The Real (and Imagined) Problems with the U.S. Corporate Tax Code

By Kimberly Clausing

The United States corporate tax system is in desperate need of reform, and there are many sources of discontent. The U.S. raises less corporate tax revenue than peer countries do, and the system is mind-numbingly complex, rife with distortion, and widely perceived to be unfair. The corporate community is also concerned that our current system inhibits competitiveness, holding American companies back.

However, these complaints are not all created equal; there is little evidence of a competitiveness problem for U.S. multinational firms. The U.S. corporate tax code should be reformed, but not every proposed fix is a good one. To fix corporate taxes, we have to understand which criticisms of our current system are legitimate and respond accordingly.

U.S. companies are not being held back by the corporate tax code

Observers often note two things that are unusual about the U.S. corporate tax code. First, tax rates appear to be relatively high, at 35%. Second, the U.S. has a “worldwide” system, meaning it taxes profits made abroad. They compare this system to “territorial” systems in countries that do not tax foreign income. At a glance, it looks like U.S. companies are taxed at higher rates on more of their income. Yet this characterization is misleading. For one thing, the actual, or “effective,” rate at which companies pay tax is both far lower than the “statutory” rate of 35% and quite similar to effective tax rates faced by companies in peer nations. Also, U.S. companies don’t pay taxes on debt-financed investments, which amounts to a subsidy.

And in practice, the foreign income of U.S. multinational corporations is often taxed more lightly in the United States than it would be under other countries’ territorial systems. Many foreign systems actually do tax some foreign income due to anti-abuse provisions; for example, if the foreign tax rate is below some threshold level, such systems will tax that foreign income immediately in the home country. By contrast, the United States collects very little tax on foreign income, since no tax is collected until foreign income is repatriated, and we allow foreign tax credits to shield taxes that would normally be due on royalty income.

In short, tax rates are lower for companies in practice than in theory, and the distinction between the U.S. worldwide system and other countries’ territorial systems is less clear cut than it seems.

Furthermore, looking at the data, it is difficult to make the case that U.S. multinational corporations are not competitive. After-tax profits are at historically high levels; they were more than 50% higher as a share of GDP in the years 2010-2015 than they were over the prior 20 years. Further, U.S. based corporations make up a disproportionately high share of the Forbes Global 2000 list of the world’s most important corporations (in terms of profits, assets, market capitalization, or sales).

There is no doubt that U.S. corporations are global leaders. They are also global leaders in tax avoidance, giving rise to concerns in Europe and elsewhere that their tax planning innovations have reduced government tax revenues. European Union officials have recently argued that U.S. multinational corporations have received excessive amounts of tax relief from E.U. member states. Due to the aggressive use of corporate loopholes, some U.S. multinationals have achieved effective tax rates in the single digits; most U.S. multinational corporations face effective rates that are far lower than the U.S. statutory rate.

The U.S. collects less corporate tax revenue than peer countries, by about 1% of GDP. A large part of the problem is profit shifting to tax havens; I estimate that the cost of such profit shifting for the U.S. government is more than $100 billion each year in lost revenue. But there are other reasons for weak U.S. corporate tax revenues, including our relatively narrow corporate tax base and the preference in the U.S. tax code for non-corporate business structures. In addition, certain types of investments are tax-preferred, and the system encourages debt-financed investments over equity-financed investments. This preference for debt creates financial vulnerability for the U.S. economy in times of hardship.

In short, while it is hard to identify a competitiveness problem, the U.S. corporate tax system still badly needs reform. It is not efficient or equitable, and it does not raise as much revenue as it should. Yet the corporate tax system plays an indispensable role, raising revenue and enhancing the progressivity of our tax system. Any effort to reform the system needs to remember that.

Why the corporate tax is indispensable

First, the corporate tax is a crucial tool for taxing capital income and it cannot be easily replaced by further taxing individuals. At present, the U.S. government provides tax-free treatment for most income earned in retirement accounts, pensions, college savings accounts, and non-profits. Removing these exemptions could be politically toxic, and as long as these exemptions exist, moving capital taxation to individuals would mean losing a large amount of tax revenue.

Second, the corporate tax acts as a backstop for the individual tax. Money moves to where it is least likely to be taxed — absent a corporate tax, the corporation would essentially become a tax shelter.

Third, despite some early economic models that suggested that taxing capital was less efficient than taxing labor, more recent work suggests that optimal capital tax rates may be quite similar to optimal labor tax rates. This work includes more realistic assumptions about capital markets and savings, and it accounts for the possibility that much capital income is due to excess profits, also known as “rents.” Treasury economists have calculated that the fraction of the corporate tax base that qualifies as excess returns averaged 60% from 1992 to 2002, but it has since increased to about 75%. To the extent that corporate profits amount to excessive returns or rent-seeking, there’s less efficiency cost to taxing them. Further, it is important to remember that it may be difficult or impossible to crisply distinguish capital and labor income for many high-income taxpayers.  And, since most capital income is exempt from tax at the individual level, this leaves an essential role for the corporate tax in taxing capital income and rents.

Fourth, the corporate tax is progressive, since it falls heaviest on relatively concentrated sources of income, such as capital income and rents. In other words, it falls heavily on the rich. While the corporate tax may harm workers somewhat, it likely burdens workers less than alternative taxes such as the payroll tax or labor income taxes. In an era of extreme income inequality, progressive tax instruments like this are desirable.

What corporate tax reform should look like

Given that the U.S. needs a healthy corporate tax system, the next question is how to better design one. A key principle of any corporate tax reform should be to lessen distortions and reduce tax-planning shenanigans by removing tax preferences for certain types of investments and income. Reforms should also reduce the current tax preferences toward debt-financed investment, toward pass-through business income, and toward capital income relative to labor income.

We should also change the way foreign profits are taxed, but not by giving up on taxing them. At present, we allow the deferral of U.S. taxation on foreign income until “repatriation” – meaning until the money is brought back to the U.S. — but if we instead taxed foreign income the year it’s earned, that would remove the disincentive to bring money home as well as the tax incentive to shift profits to tax havens. Accompanied by a lower statutory rate, this reform need not raise tax burdens on average, but it would remove the tilt of the playing field toward low-tax countries. A more fundamental reform would require worldwide corporate tax consolidation so that a multinational business reported all of its global operations across parents and affiliates together; this would better align our tax system with the reality of globally-integrated corporations.

In terms of more incremental reforms, a minimum tax would ensure that companies operating in the lowest tax countries pay at least some level of taxes. 

This would be a big step toward reducing profit shifting toward tax havens and protecting the corporate tax base. Other helpful incremental steps include stronger “earnings-stripping” rules and anti-corporate inversion measures such as an exit tax.

Taxing foreign income as it is earned would eliminate the tax incentives behind large build-ups of unrepatriated foreign income, estimated at $2.6 trillion now. This income is often invested in U.S. capital markets, and it increases the credit-worthiness of U.S. multinational corporations that are unconstrained in their ability to finance worthy investments. But corporations are eager to return profits to shareholders and are inhibited by their anticipation of more favorable tax treatment if they delay repatriation. Settling the future tax treatment of foreign income should be a key goal of corporate tax reform. But the U.S. Congress did a great disservice when they enacted a one-time holiday on dividend repatriation as part of the U.S. Jobs Creation Act of 2004. Reformers should settle the issue for real, but one-time tax “holidays” on income that has already been earned are a step in the wrong direction.

A predictable and healthy U.S. corporate tax is an important part of the larger tax system. Addressing the way the U.S. taxes foreign profits should be on the table. But moving the U.S. tax system to a “pure territorial” tax system would turbocharge profit shifting to tax havens. Absent adequate corporate tax base protections (e.g., a well-designed minimum tax), such reforms would make a bad system worse.

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