Corporate Tax Options — A Tangled Mess

Corporate Tax Options — A Tangled Mess

Iva Hruzikova/The Fiscal Times

Today, Treasury secretary Tim Geithner and other senior Treasury officials are meeting with a group of business executives to kick off a discussion of tax reform. Since almost everyone on both sides of the aisle thinks the U.S. corporate tax rate needs to come down to be more competitive with other countries, there is at least theoretically some basis for negotiation. The big question is what revenue-raising measures will be part of the deal to keep it revenue-neutral.

Presently, the basic corporate tax rate in the U.S. is 35 percent. It started out at just 1 percent in 1909, rose to 40 percent during World War II, and to 52 percent during the Korean War. The Kennedy/Johnson tax cut reduced it to 48 percent in 1965. It fell to 46 percent during the Carter administration, and the Tax Reform Act of 1986 lowered it to 34 percent. Bill Clinton raised it to 35 percent and it’s been there ever since.

After the 1986 act, the U.S. had one of the lower corporate tax rates in the world. Germany had a rate of 56 percent; Italy, 52 percent; Japan and France, 42 percent; the U.K, 35 percent; and Canada, 29 percent. But by 2010, the U.S. had one of the higher rates. Germany’s rate was down to 15 percent; Italy, 27.5 percent; Japan, 30 percent; France 34 percent; the U.K., 28 percent; and Canada, 18 percent. And last month Japan announced a further cut in its corporate rate to 25 percent.

France, Italy and the U.K. impose no subnational
corporate taxes, nor do most other OECD countries.

The U.S. is also one of only a few major countries to impose corporate income taxes at the state or provincial level. The Organization for Economic Cooperation and Development estimates the average state corporate tax rate at 6.5 percent. Because state taxes are deductible at the federal level, the combined rate works out to about 40 percent. France, Italy, and the U.K. impose no subnational corporate taxes, nor do most other OECD countries.

It is taken for granted by politicians that the corporate tax has a critical impact on competitiveness. But the term “competiveness” is basically devoid of meaning. To economists, it essentially means productivity. On this score, the U.S. still ranks at or close to the top of major countries. According to the Bureau of Labor Statistics, real gross domestic product per employed person in the U.S. was $99,763 in 2009, well above France ($84,978), the U.K. ($77,878), Italy ($77,363), Canada ($75,676), Germany ($74,120), and even Japan ($65,507).

More subjective measures of competitiveness also rank the U.S. near the top. In 2010, the World Competiveness Yearbook put the U.S. in third place among all counties; only tiny Hong Kong and Singapore ranked higher. The World Economic Forum ranked the U.S. in fourth place, behind Switzerland, Sweden and Singapore.

There is a pervasive sense among many if not most Americans that
our competitiveness is slipping. The reality is somewhat different.

Nevertheless, there is a pervasive sense among many if not most Americans that our competitiveness is slipping. I think this mainly has to do with the large trade deficits we have run for some years. The reality is somewhat different. The U.S. is the third largest exporter in the world, with exports not far behind powerhouse China. According to the World Trade Organization, in 2009 the U.S. exported $1.056 trillion worth of goods while China exported $1.202 trillion. However, we imported considerably more: $1.605 trillion versus $1.006 trillion for the Chinese.

Insofar as people are concerned about our international competitiveness, there is not a great deal that tax policy can do. Promoting more research and development would help, but it’s increasingly difficult to keep the benefits at home. Raising productivity would help exports by lowering production costs for domestic producers, but since U.S. productivity is already much higher than most people realize, this is not likely to have much impact on the trade balance in the short run.

The thing that would help most would be if the U.S. raised its national saving, since the trade deficit largely represents imported saving. Financing more of domestic investment internally would automatically reduce the trade deficit and may also raise investment, which would improve productivity.

Unfortunately, experience shows that tax incentives for saving tend to mainly affect the composition of saving, as people move money around to get a tax benefit, rather than the total amount. More importantly, from a macroeconomic point of view, the saving done by corporations and governments is far more important than that done by individuals.

Insofar as corporate and government saving is concerned, the most important thing to remember is that borrowing and debt are negative saving. Thus, reducing corporate borrowing and encouraging firms to raise capital through retained earnings and issuing stock would unquestionably improve national saving. The main reason corporations borrow so heavily is that interest payments are deductible whereas dividend payments are not. This makes borrowing a far cheaper way of raising capital than common stock. Therefore, one attractive tax reform would be to equalize the tax treatment of debt and equity.

Replace the corporate tax, which is embedded in
the prices of goods to some extent, with a value-added tax.

Another potential reform that might improve international competitiveness would be to replace the corporate tax, which is embedded in the prices of goods to some extent, with a value-added tax that can be rebated at the border on exports and is applied at the border on imports. This would clearly improve competitiveness and put domestically produced goods and those manufactured abroad on an equal footing. (The corporate tax may not be rebated at the border because economists don’t know to what extent it is embedded in the prices of goods, and world trade law requires that to be known precisely if a tax is to be rebatable.)

Unfortunately, changes in the tax treatment of debt and equity are not likely to be on the table; nor is a VAT, owing to obsessive Republican hatred of this particular form of taxation even though every other major country has one. The only reform that is now under discussion is cutting the statutory corporate tax rate by some unspecified amount. The main constraint is the revenue cost, which will require offsets (i.e., tax increases) that will be politically contentious.

Taxable income in 1987 was 98 percent of
gross profits; by 2007, it was down to 72 percent.

The obvious place to look for offsets is the list of tax expenditures compiled by the Treasury Department and Joint Committee on Taxation. These are special tax breaks that violate basic principles of taxation. The proliferation of such breaks in recent years has caused a sharp divergence between gross corporate profits and taxable corporate income. According to the Internal Revenue Service, taxable income in 1987 was 98 percent of gross profits; by 2007, it was down to 72 percent.

The biggest corporate tax expenditure is the deferral of foreign income earned by U.S.-based multinational corporations that is not repatriated and therefore not taxed by the U.S. The Treasury Department estimates that this “loophole” will cost it $33 billion this year. But it should be kept in mind that very few other countries tax their domestic corporations on income earned in other countries. Most economists believe that the U.S. should have a similar system and tax corporations only on what they earn at home.

Lowering the statutory corporate tax rate would encourage U.S.-based corporations to repatriate more of their foreign earnings, which would offset the cost to some extent. It might also encourage some foreign companies to increase their direct investment here, which would create jobs and possibly improve the trade balance. These are good reasons to do it, provided that it is done in such a way that the budget deficit is not increased. We really can’t afford more tax cuts no matter how many times Republicans stupidly insist that they don’t add to the budget deficit.

Secretary Geithner would do well to remind the executives that the budget deficit is also an important contributor to competitiveness. Insofar as it drains capital from the economy it reduces investment, increases foreign indebtedness and enlarges the trade deficit. At some point, higher revenues are going to be necessary to reduce the long-term budget deficit and corporations are likely to bear much if not most of the higher burden unless there is another alternative available when the time comes. The secretary should encourage the corporate community to put something on the table before the budget crunch inevitably comes.

Related Links:
U.S. Lagging Behind OECD Corporate Tax Trends (The Tax Foundation) 
Google 2.4 Percent Rate Shows How $60 Billion Lost to Tax Loopholes (Bloomberg)