Corporate tax reform should encourage investment, not profit-taking

The United States needs faster growth to create the good jobs and higher living standards that Americans expect. The best way to produce higher growth is to speed up the rate of investment in new capital equipment (which includes machines, equipment, software and the like), thereby boosting workers' productivity, which has lagged significantly since the end of the Great Recession. Unfortunately, current U.S. tax policies tend to do a poor job of rewarding capital investment. In fact, rather than encouraging new investments, tax policies encourage companies to distribute profits made from things they have done in the past. It is a recipe for resting on your laurels, not reaching for the future.

Much of this problem could be addressed through corporate tax reform. Despite the heat of the presidential campaign and the fact that the administration is focusing its attention on other matters, the coming year may be the most important yet for making progress toward corporate tax reform. While Congress has been stalemated on many issues, a determined group of committee chairs and other lawmakers have been quietly laying the groundwork for a serious reform effort. In hallway conversations, committee-level meetings and listening tours around the country, they have begun educating their colleagues, forming a consensus about the problems that the current tax code poses for the economy, and exploring some possible solutions. A major focus of these ongoing discussions should be the need to encourage greater investment in capital equipment.

Congress passed legislation late last year making the research and development tax credit permanent. This was an important win for innovation and investment. However, another important provision was left behind. Known as "bonus depreciation," it encourages investment in new capital equipment by allowing companies to increase the tax deduction they can take in the first year, rather than over the lifetime of the asset. In other words, companies get a tax deduction immediately for an investment, rather than getting an equivalent deduction, but one spread out over a number of years. Because of the time value of money, the former is worth more than the latter. Although extended through 2019, the temporary nature of bonus depreciation will continue to limit its effectiveness, as will the reduction in the amount that can be immediately depreciated. Congress should expand and make this provision permanent, and lawmakers should pay for it by raising individual tax rates on dividends.

This is important because, as the Information Technology and Innovation Foundation has shown, U.S. capital investment in equipment and software has fallen dramatically since the 1980s. At the same time, as I detail in my book, "Innovation Economics," the amount that corporations pay in dividends has gone up. In fact, the ratio of dividends that U.S. manufacturers pay to the amount of capital equipment they invest in has increased from the low 20 percent range in the late 1970s and early 1980s to above 60 percent in the 2000s.

At one level, it should not be surprising that there has been a shift from using earnings to make productivity-enhancing investments to instead dispersing profits to shareholders. The 1986 tax reform legislation eliminated the investment tax credit, even though, as Larry Summers found almost a decade earlier, the evidence is clear that it spurs more investment in machinery and equipment, which in turn grows gross domestic product (GDP). Moreover, as New York University Professor Aswath Damodaran has shown, the 2003 legislation lowering the personal income tax rate on dividend income made it more favorable for corporations to increase dividends.

In other words, tax reform in recent decades has made it less profitable to invest earnings and more profitable to distribute them. It's time to reverse direction with a new round of tax reform that makes it more favorable for corporations to make the kind of productive investments that spur long-term growth instead of cashing out for short-term gain.

Making bonus depreciation permanent at as high a level as possible would be an effective way to begin because it would lower the after-tax cost of investment. Indeed, as the Congressional Research Service has noted, economists generally believe that a 1 percent decline in the cost of investment causes investment to rise by half a percent.

At the same time, taxing dividends as normal income would reduce the incentive for corporations to send profits out of the firm. In other words, this two-part tax reform would encourage companies to send out fewer profits and invest internally more profits.

Another advantage of such a deal is that it would be at least revenue neutral. Taxing dividends as normal income would raise $206 billion over 10 years, according to an estimate the Obama administration made in 2012. In fact, this tradeoff could very well reduce the deficit. Earlier this year, the Tax Foundation estimated that making bonus depreciation permanent would increase the deficit by only $74 billion after factoring in the impact on economic growth. Since Congress has since extended the provision through 2019, full extension and expansion should cost less than the tax break on dividends.

This shift in tax policy would not only be pro-growth, but also pro-fairness. According to the Tax Policy Center, almost 76 percent of the benefit of lower taxes on capital gains in 2013 went to individuals earning more than $1 million. The distribution of the costs from a higher tax on dividends should be similar, especially since companies can choose whether to award dividends or let their stock prices appreciate. And while encouraging capital investment instead of profit-taking would reduce corporate taxes, the fact is that a large portion of corporate taxes are ultimately paid for by consumers and workers, so the lower corporate taxes would be shared widely across the income spectrum through a combination of lower prices and higher wages. Moreover, it would also boost productivity, which helps all consumers.

This year can be a very productive one for tax reform. The primary goal should be to build consensus around the need for reform that prioritizes increasing capital investment and shifting the burden of taxation from companies to the richest individuals.

Atkinson is the founder and president of the Information Technology and Innovation Foundation, a think tank focusing on the intersection of technological innovation and public policy. Follow him on Twitter @RobAtkinsonITIF.