Thursday, June 12, 2014

Slashing the corporate tax rate is a no-brainer

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.


Unknown said...

I suspect eliminating the corporate income tax altogether would encourage many S-Corp owners to become C-corp owners (I know I would) in order to reduce their tax liability. In other words, personal income tax receipts would decline because many of us small business owners would be paying a lot less.

William said...

Corporate taxes should be made fair for all corporation by eliminating all loopholes and all corporate welfare. By whatever amount closing the loopholes generates in federal revenue, then the corporate tax rate could be lowered.

Personally, I think it is a huge privileged to be a citizen of the USA and also to be a corporate citizen. The Supreme Court ruled as far back as the 1930s that corporations have all the rights and benefits of "persons". I believe that corporations should therefore had all the responsibilities of "persons" and should pay their fair share of federal taxes for the privilege of operating in this country.

As Warren Buffet said recently at the Berkshire Hathaway annual meeting: "we are happy to pay US taxes because we could not have built B.H. in any other country".

Benjamin Cole said...

Because they are too complicated--and thus inherently unfair---I say eliminate all corporate taxes, also on dividends. This would also encourage equity formation, not debt.
A national consumption tax, such as a simple sales tax, and a stiff gasoline tax, make sense.
But who really designed such an infernally complicated tax code? I suspect corporate lawyers and accountants and lobbyists.
It wasn't me.

Anonymous said...

The IRC (Internal Revenue Code) is an edifice to the greatest corruption human kind has ever devised.

Person income tax must go too. Just think, then we can do away with the Nazi IRS.

If you think you are protected from the IRS because you are a lefty, you don't know anything.

steve said...

discussion of any draconian change to tax code so hypothetical as to be laughable. that said, I would like to see elimination of entire code replaced by NO deduction NO credit code that is slightly progressive but considerably lower in marginal rates. add a national sales tax of maybe 10% or so with exemptions for low priced food/clothing. eliminate corp tax but tax CG same as ordinary income. absolutely no incentives for tax bs moves. if CG tax were say 15-18% there is no way it would reduce incentive for risk taking. of course, all the accountants would have to get new jobs...

randy said...

Paul is right - any material difference in tax rates for corporations and individuals would result in organizing so that you can accumulate income in a way to pay the least taxes. That's the problem with significantly lower corporate tax rates.

Benjamin has the only practical solution - a consumption tax with a very high prebate. To be realistic, probably combined with keeping a tax on un-earned income.

Steve is right - it will never happen.

Anonymous said...

Suppose all those S Corps did reorganize as C Corps to avoid income taxes. This would further economic stimulus. Steve says taxing capital gains at ordinary income is the way to go and I agree.

But salaries to the children and relatives of the main owners of the S will need to be taxed as distributions. And the loans to same need to be taxes as distributions also.

Lawyer in NJ said...

There are two reasons for a heavy tax burden: 1) entitlements; and 2) the military industrial complex.

Each as their patrons and constituencies, a mirror image of the two major political parties.

Until and unless they are both addressed, a suboptimal tax burden will be imposed.

Probably longer than any of us will live.

Benjamin Cole said...

Lawyer-- Right on.

Anonymous said...

On further thought, the first best thing to do is eliminate in its entirely the payroll tax.

Means test SS and Medicare.

For now I would say SS and Medicare stops for anyone making $50,001 per year including all sources including SS and Medicare.

If that isn't enough then means test wealth. Say starting at $3,000,000.

Frederick W.H Collins said...

Changing from an S-Corp to a C-Corp would not be a benefit.
1. S-Corps need to pay the owners a salary the same as C-Corps.
2. Distributions from S-Corps avoid corporate taxes, but are taxed to the recipient at their tax rate.
3. Distributions from C-Corps are dividends from taxed profit that are taxable to the recipient as well.
Ergo, no benefit for making a change.

Jim and Linda Kelley said...

Yes,abandon the corporate tax,but companies will have to pick up the full cost of labor now paid in part by the government. Particularly the costs of growing the labor from age 0-20 years and retiring the labor from age 70-90 years. This will be difficult due to unfunded mandates like advanced education. The minimum wage discussion will heat up.