Don’t hold your breath

waiting for corporate tax reform in the United States

 Corporation tax rate on Map 

legend.jpg 15 to 19.9%
20 to 24.9%
25 to 29.9%
30 to 34.9%
35%+
No Data
 

President Obama says he wants corporate tax reform.
Republicans in Congress want corporate tax reform. There are even
bipartisan tax reform initiatives underway in both the House and Senate.
 

Everyone seems to agree that America’s corporate tax system is due for an overhaul.
 

But there’s an old saying that you shouldn’t count your chickens before they hatch. While there is a lot of promising rhetoric coming from Washington, it’s highly unlikely that reform will happen. Simply stated, it’s easy to agree on the theoretical need for a lower rate and fewer loopholes, but the real challenge is figuring out the proper definition of taxable income. And since Republicans and Democrats have widely divergent views on how to measure corporate income, a compromise will be almost impossible.

The need for reform

But before explaining the bad news, let’s look at why there’s so much talk about tax reform in the United States. There are three reasons why the United States arguably has one of the most punitive corporate tax systems in the developed world.

First, the federal government imposes a very high 35 percent tax rate, which is then augmented by state corporate taxes, bringing the average to more than 39 percent. Every singe European welfare state has a lower corporate tax rate than America – even nations traditionally thought to have a more left-wing orientation, such as France and Sweden.

For a long time, only Japan imposed a more onerous tax rate than the United States. But even that now has changed. After toying with the idea since 2010, the Japanese government finally pulled the trigger and reduced the nation’s tax rate. That leaves America in the unenviable position of having the developed world’s highest corporate tax rate.

But that obviously means it is theoretically possible for there to be a nation in the developing world that has a higher corporate tax rates. Well, according to a map produced by the Financial Times1, there is one nation with a worse corporate tax regime. (See Figure 1)

It’s not China, which is nominally still a communist nation. It’s not Venezuela or Argentina, corrupt and thuggish Latin American nations. And it’s not Zimbabwe, a statist kleptocracy in Africa.

The one nation in the world which is worse than the United States is the United Arab Emirates, with a corporate rate of 55 percent. But I suspect the 55 percent rate is probably some form of petroleum severance tax and that America actually has the dubious honor of imposing the world’s highest corporate tax rate.

The second problem with America’s corporate tax system is that it is imposed on worldwide income. This approach, known as worldwide taxation, requires firms to not only pay tax to foreign governments on their foreign-source income, but they are also supposed to pay additional tax on this income to the IRS – even though the money was not earned in America and even though their foreign-based competitors rarely are subject to this type of double taxation.

The U.S. system seeks to mitigate this bad effect by allowing American-based companies a “credit” for some of the taxes they pay to foreign governments, but that system is very incomplete. And even if it worked perfectly, America’s high corporate tax rate still puts U.S. companies in a very disadvantageous position.

If an American firm, a Dutch firm and an Irish firm are competing for business in Ireland, the latter two only pay the 12.5 percent Irish corporate tax on any profits they earn. The U.S. company also pays that tax, but then also pays an additional 22.5 percent to the IRS (the 35 percent U.S. tax rate minus a credit for the 12.5 percent Irish tax).

In an attempt to deal with this self-imposed disadvantage, the U.S. tax system also has something called “deferral,” which allows American companies to delay the extra tax. That’s better than nothing, to be sure, but the policy still imposes a high cost.

The third problem with the corporate tax system is the way it forces companies to overstate their income. Worldwide taxation is an example, as was just discussed, but the problem is much more extensive, which is why the statutory tax rate can be very misleading because of all the other policies that impact the actual tax burden on companies.

A couple of economists at a German think tank put together a “tax attractiveness” ranking based on 16 different variables2. The statutory tax rate is one of the measures, but they also look at policies such as “the taxation of dividends and capital gains, withholding taxes, the existence of a group taxation regime, loss offet provision, the double tax treaty network, thin capitalization rules, and controlled foreign company (CFC) rules.”

Cranking through all the numbers, these scholars rated America has having the 94th best tax system out of 100 nations, with a paltry score of .2432. The “good news” is that the United States managed to beat out Argentina and Venezuela, two of the world’s most corrupt and despotic nations. Not surprisingly, so-called tax havens dominate the top spots in the ranking. And that’s the case even though financial privacy laws are not part of the equation.

Here are all the scores from the report. They listed nations in alphabetical order, so it’s not very user-friendly if you want to make comparisons. But a simple rule-of-thumb is that any score about .6000 is relatively good and any score below .4000 suggests a country is shooting itself in the foot. (See Table 2)

Tax Attractiveness Index per Country 

This table reports mean values of the Tax Attractiveness Index (TAX) per sample country over years 2005 to 2009. The TAX represents an equally-weighted sum of 16 tax factor is restricted to values between zero and one. The closer the Tax Attractiveness Index is to one, the more attractive is the tax environment country i offers.

Country (Code)    Tax  Country (Code)    Tax 
Algeria (DZA)    0.3424
Angola (AGO)    0.3399
Argentina (ARG)    0.0890
Australia (AUS)    0.3361
Austria (AUT)    0.6178
Bahamas (BHS)    0.8125
Bahrain (BHR)    0.7554
Bangladesh (BGD)    0.3550
Belarus (BLR)    0.3765
Belgium (BEL)    0.6206
Bermuda (BMU)    0.8125
Bolivia (BOL)    0.5137
Botswana (BWA)    0.3626
Brazil (BRA)    0.3203
British Virgin Islands (VGB)    0.7739
Bulgaria (BGR)    0.4248
Canada (CAN)    0.3147
Cayman Islands (CYM)    0.7813
Chili (CHL)    0.3310
China (CHN)    0.3197
Columbia (COL)    0.3067
Costa Rica (CRI)    0.4379
Croatia (HRV)    0.3634
Cyprus (CYP)    0.7086
Czech Republic (CZE)    0.3837
  Denmark (DNK)    0.4835
Dominican Republic (DOM)    0.4036
Ecuador (ECU)    0.3730
Egypt (EGY)    0.2859
El Salvador (SLV)    0.4652
Estonia (EST)    0.6128
Finland (FIN)    0.5008
France (FRA)    0.5320
Germany (DEU)    0.5245
Great Britain (GBR)    0.5913
Greece (GRC)    0.3869
Guatemala (GTM)    0.4753
Guernsey (GGY)    0.5943
Hong Kong (HKG)    0.5120
Hungary (HUN)    0.5229
Iceland (ISL)    0.5112
India (IND)    0.3868
Indonesia (IDN)    0.2206
Ireland (IRL)    0.6694
Israel (ISR)    0.3171
Italy (ITA)    0.3705
Japan (JPN)    0.2748
Jersey (JEY)    0.7181
Kazakhstan (KAZ)    0.3533
Kenya (KEN)    0.4437
 Korea, South (KOR)    0.1505
Latvia (LVA)    0.5194
Lebanon (LBN)    0.4541
Liechtenstein (LIE)    0.5286
Lithuania (LTU)    0.4083
Luxembourg (LUX)    0.7219
Macedonia (MKD)    0.4675
Malaysia (MYS)    0.6886
Malta (MLT)    0.6639
Mauritius (MUS)    0.5395
Mexico (MEX)    0.2899
Montenegro (MNE)    0.4875
Morocco (MAR)    0.4336
Namibia (NAM)    0.5030
Netherlands (NLD)    0.7076
Neth. Antilles (ANT)    0.6398
New Zealand (NZL)    0.3547
Nicaragua (NIC)    0.4746
Nigeria (NGA)    0.4373
Norway (NOR)    0.5555
Pakistan (PAK)    0.3166
Panama (PAN)    0.4806
Paraguay (PRY)    0.5236
Peru (PER)    0.1927
Philippines (PHL)    0.2240
  Poland (POL)    0.4079
Portugal (PRT)    0.4395
Puerto Rico (PRI)    0.3217
Romania (ROU)    0.4065
Russia (RUS)    0.3560
Saudi Arabia (SAU)    0.4564
Serbia (SRB)    0.3667
Singapore (SGP)    0.6798
Slovak Republic (SVK)    0.5419
Slovenia (SVN)    0.4592
South Africa (ZAF)    0.4557
Spain (ESP)    0.4971
Sweden (SWE)    0.5747
Switzerland (CHE)    0.5981
Taiwan (TWN)    0.3157
Thailand (THA)    0.3800
Tunisia (TUN)    0.3935
Turkey (TUR)    0.4000
Ukraine (UKR)    0.4460
United Arab Emirates (ARE)    0.7682
United States (USA)    0.2432
Uruguay (URY)    0.5570
Venezuela (VEN)    0.1301
Vietnam (VNM)    0.4046
Zimbabwe (ZWE)    0.2675

By the way, it’s not clear that the study takes a comprehensive look at “depreciation” rules that oftentimes force companies to characterize investment expenditures as taxable income.

Let’s look at an example: If a company purchases a machine for $20 million, they should be able to deduct – or expense – that $20 million when calculating that year’s taxable income. A logical tax system, after all, defines profit as total revenue minus total costs. But the internal revenue code forces them to wait several years before fully deducting the cost of the machine (a process known as depreciation). Given that money today has more value than money in the future, this is a penalty that creates a tax bias against investment (the tax code requires depreciation for almost all purchases of machines, structures and other forms of investment).

Because of the complicated nature of depreciation rules, there aren’t many good international comparisons to show which nations have the most punitive policy. But it’s clear that U.S. policy has an anti-investment bias, regardless of whether the rules are better or worse than exist elsewhere.

Why reform is unlikely

So with all this powerful data on the anti-competitive nature of America’s business tax regime, why is reform unlikely? Particularly when everybody seems to agree that the corporate tax rate is too high?

There are good and not-so-good ways of lowering tax rates as part of corporate tax reform. If politicians decide to “pay for” lower rates by eliminating loopholes, that creates a win-win situation for the economy since the penalty on productive behavior is reduced and a tax preference that distorts economic choices is removed.

But if politicians “pay for” the lower rates by expanding the second layer of tax on U.S. companies competing in foreign markets or by changing depreciation rules to make firms pretend that investment expenditures are actually net income, then the reform is nothing but a re-shuffling of the deck chairs on the Titanic.

The bad news is that there are not that many genuine loopholes on the business side of the tax code. And that ones that universally are recognized as loopholes – such as ethanol credits and the fringe benefits exclusion – have considerable support from certain politicians.
At the risk of oversimplifying, there is a partisan divide on the issue of corporate tax reform. Democrats are willing to lower the corporate tax rate, but only if they can “pay for” the lower rate by expanding worldwide taxation (by getting rid of deferral), making depreciation rules more onerous, and increasing double taxation (by curtailing 401(k) protections).

Republicans, by contrast, are squeamish about these options. They may not understand the underlying tax policy principles that are at stake, but they certainly hear a lot of grousing from the parts of the business community that would be adversely impacted.

This is what makes reform such a challenge. While some individual companies will crunch the numbers and decide they can support a particular legislative package based on whether they pay more of pay less, it’s highly unlikely that the overall business community will be supportive if “reform” means they get a 20 percent reduction in the rate accompanied by rules that force them to overstate their income by an offsetting amount.

Why not forget reform and simply lower the corporate rate?

If corporate tax reform is a non-starter because of fundamental disagreements over how to define taxable income, why not just deal with the high corporate tax rate? Everybody seems to agree it’s a competitive hindrance, so why not cut the rate and worry about reform in the future?
There certainly are reasons to think this would be a win-win situation. Not only would companies be more competitive, but it’s quite possible that politicians would get more revenue. This is the “Laffer curve” issue.

The key thing to understand is that revenue feedback is driven by the degree to which a tax cut leads to more taxable income. And you tend to get bigger changes in taxable income when you lower rates on taxpayers who have considerable control over the timing, level and composition of their income.

Corporations, needless to say, fit this definition.

Which is why there’s strong evidence supporting a lower corporate rate. Consider this new research from the Tax Foundation3, which finds big “supply-side” responses from a lower corporate tax rate. They look at a wide range of options and show us “static” estimates based on conventional methodology (which assumes taxes have no impact on the economy) and “dynamic” estimates based on a model that includes changes in taxable income.(See Figure 3)

 DanM_Graph-5 

There is other evidence for big Laffer curve effects in corporate taxation. In a 2007 study4, Alex Brill and Kevin Hassett of the American Enterprise Institute found that the revenue-maximizing corporate tax rate is about 25 percent. (See Figure 4)

DanM_Graph-3.jpg

Based on the Tax Foundation and AEI research, it appears that the revenue-maximizing corporate tax rate is somewhere between 14 percent and 26 percent. So if you cut the baby in half, that would mean a federal corporate tax rate of 20 percent, a vast improvement over the current system.

Unfortunately, there is no indication that the White House would accept a pure rate cut. The political left in America is ideologically opposed to Laffer curve analysis and would view a rate cut as a giveaway to the business community.

So we are back where we started. The corporate tax system desperately needs reform, but Republicans don’t favor changes that would force companies to overstate their taxable income and Democrats won’t accept rate cuts based on the Laffer curve. 

Endnotes 

  1. http://www.ft.com/intl/cms/s/0/c8cc5dea-9189-11e2-b4c9-00144feabdc0.html#axzz2RlRDlgC8 
  2. http://econstor.eu/bitstream/10419/75220/1/749829451.pdf 
  3. http://taxfoundation.org/article/growth-dividend-lower-corporate-tax-rate 
  4. http://www.aei.org/docLib/20070731_Corplaffer7_31_07.pdf 

 

 

Corporate-tax-world-map

Figure 1
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Daniel J. Mitchell

Daniel J. Mitchell specialises in fiscal policy issues. He also is a co-founder of the Center for Freedom and Prosperity, an organisation created to preserve and protect tax competition, fiscal sovereignty, and financial privacy.

As a member of the Editorial Board of the Cayman Financial Review, Daniel’s biography can be seen on the Editorial Board details page.

Daniel J. Mitchell
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