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U.S. Corporate Tax Reform

Author: Jonathan Masters, Deputy Editor
April 5, 2012

Introduction

The United States currently possesses the highest statutory corporate tax rate in the world, at 35 percent (discounting state and local taxes). Many analysts say the comparatively high U.S. rate, coupled with a complex array of tax subsidies and loopholes, is a doubly flawed system, overburdening businesses with compliance and planning costs while reducing federal revenues at a time of rising national debt. Others point out that the U.S. system, which taxes foreign profits of U.S. multinational corporations, may put the country at a competitive disadvantage with most of the industrialized world, which only taxes domestic corporate income. At time when global economic competition is intensifying, some critics suggest an overhaul of the tax code, which last took place in 1986, is long overdue.

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Why does corporate taxation matter?

As a percentage of the economy, corporate tax dollars have declined steadily in the post-World War II period, from more than 5 percent of GDP in 1946 to hovering around 2 percent in recent years.

Corporate Income Tax as a Share of GDP chart

In 2010, corporate taxes represented the third-largest source of federal revenue, accounting for roughly 9 percent of Treasury's income (behind the individual income tax [42 percent] and payroll taxes [40 percent]).

Sources of Federal Tax Revenue chart

The way a country taxes corporations matters for two primary reasons, say economists. First, corporate taxes alter incentives and may distort domestic economic behavior in ways that are harmful for growth. Donald Marron of the Tax Policy Center says the government shouldn't favor one industry over another in the way it taxes business: "Far better would be a system in which investors deployed their capital based on economic fundamentals."

Second, different tax regimes across the world interact with each other to distort the allocation of international investment. The confluence of these micro and macroeconomic forces has significant consequences for the ability of the United States to compete and thrive in an expanding global economy.

Corporate taxation is an essential component of the national business climate, and one of several factors that multinational corporations weigh when deciding how and where to invest. Others include access to human capital, efficient infrastructure, regulatory environment, rule of law, political stability, etc. "The [United States] used to be so much more attractive in these areas," says Eric Solomon, former assistant secretary for tax policy at the U.S. Treasury Department (2006-2009),"but now we have so much more competition from abroad, so that each of these margins have become much more important."

In 2011, the United States ranked 72nd out of 183 economies worldwide in the area of corporate taxation, and 19th out of 31 OECD nations, according to the World Bank's Doing Business Project. Rankings accounted for the number of tax payments, the time spent paying, and the overall rate borne by medium-sized businesses.

A 2010 McKinsey Global Institute report on U.S. multinationals and competitiveness says that many business executives interviewed "believe that current U.S. policies--particularly in the areas of corporate taxes, limits on the immigration of skilled workers, and bureaucratic hurdles and inconsistencies--handicap U.S. companies when competing abroad."

How does the U.S. corporate tax compare internationally?

The United States has the highest statutory corporate tax rate in the world--39.2 percent (including state and local) versus an OECD weighted average of 27.8 percent (excluding the U.S.), and a G-7 average of 32.3 percent (excluding the U.S.).

Comparison of Corporate Tax Rates chart

However, the effective corporate tax rate--the ratio that companies actually pay after leveraging a myriad of tax breaks--has averaged around 26 percent in recent years (1987-2008).

US Corporate Tax Rate chart

According to a 2011 report from PricewaterhouseCoopers, from 2006 to 2009 the United States had an average effective corporate tax rate of 27.7 percent, compared with 22.6 percent for the non-U.S. OECD.

Average Effective Corporate Tax Rate chart

How does corporate taxation distort the domestic economy?

Corporate taxation distorts the U.S. economy in several important ways, according to the Congressional Budget Office. "Once economic activity takes on a pattern that is based on tax rates, resources in the economy are misallocated and inefficiency results, as economic activity shifts away from its most valuable opportunities." A 2010 White House report on tax reform notes that more than 15,000 changes to the tax code have been made since the 1986 reform, many of which are "targeted tax provisions [implemented] to achieve social policy objectives normally achieved by spending programs."

According the Fiscal Times, corporate tax expenditures (tax breaks) will cost the Treasury some $628.6 billion over the next five years.

In addition, the CBO lists the following primary domestic economic distortions created by the corporate tax:

1) Savings and Investment bias: Decreases the incentive for individuals to save (vs. consume) and for businesses to invest because it taxes income from capital. Taxes on capital/labor are often juxtaposed with taxes on consumption (i.e. value-added tax), which many economists see as more efficient and pro-growth.

2) Organization bias: Increases the incentive for businesses to organize as non-corporate entities (WSJ) (i.e. sole proprietorships, partnerships, etc.), which are not taxed. Consequently, the tax puts certain industries at a disadvantage to the extent that businesses in those industries rely on the corporate form to raise large amounts of capital from many investors.

3) Financing bias: Increases the incentive for businesses to raise capital by borrowing (debt) versus selling shares (equity), since the interest on debt is tax deductible. A greater reliance on borrowing may increase the exposure of some firms to bankruptcy, especially in economic downturns such as the recent financial crisis (FT).

4) Depreciation bias: Biases some types of capital investment over others to the extent that the IRS depreciation rules, which allow companies to spread tax deductions for a capital asset over its life span, do not reflect actual economic depreciation.

5) Compliance and Planning: The complexity of the code requires businesses to spend a great deal of money on tax compliance and planning--funds that under other circumstances would be allocated elsewhere.

In her book The Economic Effects of Taxing Capital Income, economic policy expert Jane Gravelle asserts that the combined cost of these five domestic inefficiencies (plus a bias against dividends) could surpass the total amount of corporate tax dollars collected.

What are the distortions at the international level?

Differing levels of corporate taxation across an increasingly globalized economy have the effect of distorting economic outcomes in at least three principal ways, say economists. First, a country with a corporate tax regime that places less of a burden on businesses (i.e. through a lower effective rate) will tend to draw investment away from those with higher taxes, all other factors being equal. A second distortion arises where a reduction in investment in a relatively high-tax country, like the United States, shrinks the capital available to workers and reduces wage levels as a result.

Third, the tax base of a high-tax nation may drop further as domestic companies with international operations cut their taxes by "re-characterizing" their income so as to fall in a lower tax country, or engage in other such methods like internal transfer pricing (Bloomberg). This profit shifting costs the U.S. Treasury roughly $90 billion a year, according to Kimberly Clausing, an economics professor at Reed College.

What role do multinationals play in the U.S. economy?

U.S. multinationals are domestic companies that own at least 10 percent of a foreign affiliate. According to a 2010 McKinsey report, multinationals represented less than 1 percent of total U.S. companies in 2007, but accounted for some 19 percent of private sector jobs; 25 percent of private sector wages; 25 percent of private sector gross profits; 48 percent of total U.S. goods exported; and 74 percent of research and development spending.

They are particularly sensitive to international business conditions, including inconsistencies in the way countries tax. Under the current U.S. code, multinationals not only face a relatively high tax rate at home, but are also taxed on their profits made abroad when repatriated. Most other developed countries exempt their corporations from such taxation.

Notably, the report also claims that U.S. multinationals "may also serve as 'a canary in the coal mine' of the U.S. economy, providing some indications of how other companies, and indeed the economy as a whole, may respond to increasingly intense global competition."

How does corporate tax reform factor into U.S. fiscal policy?

Any proposal for corporate tax reform will have to address the effects on federal revenue, especially given current levels of U.S. debt and the expected growth of entitlement spending over the next several decades.

"A tax package that reduces revenue is not tax reform," writes tax policy expert Bruce Bartlett in The Benefit and the Burden. "It's just another tax cut." Most economists, he says, view true tax reform as a revenue-neutral, zero-sum game with both winners and losers. In this view, if the top corporate tax rate is lowered, the tax base will need to be broadened so that some businesses will have to pay more, or funds will have to be raised through other means of taxation (i.e. consumption tax, gas tax, etc.).

Eric Toder of the Tax Policy Center says that "corporate taxes cannot be thought of in isolation," but that any corporate tax reform must be considered in the context of general tax reform that may include other changes, such as the way individuals are taxed. Many economists see the integration of the corporate and individual income tax as a solution to this problem. CFR's Ted Alden writes that it is difficult "to move discretely on any single aspect of tax reform. A tax system that is both more competitive and more fiscally responsible would require an array of changes."

More than twenty-five years later, many see the 1986 Tax Reform Act as a model for comprehensive tax reform (Forbes). This landmark, bipartisan legislation was able to achieve revenue neutrality by balancing rate reductions for both individuals and corporations with ending many tax preferences. The result was largely perceived as a more simple (as far as compliance) and economically efficient tax code.

What are some proposals for reform?

Any proposal for corporate tax reform will likely have to balance several concerns, including economic efficiency, productivity, competitiveness, equity, and the implications for federal revenue. In general, both Republicans and Democrats agree on the need to lower the statutory rate (though to different levels) and end many corporate tax expenditures. But differences remain over how to tax U.S. multinationals and whether or not the U.S. should adopt a territorial tax regime like most industrialized nations.

Republicans and many business groups claim the current U.S. system, which imposes a tax on worldwide corporate profits, puts U.S. companies at a competitive disadvantage with their foreign peers that are only subject to tax on domestic profits. Critics also allege the U.S. code, which defers taxation until profits are repatriated, encourages these businesses to park their money overseas indefinitely, discouraging the investment of these funds at home. As of 2011, U.S. multinationals held close to $2 trillion overseas (Bloomberg), much of this to avoid tax payment.

Critics of a purely territorial tax regime suggest such a system assumes that multinationals would pay a fair tax somewhere. However, they note, many multinational corporations are actually able to pay very little tax by funneling profits into international tax havens, like the Cayman Islands. Harvard Business School's Robert Pozen recommends a nuanced approach, suggesting lawmakers exempt U.S. firms from paying taxes on profits repatriated from foreign countries with an effective corporate tax rate of 20 percent or higher.

Here are some competing proposals for reforming the corporate tax:

President Obama's Framework for Business Tax Reform

• Cut the general corporate rate to 28 percent; eliminate corporate tax expenditures
• Cut the rate for manufacturing firms to 25 percent and incentivize small businesses
• Impose a minimum global tax on the worldwide profits of U.S. multinationals
• Pursue revenue neutrality

House Republican (Dave Camp R-MI) Corporate Tax Reform Plan

• Cut the corporate rate 25 percent; eliminate corporate tax expenditures
• Adopt a territorial tax system (exempting 95 percent of U.S. multinational foreign income)
• Implement several anti-abuse provisions
• Pursue revenue neutrality

Bipartisan Tax Fairness and Simplification Act (Wyden-Coats Plan)

• Cut the corporate rate to a single flat rate of 24 percent
• Allow businesses with less than $1 million in annual income to expense 95 percent of equipment and inventory for the tax year
• Keep a worldwide tax system, but allow a one-time tax holiday on 95 percent of foreign profits
• Decrease debt-financing incentives
• Cut some corporate tax expenditures

The Bowles-Simpson "Zero-Plan"

• Establish a single corporate tax rate between 23 and 29 percent
• Eliminate all tax expenditures for businesses
• Adopt a territorial tax system
• Tax reform should contribute to deficit reduction

The Peterson Institute's Corporate Tax Reform for a New Century

• Cut the corporate rate to 20 percent or lower
• Adopt a national consumption tax to reduce the budget deficit
• Adopt a territorial tax system

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