David Joy: The need for corporate tax reform

Except for Subchapter S corporations, whose profits are taxed at individual rates, the recent deal to avert the fiscal cliff left the issue of corporate tax reform unaddressed. The issues of fairness, simplicity and competitiveness continue to be debated, but so far with little progress.

The combined statutory corporate income tax rate in the U.S. is now the highest in the world at 39.1%, including the 35.0% federal rate along with state and local taxes. By comparison, according to the Organization for Economic Cooperation and Development (OECD), the combined rate in Germany is 30.2%; in the U.K. it is 24.0%, in France 34.4, and in Japan 37.0. According to the Congressional Research Service, the GDP-weighted average statutory rate among the world's next fourteen largest countries after the U.S. was 30.7% in 2010.

However, after certain deductions the actual, or effective rate paid on corporate income in the United States is significantly lower. A 2008 study cited by the CRS estimated those rates to be 27.1% in the U.S., almost identical to the 27.2% average of the next fourteen largest nations.

An additional measure, the effective marginal rate on investment (including transfer taxes) — which perhaps more accurately reflects the effect of taxes on the long-term capital spending decisions of multi-national corporations — was estimated by the Cato Institute in 2010 to be 34.6% in the U.S., compared to a weighted-average of 26.3% in the next fourteen largest countries. A 2012 update pegged the U.S. rate at 35.6% and the OECD average, excluding the U.S., at 24%.

It is this effective marginal rate differential that is most often cited as evidence of the uncompetitive nature of the U.S. corporate tax code. As a worldwide, rather than territorial tax system, it taxes overseas profits at the higher U.S. rate, rather than the oftentimes lower local rate. As a result, it encourages postponing taxation through the parking of earnings offshore. Such earnings are now estimated to total $1.7 trillion. It also discourages investment in the U.S., and encourages the transfer of earnings to low tax havens offshore. According to the Business Roundtable, each of the other seven of the G-8 countries uses a territorial system.

But whether competitiveness versus other taxing entities should be an objective of reform is disputed by some, who argue that economic efficiency should be the primary objective.

There is also a push internationally to coordinate tax policy to prevent tax competition that encourages earnings transfers. The Financial Times reports that next month, the OECD will present a report on international taxation at the G-20 meeting in Russia, designed to lay the groundwork for tightening rules on shifting profits to lower tax locales. 

In the U.S. there is general agreement that the tax code needs revising, but there is little agreement on exactly how to do it. Most would like to see the statutory rate reduced, with the lost revenue offset by a reduction in tax expenditures, within an overall objective of revenue neutrality.

The Obama Administration has proposed reducing the federal statutory tax rate to 28%, while eliminating certain tax expenditures, including incentives for oil, gas and coal production. It also proposes to tax subsidiaries of U.S. corporations operating abroad at a minimum rate on foreign earnings. And, in addition, it proposes to tax carried interest at ordinary rates, deny deductions related to the expense of moving businesses offshore, and give credits for moving operations onshore. The administration also supports international efforts to discourage transfers to lower tax regimes.

The Simpson-Bowles Commission also recommended a reduction in the rate to 28%, but goes further in recommending the elimination of most tax expenditures, and transitioning to a territorial international tax system.    

Simplicity, efficiency, fairness, and no worse than revenue neutrality should all be objectives of corporate tax reform. Ideally, reforms must also be permanent. Certainty is a prerequisite when making long-term investment decisions. Knowing the rules will give corporations the confidence to resume making the capital investments that have recently slowed.

Corporate tax reform will not be easy. Competing interests will lobby hard to retain favored provisions in the code. We saw plenty of that in the last round of tax squabbling to avoid the fiscal cliff.

And whether anything meaningful can be accomplished on deficit reduction as part of the tax reform process is uncertain. The president has said that future spending cuts must be accompanied by new tax revenue. Senate Minority Leader McConnell says the tax debate is over.

The looming deadline on the national debt is shaping up as a line in the sand over the fight to close the deficit. Republicans insist that any increase in the debt ceiling must be accompanied by an equal amount of spending cuts. The president has said he will not negotiate over the need to raise the debt ceiling, setting up a showdown.

This debate will intensify in the days ahead. Not only is the debt ceiling limit fast approaching sometime in late February, but so is the postponed effective date for the sequestered spending cuts on March 1. The ride is likely to get bumpy.

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