Wednesday, November 26, 2014

Why Give Corporations a Tax Break?

BERKELEY – US President Barack Obama has called for additional revenue as part of a balanced plan to reduce future budget deficits. But he is also proposing a significant cut in the corporate tax rate. To many, this approach seems inconsistent: Shouldn’t the corporate tax rate be raised, not lowered, so that corporations contribute their “fair share” to deficit reduction? The answer is no.

After its 1986 tax overhaul, the United States had one of the lowest corporate tax rates among OECD countries. Since then, these countries have been slashing their rates in order to attract foreign direct investment and discourage their own companies from shifting operations and profits to low-tax foreign locations. In the most recent and audacious move, the British government has embarked on a three-year plan to reduce its corporate tax rate from 28% to 20% – one of the lowest in the OECD – by 2015.

The US now has the highest corporate tax rate of these countries. Even after incorporating various deductions, credits, and other tax-reducing provisions, the effective average and marginal corporate tax rates in the US – what corporations actually pay – are higher than the OECD average.

Cutting the rate to a more competitive level would encourage more domestic investment by US corporations, and would also make the US more attractive to foreign investors. Capital has become increasingly mobile, and differences in national corporate tax rates have a growing influence on where multinational companies locate their operations and report their income.

Higher investment in the US by both domestic and foreign companies would boost economic growth, while the resulting increase in capital – new businesses, factories, equipment, and research –would improve productivity. That should, in turn, boost real wages over time (although the link between productivity growth and wage growth has weakened during the last two decades).

The pro-growth rationale for reducing the US corporate tax rate is compelling, and explains why Obama has proposed cutting it from 35% to 28% (roughly the weighted average rate of the other developed countries).

But a rate cut would be costly in terms of foregone revenues: each percentage point would reduce corporate-tax revenues by about $100 billion over the next decade. Moreover, recent studies indicate that a significant share of the corporate-tax burden falls on capital, so a reduction in corporate taxes would weaken the progressivity of the tax system at a time when income inequality is at an all-time high.

For these reasons, Obama is championing a “revenue-neutral” reform that would leave corporate-tax revenues unchanged, with the proposed rate cut financed by limiting deductions, credits, and loopholes, which would broaden the tax base.

These features add complexity to the tax code, raise the cost of tax compliance, and reduce corporate-tax revenues. They also affect business decisions about what to invest in, how to finance investments, which form of business organization to adopt, and where to produce – reflecting sizeable differences in the effective tax rates behind these choices.

As a result, broadening the corporate tax base will not be easy. Within the corporate sector, the three largest domestic tax preferences are the manufacturing production deduction, the credit for research and development, and accelerated depreciation of capital. Manufacturing companies are the major beneficiaries of these preferences, and Obama has proposed strengthening the first two.

Instead, he suggests reforming the third by tightening allowances for accelerated depreciation (as several other developed countries have done) in order to offset some of the revenue losses. But reducing the overall corporate rate would increase after-tax returns on past investments, while limiting accelerated depreciation would lower after-tax returns on new investments. And even eliminating accelerated depreciation would not broaden the tax base enough to finance a rate cut to 28%.

Likewise, while limiting the deductibility of net interest for corporations, as many other developed countries have done, would broaden the tax base and discourage excessive reliance on debt financing, it would increase the tax burden on major investments in physical capital, which are often debt-financed.

Reducing the tax preferences for non-corporate business entities (such as partnerships) that pass their income through to their owners’ individual returns would also broaden the tax base subject to the corporate-income tax. Pass-through companies now account for more than 80% of net business income (by far the highest share in the developed countries). Several of these entities are very large and profitable, and enjoy the same legal benefits as corporations. Economic logic suggests that businesses of similar size and engaged in similar activities should not pay different tax rates based solely on their organizational form.

The fact that a large share of business income is currently taxed as personal income makes it difficult to separate corporate tax reform from personal tax reform, as Obama and members of Congress would prefer to do. Moreover, keeping the two areas of reform separate rules out the approach adopted by several other developed countries, which have offset some of the revenue losses from cutting corporate tax rates by increasing taxes on corporate equity income at the personal shareholder level.

This approach also addresses concerns about the regressive effects of a cut in the corporate rate. It is both more progressive and more effective: with highly mobile capital, it is far easier to collect taxes from individual citizens and resident shareholders than from multinational companies.

According to a recent study, restoring tax rates on dividends and capital gains to their pre-1997 levels of 28% could finance a reduction in the US federal corporate tax rate from 35% to 26%. This change would both reduce the incentive for corporations to shift investments abroad and increase the progressivity of the US tax system.

Similarly, a modest carbon tax or value-added tax, with credits or subsidies to offset the regressive effects on low-income households, could generate enough revenue both to pay for a significant reduction in the corporate tax rate and to make a meaningful contribution to deficit reduction.

There is no inconsistency between a progressive, balanced deficit-reduction plan and lowering the corporate tax rate. Of all taxes, corporate taxes are the most harmful to economic growth – without which meaningful deficit reduction is far more difficult to achieve.

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    1. CommentedG. A. Pakela

      Why worry about the possibility of individuals who take on investment risk, with the possibility of losing some or all of their investment dollars, of getting richer if the investment pans out? What would you rather have, those same individuals squandering their money on themselves? Even if pro-investment tax policies do increase inequality, is that outcome worse than the rich simply spending their income on themselves? Increased investment equals increased job opportunities for job seekers. Quite frankly, if someone gets rich because they created an job opportunity for me, one of my kids or a neighbor I could care less. Who do you think hires people in "flyover country?"

    2. CommentedEugene Devany

      The article fails to mention that every developed country in the world, except the U.S., uses a VAT to keep business income tax rates low. 4% VAT could lower the C corporation rate to 8% (because tax expenditures are not needed with low rates). Read about the low 2-4-8 Tax Blend rates at

    3. CommentedProcyon Mukherjee

      Corporate tax has two issues, one is who actually bears the brunt of the tax among the key stake holders and secondly what is the division between capital and labor. Study has shown that the brunt of the tax is actually taken by shareholders and employees, the customers do not take the brunt as prices cannot be raised to offset the tax rate impact due to competition. But study is not very decisive as to the share between capital and labor.

      But it leaves a looming doubt that when capital is so mobile and there are competing places with similar situation (in terms of ‘ease of doing business’ and ‘capital to labor ratios’), what determines the start-up of the business and in what pecking order does corporate tax rates come?

      For S&P 500 the top 20% average less than 20% in their overall tax rates, and there are some who are in the less than 15% bracket. This gives a probable distribution of the share of U.S. profits made by large corporations within U.S. and outside U.S., with the share of profits rising outside of U.S.

    4. CommentedAlton Cheung

      The same zombie argument again?

      US tax is not higher than other developed countries, OECD weigh tax rate with country size, so larger countries will have higher tax rate:

      US corporations are paying at an effective rate of ~12%, not the statutory rate of 35%, Warren Buffer says so:

      And no, if you want to reduce the deficit, money has to come from somewhere. Cutting tax means less revenue. The US isn't suffering from a lack of competitiveness (see Warren Buffet again), it is weak domestic demand that creates this slump.

    5. Commentedradek tanski

      Loving it. Governments negotiating leverage eroding as the world globalizes. Companies wisely playing off different socialist pandering politicians against each other.

      No more of that taking 100% risk but only 50% of the profits.

      Interesting fact. No socialist country has ever beaten a capitalist one in a war. Too much capital wastage on values and ideals.

    6. CommentedBrett Blake

      It won't work. I don't know how many times it needs to be stated. IT. WON'T. WORK. We got into this mess through exactly this race-to-the-bottom dynamic - so she and the president propose more? Just in the past few weeks, Russia recently cut interest rates while Japan is chided for manipulating its currency. Not to mention ongoing renminbi manipulation. One could ignore people like this except they need to be pushed back on at every opportunity, because this is yet another pretty good definition-of-insanity illustration here.

    7. CommentedThomas Haynie

      I get the argument but I’m not completely sold on it. At what point do we tax cut ourselves out of a country worth living in? Isn’t the increasing wealth gap a problem on that needs to be dealt with also? Last I checked, which I admit was some time ago, that strategy didn’t work out as expected for Ireland. At least in terms of its translation to reduced unemployment.