There is significant talk in Washington about the need for comprehensive corporate tax reform. Such reform could be the most important economic policy decision Washington makes. Its effects would likely have critical implications for the health of the U.S. economy for years to come.
But despite the talk, it’s not clear when or even if Congress will pass legislation. Indeed, it may not be until after the 2016 Presidential election that Congress is able to do this.
But regardless, it’s worth considering what kind of tax reform would be best for manufacturers in the U.S. One reform that would help would be a lower effective corporate tax rate. At a combined state-federal rate of 39%, the United States has the highest statutory rate in the world. But there is also evidence that the United States has one of the highest effective corporate tax rates in the world, especially for manufacturers. And higher corporate rates reduce economic growth, including reduced international competitiveness.
Unfortunately, both political parties have embraced the view that any corporate tax reform plan should be revenue neutral, which by definition means that the effective rate for corporations in the United States, on average, would remain unchanged. Reform advocates argue that this will be pro-growth because of the elimination of economically distorting tax incentives (more on this below).
Meanwhile, many Republicans don’t want a lower effective corporate rate because they rightly understand it will increase the pressure to increase taxes on individuals, while many Democrats don’t want to cut the effective corporate rate because they fear it will mean reduced spending on things like entitlements. But without a cut in the actual amount of tax corporations, especially manufacturers pay, the economic benefits to the U.S. economy will be limited.
Moreover, keeping to the straightjacket of revenue neutrality will mean elimination of deductions, credits and other incentives in the code. While some of these incentives can likely be jettisoned with little or no harm, and perhaps even overall economic gain, at least three will likely come not only at the expense of growth and competitiveness, but also manufacturing health.
A Closer Look at Some Tax Credits
Let’s start with the research and experimentation (R&D) tax credit. Eliminating this credit would provide enough tax expenditure savings to cut the corporate rate from 35% to 34%. But given that manufacturers perform 68.4% of all U.S. business R&D it’s clear that eliminating the R&D credit will on average increase the taxes manufacturers pay, while it will reduce the taxes for sectors like retail, trade and financial services that spend much less on R&D.
Another incentive often mentioned as deserving to be on the chopping block is accelerated depreciation, also known as the Modified Accelerated Cost Recovery System. MACRS lets firms depreciate for tax purposes investment in capital goods faster than regular depreciation. Elimination of MACRs would generate enough savings to allow the statutory rate to be reduced by 3 percentage points. But given that manufacturers are responsible for 27.2% of capital goods investment (while accounting for just 17.6% of U.S. corporate profits), eliminating MACRS will by definition lead to higher effective taxes for manufacturers.
A third incentive on the table is Section 199, the Domestic Production Deduction. 199 was put in place to replace the Foreign Sales Corporation (FSC) law that was ruled illegal by the WTO in 2000 and was intended to help U.S. exporters. Eliminating this would allow the corporate rate to be lowered by 1 percentage point, but because the credit is targeted at manufacturers, it would lead to manufacturers paying an effective tax rate 3 percentage points higher.
So at least on the three main business tax incentives being considered for repeal as a way to pay for rate reduction, elimination would lead to manufacturers actually paying more, not less in taxes.
So what should corporate and business tax reform do?
Reducing Specific Tax Rates
Congress should bite the bullet and realize that the U.S. cannot afford to have very high effective corporate tax rates. It should reduce the statutory rate to something closer to 20%. But rather than eliminate key growth incentives to pay for deep rate reduction, it should preserve and expand them.
This means keeping the Section 199 incentive while expanding incentives for investing in R&D and capital equipment. In particular, Congress should increase the rate on the Alternative Simplified R&D Credit from 14% to at least 20% and transform MACRS from a deduction to an investment tax credit modeled on the ASC.
Some manufacturers will respond that the role of the tax code is to raise money, not try to reward companies for certain types of behavior society favors (e.g., investing in R&D). This would be a valid policy argument except for the fact that investments in things like equipment, software and R&D “spill over” to society and create benefits above what the firm gets. Without incentives to invest in growth engines like R&D and new equipment and software companies will underinvest from a societally optimal level. Moreover, there is increasing evidence that because of pressures from equity markets for short-term results, companies underinvest in things like R&D and even machinery that have a longer payoff. As such ensuring that the tax code rewards investments in equipment, software and R&D will not only help the economy, it will help firms be more successful.
Finally, this all raises the key question of how to pay for all of this. Despite the fact that a lower rate and expanded investment incentives will generate some compensating tax revenue gains from added growth, it makes little sense to pay for these through growing the budget deficit. In response, Congress should enhance revenue by raising individual taxes by things like taxing dividends as normal income and eliminating the home mortgage interest deduction. We should also reduce spending in other parts of the budget by raising the retirement age so that people consume less entitlements and work and pay taxes longer.
While easy in concept, these are clearly hard in practice. Too few voters want to make a sacrifice for the good of the nation and the good of the next generation. But in many ways we have no choice—if we don’t rebalance investment and consumption, while also generating a more competitive business tax code, America will continue to lose in the race for global competition, and jobs and economic growth will suffer.