The corporate income tax is the most poorly understood of all the major methods by which the U.S. government collects money. Most economists concluded long ago that it is among the least efficient and least defensible taxes. Although they have trouble agreeing on—much less measuring with any precision—who actually bears the burden of the corporate income tax, economists agree that it causes significant distortions in economic behavior. The tax is popular with the person in the street, who believes, incorrectly, that it is paid by corporations. Owners and managers of corporations often assume, just as incorrectly, that the tax is simply passed along to consumers. This very vagueness about who pays the tax accounts for its continued popularity among politicians.

The federal corporate income tax differs from the individual income tax in two major ways. First, it is a tax not on gross income but on net income, or profits, with permissible deductions for most costs of doing business. Second, it applies only to businesses that are chartered as corporations—not to partnerships or sole proprietorships. The federal tax is levied at different rates on different brackets of income: 15 percent on taxable income under $50,000, 25 percent on income between $50,000 and $75,000, and rates ranging from 34 to 39 percent on income above that. The lower-bracket rates benefit small corporations. Of the 4.8 million corporate tax returns filed in 1998, more than 90 percent were from corporations with assets of less than $1 million. The lower rates, however, had little economic significance. More than 91 percent of all corporate tax revenue came from the 1.5 percent of corporations with assets greater than $10 million.

States levy further income taxes on corporations, at rates generally ranging from 3 to 12 percent. Because states typically permit deductions for federal taxes paid, net rates range from 1.9 to 4.9 percent. Some localities tax corporations as well. One main reason that state and local corporate income taxes remain low is that corporations can easily relocate out of states that impose unusually high taxes.

How the corporate income tax arose and how it has survived over the decades is a case study of the perniciousness of bad ideas, of why tax systems are often so much worse than they need be, and of how little influence the economics profession has over government policy. Except for emergency taxes in wartime, corporate profits were first taxed in 1909, when Congress enacted a 1 percent tax on corporation income. The rate rose to 12.5 percent a decade later, and progressive rates—that is, rates that increase with income—were added in 1932. Surtaxes on corporate income were added for “excess profits” and “war profits” during both world wars. The highest peacetime rate, 52.8 percent, was reached in the 1960s.

In the 1940s and early 1950s, the corporate income tax provided about a third of federal revenues, and as recently as 1966, the proportion was 23 percent. It declined steadily for the next twenty years, reaching a nadir of 6.2 percent in 1983. This was partly by design: Congress cut the top corporate tax rates from 52.8 percent in 1969 to 46 percent in 1979, and during much of that time, tax law permitted relatively generous deductions for capital expenditures, either through accelerated depreciation schedules or through such devices as investment tax credits, so that the average tax rate paid by corporations fell even more sharply. Recent research has found that an equally important reason for the relative decline in corporate tax revenue is that U.S. corporations became less profitable. Corporate profits as a percentage of corporate assets, which averaged nearly 11 percent during the 1960s, were less than 5 percent from 1981 through 1987 and did not exceed 6.2 percent through 2000.

The Tax Reform Act of 1986 was designed to increase the share of federal revenues collected via the corporate income tax and to decrease the share from the individual income tax. While the top corporate tax rate, like the individual rate, was cut—to 34 percent—deductions for capital expenditures were severely curtailed and the investment tax credit was repealed. As a result, the effective tax rate for many corporations rose. The effort achieved its narrow goal somewhat: corporate taxes as a share of total federal receipts climbed back to more than 10 percent in the late 1980s. The top rate was raised a point, to 35 percent, in 1993, and corporate taxes rose to more than 11 percent of total revenues in the mid-1990s. As corporate profits contracted after the stock market crash of 2000 and the ensuing recession, however, so did corporate tax receipts. By 2003 they had declined to 7.4 percent.

From an economic point of view, the central problem with the corporate income tax is that, ultimately, only people can pay taxes. Economists have had great difficulty in assessing the incidence of the corporate tax—that is, determining on which groups of people the burden falls. As early as the seventeenth century, Sir William Petty, one of the progenitors of modern economics, argued that a tax on the production and sale of commodities would eventually be shifted by producers to consumers, who would pay it in the form of higher prices. Later classical economists disagreed, contending that taxes on corporate income fell on owners, making it, in effect, a tax on capital. They thought it could not be shifted because, theoretically, a corporation already charging prices that produce maximum profits could not increase prices further without reducing people’s demand for its goods.

Modern economic opinion is divided on the incidence of the corporate income tax, but few economists today believe its burden falls entirely on the owners of capital. The latest thinking is that, since capital is mobile, it will flow to investments that produce the highest after-tax returns. The corporate income tax raises the cost of capital and reduces after-tax returns in the corporate sector, and thus leads to a migration of capital into noncorporate or taxexempt sectors of the economy. This migration has two effects: it lowers the supply of capital available to corporations, and it causes a reduction in rates of return in the noncorporate sector as capital becomes more plentiful there. The ultimate effect, therefore, is to lower returns for all owners of capital across the economy. One important result of this capital migration is that the burden of the corporate income tax, over time, shifts to workers: with a smaller capital stock to employ, workers are less productive and earn lower real wages. In a 1996 survey, public finance economists were asked to estimate what percentage of the corporate income tax in the United States was ultimately borne by owners of capital. While their answers varied, the average response was 41 percent, meaning that the professional consensus is that more than half the burden is eventually shifted from owners of capital to workers or other groups.

Most economists agree that the corporate income tax causes two major inefficiencies. First, it penalizes the corporate form of business organization because income is taxed first at the corporate level and again when paid to stockholders as dividends. A traditional justification for singling out corporations is that they receive special benefits from the state and should pay for them. There are two problems with this rationale: first, if it were true, then all corporations, not just profitable ones, should pay; second, current corporate tax rates seem disproportionately high for this purpose. But the fundamental problem with this traditional justification is that it harkens back to the eighteenth century, when a corporate charter carried with it state-granted privileges such as monopoly power or exemption from specific laws. Today, corporations are created by private contract, with the government acting merely as registry and tax collector.

Recent experience shows this disincentive to the corporate form of organization at work. U.S. companies with thirty-five or fewer shareholders can elect what is called Subchapter S status. So-called S corporations have taxable income passed through to the tax returns of the owners, as in a partnership, instead of paying the corporate income tax. In the five weeks surrounding year-end 1986, after enactment of the tax reform bill, which raised the effective rate of corporate taxes, 225,000 companies elected Subchapter S status, compared with 75,000 for all of 1985.

The second major flaw in the corporate income tax is that it misallocates capital by favoring the issuance of debt over equity because interest payments are tax deductible, while dividend payments are not. This favors investments in assets more readily financed by debt, such as buildings and structures (which can be used for many purposes, and thus are more easily used as collateral for loans) over investments more logically financed by stock, such as specialized equipment or research and development. In addition, the deductibility of interest payments favors established companies over start-ups because the former can more easily issue debt securities. Some economists, focusing on this last phenomenon, have argued that this feature makes the corporate income tax a tax on entrepreneurship. During the 1980s, U.S. corporations issued huge amounts of new debt. Corporate bonds outstanding increased from less than $500 billion in 1980 to $1.4 trillion in 1988. At the same time, many corporations reduced their outstanding equity by buying back their own shares. The increased emphasis on debt financing was much more pronounced in the United States than elsewhere. In 2003, Congress took a step toward leveling the playing field by creating a special top tax rate for dividend income of 15 percent (previously, it was taxed as ordinary income at rates as high as 38.6 percent).

An additional problem with the corporate income tax is the way it is levied on multinational companies. The U.S. government taxes income earned both in the United States and abroad. Many other countries have more “territorial” tax regimes, which, in effect, tax only domestic income. The United States does grant tax credits, which allow companies to reduce their tax burdens by the amount of taxes paid to other governments, and other loopholes have been added over the decades, but the system has led to enormous complexity, especially for companies that have many operations and subsidiary companies abroad. Profits for subsidiaries are taxed only when they are returned, or repatriated, to the parent company, creating incentives for companies to reinvest foreign profits outside the United States and necessitating vast amounts of record-keeping.

The corporate income tax has survived all efforts to reform, repeal, or replace it, and there is little reason to expect a change in the near future. The simplest fix would be to equalize the treatment of interest and dividends, either by allowing corporations to deduct dividends or by granting an offsetting deduction or credit to stockholders. Most other large industrialized nations use the latter method. A more far-reaching reform, one recommended by economists for decades, would be to completely integrate the corporate and individual income taxes. One way to do this would be to treat corporations as partnerships for tax purposes (i.e., treat all corporations like S corporations), imputing all the profits to shareholders and taxing them under the individual income tax. The chief objection to this approach is that stockholders would face a tax liability for profits not distributed as dividends by the corporation. Several integration schemes have been proposed and rejected in the past. Many economists have recommended changing the tax rules for multinationals to eliminate the taxing of overseas profits, both for simplicity’s sake and to improve the competitiveness of U.S. companies.

The arguments in favor of leaving the corporate income tax alone are politically compelling. For one thing, the tax has a proven ability to raise revenue, an important consideration for a nation that has run chronic budget deficits. For another, the old aphorism that “an old tax is a good tax” has some validity. Any major change in the tax code changes expectations and imposes new costs and complications during the transition period. But the most compelling rationale for the corporate income tax is the difficulty in assessing its incidence. Since no political constituency sees itself as the primary payer of the tax, none is willing to lobby aggressively for change. Indeed, the art of taxation, as seventeenth-century French administrator Jean-Baptiste Colbert reportedly said, “consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.” Judged solely by this standard, the corporate income tax has worked well.

About the Author Rob Norton is an author and consultant. He was previously the economics editor of Fortune magazine.