As 2020 began, the U.S. business tax system was ill-suited to the nation’s economic challenges. After the excessive tax cuts of 2017, the U.S. corporate tax raised only one-third as much revenue, relative to gross domestic product (GDP), as those of U.S. trading partners in 2018 and 2019. The system of taxing pass-through businesses—businesses that do not pay the corporate tax—was already leaky, but it was further weakened by the inefficient pass-through deduction of the 2017 tax law. These business tax cuts lavished rewards on those at the top of the income distribution without demonstrably boosting either business investment or wages. As a result, the U.S. tax system is less progressive than what came before, despite prior decades of uncontested increases in income inequality. The new tax law is also ill-suited to a global economy, explicitly favoring offshore earnings, rather than those in the United States.
Now, the COVID-19 crisis has raised unprecedented threats to public health and the economy. Both the Federal Reserve System and Congress have leapt into action. Congress passed multiple relief packages, including the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March, which provided about $2 trillion in funding for response and relief.
While many of the provisions of the CARES Act provide critical relief at this urgent time, the business tax cuts in the bill should have been more carefully targeted. It is also essential that Congress counter the expectation that crisis measures will be extended post-crisis and instead pursue revenue-raising business tax reform once the crisis is past. This column outlines three principles for an efficient and equitable business tax system that is fit for purpose.
Principle 1: Business assistance should help companies facing temporary liquidity issues due to the coronavirus crisis
In many industries, legitimate public health measures have generated a complete shutdown of business. It is therefore crucial to provide liquidity to companies struggling due to no fault of their own. Plentiful assistance can protect employer-employee relationships and business networks during this extraordinary time. Companies in distress should receive easy access to credit, rather than being forced into bankruptcy.
The Federal Reserve, through the banking system, and the U.S. Treasury Department, through loan guarantees, are working on these challenges; Congress has played an important role providing funding. The CARES Act, as well as an April extension, funded two loan sources for small businesses: the Paycheck Protection Program (PPP) and the Economic Injury Disaster Loan (EIDL) program. There are some questions regarding whether these programs are ideally designed, but such issues are beyond the scope of this piece.
The CARES Act also includes tax provisions aimed at increasing business liquidity, including an employee retention job credit, postponement of employer payroll taxes, generous loss carryback provisions, and reduced interest limitations. While liquidity support through lending or postponed tax payments will, hopefully, be paid back, other forms of assistance typically will not be recouped, so it is particularly important for such provisions to be temporary and well-targeted.
What will happen to taxpayer funds?
During the Great Recession, the Troubled Asset Relief Program (TARP) dispersed large amounts of funds, but overall, TARP lending was paid back relatively swiftly when conditions normalized. The same pattern will likely hold in the months ahead. Businesses are illiquid due to today’s conditions, but they are not fundamentally insolvent under normal conditions. Therefore, appropriations for loans and loan guarantees may not reflect the true cost to taxpayers since many loans will be repaid. As a consequence, the Congressional Budget Office has lowered the estimated cost of the CARES legislation by about $450 billion.
Hopefully, for most industries, the situation after the crisis will be similar to that beforehand. For example, people will fly again, and in the meantime, Boeing and the airlines have good claims for temporary assistance. Still, some companies should shrink. For example, it will be difficult for the cruise industry to return to its former state: Many customers may reevaluate whether cruises are healthy vacation choices, and after the crisis, the ideal size of this industry may be smaller. For this reason, propping up the cruise industry is unlikely to be a good use of government funds.
Importantly, major cruise companies have also avoided U.S. incorporation for tax purposes. As a consequence, U.S. taxpayers need not feel obligated to provide assistance. The CARES Act usefully excludes companies incorporated in other countries from assistance backed by the U.S. Treasury. If cruise companies based in tax havens sink as a result, the federal government can help U.S. workers but should not mourn these companies. Indeed, other countries—including Denmark and France—have denied assistance to any company incorporated in a tax haven.
Principle 2: Business tax cuts should be carefully targeted and explicitly temporary
Many businesses will suffer losses in 2020 due to COVID-19 shutdowns. Under current law, when companies make losses, they are allowed to use those losses in future tax years to offset taxable income—although only 80 percent of taxable income can be offset with prior losses. The CARES Act relaxed this treatment of losses in two ways: 1) It allowed losses to offset past taxable income in the five years prior—otherwise known as loss carrybacks; and 2) it removed the 80 percent limit.
Allowing companies special tax treatment for 2020 losses may be justified, as those losses were due to unusual circumstances. That said, the results of favorable tax treatment for 2020 losses take time to materialize, since companies will not file their 2020 returns for some time, and companies are likely to need swifter assistance. Nontax measures, such as loans, may provide more effective short-run relief.
During the crisis, many businesses will also face higher debt burdens. The tax code generally allows businesses to deduct interest on debt, but those deductions are subject to certain limits. Allowing higher limits on company debt in 2020 is sensible, as companies may need to take on higher debt burdens to survive. The deductibility of debt payments is limited to 30 percent of company earnings, but a more generous limit of 50 percent—as allowed in the CARES Act—may be a useful temporary measure.
Still, the recent coronavirus relief bill is poorly targeted in several respects. First, it eases limits on loss deductions for losses incurred not only in 2020, but also in 2018 and 2019. Similarly, it allows greater deductions for interest paid not only in 2020, but also in 2019. Yet 2018 and 2019 were unaffected by the current COVID-19 crisis. There is no reason to target corporate tax cuts toward those companies that were reporting losses—or highly indebted—during years when the economy was expanding, before the crisis hit. If the purpose is to channel money to all companies affected by the crisis, it is misguided to target assistance toward companies with losses or high debt in 2018 or 2019.
Second, the legislation allows excessively large loss deductions. It allows companies to “carry back” their losses for five years—that is, they can deduct losses from 2018, 2019, and 2020 against their profits from five years prior. Since the 2017 tax law sharply cut the corporate tax rate from 35 to 21 percent, companies can now deduct many of the losses they incurred from 2018 to 2020 against a 35 percent tax rate, instead of today’s 21 percent rate. While a long carryback period for 2020 losses may be reasonable, loss carrybacks should be applied based on the current corporate tax rate. For example, $100 of losses carried back to 2017 should generate $21 in tax benefits, not $35.
Third, the CARES Act relaxed pass-through business loss limitation rules in a way that was particularly poorly targeted. Under the 2017 Tax Cuts and Jobs Act (TCJA), owners of pass-through businesses were limited in the extent to which their business losses could be used to offset their ordinary income, with limits of $250,000 for single filers or $500,000 for married couples. These loss limits—and those above—were an explicit part of the revenue bargain under the TCJA; they helped offset part of the cost of the law’s business tax cuts. The CARES Act relaxes these limits, but it only helps those with very high incomes since everyone else could already use their losses to offset income. The taxpayers that benefit are likely to be in real estate or hedge funds. The Joint Committee on Taxation has estimated that this provision alone will cost $135 billion, with 82 percent of the benefits going to those with more than $1 million in income.
Any business tax cuts should be temporary
Corporate lobbyists are active in promoting business tax breaks. Every time companies get tax breaks, there are temptations to simply renew them as if they were always intended to be permanent. However, tax breaks in response to the current public health emergency should be explicitly temporary. Policymakers must therefore stiffen their resolve to resist extending crisis measures after the crisis.
More generally, it is important to recognize that all tax relief measures come with opportunity costs. As the United States faces skyrocketing unemployment and the prospect of a very deep recession, policymakers should aim for the most effective use of relief—and, later, stimulus—funding. It is essential to devote resources to unemployed workers, lower-income families, and states and localities that have been particularly hard-hit. Moreover, it will be impossible to strengthen the economy until the virus is under control, so the very first priority must be controlling the public health crisis, which requires substantial resources for testing, vaccines, and treatment.
Principle 3: After the crisis, the corporate tax needs to be stronger
Taxpayers should assist businesses now. However, unaffordable tax cuts should not be lavished on highly profitable companies, as they have been in recent years. When the crisis is over, the business community should do its fair share to fund the government. Even during the pandemic, those companies earning profits can contribute more.
The 2017 TCJA cut corporate and pass-through business taxes excessively. In 2018 and 2019—before the crisis—corporate tax revenues had already dipped to 1 percent of GDP, a ratio far lower than those of peer nations. In addition, the pass-through business tax cut was widely reviled as a provision that simultaneously made the tax code less efficient, less equitable, and more complex.
The corporate tax mostly burdens excess returns to capital, and there are strong efficiency, equity, and revenue reasons for strengthening the corporate tax. From an efficiency perspective, a tax on the excess returns to capital does not distort investment or harm workers. From an equity perspective, the corporate tax mostly falls on those at the top of the income distribution; all other taxes—save the estate tax—more heavily burden labor and middle-class Americans.
After the crisis, policymakers should increase corporate tax rates and take measures to protect the corporate tax base from erosion due to international profit shifting. As the nation faces higher debt ratios and pressing fiscal needs in the years ahead, strengthening revenue streams will be important. Moreover, the corporate tax remains an indispensable tool for taxing capital income, as about 70 percent of U.S. equity income is untaxed by the government at the shareholder level.
Strengthening business taxation need not wait for the crisis to end. Indeed, businesses will not pay profit taxes until they earn profits. Although the peak of the crisis is not a good time for any immediate tax increase, policymakers should plan for a quick repeal of the pass-through deduction, a higher corporate tax rate, and stronger measures to counter corporate tax base erosion. Many companies will not be profitable in the near term, but increasing profits taxes will boost revenues once companies start earning profits. Even then, some companies may have losses to carry forward.
In addition, other companies may have windfall profits associated with dramatic changes in the demand for their goods or services during the pandemic. These companies can afford to pay more taxes right away.
Does the United States need new types of taxes?
Some observers have argued that today’s situation may call for an excess profits tax. In many respects, the corporate tax is already an excess profits tax. Most of the normal return to capital is already exempt from taxation under current tax rules, which allow full expensing for equipment investment, deductibility of most debt-financed investments, and generous depreciation allowances for most structures. Relatively modest reforms could make the U.S. corporate tax even more like an excess profits tax.
While some companies may be profiting off the pandemic, companies often maintain business practices that generate excess profits; a robust corporate tax could tax such profits whether in a crisis or a more typical situation. Furthermore, the rising importance of market power makes the corporate tax an essential policy tool. Taxing excess profits is less distortionary than taxing the normal return to capital, and a strong corporate tax counters the market power of large companies.
Conclusion
COVID-19 has generated a laudable sense of shared sacrifice in a time of national devastation and disruption. Before, during, and after the crisis, the fiscal needs of the country far outstrip revenue streams, and these shortfalls are occurring amid a context of widening income inequality. While it is reasonable for taxpayers to assist businesses in times of trouble, more should be expected from highly profitable companies—both now and in the future. As the nation moves forward from this crisis, strengthening business taxation should be at the top of the agenda.
Kimberly Clausing is a senior fellow at the Center for American Progress.
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