The Essential Case for Business Tax Reform

September 25, 2017

Courtesy of an easy-money Federal Reserve, US growth reached 3 percent in the quarter ending June 2017. Exceptionally low interest rates have put Americans back at work, boosting output and spurring consumer confidence. But this party can't last when labor productivity growth is stuck at 1.1 percent, the dismal record since the Great Recession.

Soon everyone who wants a job will already be working, just entering the labor force, or moving between jobs. Since the US labor force will grow at only 0.5 percent per year through the mid-2020s, total output can at best grow at 1.6 percent annually—about half of President Trump's 3 percent target—unless productivity improves sharply.

That arithmetic underlies the essential case for business tax reform. The core objective of tax reform is to boost labor productivity by accelerating investment, both in physical capital and knowledge capital. Government doesn't know how to create more world-class innovators—like the Thomas Edisons and Henry Fords of yesteryear, or today's Bill Gates and Elon Musk—but it can easily raise the prospective return on new investment by lowering the tax bite. In this way, government can encourage myriad small improvements that collectively boost productivity.

In 1986, President Reagan and a bipartisan Congress cut the corporate rate from 46 percent to 34 percent. While that change gave the United States a lower corporate rate, other features of the 1986 act sharply increased federal taxation of business activity. On balance, the 1986 act did not provide a spur to US investment.

However, nearly all other advanced nations slashed their own corporate rates in the 1980s, 1990s, and 2000s. By 2017, after nudging its own rate up to 35 percent, the United States had the least favorable tax regime for business investment among OECD countries. No surprise: US investment in physical and knowledge capital taken together has hovered under 14 percent of GDP for the past three decades. When it comes to boosting productivity, it takes brilliant innovation to compensate for anemic investment. The United States luckily enjoyed some of that brilliance in the 1990s and early 2000s, in the form of information technology. Since the Great Recession, nothing new has come along to replace the hard work of more investment.

Fortunately, three business tax reforms could boost investment to the upper teens as a percent of GDP, and move the US economy closer to 3 percent annual growth.

  • First, the federal corporate rate should be slashed—Trump says 15 percent, but a 25 percent rate would bring the United States near the middle of statutory rates imposed by advanced countries.
  • Equally important, the law should allow business investment in structures, equipment, and infrastructure to be expensed, deducted from taxable income dollar for dollar in the year incurred. This will inspire profitable firms to seek productive uses for their cash, rather than send fat checks to the IRS.
  • Third, like other advanced countries, the United States should adopt a territorial system for lightly taxing the earnings of foreign subsidiaries of US multinational corporations. Such earnings might be subject to a minimum tax of 10 percent (allowing a credit for foreign taxes). This change will make the United States an attractive location for multinational headquarters rather than a victim of corporate inversions.

Business tax reform that spurs investment and productivity is quite different than personal tax cuts. To sell their package, President Trump and Treasury Secretary Steve Mnuchin must make the case that the core purpose of tax reform is to boost US productivity, not to make life easier for the top 1 percent.

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Gary Clyde Hufbauer Senior Research Staff