There are many good reasons to undertake corporate tax reform this year. Politicians from both sides of the aisle have declared support for cutting the headline corporate tax rate and recouping the lost revenue through a broadening of the tax base. President Obama’s budget for fiscal year 2016 calls for a cut in the corporate tax rate from 35 to 28 percent (with a special rate of 25 percent for manufacturing). Former Ways and Means Chairman David Camp’s tax reform proposal from last year called for a cut in the rate to 25 percent. The recent Rubio-Lee proposal would similarly cut the rate to 25 percent. There is even speculation that Paul Ryan and President Obama may be working on a deal to cut headline rates this year. Here’s why we need to get this done.
Rates out of line
Over the past several decades, countries around the world have dramatically cut their marginal corporate tax rates in an effort to attract investment and global capital. Over a similar time period, the U.S. has only enacted two significant changes to its marginal corporate tax rate. The first was in 1986 when President Reagan cut the headline corporate tax rate to 34 percent, and the second was in 1993 when President Clinton increased the top rate to 35 percent. Twenty-three years later, our headline marginal corporate tax rate stands at 35 percent, notably higher than the average of 23 percent for other OECD countries.
This is true not just when we consider the headline federal rate, but even when we consider effective tax rates. Effective tax rates account for the various deductions and credits that firms use to lower their tax liability. As per my own analysis for the year 2010, the U.S. had higher effective tax rates than almost every other OECD country. A more recent 2013 study from the Tax Foundation finds that the U.S. has the highest marginal effective tax rate in the developed world.
Why does this matter?
Bad for investment
There is a large literature in economics that shows high corporate taxes cause freely mobile capital to flow from high tax to low tax jurisdictions. In other words, the U.S. loses investment as a result of uncompetitive tax rates.
This flight of capital was evident during the recent debate over tax inversions. A tax inversion occurs when a corporation purchases or merges with a foreign corporation, then subsequently declares the new resulting corporation to be domiciled in the foreign country that has a lower corporate tax rate than the U.S. To change its legal domicile, the company does not need to relocate its physical headquarters or change any of its business activities. It merely needs to file new paperwork after the merger.
Take the case of Burger King. Last year, Burger King was in talks to buy Tim Hortons in Canada and create a new holding company headquartered in Canada. A KPMG total tax index showed that when accounting for all types of taxes, Burger King would be better off inverting and registering its headquarters in Canada where the total tax index was 53.7 relative to the U.S. index at 100. In other words, total tax costs on firms in Canada are 46.4 percent lower than in the U.S..
In response to the threat of inversions, President Obama called these firms “unpatriotic” and directed the Treasury to come up with new rules to stop inversions or minimize the tax benefits of inversions, which the Treasury subsequently did. However, as most economists will tell you, the problem is not with the firms who are trying to invert and stay competitive but with the U.S. corporate tax code that puts such a heavy tax burden on its firms.
Bad for US multinationals
Another problem with our system of corporate taxation is the worldwide system of taxation, where U.S. multinationals are expected to pay the U.S. corporate tax on profits earned overseas (net of foreign taxes already paid). By itself, this aspect of U.S. taxation would place U.S. multinationals at a competitive disadvantage relative to other firms in foreign markets. However, companies can defer paying U.S. tax on active foreign income until it is repatriated to the U.S. parent. This has unnecessarily resulted in U.S. firms holding cash worth almost $2 trillion in foreign countries to avoid repatriation taxes. This is termed the “lockout effect”. The U.S. is an outlier when it comes to the OECD countries in this respect since most of these countries use a territorial system of taxation where firms only owe taxes in the country of operation. Lowering tax rates and shifting to a territorial system of taxation may help avoid many of these problems.
Bad for workers
One of the least understood things about the corporate tax is that it is indirectly a tax on workers. Unlike personal income taxes which apply to individuals, corporate income taxes apply to “corporations”. Corporations comprise of shareholders, workers and consumers. The tax can be shifted onto consumers in the form of higher prices, to shareholders in the form of lower returns on capital, and workers in the form of lower wages. Over the last few years, a growing literature suggests that a significant share of the tax is borne by workers in the form of lower wages. In research that I published with Kevin Hassett, we analyzed data from 66 countries and found that high taxes reduce capital formation, which leads to low worker productivity and lower wages for workers. Other papers find similar results, though the magnitude of the burden differs.
Bad for revenues
Despite the high rates, the corporate tax yields low revenues. Overall, the corporate tax contributes only about 10 percent of total federal revenues. When we compare revenues in the U.S. to other OECD countries, we fall below the average for these countries. As per a recent report by the Congressional Research Service, while the average OECD country collected corporate tax revenues equal to 3 percent of GDP, the U.S. was at 2.3 percent. This is despite (and perhaps because of) the fact that these countries have lowered their rates over time while the U.S. has not. Some of these countries have adopted base-broadening policies to offset tax rate decreases, such as limitations on interest deductibility and depreciation, which may be worth pursuing in the U.S. as well.
There are many problems with the U.S. corporate tax code. However, the solution is not to impose more burdensome regulations on firms. We cannot force companies to stay in the U.S., provide jobs and invest. We cannot force them to repatriate foreign earnings held overseas. We cannot force them to pay their “fair share” of tax, whatever that might imply. The only feasible and practical long-term solution is for the U.S. to reform its corporate tax code, align it with the rest of the world and compete for global capital like every other country. The good news is that there is growing consensus on many of these issues. Let’s not allow disagreement in other areas of policy to thwart progress on this common sense reform.