Now that the dust has settled a bit on President Obama’s proposal – really, a framework – to reform the corporate tax code, let’s see what all the shootin’s fer.
To understand what’s going on here, you need some context. For years, every tax reform conversation has gone like this:
Conservative: "Taxes are too high – they’re killing growth!"
Liberal: "No, they’re not; and anyway, we need the revenue to support the government!"
Lots of variations on "no, we don’t!" and "yes, we do!" … then:
Liberal: "Look, what if we lower tax rates and broaden the tax base by closing a bunch of loopholes – then you get the lower rates and I avoid losing revenue?"
Conservative: "Well … it is true that Ronnie Reagan himself agreed to something like that back in 1986 …. Of course, RR would be kicked out of the party as a centrist today, but … I might be able to agree to that."
Clearly, since this ends in compromise, it is a contemporary fantasy. But it’s also the motivation behind the White House’s framework to reform the corporate income tax.
Here’s what you need to know about the mechanics of all this: The statutory corporate rate – what’s written in tax law – is 35 percent. But, as shown in Table 2 here, the actual rate businesses pay on average is 26 percent. The reason for the difference is the scads of loopholes in the code. LIFO inventory (last-in-first-out) is favored relative to FIFO (first-in-first-out) inventory. (LIFO means you sell the stuff you most recently added to inventory; FIFO means you sell the stuff you added a while ago.) Offshore profits are favored relative to domestic profits (which is especially nuts). Debt financing is hugely favored over equity financing.
So the corporate part of the code seems like a prime candidate for this broaden-the-base, lower-the-rate type of reform, which basically describes the White House’s framework. They suggest taking the rate down to 28 percent and (pretty vaguely, unfortunately) closing some fat loopholes, including,
• pass-through entities: This is a maneuver where people pass business income over to their personal taxes, to take advantage of lower tax rates on the personal side of the code (it’s one reason Gov. Romney pays so a low rate – below 15 percent – given his income). Thirty years ago, 10 percent of tax receipts were passed through like this; now it’s 35 percent.
• debt financing: As noted above, one reason we’ve tended to go boom and bust in recent decades is the tax incentives for business to finance their investment through leverage (borrowing) versus issuing shares of stock.
• overseas deferral: If you’re a multinational company that’s made profits in say, Germany, you can pretty much keep them there as long as you like and avoid U.S. corporate taxes. From a tax-planning perspective, that makes it cheaper to produce abroad than here.
Some of my more hard-boiled, skeptical readers might be entertaining the notion that what the biz community really just wants is rate cuts and not base broadeners. So the first thing to watch for is folks backing away from that part – and remember, without that part you can’t do this, or at least you can’t do it without losing revenue (more on that in a moment).
Here’s conservative economist and Bush administration staffer Doug Holtz-Eakin complaining about the plan to reduce deferral of overseas earnings; same with the Chamber of Commerce (both want something called a territorial system, which allows permanent deferral). I debated Steve Forbes the other night on the Larry Kudlow show and he didn’t like the idea of limiting interest deductibility. Others, like supply-sider Art Laffer, whom I also debated on the Kudlow show, were more consistent, willing to trade the lower rate for the broader base.
Given partisan gridlock, this isn’t going anywhere soon anyway. But one thing I like about it is it the way it calls a bluff: Conservatives who fail to support this approach sacrifice their privilege to complain about high rates.
Finally, my colleague at the Center on Budget and Policy Priorities, Chuck Marr, makes an important point here: Revenue neutrality – trading off the broader tax base for points on the rate – is actually a low bar in these days of significant revenue needs. As Chuck put it:
The main shortcoming of the Administration's framework is its revenue target. All else being equal, corporate tax reform that is revenue-neutral would be an economic positive. All else, however, is not equal. The United States faces unsustainable long-term budget deficits that risk compromising future economic growth. Policymakers will face wrenching choices that, among other things, are likely to put downward pressure on investments in science research, infrastructure, and education — areas where well-designed investments hold promise of boosting productivity and hence future economic growth. The corporate sector itself has a stake both in the nation's long-term fiscal sustainability and in adequate productivity-increasing investments.
This implies more base broadening than rate lowering so as to end up with revenue-positive corporate tax reform. I’d settle for rev-neutrality, but I’d rather have rev-positive. That said, the thing to watch out for is revenue-losing reform. If conservatives are bluffing about the base, that’s where this leads, and that’s much worse than no reform at all.