Corporate Income Tax As a Real Option on Corporate Earnings

Abstract

The conventional wisdom has been that lowering the corporate tax will enhance economic growth and hence create more jobs. If merely lowering the tax rate can accomplish this, then elimination of corporate tax should create an economic boom. However, despite this possibility, the United States has yet to make a shift to value added (VAT) or consumption based tax system. Moreover, one of the most popular criticisms of the corporate form of business organization is the "double taxation" of dividends. It is argued that corporate income is taxed once at the corporate level and second at the shareholder level as dividend income tax. Even though this concept assumes that taxes follow the money rather than the economic unit, policy makers have tended to advocate reduction in or elimination of the tax on individual dividend income. In addition, elimination of corporate tax according to the stance of policy makers and lobbyist should spur economic growth and avoid the perceived double taxation of dividends. Yet, no pro-business entities have proposed the elimination of corporate taxes. The objective of this paper is to demonstrate that among other reasons, the corporate tax system provides an option contract on the earnings of the corporation. The corporation is the seller of the contract, while the government is the holder of the call option contract. If the corporate sales exceed the break-even sales, the government and the shareholders split the profit based on the firm's corporate tax rate. If on the other hand the sales volume is below the break-even point, all taxes collected on sales are used to offset the shortfall. Thus the existence of corporate tax in and of itself has value to the corporation and hence the shareholders.