The Quickest Way To Wreck Corporate Tax Reform

Republicans and Democrats have started discussing proposals to cut the corporate income tax rate. It's about time. Governments around the world, recognizing that the corporate tax is flawed and economically destructive, have reduced their tax rates in recent decades. Meanwhile, the United States has stood pat, leaving us with the highest corporate tax rate of any developed country.

If we're not careful, though, a deal that cuts the corporate rate could end up doing more harm than good. The problem is that Congress and the Obama administration are thinking of pairing the rate cut with a slow-down of companies' depreciation deductions. That's a bad combination.

A key goal of corporate tax reform should be to reduce the tax penalty on business investment. Investments in equipment, factories, and other forms of capital help power the long-run economic growth that boosts wages and living standards for American workers. By itself, a corporate tax rate cut reduces the investment penalty by letting companies keep a bigger fraction of the payoffs from their investments. But, that doesn't work if the rate cut is accompanied by a slow-down in depreciation deductions.

Depreciation deductions allow companies to write off their investment costs over a period of years. That may sound like an obscure accounting issue, but it's of vital economic importance. Even as the corporate tax soaks up part of the investment payoffs, depreciation deductions offer tax relief to cover part of companies' investment costs. And, because a dollar today is worth more than a dollar tomorrow, faster depreciation deductions mean bigger tax relief for investments.

If depreciation is slowed down enough to offset the full revenue loss from the rate cut, then there's no reduction in the investment penalty, on balance. The depreciation changes take back with the left hand everything that the rate cut gives with the right hand. That policy trims other distortions built into the corporate tax, such as its bias in favor of debt and its incentive for companies to play accounting tricks that book profits outside the United States. But, it doesn't reduce the investment penalty.

In fact, the policy makes the tax penalty on new investments bigger. To see why, let's separate out the old capital now in place - past investments that are still producing output - from new investments. For old capital, a rate cut paid for with slower depreciation is a big win. All of its future payoffs get taxed at the lower rate. Yet, it's spared from the depreciation slow-down - the longstanding rule is that depreciation changes apply only to new investments.

If the overall reform package is revenue-neutral and old capital comes out ahead, then new investments have to pick up the slack. For new investments, the loss from the depreciation slow-down must outweigh the benefits of the rate cut, amplifying the tax penalty.

That means we end up with the worst of both worlds. First, we shower windfalls on investments that have already been made by giving companies tax savings that they were never promised. This reward for past investment is senseless - we can't change the past. Then, we turn around and raise the tax penalty on new investments, which can still be changed. And they will be changed - the stiffer penalty will discourage investment and slow economic growth.

Why is this bad combination being considered? Maybe because the rate cut is easy to understand and the harm of slower depreciation is easy to overlook. Or, maybe because many large and established businesses support it. That's hardly a surprise - those businesses would love a windfall tax break for their old capital. And, they may not mind a bigger penalty on new investments, especially if it applies to investments by start-ups who could challenge their market shares. But, Congress shouldn't cater to their wishes.

Yes, let's cut the corporate tax rate. But, let's not slow down depreciation to pay for it. Let's phase in the rate cut gradually, to trim the revenue loss and diminish the windfall to old capital. Let's recoup some revenue by cutting back on corporate deductions for interest payments, a measure that will also reduce the tax bias in favor of borrowing. And, let's extend the reform to individual taxes and craft a comprehensive revenue-neutral package.

Although the details of corporate tax reform may sound technical, the stakes are high. We can't afford to give windfalls for investments made in the past. Instead, we should reward the new investments that will help move us towards a prosperous future.