The Obama administration has been signaling that a corporate tax overhaul is on the horizon. But will this plan help workers and lead to economic growth?
Several hearings have been held by the House Ways and Means Committee as well as the Senate Finance Committee on broad based tax changes. Treasury Secretary Geithner has suggested that the reform will be revenue-neutral, and by all indications, the proposal will involve a lowering of the statutory rate, accompanied by a broadening of the tax base.
Reform is desperately needed. At 39.2 percent, the United States has the second highest combined federal and state statutory corporate tax rate in the industrialized world. These high corporate tax rates, however, have not translated into high revenues for the U.S. In fact, the U.S. collects less corporate tax revenue as a percent of GDP than most other OECD countries.
A refrain in the reform debate is that the United States collects relatively little revenue because the myriad loopholes in the tax code allow firms to effectively pay much lower taxes. In other words, actual taxes paid as a fraction of profits are much lower than the 39.2 percent.
The fact that effective taxes paid are low should not surprise us. When firms make decisions about investment, they compare the post-tax return on investment that capital can expect to earn in different locations.
The difference between the pre-tax return and the post-tax return expressed as a fraction of pre-tax economic profits is termed the effective average tax rate (EATR). More simply, it is the tax liability that a firm may expect to incur as a fraction of pre-tax economic profits in country x. The reason this differs from the statutory rate is because it allows for other features of the tax code such as depreciation allowances or interest rate deductions that enable firms to ultimately pay a lower rate on their profits than the statutory rate of 39.2 percent.
Yet by several metrics, the United States' effective rates are nearly as uncompetitive as its statutory rates. The World Bank ranks the United States tax climate as third worst in the industrialized world for incorporation when considering the effective rates. A study conducted with an AEI colleague puts the U.S. tax climate at second worst for locating investments in plants and machinery. A 2010 paper by tax experts Markle and Shackelford also concludes that over the period 1988 to 2007, U.S. multinationals faced the highest effective average tax rates after Japanese firms.
The international tax literature has consistently shown that countries compete over effective tax rates for mobile capital. Capital flows from high-tax to low-tax jurisdictions. So, high effective tax rates in the United States drive investments away to countries with lower rates and more generous allowances, deductions, and exemptions. Hence it is no surprise that corporate tax revenues in the U.S. are amongst the lowest in the OECD.
The Obama administration's plan will broaden the base by eliminating certain deductions, exemptions and "loopholes", and lowering statutory rates. This approach has some merit. It could lead to less tax avoidance and the associated compliance costs and efficiency losses. For example, GE paid no taxes to the federal government last year, but in order to do so, the company maintains a tax department of over 1000 people.
Reform will also make it more difficult for the government to pick corporate winners and losers by manipulating the tax code. A loophole is different from a subsidy in name only, and reducing the ability of well-connected corporations and politically-valuable industries to gain advantages through the tax system will lead to a more competitive U.S. economy.
The Administration's plan, though, could prove flawed if it fails to target effective rates. A reform that leaves effective rates unchanged will do little to improve the competitiveness of the United States as a location for investment and incorporation. If economic growth is a goal, and it should be, then tax reform ought to lower effective tax rates.
Economic growth is not the only reason to lower effective rates. Recent theoretical and empirical research indicates that the corporate tax hits workers almost as much, if not more, than capital owners. Many people are surprised by this result because who actually bears the burden of the corporate income tax is not obvious.
Corporations are, after all, just legal structures that bring together shareholders, workers, and consumers. Policymakers tend to assume that the tax burden falls on capital holders. However, recent research indicates that as capital flees to lower tax jurisdictions around the world, workers have less capital to work with, become less productive, and are ultimately left to bear the brunt of the tax in the form of lower wages.
Theoretical research finds that labor bears about 40 percent of the corporate tax burden. Recent empirical research indicates even higher effects. For instance, Hassett and Mathur (2010), Felix (2007), Desai et al (2007) and Arulampalam et al.(2008), have demonstrated that about 75-100 percent of the burden of corporate taxes could potentially be borne by workers in the form of lower wages. Therefore, in the current economic climate, cutting the corporate tax could yield a double dividend in terms of much needed higher revenues as well as improved conditions for workers.
The United States has not cut its corporate tax rates since 1993 and has been left behind while the rest of the developed world races to cut rates and attract investment. To promote economic growth, help workers and increase revenues, we need an "effective" tax reform sooner rather than later.