Economic double taxation

What Is Economic Double Taxation?

Economic double taxation refers to the phenomenon where the same income is taxed twice, but at different levels of the economic chain, often impacting both a corporation and its shareholders. This concept falls under the broader financial category of taxation and public finance. It most commonly occurs when a company's profits are taxed at the corporate level via corporate income tax, and then the portion of those profits distributed to shareholders as dividends is taxed again as investment income at the individual shareholder level. This dual taxation means that the earnings are subject to tax once when earned by the corporation and a second time when received by the investor.

History and Origin

The imposition of a corporate income tax in the United States dates back to 1909, initially as an excise tax. In 1913, with the ratification of the Sixteenth Amendment, the corporate tax became a direct income tax. While the 1909 act and subsequent 1913 income tax initially included an exemption for dividends from corporate income, this exemption was repealed in 1936.⁵ Since then, corporate income has generally been taxed at the corporate level, and then dividends distributed from those taxed profits have been subject to taxation again at the shareholder level.⁴ This dual levy on corporate earnings and their subsequent distribution is a foundational aspect of economic double taxation in many jurisdictions. Historically, the highest federal corporate tax rate in the U.S. peaked at 52.8% in 1969.³

Key Takeaways

• Economic double taxation occurs when a company's profits are taxed, and then the distribution of those profits (e.g., dividends) is taxed again in the hands of the shareholders.
• This form of double taxation is distinct from juridical double taxation, which involves two or more countries taxing the same income of the same taxpayer.
• It primarily affects corporations and their equity investors, leading to a higher overall tax burden on corporate earnings compared to other business structures like partnerships.
• Various tax policies, such as dividend imputation systems, lower dividend tax rates, or tax deductions for dividends paid, are used to mitigate its effects.
• Understanding economic double taxation is crucial for tax planning and evaluating the after-tax returns of equity investments.

Interpreting the Economic Double Taxation

Interpreting economic double taxation involves understanding its impact on corporate financial decisions and investor returns. For corporations, the presence of economic double taxation can influence choices regarding financing (debt versus equity), dividend policy, and reinvestment strategies. For instance, companies might favor debt financing, as interest payments are typically tax-deductible for the corporation, unlike dividend payments. This reduces the company's taxable income and avoids a second layer of tax at the shareholder level.

For investors, economic double taxation directly reduces the after-tax return on their equity investments. The total effective tax rate on distributed corporate profits is a combination of the corporate income tax rate and the individual income tax rate on dividends. Investors must consider this cumulative burden when evaluating investment opportunities and comparing different asset classes or business structures. The true cost of capital for a corporation and the net returns for its shareholders are both affected by the extent of economic double taxation.

Hypothetical Example

Consider "Alpha Corp," a hypothetical company that earns $1,000,000 in pre-tax profit in a year. Assume the corporate income tax rate is 21%, and the individual tax bracket for qualified dividends is 15%.

1. Corporate Level Taxation: Alpha Corp first pays corporate income tax on its $1,000,000 profit.

   • Corporate Tax = $1,000,000 * 0.21 = $210,000
   • Remaining Profit After Corporate Tax = $1,000,000 - $210,000 = $790,000

2. Dividend Distribution: Alpha Corp decides to distribute $500,000 of its after-tax profit as dividends to its shareholders.

3. Shareholder Level Taxation: An individual shareholder, who receives $10,000 in dividends from Alpha Corp, will pay individual income tax on this amount.

   • Individual Dividend Tax = $10,000 * 0.15 = $1,500

In this scenario, the initial $1,000,000 of profit earned by Alpha Corp has been subject to two layers of taxation: first at the corporate level, and then a portion of it again when distributed as dividends to shareholders. The overall tax burden on the portion of profits distributed as dividends is significantly higher than if it were only taxed once.

Practical Applications

Economic double taxation is a central consideration in several areas of finance and policy:

• Corporate Finance Decisions: Companies often weigh the implications of economic double taxation when deciding whether to retain earnings for reinvestment or distribute them as dividends. The desire to mitigate this burden can influence capital structure, potentially favoring debt over equity financing.
• Investment Strategy: Investors, particularly those focused on dividend-paying stocks, must account for the dual tax impact on their capital gains tax and dividend income. This often plays a role in asset allocation and investment vehicle selection, such as choosing tax-advantaged accounts.
• International Tax Policy: While primarily a domestic issue, the principles of economic double taxation also influence international tax agreements. For example, some countries employ a dividend imputation system to reduce or eliminate the second layer of tax for domestic shareholders, making their tax systems more competitive.
• Government Revenue: For governments, economic double taxation represents a significant source of revenue, derived from both corporate profits and individual investment income. However, policymakers also consider its potential impact on economic growth and capital formation. Public companies, like THEON, regularly report their dividend payments as part of their financial updates, demonstrating the practical flow of taxed corporate earnings to shareholders.²

Limitations and Criticisms

One of the primary criticisms of economic double taxation is that it can distort economic decision-making. By taxing corporate profits twice, it may discourage companies from distributing earnings as dividends, incentivizing them instead to retain and reinvest capital, even if more efficient investment opportunities exist elsewhere. This can lead to inefficient allocation of capital within the economy.

Furthermore, economic double taxation can place traditional corporations at a disadvantage compared to other business structures, such as partnerships, S corporations, or sole proprietorships, which are typically subject to pass-through taxation (income is taxed only once at the owner's individual tax rate). This disparity can influence legal entity choices for new businesses. Critics argue that this system makes equity financing more expensive for corporations, potentially hindering economic expansion and job creation. While some countries offer a tax credit or imputation system to alleviate this burden, it remains a point of contention in many tax codes.

Economic Double Taxation vs. Juridical Double Taxation

It is important to distinguish between economic double taxation and juridical double taxation.

Economic Double Taxation occurs when the same income is taxed twice at different levels of the economic chain for different taxpayers. The most common example is corporate profits being taxed at the company level, and then the dividends paid from those profits being taxed again at the individual shareholder level. Here, the corporation is one taxpayer, and the shareholder is another.

Juridical Double Taxation occurs when the same income of the same taxpayer is taxed by two or more tax jurisdictions. This typically arises in an international context, for instance, when a company earns income in one country (where it is taxed) and then remits that income to its home country (where it is taxed again). International tax treaties, such as those modeled on the OECD Model Tax Convention on Income and on Capital, are designed to mitigate juridical double taxation, often through mechanisms like the foreign tax credit.

The key difference lies in who is being taxed and by whom. Economic double taxation involves different entities (company and shareholder) by the same jurisdiction, while juridical double taxation involves the same entity being taxed by different jurisdictions.

FAQs

What types of income are subject to economic double taxation?

Economic double taxation primarily applies to corporate profits that are first taxed at the company level and then again when distributed to shareholders as dividends. While capital gains from selling shares might also relate to underlying corporate profits, the direct act of buying and selling shares is usually subject to capital gains tax at the shareholder level, separate from this specific form of double taxation.

How do governments address economic double taxation?

Governments employ various methods to mitigate economic double taxation, though complete elimination is rare. Common approaches include:

• Lower Tax Rates on Dividends: Many countries tax qualified dividends at a lower rate than ordinary income tax.
• Dividend Imputation Systems: Some countries provide shareholders with a tax credit for the corporate tax already paid on the distributed profits.
• Deduction for Dividends Paid: A few systems allow corporations to deduct dividends paid from their taxable income, reducing the corporate tax base.

Does economic double taxation apply to all businesses?

No, economic double taxation generally only applies to C corporations (or equivalent corporate structures in other countries) that are taxed as separate legal entities. Pass-through entities, such as S corporations, partnerships, and sole proprietorships, are typically not subject to economic double taxation. Their profits are "passed through" directly to the owners and taxed only once at the individual owner's tax rate.

How does economic double taxation affect investors?

For investors, economic double taxation reduces the net return on dividend income. Since the profits have already been taxed at the corporate level, the subsequent taxation of dividends means that a smaller portion of the original corporate earnings ultimately reaches the investor after all taxes are paid. This can influence an investor's preference for growth stocks (which retain earnings) versus income stocks (which pay dividends). IRS Publication 17 provides detailed guidance for individuals on how various types of income, including dividends, are taxed.¹