Corporate tax reform shaping up to be key issue in 2008

The Bush administration lacks the political strength to tackle any significant overhaul of the current tax system. However, Treasury Secretary Henry Paulson’s initiative — on July 26 he hosted a conference on business taxation and global competitiveness — is one of several examining the competitiveness aspects of various areas of regulation, and could provide a basis for future reform.

U.S. policymakers, at both the federal and state levels, have become increasingly attuned to the impact of regulation on the relative competitiveness of firms, sectors (including financial markets) and overall economic performance. Paulson has been at the forefront of efforts to recast the regulatory system in a less anti-competitive manner.

Paulson’s limited influence

However, his influence has been partly vitiated by criticisms that these ostensibly non-partisan initiatives have skewed too far in a business-friendly direction:

• ‘Lame duck’ administration. Even if the political will could be mustered, insufficient time remains in President Bush’s term to undertake a comprehensive reform of the tax code. This issue was on the agenda earlier in Bush’s second term, and in early 2005 he convened an advisory panel on tax reform that produced recommendations in November 2005. Yet shortly thereafter, the administration abandoned the cause of comprehensive tax reform in order to pursue ultimately unsuccessful efforts to overhaul the Social Security system.

• Congressional complications. Paul­son’s latest effort may, in part, be designed to preempt Democratic Party proposals to initiate “targeted tax increases.” Congress is currently considering reforming some tax code provisions that hedge funds and private equity principals have employed to pay lower effective tax rates; increasing the tax burden on oil company profits by tinkering with the system of allowable deductions; and making it more difficult for U.S. corporations to relocate to offshore tax havens.

Tax code complications

Corporate tax policy is just the latest area to attract the attention of regulators concerned about relative U.S. economic performance. The prevailing regulatory model undergirding the U.S. tax code is largely a rules-based rather than a principles-based system. In 1980, the United States imposed a relatively high level of taxation on corporations. This shifted radically in 1986, when Washington enacted landmark tax reform that both simplified the tax code and reduced rates; supporters suggest this policy change fueled economic growth, stimulated investment and encouraged economic risk-taking. (Despite attention to the issue, U.S. tax policy has not been able to stimulate appreciably the national savings rate.)

Yet since that tax reform was enacted, incremental changes to the tax code have led to a return to a relatively high tax regime:
• Compliance costs. The U.S. tax code is substantially more complex than that of other industrialized countries, including EU member states and Japan. Corporations spend an estimated $40 billion annually on compliance. Furthermore, its rules-based nature encourages tax-driven transactions that may have little underlying economic merit.

• High top rate? The United States has the second-highest statutory tax rate on corporate income among Organisation for Economic Co-operation and Development (OECD) countries — 39 percent (including state corporate taxes) — substantially exceeding the OECD average of 31 percent. However, this nominal figure substantially overstates the actual relative discrepancy, as many companies enjoy sector-specific tax breaks (or employ tax-favorable structures), with the result that the effective tax rate for many companies is much lower than the nominal figure might suggest.

• Global reduction trend. Nonetheless, other countries are acting to make their corporate tax rates more competitive. Germany is poised to lower its rate from 38 percent to 30 percent in 2008; China has agreed to legislation to apply a uniform domestic and foreign tax rate of 25 percent; and other OECD countries such as France, Japan and the United Kingdom are also examining corporate tax-reduction policies. These changes will force the United States to reconsider its policies, as high tax rates contribute to outsourcing of operations and influence corporate allocation of investment decisions.

Competitiveness study

The Treasury Department on July 23 presented a new study examining the impact of business taxation on global competitiveness:
• Investment distortions. The tax code incorporates complex depreciation schedules, targeted tax preferences and incentives for small businesses and entrepreneurship. Investment income is taxed differently across sectors, industries, asset types and means of financing. Uneven taxation distorts investment decisions, causing them to be based in part on tax considerations rather than on their fundamental economic merit.

• Multiple levels of taxation. Corporate profits are subject to as many as three layers of tax: corporate income tax, investor-level taxes on capital gains and dividends, and the estate tax. The Bush administration enacted some tax cuts that addressed this issue by reducing the long-term capital gains rate, but significant overlap remains. Tax considerations lead corporations to issue more debt than may be economic, since interest on corporate bonds is taxed less heavily than are corporate profits.

Corporate tax conference

Paulson on July 26 convened a conference on the competitiveness aspects of the current corporate tax code:

• Bipartisan attention. The conference included prominent Republican policymakers, including a former chairman of the Council of Economic Advisers (CEA) under President Ronald Reagan, Harvard Professor Martin Feldstein, and a former CEA member under President George H.W. Bush, Stanford Professor Michael Boskin; former Federal Reserve Chairman Alan Greenspan; corporate leaders including Jim Owens, chairman and CEO of Caterpillar, and Fred Smith, president and CEO of FedEx; and critics of Bush administration policies such as William Gale of the Brookings Institution.

• Little consensus. Yet despite the presence of esteemed policymakers past and present, little consensus emerged on what steps should be taken to overhaul the corporate tax code so as to stimulate corporate and overall economic performance.

Future expectations

The Bush administration’s budget policy will leave a legacy of high deficits to its successor. Therefore, comprehensive tax reform will be a necessary component of a sounder budget policy. This reform will not be limited to the corporate side, but will need to address long-standing problems with the individual income tax system, especially the “backdoor” incremental tax increase imposed by the Alternative Minimum Tax on steadily increasing proportions of middle-class taxpayers:

• Outline for reform? The shape of future tax reform will be strongly dictated by the partisan make-up of the next Congress and administration. It is unlikely that a far-reaching reform could succeed unless both Congress and the administration are under the control of the same political party. Tax equity provides a powerful slogan, but the current tax code includes many targeted provisions put into place to promote certain industrial sectors. It will prove very difficult for the political patrons of these sectors to enact such change. Still, although difficult, such reform is not impossible: The Democratic Congress (with the support of the front-runners for the party’s presidential nomination) is currently considering eliminating tax treatment that has allowed private equity principals and hedge fund managers to pay substantially reduced tax rates, even though these sectors have been strong contributors to party coffers."

• Paulson legacy. The latest conference will have little direct effect on any future tax reform, but by sponsoring this conference, Paulson has placed competitiveness aspects front and center for policymakers to confront in future discussions of reform.

Oxford Analytica is an international consulting firm providing strategic analysis on world events for business and government leaders. See