ITAX FOUNDATION, INC.

50 Rockefeller PlazaNew York, N .Y. 10020

Coranment Finaam Brkf No_ 29De►enba 197

PricesiAOPerCopy

Copyright 1977Tim Fr:,-smuax, INC.

ForewordParticularly since the credit crunch of 1973-I974, the matter o f

double caution of corporate earnings has re-emerged as an impor-tant tax policy topic- Tentative moves have been made by berth th eFord and Carter Administrations and by members of the tax-writingcommittees of Congress to redr_- :.1. this long-standing inequitywhich more and more is being -icared as a real economic problem

yexerting a drag on economic performance .

WhHe designing an effective, workable program to alleviate thedouble taxation of corporate earnings has proven to be a large task ,most tax policy observers agree that the issue should be pressed_ I nthis spirit the Tax Foundation is pleased to present the findings o fMartin Feldstein and Daniel Frisch of Harvard University . whocompare the effects of several integration plans on the economy an ddistribution of tax burdens-

T he Tax Fo - :ndation is a publicly supported, nonprofit organiza -tion, founded in 1937 to engage in nonpartisan research and publiceducation on the fiscal and management aspects of government . Itspurpose, characterized by the motto "Toward Better Governmen tThrough Citizen Understanding," is to aid in the development ofmore efficient and economical government . It serves as a national in -formation agency for individuals and organizations concerned with

-problems of government expenditures, taxation, and debt .

TA FousDATIQN, i%*c _December 1977

3

Summary

Corporate Tax Integration :A Quantitative Comparison of Alternative s

Martin FeldsteinDaniel Frisch

This paper explains how the dividend credit method of integration _would operate and presents quantitative estimates of the impact o falternative forms of integration _

The total tar change and its distribution by income class aregiven at

_1918 levels . One possible form of integration, a 30 percent dividen dreceived credit, would reduce the tar on corporate source income by$6.8 billion . This would lower the avera ge effective tar rate ort cor-porate source income, includin g the corporation tar and the subsequen tpersonal tar on dividends and capital gains, from the current 41 percen tto ~13 percent . The tar on corporate source income would be cut by 18percent for low income shareholders (with AGI of 55,000 to 510,000);this reduction would gradually decline to a cut of 6 percent forshareholders with incomes over 5500,000 .

The basic quantitative estimates indicate the following sixconclusions .

(1) The likely forms of integration would raise the return to equityinvestors and encourage equity investment .

(2) A 30 percent dividend received credit would reduce the tar oncorporates ,urce income by approximately the same amount a sa reduction in the corporate tax rate -=from 48 to 4 3pc ^crt .

(3) Sort. • forms of integration could actually raise the effective ta xon c )rporate source income ; it is important to evaluate eac hproposal separately .

(4) The effect u► any dividend credit plan depends substantially o nhow firms respond in adjusting their dividends .

(S) The impact of integration depends on what other changes in th etax law are made at the same time .

(6) In evaluating the impact of any change, it is important to ex -amine the full tax effect including the implied tax on accruin gcapital gains and not just the immediate impact on ta xcollections .

Corporate Tax Integration:A Quantitative Comparison of Alternatives

B_v Martin Feldstein* andDaniel Frisch*

The basic principle of reducing th edouble taxation of dividends throughsome form of corporate tax integratio nhas received increased political attentio nand support from both Democrats an dRepublicans. Former Treasury SecretarySimon introduced a divi1end credit planas part of the Ford Administration's 197 5tax reform package. During his cam-paign, President Carter also declaredthat he favored some form of double tax-ation relief. Throughout 1977 theTreasury Department actively consideredvarious plans for corporate tax integra-tion . Regardless of what happens i n1978, corporate tax integration hasbecome an issue that requires carefulconsideration .

The corporate tax integration label i sin fact applied to a very wide variety o fproposals . They differ substantially intheir over-all impact and in the way in

which they distribute their benefits . Aninformed debate on these alternatives is aprerequisite of good political choice . Th ecurrent report presents quantitativeestimates of the effects of different in-tegration proposals.

We begin in the next section by remind-ing ourselves of the features that makecorporate tax integration a worthwhilenational goal as well as an advantage toequity investors . Section 2 then explainshow the most likely form of integra-tion—the partial dividend taxcredit—would operate . Our main quan-titative analysis of the effect of integra-tion is presented in Section 3 . Finally, toemphasize that the impact of integratio ndepends on the other changes that aremade in the tax law, we repeat theanalysis of Section 3 in combination wit hthe type of proposals in the Treasury'sdraft option papers of September 1977.

1 . The Advantages - of Integration

Although integration proposals diffe rsubstantially in many respects, they shar ecertain important qualitative features .Most basically, any integration schemeworthy of the name will lower the tota ltar burden on corporate source income .

This lower effective tax rate will reducethe current disincentive to corporate in -vestment and to equity investment in par -ticular . The current distorted incentive touse debt finance would also be reduced .All of this would make for a better use o f

•Ikpartment of Economics . Harvard University . and National Bureau of Economic Research . This repor tdescribes the results of research done during the past 18 months . A Tax Foundation adsisory group ha sbeen particularly helpful throughout the period . Farlicr results were presented in M . Feldstein and D.Frisch . "Corporate Tax Integration : The Estimated Effcets on Capital Accumulation and Tax Distributio nof Two Integration 1'rolx~sals ." Nurrnna! Tux Journal. March 1977. This report is distributed tostintulat ediscussion and has not been reviewed by the National Bureau of Economic Research .

6

our nation's capital stork a p. d therefore a_greater real national income . `

It is worth noting that these same ad -vantages would generally be achieved b ylowering the corporate income tax rat ewithout the added complexity of cor-porate tax integration . : Why then domany tax policy analysts apparentlyfavor some form of integration as th evehicle for at least part of the reduction i nthe effective tar on corporate sourceincome?

The primary reason is that the benefitsthat result from integration aredistributed among investors in a very dif-ferent way from the benefits of a cut i nthe corporate tax rate. A general cut i nthe corporate tax rate would benefit all

_ corporate shareholders equally . In con-trast, the type of integration recentlydiscussed by the Treasury might not pro -

` vide anv such benefits to pension funds ,charities, foreign shareholders, an dothers who are not subject to the persona lincome tax_' The tax cut implied by in-tegration is thus concentrated on in-dividual taxpayers . Moreover, among in-dividual taxpayers, the tax cut achieve dby integration is greatest for the low in -conic shareholders and least for the hick

income shareholders _

Everyonewill judge theequity of thesedistributional differences between in-tegration and a genera: corporate rate ru tbyhisown standard of fairness . But thereis more to the comparison than dif-ferenc--s in distributional justice. Whil eeither integration or a corporate rate cu twould be expected to attract more invest-ment to the corporate sector, the size o fthis effect per dollar of tax cut will be dif-ferent because different kinds of in-vestors—foreign investors, pensio nfunds, charities, and individuals at dif-ferent income levels—will not respond i nthe same way to changes in after-tax ratesof return.

If a primary purpose of integration i sto encourage equity investment, is it wiseto eliminate charities and othe rfiduciaries? Would we get more impac tper dollar of tax cut by giving greate rreductions to higher income taxpayers o rto lower income taxpayers? Unfortu-nately, we do not yet know the answersto these important questions_ in th edesign of a maju, change in the tax o ncorporate source income, these issue sdeserve more attention than- they havereceived . `

Thesc advantages of integration aredisditiscd more fully in M . Feldsicin :aid 1) . Frisch . °Corporatc Ta xInteg ration : The Btiniated F' ffcas on Capital Accumulation and Tax Diurihution of Tvvo Inte gratio nPropo '.11% ." Narimial Tax Journal. \larch 1977 . The hither after-tax return on cquity in%estmcnt migh taisoenunuagca higher savin g ratcand thcreforca greater total raicof capital accumulation . The likely ini -pact of integration on sa%inc is a complex yuvtitiun and drpcitds on the particular form of inie_gration . Th enature of the saving responsc is also discussed in Fcldsiein and Frisch .

A corporate ia\ :tit could not reduce the bias ag aimt dis idcads but this isdifferent in kind front theolhC rdistortions that affect capital formation, risk taking, etc .

' Although thcsc exclusions have been s feature of the proposals discuscd by the C'arier Administration .theyarc not a ncccssary aspect of integration . The Ford Administration's integration proposal ssould halv eused it dividend paid credit in conjunction with a dividend recci%cd credit to altos such shareholders torn -joy sonic of the licnelit of integration .

` %qme work on these issues is currently tinder Nay as par of the program on llosincss 'l axation an dFutancc of Htc National Ifurcati of Economic Research . Form indication of the intporGnticot these issues .sec M . FOiNicin and J . 5lentrod . '•Personal Taxation . Portfolio Choicc. and the Effect of the CorporateIncome Tax ." National Bureau of Econoinic Research Working taper . 1978 .

2. The Dividend Tax Credit Metho d

Until not long ago, many busines sspokesmen welcomed any form of cor-porate tar integuucior as a desirable relieffrom double taxation . There is now agrowing realization that the form of in-tegration is extremely important . 4 par-tial dividend credit method now appearsto be the most likely form of integration .The current section will thereforeexplai nthe working of the dividend credi tmethod in general and, more specifically ,the partial dividend credit method. `

It is useful, however, to begin byreviewing the complete "partnershi pmethod" of integration . This providesone standard against which to compar eall other integration proposals. it is also areminder that integration can actuall yraise the tax rate for some investors andtherefore can have a net effect quite con-trary to the intended purpose of integra-tion . `

To see this, it is useful to consider theextreme case of a company that pays nodividend to an individual shareholde rwith a 70 percent marginal tax rate. Fo rsimplicity, assume that the corporatio npays the full 48 percent corporate tax rat eand has no credits to offset any of this taxliability . If the corporation earns on edollar per share, it retains profits of fifty-two cents per share. Since the share-holder receives no dividend, there is nopersonal tax to be paid under current law ;the total tax iiability is the 48 percent pai dby the corporation. In contrast, underpartnership method integration, the cor-poration has no tax to pay but the in-dividual must pay a seventy cent tax . In-tegration thus raises the total tax liabilit yby twenty-two cents .

In making this comparison, w e have ig-nored the fact that retained earnings en -tail a future capital gains tar liabilit yunder the current system but not underthe partnership method of integration .The effective magnitude of the extr acapital gains tax would depend on whe nthe stock was sold and on the investor'scapital gains tax rate at that time. As apractical matter, the present value of thisfuture tax liability is likely to be substan-tially less than twenty-two cents .

Although we have examined an ex-trcme case to emphasize the point, it is cnot necessary to consider a 70 percen ttaxpayer or a company without dividendsto find that switching to partnershipmethod integration would actually raisesome investors' tar rates on corporatesource income . This would have theundesirable effect of increasing the taxpaid on corporate investment and reduc-ing the general incentive to save.

The proposal to apply the 50 percen tceiling on tax rates to all income (and no tjust to so-called personal services incomeas at present) would virtually eliminatethe possibility that integration could in -crease any shareholder ' s total tax on cor -porate source income . But it would alsomean that the partnership method of in-tegration would involve a much greate rloss of tax revenue . It therefore seem slikely that, with either the current taxrates or the discussed reduction, the part -nership method of total integratio nwould be rejected in favor of some for mof limited integration .

The most likely proposal will be soni cform ofdividend received credit in which

'this %cction drasss extcnsiccly tun M . Feldstein, "Tax Reform and the Imcstor." Data Resources Review.Ckaober1977 .

` This possibility of a perverse effect is stressed in the paper by Feldstein and Slcmrod cited above .

shareholders are allowed to treat some The basic mechanics of the full divi-

_fraction of the corporate tax payments as dend received credit are shown in Tabl ea withholding of personal tax . The choice t . To simplify the arithmetic. we have

-among the different possible methods of assumed that the statutory rate of th edividend received credit integration can corporate income tax is 50 percent in-make a big difference to the impact of the stead of the actual 48 percent . Column Itax change on asset markets and on the reviews the situation under the existing

_=

kinds of companies and shareholdkrs law and from the point of view of awho benefit . Although a full dividend shareholder with a 30 percent margina lreceived credit plan has been wider tax rate. A corporate profit of S100 im -discussed, there is little chance that it plies a corporate tax liability of S50 . Ifwould be proposed or adopted . It is the firm has tax credits (i.e., the invest-nevertheless useful to consider _his com- ment tax credit and foreign tax credits) o fplete credit plan before examining the S15—roughly the current average—th emore limited credit options that aremore _ actual corporate tax payments arc S35 .likely to emerge. This is shown in lines 2 through 5 . %Vc

TABLE 1

EFFECTS OF ALTERNATIVE FORMS OF CORPORATE TAX-INTEGRATIO NWITH UNCHANGED CASH DIVIDENDS

-

L

Full Dividend

Partial niviaend

cCurrent Law Cre6ta

ReceivM Cre6tb_Received(1)

(2) (3)

(4)

(5)

(6)

1_ Individual marginal taxrate

30%

50% 30%

50%

30%

50 %-2. Corporate profit

5100

$100 $100

$100

$100

$1003. Corporation tax

50

50 _-=50

50

-' 50

50

„4. Tax credits

15

15 15

15

15

I55 . Corporation tax paid

35

35 35

35

35

356. Retained earnings

35

35 35

35

35

35

-7. Dividend

30

30 30

` 30

30

308. Gross•uptwithholding

--

-- 'M

30

16

1 69. Total dividend

30

30 60

60

46

4 610. Personal tax on total

dividend

9

15 18

30

14

2311 . Withholding credit

--

-- 30

30

16

1 612 . Net personal tax

9

15 (--12)

0

(—2)

713 . Spendable dividend

21

15 42

30

32

23

a . Based on statutory corporate income tax rate of 50 percent .

-b . Limited to 35 percent tax rate .

9

assume that S35 is af:o retained by th ecorporation, and the remainin g S30 is:Paid in dividends. There is no grossing-up under the current law, so the S30 pai dby the corporation is also the amount onwhich the personal tax is levied . With a 30percent marginal tax rate, this implies atax of S9 fline 12)_ This leaves spendabledividends of 521, as shown in lin_ 13- Asimilar calculation for a shareholder with-a 50 percent marginal tax rate i spresented in column 2; his spendable div- -idends arc S15 under current law .

Consider now how the full dividen dcredit plan affects the 30 percent tax-payer- This is shown in column 3. Thefirst seven rows are exactly the same as incolumns 1 and 2, reflecting the assump-tion that firms continue to pay the samedividend and 11cep the same retainedearnings as under the current law; we wil lreturn t o this issue below . The gross-u pshown in row 8 is the distinguishin gfeature of this plan . The easiest way to

-think about this is to regard part of thecorporate tax payment as a withholdingof personal income tax on a largeramount of dividend. With a full dividendreceived credit, this withholding isassumed to take place at the full cor-poratc tax rate, or 50 percent, in the cur -rent example_ This implies that thewithheld tax is equal to the dividend paidout . In the language of the gross-up-and-credit formula, S30 of dividend paidgrosses-up to a $60 "total dividend "shown on line 9 . Another way to view thi sis to think of the company paying a S60dividend but subject to a withholding ta xat the full corporate rate of 50 percent ;the remaining corporate tax payment o fS20 is on the retained earnings and is no tconsidered withholding .

What happens next is the most impor-(ant step . The individual shareholder in -dudes the total dividend of S60 in his tax -,able income . With a 30 percent margina ltax rate, this $60 implies a tax-liability of

Sl8 (shown on line 10)_ The individua lalso receives a tax credit of S30 for th eportion of the corporate income tax thatis treated as withholding . On balancethere is a net credit of S12 ;i-e_, S30 minusS18) available to offset other personal ta xobligations or to receive-as a rebate _Thus, the full dividend received credi tplan changes the personal tax from a S9tax liability to a S12 tax credit . Put dif-ferently, the spendable dividend risesfrom S21 under current law to S42-w_; tl:the full dividend received credit . -

A similar calculation for a shareholderwith a 50 percent marginal tax rate isshown in column 4. The only difference isin the shareholder's personal tat liability .With S60 of total dividends, the persona ltar liability is S30_ This is just offset bythe withholding credit ; -here is no extratar to pay on the dividend. Thus, the fulldividend received credit completelyeliminates the S15 of tae that theshareholder would pay under the currentrules . His spendable dividend is doubledfrom SIS to 530.

Note that all shareholders benefi tunder the full dividend received credi tand that the benefit per dollar of divi-dend or profit is greater for the lowerincome shareholder . Because a with -holding method is used, the benefits nee dnot be extended to foreign shareholders,pensions, charities, and others who donot file the individual tax return .Moreover, since the tax reduction i slimited to the proportion of profits thatare paid out as dividends, the cost to theTreasury need not be as great as under thepartnership method of integration . Why ,then, will the full dividend credit methodnot be adopted?

The basic reason is that the full divi-dend received credit would cause mos tshareholders to put great pressure o nfirms to pay out all of their profits asdividends . And if all profits were in fac tpaid out, the dividend credit plan woul d

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TABLE 2TAX CONSEQUENCES OF AN INCREASE IN DIVIDENDS PAID

r ;_

Fur Dividend

Partial MidendQrrent LOW

Received Credita

Reaeired Credits(1)

(2)

(3)

(4)

(5)

(6)

1 . Individual marginal ta xrate

_30%

50% 30%

50%

30%

50%

_ 2- Dividend

-$1-00

51100 $1 .00

51 .00

Sl_00

51 .00

3. Gross-up:'withholding 1 .00

1 .00

0 .54

0.54

-

4_ Total dividend

1.00

1 .00 2.00

2-00

154

1 .54

5. Personal tax on totaldividend

0 .30

0.50 0.60

1 .00

0.46

0.77

6. Withholding credit

--

-- 1 .00

1 .00

054

0.54

7 . Net personal tax

0.30

0.50 -0.40

0

-0.08

0 .23

-

a . Based on statutory corporate income tax rate of 50 percent.b_ Limited to 35 percent tax rate_

be equivalent to full integration by the shareholder with a 30 percenr marginal

-partnership method. The resulting tax rate of an extra dollar of dividends paid

=loss would be too great to .-be politically by the company. The extra dollar of cas hacceptable. dividend implies a gross-up of SI AO and ,

therefore, adds S2 .00 of total dividend t oTable 2 shows just why this pressure the shareholder's taxable income; this is

for full payout would come about . Under shown in line 4 " With a 30 percent_current tax law, shareholders can receive marginal rate, the personal tax on thi sdividends from one firm and invest them total dividend is 60C . But with a credit o fin another only by paying an additional ,x1 .00, the net impact on the individual' spersonal income tax . For a shareholder tax liability is actually a decrease of 40C .with a 30 percent marginal rate, only The shareholder, therefore, ha :. S1 .40 for

_ L.- seventy cents per dollar of dividends is reinvestment, even though the company

favailable for reinvestment ; a 50 percent reduced_ its retained earnings by onl ymarginal rate implies that half of the divi- S1 .00.

_

dend is "lost" in personal taxes on the _way

to

reinvestment . The

familiar Any shareholder with a marginal rat e

calculation is reviewed in columns 1 and below 50 percent reduces his personal tax

2. The current tax law thus provides a liability when his dividends are increased .

strong incentive to retain earnings rather For a 50 percent

marginal

tax rate

-than to pay them out for reinvestment . shareholder, the withholding credit ex-

actly equals the extra personal tax liabili -Just the opposite would be true under ty, so there is no net effect of paying extra

„the full dividend received credit rules . dividends . Moreover, retained earningsColumn 3 shows the consequences for a entail a potential future capital>gains tax

which is avoided when dividends arepaid-

In short, with a lull dividend credi tplan . every shardiolder with a marginaltax rate of 50 percent or less would payloner taxes if all profits were ;+eeUout asdividends. There would be strong

;_ . pressure on companies to pay outeverything in this way. if the topmarginal tax rue were lowered to 50 per-

_ cem, the pressure for complete payou twould be irresistible. The attempt to limitthe cost of integration by restricting it todividends would thus be failed becaus eall profits would be paid as dividends .The very high cost of this complete in-tegration, as well as corporat e

= management 's opposition to a tax lawthat would, in effect, forge act profits tobe paid out, make it dear that th lulldividend received credit is very unuke yto be enacted.

These problems can be avoided by amore limited form of dividend receive dcredit . The simplest approach would b eto use a rate lower than the full corporatetax rate for calculating the gross-up andcredit . Columns 5 and 6 of Table I sho wthe implications of using a 35 percent rat einstead of the SO percent rate for this pur -pose. The first seven litres show the sam efigures as in the full credit analysis. inparticular, we continue to assume thatthe company pays S30 of dividends. A 35percent rate implies a gross-up of 516 ,ix-, 35 percent of the fu►1 dividend of S4 6implies a withholding tar of S16 and acash dividend of 530.' The personal tarliability on the S46 of full dividend is S1 4at a 30 percent marginal tax rate . With awithholding credit of 516, the net tax ef-fect is actually a S2 credit . The spendable(or reinvestable) dividend is, therefore,532. Note that this is less than the S42 o fspendable dividends with the full divi-

dend received credit (column 3), but Sl Imore than the spendable dividends undercurrent law.

The corresponding analysis for ashareholder with a SO percent marginaltax rate is shown in column 6. The re-duced dividend received credit cuts hispersonal tax liability on S30 of div ideud sfrom SIS under current law to only S7.

Reducing the credit rate to 35 percentlimits the cost of integration per dollar o fdividend and also avoids the pressure fo ra 100 percent F-kyout that would existwith the full d --';end credit. Table 2shows the impact of a dividend increaseunder the 35 percent tax credit plan . Forashareholder with a 30 percent marginaltax rate, an eara dollar of dividendreduces the personal tax liability by 8c .Although this is much less than the 40creduction unrier thelull credit rule, suchshareholders wou'.d still prefer to see allprofits paid out as dividends . But for ashareholder with a SO percent tax rate, a neara dollar of dividend raises the per-sonal tax liability by 23c . High taxbracket shareholders would . therefore,oppose a complete payout of profits . Onbalance, dividends would be expected t orise with a partial rate dividend creditbecause $I of dividends involves less tatthan at present for shareholders at everyincome level, but the dividend increasewould be to less than full payout -

There are, of course, other ways o flimiting the dividend received credit . Thechoice among them and the exact methodof implementation could have importan tconsequences . Although this is not ; n ap-propriate place to examine these alter-natives in detail . two options arc worth abrief comment .

An alternative to the part;-A credit rat ethat has been discussed by tax specialists

The general formula is that the full dividend rguak the cash dividend divided by (1-0 Mherec is the credi trate . The v►ithholdung aedit per dollar of cash dividend is thus et(t-c).

12

is to permit credit for the full corporatetax rate but only on put of the dividendsthat are paid_ For example, individualsmight be allowed to apply the gross-upand credit at the rate of i0 parent on hal fof their dividends. This method and thepartial rate credit are really exocttrequiramt for an appropriate choice ofrates- For example, the full credit appliedto half of the dividends is equivalent to a33 percent credit for all dividends_ illofthe consequences are, therefore, th esame-

A more important alternative would beto relate the gross-up and credit rate toeach corporation's so-called effective taxrate; i.e., to the corporation's use of theinvestment tax credit, the foreign taxcredit, accelerated depreciation, andother so-called tax preferences . There aretwo basic approaches. The first wouldreduce the rate of gross-up and credit tothe extent that the corporation's 'Wee-the tax rate" is less than the statutoryrate. This would, in effect, require a cor-poration to forego its ITC, its foreign taxcredit, and other favorable features ofthe tax law to the extent that it paid outany dividends. This would undermine thepurposes for which these features wereoriginally included in the law . It wouldhave the peculiar effect of inducing firmsto reduce their own incentive to invest .

The idea of "preventing shareholdersfrom claiming withholding credits fortaxes never paid" appears to have apowerful political appeal even though i tis in effect a partial withdrawal of suchwell-regarded features of the tax systemas the investment tax credit . Fortunately,such a limit is not likely to be an effectiv econstraint if the dividend credit rate is

relatively lour- It may, however. inducefirms to limit their dividend payout ratesto the amount that could take advantag eof the integration option. For some in-dividual companies, the effect of such alimit could be very important but a nanalysis of this problem ties beyond theproper scope of this report -

Foully, we should note that althoug hwe have been describing what are know nas dividend received credits . the samebasic cakulations apply to dividend paidcredits. The prim&-y ope-tional dif-ference is that the dividend paid creditsare paid to the firm instead of theshareholder. From the point of view o fthe individual shareholder, the twomethods should be equivalent . Moreprecisely, the dividend paid creditmethod makes it possible to have thesame combinations of spendabledividends. retained earnings, and totaltaxes, as the dividend received credit-Firms should therefore choose the samepayout rate under either system, leavingthe firm and the shareholder with thesame retained earnings and dividends .The primary difference between the divi -dend received and dividend paid methodsis therefore in the implicit treatment o fforeign shareholders, pensions . charities,and other excluded from receiving thedividend received credit- Because thedividend paid credit applies to al ldividends without regard to the status ofthe shareholder, this method extends th ebenefit of integration to all types o fshareholders . In what follows, we con-centrate on the dividend received creditbut indicate the increase in the tax cu tthat would result if a dividend paid credi tmethod were used instead .

, We ignore for the moment shareholders Nho are not domestic ind ividuals .

13

3. The Effects of Integration

We are now ready to turn to theprimary focus of this study: the estimatesof the quantitative impact that differentintegration proposals would have on thetaxes paid on corporate source income_Our estimates are not macroeconomicprojections based on an aggregateeconometric mold_ Instead . we makeour calculations by using a sample o fmore than 28.000 actual individual in-come tax returns for 1 9773 . This sampleofreturns was selected by the Treasure i nsuch a crag that our cakWations canestimate the effects for all taxpayers -

Although our analysis is based onreturns for 1 973, these returns have beenprojected to represent the situation inI978 . It is important to bear in mind thatthe rdative effects of different proposalscan be estimated well even if the ex-trapolation from 1973 to 1978 does notestimate the actual profits and taxes for1978 with great precision .

This section focuses on the effects o fintegration in the context of the tax law asit exists in the middle of 1977- In the nex tsection, we analyze the combination ofcorporate tax integration and the collec-tion of tax reform options recommendedby the Treasury in September 1977-

Our analysis examines only the firstround effects of integration . In par-ticular, our calculations assume nochange occurs in (I) the pretax profits o fcorporations, (2) the debt-equity ratiosof corporations, and (3) the ownership ofcommon stock . Clearly all three of thesewill change over time and these changeswill be important for the ultimate effectof any integration plan. At present, our

knowledge of the likely corporateresponses is too Limited to try to includ ethan in the analysis- The results musttherefore be regarded as estimates -fth-fast-round effects and therefore . +hestarting point of the drain of conse-quences that would follow integration -

Our estimates are concerned with thetotal tax burden that individuals pay oncorporate source mcome Me therefor eaugment the information on the persona ltax returns in our sample with an esti-mate. based on each individual's divi-dend income. of the individual's cor-porate source income (i.e.. the corporat eprofits earned on the stock he owns) an dthe corporate tax that he pays . The im-mediate statuton tax on corporatesource income associated with cadsreturn is therefore the sum of the cor-porate tax paid (net of credits) on that in -come and the personal tax paid on thecorresponding dividends. The immediatestatutory tax is a faulty measure of thetotal tax liability on corporate sourcc in -come because it ignores the accruingcapital gains liability that must some da ybe discharged. We have therefore esti-mated this accruing capital gains liabili -ty. reduced it by a factor of two becausethe tax can be postponed for a period oftime, and then added this extr a"equivalent capital gains tax" to the im -mediaiestatutor4 tax to obtain a measurewhich we denote thefull taxon corporatesource income_'.

Although estimation of the equivalentcapital gains tax contains substantial ap-proximations, we believe that th ecalculated changes in the full tax arc a

' More spaifscalI4 . we calculate the capital (vain in each period as the sum of two contp rictus_ Fire . eachdollar of retained earning . i% a ..umcd is raise share values ha one doikr . tic;ond. inflation is a.tumcd t oraise share priccs in propoxtion to the inw raase in the prat ks ei : %c a.tume a 6 per:cnt inflation rate for thi spurpose_ The sumofthewtaouwr ;e.oftkuninalcapital gains i .disidcdb} iwoasa :rudcadjuvinent forthe futurity- of the actual realization and the result is then addctl io current (i .e.. 1975) capital gains.

14

better measure of the impart of tax revi-sion than the corresponding changes i nimmediate statutory tax collections. Thisdistinction is particuiarly important i nevaluating integration if capital gains areto be taxed in full; we return to this in thenett section . With the actual 1977 tarlaws. there is little difference in the com-parison of the full tax consequences andthe statutory tax consequences of in-tegration- The basic estimates of this sec-tion relate to changes in the full tat ; acorresponding table of changes in th estatutory tax is presented in appendixTable .4-1 .

We have analyzed the estimated effectsof six different tax proposals : a completedividend credit plan using the 45 percentcorporate tax rate;" partial dividendcredit putts of 30 and 20 percent; com-plete integration by the partnershi pmethod; and reductions in the averagecorporate tax rate from 45 to 42 percen tand to 40 percent without any integra-tion .'" Our analysis of the dividendcredits assumes that the available creditsare not limited because of so-called taxpreferences- With the complete dividendcredit plan (i.e., the 43 percent credit) ,this requires that such things as the in -vestment tax credit and the foreign tatcredit be "passed through" toshareholders. With the partial dividendcredit plans (i.e., the 20 percent or 30 per-cent credit), the existence of "tarpreferences" would not reduce th eavailable credit for most firms. Even ifthe dividend credits are limited only tothe amount of tar actually paid, a firmcan take advantage of the full credit if its

dividend payout rate is not extremelyhigh-

As we noted in the previous section,the effect of an integration proposal ca ndepend crucially on the response o fdividends to the tax change- We thereforeanalyze three quite different assumptionsabout the change in dividends- Of course ,any change in dividend payout rates maytake several rears to evolve. Since ,̂ v areinterested in the effect of the new taxrules after such a new dividend payoutrate is established, we shall assume thatthe full change occurs immediately sothat our simulations for 1978 can reflectthe eventual dividena payout pattern.The first of our three alternative assump-tions is that companies continue to paythe same dividends to their shareholders(i.e., literally to write the same dividendchecks that they would if there had beenno change in the tar law) and therefore tomaintain the same retained earnings.This "direct dividends held constant"assumption implies that all of the taxreduction becomes an increase in spend-able dividends and none of it becomes a nincrease in retained earnings. The sec-ond assumption, which we refer to as"total dividends held constant," is tha tfirms reduce the cash dividends they pa yso that the sum of the new cash dividen dplus the credit the shareholder receivesfrom the government equals the old divi -dend. This implies that the taxable divi-dcnd remains the same- z : Of course, th ecredit implies that this unchanged "totaldividend" is taxed more lightly than a tpresent so that spendable dividends rise(although by less than with direct

This is the wcieStcd awrageof thcsratutory co : poraic tax rates because of the reduced rates on profits o fless than S0 .000 .

" With the intccratio n opti.uts (i.e. . the first four , top.s~ls), we aswmc that the iurrcnt SIM disi.lendexdusion is cfiminated . it would of course be possible to retain the exclusion and apply the integratio nonly to di%idcnds in cwc%s% of St00 .

` 7 In the tams of Taf+t : I of the prey i.uts scition . she *%4kh di%idcnd"of line 7 is rcdu,.W so that the "totaldividend"of line 9 remains the same as under current law .

is

dividends held constant). Finally, weshall look at the extreme assumption thatall income is paid out as dividends, i.e. .that retained earnings are reduced t ozero. As we showed in Section 2, undersome tax plans there would be very strongpressure for such an extreme change individend policy_

Our extrapolation to 1978 implies ag-gregate taxable corporate profits" o f5182.9 bullion-- The corresponding cor-porate tax liability is 583.0 billion; afterthe investment tax credit and foreign taxcredit . the net corporate tax liability isS61 .'r billion . We estimate total dividends(excluding intercorporate dividends) o f539-1 billion. Individuals who file per-sonal tax returns received S32-9 billion ofdividends from C .S. corporations . Wecalculate the personal tax on thesedividends to be SI1-8 billion. Togetherwith the pro rata share of net corporatetax liability, the combined tax on the cor-porate source income attributed to in-dividuals is $63 .1' billion. This is anwrtrage effective tax rate of 41 percent .When the imputable capital gains tax isadded, the full tax on corporate sourceincome becomes S7=_5 billion for an ef-fective rate of 4" percent _

The basic estimates are shown in Tabl e3. We will review the first of the alter-natives in some detail and commentbriefly on a few others . The reader wil lthen be in a position to examine all of th eremainin g simulations .

A 20 percent dividend credit (simula -tion A 1 of Table 3) would reduce the ful ltax on corporate source income by $3 .8

billion if direct dividends are held con-stant- If the credit is extended to pen-sions, charities, and otters who are notsubject to the U .S- personal income tax,the tax cut would be increased by SI . Sbillion to S5 .3 billion . The 53 .8 billion taxcut is equivalent to a ; percent reductionin the full tax on the corporate source in-come of indivdiduals of $72.5 billion-The tax reduction is proportionatelygreatest at the low income levels andbecomes smaller as income rises . Fortaxpayers with 1978 adjusted gross in -comes between S5.000 and SI0.000. thefull tax on corporate source income isreduced by 10.5 percent . When AGIreaches the 530.000 to 550,000 range, thereduction is only 4.7 percent . At thehighest incomes, the reduction is dose to3 percent- This progressivity is easy tounderstand since everyone receives thesame 20 percent credit but the credit is ineffect subject to tax at the individual' spersonal marginal tax rate.

The patterns of tax reduction shown i nthe last four columns of the table aremore surprising . The 20 percent taxcredit reduces total income taxes—Le-the sum of the personal income tax andthe corporate tax—by I .4 percent wit hthe greatest reduction at the lowest in -come level . AIthough dividend income i smore important at hi gher incomes, th elow income individual p-ys little personaitax . For these individuals, the corporat etax is therefore relatively more impor-tant . A reduction in the tax on corporat esource income is therefore a greater pro-portional reduction in total taxes .

Taxable corporatc profits arc of course different from the profits rczocdcd in the national income andprod uttaccounts . Forarccentexplanation oftheditfrencci.MAenthcsetwoconccpts .seeTableS .S.

-66 in U .S . Dcpartmni of Gunmrcc. Sunrv~ ;jCurrrxt Buurrtcc. Jul 1976 . — U .S. National incomcandProduct accounts . 1973 to Second (quarter 1976 . " Section 8 : Supplcnicitury Tablcs .

- Remember that the simulations are not a fsxxau but an eztra ;sslation of the cspericnce of a basdincstar. A more accurate forecast of 1978 profits could have %cry tittle effect on the results that we wil lpresent .

" A full tabulation of tav rcJucrion by AGI -spre!- sled in Table A-2 . More detailed resultsof thesimula-tions arc asailablc from the authors .

16

TABLE 3

ESTIMATED EFFECTS OF ALTERNATIVE TAX INTEGRATION PROPOSALS"Full Tax Liability

ChsnOe In Tex by Aal CloseChange In Tax Percentage Change In Total Te a

4111111lons

l

Dollars) Par

Change In Tax (Personal Income Tax plus Tea onr'

-.

Individua l dual

All on Corporate source Incomerts'n

. ,_ ~orporale sourc e ~ .,

. . .'

Inaom") „, .. ,Proposal and Dividend Assumption Tax payers

share .only

holders lOver.

$30,00aall

,10,000

60,000 --- -660o 000,1,00",000 Over.

1111,0004all

10,000$30,00a00,000 6100 000.1,O .m-

A . Partial Dividend Credit : 20!'oAl . Direct dividends constant --33 .78

-$5,34 -5.2%

-10.5%

-417% -3.5% -1 .4%

-310% -019% -2.3 %A2 . Total dividends constant -5.11

-6,35 -7.1

-9 .8

-5 .6 -6 .9 -1 .8

-2,8 -1 .3 -4 .6A3 . 100% payout *11,19

•h6 .98 4 . 15 .4

-11 .9

4. 14,8 4. 33 .3 4°4 .0

-3,4 4. 2.9 '1'22 .08. Partial Dividend Credit : 30 %

01 . Direct dividends constant -6.74

-9 .42 -9.3

-18.3

-8 .8 -010 -2.4

-5 .2 -0 -3 . 982. Total dividends constant -7.89

-9.76 -1019

-15.1

-1013 -10,3 -2.8

-4.3 -2.0 -6,883.100 : payout 4. 3,99

-3,23 4 . 5 .5

-31 .2

4'511 •f•28.9 411 .4

-819 4. 0.9 4. 17 .8C . Complete Dividend Credit : 45 %

C1,Diracldividends constant -13.08

-18.17 -18.0

-•35 .0

-17.6 -11 .1 -4 .7

-919 -3 .4 -7 .3C2 . Total dividends constant -12.06

-14,86 -15.6

-22 .9

-16 .1 -15,3 -4 .4

-6 .5 „. 3 .1 •10 . 1r

C3 . 100% payout •-11,21

-24 .98 -1515

-•71 .6

-15 .6 +31 .1 -4,0

-20.3 -310 460 . Complete 'Ptatn*rsh1p"

Integration -11 .67

-24,67 -1511

-6819

-18.2 4 . 9.1 ~ 4 .2

--19.6 -3 .1 4. 6,9E. Corporals Tax Rate Reduction :

45 percent to 42 percent -4,51

»5 .49 -6.2

-8 .2

-6 .3 -517 "43 -1.2 -3 .8F. Corporate Tax Rata Reduction :

45 percent to 40 percent -7.19

••8 .75 -919

-13 .1

-918 -911 -2 .6

x°3,7 -1 .9 -6,0

a Estimates relate to 1978 . The tax law as of 1977 applies except lot the Intogtalion proposals . Tax changes relate to "lull lax" as dellnod In the taxi ; ace appendi xTable A•1 for "statutory lax" changes . Tax changes for All Mil classes are pie3anted In appendix Table A-2,b The Change in lax for "All Shareholders" would result it charities, pensions, and foreign shareholders were eligible lot the full tax ctodil .v

If corporations respond to the 20 per-cent dividend credit by cutting their cashdividends to keep "total dividends" (ice_,taxable dividends) unchanged, theresulting tax cut is increased from S3 . 8billion to S5.1 billion. The lowerdividends result in a greater tax reductionfor high income individuals, thus reduc-ing the over-all progressivity of the taxchange.

Alt increase in dividends could actuallycause a substantial rise in t-x payments _Although a 20 percent dividend credi tshould not induce a full payout of al ldividends (simulation A3). the simula-tion is interesting as an indication of th eway in which integration could, by induc -ing a higher payout, dilute its own value .

The 30 percent tax credit results in asubstar tially higher tax reduction . Wit hdirect dividends unchanged, the total in-dividual tax on corporate source incom efalls by S6.7 billion_ Extending the credi tto all shareholders raises this loss by S2 .7billion. Again the cut is very progressive,falling from an 18 percent reduction forshareholders with AGI between 55,000and S 10,000 to 6 percent for very high in-come shareholders -

A complete dividend credit (i.e_, witha45 percent rate) would reduce taxes b ySI3 billion. A comparison of the three

dividend opeions shows that a substantialdecrease in dividends would reduce th eeffective tax cut (by limiting the amountof dividends that can benefit from thecredit) while a substantial increase i ndividends would also reduce the effectiv etax cut (by pushing shareholders intohigher marginal tax brackets) _

Complete inte gration by the partner-ship method is ven similar to the com-plete dividend credit combined with the100 percent dividend payout .-` Theprimary difference is that with complet epartnership integration, the investmenttax credit is not subject to personal tax ,while with the 100 percent payout, weassume that the ftrtte pays out the invest-ment tax credit and therefore subjects i tto the personal income tax .

Finalh, simulations E and F presen treductions in the corporate tax ratewithout any integration or dividendcredit . A three percenta ge point reduc-tion (from a current effective rate of 45percent to 42 percent) reduces the tax onthe corporate source income of in-dividuals by S4 .5 billion, about as muchas a 2S percent dividend rcceivcdcredit - 1 7

Similarly, a five percentage point reduc-tion in the corporate tax rate reduces th etotal tax on the corporate source incom eof individuals by more than a 30 percen tdividend tax credit .

4. Tax Integration and General Tax Refor mCorporate tax integration has recentl y

been discussed as part of a package ofsweeping changes in the taxation o fcapital income. The proposal developedby the Treasury staff in 1977 containe dtwo features in addition to integration

that would be of particular importance t oinvestors . First, the proposal called fo ran across-the-board reduction in per-sonal tax rates, with a top rate of 50 per-cent applying to investment income aswell as to "personal services income ."

%V th the partner+hip mcthAQ . protit% arc taxed %hedger or not they arc paid out . W separate simufatiottsfor different dividend as%umpiion% need be caladatcd .

since she corlwasc lac rate reduction automatically bcnctiis all sharchoidcrs, the total tax reduction isacivally S5.5 billion .

18

Second, capital gains would be taxed atthe same rates as ordinary income.Although this proposal is unlikely to beintroduced, it is instructive to examinehow changes such as these would affectthe over-all taxation of corporate sourceincome and would alter the impact ofintegration-'s

Three major conclusions emerge fromthe estimates presented in Tables 4 and 5of this section. Furst, the proposalwithout any integration would have en-tailed a very large increase in the tax oncorporate source income. The heaviertaxation of capital gains would muchmore than offset the reduction in ta xrates. A modest dividend credit of 20 per -cent would still leave the package with anet increase in the tau on corporatesource income.

Second, because most of the extra tarburden would occur in the future throughthe heavier taxation of capital gains, th et raditional method of measuring the im-mediate tax impact would hide the trueeffect . The immediate statutory impac tof the proposal without integrationwould be to leave the tau on corporatesource income essentially unchanged . Incontrast, the change in the full tau(including the discounted future capitalgains tax) would be a S5 .7 billion increase

for 1978 . With a 20 percent dividendcredit and no change in dividends, the im -mediate statutory tax changes would be aS5 .2 billion tax cut while the more ac-curate full tax change would be an in -crease of S1 .2 billion .

Third, the incentives for dividenddistribution would be very different if adividend credit plan were combined wit hthe Treasury- staffs proposal for moregeneral tax reform . In particular, a divi-dend credit of 30 percent or more wouldprovide a strong incentive to pay out al lincome as dividends . Even for taxpayerswith adjusted gross incomes of $50,000,the combined tar rules would producethe lowest tar burden if the dividen dpayout rate were raised to 100 percent .This is in sharp contrast to the incentive sunder the current rules with which a 3 0percent credit would provide little incen-tive for greater dividends .

These conclusions can be seen in moredetail by examining Tables 4 and S. Table4 shows the effects on the full tax on cor-porate source income of the Treasur ystaff proposal alone and with differen tcombinations of tau integration pro-posals . Table 5 presents the an_ [oeousfigures for the immediate statutory- tauchanges.

"Our analysis of this general reform proposal alit) includes a number of other features containcd in th eSeptember 1977 Treasury staff proposal . including the replacement of the personal csemption h% flatcredits, increase in the standard deduction . elimination of some itcmimd deductions . and replacement o fthe minimum tat by limits on deductions and credits . The package of ta% changes a cludrn integratio nincludes a reduction in the "full personal t"" of S22 billion ; the °inuncdiatc statutory tax" is reducedby S28 billion .

19

I

c TABLE 4

ESTIMATED EFFECTS OF COMBINING CORPORATE TAX INTEGRATION WITH A "GENERAL TAX REFORM"Full Tax LlablIlly

Change In Tax by A01 Chess

Change In Tax Percentage Change In Total Ta x(Billions of Dollars) Percentage Change In Tax (Personal Income Tax plus Tax on

on corporate source Income Corporate Bourne Income)

Taxpayers Share . Over.

$5,000•

$30,000• 5500,000• Over

5G,000 570,000• 5600 000•Proposal and Dividend Assumption Only __ holders1° - _

all

T~ M 10,000

50,000 1,000,000 all

110 1000 60 1000 1 1000,000

Reform Only +$5.71 - +7,9%

+5 .6%

+8.8% +4,9% ` -7.6%

' 24 .0% -7.6% •1 . 6.4 %

A. Partial Dividend Credit : 20 1,'o+1 .6

-4 .6

+3 .1 1 -817 2 . 7Al . Direct dividends constant +1 .17 •-50 .39 -018 -9.5

28 .9 • IA2. Total dividends constant +0.84 -0.40 4 . 1 .2

-3 .6

+2 .6 -117 -9.6

-26 .6 -6.8 +2 .0A3. 100% payout +4.42 +0 .21 +811

-11.7

+8.3 4. 8 .4 -940

-28.9 -7 .7 •1-8. 6

8 . Partial Dividend Credit : 30 %81 . Direct dividends constant -2 .34 -5.01 -3.2

-12.2

-1 .6 -4.7 -10.7

•-29 .0 -9 .6 0. 0K. Total dividends constant -1 .79 -3.66 -2 .5

-8 .5

-1 .0 -5.0 -10.6

x•28 .0 -9.5 -0. 283 . 100% payout -4.77 -11.99 -6.6

-31.6

-4 .2 -2.3 -1116

•-34,5 -10 .1 +11 6

C. Complete Dividend Credit : 45 %Cl . Direct dividends constant -9 .94 -15.03 -13 .7

+28.8

-11 .9 -13.4 -13.5

-33.7 -11 .8 -5 .7C2 . Total dividends constant -5 .74 -8.54 -7.9

-15.9

-6 .4 -10.0 -12.0

-30 .1 -10.6 -3. 5C3 . 100% payout -24.60 --38 .37 -33.9

-74 .1

-31 .0 -25.6 -18.8

-46.7 -15.3 -13. 8

D. Complete "Partnership" "Integration -23.35 •-36 .35 -32 .2

-70.3

-29.3 -24 .5 -16.3

-45.5 •-15 .0 -13 . 1

E. Corporate Tax Rate Reduction :45 percent to 42 percent +1 .58 40 .58 +2.1

-2.2

+3 .1 -0.3 -9.3

-28.2 -8 .7 4. 2, 9F. Corporate Tax Rate Reduction :

45 percent to 40 percent -0.91 -2.47 -1 .3

-617

-0 .2 -3 .4 -10.2

•-27 .5 -9 .4 •1-0 .8

a See text for description of the "Oenural Tax Reform," Estimates relate to 1078 . Tax changes relate to "full tax" as defined In the text .bThe change in lax for "All Shareholders" would result if charities, pensions, and foreign shareholders were eligible for the lull lax credit .

N

TABLE b

ESTIMATED EFFECTS OF COMBINING CORPORATE TAX INTEGRATION WITH A'"GENERAL TAX REFORM""Immediate Statutory Tax Liability

Change In Tax by A01 Clos eChange In Tax Percentage Change In Total Ta x

(Billions of Dollars) Percentage Change In Tax (Personal Income Tax plus Tax o non Corporate Bourse IncomeCorporals course Income)Indivldusl

TaV1817 rsAll

Share .b

Over .a _ . . .

$5,00010•

=30,000•0

6600000•OOd/ 000 Over.

66,000 •10,000all170,000•

><800000 •50,000

1W,000Proposal and Dividend Assumption h all ,000 60,000 1 ,

Reform Only -$0 .24 - -0.4% -1.9% -1 .0% -2.1% -10.3%

-28.6% -9.8%

+4.8%

A. Partial Dividend Credit: 20 %Al . Direct dividends constant -5.24 -$8.80 -8.2 -14.6 -818 -3,9 -12.2

-30.0 -11.1

+0 . 7A2 . Total dividends constant -6.45 -7.69 -10.1 -13.5 -10.7 -7.2 -12.6

-29.7 -11.4

-114A3.100% payout +8.13 +3 .92 +12.8 -14 .8 +13.8 +25 .3 -7.2

-30.1 -7.3

+1918

S . Partial Dividend Credit: 30 %B1 . Direct dividends constant -8 .99 -11 .66 -14.1 -23.7 -15.1 -8 .2 -13.6

-32 .4 -12.2

-2 . 182 . Total dividends constant -9.73 -11 .60 -15.3 -19 .4 -16.1 -1119 -13.9

-31 .3 -12.3

-4 . 483 .100% payout -1 .18 -8.40 -1.6 -35.7 -1.2 +14 .0 -10 .7

-36 .0 -918

+12 . 2

C. Complete Dividend Credit : 45 %Ct .Direct dividends constant -17.01 -2210 -26.7 -42.6 -28.2 -17.5 -16.8

-37.6 -14.4

-~8 . 1C2 . Total dividends constant -14.67 -17.47 -23.0 -28.3 -24.1 -1819 -15.7

-33.7 -13.7

-9 . 003 .100% payout -21 .20 -34.97 -33.3 -83.6 -33.5 -10.6 -18.1

-48.6 -15.3

-3 . 6

D . Complete "Parinershfp"Integration -20.99 -33.99 -33.0 -80.4 -33.3 -11.4 -1810

-47 .7 -15.2

-4 . 2

E. Corporate Tax Rate Reduction: 1 1

45 aercent to 42 percent -5.42 -6.40 -8.5 -11.3 -9.5 -5.2 -12.2

-29.1 -11 .2

-0 . 2

F . Corporate Tax Rate Reduction :45 percent to 40 percent -8.49 -10.05 -13.3 -1619 .-14 .6 -0.01 -13.4

-30.8 -12.1

-3A

a See text for descrip!lon of the "General Tax Reform ." Estimates relate to 1978 . Tax changes relate to "Immediate statutory tax" as doscrlbed In the text .

5. Cor

Our qualitative analysis indicates tha tthe likely forms of integration wouldgenerally achieve a small reduction in theeffective tax on corporate source income.This would provide a moderate incentiv efor increased corporate investment, fo rgreater saving, and for less reliance o ndebt . The incentive to increase dividendpayout rates would be relatively small .

Shareholders at all income levelswould benefit f_:, .n a dividend credit bu tthe relative cut in the tar on corporatesource income would be greatest forlower income shareholders . Although re-cent proposals would exclude charities ,pensions, and foreign shareholders, thisis not a necessary feature of the dividendcredit plan. Extending a 30 percent creditto these groups would increase the tarreduction by $2 .7 billion .

Our detailed analysis of alternativeplans shows that relatively smaller dif-ferences in integration plans can impl yvery big differences in their effects on

idusion

total tax liability. Moreover, the changesin tax liabilities implied by any integra-tion proposal depend crucially on ho wdividend payout rates adjust and on th eother tar changes that occur at the sametime. Our estimates also show the impor-tance of examining the "full taxchanges " (including the implied tax o naccruing capital gains) and not just th eimmediate tax impact that is traditionallycalculated by the Treasury and th eCongress.

In reviewing our estimates, readersshould bear in mind that these must beregarded as "first-round effects ."Changes in the effective tax rates on cor-porate source income would eventuall yalter the patterns of share ownership, themixture of debt and equity finance, andthe level of pretax corporate profits .These effects deserve careful study asnew approaches to the taxat ;on of cor-porate income arc developed during th eyears ahead .

22

1

TABLE A-1

EFFECTS OF ALTERNATIVE TAX INTEGRATION PROPOSALS 'ESTIMATEDImmediate Statutory Tax Liabilit y

Change In Tom by AGI Clan_Change In Tax frorconixpe Change In Total Ta x

(Billions of Dollars) Percentage Change In Tax (POsonal Income Tax Plus Tax onon Corporate Source Income _

Corporate source income)lndlvtduaf

AllTaxpayea

Share. over.

$5,00x.

$90,006 1500.106 over .

$5.006 '630,500 . $500,006Proposal and Dividend Assumption _Only

holdersb all

10,000

80,00 0-

~~1,000,000 all

10,000 50,000 1,000,000A. Partial Dividend Credit : 207.

Al . Direct dividends constant -$4.18

-$5.74 -6.6%

-11 .9%

-816% -3.9% -1.6%

-3.24 -1.1% "-2.5'/•A2. Total dividends constant -6.10

-7.34 -•9,6

-11 .3

9 .4 --9 .1 -2.3

=3.0 -1.6 -5 .9A3.100% payout +16 .88

+12 .67 +20,5

-10.4

+27 .7 '+44,4 +6,3

-2.8 +4 .6 +28 .7

8. Partial Dividend Credit : 30•/.B1 . Direct dividends constant -7.37

-10.04 '-11 .6

-20.7

-12 .0 ' -6.8 '-2,7

~-5 .6; .

-2, -4,3B2. Total dividends constant -9.37

-11 .24 -14.7

-17.3

-14,8 --13 .7 -3,5

-4.7 -2,5 -81983.100% payout +9.61

-2 .39 +15 .1

-31,5

+15.6 +37,7 +3,8

-8,5 +2,7 ; +24.3

0

C . Complete Dividend Credit: 45•/.Cl . Direct dividends constant -14 .09

-19 .18 -22A

-39.5

-23.4 -12,2"-10.7 -3,9

. 7 .0

C2. Total dividends constant -14 .28

-17 .08 -22.4

-26 .2

-22.8 -20.8 -5,3

-7 .0 -3,8C3 .100% payout -5.74

-18,51 -9.0

-76.1

-9,1 +23,0 -2,1

-20.4 -1 .5 +14 . 8

D. Complete "Partnership "Integration -6.78

-19.76 -10.8

-73.7

-10.8 +19 .8 -2.5 '

-19,8 +1,8

E . Corporate Tax Rate Reduction:45 percent to 42 percent -5.18

-6,16 -811

--9 .4

- -8 .5 -7,4 0 -1',9

0-02 .5 -1 .4 -4 . 6

F . Corporate Tax Rate Reduction:45 percent to 40 percent -8.25

-9.81 -13.0

-14,9

-13 .5 -11 .7 -3,1

-4,0 -2.3,

7 . 8

a Estimates relate to 1978 . ' i he lax law as of 1977 applies except for the Integration proposals, Tax changes relate to "lull tax" as defined In the text, Tax changes

)

'>for all AGI classes are presented in appendix Table A•2 .CThe change in tax for "All Shareholders" would result if charities, pensions, and foreign shareholders were eligible for the lull tax credit .N

,

-

r r "h _

s

al' s

I rn .' 1

TABLE A•2

PERCENTAGE CHANGE IN FULL TAX ON CORPORATE SOURCE INCOME BY AOI CLASS'

--

Proposal and Zero to =5-ow $10.000. -=1510ea $20,006 T $30,000. $50,000. =100,00a -Dividend Msumption $5,000 10,000 15 1000 20,000 30,000 501 000 100,000 50.000 1100 0 10110 81,000,000+ Classe s

A . Partial Dividend Credit : 20% - --°- _ _

Al, Direct dividend constant -11.9% -10.5% -9.4% -7.5% -6.0% -4.7% -4,1% -3.6% -3.6% r-3 .7% -5.2 %A2. Total dividend constant -10.6 -9.8 -9.2 -810 -7 .1 -6,5 -6.3 -6,2 -6.9 -7 .3 -7 . 1A3. 100% payout -20.4 -11.9 -5.6 +1 .7 +910 +14.6 +19,9 +26 .1 +33 .3 +38.8 +15,4

8 . Partial Dividend Credit : 30%

'81 . Direct dividend constant -20.8 = mi -16 .5 -13 .6 -11 .1 - 8.8 -7r4 -5.8 '',-8.0 -6.3 -9 . 382 . Total dividend constant -16 .2 -15 .1 -14 .3 -12 .6 -11 .4 -10.3 -918 -9.4 ~-10.3 -1018 1--10 . 983.100% payout -43 .3 -31 .2 -22.5 -12 .6 -2r9 +5.1 +12 .1 +19.8 +25.9 +30,0 > +5 . 6

C. Complete Dividend Credit : 45 %Ct . Direct dividend constant -40 .0 -35 .0 -31 .6 -26 .5 -22 .1 -17.6 -14,3 -10.9 -11,1 -11 .7 -x18 .0C2 . Total dividend constant -24.7 -22.9 -21,8 -19.5 -17.7 -16.1 -15.0 -14 .1 -15.3 -1810 -1618C3 . 100% payout -92.0 -7.2 -57.5 -42.3 -27,8 -15,6 - 4.8 +6.2 +13.1 +15.5 -15,5

D. Complete "Partnership"Integration -87 .7 -68 .9 -55.9 -41 .5 -27.9 -18,2 -5,8 +4,5 +10,4 +12.6 -18, 1

E. Corporate Tax Rate Reduction :45 to 42 percent -8.9 -8r2 -7r9 -7.2 -6.7 -6.2 -5,7 -5.4 -5,7 -6.0 -64

F. Corporate Tax Rate Reduction :45 to 40 percent -14 .1 -13.1 -12.8 -11 .0 -10.7 -9,8 --~9,0 -8.5 -9.1 -9.5 -9.9 "

a Estimates relate to 1978. The tax law as of 1977 applies except for the Integration proposals, Tax changes relate to "full lax" as deflned In the text, The results fo r"all classes" include taxpayers with AGI less than zero.

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