What's Holding Back Corporate Tax Reform?
Talk to virtually any business leader, and they will tell you one of their great frustrations with Washington is that even when everyone seems to agree on a problem and a need for action, nothing ever seems to get done.
Take tax reform, for example. Leading Republicans and Democrats agree that America's current system of taxing corporations is not just outdated, but also hurts our nation's competiveness and pushes companies to relocate their corporate domiciles abroad. Most even agree on the top-line reforms: lower the corporate tax rate, broaden the tax base, and reform the current system of taxing companies on their worldwide income.
If the president and congressional leaders from both parties agree on the problem and the solution, why doesn't anything ever get done? Often people suppose that the lack of progress must be because elected leaders either are not really committed to reform or are secretly protecting their favorite special-interest tax breaks.
The obstacles are much less nefarious. In reality, the top-line talking points on which everyone agrees paper over the major obstacles to enacting reform and also mask the fundamental differences between the two parties.
If we want to improve the odds of enacting real tax reform, we have to be honest about these challenges and the different approaches taken by Republicans and Democrats. Here are four key areas where such differences emerge.
1. Corporations and Pass-Throughs
Much of the discussion around tax reform centers on lowering the top corporate tax rate, which, at 35 percent, is the highest in the industrialized world and puts American businesses, especially multinationals, at a competitive disadvantage.
Most businesses in America, however, are not traditional corporations. Most are what are called pass-throughs — partnerships, S-corporations, or sole proprietorships — where the owners pay business taxes on their personal tax returns. These pass-throughs earn 64 percent of all business income and constitute 55 percent of all private-sector employment. The current top tax rate for pass-throughs — which is to say, the top personal income-tax rate — is 39.6 percent.
It is simply unrealistic to substantially cut the tax rate for corporations without also reducing taxes for pass-throughs. In addition to the political difficulty of enacting reforms that cut taxes for large corporations, but not small businesses, imposing radically different tax systems on businesses based on how they are legally organized will make the tax code even more complex. Some businesses will be incentivized to change their legal structure purely for tax purposes. But while there is consensus on reducing the corporate rate, there is vast disagreement between the parties about how, and sometimes even whether, to reduce taxes for pass-throughs.
2. Territorial vs. Worldwide Taxation
Over the past 25 years, the majority of industrialized nations have moved away from taxing domestic businesses on the income they earn worldwide in favor of taxing them on the income they earn domestically, a system referred to as territorial taxation. Today, the U.S. is one of just six OECD nations — out of 34 total — that impose a worldwide tax system on their businesses, though the U.S. allows companies to defer their taxes until profits are repatriated to the U.S. As a result, U.S. companies hold approximately $2 trillion in profits overseas rather than bringing that money back into the U.S.
While both Republicans and Democrats want to reform this system, they have very different ideas of reform. Most Republicans advocate a move to a territorial system (possibly with a low rate of worldwide taxation to avoid base erosion). On the other hand, the president and many Democrats want to impose a 19 percent tax on all worldwide income while eliminating deferral.
Bridging this difference isn't just about choosing the right tax rate; it also means resolving a fundamental disagreement in approach. A territorial approach focuses on incentivizing multinational companies to locate and operate in the U.S. Alternatively, an approach that combines worldwide taxation with an end to deferral is much more about maintaining the international reach of the IRS.
3. Innovation Boxes vs. a Lower Overall Rate
The latest challenge to tax reform involves whether the U.S. should follow the lead of other nations, including the U.K., France, and China, and adopt an "innovation box" — a lower tax rate on income derived from intellectual property. Leaders in both parties initially indicated support for adopting some form of an innovation box.
Arguments in support of an innovation box include encouraging more R&D and incentivizing companies to locate their IP and manufacturing domestically. On the other hand, companies without significant revenue from IP, or that fear their IP won't qualify for the innovation box, are concerned that they will be stuck paying a higher tax rate in order to subsidize the lower rate for the innovation box.
4. Capital Investment vs. a Lower Overall Rate
Some companies pay an effective tax rate — i.e., the percentage of their total income that goes to taxes — that is very close to the top marginal tax rate on business income — which, again, at 35 percent is the highest in the industrialized world. For many of these companies, the priority is lowering the top marginal tax rate.
Other companies, while they may care about the top rate too, make large capital investments and want to deduct the cost of those investments on their taxes as soon as possible. Under current law, business investments usually must be slowly deducted, or "depreciated," over 5, 7, 20, or even 39 years. These companies want to move as much as possible toward full and immediate expensing of capital investments and certainly don't want to lengthen depreciation lives any further.
The problem is that it is very difficult and expensive to have both lower business tax rates and more favorable treatment of capital investments, which requires policymakers to weigh the tradeoffs.
These are just some of the broad questions that make tax reform difficult despite a universal consensus that some type of reform is necessary. Each of the problems described above can be overcome, but not until we move beyond the talking points of tax reform. We must acknowledge the difficulties that lie ahead and encourage policymakers to get creative about solutions that can bridge the differences that exist between the two parties and between various stakeholders.
Neil L. Bradley is chief strategy officer at the Conservative Reform Network.