President Barack Obama’s State of the Union speech delivered on an idea he’s been telegraphing for weeks: corporate tax reform. And there are hints the changes he will seek could be major. But some companies will lobby hard against losing tax breaks to pay for a rate cut. Turning even sensible proposals into law is no sure thing.
For the most part, Obama has kept his distance from the long list of recommendations put forward by the debt commission he created last year. Tackling business taxes is turning out to be the exception. The panel suggested lowering the top U.S. corporate rate to 26 percent from 35 percent today and taxing only domestic income as a way of promoting economic growth. Yet it also called for eliminating all business tax breaks to fund the reductions and reduce the budget deficit.
Obama echoed the basic thrust of the panel’s proposal in his national address, though not the specific numbers. But his call for “fundamental reform” that was “revenue neutral,” implies that he wants to do more than just tinker with the existing tax code. Those goals can only be met by sharply lowering the overall rate and dramatically reducing loopholes. Importantly: Obama did not hint that some of the money from simplifying the tax code be used for lowering the deficit, as the panel suggested. Republicans would likely view that as a tax hike and firmly oppose.
Not all companies will be pleased with the prospect. Some multinational companies, such as Pfizer, Hewlett Packard and Qualcomm, have successfully worked around the current system to have consistently managed effective tax rates closer to 20 percent or lower.
And lobbyists from a host of industries, including venture capital, private equity, and the oil patch, where tax-advantaged master limited partnerships are all the rage, will flood Capitol Hill and claim ending this or that tax subsidy will hurt competitiveness. Just look at this chart (from the NYTimes):
It’s been 25 years since the tax code was meaningfully reformed. That argues for Obama to slice indiscriminately through the Gordian Knot of corporate welfare by doing away with all business tax favors. Put everyone in the same boat and let markets choose winners. Yet as common-sensible as that sounds, it may be every bit as challenging as passing health and financial reform. This good idea will take some heavy lifting.
But it needs to be done correctly. Americans for Tax reform has some solid suggestions:
1. The rate needs to come down — way down. Our 40 percent rate is much higher than the average European rate of 25 percent. Ideally, we’d want to be under that in order to attract jobs and capital from the rest of the world
2. Don’t raise taxes. The President has argued this should be a tax revenue-neutral exercise. While we would prefer a net tax cut (at least on paper in a static score), revenue-neutrality should be the worst revenue case. This should not be an excuse to raise net taxes (like the President’s Debt Commission did).
3. Move from “worldwide” to “territorial” taxation. As part of reform, the corporate tax system should migrate away from “worldwide” taxation (where all income of U.S. companies from all around the world is liable to be taxed by the IRS) to “territorial” taxation (where only U.S.-source income is taxed). This is what the rest of the world by and large does, and would make all the international deferrals and credits unnecessary.
4. Resist the temptation to lengthen depreciation lives. The proper tax treatment of business purchases is immediate expensing (as was contained in the December tax deal). Going in the other direction by lengthening depreciation lives will only bias toward consumption and away from productive investment. It’s the government picking winners and losers, and hurting economic growth in the process.
5. Remember that the corporate income tax is only the first act of a two-act play. After-tax corporate profits distributed to shareholders are double-taxed as dividends. After-tax corporate profits retained by firms eventually come out in the wash as taxable capital gains to shareholders. An integration of both bites at the apple would truly be a pro-growth and comprehensive tax reform effort on the corporate side.
6. Don’t forget about corporate capital gains and dividends received. Unlike individuals, corporations don’t have a preferential rate on capital gains, and cannot exclude all the dividends received from other corporations. Dealing with the capital stock and portfolio income of corporations is a necessary component to reform.
7. Don’t pick winners and losers. President Obama seems to have a particular vitriol reserved for energy companies, as exemplified (again) in his SOTU speech. This hatred should not cause this sector to suffer more base-broadening than other sectors. Conversely, favored companies should not get light treatment. Rather, the goal of a revenue-neutral corporate tax reform (as opposed to a simple rate cut, which remains ATR’s preference) should be to broaden the base as much as possible in order to lower the rates as much as possible. How individual companies or sectors do is not particularly relevant.