As Congress debates what to do with more than 50 tax preferences that expired on January 1, it is important not to lose sight of tax rates in relation to tax preferences. Today, the benchmark by which all tax reform policies are measured is the concept of “revenue neutrality.” A revenue-neutral tax reform is one in which tax revenues lost from lowering rates are balanced out by the savings obtained from abolishing tax preferences.
In the case of corporate taxation, these include reductions in rates for specific industries and the domestic production activities deduction. While there are compelling arguments both for and against many individual tax preferences, corporate tax preferences are hard to justify.
The U.S. has the highest statutory rate in the world, at 35 percent (or 39.1 percent including the average state level corporate rate). Reforming this barrier to entry in the U.S. marketplace would unambiguously attract firms, create more jobs, and lead to higher wages for workers.
The Congressional Budget Office estimated that tax preferences are now worth 8.2 percent of U.S. GDP ($1.28 trillion in 2014). A report by the Committee for a Responsible Federal Budget outlines several tax reform plans that have been proposed over the last decade, all revenue positive, with an aim to lower the deficit. Even the Simpson-Bowles 2010 “Pure Zero Plan,” by far the most aggressive in terms of lowering tax rates, provides a hefty $1.75 trillion budget surplus. In all of these plans, the key is the elimination of tax preferences.
In light of the numerous proposals, the important question to ask is what is likely to happen, rather than simply what could happen. To this end, a look at the past should prove beneficial.
Economists have long studied the ability for firms to “vote with their feet,” and in today’s increasingly global marketplace, the largest corporations with the most jobs tend to be the most mobile, implying that countries should use caution when crafting their corporate taxation policies.
Equally important are the efficiency concerns in minimizing the distortionary effects of corporate taxes. Most obviously the “double taxation” aspect of the tax code, where firms’ profits are taxed first via the corporate income tax rate on firms, and then a second time through dividends and capital gains taxes on individuals, has serious implications for the way firms organize.
Economists have noted the increase in S-corporations, partnerships, and LLCs since the 1986 Tax Reform Act. Since these forms of firm structure are exempt from the corporate income tax (they instead file as individuals), entrepreneurs responded to the increase in the corporate tax burden by changing their behavior and organizational structure.
Even less obvious are the tax system’s effects on the ways firms finance new investment projects. Because interest payments to bond holders can be deducted from firms’ taxable income, firms tend to favor debt financing over equity financing. Tax incentives also cause firms to get creative. In 1993, Goldman Sachs invented “Monthly Income Preferred Stocks”, which served as an intermediary between buyers and sellers of securities purely for the purpose of taking advantage of the deductibility of interest payments by forming LLCs. Later, Merrill Lynch followed suit with its “Trust Originated Preferred Securities” which used a trust instead of an LLC to accomplish the same thing.
These are complicated financial innovations, but a policy change as simple as getting rid of the tax-preferred treatment of interest payments would eliminate the need for them entirely. Attempting to “balance out” the returns between debt and equity financing by extending the exemption to equity profits would only result in firms arguing over profit valuation, further complicating things. However, eliminating the interest payment exemption could lead to firms migrating away from the United States.
The efficiency costs of these distortions are hard to measure empirically, so it is difficult to convey the importance of avoiding them to policy makers. Still, a unifying theme of any quality tax reform proposal should be to tax real, not financial, transactions. Corporate and individual incomes, not transactions between them, should be taxed. These transactions are important for economic efficiency, and taxing them hampers the allocation of resources to meeting society’s most desired ends. An obvious difficulty with all of this is the line between financial and real. Any tax reform would necessarily draw some line, and incentivize firms and individuals to expend resources interpreting it to their advantage.
As Congress seeks to bring about lasting and objective improvement in the U.S. federal tax system, members will need to anticipate corporate behavior from any policy changes they propose. Eliminating tax preferences will affect firms disproportionately, as the effective rates firms pay varies both across and within industries.
During the five year span from 2008 to 2012, the utilities, gas, and electric industry paid an average effective tax rate of 2.9 percent, much lower than the 18.8 percent rate paid by the financial industry. At the same time, the number one individual firm in terms of received tax subsidies over the same 2008 to 2012 period was the financial firm Wells Fargo, netting over $21 billion in tax breaks, while the highest ranked utilities firm was American Electric Power, taking in “only” a little over $4 billion.
Eliminating corporate tax preferences could have very complicated implications on firm migration, especially since inversions have become more common in recent U.S. History. Forty-one U.S. companies have relocated to lower tax locales in the last three decades, and eleven have taken place in just the last two years. Attempting to solve the problem by adding more tax preferences, or by forcing U.S. based corporations to stay in the country, would only add to the complexity. Given the variation in “winners” under the current system, eliminating tax preferences would affect firms to varying degrees.
Under current law, new capital purchases can be deducted from taxes only gradually over time, which introduces an “anti-investment” bias. Firms undertake fewer projects because the cost of capital is higher than it otherwise would be. Deducting the full value of capital all at once, rather than via the “economic depreciation” method that requires Congress to be an expert on all forms of assets and the rates at which they depreciate, would encourage more investment by allowing firms to write off capital purchases the moment they are made. In the long run, this policy would help pay for lowering the corporate tax rate, netting the government $121.3 billion, according to the Tax Foundation.
Lastly, the U.S. has the highest corporate income tax rate in the developed world, at 35 percent, or 39 percent including the average state level corporate tax. In 2013, Canada's corporate rate was 26.1 percent, while the OECD average was 25.5; all smaller numbers that mean more jobs for those countries, and adding up to highly elastic capital markets in the U.S.
Reforming the corporate tax rate would create a more transparent policy than the current law. The firms with the most to lose all have thriving lobbying offices in Washington D.C., at least for now.
Steven Gordon is an economics PhD student at the University of Kentucky, and a contributor to Economics21. You can follow him on Twitter here.
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