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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