Japan and the United States share a dubious distinction: They both tax corporate income at remarkably high rates. In his skillful analysis of Japanese corporate taxation, Satoshi Sekiguchi has identified a variety of political and economic factors that have sustained high rates in postwar Japan, including the low share of national income accruing to labor and the relatively large share going to capital. That differential has given corporations a greater capacity to pay, while also fostering political interest in tax relief for individuals.
The story in the United States is not entirely dissimilar, but it differs in key ways. The persistence of high corporate tax rates in the United States is a function of three key factors: budgetary pressures, popular opinion, and sectoral divisions within the business community.
The Persistent Problem
The corporate income tax in the United States is like the weather: Everyone complains about it but no one does anything about it.1 For decades, American companies -- and their lobbyists -- have been complaining that the corporate tax regime is unfair and unwieldy, that its rates are too high and its compliance burden overwhelming, and that it slows economic growth and destroys American jobs.
Policy experts who like the idea of taxing business profits have also been critical of the American attempt to do so. Rampant tax avoidance has gutted this leaky levy, they say. U.S. statutory rates may be among the highest in the world, but the country's effective rates are far lower, at least for industries and corporations able to exploit loopholes and tax incentives.
Economists, meanwhile, have grown increasingly lukewarm about the corporate tax. Long cognizant of its shortcomings, they have redoubled their complaints that it curbs capital formation and encourages the misallocation of investment resources within the economy. Globalization has magnified these flaws, increasing capital mobility and raising competitive pressures on U.S. business.
The diverse chorus of complaints -- from politicians, interest groups, and academic experts -- has been growing louder in recent years, fostering a rare, if vague, consensus on the need for sweeping reform. In his 2011 State of the Union address, President Obama made the case nicely.
"Over the years, a parade of lobbyists has rigged the tax code to benefit particular companies and industries," Obama said. "Those with accountants or lawyers to work the system can end up paying no taxes at all. But all the rest are hit with one of the highest corporate tax rates in the world. It makes no sense, and it has to change."
That statement brought Congress to its feet. Who could disagree? Even business leaders -- especially business leaders -- have supported Obama's call for reform. But what might that reform actually look like? Despite different groups jockeying to harness the groundswell of pro-reform sentiment, the nature of reform has remained deeply uncertain.
As it has for years. Indeed, many of the most serious flaws of the corporate income tax have been obvious for decades. Calls for reform have been nearly constant, as has legislative tinkering. Yet the basic dysfunctions of the corporate income tax have remained more or less intact. In particular, the tax continues to suffer from a toxic, if predictable, combination of high rates and aggressive avoidance.
What's been standing in the way of real change?
The State of the System
Before trying to answer that question, let's ask another: What, exactly, is wrong with the corporate income tax?
The list is long, but it begins with the notion of double taxation. Under the federal income tax, corporate profits are already taxed at the individual level, either when distributed to shareholders (when dividends are included in personal income) or when stock changes hands (when retained profits are taxed as capital gains).2 By imposing yet another tax on profits at the level of the business entity, the corporate income tax reduces the return to investment in corporate activity. That, in turn, reduces the total amount of investment in the economy and encourages a misallocation of investment capital between corporate and noncorporate businesses.3
Inefficiency is bad enough when considered in isolation, but it's even more pernicious in a globalized economy in which capital and investment flow easily across borders. Over the last quarter century, competitiveness worries have dominated discussions of corporate tax reform, especially as statutory tax rates have fallen around the globe.
The top U.S. tax rate on corporate income is almost the highest in the world, second only to Japan's. And the Japanese have announced plans (currently on hold as a result of the March 2011 earthquake) to reduce their rate. Absent similar reform, it seems likely that the United States will soon lead the world in taxing corporate income. A dubious distinction, to be sure.
A high relative tax rate hinders U.S. competitiveness in the global marketplace. By limiting the after-tax returns of investment in U.S. plants, facilities, research, and development, the corporate tax makes it harder for the United States to attract and retain capital. The most obvious effect of this difficulty is an outmigration of jobs and investment to low-tax jurisdictions.4 In many respects, these problems are inherent in the conception and design of the U.S. corporate income tax. The very existence of the tax causes some of them, and its comparatively high rates cause many of the others.
But if the corporate tax is flawed in conception, it's also badly broken in operation. Compliance costs are hard to measure but certainly substantial. In 2005 the Government Accountability Office issued estimates pegging them at $40 billion to $85 billion annually.5
In 2010 General Electric paid no corporate income taxes, despite some $5.1 billion in domestic U.S. profits. But to accomplish that impressive feat of tax avoidance, the company had to file a 57,000-page tax return. The mind reels at the waste of human capital inherent in preparing such a return (not to mention the task of reviewing it once it's delivered to the IRS.)6
GE's tax return is only one (particularly egregious) example of a larger problem: the rise of aggressive tax avoidance. Over the past decade, the average effective tax rate of the nation's 20 most profitable companies has fallen by 5.5 percentage points, from 35.8 percent to 30.3 percent, according to one estimate.7 Over a longer time horizon, average effective tax rates have dropped even more: according to the Congressional Research Service, from a high of 55.8 percent in 1951 to 28.4 percent in 2010.8
The long-running decline in effective corporate tax rates derives partly from rate reduction, especially in the years leading up to 1986. Since then, the continuing decline has been driven by the tax code's favorable treatment of the foreign earnings of U.S. multinationals.9 Investment incentives have also played an important role. And sophisticated tax planning has been crucial. American corporations have become "world leaders in tax avoidance," according to Edward D. Kleinbard, a tax law professor and former chief of staff of the Joint Committee on Taxation.10
Search for Solutions
If the corporate income tax is so badly broken, why can't we get rid of it? Or at least make it less onerous? After all, the problems of the U.S. corporate income tax suggest their own remedies.
Efforts to eliminate double taxation usually go by the name of integration, a process that would eliminate (or ameliorate) the second level of tax on corporate profits. Techniques for achieving this integration are varied -- and generally complex. But they have been debated for years and are reasonably well understood by both experts and lawmakers.
Similarly, tax avoidance can be curbed through tighter enforcement, and over the years, lawmakers have repeatedly tried to crack down on aggressive avoidance techniques, including the proliferation of so-called tax shelters.
But not all avoidance is a result of legally dubious tax planning. Low effective rates are also a function of perfectly legal tax breaks -- incentives deliberately added to the tax code by willing lawmakers. If low effective tax rates are the problem, then elimination of tax preferences is part of the solution.
Perhaps the most promising approach to corporate tax reform, however, is also the simplest and most obvious: rate reduction. As my colleague Martin Sullivan has argued, lower rates would not solve every problem plaguing the corporate income tax, but they would mitigate almost all of them.11 Even absent other reforms, lower rates would lessen the adverse economic impact of double taxation and reduce incentives for avoidance. And if American companies competing in a global economy are truly hobbled by excessive tax burdens, then lower rates would make things better.
Impediments to Reform
But if rate cuts are the obvious solution, they are not easy to implement. The impediments to corporate tax reform -- especially when defined as rate reduction -- are numerous and powerful.
Over the years, budget constraints have made any sort of revenue-losing corporate tax reform a hard sell. The corporate tax yields far less now than it once did, both as a share of total federal revenue and as a percentage of GDP. But it's still a major source of money. In 2010 the tax raised $198 billion, or 8.9 percent of total revenue. That's a far cry from the 23.2 percent of total revenue that it provided in 1960, but it would still be hard to replace.12
If corporate tax reform in an era of austerity must be revenue neutral -- and not a net tax cut -- then low rates will come at a price. Specifically, corporations will have to sacrifice various incentives and tax preferences that now keep effective rates manageable. And since most of these incentives have clearly defined constituencies (as well as some genuine public benefits), repealing them will be difficult and possibly unwise.
Popular opinion has also been a complicating factor. Americans may not love taxes, corporate or otherwise, but their support for corporate tax reform has never been clear. In a March 2011 poll, for instance, 37 percent of respondents said taxes on corporations should go up, not down; 26 percent wanted to see them cut; and 32 percent wanted them to stay the same.13 Altogether, not exactly a ringing endorsement for sweeping reform -- or at least not in the form of rate reduction.
Earlier poll data suggest much the same thing. Americans have never been great fans of any tax, but when pressed to identify desirable ways of raising additional revenue, they have consistently cited corporate taxes as one of the best options. (Raising taxes on the rich, variously defined, has also enjoyed considerable support.)
Still, the survival of America's dysfunctional corporate tax stems not simply from budget pressures or the tax's (relative) popularity with voters. It also reflects the (surprising) weakness of its opponents. In particular, divisions within the business community have consistently obstructed efforts to reform the tax. The levy's uneven impact has made it hard to develop a coherent consensus for reform, at least among private sector lobbyists.14
Some industries face much higher effective tax rates than others.15 As a group, manufacturers have been particularly successful at reducing their tax burden through various preferences included in the law, including favorable depreciation rules and domestic manufacturing credits. Likewise, high-technology companies and pharmaceutical firms have also done well under the current regime, in part because they invest heavily in tax-advantaged research and development activities.
By contrast, financial firms and retailers have been less successful at finding relief from high statutory rates. Faced with a relative lack of tax preferences, they have pursued more generalized reform, including marginal rate reduction. But lacking support from the more successful tax avoiding industries, they have never met with much success.
The Modern History of Failure
Over the past 30 years, corporate tax reform has been a constant topic of political debate in the United States, but few would make a claim for real progress. Crackdowns on corporate tax shelters have enjoyed some success, but their capacity to slow the long-term erosion of the corporate tax remains uncertain. Efforts to ameliorate the double taxation of corporate income have also made headway, especially in 2003 when lawmakers sharply reduced shareholder-level taxes on distributed profits.
But ambitious efforts to recast the corporate income tax -- chiefly by lowering its rates -- have been a failure. This failure is best explained through the interaction of popular opinion and business disunity. With voters either hostile or indifferent to rate cuts, many industries and individual companies have focused instead on securing narrow preferences tailored to their own needs. They have also developed a sophisticated capacity to reduce effective rates without challenging politically popular statutory rates.
The practical success of such do-it-yourself tax reform has sapped political support for more fundamental change, at least within the community. And absent a unified community, lawmakers have been unwilling to act.
Ultimately, globalization may force change in the U.S. corporate income tax. But the timing of that change remains unclear. Absent some sort of crisis -- or a reduction in budgetary pressures that might make room for a revenue-losing solution -- the prospects for reform seem dim.
1 This metaphor is popular among observers of the corporate income tax. Daniel Shaviro uses it to open his recent fine analysis of the levy in "Decoding the U.S. Corporate Tax" (2009).
2 Under existing law, dividends are taxed at a special reduced rate of 15 percent, as are capital gains. This rate preference was enacted to help minimize double taxation.
3 The design of the corporate income tax, and its favorable treatment of interest expenses, also tends to distort corporate financial decisions, promoting a heavy reliance on debt, rather than equity, financing. The individual taxation of dividends, moreover, creates a tax incentive for corporations to retain rather than distribute earnings. On the inefficiencies created by the corporate tax, see Martin A. Sullivan, Corporate Tax Reform: Taxing Corporate Profits in the 21st Century 29-34 (2011).
4 As yet, however, the U.S. corporate tax regime does not seem to be causing American multinational corporations to flee to distant shores. See Eric J. Allen and Susan C. Morse, "Firm Incorporation Outside the U.S.: No Exodus Yet," Oct. 28, 2011, available at http://papers.ssrn.comsol3/papers.cfm?abstract_id-1950760.
5 GAO, "Summary of Estimates of the Costs of the Federal Tax System," Aug. 2005, 13, Doc 2005-19816, 2005 TNT 187-20.
6 On the size of GE's return, see John McCormack, "GE Filed 57,000-Page Tax Return, Paid No Taxes on $14 Billion in Profits," The Weekly Standard, Nov. 17, 2011, available at http://www.weeklystandard.com/blogs/ge-filed-57000-page-tax-return-paid-no-taxes-14-billion-profits_609137.html. On the company's lack of tax liability in 2010, see David Kocieniewski, "G.E.'s Strategies Let It Avoid Taxes Altogether," The New York Times, March 24, 2011, available at http://www.nytimes.com/2011/03/25/business/economy/25tax.html?pagewanted=all.
7 Martin A. Sullivan, "Let's Promote the Competitiveness of All American Businesses," Tax Notes, Dec. 5, 2011, p. 1175, Doc 2011-25091, or 2011 TNT 233-1.
8 Inconsistencies among estimates of effective tax rates reflect differing methods; there is no standard formula for calculating such rates. Some estimates find effective rates to be far lower than those quoted above. For instance, Citizens for Tax Justice recently estimated the average effective tax rate during 2009-2010 at 17.3 percent. See Citizens for Tax Justice and the Institute on Taxation and Economic Policy, "Corporate Taxpayers & Corporate Tax Dodgers 2008-10," Nov. 2011, Doc 2011-23066, 2011 TNT 213-26. In general, this paper relies on estimates by the CRS and Tax Analysts.
9 Mark P. Keightley, "Reasons for the Decline in Corporate Tax Revenues," CRS (Dec. 8, 2011), Doc 2011-25781, 2011 TNT 237-25. Inconsistencies in estimates of the effective corporate tax rates reflect differing methods.
10 David Kocieniewski, "U.S. Business Has High Tax Rates but Pays Less," The New York Times, May 2, 2011, available at http://www.nytimes.com/2011/05/03/business/economy/03rates.html?_r=1.
11 Sullivan makes a persuasive case for the myriad benefits of rate reduction in his recent book.
12 Office of Management and Budget, "Budget of the United States Government, Fiscal Year 2012: Historical Tables" (2011), tables 2.1 and 2.2.
13 CBS News/New York Times poll, Mar. 2011. Retrieved Dec. 6, 2011, from the iPOLL Databank, the Roper Center for Public Opinion Research, University of Connecticut; available at http://www.ropercenter.uconn.edu/data_access/ipoll/ipoll.html.
14 On the history of sectoral divisions within the business community and their impact on corporate tax reform, at least through the late 1980s, see Cathie J. Martin, Shifting the Burden: The Struggle Over Growth and Corporate Taxation (1991).
15 For a recent analysis, see Tax Notes, July 25, 2011, p. 330, Doc 2011-15854, or 2011 TNT 142-4.
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