ECONOMIC

TAX INTEGRATIONIntegration of the corporate and personal income taxes to eliminate thedouble tax on corporate income is another proposal that has been recommendedas a means of improving the allocation of capital resources andraising the aggregate rate of investment. Under current law the first $25,000of corporate income is taxed at a rate of 20 percent, the second $25,000 at22 percent, and all income above $50,000 at 48 percent (22 percent plus asurtax of 26 percent) .* In addition shareholders must pay individual incometaxes on distributed profits (dividends) ; and retained earnings are taxedagain, though at lower effective rates, when capital gains are realized fromthe sale of stock. Thus, while income from noncorporate businesses andwages and salaries is taxed only once, corporate income is subject to a doubletax. This extra tax creates a number of distortions affecting the financialstructure of corporations and the overall allocation of capital resources,which impair economic stability and reduce total output.First, because after-tax rates of return on capital tend to be equalized bymarket forces, the higher rate of tax on corporate income implies that anextra dollar invested in the corporate sector must yield a higher before-taxrate of return than an extra dollar invested in the noncorporate sector. Thedouble tax therefore discourages capital resources from flowing into higheryieldingprojects in the corporate sector, the result being a net loss in output.Second, since retained earnings are generally translated into capital gainsin the form of higher stock prices, and these gains are taxed at preferentialrates, the tax burden on distributed profits is relatively larger than thaton undistributed profits. Corporations thus have an incentive to reducedividends and increase retained earnings. This phenomenon may producea misallocation of capital within the corporate sector as investment is encouragedin older established firms with a high level of retained earningsand discouraged in newer firms, which usually rely more heavily on capitalmarkets to raise funds. Moreover certain investment projects may be undertakenwith internally generated funds, despite the fact that they might notbe worthwhile if financed with capital from external sources. Third, thecombination of high inflation and the tax-deductibility of interest paymentshas encouraged many corporations to raise debt-equity ratios tolevels where the risk of bankruptcy may have risen substantially. Such firmsare thereby made more vulnerable to business cycle developments and mayexperience increasing difficulty in raising funds in capital markets. Finally,the increase in the tax burden resulting from the double tax is relativelygreater for lower-income stockholders.It is also sometimes claimed that the double taxation of corporate incomereduces the national rate of saving and that integration would be desirableto increase capital formation. Taken by itself, integration would lower taxes*The Tax Reform Act of 1976 extended these brackets and rates only through theend of 1977. The President has proposed that the first two brackets and rates bemade permanent, and that the surtax be permanently lowered to 24 percent.The latter change would yield a combined rate of 46 percent on corporate incomeover $50,000.166