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When Does a Corporate Income Tax Become a VAT? Or Why Do Conservatives Oppose a Flat Tax for Business?

e21 | 01/30/2012 |

On the heels of his State of the Union Address, President Obama’s Administration is planning to release a reform proposal for the corporate tax system. The plan is supposed to be released in early February, perhaps on the same day as his budget proposal for fiscal year 2013.

This is not the first time that expectations have started to spike ahead of a potential catalyst for reform. Wall Street Journal editor Steven Moore noted towards the end of last year that Congressional negotiators were in advanced tax reform talks in the context of the Super Committee. Specifically, the reports indicated that negotiators may trade fewer deductions for capital spending and interest for lower corporate tax rates of “between 25% and 28%, down from 35% now.” The Ways and Means Committee then released a table demonstrating that the “revenue neutral” corporate tax rate would be 28%, which means that the revenue generated from the elimination of all tax expenditures could reduce the statutory rate by 7 percentage points. Further reducing the rate to 25% would require changes to the definition of “corporate income” to disallow deductions for what are currently considered legitimate business expenses.

The problem with an effective tax rate of 28% is that the average effective corporate tax rate today is just 24%. Thus, the elimination of tax credits and other preferences actually increases taxes on the “typical” corporation. Of course, there is no such thing as “typical,” as the tax burden differs substantially by industry, with mining and drilling firms facing an effective tax rate of 9.2%, while computers and software firms pay 31.8% of their income in taxes. A key determinant of an effective tax rate is the size of a firm’s inventories, which are disadvantaged relative to capital equipment from a tax perspective and carry an effective tax rate of more than 34%. The key point is that a reduction of the top tax rate to 28% would help very few industries and cutting deductions for capital spending could raise the effective tax rates for many more firms.

Effective Total Business Tax Rates by Industry 
 Corporate TotalTotal Including Non-Corporate Firms
Equipment20.8%19.9%
Computers & software31.8%30.7%
Communications equipment & instruments18.5%17.9%
Office equipment & furniture18.9%17.3%
Automobiles29.7%28.6%
Other vehicles & transportation equipment15.8%15.4%
Machinery17.7%16.9%
Fabricated metal products & general industrial equipment16.9%16.4%
Other equipment23.8%22.8%
Structures26.1%10.5%
Residential buildings23.8%0.9%
Nonresidential buildings30.8%29.1%
Mining & drilling structures9.2%9.0%
Other structures19.7%19.2%
Inventories34.4%32.4%
Land31.0%12.9%
Total26.3%13.8%

Worse, unlike on the individual side, it is not clear that trading reduced rates for fewer deductions is actually a net positive economically. To get rates to 28%, Congress would have to eliminate both accelerated depreciation and the expensing for research and development. Both changes would raise the effective marginal tax rate on new investment, which could make the economy smaller by reducing investment and the capital stock. (Note that eliminating the expensing related to research and development is different from eliminating the R&D tax credit that provides and additional layer of tax benefits for certain expenditures.)

So, to recap, revenue-neutral corporate tax reform: (A) has little support among corporate constituencies because it creates as many (or more) losers as winners and; (B) would be scored by most economic models as reducing economic growth because, in effect, the lower statutory tax rate is achieved by increasing taxes on new capital expenditures. Needless to say, it’s at this stage in most policy cycles – as expectations build and fall in tandem with news reports – that corporate tax reform efforts generally fizzle. However, this need not be the case this time around. As reviewed at the outset, rate reductions below 25% require redefining “corporate income.” This would include the disallowance of normally permissible deductions, including those for wages, benefits, and administrative overhead.

As e21 explained previously with respect to the individual income tax, conservatives would be wise to trade lower rates for fewer tax expenditures even if it results in more revenue. There is nothing different conceptually between the mortgage interest deduction and a program whereby the Department of Housing and Urban Development mailed checks to homeowners based on a complex formula. The problem is that not every instance of “spending through the tax code” is classified as a tax expenditure, including and most notably, refundable tax credits where a household receives a check from the IRS despite owing no tax.

These complications seem quite modest when compared to the taxation of corporate income. The very concept of “corporate income” is an abstraction, as the government’s share of corporate revenues comes from flows that would have otherwise accrued to shareholders, employees, management, suppliers, and customers. As Greg Mankiw has said, “a corporation is not really a taxpayer at all. It is more like a tax collector.” Interestingly, the fewer the allowable deductions and the broader the base, the more the corporate tax looks like a consumption tax rather than an income tax. A value-added tax (VAT), for example, is essentially a corporate income tax where the only allowable deduction is for the cost of inputs. The fewer the deductions, the more clear is the corporation’s role as tax collector rather than taxpayer.

Corporate income taxes only generate 2% of GDP in revenue. In 2007, Treasury estimated that the elimination of all deductions aside from the purchases of goods from other businesses could allow the revenue neutral rate to be reduced from 35% to just 5% or 6%. This assumes the tax base for the corporate tax would be equal to about 41% of GDP, as is the case in most European VAT systems, up from the current tax base of just 10% (or so) of GDP due to the allowable deductions.

In short, if Congress were to embrace tax reform on this scale, it would be quadrupling the tax base in exchange for slashing the tax rate by 85% (from the current corporate level of 35% to 5%). This seems to be the clearest example of trading low rates for a broad base, as is generally counseled as the best course of action by many economists. A 5% or 6% rate would reduce the effective marginal tax rate on investment from its current level of 17% to 8%, which would increase the size of the economy.

Why do so many tax experts that normally recommend broadening the base and lowering rates have such difficulty accepting corporate tax reform of this scale? Largely because of an ideological aversion to big government. The VAT is thought to be like a drug. When in need of more revenue, politicians can simply turn the VAT-dial and increase the revenue flowing into their coffers. This may be true, but that’s because of the economic efficiency of the tax. The more efficient the tax structure, the lower the compliance costs and the less well organized the political opposition will be to increasing that specific tax. However, the same calculus is as true for the individual flat tax as it is for a business activity tax (BAT). Yet, most conservatives that actively promote a flat tax on the individual side vigorously oppose a BAT.

The basic intuition is simple: because it is so easy to identify the “losers” if the mortgage interest deduction were eliminated, those at risk organize politically to maintain their tax preference. By doing so, they provide political pressure for less revenue. This helps to keep the government smaller than it otherwise would be.

Obviously, the politics of tax distribution can be more important than economics. As shown in Table 3 of a 2006 Treasury analysis, the portions of the Bush tax cuts that enjoy practically universal consensus in support (child tax credit, marriage penalty relief, 10% bracket, etc.) actually reduce the size of the economy, on net. Conversely, the portions the Obama Administration seeks to repeal (current top marginal rates, capital gains and dividends) actually increase the size of the economy rather substantially. In this case, the revenue loss from the less efficient tax policy is politically acceptable even as the revenue loss from the more economically productive tax policy is not because of the political clout of the impacted constituency, who often espouse the “other” positive social policy effects like household formation.

In the end, the super committee failed to advance tax reform at the end of 2012. But, if this next debate in early February does serve as a catalyst for fresh Congressional action – presuming that Obama’s approach will be a base-broadening tax reform proposal – many conservatives will have to rethink a policy position that advocates a broad base, low rates, and maximum efficiency in the individual context but is so averse to the same ideas applied to business taxes. The most economically efficient taxes are the ones that appear easiest to increase. This is just as true if the flat rate is applied to individual or corporate net revenues.


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