Jan. 26, 2012
In his January 2012 State of the Union address, President Barack Obama called for cutting taxes for companies that produce in the United States, especially high-tech manufacturers. He proposed eliminating deductions for firms that move jobs abroad. And he suggested a minimum tax on all multinational corporations.
The suggestions echoed, but were less sweeping, than Obama’s proposal in his January, 2011 State of the Union that Congress should, “Get rid of the loopholes. Level the playing field. And use the savings to lower the corporate tax rate for the first time in 25 years – without adding to our deficit.”
Both appeals were shrewd political maneuvers designed to appeal both to progressives, who have long complained about corporate manipulation of the tax code, and to conservatives who have long fretted that high U.S. corporate tax rates undermine the competitiveness of American companies in the global market.
And the president is not alone. GOP presidential candidate Mitt Romney advocates cutting the corporate tax rate, as does his Republican opponent Newt Gingrich.
Despite such advocacy, reform of corporate taxation is all but dead in an election year. An overhaul now seems unlikely before 2013 at the earliest, as part of a rewriting of the tax code. Delay may be inevitable, but it is still a mistake. Corporate tax reform could level the playing field internationally, promote the competitiveness of U.S. companies, and create jobs sooner rather than later. Done right, it could also distribute the tax burden more fairly, create jobs, and generate revenue that would help reduce the budget deficit.
Progressives need to make corporate tax reform – not simply corporation bashing – a cornerstone of their economic agenda in the 2012 election campaign. It is good economics, good politics, and the right thing to do.
Who Bears the Corporate Tax Burden?
Corporate taxation has long been the subject of contentious debate. Progressives have argued that since the corporate tax is largely borne by the owners of capital, who tend to have higher incomes than other taxpayers, high rates of corporate taxation are inherently fairer than income taxation and should figure more prominently in the American tax code. Conservatives have contended that the corporate tax burden is simply passed on to consumers in the form of higher prices and paid for by workers through lower wages, making corporate taxation regressive. Businesses also assert that cutting corporate taxes would attract large investment flows into the United States, which would create jobs or expand the taxable income base, raising revenues.
The current U.S. corporate tax rate of 39 percent is the highest among major economies. This factoid alone has framed the debate over corporate taxation, convincing people on both the left and the right that America needs a lower corporate tax rate that puts it some place in the middle of the international pack.
But there is mounting evidence that hugely profitable American companies, such as GE and Cisco, pay taxes at a fraction of the statutory rate, when they pay any taxes at all. The average effective U.S. corporate rate, after allowing for various write offs, is only 23.5 percent – lower than that in Japan or Canada. By this measure, there is no reason to take a meat ax to corporate tax obligations.
Nevertheless, the case for cutting the corporate tax rate remains compelling. The effective rate among many of America’s competitors is also lower than their statutory rate. So any reform of both rates and loopholes needs to be done with an eye toward a level international playing field.
Seventeen countries reduced their corporate tax rates in 2009-2010. To keep job-creating investment in the United States, Washington needs to do the same. With a rate that is 11 percentage points above the OECD average, a cut of 7 to 10 percentage points would be reasonable, bringing the U.S. rate down to the statutory or effective OECD average. Republicans in the U.S. House of Representatives have already proposed cutting the corporate rate to 25 percent, as has GOP presidential candidate Mitt Romey.
However, at a time of rising concern about the U.S. government’s deficit and debt levels, it would be irresponsible to cut corporate taxes if doing so would erode much-needed government revenues. Jane Gravelle of the Congressional Research Service has found that a significant cut in U.S. rates would actually cost the Treasury substantial tax revenue.
But rates can be cut significantly without sacrificing fiscal prudence, if done right. In a study for the Peterson Institute for International Economics, Gary Hufbauer and Woan Foong Wong found that with a 10 percentage point cut in the corporate tax rate “the loss of corporate tax revenue is more than offset by the gain in revenue from personal income taxes and other taxes.”
However, the Hufbauer-Wong conclusion depends on corporations investing their added revenue, not simply banking it, as they are now doing with their profits. This all-important caveat argues forcefully for tying any tax rate cut to new corporate investment commitments.
It would be economically dubious and politically impossible to force corporate investment in return for tax reform. Society would not benefit from companies squandering their tax savings on expanding economically inefficient capacity they don’t need.
A better approach would be to leverage corporations to invest some of their tax savings in rebuilding America’s crumbling infrastructure, where some economists estimate the investment shortfall now exceeds $2 trillion.
Corporations could receive a tax credit if they devoted a portion of their tax savings to purchasing bonds issued by a national infrastructure bank. This would drive investment that would not otherwise take place, creating demand without adding to excess capacity, generating a more sustainable economic recovery. While a tax credit would add to the cost of tax reform by creating a new tax expenditure, the additional jobs and economic activity such investment would generate should more than compensate for the loss of revenue.
Of course, such an initiative would complicate corporate tax reform because it would require additional legislation. But Senator John Kerry has already introduced a proposal to create an independent, nonprofit bank that would leverage private investment into infrastructure projects. Progressives should make passage of corporate tax reform dependent on creation of an infrastructure bank to channel some of the corporate savings into job-creating investment.
Broadening the Base
The U.S. tax base, the universe of taxable corporate profits, was just 13 percent of the economy in 2007. The OECD average, not including the United States, was 22 percent. So, while the effective U.S. corporate tax is 6 percentage points higher than the OECD average, the U.S. tax base is 9 percentage points of GDP smaller than the average in comparable countries. There is great room to broaden the corporate tax base while cutting rates, raising additional deficit-cutting revenue.
Paris’ experience shows what Washington could accomplish. France has the lowest effective corporate tax rate in the OECD at only 8.3 percent, but the broadest tax base by far: 35.7 percent of GDP. With that low rate and broad base, corporate tax revenue in France accounts for the same percentage of GDP, 3 percent, as that raised by the United States, with its higher rate and narrower base.
Voters back such base-broadening. In a May 2011 poll by the Pew Research Center, 62 percent of Americans favored limiting tax deductions for large corporations. And despite reluctance of Congressional Republicans to tighten tax loopholes and tax expenditures, 62 percent of GOP voters and 67 percent of Independents supported curbing corporate tax deductions. A September 2011 Gallup poll found similar support for raising taxes on corporations. Fully 70 percent of Americans favored increasing taxes on some corporations by limiting certain tax deductions.
One way to broaden the base would be to require more businesses to be taxed as corporations. Only 18 percent of U.S. businesses are incorporated, the lowest proportion by far among comparable OECD countries. The reason: U.S. tax law permits individuals to be taxed at individual not corporate rates if they are in limited liability corporations, such as law firms, and other pass-through entities.
In 1980, 3 percent of business receipts were accounted for by such “pass-throughs.” By 2007, 20 to 50 percent of such receipts went through pass-throughs.
Hufbauer and Wong have concluded that if the U.S. taxed pass-through entities at current corporate rates, corporate tax revenues would almost double. This would provide ample revenue to use for tax credits to incentivize corporations to invest in infrastructure bank bonds.
Encourage Job-Creating Repatriation
Most countries (27 of the world’s 34 largest industrial economies) tax corporations on a territorial basis, only going after profits the firms make at home. Washington taxes American companies on their global income, but gives them a credit for the foreign corporate taxes they pay. And it allows firms to defer paying U.S. taxes until that income is brought back to the United States. Currently U.S. corporations have overseas cash holdings of almost $2 trillion.
Some business lobbyists want to adopt a territorial corporate tax. They contend that taxing foreign profits when they are made, wherever they are made, disadvantages U.S. corporations that compete against foreign firms in third markets and do not face similar taxes from their home governments. Critics of a territorial tax system argue that such treatment would reduce the cost of foreign investment relative to that of domestic investment, effectively exporting U.S. jobs.
This debate over a territorial tax starkly highlights the contrast between national and corporate interests in a global economy. The most efficient allocation of capital would best be served by comparable corporate tax regimes allowing companies to deploy capital based on the best return on their investments, without regard to how and when it may be taxed. But it is not at all clear a territorial tax is in the best interest of the country.
As Robert Pozen of the Harvard Business School has noted, the rationale for adopting a territorial tax implicitly assumes that U.S. firms already pay foreign taxes somewhere at some reasonable rate. But much of overseas American corporate income is funneled into foreign tax havens in the Cayman Islands and elsewhere, where they pay little tax. U.S. conversion to a territorial tax system, without some recognition of this fact, would simply reduce overall corporate tax obligation.
Accommodating the current U.S. corporate tax system with the territorial tax system is doable, however. As Pozen suggests, Congress could “exempt from U.S. taxes corporate income earned in foreign countries with an effective corporate tax rate of 20 percent or higher. Such earnings could be repatriated to the U.S., subject to payment of a 5 percent administrative charge.”
Short of a territorial tax system, some Republicans are pushing for a tax holiday that would allow U.S. companies to repatriate foreign profits and pay a maximum tax rate of 5.25 percent. The reduced rate would be applicable to earnings above the annual average earnings repatriated in the five most recent taxable years. A fine of $25,000 per worker would also be imposed if a company reduces its average employment level in the two years after taking advantage of the repatriation holiday.
The rationale for the fine is experience with the American Jobs Creation Act of 2005, which offered corporations a tax holiday in return for their promise that they would invest their savings in the United States. But the Congressional Research Service and other studies have found that most of the largest beneficiaries of the repatriation act actually cut jobs in 2005 and 2006. Many used the repatriated funds to repurchase stock or to pay dividends.
There could be more job-friendly approaches to repatriation. Former President Bill Clinton has suggested applying a 20 percent tax rate on repatriated profits, which would be reduced to 10 percent if corporations reinvested the repatriated funds in a manner that increased employment in the United States. Chicago mayor Rahm Emanuel has suggested a 15 percent tax rate, with the tax receipts placed in a new infrastructure bank to create jobs through investment in roads and bridges. Another approach could be to allow firms to pay no taxes at all on profits brought back and reinvested in infrastructure bank bonds. The level of taxation for repatriated funds could also be tied to whether they are invested over and above the average of the company’s investment in the years prior to the financial crisis, as long as the investment increased employment above that average.
The United States needs to create jobs and increase revenues to lower public indebtedness. Corporate tax reform can be a means to pursue both these goals. It is too important to be sidelined by the debt ceiling debate and partisan battles over deficit reduction. Lowering corporate taxes can be part of the solution – if done right, with an eye to competitiveness, revenue neutrality or enhancement, and fairness.
To see the Economic Growth Program’s progressive proposal to cut the corporate income tax, click here.