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The one thing on which our political leaders seem to agree is the need for corporate tax reform. Barack Obama and Mitt Romney unveiled new proposals on the same day last month, with President Obama cutting the top corporate tax rate to 28% and Mr. Romney reducing it to 25%. Rick Santorum would cut the rate to 17.5%, and to zero for manufacturing. Congressional action is bubbling below the surface as well.
This flurry of proposals is a result of increased awareness of how out of step America is with the rest of the world. The U.S. is currently an outlier within the 34-member Organization for Economic Cooperation and Development, with a combined state and local corporate tax rate that is about 15 percentage points higher than the average of our trading partners.
But amid all of the promising rhetoric there is significant cause for concern. Many proposals, particularly those of Messrs. Obama and Santorum, seem to have unlearned many of the lessons of modern economics.
An explosion of recent empirical work documents that labor bears much of-and, in some analyses, all of-the burden of the corporate tax.
Three shifts in the economic environment since the 1960s, each recognized by most economists, provide an essential guide to reform.
First, U.S. tax policy can no longer treat the U.S. as a closed economy. Capital and business activity are increasingly mobile across national boundaries and highly responsive to variation in the net tax paid across locations. Second, the word “business” is not synonymous with “corporation”-pass-through (noncorporate) businesses are almost as important in the aggregate as old-fashioned corporations. Third, economic research has stressed that both corporate taxes and investor-level taxes on dividends and capital gains contribute to the tax burden on corporate equity. Investors factor in the total capital tax, both individual and firm level, when making decisions.
A key implication of the first point is that the rapid increase in international capital mobility has significantly altered the calculus of redistributive policies. Conventional analyses of who bears the burden of the corporate tax conclude that the tax is borne by owners of domestic capital.
But an explosion of recent empirical work documents that labor bears much of-and, in some analyses, all of-the burden of the corporate tax. This is because the corporate tax depresses investment in the domestic economy, reducing productivity and ultimately workers’ wages.
The effects even spread to the union sector. A recent study by economists R. Alison Felix and James R. Hines shows that union wage premiums in the U.S. increase sharply when state corporate income tax rates go down.
Mr. Obama’s plan, as if designed by Rip Van Winkle, is blind to this major shift and is thus a weak tonic for the flagging economic recovery. While the president proposes reducing the corporate tax rate, other changes that are portrayed as “loophole closing” on multinational firms make his plan a net increase in corporate taxes collected.
Mr. Obama, ignoring the second reality, would also raise taxes on noncorporate business, in the interest of requiring the “rich” to pay for the “privilege” of being an American, to paraphrase a recent statement by Treasury Secretary Tim Geithner. Noncorporate business accounts for 36% of business receipts, 44% of business taxes, and 54% of private-sector employment.
A unifying characteristic of the many types of noncorporate businesses is that their owners pay taxes at individual rates. A substantial body of economic research has found that changes in individual marginal tax rates clearly impact noncorporate firms’ investment levels, hiring practices and wages.
In addition, Austan Goolsbee, the former chairman of Mr. Obama’s Council of Economic Advisers, did pioneering work in the early 2000s documenting that the organizational form of firms is highly responsive to tax changes, arguing at the time that this significantly increases the likely deadweight loss associated with the corporate tax. Mr. Goolsbee’s work suggests that the Obama proposal would cause costly reorganization.
While cutting corporate tax rates with his left hand, Mr. Obama would increase tax rates with his right by radically increasing tax rates on dividends and capital gains. Modern economic theory and empirical evidence-including a series of papers by one of us (Hassett) and Alan Auerbach of the University of California, Berkeley-show that raising taxes on dividends at the individual level increases the cost of equity capital and lowers asset prices, harming consumers while hindering firms’ ability to hire workers.
The plans of Messrs. Romney and Santorum have significantly more promise. Both would bring down rates on corporate and noncorporate income, though only Mr. Romney would do so in a revenue-neutral way (the Santorum plan adds greatly to federal deficits). According to one study, a top marginal tax rate on individual incomes of 28% as proposed by Mr. Romney, compared with Mr. Obama’s proposed top marginal rate of 39.6%, would increase the wage bill of noncorporate businesses by over 6%, raise investment by 10%, and push business receipts up by 16%.
And by proposing special tax breaks for manufacturing, Mr. Santorum follows Mr. Obama’s incorrect lead and introduces a significant economic distortion. In a world with highly mobile capital, tax policy needs to be neutral toward different forms of business activity and not succumb to the temptation to pick winners and losers. We are aware of no serious economic argument to support such a policy direction.
A 21st-century business tax policy would recognize the roles of globalization, the side-by-side organizations of corporate and noncorporate business, and double taxation of corporate equity returns. Mr. Obama’s tax reform proposal takes a wrong turn in each area and appears motivated by a poor understanding of the impact of capital taxation on business behavior and the welfare of middle-class Americans.
It is reassuring that political leaders on both sides of the aisle recognize the need for corporate tax reform. Let us hope that the reform that eventually becomes law is attentive to the realities of the 21st-century economy.
Kevin Hassett is a senior fellow and director of economic policy studies at AEI. Glenn Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. He is an economic adviser to Mitt Romney.
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