This tax reform series looks at the impact of tax reform legislation currently floating through Congress. It is expected to reach the President’s desk before the end of the year and will ultimately impact every single part of the U.S. economy. The goal of the legislation is to boost economic growth and to that end, the centerpiece is a reduction in the corporate tax rate, from 35 percent to 20 percent. There are two key assumptions driving this:
In this series, we first tackle the question of whether U.S. corporations face a large tax burden that makes them less competitive on the global stage. Future posts will look into whether higher corporate profits actually result in higher investment spending as well as some other consequences, perhaps unintended, of the legislation.
The Reagan Tax Reform Act of 1986 has been a benchmark for tax legislation since it is believed to have generated solid economic growth. The goal of that legislation was to reduce the tax burden on businesses and individuals, while remaining deficit neutral by broadening the tax base. The corporate tax rate was dropped from 46 percent to 34 percent and almost all individuals and households saw their personal income tax rates fall. Interestingly, the bill actually ended up raising average business taxes by removing a number of deductions and investment incentives. Also, provisions like an increase in the capital gains rate (from 20 percent to 28 percent) resulted in revenue-neutral legislation.
The current proposal is decidedly different. For one, it is expected to cost close to $1.5 trillion over the next decade, or $1 trillion after accounting for growth. In addition, the legislation cuts the corporate tax rate permanently, as well as allowing businesses to deduct the full cost of investments in the year they are made (this provision is set to expire in 2023). The bill does limit interest deductibility, in a bid to raise revenue, though it does not do away with it altogether as was originally expected. On the personal income side, tax cuts are also expected to be temporary, with most provisions expiring within a 10-year window.
Are corporate taxes too high?
The United States’ marginal corporate tax rate is in fact one of the highest in the world at 35 percent. This is especially high when compared to other regions like Europe and Asia – the weighted average corporate tax rate in the European union (EU) and Asian countries are 26.9 percent and 26.2 percent, respectively. However, 35 percent is not what U.S. companies actually end up paying.
In fact, U.S. corporations pay far lower than their counterparts in other developed nations, according to the OECD. Out of 5 select developed countries, we found that only Germany had a lower tax collection as a percentage of GDP. The other four – Ireland, the UK, Japan, and Korea – all collected more taxes as a percent of GDP than the U.S. As a percentage of GDP, U.S. tax collection has been below the OECD average since 1982.
We also looked at the effective tax rate that is paid by some of the largest companies in the United States. We analyzed financial data of all the Dow 30 companies and found that, over the past five quarters, only one paid a median effective tax rate greater than 35 percent – Home Depot at 36.2 percent. The median effective tax rate for the entire Dow 30 over the same time period was only 25.4 percent. 21 companies from the Dow had an effective median tax rate below 30 percent, while 7 companies had median tax rates below 20 percent.
In fact, on aggregate, U.S. companies have seen a steady reduction in their effective tax rates since the 1960’s.
From the 1960’s to early 1980’s, the effective tax rate fluctuated between 40 and 35 percent before falling below 30 percent after the 1982 recession. As the economy began to recover in the mid-1980’s, the effective rate rose back to around 35 percent. However, since the 1990’s, companies began receiving a number of business friendly incentives , as well as taking advantage of various accounting loopholes in the tax law, largely reducing their tax bill. In 2004, the Bush administration initiated the Homeland Investment Act , which allowed companies to repatriate foreign holdings from abroad at a discounted rate. This influx of repatriated cash likely resulted in the effective tax rate rising, but solely lowered back down in the subsequent years. In 2016, the effective tax rates on corporations fell even further to 23 percent.
A Treasury study also shows that the average effective corporate tax rate across major industries was less than 30 percent between 2007 and 2011. Sectors like utilities, leasing, transport and finance pay the least, with average effective tax rates less than 20 percent during the period.
Companies have been able to see a real effective reduction in taxes due to aggressive tax shifting strategies (to tax havens) and a variety of business-friendly tax credits and deductions in the United States. These cost the government an estimated $660 billion over a five-year period (2012-2016), according to a 2010 study from the Tax Foundation. For example, many large multinational companies can defer income from controlled foreign corporations until they transfer overseas profits back into the United States, if the U.S. based company is replaced by a foreign parent or becomes a subsidiary of a foreign parent ( called corporate inversion ). However, nearly all of this money is almost never transferred back since companies wait for a tax holiday (like in 2004). Apple is one of the most well-known companies that have come under fire for conducting corporate inversion and avoiding significant U.S. corporate taxes.
U.S. corporations also reduce their tax liabilities through tax code provisions like the manufacturing deduction. While there are several legitimate uses of this deduction, an absurd example of a company taking advantage is the Cheescake Factory , which has reportedly claimed the deduction for manufacturing slices of cheesecake and garnishing them.
U.S. corporations have obviously found strategies reduce their tax burdens resulting in effect tax rates far below the marginal tax rate of 35 percent. So it is not clear that U.S. firms, especially the large ones, are at a competitive disadvantage globally thanks to the current tax code. While there may be a benefit to having a simpler tax code, so that corporations spend less effort on mitigating their tax liability, the reality is that even a reduction of the marginal rate to 20 percent is not significant enough to lower their tax burden, especially if some of the other incentives are also taken away.