America needs corporate tax reform

To be successful in boosting economic growth, U.S. policymakers must consider the impact of corporate taxes on global competitiveness. The preponderance of evidence both here and overseas shows that companies respond to changes in costs when making investment decisions, yet America subjects its companies to one of the highest, most complex tax systems in the world.

Other developed nations have steadily lowered their corporate tax rates over the past few decades in an attempt to attract more business investment. Yet the U.S. rate has not dropped in almost three decades, making it the highest statutory rate among developed countries. Although the tax code is littered with special provisions, U.S. effective tax rates are also five to ten percentage points higher than those of other nations.

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A large body of economic literature has studied the impact of corporate taxes on wages, investment, and research and development. While there are always dissenting opinions, a consensus has developed on several points. First, workers ultimately pay a large portion of corporate taxes (one study estimates between 45 percent and 75 percent) in the form of lower wages. Second, companies respond to lower tax rates by investing more. In fact, a 10 percent fall in the effective tax rate increases the investment-to-GDP ratio by 2.2 percentage points. On the other hand, raising corporate taxes by one percent of GDP reduces GDP by 2.5 to 3 percent.

Our corporate tax law also gets international activity wrong. Almost every other country does not tax companies headquartered in their country on their worldwide income. Unfortunately, we do when companies bring their foreign earnings back home. As a result, companies have a strong incentive to keep profits abroad, often investing them in other countries rather than here. The net result is a law that does not raise much revenue but encourages firms to invest overseas.

Given the complexity of the tax code, it is tempting to argue for the elimination of all special tax provisions, subjecting all corporate activity to the same, hopefully lower, rate. But this fails to recognize that not all tax incentives are bad. To be sure there are many tax provisions that should be eliminated or reduced, but credits that encourage economic investment and growth should be retained and enhanced to further incentivize development in the United States.

A principal example of the latter is the research and development tax credit. A large number of studies have shown that the R&D credit causes companies to conduct more research in the United States and that this in turn has large social benefits. The President’s own tax proposal argues that each dollar of revenue foregone by the tax credit leads to an extra dollar of research, producing a social benefit of $2 to $3. These types of tax incentives, including faster expensing of new capital investment, should be increased even as the statutory rates are cut. Our goal should be to make effective U.S. corporate tax rates at least broadly competitive with other major nations.

Even if some revenue is lost in the short term, lower corporate rates would increase growth and improve the debt-to-GDP ratio, thereby improving our ability to repay the debt. When the Chairman of the House Ways & Means Committee recently introduced a comprehensive reform bill, the Joint Committee on Taxation estimated that it would raise $3 billion over ten years under traditional scorekeeping methods. But the Committee also estimated that it would bring in an additional $50 to $700 billion in new federal tax revenues as the result of faster economic growth.

That being said, to address our budget difficulties we should offset corporate rate decreases with higher individual taxes. By reducing popular tax expenditures that disproportionately benefit higher-income Americans (such as the home mortgage deduction) and by taxing capital gains, carried interest, and dividends as normal income Congress could raise significant revenue. Beyond that, Congress should consider carbon taxes and a consumption tax as sources of revenue to reduce corporate rates even lower.

Capital is only likely to become more mobile over time. Corporations, especially the most dynamic ones, are likely to have more choices about how to structure their organizations and finances, where to locate their headquarters and operations and how to send profits to shareholders. All of this will make tax collection more difficult. Other countries are competing for this high-value-added production and jobs by lowering their corporate tax rates. The United States must follow suit.

Kennedy is a senior fellow with the Information Technology and Innovation Foundation and author of the report Assessing U.S. Corporate Tax Reform in an Age of Global Competition.