New Economic Studies Likely to Influence Corporate Tax Reform Debate
January 2014On January 6, 2014, the Congressional Research Service (CRS) issued two reports to Congress that are likely to influence the corporate income tax reform debate in the United States. One report addresses differences in corporate tax rates among countries, and a second report addresses various economic considerations arising from reducing the U.S. corporate tax rate and increasing the corporate tax base. We discuss selected aspects of both reports below as they contain numerous implications for corporate tax reform.
The corporate income tax is a significant source of revenue for the U.S. federal government. Today, it is the third largest source of government revenue, ranking behind the individual income tax and payroll taxes, and ahead of excise taxes and estate and gift taxes. In recent years the corporate income tax has accounted for about 2% of U.S. GDP and 10% of all federal tax revenues.
The corporate income tax as a share of government revenue has declined over time. This is attributable to several factors, including reductions in the corporate tax rate, more liberal depreciation rules and the growth of unincorporated business entities (discussed below). Nevertheless, the corporate income tax remains a significant source of revenue for the federal government. That is the reason corporate tax reform is often discussed in a revenue neutral context.
International Corporate Tax Rate Comparisons and the Policy Implications
Various measures of the U.S. corporate tax rate
Tax is cost of doing business. Differences in corporate tax rates among nations are widely believed to affect the competitiveness of the companies resident in those countries for tax purposes. In 2010, the U.S. statutory corporate tax rate was 39.2%, while the average statutory tax rate of OECD countries (excluding the United States) was 25.5%. In fact, the U.S. statutory corporate tax rate has remained fairly constant over the last 25 years, while the average statutory corporate tax rate in other OECD countries has dropped considerably. Advocates for corporate tax reform often point to this differential as a reason for cutting the U.S. corporate tax rate.
The report reviews a number of studies comparing various measures of the corporate tax rate, which are too numerous to describe here in detail. The report also considers two measures of the corporate tax rate, other than the statutory tax rate, one of which makes the United States look somewhat more competitive than does the statutory rate comparison. For example, a study of effective tax rates for the year 2006, compares the United States to the OECD countries (excluding the United States). The U.S. effective corporate tax rate was 29.5%, while the effective corporate tax rate for the other OECD countries, weighted by GDP, was 28.4%. Since then, some OECD countries have cut their corporate tax rates, however, so this comparison may not be wholly accurate today.
The effective corporate tax rate takes into account corporate tax incentives (i.e., “tax expenditures”). The report notes that the effective tax rate “is probably more suited to assessing the true relative burdens on investment than the statutory tax rate. However, these types of tax rates may not capture timing effects (such as accelerated depreciation) very well and generally depend on accounting measures of profit that may vary across countries.”
Another measure of the corporate tax rate is the marginal corporate tax rate. The report notes that this rate “in theory, [is] the appropriate measure for determining the effect of tax rate differentials on investment.” For example, in 2010 the U.S. average marginal corporate tax rate was 34.6% while the OECD average marginal tax rate, excluding the United States and weighted by GDP, was 23.6%.
Thus, under two measures of the corporate tax rate, the U.S. corporate tax rate appears to be quite a bit higher than the corporate tax rate of other OECD countries and therefore less competitive.
Revenue neutral rate reduction
The report considers how a revenue neutral corporate tax rate reduction could be achieved in the United States. Eliminating all corporate tax expenditures the report concludes would allow a reduction in the corporate statutory tax rate of 7.9 percentage points. Thus, even if all corporate tax expenditures were eliminated, the U.S. statutory corporate tax rate would still be considerably higher than the OECD weighted average rate.
Two major components of corporate tax expenditures are accelerated depreciation for equipment and the deferral of taxation of foreign source income. Eliminating accelerated depreciation would fund a 3 percentage point tax rate cut. Eliminating deferral of tax on foreign source income would fund a 3.1 percentage point rate cut. A corporate tax rate cut would also broaden the tax base by reducing the foreign tax credit, because the foreign tax credit limitation is tied to the U.S. tax rate.
Implication of growth in U.S. unincorporated businesses
The report notes the share of U.S. business income that is earned by corporate entities has declined from 80% in the 1980s to about 50% today. This shift is due to various factors including liberalization of the S corporation rules, the rules governing the taxation of publicly traded partnerships and the proliferation of LLCs and limited partnerships that provide both pass-through treatment and limited liability for business owners.
The report notes that if the share of business income earned by corporate entities could be increased to the level of the 1980s (presumably by new legislation restricting the use of pass-through business entities), an additional three percentage points of corporate rate reduction could be achieved. This would allow the U.S. statutory corporate tax rate to approach the OECD statutory corporate tax rate. The author is not aware, however, of support for legislative proposals that would impose such restrictions on pass-through business entities.
Corporate Tax Reform: Issues for Congress
This report considers various economic issues associated with a cut in the corporate tax rate and reviews and analyzes economic studies evaluating the consequences of the corporate income tax. We will briefly discuss key five elements of the report.
The corporate income tax as a backstop to the personal income tax
Currently the top personal income tax rate (39.6%) is higher than the top corporate income tax rate (35%). As the corporate tax rate is reduced, the incentive to shift business income from pass-through entities to C corporations increases. This is due in part to the effect of graduated corporate tax rates. The report also concludes that, in light of the current 15% tax rate on dividends, a reduction in the corporate tax rate to 27% would lead to a shift of income to C corporations for corporations that distributed less than 73% of their income.
The accumulated earnings tax (section 531 et seq.) is intended to counter the incentive to accumulate income in C corporations when there is a disparity between the individual and the corporate tax rate. The report does not mention this tax. However, it does discuss other means of negating this incentive, e.g., increasing the tax rate on dividends and capital gains.
Whether a corporate tax cut will increase tax revenues
The report includes an extensive discussion and analysis of recent research focusing on whether a reduction in the corporate income tax rate could lead to an increase in tax revenues, i.e., whether there is a “revenue maximizing” corporate income tax rate. Clearly, demonstrating that a reduction in the corporate income tax rate would increase revenues would garner much political support for such a reduction. The report finds that there is a variance among the sophistication of the various studies supporting the conclusion. The report examines the theoretical arguments supporting the position that a rate reduction could lead to an increase in tax revenue and concludes they are unpersuasive.
The report also analyzes certain empirical studies supporting the position that a rate reduction could lead to an increase in tax revenues. In general, it finds fault with the studies examined.
Who bears the corporate income tax?
As between capital and labor, the traditional view has been that the corporate income tax is generally borne by capital (rather than labor). However, there been some recent studies suggesting that the corporate income tax was born by labor and therefore regressive. Progressive taxes are generally preferred to regressive ones. Thus, such a finding would provide support for a corporate tax rate reduction.
Following an extensive analysis of these studies, the report concludes “it appears that most of the burden of the corporate tax falls on capital (and were debt considered, it is possible that labor benefits from the tax). Thus the tax is a progressive one.”
Distortions caused by the corporate income tax
The corporate income tax in its current form creates various economic distortions, which are described in the report. For example, differences in depreciation and amortization rules lead to differential tax rates across asset types, which are distorted. Also, the aggregate tax burden on debt, the report concludes, is slightly negative. By comparison, the tax burden on equity is close to 40%. Finally, the corporate income tax leads to misallocation of capital between incorporated and unincorporated businesses.
The report states “[c]onsidering all these distortions together, they are probably in the range of 10% to 15% of corporate tax revenues, a magnitude that could be considered a significant component of the burden of the tax. However, given the revenue needs of the government, there would also be distortions, perhaps smaller, associated with alternative taxes. Ways to reduce these distortions may, however, be worth considering.”
Potential revisions to the corporate tax
The report briefly describes three potential revisions to the corporate tax. The first is to broaden the corporate tax base and use the revenues to reduce the tax rate or to provide various investment incentives. A second reform would be to adjust the interest deduction and income for inflation. The final reform suggested is an increase in the individual tax rate (e.g., by increasing the tax rate on dividends or capital gains) to fund a reduction in the corporate tax rate or taxing large unincorporated businesses as corporations.
These reports are helpful to the corporate tax reform debate because they draw together many key elements of the corporate tax reform picture for the interested parties to consider. Although the CRS is a nonpartisan government office, some of the economic analysis in the report is likely to be controversial and be disputed.
In the author’s view, the current disparity in tax rates between the United States and the rest of the OECD should provide the impetus for a reduction in the corporate income tax rate. The likely path to such reduction is a revenue neutral one in today’s political and budget environment.
U.S. business must ultimately support a significant reduction in tax expenditures in exchange for a corporate rate reduction. Crafting legislation that garners sufficient support will prove politically difficult and time-consuming. In particular, because deferral of U.S. tax on foreign income has been a key element of most U.S. multinationals’ tax strategy for decades.
Although President Obama did mention corporate tax reform briefly in his State of the Union address to Congress on January 28, his administration does not appear willing to take the lead in this effort. Corporate tax reform (either on its own or as part of a broader tax reform agenda) therefore will require a bipartisan effort of Congressional leadership. Senator Baucus, the chairman of the Senate Finance Committee, is retiring from the Senate, and Representative Camp is stepping down as chairman of the House Ways and Means Committee. It remains to be seen whether their successors, in cooperation with U.S. business groups, are willing to invest the time and effort to move corporate tax reform forward. In any event, many believe such an effort is unlikely this year, because of upcoming Congressional elections.
 The Congressional Research Service is a part of the Library of Congress. The office is non-partisan and provides policy and legal analysis to committees and members of the U.S. House of representatives and the Senate. Jane G. Gravelle, International Corporate Tax Rate Comparisons and Policy Implications (January 6, 2014); Jane G. Gravelle, Corporate Tax Reform: Issues for Congress (January 26, 2014). Both reports are available at www.crs.gov/. Weighting by GDP is more realistic because smaller countries tend to have lower tax rates (e.g., Ireland and the Benelux countries).KEYWORD: Corporate Tax Reform
Tax Insights Blog