Options for Corporate Tax Reform in 2017

The following was adapted from remarks originally given at the Fall 2017 meeting of the Brookings Panel on Economic Activity on September 8, 2017.

The U.S. corporate tax system is wrought with problems that have accumulated over many decades. The Tax Reform Act of 1986 (TRA86) provided a major overhaul of the personal income tax, reducing the top rate from 50 percent to 28 percent while maintaining revenue and distributional neutrality. But it did little to improve the corporate tax system. Indeed, TRA86 actually raised corporate tax revenue in order to pay for reductions in personal rates. Moreover, the specific changes in depreciation rules brought about by TRA86 reduced investment incentives, biasing the tax system in favor of owner-occupied housing instead of productivity-enhancing investment in business structures and equipment.

The House Republican plan, which was developed while Paul Ryan was chairman of the Ways and Means Committee, proposes to do five important things: (i) reduce the overall corporate tax rate; (ii) correct the tax treatment of the profits earned by the foreign subsidiaries of U.S. corporations; (iii) replace the traditional corporate tax with some form of cash-flow corporate tax; (iv) deal with pass-through businesses in an efficient and equitable way; and (v) avoid increasing the fiscal deficit while doing these things.¹ I briefly comment on each of these five goals below.

I. Reducing the Corporate Tax Rate

The U.S. federal corporate tax rate is presently at 35 percent, the highest among all the major industrialized countries. In addition, individual U.S. states levy corporate taxes at an average rate of 9 percent. Because state taxes are deductible when calculating federal taxable income, the overall corporate tax rate is closer to 40 percent. In contrast, the average rate among countries that belong to the Organization for Economic Cooperation and Development is about 25 percent.

The effective corporate tax rate is reduced by accelerated depreciation of investment in plants and equipment and by the deduction of nominal interest payments rather than the lower real interest payments. These are similar to the practices in other industrial countries.

The House Republican plan calls for reducing the statutory rate from 35 percent to 20 percent. The Trump presidential campaign called for reducing it to 15 percent.

Reducing the corporate tax rate would attract funds to the corporate sector from other uses, such as owner-occupied housing and agriculture. It would also attract foreign capital to the U.S. corporate sector. These shifts would increase the efficiency with which capital is allocated across sectors and across international markets. The increased capital in the U.S. business sector would raise the productivity and real wages of American workers. It would also increase real GDP growth as the corporate capital stock grows.

Although lowering the corporate tax rate would have substantial economic benefits, it would also have a significant budgetary cost. Because the corporate income tax presently accounts for about 1.6 percent of GDP, cutting the rate from 35 percent to about half that level would directly reduce revenue by about 0.8 percent of GDP. Though this would be partly offset by the faster economic growth and by the rise in real wages and profits, there would still be an increase in the budget deficit. To limit the revenue loss and achieve a long-run balanced budget, the statutory rate will probably need to be reduced to no less than 25 percent, a point to which I return below.

II. Correcting the Tax Treatment of the Profits Earned by the Foreign Subsidiaries of U.S. Corporations

The United States is virtually alone in how it taxes the profits earned by the foreign subsidiaries of domestically based corporations. Consider a foreign subsidiary of a U.S. corporation that earns profits in Ireland. It pays the Irish government a 12 percent tax and is then free to do what it wants with the after-tax profits. It can invest them in Ireland, or hold them in financial assets, or invest them in any other country in the world. But if it brings these after-tax...