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How to Save Corporate Tax Reform: Stop Exaggerating the Revenue Cost

by and Martin Vieiro | May 7th, 2012 | 10:27 am
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Until recently, corporate tax reform was a bipartisan priority. Commissions with a Democratic slant and a Republican slant both argued for a cut in the statutory US corporate tax rate – the highest among advanced countries – from 35 percent to the neighborhood of 25 percent.1 Congressional Republicans and President Obama’s Treasury Department agreed. But now, as the Financial Times has reported, corporate tax reform has slid to the bottom of Washington’s “must do” pile, not only for 2012 but also for 2013 and beyond.

Simple-Minded and Erroneous Math

The possible demise of corporate tax reform has been caused by, among other things, flawed revenue estimates issued year after year by the Congressional Budget Office (CBO) and echoed, among others, by the Congressional Research Service (CRS) and the Treasury Department.2 The simple-minded but erroneous math behind these estimates is explained by the CRS. Between FY2012 and FY2021, projected corporate revenue at the 35 percent statutory rate is $3,923 billion. Hence a cut in the rate by 10 percentage points will supposedly slash collections by a fraction of 10/35, or $1,121 billion over 10 years, or roughly $112 billion per year. By this arithmetic, each percentage point cut in the corporate rate is scored as costing the Treasury $11 billion per year.3 The logical conclusion is that the $11 billion revenue loss has to be “paid for” by curtailing business deductions, such as accelerated depreciation or the foreign tax credit. This logic sets up a food fight between firms that currently benefit from the deductions and firms that potentially benefit from the lower rate – with the potential of sinking the reform.

What’s Wrong with the Math?

While it was oversold in other dimensions of tax policy, the Laffer curve – the Reagan era notion that reduced tax rates produce greater tax revenues—actually describes the response to high corporate tax rates.4 Three things happen when the US corporate tax rate is stuck at 35 percent: projects are abandoned; firms locate facilities abroad; and firms organize as “pass through” entities (master limited partnerships, etc.) to escape the 35 percent rate. Macro-economic models and econometric evidence both demonstrate that cutting the corporate tax rate to 25 percent would lose little or no revenue over a 10 year period, because the corporate tax base would expand enough to pay for the lower rate.5 And in the process, jobs will be created and America will prosper. One of the most persuasive econometric studies, by Mertens and O’Ravn, examined US data from 1950 to 2006, and found that the “increase in the tax base is sufficiently large that the corporate income tax cut leads to a small decline in corporate tax revenues only after the first quarter and a surplus thereafter.” The authors conclude that “cuts in corporate income taxes are approximately self-financing” and that “a one percentage point cut in the [average effective corporate tax rate] raises real GDP per capita on impact by 0.5 percent and by 0.7 percent after five quarters.”

Phasing in Corporate Rate Cuts

Despite the evidence, the CBO and Treasury are set in their revenue estimating ways and it seems unlikely that they will improve their modeling anytime soon. Therefore, to get corporate tax reform back on track, we propose to phase in rate cuts and convince the skeptics by retrospective application of the Missouri motto: “Show me.” In our plan, the rate would be cut by 2 percentage points every odd year, starting in 2013, for the next 10 years – in other words, 10 percentage points over 10 years. If experience in the next odd year (starting in 2015) shows that receipts are significantly less than the simple-minded math would estimate, the next scheduled cut would be delayed until revenue in fact catches up with simple-minded math.

Our approach would ensure that the CBO could not score the cut as costing more than 2 percentage points—in other words, $22 billion a year, not $112 billion. At that price, corporate tax reform is eminently practical without triggering a food fight. The only reform that’s needed is to reverse the migration of large business firms into the ranks of “pass-through” entities. With an appropriate sales or asset test, it should be possible to corral enough master limited partnerships and the like back to the realm of normal Subchapter C corporations and raise at least $22 billion annually.

Notes

1. For a recap of commission proposals, see Hufbauer, Gary C. and Wong, Woan F., “Corporate Tax Reform for a New Century”, Policy Brief 11-2, Peterson Institute for International Economics, Washington DC, April 2011. Available at: http://www.piie.com/publications/interstitial.cfm?ResearchID=1811

2. The Hamilton Project, which should know better, recently repeated these errors in its publication. See page 18 of Greenstone, Michael, Koustas, Dmitri, Li, Karen, Looney, Adam, and Samuels, Leslie. “A Dozen Economic Facts About Tax Reform.” The Hamilton Project – Brooking Institution. May 2012. Washington, DC. Available at: http://www.brookings.edu/papers/2012/05_tax_greenstone_looney_samuels.aspx

3. Second order refinements in the simple-minded math deal with such matters as tax credits.

4. Arthur Laffer makes much of the claim that after a certain level, high tax rates diminish tax revenue owning to evasion, avoidance, and a decrease in economic activity. See, for example, Laffer, Arthur. “The Laffer Curve: Past, Present, and Future.” Heritage Foundation Backgrounder #1765. June 2004. Available at: http://www.heritage.org/research/reports/2004/06/the-laffer-curve-past-present-and-future

5. The Institute for Research on the Economics of Taxation (IRET) reports that a 10 percentage point corporate tax rate cut would boost GDP by over 2 percent and increase federal receipts by $19 billion (taking into account individual income and payroll taxes). The Peterson Institute for International Economics, using panel data for OECD countries, finds that a one-percentage point increase in the corporate rate slightly decreases corporate tax revenues expressed as a percentage of GDP. These studies are summarized in Hufbauer, Gary and Vieiro, Martin, “Right Idea, Wrong Direction: Obama’s Corporate Tax Reform Proposals.” Peterson Institute for International Economics Policy Brief. Forthcoming 2012. Washington, DC.

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