Mr. Chairman and members of the subcommittee, it is a great privilege to have the opportunity to appear before you today. My name is Eric Engen. I am a resident scholar at the American Enterprise Institute in Washington, D.C. where my research focuses on the effects of tax and budget policy on the economy. My testimony provides some perspectives on reforms of the current corporate tax system and international competitiveness.[1]

My principal conclusions are as follows:

! The competitiveness of U.S. firms in a global economy is influenced most significantly by the level of taxation on capital, especially relative to the tax burden imposed on firms in other countries. In particular, higher marginal corporate tax rates in the United States and the double taxation of dividends puts U.S. firms at a tax disadvantage. The ETI regime exists to try to offset some of this disadvantage.

! Simply repealing the ETI regime does not do anything to address the reasons for implementing the ETI in the first place.

! Reducing corporate income tax rates and integrating the corporate income tax with the personal income tax so that dividends are not taxed twice would significantly improve the economic incentives for investment and make U.S. firms more competitive. However, the corporate tax base should be broadened, or other revenues raise, and/or spending should be reduced so that these tax changes do not have negative consequences for the federal budget.

! An alternative that would go even further to reduce the tax distortions on capital formation, increase investment, and boost U.S. competitiveness would be to fundamentally reform the income tax system by replacing the corporate income tax, and possibly the personal income tax also, with a consumption tax. While this type of fundamental tax reform would likely have the largest payoff, it would, however, be more difficult to implement.

The extraterritorial income (ETI) regime exists to help offset some of the efficiency-distorting and anti-competitiveness features of the tax system for corporate income in the United States. The WTO=s decision to rule that the ETI is a prohibited export subsidy, along with earlier adverse decisions regarding the foreign sales corporations (FSC) regime and domestic international sales corporations (DISCs), has led most international tax law experts to conclude that it does not appear possible to comply with WTO and replicate the tax benefits of the ETI statute. This situation provides an opportunity to rethink the current U.S. corporate income tax structure and consider whether more fundamental tax reform would have even greater postive effects than a FSC-ETI-like regime on the competitiveness of U.S. businesses in the global economy.

The global economy is expanding rapidly. It is vital to the growth of the U.S. economy for U.S. businesses to be internationally competitive. Economic growth and a higher standard of living in the United States are ultimately achieved by increasing the productivity of U.S. workers. Increased productivity requires investment, which is funded by saving. Investment is comprised of both physical investment--such as purchases of plant, machinery, and equipment--and investment in human capital--such as education and research. It is greater savings and investment and productivity that gives businesses improved capabilities to produce goods and services, at relatively lower costs, that are demanded in foreign markets.

Businesses must not only contend with making fundamental economic decisions concerning what investments to make, how to finance those investments, what workers to hire, what products and services to produce, where to locate production and distribution, and what markets to enter, but also how to deal with taxes imposed on their activities. Tax revenue must be raised somehow by the government, but the goal should be to raise revenue in a manner that imposes the fewest and smallest distortions on fundamental economic behavior. Taxes that discourage saving and investment, distort the types of investments that are made, and that cause resources to be wasted on tax administration, compliance, and avoidance activities, reduce the rate of growth of the economy and living standards and hinder the international competitiveness of businesses if these tax burdens are greater than in other countries.

When compared to our primary economic competitors, such as countries in the OECD, the United States has a relatively high corporate income tax rate and, unlike most of these competitors, does not provide relief for the double taxation of corporate income.[2] The U.S. corporate income tax rate is 35 percent while the average corporate income tax rate for OECD member countries is about 30 percent.[3] Moreover, the United States is one of only three OECD member countries that does not have provisions in its tax code for some relief from the double layer of taxation of corporate dividends.[4] Coupled with individual income tax rates (which, after last year=s tax cut, currently range from 27 to 38.6 percent for most shareholders), the overall marginal tax rate on distributed corporate income can easily be over 60 percent. Even if corporate earnings are retained but ultimately dispersed to shareholders through the redemption of stocks that give rise to capital gains, which are typically taxed at a 20 percent rate in the personal income tax, the tax bite on the return from investment in corporate capital is still quite sizable.

These features of the U.S. corporate income tax come at an economic cost. Most importantly, high marginal tax rates discourage saving and investing in corporate capital. Moreover, because dividends are not tax deductible while interest on debt is deductible, corporations are encouraged to finance their activities through debt or retained earnings and discouraged from distributing dividends. [5] These distortions of corporate investment and financial policy reduce productivity and economic growth in the United States. Moreover, higher taxes in the United States on the returns to corporate capital also inhibit the competitiveness of U.S.-based companies in foreign markets. As financial markets become more global, U.S. investors may tend to be more willing to invest in foreign-based rather than U.S.-based companies. Mergers may be more likely to be set up as a foreign acquisition of a U.S. corporation. Transactions where a foreign subsidiary acquires a U.S.-based parent company may become more frequent. The high rates of taxation on the return from corporate investment can tend to make the United States a relatively unbecoming location for the headquarters of a multinational corporation, which can, in turn, cause U.S. multinationals share in the global market to shrink and the promotion of U.S. exports to decline.

Following the WTO=s adverse ruling, some people have suggested that the Congress should simply repeal the ETI regime and be done with the matter. It has been argued that the revenue gain from repeal of the ETI would help improve the federal deficit, and that repeal of the ETI regime would help show that the United States supports free trade principles. Others have proposed that the revenue gained from repeal of the ETI structure could be used to cut other components of the corporate income tax, such as reducing or phasing-out the corporate alternative minimum tax (AMT). While eliminating or reducing the AMT--especially as many businesses are currently still trying to recover from the recent economic slowdown--would be a laudable achievement within the current framework of the corporate income tax system, it still is only a step in addressing the problem of hefty corporate tax burdens for U.S. firms relative to their competitors, and does not fully address the competitiveness issues for U.S. companies that initially led to the creation of the EGI and similar regimes.

A much more fundamental change that would address the U.S. corporate tax burden and competitiveness directly while still maintaining the basic structure of the current corporate tax system would involve: 1) reducing the U.S. corporate tax rate commensurate with the corporate tax rate(s) of U.S. competitors, and 2) provide relief from the double taxation of dividends. Both of these changes would increase corporate investment and productivity in the United States, and put the taxation of U.S. corporations more on par with its primary economic competitors, thus increasing the competitiveness of U.S.-based firms and reducing the pressures for an ETI-like regime that is viewed by the WTO and other countries as a corporate subsidy and a hindrance to free trade.

Reducing the U.S. corporate income tax rate from 35 percent to 30 percent, for example, would remove all or much of the difference in corporate rates between the United States and other OECD countries and increase U.S. investment and productivity. A decrease of this magnitude is not unprecedented. The Tax Reform Act of 1986 reduced the U.S. corporate income tax rate from 46 to 34 percent. Moreover, corporate tax rates in OECD countries have decreased, on average, about 11 percentage points over the past 15 years--from about 41 percent to almost 30 percent.[6] These reductions in corporate tax rates in other countries have increasingly tested the competitiveness of U.S. companies and will likely provide ongoing temptation for companies to headquarter outside of the United States.

There are several different methods in which relief could be provided for the double taxation of corporate dividends in the United States. One would provide a shareholder credit for corporate taxes paid. When a corporate shareholder receives a taxable dividend, the shareholder would be entitled to a credit against their taxes for the corporate taxes effectively paid on the dividend income. Most countries that have tax relief for double taxation of dividends use a form of the shareholder credit. However, the Treasury Department advised against this approach in a 1992 report because of the complexity of actually implementing the shareholder credit.[7] In its report, Treasury recommended instead that dividend tax relief could be better implemented if a shareholder was allowed to exclude from gross income the dividends received from a corporation. I concur with Treasury=s assessment that this dividend exclusion framework is simpler than a shareholder credit, and could be implemented with little structural change to the tax code.[8].

Both of these tax changes would reduce revenue collected by the federal government. Because both lowering the corporate income tax rate and removing the double taxation of dividends would reduce the cost of capital to corporations and spur investment, which in turn would tend to increase GDP, the official score of the lost revenues from these changes would likely be greater than the actual revenue reduction. Nevertheless, some additional revenues would have to be raised, or spending reduced, in order for these corporate tax changes to be budget neutral. A good general principle for revenue-neutral tax reform is often Abroaden the base and lower the rate.@ Since a corporate tax rate reduction is what is being proposed here, then this principle would suggest that some broadening of the corporate tax base should be considered. On the spending side, government subsidies to corporations should probably be considered first but other spending should also be put up to scrutiny. Indeed, the degree to which the corporate tax rate can be reduced and the degree to which dividends can be excluded would seem to almost certainly depend on the willingness of the Congress to undertake some of these more unpopular measures.

A much more substantial tax reform would be to completely replace the corporation income tax with a consumption tax such as a national sales tax or a value-added tax (VAT). A sales tax would be imposed and collected on sales to final, or end-use, consumers, and would likely be similar to the broad-based sales tax levied many state governments. The more likely method that would be used to implement a VAT would be a credit-invoice VAT. In a credit-invoice VAT, the tax is applied to gross sales by firms and credits for previously paid taxes on gross purchases are allowed. While probably more difficult to implement than the changes to the corporate income tax suggested above, replacing the corporate income tax with a consumption tax would remove a large portion of the distortionary tax burden on capital formation in the United States.[9] The lower cost of capital would increase investment, improve productivity, and enhance the competitiveness of U.S. firms in foreign markets. Moreover, the sales tax rate or VAT rate could be set such that the revenue expected to be lost from the corporate income tax was made up by the revenue expected to be generated by the consumption tax.[10]

Some have argued that the distributional impacts of this type of tax change would be a shift in the tax burden from corporations to consumers. However, this argument typically only reflects the statutory, or legal, incidence of the corporate tax and a consumption tax. From an economic perspective, an important principle is that only individuals ultimately bear the incidence of taxes. Moreover, all individuals are consumers, while at the same time, most individuals also are workers and/or capital owners. Furthermore, the economic incidence of the corporate income tax is still a contested issue in the economics profession. Although the corporate income tax has traditionally been thought to ultimately be born by capital owners, more recent analysis has suggested that labor may bear some of the corporate income tax burden or even more of the tax burden than capital owners. Thus, the actual distributional effects of switching from the corporate tax to a consumption tax would be much more complicated than this simple argument suggests and would depend importantly on the initial assumptions about the incidence of the corporate income tax. That said, the Apolitical incidence@ of this type of tax reform would almost certainly be argued by opponents of this type of reform along the lines of Ait is a tax cut for rich corporations financed by tax hikes on poor consumers,@ and that argument may very well win the political debate.

An alternative to replacing just the corporate income tax with sales tax or VAT--that may be more politically viable--would be to fundamentally change the entire income tax system. Both the corporate income tax and the personal income tax could be replaced with a flat tax or with a variant of the flat tax, which I support, that has been proposed by well-known tax economist David Bradford of Princeton University.[11] Bradford’s proposal, which he calls the X tax, is a two-component system comprised of a business tax that would replace the corporate income tax and a compensation tax that would replace the individual income tax. All businesses pay tax at a flat rate on a base consisting of the receipt from all sales, including sales from inventories and sales of existing assets, less the outlays for purchases from other businesses. This part is similar to a VAT and essentially allows complete expensing for all investment. In addition, businesses deduct all payments to workers. Workers pay tax on the amount received from businesses. Total compensation can be taxed progressively, if desired, with an earned income credit for low-compensation tapayers, and successively higher rates starting at zero on higher levels of compensation. To avoid income shifting, the top rate of the compensation tax should be the same as the business tax rate. No other income, such as interest, dividends, rent, and capital gains, is include in the compensation tax base. Thus, normal returns to capital are not taxed at either the business or individual level. With regard to distributional concerns, the tax burden on workers is adjusted according to their earnings.[12] Within the context of the international economy, it would still have to be determined whether the X tax would be a destination-based system or an origin-based system in its treatment of cross-border transactions--there are pluses and minuses associated with either treatment.

Although this approach goes well beyond what to do in the near term regarding the ETI regime, this type of fundamental tax reform, in my opinion, holds the most promise for ultimately making U.S. businesses more competitive by putting them in a tax environment that promotes saving and investment and that ultimately leads to higher productivity. However, a tax reform of this magnitude would not be easy to enact, even if it is worthwhile. One of the potentially toughest issues in fundamental tax reform is the transition from the old tax system to the new tax system. In particular, there is a sort of free-rider problem that would tend to arise. Whereas a majority may agree that the new tax system would be a better overall system, many groups would want to keep their favorite tax preference from the old tax system. However, if most or all of those tax preferences in the old income tax system are then incorporated into the new consumption-based tax system then many of the advantages of the tax reform become diluted.

Notes

[1] I am testifying on my own behalf and not as a representative of AEI.

[2] Dividend payments are not deductible in the corporate income tax and thus are included in the taxable incomes of corporations. The second layer of taxation arises because dividends are also included in the taxable income of shareholders facing the personal income tax. (This second layer of taxes on dividends can be avoided only if the shareholder is tax-exempt, such as a non-profit organization, although personal tax payments are delayed until withdrawal if the dividends go to shares held in a tax-preferred retirement or insurance arrangement, such as a 401(k) or other pension plan, an IRA, or variable annuity.)

[3] For example, the corporate income tax rate is 25 percent in Germany, 27 percent in Canada, 28 percent in Sweden, and 30 percent in the U.K. and Japan. These figures are for 2001 and are from the American Council for Capital Formation, AThe Role of Federal Tax Policy and Regulatory Reform in Promoting Economic Recovery and Long-Term Growth@ (November 2001).

[4] The Netherlands and Switzerland are the other two OECD countries that do not have some method for reducing the double taxation of corporate dividends. Most OECD countries relieve some of the double taxation of corporate dividends through a credit, exemption, or lower tax rate for dividend income in the personal income tax on shareholders.

[5] In the wake of the Enron debacle, renowned financial economist Jeremy Siegel, a professor in the Wharton Business School at the University of Pennsylvania, noted that it is the corporate tax codes discouragement of dividend payments that helped allow the misinformation about the financial position of Enron to be accepted by its shareholders. If shareholders expected companies to pay dividends then companies that were in financial trouble would be more easily identifiable because it is would be difficult for them to pay dividends. (ADividends, Not Growth, Is Wave of Future,@ The Wall Street Journal, 08/21/2001.)

[6] These figures are from the American Council for Capital Formation, AThe Role of Federal Tax Policy and Regulatory Reform in Promoting Economic Recovery and Long-Term Growth@ (November 2001).

[7] Department of the Treasury, AIntegration of the Individual and Corporate Tax Systems: Taxing Business Income Once@ (January 1992).

[8] Indeed, for about a decade prior to its repeal in the Tax Reform Act of 1986, taxpayers were permitted a limited exclusion of dividends from gross income in the personal income tax.

[9] I am assuming in this scenario that the individual income tax is unchanged and capital income is still taxed at the personal level.

[10] An official Astatic@ score of this tax change would not account for the increase in GDP resulting from the higher investment and productivity that would stem from the lower tax burden on capital. If a static tax score was used then the consumption tax rate might be set higher than what actually ends up being necessary to generate the same revenue. If that ends up being the case, then consumption tax rate could be adjusted down after an increase in revenue becomes evident.

[11] David Bradford, AUntangling the Income Tax@ (1986) and ABlueprints for International Tax Reform@ (2001).

[12] This very brief thumbnail sketch of the X tax does not elaborate on many of the other problems in the existing tax system that this type of tax reform would address.

Eric M. Engen is a resident scholar at the American Enterprise Institute.