Cut the Corporate Tax, Forget Revenue Neutrality
There is universal recognition in Washington that the 35 percent federal corporate tax rate is out of step with our global competitors and should be lowered at least to 25 percent in order to improve U.S. competitiveness and economic growth. And while there clearly is a need for comprehensive tax reform, many have suggested that lawmakers move forward with corporate-only reform, provided that it be accomplished in a revenue-neutral manner by broadening the corporate tax base.
While corporate-only tax reform may appear to be less complicated and more expeditious than comprehensive reform, there are three reasons to believe that the goal of revenue-neutrality and economic growth are at odds with each other.
First, those who argue that we should just widen the tax base and lower tax rates greatly overestimate the amount of "loopholes" in the corporate tax code. According to the latest federal budget, there are roughly 80 corporate tax expenditures that have a total budgetary value in 2015 of $118 billion. By contrast, there are roughly 100 tax expenditures in the individual income tax code with a total budgetary value of $1.1 trillion.
Although there are numerous parochial items in the corporate code, the majority of these provisions perform important functions, such as ameliorating double taxation, correcting what would otherwise be an overstatement of income, or moving the code toward a less distorting tax base. Examples include: the deferral of income from controlled foreign corporations; accelerated depreciation (MACRS); and, the expensing of research and experimentation (R&E) expenditures.
Furthermore, the math is quite challenging. According to an estimate by the Joint Committee on Taxation, the static cost of cutting the corporate tax rate to 25 percent is about $1.2 trillion over ten years, with another $100 billion required to eliminate the corporate Alternative Minimum Tax. However, adding up all of the corporate tax expenditures totals roughly $1.8 trillion over the next ten years, of which $800 billion is the supposed cost of the deferral of U.S. tax on foreign-earned profits.
Setting aside deferral-which ought to be solely reserved for international tax reform-the numbers suggest that even if lawmakers were to eliminate every other corporate tax expenditure, they would still fall short of financing a 10 percent reduction in the federal corporate rate in a statically measured, revenue-neutral manner. What then?
The second complication to corporate-only tax reform is that many corporate tax expenditures are also available to the roughly 33 million pass-through businesses such as S-corporations, partnerships, and sole proprietorships. Indeed, three-fourths of all corporate tax expenditures also benefit pass-through businesses, including the R&E tax credit, the Section 199 manufacturing deduction, accelerated depreciation, the tax credit for low-income housing, and the charitable deduction. The value to C-corporations of these widely available provisions is $43 billion, whereas the value to pass-throughs of those same provisions is $92 billion, more than twice as much.
Eliminating these provisions to finance corporate-only reform would effectively raise taxes on pass-through firms without providing any corresponding reduction in their tax rates. Even if lawmakers were to attempt to hold pass-throughs harmless, it would require complicating the code by creating one set of rules for C-corporations and another for pass-throughs.
The third challenge to those who insist on revenue-neutral corporate tax reform is to find offsets that don't diminish the growth potential of a pure rate cut.
According to the Tax Foundation's Taxes and Growth model, cutting the corporate tax rate to 25 percent with no offsets would boost economic growth by at least 2 percent over the next decade or so, increase business stocks by 5.8 percent, raise the wage rate by 1.7 percent, and create the equivalent of 377,000 jobs; with the added bonus that the rate cut begins to pay for itself by the end of the decade.
However, our model also shows that the negative economic effects of eliminating many of these corporate tax preferences would negate all of the growth generated by the rate cut. For example, our model shows that eliminating accelerated depreciation would reduce the level of GDP by 1.2 percent over a decade, by itself erasing more than half the gains from the rate cut. Eliminating the remaining corporate tax expenditures would wash away the rest of the gains. The result is a revenue-neutral tax plan, but no economic growth, no jobs, and workers no better off.
Considering these issues, lawmakers would do well to rethink the self-imposed restriction of revenue neutrality, and focus on creating the maximum amount of economic growth, even if that comes at the expense of federal revenues. While there are corporate tax breaks that could be eliminated without dampening the growth effects of the rate cut, there are not nearly enough of these to fund a rate cut on a static basis.
On the other hand, lawmakers could take into account the long-run effects on tax revenues from the additional growth generated by the corporate rate cut. Any short-term deficits could be covered by eliminating the least harmful tax expenditures or spending cuts.
Cutting the corporate income tax rate is critical to restoring U.S. competitiveness and boosting economic growth. But lawmakers have a choice: they can eliminate most corporate tax expenditures and risk eliminating the growth effects of the rate cut; they can find offsets outside of the corporate code to maintain overall budget neutrality; or, they can relax the constraint of revenue neutrality and either accept a transitory deficit or look to spending restraint to cover the revenue gap. Given these choices, growth should always win out.
