The hottest corporate finance topic in recent weeks has been “merger inversions”, in which American companies are acquired by or merge with non-US based corporations. The combined entity is then re-incorporated abroad in order to shield future earnings from high US corporate income taxes. Treasury Secretary Jack Lew and the President have called these transaction “economically unpatriotic”and have called on Congress to raise the drawbridge and only allow corporations to escape the IRS if foreign share ownership is more than 50% of the combined entity.
History of the US Corporate Tax
The first US corporate income tax was implemented from 1861-1872. The current iteration began with the federal excise tax on corporate income in 1909, which predated the ratification of the 16th Amendment in 1913 that gave Congress power to levy income taxes on individuals. The original tax rate was 1% of income for both individuals and corporations. As with any other tax, the rate paid only increased over time.
Today the U.S. has the highest nominal corporate income-tax rate in the developed world. While U.S. corporations face a combined federal-state statutory tax rate of 39.1%, our competitors in the Organization for Economic Cooperation and Development (OECD) face an average rate of 25%. France’s tax code—typical of most OECD countries—exempts 95% of foreign-source income from taxation, while the U.S. tax code fully taxes such income.
Despite the high nominal rates, the US tax code is littered with deductions and preferences that dramatically lower the effective tax rate paid by corporations, leading many Americans to consider the “crony capitalist system” essentially corrupt. Overseas income of American corporations is taxed only when it is repatriated to the US. This has led to the holding of as much as $2 in unrepatriated corporate profits and huge disincentives to ever bring it home. The following chart indicates that the effective tax rate is actually lower in the US than in most of the OECD.
As one can discern from the chart above, it’s not that the average amount of tax paid is too high, because corporations utilize deductions like depreciation and interest. It is the marginal tax rate that is the impediment to the US economy.
According to Laura Tyson, former chairwoman of President Clinton’s Council of Economic Advisers,
“America’s relatively high rate encourages U.S. companies to locate their investment, production, and employment in foreign countries, and discourages foreign companies from locating in the U.S., which means slower growth, fewer jobs, smaller productivity gains, and lower real wages.”
Why do we have a Corporate Tax?
Economists are broadly divided about whether corporate taxes are paid by capital or by workers. Superficially the corporate tax is on capital, but many economists believe that workers ultimately pay much of the tax in the form of lower wages. This results from lower capital investment due to a higher cost of capital, which reduces productivity and therefore wages, and because capital investment moves to other countries where corporate income taxes are lower. The Tax Policy Center pegs the portion of corporate taxes paid by workers as 20% of such taxes.
What cannot be argued is how the current tax regime is affecting corporate behavior. Corporate taxes encourage the use of debt rather than equity financing because interest reduces taxes and paying dividends increase taxes. More debt increases business risk of failure and discourages new investment by increasing the cost of capital.
Overall, corporate taxes generated in 2013 were $330 billion, about 10% of federal revenues from all sources. If there were no corporate tax, from where will the tax revenue be replaced? A recent National Bureau of Economic Research paper titled Simulating the Elimination of the US Corporate Income Tax shows the many positive effects of eliminating the tax entirely. Summarizing the findings, author Laurence Kotlikoff said
“They simulate corporate tax reform in a single good, five-region (U.S., Europe, Japan, China, India) model, featuring skilled and unskilled labor, detailed region-specific demographics and fiscal policies. Eliminating the model’s U.S. corporate income tax produces rapid and dramatic increases in the model’s level of U.S. investment, output, and real wages, making the tax cut self-financing to a significant extent. Somewhat smaller gains arise from revenue-neutral base broadening, specifically cutting the corporate tax rate to 9 percent and eliminating tax loop-holes.”
As this study shows, cutting the corporate tax rate would increase total corporate tax receipts. At first blush, this might seem to be a surprising result. It shouldn’t be. Corporations, run by people, respond like individuals to incentives. By taxing repatriated profits at 39%+, the federal government gets far fewer repatriated profits. If one examines tax receipts following tax cuts, it is clear that tax cuts yield higher federal tax receipts. In the last instance, the four years of the Bush Presidency after the 2003 reduction in tax rates saw a 44% increase in Federal tax revenues. With regard to corporate taxes, revenue increased following rate cuts in Canada in recent years. Some economists dispute the correlation as less than perfect due to many other factors including the business cycle of recession and expansion, but these results are mirrored across the OECD.
It’s time for Congress to reform a tax system that mainly benefits other countries. Ideally, Congress would pass comprehensive tax reform for both business and individuals, but reforming today’s corporate tax alone is easier to do. The argument for reform is that it can be easily made to be revenue neutral or better, it improves “social equity”, and reform provides ongoing incentives for corporations to remain and invest in America. Theoretically, reform should receive broad bi-partisan support.
The US should lower the corporate income tax to 10% and eliminate the capital gains and dividends tax preferences for stocks and mutual funds for individuals. These gains have traditionally been taxed at lower rates (to the dismay of progressives) to mitigate the impact of “double taxation” since every dollar of corporate income is taxed before it is distributed to shareholders. Excluding non profit institutions, about 91% of stocks and mutual funds are held by those in the top 10% of household wealth, or foreigners, so this is a very progressive, well targeted tax.
Eliminating corporate taxation reduces the incentive to lobby for special tax breaks, reducing crony capitalism. Further, reducing the tax to about a quarter of what it was greatly reduces the incentive for corporations to spend money on non-productive tax sheltering activities.
Lowering the corporate tax rate from the highest in the OECD world to the lowest would be an incredible draw to companies currently domiciled abroad. If a corporation can move its headquarters and tax base to the premier destination in the world where their operations are protected by the American rule of law, we would eliminate the inversion issue entirely. Instead of trying to intimidate American corporations into remaining here, let’s just make it more attractive to stay. Turn the problem into an opportunity for any multinational company to pay their (lower) taxes here.