Blue Skies for Business Tax Reform? Part 2: Lower the Corporate Tax Rate

April 19, 2016 12:15 PM

In a previous post, we showed that 2017 could be auspicious for modest corporate tax reform. Reform might combine three elements: a lower corporate tax rate; a tax repatriation holiday; and a larger role for “pass-through” taxation. This blog discusses the corporate tax rate.

The US statutory corporate tax rate (federal and state combined) is the highest in the world among major nations (table 1). Few firms, either in the United States or abroad, pay the statutory rate on their reported earnings, owing to various deductions in computing taxable income and assorted credits against taxes owed. To reflect deductions and credits, corporate tax rates are often evaluated in terms of average effective rates. Even so, the US average effective corporate tax rate (federal and state combined) on large firms—those that compete in the international economy—is high in comparison to peer countries (table 1).

Table 1 Statutory and average effective corporate tax rates in systemically important countries (percent)
Country Statutory corporate tax rate, 20151 Average effective corporate tax rate, 20142
Australia 30.0 26.0
Brazil 34.0 24.9
Canada 26.3 3.9
China 25.0 10.9
France 34.4 0.5
Germany 30.2 23.2
India 34.6 24.9
Italy 27.5 19.5
Japan 32.1 28.9
Korea 24.2 18.2
Mexico 30.0 25.4
Netherlands 25.0 20.4
Poland 19.0 14.5
Russia 20.0 8.9
South Africa 28.0 21.7
Spain 28.0 13.3
Sweden 22.0 13.1
Switzerland 21.2 9.3
Turkey 20.0 17.9
United Kingdom 20.0 19.2
United States 39.0 28.1
Unweighted average, excluding US 26.6 17.2
1. The statutory corporate tax rates for OECD countries (all countries except Brazil, China, India, Russia, and South Africa) represent the combined central and subcentral corporate income tax rates. 
2. Average effective corporate income tax rates measure the average rate a firm might expect to face on an investment project, taking into account the possible range of profitability outcomes. 
Sources: Statutory corporate tax rates for OECD countries are from OECD Tax Database, 2015; Statutory corporate tax rates for non-OECD countries are from KPMG's 2015 Global Tax Rate Survey; average effective corporate income taxes are from Paying Taxes 2015: The Global Picture, World Bank and PricewaterhouseCoopers.

Cross-country comparisons make the case for cutting the US statutory rate to the range of 25 to 28 percent. Keeping the same corporate deductions and credits, this reform would lower the average effective rate to a range of 18 to 21 percent. While the reform makes economic sense, politically it will be difficult for two reasons. First, any corporate tax rate cut will be portrayed by opponents as a means of enriching the top 1 percent of households.1 That argument could be offset by enacting higher tax rates on upper-bracket households. But higher personal income tax rates will trigger a second objection, this time from small business firms that are taxed on a “pass-through” basis. These firms allege “unfairness” if tax law changes make them pay higher tax rates, while corporations pay, at the business level, lower tax rates. Contrary to this allegation, in absolute terms, per $100,000 of business earnings, small business households would still pay less tax than shareholder households that pay tax once at the business level and a second time on dividends or capital gains. Table 2 illustrates the comparisons both under current law and with a 28 percent federal corporate tax rate. Table 2 assumes that households and Subchapter C corporations both pay taxes at the maximum federal statutory rates.2

Despite the illustration in table 2, Senator Orrin Hatch, chairman of the Senate Finance Committee, has claimed that lower corporate rates without reducing the personal income tax rate would “have a uniquely damaging impact on small businesses and the jobs that they provide.”

Keeping this argument and its powerful proponent in mind, the best that might be achieved under a Democratic White House and a Republican Congress is a reduction in the corporate statutory rate to someplace between 25 percent, the rate proposed by Governor John Kasich, and 28 percent, the rate proposed by President Barack Obama.3 Assuming that the past relationship between statutory and effective corporate tax rates holds, a 28 percent statutory rate would imply a 21 percent effective rate. This would significantly improve the competitive position of US firms in the world economy. Yet, as table 2 illustrates, pass-through entities would still have a tax advantage over Subchapter C corporations.

Table 2 Tax burdens, pass-through entity vs. Subchapter C corporation, assuming statutory federal tax rates
  Pass-through entity, 39.6% current rate Subchapter C corporation, 35% current rate Subchapter C corporation with 28% statutory rate
Business profits $100,000 $100,000 $100,000
Corporate income tax1  —  $35,000 $28,000
Net income after tax $100,000 $65,000 $72,000
Personal income tax2 $39,600
Capital gains tax3  —  $13,000 $14,400
Total after-tax income $60,400 $52,000 $57,600
Total tax rate 39.60% 48.00% 42.40%
1. Under current law, the average effective corporate tax rate for Subchapter C corporations is 28 percent, as shown in table 1. If the statutory tax rate is lowered to 28 percent, keeping the same corporate deductions and credits, the average effective rate would fall to about 21 percent.
2. The average effective personal income tax rate on pass-through income under current law is about 19.5 percent based on Cooper et al. (2015).
3. Assumes that all after-tax corporate income is ultimately taxed at the current capital gains rate of 20 percent.
Source: Cooper et al. (2015).

Reference

Cooper, Michael, John McClelland, James Pearce, Richard Prisinzano, Joseph Sullivan, Danny Yagan, Owen Zidar, and Eric Zwick. 2015. Business in the United States: Who Owns It and How Much Tax They Pay. Tax Policy and the Economy 30.

Notes

1. Many people vaguely feel that the corporate income tax amounts to a tax on the rich, especially the top 1 percent of households. Insofar as the ultimate payers are shareholders rather than workers or consumers, this is roughly right, since the top 1 percent of Americans hold nearly 50 percent of shares owned by households. However, the bottom 99 percent own shares as well, as do pension funds, college endowments, and art museums. See Hufbauer, Jung, Moran, and Vieiro, The OECD’s ‘Action Plan’ to Raise Taxes on Multinational Corporations, PIIE Working Paper 15-14, September 2015.

2. Research by Cooper et al. (2015) indicates that pass-through households pay an average effective rate of 19.5 percent (20 percentage points below the maximum federal statutory rate) and, as shown in table 1, Subchapter C corporations pay an average effective rate of 28.1 percent (7 percentage points below the federal statutory rate). In other words, the tax preference for pass-through households is greater in effective tax rate terms than in statutory tax rate terms.

3. Obama’s 28 percent rate proposal was coupled with the denial of significant corporate deductions. Elsewhere we have explained why eliminating the corporate deductions would be a bad idea.