Time for a grand bargain on corporate tax reform

The recent debate over corporate inversions (U.S. companies reincorporating themselves in nations with lower tax rates) threatens to derail progress on comprehensive tax reform even further. The administration and some in Congress seem set on treating the symptom rather than the disease. This is unfortunate because broader reform is both necessary and doable. America’s complex and outdated corporate tax code imposes significant costs on the incentives to invest here and on our competitiveness in overseas markets. Moreover, the broad outlines of a possible bipartisan deal are already visible and they center around four principles.

{mosads}The first is the cost of tax reform. Tax reform as a whole should be revenue neutral. Many Democrats have expressed an intention to use reform of the corporate code to raise revenues. Yet the Congressional Budget Office reports that federal revenues are at their historic average as a percent of GDP and that, under current law, they will rise further to 19.4 percent by 2019. Attempts to force corporations to pay higher taxes amount to attempts to kill reform.

But revenue neutrality needs to be defined to include dynamic effects. There is a lot of debate and uncertainty around dynamic scorekeeping. But few people doubt that wise tax reform would produce at least moderately sized economic benefits. When the Chairman of the House Ways & Means Committee recently introduced a reform proposal, the Joint Committee on Taxation estimated that it would raise only $3 billion over 10 years on a static basis. But, once the full growth effects were considered, the revenue increase jumped to somewhere between $50 and $700 billion. We should at least be able to agree on giving effective reform credit for raising at least some revenues from growth.

The second principle is that while tax reform should be revenue neutral overall, reform should lower corporate taxes while raising individual taxes. Ultimately all taxes are eventually paid by individuals, not institutions. But corporate taxes have a much larger negative effect on investment and growth in part because corporations compete internationally (individuals do not). It is therefore important to lower effective corporate tax rates as far as possible. This needs to be done by significantly lowering the corporate statutory tax rate while at the same time expanding several key growth-inducing tax incentives. To the extent that the dynamic budget effects do not compensate for lost tax revenues, the difference should be paid for by increasing individual taxes. Higher individual rates also help address very real concerns about equity and inequality. A first step would be to raise tax rates on capital gains and dividends and eliminate the lower rate for carried interest. If additional revenues are still needed, slightly higher rates on those with the highest incomes should be considered. It would be preferable, though, to limit the ability to take deductions rather than raising marginal rates.

We recognize that this could create an incentive for non-corporate businesses to shift income into corporate forms. The tax reform legislation of 1986 lowered individual rates much more than corporate rates. The result was a large shift away from corporate income toward pass-through entities. One consequence of this was that traditional measures of income inequality worsened. While we recognize the problems with reversing this, we believe that the benefits of lower corporate taxes, which after all are borne by everyone, outweigh the costs of higher individual taxes.

The third principle concerns investment incentives. The primary focus of reform should be to lower statutory rates by as much as possible. But one problem with this is that most of the immediate gains go to existing investors rather than new ones. Robust productivity growth and national competitiveness require additional investment, particularly in new equipment, software and research and development. To partially address this, Congress should increase the generosity of the research and development credit, while simplifying it. It should also allow all businesses, not just small ones, to expense the costs of capital equipment investments in the first year. A growing body of evidence shows that these reforms would encourage investment and boost growth.

Finally, we need a compromise on territoriality. Most countries do not tax corporate income earned abroad. The United States does, at a 35 percent rate, but only when the earnings are brought back home. As a result, many companies just keep the money overseas. Lowering the statutory rate to between 20 and 25 percent solves much of this problem. But in order to deter tax havens, Congress could perhaps agree on a 10 to 15 percent rate on foreign income with no deferral. Most countries are still above this rate, so the provision would have a minor effect on the competitiveness of U.S. corporations. This would give tax havens a strong incentive to increase their rates to this new floor in order to attract investment.

To achieve the goals presented in these principles, both parties will have to compromise in ways that will trouble their respective bases. Democrats, especially President Obama, will have to agree to cut corporate taxes, while Republicans will have to agree to raise taxes on individuals. We’re not saying this is easy. We are saying it is necessary if the U.S. economy is to have any chance at being globally competitive. Attempts to temporarily stem the number of inversions resurrect a strategy that Congress has tried and failed at before. But comprehensive reform that promotes investment, growth and competitiveness would be a lasting legacy for any president and Congress that accomplishes it.

Atkinson is president of the Information Technology and Innovation Foundation (ITIF) and Kennedy is a senior fellow with ITIF and former chief economist for the U.S. Department of Commerce.