Half-Baked Corporate-Tax Reform

We know the corporate income tax needs to be reformed. This proposal, unfortunately, is not the answer to our problem.

This article originally appeared in National Review Online

Today the president will make the case for his reform of the corporate tax. The reason, the administration claims, is that the U.S. business tax code is “uncompetitive, unfair, and inefficient,” and hence, in need of a major revamp. The plan will propose cutting the corporate-tax rate down to 28 percent from its current 35 percent, eliminating some tax deductions while expanding others, imposing a minimum tax on foreign income of U.S. companies, and creating a special rate for manufacturers. The plan will be light on details and will likely remain this way.

Tax reforms are very hard to conceive and to implement. Still, this plan misses an opportunity to do the right thing and finally properly reform the corporate tax code. Here are some of the reasons:

1. The reduction in the corporate-tax rate is a first good step but it’s not enough to put the U.S. on par with countries with competitive tax rates. Among OECD nations in 2010, the top national statutory corporate-tax rates ranged from 8.5 percent in Switzerland to 35 percent in the United States. The picture changes only slightly once we add subnational corporate-tax rates to the top national rate. Reducing the rate to 28 percent would move the U.S. from the second-highest rate to the fourth-highest rate.

2. The plan reduces the rate but fails to address what is perhaps the biggest penalty imposed by the current corporate tax: The worldwide tax system. Under the current system, profits made by an American-owned computer plant–think Apple or Microsoft–are subject to U.S. taxes whether the plant is located in Texas or Ireland. Most major countries don’t tax foreign business income. In fact, about half of OECD nations have “territorial” systems that tax firms only on their domestic income. It means that American corporate profits earned abroad and at home are taxed at a higher rate than in most other countries. By the way, that’s why corporations get a “break” on their U.S. tax bill as long as their profits are not repatriated. As a result, many companies are not bringing their profits back to America. You know that a tax system is bad when it drives business decisions.

As AEI’s James Pethokoukis noted this morning, the president’s Deficit Commission has argued that the US should move away from a worldwide tax system and so did its Jobs Council:

While most other developed nations have adopted territorial systems that exempt most or all foreign income from taxes when they are repatriated, the U.S. subjects all worldwide earnings to the corporate income tax when they are brought home to the U.S. This approach actually encourages U.S. companies to keep their earnings abroad rather than investing them here at home. Adopting a territorial tax system would bring us in line with our trading partners and would eliminate the so-called “lock-out” effect in the current worldwide system of taxation that discourages repatriation and investment of the foreign earnings of American companies in the U.S.

A failure to move to a territorial tax system makes the cut in rate almost moot. A punishing tax system gives corporations incentives his is bad for the competitiveness of US companies operating abroad: It means that even after the tax rate is lowered to 28 percent, companies earning income in countries tax have lower corporate tax rates than 28 percent (most countries except Japan, France and Belgium) and who brings their income back to the US, would still have to pay a higher rate than the foreign companies they compete will abroad.

3. Related to this issue is the idea to implement a tax on US companies’ foreign earning. The president’s proposal–and most newspapers reporting on the issue–makes it sounds as if US companies don’t pay any taxes on their foreign earnings. It is not true. A US company operating abroad pays taxes in the country where the income is earned. Under the current system, and if the company keeps its income abroad, it likely means that it pays less taxes on that income that on its US earning since the US tax is so high. Adding an extra layer of taxes on US companies competing abroad, and hence making then less competitive, is hardly the answer to the discrepancy. The tax reform should have lowered the rate and move to a territorial tax system.

Maybe more importantly, a minimum tax on multinational corporations’ foreign earnings is meant to discourage “accounting games to shift profits abroad.” The president has also expressed his desire discourage the decision by US companies to relocation of production overseas. Where a company operates and does business shouldn’t be the president’s decision. However, this also fails to acknowledge that this behavior by US corporate is the product of how punishing the current system is. Making it less efficient or more punishing can’t be the answer.

4. The reform could penalize workers in America and workers employ by US companies abroad more than they already are. First of all, corporations don’t pay taxes, individuals do. Second, in this case, the individuals paying it are not necessarily the shareholders. In recent years, several much-discussed studies have found that it is likely that much of the burden of the tax is borne not by capital but by domestic labor, in the form of lower wages. For instance, this December 2010 paper by economists Aparna Mathur and Kevin Hassett shows the link between corporate tax rates and the average manufacturing wage (in U.S. dollars) for 65 countries over a period spanning 1981–2005. They find that there is a clear negative link between the two, suggesting that higher corporate tax rates lead to lower worker wages. They test this theory using regressions controlling for a bunch of other factors, and find that a 1 percent increase in the corporate income tax leads to an almost 0.5–0.6 percent decrease in hourly wages.

In a 2006 study, the economist William C. Randolph of the Congressional Budget Office estimated who wins and who loses from this tax. He concluded that “domestic labor bears slightly more than 70 percent of the burden.”

Other economists have confirmed these findings.

5. This tax reform continues the tradition of picking winners and losers. For instance, while it eliminate some of the deductions that companies are getting, it won’t get rid of all of them and it will even expand the deductions for a special few. This is wrong. If deductions represent an unfair benefit granted to a special industry–as the president explains in his budget–then all deductions should be eliminated. Why getting rid of deductions for gas and oil and create special treatment for the manufacturers?

We know the corporate income tax needs to be reformed. This proposal, unfortunately, is not the answer to our problem.