The labyrinth of corporate tax reform

In the last two decades, there have been sweeping reforms of the corporate income tax in many countries around the world, with many countries lowering corporate income tax rates and broadening the corporate tax base. In addition, several countries, including the U.K. and Japan, have moved from a worldwide (taxing profits of domestic companies both at home and abroad) to a territorial (taxing profits of firms located within its borders) corporate tax system. The United States, however, has not significantly reformed its corporate income tax since the Tax Reform Act of 1986. As a result, given the widespread reductions abroad, the U.S. has the highest corporate income tax rate of all developed countries.

More recently, a growing number of U.S. companies have considered inverting so that they can more effectively compete with foreign-based companies. This process is referred to as a “corporate inversion,” which occurs when a domestic company buys a foreign company and then chooses the foreign location as its new corporate headquarters. The Obama administration recently imposed new rules on firms that invert in an effort to limit the tax benefits of corporate inversions. While these rules may reduce the potential number of inversions, they will also make it more difficult for American firms to compete at home and abroad. These issues underscore the need for Congress and President Obama to tackle corporate tax reform when the next Congress convenes in January.

{mosads}But what form should corporate income tax reform take? Fortunately, the Tax Reform Act of 2014 (TRA 2014) and the analysis of that reform provide a useful framework. TRA 2014 was structured as a base-broadening, rate-reducing (BBRR) corporate (and individual) income tax reform, as well as a reform of the treatment of international income.

BBRR corporate income tax reforms generally are structured to equalize the tax treatment of investment across assets and industries and to reduce the cost of capital by decreasing tax rates in order to reduce tax-induced distortions and promote economic growth. However, under a BBRR reform, the rate reduction applies not only to new investment, but also to the income earned by existing capital. This creates a windfall gain for the owners of existing capital, and a corresponding revenue loss to the government which can offset part or all of the gains of a BBRR reform (because those revenues are effectively made up by imposing higher taxes on new investments). In addition, BBRR reform would encourage economic growth to the extent it reduces other inefficiencies associated with the corporate income tax, such as reducing incentives to shift income or production to avoid taxes or the misallocation of investment across industries and types of assets.

The international considerations mentioned above make it more likely that a BBRR reform will generate positive macroeconomic effects. A reduction in the statutory corporate income tax rate will result in a reallocation of highly mobile capital to the U.S. and reduce the amount of income shifted out of the country, which provides a “free” source of revenue — effectively a corporate income tax rate cut without the costs of base broadening mentioned above — that may significantly increase the benefits of a BBRR reform. In addition, the changes in trade that accompany a reversal of income shifting also have positive effects, increasing net exports and thus output. Note, however, that the importance of such effects depend on the amount of income shifting that is occurring before the reform, as well as the magnitude of the reduction in income shifting that would accompany a reduction in the corporate income tax rate in the U.S., both of which are subject to debate.

A BBRR reform would be more likely to result in positive macroeconomic effects if it increases investment, encourages mobile capital to return to the U.S. and reduces income shifting as much as possible. This implies that to increase the growth effects of a BBRR reform, policymakers should adopt only partial base broadening, maintaining provisions such as accelerated depreciation that reduce the cost of capital, and should use all revenues from corporate base broadening to reduce the corporate tax rate as opposed to using a portion of the revenues to reduce non-corporate and individual tax rates. (However, it should be noted that enacting corporate and individual reform simultaneously may require that part of the individual rate reduction be financed by corporate revenues, even though this may not be optimal in terms of promoting economic growth.) Lowering the corporate tax rate in this manner would attract businesses to the U.S. and increase investment by existing U.S. businesses.

Finally, corporate reform should move the U.S. toward a territorial system of taxing international income, especially given that the current system that allows deferral and foreign tax credits is essentially a costly (in terms of resources spent by firms) method for firms to effectively alter the current worldwide tax into a territorial-like system. In contrast, moving more toward a comprehensive worldwide system would only make it harder for U.S. firms to compete abroad. Congress and President Obama should act early next year to reform the corporate tax by adopting a proposal that modifies the corporate and international reforms in TRA 2014 as outlined above so that our country’s corporate tax system will promote U.S. businesses at home and abroad.

Diamond is the Edward A. and Hermena Hancock Kelly Fellow in Public Finance at the Baker Institute, an adjunct professor of economics at Rice University and CEO of Tax Policy Advisers, LLC.