENDIX A 

Collections fr.om Corporation Income and Excess-Profits Tues~ 

Individual Income Taxes, and Total Internal ReTenue~ 

Fiscal Years 1925-1945 

(Mone~ amounts 1n millions) •

• •

• •

• : CorporaUon •

• •

• •• •

• income end •

• Corporation : : exceas-profi ts Total > l!'iscal •

• income and •

• Individual •

• taxes e.s a 

year •• excess-profits •

• income taxea •

• 

interna.l : percent of · . .. revenue g/ . .

• · taxes !/ • • •

• total- internal • . • •

• •

• . revenue •

• •• •

• teercent}

1925 $ 916 $ 845 $ 2,584 35.4 1926 1.095 879 2,836 . ~s.6 1927 1,308 912 2,866 5.6 1928 1,292 883 2,791 46.3 

1929 1,236 1,096 2,939 42.1 

1930 1,263 1,147 . 3,o4o . 41.5 

1931 1,026 834 2,428 42.~ 

1932 630 427 1,558 40.4 

193~ 1,620 24.3 

193 ~~ ~~ 2,672 15.0 

1935 579 527 3,282 17.6 

1936 753 674 ,,494 21.6 

1937 1,088 .1,092 ,6~ 23.5 

1938 1,343 1,286 5,6 23.s 

1939 1,156 1,029 5,162 22.4 

1940 1,148 982. 5,323 21.6 

1941 2,0~ 1,418 7,352 j 27-~ 1942 4,7 l/. 3,263 13,030 36. 

19~ 9,669 l/. 6,630 22,369 43.2 

19 1.4, 767 !/ 18,261 40,120 . 36.s 

1945 16,027.'J./ 19,034 . 43,soo 36.6 

Source: Annual R~ort of t~e Secretary of the Treas:!1:7 for 19ij5. PP• 4g~' 

487. .. !/. Includes unJust enrichment t~, 1937-1945. 

y Includes income tax on Alaska Railways except in fiscal years 1935,· 

1936, and 1937, during which time these receipts were considered trust • 

fund receipts. · 

'J} Include,s amounts refundable as postwar credit age.inst excess-pro:f'i ts 

tax, and re:f'unds attributable to carrybacks of unused excess-profits 

credits and net opere.ting losses, etc. 
• 

- 71 -

APPENDIX B 

.ProgressiYity of a Flat-rate Corporate Income Tax 

on Distributed Profita 

.. 1.eeDeterminants of progressivityee

� This discussion of the progressivity of the corporate income tax re- lates to its effects on individual incomes. It is concerned with statis� 

tical 9&gregatea or averages rather than with particular cases. In these 

terms, the over-all progress1v1ty of a flat-rate corporate income tax depends on: (1) the distribution of dividends b1 individual income classes in 

relation to the distribution of total income and (2) individual income tax 

rates on dividends paid to stockholders. 

2.eeEstimates of tax load on various individual. ·income cl�ssesee

a�tributable to corporate tax on distributed profitsee

The following table shows what� be called the "net corporate tax" 

on distributed profits. taking into account the two factors mentioned above. 

The table uses the 1942 diatri bu.ti on of income and dividends by individual 

income classes anq a hypothetical set of individual income tax rates. The 

table relates to distributed corporate profits. including in distributed 

profits the portion of the corporate tax allocable to dividends actually 

paid. The table deals only with profits distributed to stockholders subject to individual income tax, under the 1942 exemptions. It does not "include profits distri'buted to non-taxable 1nd1viduel1, foreigners, and in- stitutions. 

Column 2 of the table shows the increasing importance of dividends as 

a source of. individual income in successively higher income classes. The 

f!'gures in this and other columns relate to aggregate income of all ind.12 

vidua.11 in the various income classes, not merel7 to dividend recipients. y Column 3 show� the impact on aggregate individual income of a 4o-percent 

corporate tax on distributed profits - without allowance for the tact that 

a part of the profits taken by the corporate tax would have been taken by 

the regular individual tu. Columns 2 and 3 suggest that a flat-rate corporate tax may have, in the aggregate. a marked.17 progressive effect on 

'fl Statistics of Income for 1942, Pa.rt -1, does not show the number of re- turns reporting various kinds of income in ea.ch income class. It is 

reasonable to assume, however, that in 1942, as in prior years, the 

increasing importance of dividends as income rises is attributable to 

two factors: (1) a larger proportion of individuals receiving dividends 

in high-income classes than in low-income classes and (2) dividends 

constituting a larger fraction of the total income of dividend recip-. 

ienta in high brackets than in low. 

•
- 72 -

. · 8 Net Corporate Tax" on Distributed Profits 

4o-Percent Corporate Tax on Distributed Profits Stated as a Percent 

of Aggregate Individual Income in Different Income Classes 

(1) (2) (~) (4) (5) 

4o=°percent : 

Adjusted corporate tax: "llet corporate di id d . : on distributed : Marginal Individual tax11 v en 8 : pro:f'ita as individual as 

net income as percent of: percent of : income tax percent of 

classes ad.Justed : adjusted : rate adjusted

· individual (thousands): i ndividual :individual net :(bT,pothetical):

•. net income 1 1 i • net income g/ • ~: ncome • 

: :(40% of col. 2): 

o - $ 4 2.4~ 0.9~ 1~ o.s~ 

$ 4 - 6 s.o 3.2 21 2.5 

6 - g 13.9 5.6 25 4.2 

S - 10 17.. 1 6.8 29 4.9 · 10 - 14 20.2 8.1 33 5.4 

14 - 15 22.5 . 9.0 5.7 

15 - 20 24.2 9.7 lI 5.7 

20 - 25 26.7 10.7 45 5.9 

25 - 30 .2s.9 11.6 48 6.o 

31.5 12.~ 51 6.2 ~: 4o 34.6 13.s 54 6.4 

50 - ~ 36.1 14.5 6.2 gJ 6o - so 3s.3 15.3 6.1 

80 - 100 41.2 16.5 - / 

62 6.3 

100 • 200 45.2 18.1 64 6.5 

200 and over 53.s 21.5 65 7.5 

. . Y Aggregat& dividends (including dividends estimated to be paid to individuals through fiduciaries) and aggregate net income of individual• 

:trom Statistics of Income tor 1942, increased b~ the 40-percent corporate tax on distributed corporate profits. Dividends received by individuals filing Form 104oA estimated on the basis of the ratio of 

dividends to 1 other income" reported by individuals in the same income 

class filing Form 1o4o. · • 

g/ The 4o-percent corporate tax on distributed profits as a percent of 

individual net income, reduced b7 the individual income tax that would 

have been due had the corporate tax on distributed profits been added • 

to dividends paid to individuals. This is: (column 3) X(1.00 percent - column 4)•. Mq not cheek exactly, due to rounding • 

• 
- 73 -

ind.1vidual incomes. But the analysis cannot be left here. Column 3 does' 

not reflect the effect of the second major determinant of the progressiv- . ity of the corporate tax. the individual income tax rates on dividends. 

The figures in Column 3 may be thought of as showing the "gross corporate 

tax11 on distributed profits, in contrast with the "net corporate tax," 

which is shown in Column 5. , 

Column 5 of the table shows the "net corporate tax" on distributed • profits, taking into-account the effect of both ma,Jor determinants of the 

progressivity of the tax. The figures in Column 5 are called the "net 

corporate tax• because the~ show the "gross corporate te.:x" (Column 3) reduced by the individual income .tax that stockholders would have had to pay 

if their dividends had been increased by the amount of the corporate tax 

on-distributed profits. This adJustment must be made to get·a true picture 

of the net tax load attributable to the corporate tax. Comparison of 

Columns 3 and 5reveala that the net effect of the corporate tax is much 

leas progressive than one.would suppose merely from inspect!on of figures .,. on the distribution of dividends among individual income classes·. :But the 

"net corporate tax:11 on distributed profits is broa.dl;r progreastve in the 

sense that, in the aggregate and on the average. it ia a greater percent~e 

of high incom~s than of low incomea. 

a. Technical reservations regarding eatima.tea 

Some reservations of both a technical and a conceptual nature appl.7 

to in_terpretation of the table. The technical reservations concern mainly 

the crudit7 of the computations. All income recipients in a given net income class are assumed1to be subJect to the same marginal tax rates. 

Actually, these rates would very conaiderabl.7, depending on 8'1Ch factors as 

the number or personal exemptions and the portion of the income represented 

by long-term capital g~ins. The former factor ia probabl7 especiall7 important in the lower brackets, the.latter in the upp!"r brackets; Despite 

these limitations, the figures are believed to give a picture which is 

reasonably accurate in the large, if not in specific detaila. 

b. Conceptual problems 

On the conceptual level, the moat obvious point to be mentioned is 

the fact that the table assumes that the corporate income tu: on distributed profits rests entirely on dividend recipients. It is tacitly assumed 

that any reduction in that tax would be fu.117 reflected in additional dividend -oayments, distributed in the same manner as dividends actually pa.id 

'" in 1942. · 

. . , ' 

Another basis for differences in interpretation of the estimates re- lating to the distribution of the ~orporate income tax concerns the definition of tax progression. 
- 74 -

3. Note on the definition of progressionee

In a strictly formal sense a progre.ssive tax usually hs.s been· definedee

as one the rate of which increases_ as the base increases, and a regressive 

tax, one for which th� rate decreases· as the base increases. However, general usage relates the effective rate ·or a:ay tax to the income of persons 

assumed to bear it. Thus an excise tax, which is nominally proportional, 

is ordinarily se,id to be regressive in effect. 

Even by the inco�e standard the concept of progression 1s somewhat 

vague. Comparisons of the degree of progression of different tax schedules 

are even less exact. Apparently the most usual _approach is to measure progression by the ratio of effective te.x rates on net income before te.xes of 

high-income groups to effective rates on low-income groups. A ratio 

greater than one indice.tes that a tax is progressive, and presums,bly the 

higher the ratio the greater the degree·or progression. 

:But another logical definition is to say that a progressive tax is one 

that reduces the inequality of individual incomes -- after taxes. This 

a:pproach mea.sures progressi vi ty by the ratio of income after taxes in highincome groups to income in low-i�come groups. 

These two definitions msy conflict when different degrees of progression are compared. For example, suppose the effective income tax re.te is 

10 percent on a $1,000 income and 50 percent on a $50,000 income. The tax 

is progreessive by either definition. The upper bracket rate is 5 times the 

lower,- and the higher income is 50 times the lower before te.x but only 27.s 

times the lower s!ter te.x. 

Now suppose that an additional 10 percentage points are added to the 

rate schedule in each bracket, ma.king the rate·s 20 percent and 60 percent. 

Does the addition increase or decrease the progressivity of the income tax'l 

The top rate is now only three times the lower, end by the first stendard 

progression hB.s decreased. But the additional 10 percentage points of tax 

talces 1/9 of the lower income reooining after the original tax and 1/5 of 

the upper. Tpe spread between incomes e�ter tex has been reduced. The 

higher income e£ter tax is now 25.0 times the lower, as compared with 27.s 

times the lower under the previous schedule. 

On the assumption that the corporate te.x is not shifted, it appears to 

beebroa.d.lyeprogressive according to both definitions. However, it is more 

progressive on the second definition (reduction ineinequs.11 ty of incomes 

after taxes) thBn on the first and more usual definition. In the first 

defini t'ion the corporate tax, even though itself mildly progressive, may 

decres.se the progreasivi ty of the whole tax system: According to the 

second definition, it, clearly increases progressivity of the whole system. 

Formal progression is, of course, only one aspect of the equity and 

economic effects of a tax or a tax system. The weight of taxation and the 

absolute amount of income left after taxes in both high• and low-income 

groups must also be taken into account. 

•
--75 -

4. Recovery of revenue attributable to corporate

te.x on distributed profits

The "net corpore.te tax" shown in Column 5 of the preceding table is 

roughly equiva�ent to the following increases in individus.l surtax rates: 

Percentage points Surtax net income , . increase in ( thousands) individual surtax 

0 - $2 2 

$2 - . 4 4 

4 -· 6 5 6 - g 6 

Sand over 7 

This means, subject to the assumptions and limitations already mentioned, that the part of the corporate tax imposed on profits distributed 

to stockholders subJect to individual income tax could be approximately 

recovered from the same individual hi.come groups by the foregoing increntes 

of individual surtax rates.!/ The revenue would be recovered from the 

same individual income classes estimated to have borne the corporate tax 

on distributed profits in 1942. but not in the same amount from eveey individual within each clsae. The increased surtax would/apply to all individuals with taxable income in the various brackets, not·to dividend 

recipients alone. 

il, Assuming, among other things, the 1942 distribution of dividends and

previously existing individual tax rates as shown in Column 4 of the 

previous table. 
• • 

APPENDIX C 

New Domestic Corporate Security Issues by Types,!/ 1921-1945 

(Money ll!llOunts in millions) 

1Total stock ss 

Year •· 

Total, 

all types 

of issues. 

Short•term 

bonds and 

notes 

Tot1tl. 

long-term 

issues 

Long-term 

bonds and 

notes 

Preferred 

stock 

Common 

stock 

Total 

stock 

percent of 

total ·long- term issues 

(:2ercent} 

Total ~new ca,:,ital and refund!~) 

1921 

1922 

192l 192 

1925 

$ 2,269 

2,947

3,166 

~,522 ,222 

$ 21,

13 

lSl 

336 

308 

$ 2,056

2,813 

2,985

3,186 

3,914 

$1,781 

2,1~2

2,2 9 · 2,320

2,667 

$ 75 

G63 

34l 

637 

$ 200 

288 

329 

520 

610 

$ 275 

621 

736 

,866

1,247 

13.4 

22.1 

24.7 

27.2 

31.9 

1926. 

1927 

1928 

1929 

1930 

4,575

6,50s 

6,930 

9,377

4,957 

295 

303 

265 

251 

620 

4,280 

6,205

6,665 

~,126

,337 

3.059 

4,466 

3,174 

2,369

2,810 

544 

1,055 

1,397

1,695 422 

677

684 · 2,094 

5,062.

1,105 

1,221 

1,739

3,491 

6,757

1,527 

2s.5 

28.0 

52.4 

74.o 

35.2 ...,, 

°' 

1931 

1932 

1933 

1934 

1935 

2,371 

644 

380 

489 

2,268 

4oo 

214 

89 

168 

51 

1,971

430 

291 

321 

2,217 

1,628

406 

139 

287 

2,066 

148 

11 

15 

3 124 

195 

13 

137 

31 

27 

3:? 

152 

34 

151 

17.4 

5.6 

52.2 

10.6 

6.8 

1936 

1937 

1938 

19~9 19 0 

4,~79

2. 34 

2,141 

2,117 

2,763 

63 

95 

11 

79 

39 

4,516 

2.339 

2,130

2,038

2,724 

3,963

1,579

2,032 

l,So4 

2,396 

271 

468 

79 

161 

246 

2132 

292 

19 

73 

S2 

553 

76o 

98 

234 

328 

12.2 

32.5 

4.6 

11.5 

12.0 

1941 

1942 

1943 

1944 

1242 

2,619

l,o42 

1,061 

3,118

6,166 

43 

5

;s 

14 

46 

2,576

1,037 

1.0~ 3,1

6,120 

2,277 

qos 

849 

-2.592 

4.811 

219 

110 

1;1

411 

1,031 

80 

19 

43 

101 

27s 

299 

12, 17 

512 

1,309 

11.6 

12.4 

17.0 

16.5 

21.4 

For footnotes sea P• 78 
.. . 

New Domestic Corporate Security Issues by Types, y ~9'21-1945 (co!1tinued) 

(Money amounts in millions) 

Year : 

Total, 

all types 

of issues I 

Short-term 

bonds and 

notes 

I Total, 

, long-term 

issues 

Long-term 

bonds and 

notes 

Preferred 

stock 

Common 

stock 

Total 

stock 

tTotal stock BB 

I percent of 

. . total long- term issues 

!:eercent} 

New cal!ital 

1921 

1922 

1923 

1924 

1925 · 

1,702

2.211 

2,635 

3,~ 3, 

161 

104 

143 

276 

221 

1.541 

2.107 

2.492 

2,753

3,383 

1,276

1,537 

1,83,

1.92 

2,231 

71 

293 

335 

318 

594 

194 

277 

324 

511 

558 

265 

570 

659 

829 

1.152 

17.2 

21.1 

26.4 

30.1 

34.1 

1926. 

1927 

1928. 

1929 

1930 

1931 

1932 

1933 

1934 

1935 · 

3,754

4,657

5,347 

.8,003

4,483 

1,551 326 

161 

l-78 

4o4 

249 

221 

211 

205 

520 

2si ,3 

17 

32 

11 

3,505

4,436' 

5,136 

7,798 

3,693 

1,262 

292 

144 

146 

393 

·2,41g 

2,962 

2,17~ 1,87

2,46o 

951 

271 

24 

112 

323 

509 

874 

1,149

1,517 412 

116 

11 

15 

3 

55 

578 

'6oo 

1,812

4,407

1,091 

195 

10 

105 

31 

15 

. 

1,087 

1,474

2,961

5,924

1,503 

311 

21 

120 

34 

70 

31.0 

33.2 

57.7 

76.0 

4o.t 

24.6 

7.2 

83.3 

23.3 

17.s 

· 

...... 

...... 

I 

, 1936 

1937 

1938 

· 1939 

194o 

1,193

1,226

874 

384 

736 

23 

48 

4' 

5

12 

1,170

1,178 

870 

379 

724 

817 

769 

803 

282 

589 

90 

205 

48 

26 

61 

263 

204 

19 

71 

74 

353 

4o9 

67 

97 

135 

30.2 

34.7 

7.7 

25.6 

18.6 

1941 

1942 

1943 

1944. 

1945 

For footnotes 

1,062 . 625 

376 

651 

1,256 

aee P• 78 

24 

3 

23 

2 

2 

1,038 

. 622 

353 

1.~ 

865 

503,

261 

425 

6oo 

94 

103 

55 

133 

429 

79 

16 

37 

91 

225 

173 

119 

92 

224 

654 

16.7 

19.1 

26.1 

34.5 

52.2 
Nev Domestic Corporate Security Issues by Types.!/ 1921-1945 (concluded) 

{Money amounts in millions) 

:Total stock as 

Total. Short-term Total. Long-term percent of

Year Preferred Common Total all types bonds and long-term bonda and total long- atock stock stock of issues . notes inuea notes term issues 

ercent 

RefUnding 

1921 568, 52 516 506 4 6 10 1.9 

1922 735 29 706 655 1'o ll 51 7.2 

1923 530 37 493 416 72 5 77 15.6 

1924 492 6o 432 396 28 g 36 s.3 

1925 613 87 531 436 43 52 95 17.9 

1926 

1927 

1928 

1929 

1930 

819 

1.851 

1.5s4 

1·lt, 

45 

82 

54 

46 

100 

- 774 

1.769 

1.530 

1.3~ 

37 

641 

1.504 

999 

496 

351 

34 

lSl 

24-s 

178 

9 

99 

84 

283 

6f' 

133 

265 

531 

833 

23 

17.2 

1G.o 

3 .7 

62.7 

6.1 _, 

OQ 

1931 820 111 709 677 32 32 4.5 

1932 

193G 

193 

1935 

318 

219 

312 

1,863 

1!30 

72 

137 

39 

138 

147 

175 

l,824 

135 

115 

175 

1,743 

y 

69. 

3 

32

-

12 

3 

32 

81 

2.2 

21.s 

4.4 

1936 

1937 

3.3ss 

1.210 

1'o 

47 

3,348 

1,163 

3,147 

810 

181 

264 

20 

89 

201 

353 

6.o 

30.4 

1938 1.26s 7 1,261 1.229 31 1 32 2.5 

19~ 19 

1,733 

2.027 

74 

27 

1,659 

2,000 

1,522 

1,807 

135 

185 

2 

g 

137 

193 

s.3 

9.7 

1941 

1942 

19i2 

19 

1,557 

418 

685 

2,466 

19 

2 

16 

12 

1,538 

416 

669 

2,454 

l,412 

1'<>5 

587 

2,166 

125 

g 

76 

278 

l 

g 

10 

126 

11 

82 

288 

8.2 

2.6 

12.3 

11.7 

1945 4,912 45 4,867 4,212 6o2 53 655 13.5 

Source: Commercial and Financial Chronicle series: 1941-1945, Commercial and Financial Chronicle, Vol. lb3, No. 4459 

(January 28, 19~6), P• 507; prior yeara, Statistical Abatract of the United-States, annual volumes. 

Preferred stocks of no par value and all common stqcks are taken at their offering price, other isaues at pu. Y. y Lesa than $0,5 million. 

.... 
: 

4 

s3.3 - 3.9 -

49.5 

4.4 

o.4

4.o 

1944 3s.9

-_79 -

APPElIDIX D 

Net ·savings of Corporations and ·Individuals, J/ 1929-1945 

(Billions of dollars) 

• . • . . Net se.vings of 

'Net savings individuals ·Calendar National • : . of : including year income • � . . corporations y • unincorporated • 2/ (' •

. . businesses

6s.9

1929

1930 

s.s

5.s

1.2 

1931

1932

1933 

�-.o

5 

'42.3 

- 5.s 5.4 - 6.4 , 2.6 - 2.s 2.1

1934 2.1 3.3 ' 1•.

3 · 4.1 ·-

1935 55.7 - 1936 64.9 0.9 6.1

6.7 - I 

6.o_

1937 71.5 - 0.8

1938 64.2 - .1.5 

1939

194o 

70.s 

77.6 1.8

1941

.. 1942 

,1943

7.5

14.2

28.6 

96.9 · 122.2

149.4

4.4

5.5 33.3 

1945 

160.0

1 5.4

161.0 4.5 34.9 

Source: Estimates of the Department of Comierce� .survey of CUrrent 

:Buainesa, Ma7, 1942; Ms,rch, 1943; and February, 1946. 1

y' These estimates are derived fro� figures used in national income estimates, and must be interpreted in that light. The ·natfonal-income 

estimate of corporate profits, 'for exa.'IJ_ple, e;xcludes capital items, 

such as capital gains and losses and inventory revaluations. There- • fore, the estimate of net corporate savings given here differs -from

the figure that can be derived from Statistics of Income. 

g/ The definition of net ,savings for corporations differs somewhat from

,_ that of net savings for.individuals •. For corporations, allowances for 

depreciation, depletion, ·and other business reserves are deducted before arriving at the net savings figure. For individuals, simiier 

business reserves a.re deducted for unincorporated businesses, but such 

'items as depreciatiou on owner-occupied houses and other con1umere' 

durable goods are not deducted.