Corporate Income Tax Rates in the U.S. Are Among the Highest in the World
Amid growing concerns about U.S. economic competitiveness, policymakers are awakening to the fact that America has one of the world's most inefficient corporate income taxes.
Rep. Charles Rangel (D-New York), chairman of the U.S. House tax committee, has proposed reducing the federal corporate tax rate from 35 percent to 30.5 percent. Henry Paulson, secretary of the Treasury, is also promoting a corporate tax rate cut.
Their efforts merit wide support, as businesses and workers alike would benefit from rate cuts that would spur rising investment and improve productivity.
Rangel and Paulson seem to assume a corporate rate cut needs to be matched with tax increases to ensure government revenue isn't reduced. But there is growing evidence that a corporate rate cut would generate strong, dynamic responses that would produce higher, not lower, federal tax revenues.
Britain and the United States launched the corporate tax cut revolution in the mid-1980s. Since then, every major nation has cut its rate. In the European Union, the average corporate tax rate has fallen from 38 percent to 24 percent since 1996. Further cuts are in the pipeline in Britain, Germany, and other countries.
Canada has announced a cut to its federal corporate rate from 22 percent to 15 percent. The United States is lagging behind with a combined federal and state rate of about 40 percent.
Rates Cut, Revenues Rose
In most countries, corporate rate cuts have coincided with rising tax revenues. For a group of 19 advanced economies with data back to 1965, I calculated the average statutory tax rate and average corporate tax revenues as a share of gross domestic product.
The accompanying figure shows the average rate was 40 percent or more prior to the mid-1980s. But then supply-side tax policies gained support, and tax rates plunged. The average rate in the 19 countries fell from 45 percent in 1985 to 29 percent by 2005.
During the same period, corporate tax revenues soared from 2.6 percent to 3.7 percent of gross domestic product (GDP).
One reason is that many countries broadened their corporate tax bases during the late 1980s, often by reducing depreciation deductions. But since then, most countries have not broadened their corporate bases by much, if at all. The average value of depreciation deductions across major countries has been roughly unchanged in 15 years, and effective tax rates, which include features of the tax base, have fallen with statutory rates in recent years.
Taxpayers Respond to Cuts
The main factor causing the surge in corporate tax revenues appears to be taxpayer responses to reduced tax rates. Lower rates generate real and financial responses from businesses, prompting them to report higher profits.
Research has found corporations are increasingly responsive to taxes in the global economy across many dimensions. The University of Michigan's James Hines concluded, "Evidence indicates that taxation significantly influences the location of foreign direct investment, corporate borrowing, transfer pricing, dividend and royalty payments, and research and development performance."
Countries that raise corporate tax rates increase the pre-tax returns required of new projects because after-tax returns tend to be equalized across countries. The result is that fewer investment projects are undertaken, and capital emigrates. With a smaller capital stock, labor productivity and wages fall, and government revenues drop.
The University of Toronto's Jack Mintz noted, "Economic studies show conclusively that business taxes significantly affect investment in a country." His analyses show "high effective tax rates on capital result in less foreign direct investment and therefore less economic growth."
Revenue Base Grows
Harvard University's Greg Mankiw and Matthew Weinzierl examined the revenue impact of tax cuts to capital, such as corporate income tax cuts. They found tax cuts would only lose about half the revenue otherwise expected, because rising investment generates offsetting revenues over the long run.
In a 2006 study, German economists Mathias Trabandt and Harald Uhlig estimated similar dynamic revenue responses.
In addition to these real investment effects, corporate tax changes prompt an array of financial or tax avoidance responses. At the domestic level, corporate tax cuts can induce noncorporate businesses to switch to taxable corporate status. At the international level, tax cuts can induce companies to change their policies on dividend repatriations, transfer pricing, debt financing, foreign affiliate structure, intellectual property, and other items.
Laffer Curve Effects
Considering the range of real and financial responses to corporate taxes, it is likely that cutting the high U.S. corporate tax rate would induce a large expansion of the tax base over time. Both U.S. and foreign firms would invest more in the United States, and they would have less incentive to shift reported profits to other countries.
The Laffer curve illustrates the idea that above a certain tax rate, cuts to the rate cause the tax base to expand sufficiently for revenues to increase. The U.S. corporate tax rate seems to be above that rate, and thus in a strong Laffer zone.
The U.S. statutory corporate tax rate is the second highest of the 30 nations in the Organization for Economic Cooperation and Development (OECD), and by one estimate the effective rate is the highest. Yet U.S. corporate tax revenues as a share of GDP are below average.
Large Cut Needed
Economists Alex Brill and Kevin Hassett looked at these relationships in the OECD for 1980 to 2005. They found increases to corporate tax rates in the OECD above 26 percent tended to reduce government revenues.
The U.S. corporate tax rate is 14 percentage points above that rate, and thus probably far into the Laffer zone.
A modest corporate tax rate cut would likely result in no government revenue losses in the long term. But the goal of policy should be to maximize economic growth, not tax revenues, and thus a much larger rate cut is in order. I've proposed that the corporate rate be cut to 15 percent within a major overhaul of the tax code.
That wouldn't quite match Ireland's 12.5 percent corporate rate, but it would reduce tax avoidance, make the United States a premier location for international investment, and supercharge American growth and innovation.
Chris Edwards (firstname.lastname@example.org) is director of tax policy studies at the Cato Institute. A version of this article appeared in Cato Institute Tax & Budget Bulletin No. 49. Used with permission.
For more information ...
"Corporate Tax Laffer Curve," Cato Institute Tax & Budget Bulletin No. 49: http://www.heartland.org/article.cfm?artId=22798