Corporate income tax Summary

  • Last updated on November 10, 2022

Corporate income taxes became an important source of government revenue in the twentieth century and were a major influence on corporate policy, especially financial structure and accounting methods.

Corporations, chiefly in banking and insurance, arose early after the United States won its independence in 1783. From the 1830’s, railroads became the first truly big-business corporations. The early corporations were routinely subjected to various taxes although these taxes were not based on their profits. The U.S. Civil War brought the first federal experiments with taxation of income. Although the new tax applied to corporation income as well as personal, corporations found the tax easy to evade. It yielded little revenue and was repealed soon after the war ended in 1865.Income tax;corporateTaxation;corporate income tax

The domain of business corporations expanded greatly after the Civil War, extending into manufacturing and trade. Accounting standards were improved, and disclosure of corporate finance became more extensive. Corporations were unpopular and, therefore, a politically suitable object of taxation. The Wilson-Gorman Tariff Act of 1894Wilson-Gorman Tariff Act of 1894 imposed a 2 percent tax on personal and corporate income over $4,000. In 1895, the Supreme Court held this income tax to be unconstitutional because it violated the constitutional requirement that any direct tax must be proportional to the population.

The Modern Tax

In 1909, Congress imposed a 1 percent tax on corporate net income above $5,000, calling it an excise tax to bypass the constitutional issue. In 1909, some 262,000 corporations filed returns, and the tax yielded about $21 million. The constitutionality issue was soon settled by the adoption of the Sixteenth Amendment, which authorized an income tax. A comprehensive income tax law in 1913 extended the 1 percent tax on corporate profits. By 1913, the corporate income tax accounted for 5 percent of federal government tax revenue, as 317,000 corporations submitted returns and the government received $43 million in revenue. The corporate tax rate was raised to 2 percent in 1916.

The enormous increase in federal spending during World War I[World War 01];corporate taxWorld War I brought an increase in the corporate tax, which jumped to 6 percent in October, 1917. In addition, the law imposed an excess-profits tax, levied on profits in excess of those received in 1911-1913. This provision was a huge source of revenue, yielding $2.2 billion in the year ending June, 1918. By comparison, the personal income tax produced $600 million and the regular corporate profits tax only $48 million. Additional tax was applied to undistributed corporate profits, a policy intended to discourage a potential channel for the stockholders to avoid paying personal income tax.

After the war’s end, the taxes on excess and undistributed profits were removed. However, the government was confronted by a huge national debt that its leaders were determined to reduce. In February, 1919, the basic corporate tax rate was set at 12 percent for the profits of the previous year and 10 percent for the following years. Combined with increases in the personal income tax, these had a strongly deflationary impact and contributed to the painful depression of 1920-1922. The depression was brief, and the revenue success of the federal tax on profits led to imitation of the federal government by state governments. During the 1920’s, the states were receiving about 5 percent of their tax revenue from this source.

Further federal increases yielded an average rate of around 11 percent from 1922 through 1924. By this time, the corporate tax had emerged as the centerpiece of the federal tax system. Federal revenues from the corporate tax exceeded $1 billion each year from 1926 through 1931 and topped personal income tax revenues each year until 1934. Tax paid reached 11 percent of corporate profits in 1922 and moved steadily up to 12.7 percent in 1926. The abundant flow of tax revenues allowed the federal government to run substantial surpluses every year from 1920 through 1930 and significantly reduce the national debt. President Calvin Coolidge and Secretary of the Treasury Andrew Mellon agreed on the desirability of tax reductions to stimulate investment, so corporate rates were reduced and the ratio of tax revenue to profits decreased from 12.7 percent in 1927 to 10.2 percent in 1929.

The Great Depression

Because of the government’s large structural surplus, President Herbert Hoover was able to obtain a reduction in tax rates early in the Great Depression;corporate taxdownswing. In December, 1929, the corporate rate was reduced by one point. However, the continued decline in incomes lowered tax revenues, and surpluses turned to deficits. President Hoover was passionately opposed to deficit spending. In 1932, he pushed through the largest tax increase in U.S. history. On average, corporate tax collections rose from 11 percent of profits in 1930 to nearly 14 percent in 1933-1935. Profits had fallen by three-fourths between 1929 and 1932. The tax increases contributed to an adverse environment for business investment.

President Franklin D. Roosevelt was also opposed to deficit spending. He wanted to increase federal expenditures for relief and recovery, but he tried to match the increases with higher tax rates. However, the effective corporate profits tax remained in the range of 12 to 14 percent. Consistent with the antibusiness thrust of the New Deal, an excess-profits tax was imposed in 1935, but it yielded very little revenue. A tax on undistributed corporate profits was enacted in 1936 but was soon withdrawn.

As defense spending was sharply increased in 1940, the corporate tax rate was increased to 19 percent. The excess-profits tax was sharply raised. The tax base was profit in excess of 95 percent of average earnings in 1936-1939, or the dollar value of a specified percentage of invested capital. The tax rate was a staggering 86 percent. In 1942, the basic corporate rate was raised to 40 percent. The combined burden of the two was capped at 80 percent, and there were generous provisions for treatment of losses.

In World War II[World War 02];taxationWorld War II, revenue from the tax on excess profits eclipsed the regular corporate tax. Excess-profits tax revenues exceeded $10 billion in 1943 and 1944, at which time the regular corporate tax was yielding slightly over $4 billion. From 1942 through 1945, excess-profit tax revenues were $36.5 billion, more than double the $17.3 billion from ordinary corporate tax. During that period, the combined burden of the two taxes was slightly over half of all corporate profit.

Postwar Stability

At the war’s end in 1945, the excess-profits tax was repealed. However, the regular corporate tax rate was moved up to about one-third of corporate profits, where it stabilized in 1946-1949. With the outbreak of the Korean War in the summer of 1950, corporate rates were moved up again. The excess-profits tax was revived, but its bite was much gentler: Its yield in 1950-1953 was only about 10 percent of the regular corporate tax. In 1951-1953, the two taxes combined took about 48 percent of corporate profits. The end of the Korean War brought some rate reductions. Even so, the corporate income tax took about 42 percent of corporate profits until the 1980’s.

Tax reform in 1986 reduced the basic corporate tax rate from 46 percent to 34 percent, after which the rate changed very little. By 2006, the tax generated $454 billion out of total corporate profits of $1,554 billion, for a ratio of 29 percent. Between 1960 and 1980, the share of the corporate tax in total federal tax revenue declined substantially, from 23 percent in 1960 to 13 percent in 1980. The share fell below 10 percent during the early years of the new millennium. However, the surge of profits in 2004-2006 brought the share back to 13 percent by 2006.

Tax Structure

Because the tax was levied on corporate profits, it has been sensitive to all the complexities of corporate Accounting industryaccounting systems. Important issues have concerned those business expenditures that could be treated as costs and thus deducted in computing taxable profits. An example is depreciation. Expenditures for capital assets such as buildings and equipment are not normally treated as costs in the year they occur. Rather the cost is spread over the lifetime of the asset. Accelerated depreciation has allowed firms to reduce tax liability. Beginning with the presidency of John F. Kennedy, the government has periodically relaxed depreciation rules to encourage business investment. In 1981, the tax incorporated the Accelerated Cost Recovery System (ACRS). This grouped most capital assets into three categories, with depreciation lifetimes of three, five, and fifteen years. Most equipment and machinery fell into the five-year category, although vehicles were generally in the three-year component. Property and buildings could be written off over fifteen years. The ACRS guidelines were generally much shorter than the true rate of depreciation. This reduced the effective rate of the tax.

In 1962, the tax code incorporated the investment tax credit. This permitted corporations to take 10 percent of the cost of assets during the tax year as a direct credit against their tax liability. The credit was adopted to stimulate investment for economic growth and business-cycle recovery. It was suspended and reinstated periodically, depending on business-cycle conditions.

Another deductible business expense has been interest paid on borrowed money. However, dividends paid to stockholders have not been a deductible expense for the corporation. Dividends thus are taxed twice, as stockholders pay personal income tax on dividends received. This created a bias in favor of debt financing, which tended to expose corporations to greater risk. The extent of double taxation was reduced in 2003 when the personal income tax rate on dividends was substantially lowered. As a result, the percentage of profits paid out in dividends increased substantially.

An important deductible expense has been payment of insurance premiums for employee health care. From the 1940’s, employer-provided health insurance became the prevailing pattern. This arrangement created a disadvantage for those not receiving employer-paid insurance. Not all employee compensation is deductible; under President George W. Bush, Congress voted to deny deductible status to cash salaries exceeding $1 million per year to an individual. Corporations that sustain losses are allowed, within limits, to offset these against profits in earlier or later years.

Evaluating the Tax

All taxes fall on people. Economists have long disliked the corporate profits tax because it is difficult to determine which people are burdened. A 2008 study by the Organization for Economic Cooperation and Development concluded that corporate taxes were more harmful to economic growth than other types of tax because of adverse effects on investment spending for capital goods. Profit income has been a major source of funds for financing capital expenditures. Also, a high rate of expected profit is a motivator to direct investment into highly productive channels.

In the twenty-first century, increasing attention was directed at the relative level of profits tax in the United States and in European countries. From the late 1980’s, European countries steadily reduced their profits tax rates, while those in the United States remained steady. By 2008, rates in the United States were much higher than those in most other countries. Therefore, some American companies moved their home offices overseas or were bought out by foreign interests who could achieve higher overall profitability because of the lower taxes. Because of its complexity, the profits tax has had substantial compliance cost. Hiring tax accountants and tax lawyers cost firms an estimated $40 billion in 2004.

Further Reading
  • Abrams, Howard E., and Richard L. Doernberg. Federal Corporate Taxation. 6th ed. New York: Foundation Press, 2008. A detailed treatment of corporations and taxation that looks at corporation structure and taxation among many other topics.
  • Bruce, Neil. Public Finance and the American Economy. 2d ed. Boston: Addison Wesley, 2001. This college text examines the story of taxation through the twentieth century.
  • Buchanan, James, and Marilyn Flowers. The Public Finances. 6th ed. Homewood, Ill.: Richard D. Irwin, 1987. Nobel-laureate Buchanan presents a lucid overview of public finance. Chapter 25 concentrates on the corporate tax. An examination of the successive editions since 1960 covers a lot of history.
  • Panteghini, Paolo. Corporate Taxation in a Dynamic World. Berlin: Springer, 2007. Focuses on how tax policies affect the choices businesses make, including where they locate their plants and facilities.
  • Pechman, Joseph A. Federal Tax Policy. 5th ed. Washington, D.C.: Brookings Institution, 1987. Chapter 5 deals with the corporate tax, summarizing its current structure and theories of its impact.
  • Ratner, Sidney. American Taxation: Its History as a Social Force in Democracy. New York: W. W. Norton, 1942. An encyclopedic study with much detail on the legislative and judicial developments.

U.S. Civil War

Personal income tax

Incorporation laws

Internal Revenue Code

Taxation

Wars

World War I

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