Senator Max Baucus (D.-MT) this week came up with a proposal that corporate cash balances held outside the United States should be subject to a one-off tax at 20%, expected to raise $400 billion on the $2 trillion of overseas cash, which the good Senator can throw around to favored constituencies. At the other extreme, the U.S. Chamber of Commerce wants to have all non-U.S. income free from U.S. tax, an incentive to outsource everything including the logo for most U.S. corporations. Then there’s the question of dividends, still taxed at 35% corporate rate and again at 20% when received by individual shareholders. In other words, U.S. corporate taxation is a mess. So I thought this column would take a crack at designing a rational system.

Chamber of Commerce types want the U.S. to adopt a system whereby it taxes only domestic income, similar to the tax systems employed by most foreign countries. However that simply encourages companies to “manage” their international tax, inventing fanciful values for their intellectual property and thereby sheltering much of their income in tax havens. It also provides a massive incentive to companies to outsource as much as possible of their operations, leaving only a thin domestic sales operation in the U.S., since they would pay tax at 35% on domestic activities but close to zero on international activities, once tax haven and licensing possibilities had been maximized.

Even though corporate profits were at record levels of almost 10% of GDP in 2012, corporate tax receipts at $242 billion were far below their 2007 peak of $370 billion and represented only 1.5% of GDP compared to 2.0% of GDP in 1994 and 1.6% of GDP in 2004, both years like 2012 of emergence from recessions. For a different measure, corporate taxes represented only 21% of individual income taxes in 2012 compared to 24% in 2004 and 26% in 1994. Far from being decades of supply-side tax cuts, the last 20 years have seen most of the benefits of any tax reductions go to large multinational corporations, while individual taxes of one sort or another have risen. The vast increase in the number and remuneration of lobbyists in Washington DC in the last two decades has produced the inevitable result, in a relative decline in the corporate tax burden.

The solution to this is simple; U.S. corporations must be taxed on the whole of their worldwide income; not just that remitted to the United States. However tax should be levied at a rate of only 25%, well below the current uncompetitive rate of 35%. Naturally, foreign taxes paid will be offsettable against U.S. tax, at least up to a total of 25% of non-U.S. income.

There will still be a tendency to dump profits in tax havens, to offset jurisdictions where profits are taxed at much more than 25%, but tax planning to this extent should be of little concern to the U.S. tax authorities. The most important feature of this reform will be to eliminate the current tax incentive to outsource operations, thereby creating a near-zero tax rate rather than a 35% tax rate. To the extent operations are outsourced to countries like India and China, where taxes are substantial, there is of course no direct saving, but as we have seen once operations are outside the United States games can be played with “transfer pricing” and intellectual property to reduce the overall tax charge. Taxing worldwide income immediately will remove those games.

The other essential tax reform, which will itself remove many of the loophole games that currently disfigure the tax code and reduce tax revenues, should relate to dividend taxes. As with most policies he instituted, President George W. Bush designed his dividend tax cut of 2003 very poorly. He recognized the overall problem of double taxation, by which dividends are taxed twice, once at the corporate level and once at the individual level, thereby before 2003 suffering tax hits of 60% or even 70% when state taxes are included. However, his solution of reducing dividend taxes at the individual level to 15% was the wrong one. First, it allowed leftist demagogues and even President Obama to demonize the apparent tax favoritism shown to rich dividend recipients. Second it created no extra incentive for corporate management to return profits to taxpayers, since income paid out in dividends was still fully taxed at the corporate level.

The non-deductibility of dividends at the corporate level also encouraged stock buy-backs, often using the cheap leverage so helpfully provided by Ben Bernanke. These did little for ordinary shareholders, who did not have close contacts with the brokers used by the buying company, but a lot for the company’s senior management, whose stock options benefited from the reduction in share count, but did not participate in any dividends paid out by the company. A further problem was that company management was very bad at predicting economic and market cycles, so often found itself buying back stock at the top of the market, only to undertake a panic share issue at the nadir a few years later when the leverage used to produce the buyback had become an intolerable burden on the company’s finances. Like many operations in modern corporate finance, buy-backs were beneficial to management, and doubtless to the brokers undertaking them on behalf of the company, but damaging to ordinary shareholders, since they made the stock less liquid and, if badly timed, produced a direct loss for long-term shareholders.

The solution to these problems is to make dividends tax-deductible at the corporate level. Instantly, any excuse for stock buybacks disappears, because debt interest no longer has any special advantage compared to dividends, and a dollar used in a buyback instead of a dividend is a dollar on which corporate tax must be paid. Meanwhile the U.S. Treasury gains, because dividends are increased, and then fully taxed in the hands of their recipients, often at high rates.

Dividend tax-deductibility also removes any incentive for tax shelter games. Shareholders gain no advantage from a spurious tax shelter deal, or from some uneconomic leasing deal undertaken for tax advantage, because the money parked in the tax shelter or used for leasing could instead be dividended to them directly. Artificial tax structures such as REITs and Master Limited partnerships would also disappear, because investors would gain the same tax advantage from any company that paid out its income in dividends to them. Effectively every company would become an MLP, but the dividends paid out would no longer be taxed in the recipient’s hands at preferential rates.

With these three tax changes: immediate tax on worldwide income, tax-deductibility of dividends, and a reduction in the corporate tax rate to 25%, the U.S. economy would be greatly benefited, tax receipts increased, and shareholder returns maximized, as follows:

* Most of the $2 trillion estimated to be parked in offshore accounts would immediately be dividended to domestic shareholders, and taxed as income to the recipients. Senator Baucus would be happy; it would simply then be necessary for the House Republicans to ensure that the money was not spent on useless government fripperies.
* The current tax advantages of offshoring operations would disappear, increasing employment in the United States.
* The tax advantage of leverage would disappear, since both debt and dividends would be tax deductible at the corporate level. Corporate cash flow would thus be healthier, leverage and bankruptcies would decline, and emergency share issues in bear markets would be avoided.
* There would no longer be any political mileage for the argument that dividend recipients were unfairly tax advantaged; they would be taxed on dividends as on any other income.
* Spurious tax shelter and leasing deals would disappear, as would spurious option grants and share buybacks, which would result in extra corporate income tax, so be unjustifiable.
* Even those who believed in the Modigliani-Miller Theorem could no longer use it as justification for excessive debt. Overall, the cost of capital would decline, as share prices rose to reflect companies' lower cost of dividend-paying equity.
* Jobs would be created from five sources: (i) the immediate return of the offshore money (ii) the removal of incentives for offshoring (iii) the reduction in the U.S. corporate tax rate to 25% (iv) the disappearance of tax shelter and leasing deals and (v) the reduction in the cost of U.S. equity capital.

It’s a simple enough reform. And if Congress and the administration were to pass it, we would know that good policy, of either political slant, at last had a decent chance against the bad policy produced by politicized deal-mongering and lobbyists. Unfortunately, its chances in the present political climate remain slim.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)