Double Taxation Explained: Definition, Mechanism, and Debates

Julia Kagan is a seasoned financial and consumer journalist, previously serving as senior editor for personal finance at Investopedia.

What Is Double Taxation?

Double taxation refers to the taxation of the same income twice, a term most frequently associated with the combined effect of corporate income tax and dividend tax. Essentially, a corporation's profits are taxed when earned, and then taxed again when those profits are distributed to shareholders as dividends.

Key Insights

• Double taxation involves taxing the identical income stream on two occasions.
• It commonly describes the interplay of corporate income tax and tax on dividends.
• The tax system imposes a levy on corporate earnings and again when those earnings are passed on to shareholders.
• Conservative voices have long criticized this system, labeling it as unfair double taxation.
• Progressive perspectives contend that these criticisms often mask attempts to reduce taxes for wealthy business owners.

How Double Taxation Works

For decades, conservative critics have targeted the U.S. corporate tax system by highlighting the issue of double taxation. Prior to the 2017 Tax Cuts and Jobs Act, corporations faced a federal tax rate of 35%, state corporate taxes varied, and high-income individuals paid up to 20% tax on dividends received. Critics argued that this layered taxation discouraged corporate formation and distorted economic decisions.

The Tax Foundation, a conservative think tank, emphasized in 2006 that the term "double taxation" is often misunderstood; what truly matters is the effective total tax rate on income streams, not the number of tax layers.

At that time, the combined corporate and dividend tax rates were seen as sufficiently burdensome to influence business leaders to avoid corporate structures, opting instead for partnerships or other entities with more favorable tax treatment.

Data between 1980 and 2004 showed a significant rise in non-corporate business formations, suggesting tax considerations heavily influenced organizational choices.

Debate and Criticism Surrounding Double Taxation

Progressive critics argue that the outcry over double taxation often serves as a pretext for reducing tax obligations for affluent business owners, who hold a substantial share of wealth in the U.S. This viewpoint gained traction during discussions around the 2017 tax reform.

The Tax Cuts and Jobs Act lowered the corporate tax rate from 35% to 21%, but also introduced a 20% deduction for income earned through partnerships and similar entities. This adjustment aimed to level the playing field but maintained differences in tax treatment among business types, albeit at reduced rates.

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