Congress is beginning to understand that the key to a stronger economy is to give corporations a break from onerous tax burdens so that they can grow the economic pie, thus benefiting everyone. This is potentially a very big deal.
Rand Paul and Harry Reid are working on a deal to create a three-year corporate tax holiday, during which time corporations could repatriate foreign profits and only pay a 10% tax. That's a very positive step in the right direction, but it would be even better if Congress made the 10% permanent. Permanent changes to the tax code result in much more powerful and lasting changes to incentives. Slashing or even eliminating the corporate tax rate on a permanent basis would provide a powerful boost to economic growth.
At 35%, the U.S. corporate income tax rate is the highest of any developed country. The fact that corporations are refusing to repatriate trillions of dollars of overseas profits is proof that it is negatively impacting the economy. Overseas profits have already passed through the tax tollgate once, but to subject them to another 35% just for bringing them back to the states is unconscionable to any responsible corporate executive.
In an ideal world, corporate profits should not be taxed at all, since the burden of corporate taxes falls almost entirely on the customers and employees of corporations. In the end, only people pay taxes, and it's highly inefficient to tax businesses and individuals separately. Today, capital faces double and triple taxation: first on business profits, again when shareholders pay tax on dividends (paid out of after-tax profits) received, and again if and when capital gains are realized. Punitive tax burdens inhibit risk-taking and capital formation, and that in turn leads to slow growth.
And it's not just the level of the corporate tax rate that's debilitating, it's also the cost of calculating and complying with corporate taxes—which some estimate could actually exceed total corporate taxes paid. From an economy-wide perspective, The Mercatus Center last year estimated that "Americans face up to nearly $1 trillion annually in hidden tax-compliance costs, while the Treasury foregoes approximately $450 billion per year in unreported taxes." Fixing and rationalizing our tax code should be a top priority in these times of sluggish growth. Moreover, the distortions and opportunities for cronyism that our corporate tax code creates make things even worse. Getting rid of the corporate tax would instantly make subsidies and deductions a thing of the past, while turning lobbyists into an endangered species.
Thanks to the tremendous improvement in the federal government's fiscal situation in the past several years, now is a great time for Congress to consider slashing or even eliminating corporate taxes. We can absolutely afford to take the risk that cutting corporate taxes will boost the economy, resulting in little or no revenue loss within a relatively short time frame.
As the chart above shows, federal government spending has not increased at all for the past five years. That's a remarkable achievement, but it says more about congressional gridlock than about any conscious desire to limit spending. Meanwhile, tax revenues have been growing strongly for the past four and a half years, rising at an 8% annualized rate. That's mainly due to rising jobs, rising incomes, and rising profits, and only marginally due to higher income tax rates. Economic growth and some much-need fiscal austerity have essentially solved our deficit problem that just four years ago was thought to be intractable.
The five-year freeze in spending has had the beneficial effect of sharply reducing the size of government relative to the economy, as the red line in the chart above shows. Federal spending has fallen by one-fifth relative to GDP in the past five years, giving the private sector some much-needed breathing room. Meanwhile, tax revenues have risen by one-fifth, to over 17% of GDP from a low of 14.2%.
The net effect of these two developments has been to reduce the federal deficit by two-thirds, to just under 3% of GDP today. It's high time the federal government used its greatly improved finances to make an investment in corporate America by cutting or eliminating corporate taxes.
Corporate taxes represent about 10% of federal revenues currently ($296 billion in the year ending May), or about 1.7% of GDP. Personal income, social insurance, and retirement taxes account for almost all the rest of federal revenues. We could totally eliminate corporate taxes, and assuming no knock-on effects (i.e., no additional investment, no additional jobs, no increases in employee compensation), it would only increase the federal deficit from 3% to 4.7% of GDP—a mere drop in the bucket, and a level that wouldn't be unusual at all by historical standards.
But there would almost certainly be some very positive side-effects to slashing or eliminating corporate taxes. Investment would almost certainly rise, given the substantial increase in the after-tax rewards to risk-taking, as would the number of jobs and income. More jobs and more income would boost personal income, social insurance, sales, and retirement taxes. Economic growth would increase measurably, growing the economic pie for everyone. Corporations would save not only what they currently spend in taxes, but also their tax preparation and hidden compliance costs. The happy result of all this would be difficult to underestimate.
The Joint Committee on Taxation estimates that a tax holiday as proposed by Senators Rand Paul and Harry Reid would cost the government almost $100 billion over a decade, but that is a very short-sighted analysis that ignores the incentives that are keeping foreign profits offshore. I think Paul's estimate of a windfall of up to $60 billion in new revenues in three years makes more sense, and he's most likely severely underestimating the total positive impact.
The Congressional stars appear to be aligning, the budget is greatly improved, and the economy badly needs some genuine stimulus. It's time for Congress to do something smart for a change: cut or eliminate the onerous tax on capital, and watch the economy take off.