As corporate taxes shrink, who pays?

Outside in the parking lot, demonstrators held signs saying the federal income tax is unconstitutional. Inside, in a former furniture store turned software firm, President Bush's Advisory Panel on Federal Tax Reform was holding a public hearing, this one on corporate taxes.

That juxtaposition in Tampa, Fla., last week was apt. Although judges routinely knock down claims that income taxes are unconstitutional, corporate taxes are shrinking. The push is on to make them disappear completely.

There may be some economic reasons to do that. But would the nation's tax system remain as progressive?

Mr. Bush's tax cuts reduced rates for individuals. Corporations have done even better over time. Federal revenue from corporate taxes has fallen from 6.4 percent of gross domestic product, the nation's output of goods and services, in 1951 to a mere 1.5 percent to 2 percent of GDP in the last few years.

This downward drift has resulted from three factors, says Douglas Shackleford, a tax professor at the University of North Carolina at Chapel Hill.

The first is the desire for low corporate tax rates to help domestic firms compete internationally. In the United States, Congress responds by providing various loopholes, such as accelerated or bonus depreciation and research and development deductions and credits.

A second is the rising popularity of "S corporations," mostly small companies that can pass on profits tax-free to individual owners. The profits become part of the owners' personal income and are subject to taxes there. The third factor is more corporate tax planning, including the use of tax shelters. Some of these are abusive.

A new corporate tax break, a provision of the American Jobs Creation Act, was passed by Congress last fall. It permits firms to return profits held in overseas subsidiaries to the US at a 5.25 percent flat rate, down from the maximum 35 percent corporate tax rate.

It's estimated that $100 billion to $500 billion worth of profits will make their way home from abroad this year to take advantage of the teeny tax rate. If so, the repatriation of profits may give federal revenues a bit of a boost.

Already a few pharmaceutical companies and some other multinationals have announced plans to use this tax incentive, repatriating multibillions of dollars.

"It's ludicrous - like all tax holidays," says Professor Shackleford. It creates tax favoritism for some companies.

Economists see corporate taxation in a different light from most people. They note that a company is actually just a legal paper entity, not a person. The cost of corporate taxes, they say, is passed on to real people - shareholders, employees, consumers - through lower dividends, trimmed wages, or higher prices for their products and services. Economists have been unable to agree on a distribution of the tax burden for many decades. It's just too complicated.

Asked where the burden falls now, William Gentry, an economist at Williams College in Williamstown, Mass., who testified before the tax reform panel, says primarily on capital - reducing dividends, bond interest, capital gains, and perhaps even home prices.

But probably, it also falls on consumers as companies jack up prices to cover tax costs, and on workers, whose wages don't rise as fast, says Joel Slemrod, a tax expert at the University of Michigan Business School. Nevertheless, corporate taxation is "more progressive than any other tax on the books," he adds. Its costs fall mostly on the well-to-do, who still hold the bulk of corporate stocks and bonds, despite the spread of share ownership over the past 50 years.

That view is why liberals like Bob McIntyre, director of Citizens for Tax Justice (CTJ), a Washington think tank, repeatedly bemoan the shrinking corporate tax. Last month, it released a study saying corporate tax avoidance was worse at the state than at the federal level. Last fall, CTJ complained that 82 big firms paid no taxes at all in one or more Bush years.

Many pro-business conservatives and many economists want the corporate tax eliminated, or at least integrated with the personal income tax. The presidential panel will undoubtedly consider ending "double taxation" - taxing company profits first at the corporate level, then as dividend income of individuals.

One idea being tossed around would require companies to pay income taxes, but then provide shareholders notice of the amount of that taxation in sending out dividends. Shareholders could then deduct from their taxable dividend income their share of the tax paid by the company. It would be much like employers who now deduct the federal income tax from their employees' regular wages and, after the year ends, provide information on W-2 forms about how much was deducted.

But how to keep the progressivity in the tax system could be a crucial issue for the nine-member panel, which is due to report by July. Will Mr. Bush and Congress achieve major tax reform, as was done in 1939, 1954, 1969, and 1986?

"It seems conceivable that they might come up with major legislation, if not this year, maybe next year," says Shackleford.