Junk the Corporate Tax

Wednesday, September 29, 2010

Surprisingly little attention is being paid to fixing the most growth-inhibiting, anticompetitive tax of all: the corporate income tax. Reducing or eliminating the corporate tax would curtail numerous wasteful tax distortions, boost growth in both the short run and the long, increase America’s global competitiveness, and raise future wages.

The United States has the second-highest corporate income tax rate of any advanced economy (39 percent, including state taxes; this is 50 percent higher than the Organization for Economic Cooperation and Development average). Many major competitors, Germany and Canada among them, have reduced their corporate tax rate, rendering American companies less competitive globally.

Of course, various credits and deductions—such as for depreciation and interest—reduce the effective corporate tax rate. But on sum, our corporate tax still severely retards and misaligns investment, problems that will only get worse as more and more capital becomes internationally mobile. Corporate income is taxed a second time at the personal level as dividends or those capital gains attributable to reinvestment of the retained earnings of the corporation. Between the new taxes in the health reform law and the expiration of the Bush tax cuts, these rates are soon set to explode.

This complex array of taxes on corporate income produces a series of biases and distortions. The most important is the bias against capital formation, decreasing the overall level of investment and therefore future labor productivity and wages. Also important are the biases among types of investments, depending on the speed of tax versus true economic depreciation, against corporate (versus noncorporate) investment, and in favor of highly leveraged assets and industries. These biases ensure that overall capital formation runs steeply uphill.

WHERE THE BURDEN WILL FALL

Corporate taxes, like others, are ultimately paid by people. In a static economy with no international trade, shareholders are likely to bear the cost. But the U.S. economy is neither static nor closed to trade, and thus taxes tend to be borne by the least mobile factor of production. Capital is much more mobile globally than labor, and the part of the corporate tax that is well above that of our lowest tax competitors will eventually be borne by workers. In a growing economy, the diminished investment slows productivity growth and future wages.

The corporate tax still severely retards and misaligns investment. The problem will only get worse as more and more capital becomes internationally mobile.

There is considerable evidence that high corporate taxes are economically dangerous. In a 2008 working paper, Taxation and Economic Growth, the Organization for Economic Cooperation and Development concluded that “corporate taxes are found to be most harmful for growth, followed by personal income taxes and then consumption taxes.” Virtually every major tax-reform proposal in recent decades has centered on lowering taxes on capital income and moving toward a broad-based, low-rate tax on consumption. This could be accomplished by junking the separate corporate income tax, integrating it with the personal income tax (for example, attributing corporate income and taxes to shareholders or eliminating personal taxes on corporate distributions), or allowing an immediate tax deduction (expensing) for investment (which cancels the tax at the margin on new investment and hence is the priority of most economists). The Hall-Rabushka flat tax, the Bradford progressive consumption tax, a value-added tax (VAT), the FairTax retail sales tax, four decades of Treasury proposals, and the 2005 President’s Tax Commission proposals would all move in this direction.

Reducing or eliminating the harm caused by the corporate tax on investment would increase real GDP and future wages significantly. Junking both the corporate and personal income taxes and replacing them with a broad, revenue-neutral consumption tax would produce even larger gains. Nobel Laureate Robert Lucas concluded that implementing such reforms would deliver great benefits at little cost, making it “the largest genuinely true free lunch I have seen.”

Reducing taxes on new investment could help strengthen what is a historically slow recovery from such a deep recession. It would also strengthen the economy in the long term. American workers would benefit from more jobs in the short run and higher wages in the long run.

AVOIDING THE SUPERSIZE GOVERMENT

However, if a new tax device is used to substantially expand government, it will seriously erode our long-run standard of living, as the VAT has done in Europe. While better than still-higher income taxes, the European VAT has fed the bigger governments that are the primary cause of living standards that are 30 percent lower than those in the United States. Letting a good tax reform lead to a much larger government is beyond foolish. No VAT should be on the table unless it is not only revenue-neutral but also accompanied by serious spending control.

Moreover, because the portion of Americans paying no income taxes is approaching 50 percent, there exists a dangerous political dynamic that spawns ever-rising taxes to pay for ever-rising spending. We need more people with a stake in controlling spending. Replacing corporate and personal income taxes with a broad consumption tax could increase the number of those with “skin in the game.” Other reforms, a VAT for example, might be much less transparent and fail to serve this purpose.

Congresses and presidents seem unable to avoid continually tinkering with the tax code. Any tax reform riddled with special features would lose much of its economic benefit. Instead, we need a stable tax system that changes far less frequently, allowing families and firms to plan their future more reliably. Current fiscal policy, loaded with immense deficits, ever-growing debt, and the prospect of higher future taxes, is the biggest threat to such stability. Consider that to balance the proposed spending in President Obama’s budget in 2015, his deficit commission’s target year, will require at least a 43 percent increase in everyone’s income tax. Spending control is therefore vital to tax stability.

Nobel Laureate Robert Lucas concluded that junking income taxes in favor of a broad consumption tax would be “the largest genuinely true free lunch I have seen.”

American companies and their workers compete in the global marketplace while saddled with a costly, anachronistic corporate tax system. To succeed in the twenty-first century, we need to reform corporate taxation. Business investment is growing again after the recession, which is usual in a cyclical recovery with very low interest rates. But eventually structural drags, from our antiquated tax code to massive public debt, will impede investment and economic growth. Several paths, each with its advantages, lead to reform. Unfortunately, tax policy is headed the wrong way.