The corporate tax conundrum

Berkeley, CA – The United States now has the highest statutory corporate-income tax rate among developed countries. Even after various deductions, credits and other tax breaks, the effective marginal rate – the rate that corporations pay on new US investments – remains one of the highest in the world.

In a world of mobile capital, corporate tax rates matter and business decisions about how and where to invest are increasingly sensitive to national differences. The country’s relatively high rate encourages US companies to locate their investment, production and employment in foreign countries, and discourages foreign companies from locating in the US, which means slower growth, fewer jobs, smaller productivity gains and lower real wages.

According to conventional wisdom, the corporate tax burden is borne principally by the owners of capital in the form of lower returns. But, as capital becomes more mobile, relatively immobile workers are bearing more of the burden in the form of lower wages and fewer job opportunities. That is why countries around the world have been cutting their corporate-tax rates. The resulting “race to the bottom” reflects intensifying global competition for capital and technological knowhow to support local jobs and wages.

Moreover, a high corporate tax rate is an ineffective and costly tool for producing revenues, owing to innovative financial transactions and legal tax-avoidance mechanisms. A company’s legal residence and geographic sources of income can be and are manipulated for such purposes, and the incentives and scope for such manipulation are especially large in sectors where competitive advantage depends on intangible capital and knowledge – sectors that play a major role in the US economy’s competitiveness.

A lower tax rate

In the absence of close and broad international cooperation, the US must join the race and lower its corporate tax rate. A lower rate would strengthen incentives for investment and job creation in the US, and weaken incentives for tax avoidance. It would also reduce numerous efficiency-reducing distortions in the US tax code, including substantial tax advantages for debt financing over equity financing and for non-corporate businesses over corporate businesses.

But each percentage-point reduction in the corporate tax rate would reduce federal revenues by about $12 billion per year. These revenue losses could be offset by curtailing so-called “corporate tax expenditures” – deductions, credits and other special tax provisions that subsidise some economic activities while penalising others – and broadening the corporate tax base. Both President Barack Obama’s plan for business-tax reform and the Simpson-Bowles deficit-reduction plan propose reducing such expenditures to pay for a reduction in the corporate tax rate.

Corporate tax expenditures narrow the base, raise the cost of tax compliance and distort decisions about investment projects, how to finance them, what form of business organisation to adopt, and where to produce. As Michael Greenstone and Adam Looney show in a just-released report, the resulting differences in effective tax rates for different kinds of business activity are substantial.

That said, if the goal of corporate tax reform is to boost investment and job creation, broadening the tax base to pay for a lower rate could be counterproductive. Eliminating “special interest” loopholes, such as tax breaks for oil and gas, or for corporate jets, would not yield enough revenue to pay for a meaningful rate cut. And curtailing accelerated depreciation, the manufacturing production deduction, and the R&D tax credit – which account for about 80 per cent of corporate-tax expenditures – would involve significant tradeoffs.

A bad way to help workers

Indeed, cutting these items to “pay for” a reduction in the corporate-tax rate could end up increasing the tax on corporate economic activity in the US. Eliminating accelerated depreciation for equipment would raise the effective tax rate on new investments; repealing the domestic-production deduction would increase the effective tax rate on US manufacturing; and rescinding the R&D tax credit would reduce investment in innovation.

Instead of cutting proven tax incentives for business investment, the US should offset at least some of the revenue losses from a lower corporate-tax rate by raising tax rates on corporate shareholders. Most countries that reduced their corporate-tax rates have followed this path, while the US has done the opposite.

At 15 per cent, US tax rates on dividends and capital gains are at historic lows, while the profit share of national income is at an all-time high. Defenders of low rates for capital owners argue that it minimises “double” taxation of corporate income – first of the corporation and then of its shareholders. A lower corporate tax rate would weaken this justification. Moreover, pension funds, retirement plans and non-profit organisations, which receive about 50 per cent of all corporate dividends, do not pay tax on these earnings, and would benefit from a lower corporate-tax rate.

Although individual taxes on corporate income reduce the after-tax return to savings, they have fewer distorting effects on investment location than corporate taxes do, and they are more likely to fall on owners of capital than on workers. Moreover, it is far easier to collect taxes from individual citizens and resident shareholders than from multinational corporations. Apple, for example, can use sophisticated techniques to manipulate the location of its corporate income, but individual US citizens who own Apple stock have to report the dividends and capital gains that they earn from it in their worldwide income.

A recent study found that taxing capital gains and dividends as ordinary income, subject to a maximum 28 per cent rate on long-term capital gains (the pre-1997 rate), could finance a cut in the corporate tax rate from 35 per cent to 26 per cent. Such a change would reduce corporations’ incentives to move investments abroad or shift profits to low-tax jurisdictions, while increasing the progressivity of tax outcomes by shifting more of the burden of corporate taxation from labor to capital owners.

An increase in the corporate tax rate appeals to many US voters who believe that corporations are not paying their fair share of taxes and are worried about widening income inequality. But, in a world of mobile capital, raising the corporate tax rate – or simply leaving it at its current level – would be a bad way to generate revenue, a bad way to increase the tax system’s progressivity, and a bad way to help US workers.

Laura Tyson, a former chair of the US President’s Council of Economic Advisers, is a professor at the Haas School of Business at the University of California, Berkeley.

A version of this article was first published on Project Syndicate.