A Brief Guide to U.S. Corporate Tax Reform

Executive Summary

The U.S. Congress is back in session this week, and corporate tax reform is reportedly among the top items on the agenda. Of course, that doesn’t mean it’s likely to happen. While nearly everyone agrees reform is needed, individual aspects of the tax code often benefit specific companies and industries, which makes passing legislation difficult. Nonetheless, many experts agree in principle on some of the major problems with the U.S. corporate tax code, and even to some degree on how it could be improved.

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The U.S. Congress is back in session this week, and corporate tax reform is reportedly among the top items on the agenda. Of course, that doesn’t mean it’s likely to happen. While nearly everyone agrees reform is needed, individual aspects of the tax code often benefit specific companies and industries, which makes passing legislation difficult. Nonetheless, many experts agree in principle on some of the major problems with the U.S. corporate tax code, and even to some degree on how it could be improved. Here are the major issues, from how the system works today, to what reform might look like. 

How does the U.S. tax corporations?

The U.S. federal government taxes corporate profits at rates starting at 15% and rising to 35%, with most corporate income eligible for the top rate. Additionally, 44 U.S. states levy their own corporate taxes. Unlike most countries, the U.S. requires American multinationals to pay taxes on profits made abroad. But there are complications: only certain types of companies are eligible for these taxes, those foreign profits aren’t taxed immediately, and there are lots of loopholes. 

What’s wrong with the current system?

How much time do you have? Even in an era of bitter partisanship, there’s consensus that the U.S. corporate tax code has a lot of problems. The maximum U.S. corporate tax rate of 35% is considerably higher than the OECD average. Yet despite the high rate, the U.S. collects less in corporate taxes, relative to GDP, than the OECD average.

Several things explain this contradiction. First, the U.S. offers lots of tax credits and exemptions that lower the amount that companies owe. Second, taxes on the overseas profits of foreign subsidiaries don’t have to be paid until the firm “repatriates” them – meaning when it brings them back to the U.S. to pay out dividends — and so lots of firms end up amassing large cash reserves overseas in order to avoid paying taxes on overseas profits. Finally, the federal corporate tax system only applies to one type of corporate entity, the C Corporation. As a result, lots of firms are formed using alternative structures, like partnerships or S Corporations. These are known as “pass-through” or “flow-through” organizations because they don’t pay corporate taxes; instead, their profits flow directly to the owners, who are then taxed under the individual tax code.

Why does this matter?

First and foremost, corporate taxes are important because they help pay for government services. While they don’t account for as much U.S. tax revenue as they once did, they remain one of the central ways the government raises funds. According to the Tax Policy Center, “The corporate income tax is the third largest source of federal revenue, after the individual income tax and payroll taxes.”

Moreover, reforming the corporate tax code might improve economic growth. Although in general low taxes do not necessarily increase growth, corporate taxes are considered “the most harmful type of tax for economic growth”, according to the OECD. And research has found that decreases in the corporate tax rate spur investment, which in the U.S. has been surprisingly low in recent years. The inefficiency of the current system presents the opportunity to potentially increase growth while raising the same amount of tax revenue.

Who pays, and how much?

Even though the U.S. “statutory rate” on corporate profits – the rate written in law – is 35%, the “effective rate” – the amount companies actually pay – is far lower. The effective rate companies pay is just over 27%, near the OECD average. However, that number obscures considerable variability between companies. A significant minority of U.S. companies pay below 20%, including many firms in the S&P 500. Some U.S. multinationals like GE have managed to pay less than nothing some years in federal corporate income taxes.

One reason companies pay less than the statutory rate is tax expenditures — tax credits or other exemptions. The point of these is supposed to be to incentivize some sort of behavior, like investment in new machinery or R&D, or even the creation of new industries like wind power. But in 2014 the total cost of corporate tax expenditures was $154.4 billion, meaning that’s how much revenue was not collected as a result of various exemptions and credits. For comparison, corporate taxes raised $343.8 billion in 2015, so the revenue lost to tax expenditures is significant.

The largest corporate tax expenditure is the deferral of taxation on profits earned by foreign subsidiaries – about half the total cost of corporate tax expenditures comes from just that one. (For a list of other significant corporate tax expenditures, try here or here.) So, the primary way that multinationals in particular lower their tax burden is by keeping profits “offshore” to avoid paying taxes. This isn’t just about opting not to repatriate foreign profits; research shows that firms make choices about which subsidiary should own intellectual property based in part on local tax rates. For instance, “Apple’s accountants have found legal ways to allocate about 70% of its profits overseas, where tax rates are often much lower,” according to The New York Times.

And the share of firms to which any of this applies has decreased. In 1985, roughly half of companies were structured as C Corporations, meaning they were required to pay corporate taxes. Today, fewer than 20% of firms are C Corporations, meaning that the rest – representing half of business profits in the U.S. – are flow-through entities not eligible for corporate taxes.

But when companies do pay taxes on their profits, where does the money come from? In other words, who would get those profits if they weren’t paid in taxes? Shareholders? Workers? Customers? This is the question of tax “incidence,” and in the case of corporate taxes there’s no real consensus. You can read an overview on this debate here, and the upshot is that at least some portion of corporate taxes come out of workers’ paychecks.

What should corporate tax reform look like?

There are lots of ideas, many of them conflicting. In 2012, Mihir Desai of HBS laid out his vision here at HBR. And earlier this year he commented on the Trump administration’s early framework for reform, as well as Speaker Paul Ryan’s border tax proposal. Eric Toder and Alan Viard have also argued that we need to tax shareholders more and companies less. Toder has explained that tax reform cannot be cover for another tax cut. And Kimberly Clausing explained why the corporate tax is indispensable.

Perhaps the most popular phrase in corporate tax reform is “lower rates, broaden the base.” That means lowering the top statutory rate from 35% while eliminating some expenditures. Economists tend to favor such a shift, but behind every exemption and credit is a lobbyist fiercely fighting for it to stay.

Another popular idea is to no longer allow businesses to deduct interest payments when calculating their tax liability. The thinking is that creates an incentive for businesses to fund themselves using debt rather than equity.

One of the toughest questions in corporate tax reform is how to treat foreign income. The U.S. is unusual in its approach of fully taxing profits of U.S. companies made overseas, and some reformers argue for a territorial system that doesn’t tax profits made abroad. But on its own, such a change would do little to address one of the major reasons for reform: that many U.S. companies pay so little in taxes by holding cash offshore. And while there are periodic calls for a repatriation “holiday” in which U.S. companies could bring home foreign profits and pay a lower rate, research on the last such holiday in 2005 showed most of the money went to shareholders, not new investment.

Despite the complexity, there remains considerable common ground among economists and policy experts on corporate tax reform. The politics are less hopeful. In theory, as Toder writes, tax reform should be bipartisan. In practice, don’t hold your breath.

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