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The Stubbornest Tax

by Kevin A. Hassett

Why the U.S. hasn’t cut corporate rates, and why it really should

The first order of business for a Republican president next year should be corporate-tax reform. But even if Republicans win big in the fall, undoing America’s largest policy error will be an almost impossible political lift, unless enough people in both parties come to grips with the counterintuitive economics of corporate-tax reform.

The U.S. is radically out of step with contemporary corporate-tax practice. On April 1 of this year, Japan reduced its combined corporate-tax rate — that is, its federal rate plus the average corporate tax levied by state and local governments — from 39.5 to 38 percent, leaving the U.S. with the highest rate among the developed nations in the OECD. Across the entire earth, the U.S. now has the third-highest recorded combined rate, at 39.2 percent, with only the Democratic Republic of Congo and Guyana treating corporate profits more harshly. Further, the U.S. is one of the few countries in the world to tax money that its corporations earn abroad once that money is repatriated; other nations tax only the activity that occurs within their borders.

The average combined rate in the OECD is now 25.4 percent, leaving the U.S. a whopping 13.8 percentage points higher than its typical trading partner. This gap actually understates the harm to U.S. job creation, because when a multinational corporation decides where to put a new plant, it compares the U.S. with the best possible alternative, not the average alternative. If a firm locates a plant in the U.S., it will, after state and local taxes, keep only 60 cents of every dollar the facility earns. If it locates the new plant in Ireland, it will keep 87 cents.

How did we get here? The lion’s share of the blame can be pinned on Democrats. They are in so much denial on this issue that President Obama’s proposed corporate tax “reform” actually would increase the taxes paid by U.S. corporations.

President Obama is not the first Democrat to ignore the economics of the issue. In 1993, President Bill Clinton signed into law the Deficit Reduction Act of 1993, which increased the federal corporate-tax rate from 34 to 35 percent and the combined rate from 38.9 to 39.7. The change came just after an explosion of academic literature that identified clear links between lower corporate-tax rates and economic growth. That literature set off a blizzard of corporate-rate reductions that continues to this day, and only a few increases have occurred over the same period.

However unfortunate it was, the 1993 increase kept the U.S. close to the average for the OECD countries. At the time, ten countries had a federal corporate-tax rate higher than 35 percent, while three matched the U.S. rate. Much has changed since then, and not in our favor. While the United States has kept its federal rate constant for almost 20 years, our trading partners have cut theirs. The OECD federal average has fallen from 34.3 to 23.6 percent. The post-Communist countries of Central Europe all lowered their rates from around 40 percent to 19 percent. Germany, a country that in 1993 was at the very top of the pack with a corporate-tax rate of 50 percent, also more than halved its rate — it has been 15.8 percent since 2008. Denmark reduced its rate in four steps by a total of nine percentage points. This wave of reductions, which intensified in the early 2000s, has left the United States a sad outlier within the OECD. All told, there have been 132 federal-corporate-tax-rate reductions in the OECD since the U.S. increased its federal rate to 35 percent.

The link between an attractive business climate and jobs and wages has been widely acknowledged across the political spectrum. Take our neighbor to the north. Canada currently has a federal corporate-tax rate of only 15 percent, and it started its path toward Art Laffer’s heaven under the guidance of the same Liberal party that constructed the Canadian welfare state. The 2000 budget, prepared by Liberal finance minister Paul Martin, proposed a cut in the federal corporate-tax rate from 28 to 21 percent over the course of five years. According to Canada’s Department of Finance, Martin believed at the time that “if no action were taken, Canada’s general corporate tax rate would not be competitive with those of our trading partners.” The conservative government elected in 2006 and led by Stephen Harper finished the job, bringing the rate to its current level.

There is little chance that the Left in the U.S. will be so reasonable. But the sad fact is that Republicans have been terrible on this issue as well. President Bush and the Republicans controlled all the levers of government in the 2000s, and stood idly by as rates fell around the world.

Republicans made that choice because of the dirty little secret of corporate-tax reform: Most U.S. corporations are not excited about it. The reason is simple. The current code is actually pretty friendly to big firms, which can avoid American taxes by locating activity abroad. An American multinational pays the high U.S. tax on profits earned domestically, and on profits earned by its foreign subsidiaries that are repatriated to the U.S. But if a firm earns money in Ireland, that money will be subject to U.S. taxes only when the company transfers it back to America.

So what do firms do? Naturally, they locate as much activity as they can in low-tax countries, use every legal trick in the book to make overseas subsidiaries receive as much of their profits as possible, and then leave the money sitting in foreign bank accounts.

These efforts are so successful that U.S. firms, on average, are paying about a 17 percent tax rate on their foreign earnings. This rate is available to any firm that has highly mobile production. The only big losers are traditional manufacturers such as Boeing, which are stuck with high-taxed big facilities here in the U.S., and American workers, who watch as workers in low-tax countries get all the new jobs.

Thus, a Republican who offers to reduce the U.S. rate to, say, 25 percent is offering something that has very little value to most corporations. They are already getting a better deal abroad. And those with big overseas profits will be especially wary of reform, since a couple of closed loopholes could easily wipe out the benefits of the lower rate. That doesn’t mean we shouldn’t make incremental changes. At the margin, American firms will likely choose to locate more activity in the U.S. if the rate is lower. Benefits to American workers have been predicted in a number of recent studies, such as a 2007 paper by Alison Felix; work done by Mihir A. Desai, C. Fritz Foley, and James R. Hines; and my own research with Aparna Mathur. All the studies conclude that labor bears much, if not all, of the burden of the corporate tax. It is counterintuitive, but a lower rate would therefore benefit workers more than corporations. Workers and their liberal allies around the world seem to have figured this out. But here in the States, they haven’t.

So there we have it. Corporations will give only two cheers for Republican attempts to reduce the rate. Workers, who would reap most of the benefits of the reform, are under the allure of Obama’s economically illiterate propaganda. Corporate-tax reform will happen in the U.S. if the corporate sector patriotically embraces it, even though the direct pecuniary benefits to individual corporations are small, uncertain, and eventually diffused into higher wages. It will also happen if the American Left produces a leader who is at least as reasonable as the average Canadian Liberal.

In other words, don’t bet on it.

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