A couple of weeks ago, President Obama released his proposed “grand bargain” – which was a trade of a corporate tax reform, with a reduced tax rate, for a one-time increase in “public investment” spending that was alleged to increase economic growth. A recent CED blog discussed the spending components of the President’s package, which were a mixed bag, and did raise some questions about the soundness and viability of the one-time approach. Now, I would like to switch to the idea of corporate tax reform.
In fact, this discussion will be a little broader, because Chairman Dave Camp (R-MI) of the House Ways & Means Committee also has had something to say about corporate reform. To be even-handed, Chairman Camp’s work has been more-detailed and more-thoroughly developed than the President’s – not totally surprising, because it is the Congress that writes the laws.
To betray my bottom line at the top, though, it seems to me that we have a long, long way to go before we will be ready to enact a serious and significant corporate tax reform. I’ll try to explain a couple of reasons why.
But first, a little historical background, which will help to uncover some principles.
In late 1981, supply-side economics was in full flower, and Washington was enamored with low marginal tax rates – for individuals. (This romance did have its rocky moments when the size of the federal budget deficit came up in dinner conversation.) However, interestingly enough, the low-tax-rate philosophy somehow was not applied to the corporate income tax. In that realm, the attitude was quite different.
I remember well conservative, free-market economists – including some names which you would recognize in an instant – taking what struck me as a distinctly anti-free-market attitude. I am an economist with friends in high places in Washington, they seemed to say to the nation’s business leaders. And for that reason, I know much better than you do how to run your business. Therefore, I will shape the corporate tax code in my own preferred image, to induce you to do the things that I know you should do in your own, and your firms’, best interest. I will maintain a high corporate tax rate – approaching 50 percent. But I will create robust tax preferences – including an investment tax credit and rapid depreciation – to subsidize (relatively, and sometimes even absolutely) and incent investments in equipment. So the investments that I know that you should undertake will be lightly taxed, in terms of present values. Meanwhile, that high corporate tax rate will punish all of the low-value investments – like the manufacturing structures into which you should place those new machines that benefit from my tax incentives.
So in other words, a high tax rate and a narrow tax base – which tax base omits the activities and investments that I in my wisdom know you should undertake – is the key to an efficient economy.
I confess that at the time this view of the world struck me as rather peculiar, especially coming from self-described free-market economists. If they had heard the same kinds of recommendations made in other aspects of the economic-policy world, I believe that they would have been appalled. I don’t quite know how this mentality became quite so influential. But those of a certain age will remember that in the wake of the 1981 tax cutting legislation, the nation found to its horror that large numbers of profitable firms were paying no income tax – because, through a wrinkle in the law called “safe-harbor leasing,” they were in effect renting the investment tax credits and hyper-accelerated depreciation deductions of less-profitable firms. One economist wag called this display “nationwide consolidated filing.” And at the very same time, despite the high tax rates that were supposed to choke off low-value investments, those tax preferences were being amalgamated into “tax shelters” – including the “see-through office buildings” that cluttered landscapes in some parts of the country, but somehow made money, after taxes, for doctors and lawyers with free cash flow to invest.
It was at about this time that some Washington thinkers were beginning to do their sums, and to realize that by closing tax preferences under the individual income tax, households could enjoy much lower tax rates, with enhanced incentives to work, save and invest, and with much reduced economic distortions across the board. But that left open the question of what should be done with the corporate income tax – especially in light of its discredited reputation following the safe-harbor-leasing debacle. In 1983, then-Senator Bill Bradley (D-NJ) and then-Representative Richard Gephardt (D-MO) put forward the second generation of their tax-reform vision, which included base broadening and rate reduction not only for the individual income tax, but also for the corporate income tax. (In the interest of full disclosure, I must note that mine was the lonely voice that suggested this approach to Bradley and Gephardt.) This notion was greeted with derision from the conservative, free-market, I-know-how-to-run-your-business-better-than-you-do economists. But over the next three years, the new vision of corporate tax reform gained traction, and eventually became law.
There were some real advantages to the low-rate broad-base 1986 corporate reform model. The previous system’s tax credits and rapid depreciation schedules rewarded proportionately the most those investments that had to struggle to justify themselves, earning just marginal returns. In contrast, the lower statutory corporate rate was appealing for projects that promised substantial success. And to be mercenary about it, corporations would want to earn their profits in a jurisdiction that promised a low tax rate on those profits. And the lower the tax rate, the smaller the economic distortions from any tax preferences that remained in the law.
The following chart illustrates the extent to which the 1986 reform broadened the tax base. It compares the ratio total amount of corporate “tax expenditures,” which might be called “tax preferences” or “loopholes” (please note that the simple sum of the estimates of the individual tax expenditure amounts is a very rough indicator) to the total amount of revenue collected plus those same tax expenditures (in other words, how much revenue would have been collected had there been no tax expenditures) for 1986 (before the tax reform), 1987 and 1988. You will notice that the significance of tax expenditures fell sharply over those three years.
But since 1986, a not-so-funny thing has happened. In 1986, the U.S. corporate tax rate took a big drop below the average of the rest of the developed world (as measured in the statistics of the Organisation for Economic Cooperation and Development [see chart below]). A plot of corporate tax rates since will show that the rest of the world picked up the U.S. approach to corporate tax reform and ran with it – reducing their statutory corporate tax rates below ours. Right now, the U.S. corporate tax rate is on the brink of earning the dubious distinction of being the highest in the developed world – not because ours rose, but because the others fell.
So the good news (in my opinion) is that the vision of corporate tax reform that withstood a tough crowd in the early 1980s and became law in 1986 has become the preferred model today. The rest of the world has embraced it, and there is a clamor in the United States for us to re-run the 1986 model again today.
But the bad news is that Washington has given insufficient thought to what that really means. And we cannot afford to get this exercise wrong.
Look at any corporate tax reform “proposal” today and you will see one ingredient presented front and center, and in indelible ink. Everyone knows precisely what his or her corporate tax rate will be. Some say 28 percent. Some say 25 percent. And everyone says that the specified tax rate will be attained by “closing corporate tax loopholes.” But no proposal thus far has gotten anywhere near the measure of tax-base broadening needed to achieve a tax rate at the specified level, without losing significant amounts of revenue.
The Administration’s proposal has perhaps the longest list of loophole closers, but it is conspicuously short in terms of the total revenue that it would raise. The Administration knows that it wants to cut back on the pace of the depreciation deductions for corporate jets, for example. But that is chump change if you want to cut 7 percentage points off of the corporate tax rate. Ground rules differ, but some calculations suggest that to finance a 28 percent corporate tax rate would require the elimination of all corporate tax preferences.
And the revenue consequences of corporate tax reform are crucial. The point of the exercise is to increase the amount of capital formation (and also the efficiency of its allocation), to increase economic growth. But if the effect of a corporate tax law change is to reduce the federal government’s revenue, and therefore to increase the budget deficit, and therefore to reduce national saving, then capital formation will go down, not up.
Broadening the corporate tax base is not easy. Consider one big potential base broadener: the tax treatment of interest expense. Some would argue that the deductibility of interest expense, when compared to the non-deductibility of dividend payments, is a “loophole.” It is alleged that the deductibility of interest leads to excessive leverage, and increases the risk of bankruptcy. A proposed remedy is to make interest expense non-deductible. The problem is that many small businesses have few alternatives to borrowing to obtain financing. Other businesses can most easily finance inventory with debt. For such firms, interest is a legitimate cost of doing business. So some would restrict any cutback of deductibility of interest expense to large firms, either measured by sales or even by the amount of interest expense itself. That might work in a few instances, but some firms that would be above any such limit could regain their interest deductions by cutting themselves into two or three pieces, each of which would be below the limit. Other businesses might fluctuate in size, and discover that they lose and then regain their interest deductions from year to year. Some firms might convert their debt-financed investments into leases, so that their lease payments are deductible and other businesses that can deduct the interest serve as the lessors and do the borrowing. Drawing lines such as these can become unmanageable, and subject to successful manipulation.
I do not envy the task of those who want to begin a dialog on this issue. An audience of any policy sophistication whatsoever will not be distracted by a claim of a very low corporate tax rate with no evidence of how it will be financed. But putting specific base-broadening proposals on the table as a first step will merely infuriate the offended interests and give them a target for their lobbying efforts. Somehow, we need to begin a substantive conversation without betraying too much of the substance. It won’t be easy. Ideally, those firms that lose tax preferences will at least get some tax rate reduction in exchange. But in a world where all policy changes taken together must reduce the deficit – a lot – there are going to be losers. And business firms are well equipped to learn very quickly what their own tax outcomes will be, and so they will not be caught by surprise.
And the temptation does not stop with the claim of a low corporate tax rate. You don’t have to look too far to see promises of still new tax preferences. So first the policymakers promise to close “loopholes,” and then they pledge to enact new “incentives” to replace them. So after the President talks about establishing a level playing field in the interest of economic efficiency, he promises a lower-than-28-percent tax rate for manufacturing – and still lower effective tax rates for “advanced” manufacturing, and for the production of clean energy. Needless to say, replacing one tax preference with another will not finance much tax rate reduction.
Let me discuss just a couple of the other big-picture aspects of this issue.
As was noted earlier, the President proposes to engage in a corporate tax reform without making any significant changes in the individual income tax. Opinions will differ, but I do not see that as a viable approach. About half of U.S. business income is taxed only under the individual income tax. Some tax law changes necessarily will affect all businesses. So if you close tax preferences for businesses small and large, but reduce only the tax rate for the largest businesses – the ones that pay the corporate income tax – then right away small business is left out in the cold. You surely have seen some stories about the building rivalry between small and big business in this corporate tax reform debate.
The President proposes to resolve this squabble by passing new separate tax preferences that apply only to small business. Again, that is counterproductive to the objective of at least doing no harm with respect to the budget deficit.
Perhaps the biggest issue on the table is the treatment of U.S. business operations overseas – which incidentally runs right into the rivalry between large and small businesses. International taxation of business is mind-numbingly complex, and I do not pretend to be the world’s foremost authority. But there are some key questions to answer – or at least at this stage of the debate, to ask. As you probably know, the United States has what is known as a worldwide tax system, which is to say that we claim the right to tax the profits of all U.S.-based firms, wherever those profits are earned. Virtually all other industrialized nations have what are known as territorial tax systems, which provide much reduced or even zero taxation of their firms’ foreign-earned profits. The United States tries to assist its firms to be competitive overseas relative to firms taxed under territorial systems by allowing deferral of tax on foreign profits until those profits are brought back to our shores. That leaves us with the worst of many worlds – the need to identify foreign versus domestic profits, which is highly complex and subject to manipulation; the loss of tax revenue on current foreign earnings; and a strong incentive for our firms to postpone tax by leaving their profits overseas.
Perhaps one way to comprehend the box in which we find ourselves is that we want, at one and the same time, to give our firms favorable tax terms overseas, so that they will be competitive, but also to give them favorable tax terms at home, so that they will have the highest feasible employment and investment in the United States. And we want to accomplish both of these conflicting objectives with respect to operations in relatively high-tax countries and relatively low-tax countries, and in competition with both home-country firms and third-country competitors in each of those countries. This system is, as mathematical economists would say, over-determined; there is no way to achieve all of these objectives.
There is, of course, another perspective, under which the most important objective is to induce U.S. firms to produce in the United States. But firms often need to produce close to their sales markets. We want foreign firms to invest in the United States, and we have observed that firms that have invested here have been more successful than others in developing products that we want to buy, and in keeping their customers satisfied. We should not be surprised if U.S. firms see advantages to competing for foreign business in the same way that we expect foreign firms to compete for our business.
Truth be told, the U.S. worldwide system – in a pure form – has much to recommend it. If every country taxed the profits of all of its firms, wherever earned, then every firm would have no way to influence its tax bill (other than to change its domicile – but let’s leave that contingency for another day). It would set up its operations wherever there was a good economic reason to do so – which is, after all, the point. There is, therefore, a strong argument that the right solution would be for every other country to adopt the U.S. worldwide system. The reality, however, is that virtually no other country utilizes the U.S. system, and none will adopt it in the foreseeable future.
To some, the adoption of a territorial tax system is tantamount to the entire issue of U.S. corporate tax reform. However, U.S. firms will continue to have competitiveness problems around the world if the U.S. corporate tax rate remains high, whether we go territorial or stay worldwide. And the U.S. economy will continue to be at risk if U.S. national saving continues to be low because of huge federal budget deficits. We have a window of time that we can use to get our fiscal house in order in a deliberate fashion; but that window will not remain open forever. We cannot reduce our corporate tax rate today and worry about the revenue consequences at some not-yet-scheduled future moment. We need to engage in corporate tax reform in a complete and responsible manner.
To do that, we need to consider whether we can build a competitive corporate tax system while collecting the current level of revenue. That may not be possible. And if it is not, we will need to determine up front how we will replace any revenue loss – which may entail even higher revenues from households than we already need, or may require even more spending reduction than we already need. The current discussion, which thus far has touched only upon the fun parts – the revenue-losing provisions of a corporate tax law change – is nowhere near to where we need to go. We have a long journey ahead if we are to reach our goal.
As I mentioned above, corporate taxation – especially including the international aspects – is extraordinarily complex. I expect that we will consider this topic another time or two before we manage to reach any firm conclusions. And I do hope that we get there.