Farewell to the Federal Corporate Income Tax: Part II
Treasury's Response and a Sensible Alternative
The first part of this blog post summarized reasons for the survival of the corporate income tax, despite its multiple defects, and explained the forces leading to its slow demise. This second part reviews the US Treasury's response to foreign tax competition, one of the forces eroding the corporate tax structure, and concludes with a proposal for a sensible if radical alternative to the corporate income tax.
Treasury response. President Obama's Treasury has responded to foreign tax competition in a predictable fashion. Treasury has offered to cut the statutory corporate tax rate, but not by much, from 35 percent to 28 percent. This change, if enacted, would probably reduce the effective average tax rate from 28 percent to 21 percent. At the same time, Treasury proposes to eliminate features of the tax code that favor corporations, such as accelerated depreciation, which in turn would serve to raise the average effective rate nearly back to its old level. Taken as a package, the Treasury proposals do practically nothing to tilt corporate incentives towards investment and production in the United States. Meanwhile Treasury has tried to plug holes in the corporate tax dike through new regulations and an international initiative.
By Treasury's own admission, corporations can easily circumvent its new regulations. Tax avoidance by multinational corporations (MNCs) has become a cause celebre in Europe, particularly Britain. One international initiative being advanced by the Organization for Economic Cooperation and Development (OECD), the association of advanced industrial democracies, involves a "base erosion and profit shifting" (BEPS) proposal, designed to tighten member country tax rules so that MNCs are less able to move fungible income (exemplified by patent royalties) to low-tax jurisdictions. BEPS enjoys the rhetorical support of many finance ministers, but the initiative suffers fundamental flaws.
In the first place, when it comes time to carry out the BEPS recommendations through national legislation, countries that follow a business model designed to attract MNCs with lower tax rates will not find it in their interest to turn off tax attractions, and MNCs will hire the same lawyers who designed the complex BEPS rules to work around them.
In the second place, even if Treasury completely prevents existing US firms from shifting part of their tax base abroad, it will not solve the underlying competitive problem. Subchapter C corporations want to leave because the US tax system puts them at a competitive disadvantage in the global marketplace. Over time this disadvantage will retard investment, innovation, and US growth.
Finally, stringent rules that curtail the flexibility of MNC operations will at some point run squarely into historical US advocacy of an open international system for trade, technology, and investment. Global supply chains for goods and services, closely linked to massive cross-border flows of direct investment, enable MNCs to lodge income in favorable tax jurisdictions. Only by coupling new income shifting rules with new taxes or other restrictions on trade and technology flows can Treasury change the underlying incentives that prompt firms to seek low corporate taxes abroad. But new restrictions would squarely contradict the tenets of an open international economy, not to mention rules agreed in the World Trade Organization and free trade agreements.
Medium-term outlook. So long as the United States maintains a corporate tax system with a rate well beyond international norms, BEPS rules, even if enacted, will fail to arrest the gradual departure of the corporate tax base from US shores. Confronted by the three forces described in part 1 of this blog post, the corporate income tax will reach a dwindling share of business activity and contribute a shrinking share of federal tax revenue. There is something to be said for a slow death: It avoids a major political battle. But the slow death of corporate taxation will impose real costs on the American economy. More firms will move their headquarters abroad or be bought by foreign companies, innovation and managerial functions will be offshored, domestic investment and innovation will lag, and the United States will lose its competitive edge.
Sensible alternative. While politically difficult, the sensible course for the United States is to tackle the problem head on, preserving and even enhancing the progressive structure of the income tax system. The starting point would be broad political acceptance of the fact that corporate taxation is not essential to a progressive tax system. What remains essential is progressive taxation of all income earned by individuals and households.
Accordingly corporations should be allowed a deduction both for dividends paid and retained earnings deemed paid, to US persons with a tax ID number. In turn, those persons would report the income (paid and deemed paid) on their own tax returns and pay income tax accordingly. This would ensure that rich households actually pay tax at progressive rates on corporate income, whether distributed or undistributed, just as they do on income received from pass-through entities.
Undistributed corporate income should include the undistributed income of foreign subsidiaries of US firms, some $370 billion in 2012. In this manner foreign earnings would be taxed properly, at the level of US households.
The core feature of this alternative is the distinction between taxation at the shareholder level and taxation at the corporate level. Corporate officers, not shareholders, decide the location of headquarters, research and development, production, and investment. When these officers think about taxes, they think foremost about the corporate tax bill, not the shareholder tax bill. Indeed, a multinational corporation with thousands of shareholders has no way of knowing their individual tax circumstances. Hence the alternative approach would not have nearly the distortive impact on location decisions that determine the future of the American economy.
Revenue impact. In 2012, US corporate profits, before taxes and dividends, were $2.01 trillion. Dividends paid were $750 billion, federal corporate taxes were $351 billion, leaving about $800 billion as retained earnings.1 Undistributed income of foreign subsidiaries was $370 billion.
Table 1 summarizes estimates of federal taxes that would be collected from household and foreign shareholders under the alternative approach. The data assumes that nonprofits and government recipients would pay no tax (a big benefit to them). Another assumption is that households would pay tax at an average rate of 24 percent on undistributed earnings deemed paid to them personally and to their retirement accounts, and on dividends paid to their retirement accounts. The 24 percent rate corresponds to the current average for the top quintile of US households—the predominant shareholders. Since almost half of household shares are held in pension funds and other nontaxable accounts, where income is not taxed until distributed, this proposal includes a measure permitting households to request a direct payment to the IRS by such funds with respect to their new tax liability.
|Table 1 Alternate US taxation of corporate income, based on 2012 activity levels (billions of dollars)|
|Recipient group||Dividends received1||US firms||Foreign affiliates||Tax rate (percent)||Revenue|
|1Data from the Bureau of Economic Analysis do not distinguish between dividend receipts from foreign and domestic corporations. We assume that nearly all dividends from foreign corporations were paid to the household sector.|
|2Includes pension funds and other indirectly held shares.|
|3We assume that 45 percent of dividends paid to households are currently paid to nontaxable accounts.|
|4Assumes that the tax rate on attributed income and dividends paid to pension funds corresponds to the current average tax rate paid by the top quintile of US households.|
|Sources: Bureau of Economic Analysis; Ellen McGrattan and Edward Prescott, 2014, "On Financing Retirement with an Aging Population," Federal Reserve Bank of Minneapolis; and authors' calculations.|
US corporations would initially pay tax at a 35 percent rate on dividends and undistributed earnings attributed to foreign shareholders—in other words, the current statutory corporate tax rate. However, the assumption is that this rate would soon drop to an average of 20 percent as new tax treaties were negotiated with foreign partners.2
According to these rough calculations, the US Treasury would collect $431 billion on corporate earnings under the alternative approach. This is considerably more than the federal corporate tax collected in 2012, namely $351 billion. Moreover the forecast estimate does not reflect the revenue payback from greater US investment and inshoring of headquarters and production located abroad for tax reasons, so it gives a conservative picture. Since most of the additional tax comes from the household sector, it might be appropriate to lower the schedule of personal income tax rates.
Too radical for now. Quite apart from revenue considerations, this proposal is almost certainly too radical for the sitting 114th Congress, and very likely for the 115th Congress that will start work in 2017. Yet modest corporate tax reforms are in the air. The next installment of reform measures—largely in response to foreign tax competition—should at least pave the way for an early death of the federal corporate income tax.3 Three such reforms are on the horizon:
- Lower the federal statutory rate to 25 percent or less (the OECD average is now 24 percent).
- To stimulate the economy and boost productivity, allow all plant and equipment outlays to be expensed immediately—in other words, a 100 percent first-year depreciation deduction.
- Adopt a territorial system for taxing income earned abroad by US firms, thereby eliminating the tax incentive for inversions and foreign takeovers.
1. Taxes paid to subfederal governments account for most of the residual difference between corporate profits after taxes and dividends and retained earnings.
2. The 20 percent rate roughly corresponds to the difference between the new US Subchapter C corporate rate, namely zero, and the average foreign corporate rate, someplace between 20 and 25 percent. We assume that both US and foreign withholding taxes on dividends paid to residents of the partner country would be zero.
3. Nothing the federal government does will encroach on the power of the states to levy their own corporate income taxes. However, competition between the states, together with strict surveillance by the federal courts to prevent "greedy" states from taxing corporate income earned outside their jurisdictional boundaries, will keep state taxation at low levels.