Can Corporate Tax Reform Really Be Revenue Neutral?

Can Corporate Tax Reform Really Be Revenue Neutral?

iStockphoto/The Fiscal Times

There is growing evidence that many large corporations are paying well less than their fair share of taxes. On November 3, Citizens for Tax Justice, a liberal group, published a study of taxes paid by the 280 most profitable U.S. corporations. It found that 40 percent of them paid an effective rate of 17.5 percent or less over the last three years, with 30 companies paying nothing and 67 companies paying less than 10 percent. 

Even so, both Republicans and Democrats believe that lowering the corporate tax rate and fixing the convoluted corporate income tax is essential to improving American competitiveness, which is the driving force in the current tax reform debate. 

Corporations complain that they pay higher taxes here than in foreign countries and that U.S. laws discourage them from repatriating foreign earnings.

One of the key problems in the corporate tax reform discussion is figuring out which tax rate really matters for corporate decisionmaking. While it is true that the statutory corporate tax rate in the U.S. is relatively high compared to other countries, it’s not clear that this is a meaningful measure of the tax burden on corporate businesses.

In order to calculate the total federal tax rate on income earned in the corporate sector, one needs to follow the trail to the owners of a corporation, its shareholders. Since they also pay taxes on the same income that is taxed at the corporate level—corporate profits are double taxed in most countries—the tax rate on dividends is also relevant to the calculation. Presently, dividends are taxed at a maximum rate of 15 percent in the U.S., compared to a federal income tax rate on wage income that can go as high as 35 percent.

According to the Organization for Economic Cooperation and Development, many countries that appear to have low corporate tax rates actually have high rates on corporate income once individual rates on distributed profits (dividends) are taken into account. For example, Ireland has a corporate rate of just 12.5 percent, compared to 35 percent in the U.S., but it taxes dividends at a rate as high as 41 percent. Other countries provide tax relief for dividends paid, which reduces their effective tax rate.

Just as with the individual income tax, many deductions and credits reduce the taxes that corporations actually pay. When one calculates the effective federal tax rate on U.S. corporations—taxes divided by gross income—the corporate tax burden in the U.S. is very competitive.

On October 24, University of Michigan law professor Reuven Avi-Yonah and Ben Gurion University economist Yaron Lahav published a study examining the corporate tax burden on the 100 largest companies based in the U.S. and the European Union. The data come from publicly available financial reports issued by the companies. The study found that while the statutory tax rate is about 10 percentage points higher in the U.S., the effective tax rate paid by U.S. and European companies is about the same because European companies get fewer tax preferences.

The study suggests that this shows a path toward tax reform. If the U.S. broadened its corporate tax base to European levels then the U.S. could reduce its corporate tax rate to European levels.

However, on October 27, the Joint Committee on Taxation of the U.S. Congress released an estimate of how much the corporate tax rate could be reduced if all corporate tax breaks were eliminated. It found that completely wiping the slate clean would only allow the rate to be reduced by 7 percentage points to 28 percent. Republicans and the corporate community have been pushing to reduce the rate to 25 percent.

This suggests that if tax reform is to be done in a revenue-neutral manner—neither raising nor lowering aggregate revenues—then reducing the corporate tax rate will have to be paid for partially by raising taxes on individuals. This would seem to be prohibitively difficult, politically. Congress can pay for tax rate cuts for individuals by closing corporate tax loopholes, as was done in the Tax Reform Act of 1986, but it is very unlikely that people will support doing it the other way around.

Ending Unfair Tax Breaks
Of course, the last three years have been difficult ones for virtually all businesses. And because losses can be carried forward into future tax years, heavy losses in the past can shield profits from taxation today. Nevertheless, it has been considered scandalous in the past for large, profitable corporations to get away with paying little, if any, federal taxes. In 1982, for example, Ronald Reagan supported the Tax Equity and Fiscal Responsibility Act, the largest peacetime tax increase in American history, in large part because General Electric had avoided paying any taxes due to its aggressive use of legal tax breaks.

One area in which there is some agreement between the two parties is on changing the way foreign income is treated. The U.S. taxes multinational corporations based here on all their income earned in foreign countries, with a credit for taxes paid in those countries. Most countries only tax their corporations on income earned domestically. However, U.S. taxes are only levied when profits are repatriated from abroad.

One suggestion has been to allow corporations a one-time tax holiday in which they would pay a lower tax on repatriated earnings. Republicans say this would stimulate growth, but there is no reason to think so because the production that gave rise to the profits takes place in other countries, and allowing a tax holiday will only make foreign production more attractive.

Furthermore, Congress instituted a tax holiday on repatriated earnings in 2004 and there is no evidence that it led to increased growth, domestic investment or jobs, according to a 2009 Congressional Research Service report. An October 11 study by the Senate Committee on Homeland Security and Governmental Affairs found that much of the money went into executive compensation and that corporations raised the amount of funds they kept abroad in anticipation of another tax holiday. For these reasons, even the conservative Heritage Foundation agrees that a tax holiday would not be economically stimulative.

While a reduction in the corporate tax rate is a good idea, figuring out how to pay for it will not be easy. It would be a bad idea to allow a tax holiday for foreign earnings unless the whole system of taxing foreign-source income is reformed. Otherwise, it will just increase the incentive for multinationals to park their profits in foreign tax havens.