Yesterday, my Tax Policy Center colleagues Steve Rosenthal and Lydia Austin published new research that could dramatically change the way we think about corporate taxes. They found that only about one-quarter of corporate stock is held by tax-paying investors—about half of what experts generally thought. That means business profits are taxed more lightly than analysts generally thought—a finding that undermines the argument that U.S. firms pay too much and one that may make policymakers reconsider their proposed solutions to the nation’s corporate tax mess.

First, a word about what Steve and Lydia found. For years, researchers used Federal Reserve data to help understand how much corporate profit was taxed at the shareholder level. The problem is that the Fed presented its numbers in a way that made it very difficult to tease out the real answer.

For example, it didn’t distinguish between households that invested in taxable accounts and those that invested through IRAs. When the Fed first started collecting and publishing these data a half century ago, IRAs didn't exist. Now they hold about one-fifth of all shares in U.S. corporations. Similarly, the Fed combined equity holdings of non-profits such as university endowments with individual investments.

Teasing out the numbers

After months teasing out the numbers, Steve and Lydia estimated that the percentage of shares in U.S. corporations held in U.S. taxable accounts has fallen by three-quarters over the last half-century, from nearly 84 percent to about 24 percent. Their analysis isn’t the last word. I suspect others will do their own calculations and come up with somewhat different results. But the basic story seems clear: Taxable shareholders own much less stock than most experts thought. Their findings were first published in the journal Tax Notes. 

But why do these geeky calculations matter?  Because they suggest that raising taxes on shareholders will generate much less money than previously assumed.

That’s bad news for Democrats such as Hillary Clinton and Bernie Sanders, who have both proposed hefty tax hikes on investors.  If three-quarters of corporate shares are held by tax-exempt entities, their opportunity to raise revenue from these initiatives may be limited.   

But they are not the only ones who will be challenged by these new numbers. Critics of the corporate tax have based much of their argument on the premise that profits are double-taxed in the U.S.—first at the very high U.S. corporate rate of 35 percent, and then again to individual shareholders, who pay rates as high as 23.8 percent on dividends and capital gains. But what if three-quarters of corporate shares are held by investors who pay no tax?   

Taxing shareholders

The corporate tax base has been under pressure for decades. Taxes paid directly by corporations have plunged—from 3.6 percent of Gross Domestic Product in 1965 to 1.9 percent in 2015. Much of that decline occurred years ago when firms began organizing themselves as limited partnerships, S corporations, and other pass-through entities to avoid the corporate-level tax.  More recently, large multinational firms have used a wide range of techniques to slash their effective corporate tax rate by shifting income to low-tax countries while moving deductible expenses to the U.S. Their list of tools is long: inversions, earnings stripping, and aggressive transfer pricing, just to name a few.

Because individual investors are less mobile than corporations, reformers are increasingly looking to shift corporate tax liability directly to shareholders. Senate Finance Committee Chairman Orrin Hatch (R-UT) is expected to propose his version of an old idea—ending the double taxation of corporate profits by taxing shareholders and letting firms deduct the dividends they pay out. My TPC colleague Eric Toder and Alan Viard of the American Enterprise Institute are developing their own model of a shareholder-level tax on corporate earnings. My former TPC colleague Rosanne Altshuler and Treasury’s Harry Grubert have designed a somewhat different version, but one that would also shift tax from firms to shareholders. 

But it isn’t so easy to shift tax liability to investors who currently pay no tax, especially when so many shares currently are exempt from investor-level tax, as Steve and Lydia found. There are design issues, as well as enormous political challenges. Just imagine how non-profits and owners of 401(k)s would react to having to pay a shareholder-level tax. For a taste, watch today’s Senate Finance Committee hearing here.

This is not to say that such a solution would be a mistake. In fact, Steve’s and Lydia’s work may support such an approach. But it comes with a warning: Policymakers have to be careful about how they build this new vessel. If not, they shouldn’t be surprised if takes on water as soon as it is launched.