Key Points
- U.S. statutory corporate tax rates are higher than other developed countries and based on worldwide income instead of domestic income.
- Corporate tax reform can address both domestic inefficiencies such as debt structure and international inefficiencies such as the lockout effect, corporate inversions and income shifting.
- More ambitious reforms may eliminate more inefficiencies. However, more research is needed to study their impact on revenue, the distribution of income, administrative costs and the response of other nations.
The Economics of Corporate and Business Tax Reform
Editor’s Note: This article is part of a series of tax-related articles sponsored by the Penn Wharton Budget Model and the Robert D. Burch Center at Berkeley. All of the articles in this series are forthcoming in a book by Oxford University Press, co-edited by Alan Auerbach and Kent Smetters.
The Economics of Corporate and Business Tax Reform examines three types of proposals to reform U.S. business taxes. The paper addresses both international and domestic reforms to businesses taxes within a single framework by examining their impact on efficiency. Dhammika Dharmapala (2016) finds that a destination-based consumption tax would correct for all of the sources of inefficiencies he identifies. However, this type of corporate tax reform is large in scope and may have significant costs. In addition, the reaction of foreign governments may have an impact on corporate tax policy reform outcomes.
The types of tax reforms discussed by Dharmapala (2016) are relevant to current policy discussion in Washington DC. For instance, in June of 2016 the House GOP released a tax plan that proposes to convert to a destination-based tax system in which only income from sales to US consumers are taxable and lower corporate tax rates. President-elect Donald Trump also proposes to lower corporate tax rates and allow for a one-time repatriation of corporate profits at a tax rate of 10 percent.
U.S. Corporate Taxes Compared to Other Countries
The U.S. business tax system is different from other countries in two main ways. First, the U.S. is the only G-7 country and one of only eight Organization for Economic Co-operation and Development (OECD) countries to tax businesses on their worldwide income. The other OECD and G-7 countries use a territorial tax system based solely on domestic income rather than both domestic and foreign income. Second, the U.S. statutory corporate tax rate is higher than all other OECD countries. In 2016, the U.S. combined federal and state corporate tax rate was 38.92, while the OECD average was 24.66. The lack of tax coordination with other countries may cause businesses to misallocate resources.
Economic Inefficiencies Caused by Corporate Taxes
Dharmapala (2016) identifies several types of economic inefficiencies that arise because of current U.S. business tax policy. These distortions impact both international and domestic activity.
First, when businesses do not repatriate profits from foreign affiliates it is known as lockout. Figure 1 illustrates the incentive for U.S. companies to leave profits as cash with foreign affiliates. Dharmapala (2016) finds that a 10 percentage point difference in corporate tax rates leads to an 8 percent difference in foreign income reported.
Figure 1: A Simple Characterization of the U.S. International Tax Regime
Source: Dharmapala (2016)
Second, tax policy also affects the location of business. A corporate inversion occurs when a business is relocated to a low-tax country while not altering business operations. Income shifting occurs when income is shifted to an affiliate in a low tax country. In 2014, the top four countries by profits of foreign affiliates were Netherlands, Luxembourg, Ireland and Bermuda. Meanwhile, the top four countries by employment of foreign affiliates were China, United Kingdom, Mexico and Canada. Businesses also choose what country to hold their intellectual property in.
Third, the U.S. tax code also affects domestic decisions such as how businesses are incorporated (C corporation or pass-through corporation). Tax policy may have an impact on asset ownership, corporate control, portfolio investments, and debt structure. For instance, Dharmapala (2016) finds that a 10 percentage point change in the corporate tax rate reduces the debt-to-asset ratio by 2.8 percentage points.
Three Types of Potential Reforms to U.S. Corporate Taxes
Dharmapala (2016) lists the impact of several potential reforms on economic efficiency.
1) Lower Corporate Tax Rates and Shift to Territorial Tax Regime
One type of reform to U.S. corporate taxes is to lower the corporate tax rate in combination with a shift to a territorial regime. Shifting to a territorial regime means that dividends paid by foreign affiliates to U.S. parent companies would be exempt from tax. The Hatch Report is an example of this type of corporate tax reform proposal.
Different proposals currently being discussed in DC lower the corporate tax rate by different amounts. For instance the plan proposed by the House GOP in June of 2016 reduces the corporate rate to 20 percent, and caps at 25 percent the rate on profits of pass-through businesses (such as sole proprietorships and partnerships) that are taxed under the individual income tax. Meanwhile President-elect Donald Trump proposes to reduce the corporate rate to 15 percent and allow owners of pass-through businesses to choose to pay a flat tax rate of 15 percent rather than the regular individual income tax rates.
A shift to a territorial regime can address the lock out of profits from foreign affiliates. Exempting dividends paid by foreign affiliates would remove the incentive to hold profits abroad. The UK and Japan experienced higher repatriations when they converted to a territorial regime. In addition, investment by their foreign affiliates declined, which indicates that they were engaging in inefficient investments. The implication is that the UK and Japan saw some benefits from their shift to a territorial tax system.
More research is needed to determine the impact of this reform on income shifting. On the one hand, lower corporate tax rates weaken the incentive to shift income to countries with lower taxes. On the other hand, a territorial regime may strengthen the incentive to shift income.
Reducing corporate tax rates could lower distortions to organization form, debt structure, and cash retention. The size of the impact on these distortions will depend by how much corporate tax rates are reduced.
Some tax reform proposals of this type include a one-time repatriation allowance at a tax rate less than the pre-reform statutory tax rates on cash holdings by foreign affiliates. A one-time allowance may generate revenue for the federal government. However, the efficiency gains of a one-time policy may not be realized if businesses believe the policy will be repeated.
Other tax reform proposals of this type include a minimum tax on foreign income. There are tradeoffs on setting the minimum tax high or low. Dharampala (2016) finds that a high tax will reduce some types of income shifting, but possibly reduce U.S. economic activity. A low tax will not reduce income shifting and possibly raise U.S. tax revenue. However, economic inefficiencies that arise due to the costs of tax planning will still be in place.
In sum, Dharmapala (2016) shows that lowering corporate tax rates and shifting to a territorial tax regime reduces the lock-out effect. However, some inefficiencies remain.
2) Formula Apportionment System
The current U.S. tax code requires separate accounting for each affiliate. Under a formula apportionment system, accounting would be consolidated worldwide. Income would be allocated according to a formula such as the fraction of worldwide sales in a given country.
Formula apportionment eliminates several inefficiencies such as income shifting, repatriation, lockout effect, and ownership distortions. These inefficiencies arise in the current system because tax is determined by the taxpayer’s residence and the source of income. With formula apportionment tax is determined by the location of the customer.
However, many domestic economic inefficiencies would remain with formula apportionment. In addition, it could create new types of inefficiencies by encouraging business to locate sales in low tax countries. In particular, businesses could shift routine in-house activities to low tax countries and acquire assets that produce income in low tax countries. Finally, formula apportionment may be problematic for a country to implement unilaterally. While moving to formula apportionment eliminates some current international inefficiencies, domestic inefficiencies remain and new ones may be created.
3) The Destination-based Cash Flow Tax and VAT-type Options
A destination-based Cash Flow Tax (DBCFT) or Value Added Tax (VAT)-type tax system would change the tax base from income to consumption. Tax would be levied on domestic cash receipts net of cash outlays, including outlays for investment (expensing) and wages. Cash receipts from exports or from foreign affiliates would not be included in the tax base. A DBCFT, paired with an individual tax on labor, would be equivalent to a subtraction method VAT combined with a deduction for payroll.
This type of tax reform would eliminate many inefficiencies in the current tax system. First, a DBCFT would eliminate distortions to decisions on the amount and location of investment. Second, borrowed funds and interest payments are treated symmetrically in a DBCFT, which eliminates inefficiencies caused by distortions to corporate debt structure. Third, there would be no inefficiencies due to income shifting, the lockout effect, ownership distortions and the misallocation of workers.
The ability of a DBCFT to eliminate some distortions will depend on the individual tax system it is paired with. For instance, there may still be inefficiencies due to the tax treatment of dividends, capital gains, and the treatment of income from pass-through businesses. Also, a DBCFT would present some administrative challenges, as no other country currently uses a DBCFT.
Conclusion
Policymakers both in the U.S. and internationally are interested in corporate tax reform. Dharmapala (2016) analyzes three types of reform proposals on the basis of their impact on economic inefficiencies. He finds that proposals with bigger, more fundamental reforms appear to eliminate more inefficiencies, but come with their own set of challenges. More research is needed on the impact of tax reform proposals on administrative costs, tax revenue, tax incidence and the distribution of income and wealth.
A discussion of this paper is provided by Rosanne Altshuler.