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The U.S. corporate tax system debuted more than 100 years ago and has evolved little to meet the challenges of today’s economy. The country would benefit greatly from a reform of this system that maintains corporate tax revenues while increasing incentives for businesses to locate, invest, and produce in the United States, thus offering the prospect of higher wages and better job opportunities for American workers.
At its peak in the 1960s, the U.S. corporate income tax accounted for more than one-fifth of all federal revenues, making it the second most important federal revenue source after the personal income tax. Figure 1 shows that since then corporate tax revenues have declined as a share of national income and total federal revenues. After the major Reagan-era tax cuts in 1981, the corporate tax has provided less than 12 percent of federal revenues in all but four fiscal years, during the period 2005–2008, when a booming financial sector generated temporarily high profits and tax revenues. Few analysts expect a rebound back to those levels.
The declining importance of the corporate income tax is particularly troubling as budget pressures increase. But beyond concerns about revenue, much of the current pressure on the corporate tax relates to the competitiveness of the United States in the global economy as a home for multinational corporations, new business investment, and production and economic activity. How U.S. corporations are taxed strikes at the heart of productivity, wages, and employment of American workers.
Avoiding the “race to the bottom”
This paper proposes an alternative treatment of international transactions that would relieve the international pressure to reduce rates while attracting foreign business activity to the United States. It addresses concerns about the effect of rising international competition for multinational business operations on the sustainability of the current corporate tax system. With rising international capital flows, multinational corporations, and cross-border investment, countries’ tax rates and tax structures are of increasing importance. Indeed, part of the explanation for declining corporate tax rates abroad is competition among countries for business activity. Given that the United States has a relatively high corporate tax rate of 35 percent, some observers suggest that we must join this “race to the bottom” by reducing rates and further eroding tax revenues to keep business activity and jobs in the United States.
Generating long-run productivity gains for American workers and firms by increasing investment in U.S. businesses is a related concern. Investments in factories, machines, software, and equipment are a key driver of increases in workers’ productivity and wages; changes in the corporate tax system that increase investment can help increase living standards for American workers. A key challenge is finding a revenue-efficient means to support new investment.
Finally, the recent economic crisis heightened concerns that the corporate tax contributes to economic instability by encouraging excessive corporate borrowing. The growing importance of the financial sector as well as increases in financial innovation and the sophistication of financial transactions have contributed to the recent financial crisis, recession, and the resultant increase in unemployment. The corporate tax system contributes to America’s private debt burden because it encourages borrowing relative to other forms of financing—interest payments are deductible whereas payments to shareholders are not. Addressing this economic distortion provides a means to facilitate a more sustainable, efficient, and stable business sector.
The corporate tax can survive as an important source of federal revenue, but its survival and the alleviation of concerns about its effects on the economy require that it be reformed to address the challenges described above. I propose changes that would set the U.S. corporate tax apart from those found abroad, but these proposals are based on ideas that are neither new nor radical and would result in a tax system better suited to today’s economy than our current system.
In brief, the reform would consist of two fundamental pieces, one affecting the treatment of investment and borrowing, and the other dealing with international transactions.
First, an immediate deduction for all investments would replace the current system of depreciation allowances. Currently, when a firm invests in a factory or other equipment, it deducts the cost of that investment over a number of years. Allowing firms to deduct the costs of investment against their taxable income in the year the investment is made reduces the after-tax cost of investments because a dollar in tax savings today is worth more than a dollar many years hence. In fact, the value of the immediate deduction for investment against taxes today exactly offsets the net present value of future taxes on that investment, reducing the effective tax rate on new investment to zero. Such a change is not novel—smaller businesses may already take advantage of immediate expensing up to a limit. In addition, the 2002, 2003, 2008, and 2009 tax cuts included temporary partial expensing to help stimulate investment and economic activity.
My proposal includes a similar change in the treatment of borrowing that would remove the current advantage to debt from the firm’s tax calculation. As noted above, business investments financed through debt receive more favorable tax treatment than equity-financed investments.
One means to rectify this disparity is to deny a deduction for interest expense in the same way that deductions are prohibited for dividend payments to equity holders. This paper takes an alternative approach that effectively achieves the same outcome but retains deductibility of interest expense: by including non-equity financial transactions in the calculation of taxable income, the new tax treatment of debt—taxable when borrowed but deductible when repaid—would mirror the symmetric tax treatment of equity—non-taxable when issued and not deductible when dividends are paid.
This system of immediate expensing and symmetric treatment of equity and debt is sometimes called a cash-flow tax because it is levied on the cash passing through a firm. For example, when calculating taxable income, firms would include revenues from both sales of goods and services and from financial transactions like bond issuances. Firms would receive deductions for payments made for the same costs as they do now—wages, cost of goods sold, interest expense—but would also deduct other financial payments, such as repayment of loans. In addition to enhancing the incentive to invest and removing the incentive to borrow, the simplified tax does not require depreciation schedules or inventory accounting—a domestic business’s tax books could look much like an individual’s annual checking account statement.
Second, a system that ignores all transactions except those occurring exclusively in the United States would replace the current approach to taxing foreign-source income. Most countries, including the United States, attempt to collect corporate taxes based on where a corporation’s profits are earned. The problems with this approach are that businesses and investments are increasingly internationally mobile and a business’s profits are intrinsically hard to attribute to a particular place; indeed, the fungibility of profits results in a system where a disproportionate share of the profits of multinational companies appear to occur in the world’s least-taxed countries. Current corporate tax systems generate incentives that result in the current environment where countries compete for multinational business activity by lowering their corporate tax rates. To remedy this situation, sales abroad would not be included in corporate revenue nor would purchases or investment abroad be deductible in the second major piece of the proposed corporate tax reform. As a result, the corporate tax would be assessed based on where a corporation’s products are used rather than where the corporation is located or where the goods are produced. Assessing the tax based on where a firm’s products are used eliminates issues of where to locate a business and incentives for U.S.-domiciled businesses to shift profits abroad to reduce U.S. taxes.
This plan therefore delivers a host of economic advantages to U.S. businesses and American workers. Promoting domestic corporate activity and encouraging investment would boost productivity, the key driver of increases in wages, employment, and living standards. Indeed, estimates of similar proposals suggest these changes could increase national income by as much as 5 percent over the long run.
Importantly, this reform would achieve these benefits without reducing corporate tax revenues. Because the United States now has one of the highest corporate tax rates among the world’s leading economies, some argue that it must lower its corporate tax rate to compete. A simple reduction in its corporate tax rate is not the answer, though, because it would leave in place all the flaws of the existing system.
This new tax system also would retain or even increase the progressive element of the corporate tax system. The proposal would effectively implement a tax on consumption in the United States that is not financed out of wage and salary income. This progressivity is tied to the shift in incentives that would make the United States more attractive as a location for corporate businesses and their new investment.
Alan J. Auerbach is the Robert D. Burch Professor of Economics and Law, director of the Burch Center for Tax Policy and Public Finance, and former chair of the economics department at the University of California, Berkeley.