U.S. Corporate Income Tax System: Once a World Leader, Now A Millstone Around the Neck of American Business, The

Special Report - Tax Foundation, Nov 2005 by Atkins, Chris, Hodge, Scott

Introduction

In the Tax Reform Act of 1986 (TRA'86) the U.S. Congress lowered the top corporate income tax rate from 46 percent to 34 percent, the largest reduction since the tax was enacted in 1909. This change, along with an earlier move in the United Kingdom, started a wave of corporate income tax reduction worldwide.1

One of the ironies of tax policy during the Bush presidency is that five years of tax-cutting legislation have left the corporate income tax rate unchanged. Meanwhile, another wave of corporate income tax reduction has swept around the world and is still underway. The United States is not the leader this time around. In fact, the U.S. is lagging behind and now has the highest combined statutory corporate income tax rate among OECD countries.

A review of corporate tax policies in the OECD countries reinforces a theme that is well developed in the economic literature: a nation will not attract new and expanded business and its attendant job creation if its corporate income tax is significantly higher than it is in comparable nations. Therefore, as the U.S. contemplates fundamental tax reform, one of the major goals should be a lower corporate income tax rate.

The President's Advisory Panel on Tax Reform has done just that in its new report, but possibly with an overly modest rate cut. The panel suggested a 31.5 percent top rate in one plan and a 30 percent top rate in an alternative plan. Both plans would improve the U.S. worldwide ranking, but the U.S. would still be taxing corporate income at a rate well above the OECD average. Lawmakers should consider reducing the federal rate to 25 percent which, when coupled with state corporate income taxes, would almost bring the U.S. rate down to the OECD average of 29.2 percent.

Corporate Income Tax Rates Falling Worldwide

After cutting 12 percentage points off its corporate tax rate in 1986, the U.S. rate stayed below the world average until 1994. That was the first effective year of the tax hike President Clinton signed into law a year after his election, the Omnibus Budget Reconciliation Act of 1993, which added a new top rate of 35 percent.2 Since then, the top federal statutory U.S. rate has remained at 35 percent. Combined with an average state corporate income tax rate of 6.6 percent, which is deductible from federal taxable income, the overall rate of tax on corporate income is 39.3 percent in the U.S. Among our major trading partners, tax competition has driven the average rate down to 29.2 percent (see Table 1).

This 10-point disparity between the U.S. rate and the average OECD rate is unacceptably high. The Congress effectively narrowed the gap, albeit slightly, when it passed the American Jobs Creation Act of 2004. Signed into law in October of 2004, this tax bill did not actually change statutory rates, but it enacted a phased-in deduction that for many firms has effectively lowered the top federal tax rate to 34 percent in 2005 and 2006, to 33 percent during the next three years, and finally to 32 percent after 2009.

Other nations are lowering their corporate tax rates much more rapidly. Congress is responding to the international trend toward lower corporate tax rates with inadequate corporate tax relief, and by enacting a complex deduction instead of a straightforward rate cut, Congress has muddied the waters and created administrative problems. Of course, it is not terribly surprising that Congress would replace one complex deduction (for extra-territorial income) with another (for qualified production activity income, or QPAI), but as a result taxpayers are having difficulty complying.3 Instead, Congress should have significantly lowered corporate income tax rates for all U.S. companies.

While the President's tax reform panel has certainly lived up to the spirit of fundamental reform by calling for expensing and the elimination of the corporate alternative minimum tax, the panel's proposal is more modest on the subject of rates. It suggests a 31.5 percent top rate as part of its "Simplified Income Tax" (Plan A) and a 30 percent flat rate as part of its "Growth and Investment Tax Plan" (Plan B). Both plans would avoid the complexity of the recently enacted QPAI deduction. The panel's business tax suggestions are meritorious throughout, but it still must be acknowledged that neither plan would keep pace with the rate-cutting approach of our trading partners around the world.

Lawmakers need to reduce the corporate income tax rate to at least 25 percent. While a rate cut of that size would certainly improve our worldwide competitiveness, by the time we enact it, we would probably just barely keep up with current worldwide trends.

While some lawmakers will be concerned about the potential loss of tax revenues that results from lowering the corporate income tax rate, the U.S. - like other high-tax countries such as Japan and Germany - collects a relatively small amount of corporate tax revenues despite having high tax rates. The economic literature (supported by the experience of low-tax countries) suggests that the increased investment and economic growth generated by the lower corporate income tax rate will be well worth the "loss" of a small amount of federal tax revenues.