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U.S. Corporate Tax Reform: Groupthink or Rational Debate?

July 19, 2011
| Reports
The United States is at risk of losing its global competitive advantage and with it faster per-capita income growth. To effectively respond, the nation must take concerted and strategic actions in a host of areas, including reform of the corporate tax code to transform it into a more effective tool to support private sector efforts to innovate and be more productive.

There is a growing consensus in Washington that the time has come for comprehensive corporate tax reform. Such reform could be the most important economic policy decision Washington makes. Its effects would likely have critical implications for the health of the U.S. economy for years to come.

While there are a range of issues any comprehensive tax reform package will have to address (including how foreign source income is taxed and the differential tax treatment of interest vs. dividends) this report addresses just two central issues:

  1. the extent to which reform should be focused on broadening the base and reducing so-called tax “distortions” on strengthening tax incentives to drive certain types of corporate investments; and
  2. the extent to which reform should be revenue neutral or cost revenue (at least in the short term) in order to lower the effective U.S. corporate rate.

If Washington is to get this right, the debate over corporate tax reform needs to be vigorous and informed by analysis and reason. Unfortunately, much of what passes for corporate tax reform policy analysis is nothing more than ideological assertions and Washington groupthink. Even among groups with differing ideologies, there is near universal belief in tax code simplicity. For example, the notion that the best tax code is one that is neutral and “doesn’t pick winners” is so widely touted that it has become conventional wisdom, is no longer even questioned and crosses party lines. Case in point, the Obama Administration’s Economic Recovery Board report on tax reform which stated: “The combination of a high statutory rate and numerous deductions and exclusions results in an inefficient tax system that distorts corporate behavior in multiple ways.” The issue of revenue neutrality is also confined by groupthink and ignores a significant body of academic research about the effects of taxes on corporate behavior. Anyone with the temerity to argue that simplicity should not be the main goal of corporate tax reform (and that the effective corporate rate needs to be lower) runs the risk of being treated with derision and disdain.

This report argues that this conventional wisdom is wrong and that if corporate tax reform follows the path laid down by the holders of the Washington economic consensus the result will be less growth, fewer jobs and reduced U.S. economic competiveness. In a world of intense international economic competition and a U.S. economy increasingly powered by innovation, a tax code that does not proactively “distort” the investment decisions of enterprises in the United States is one that is doomed to leave the United States behind in international competition. In fact, we are virtually the only nation in the world where the consensus is for eliminating, rather than expanding, incentives for business investment in innovation, capital equipment and machinery.

Rather, than a tax code that is based on the belief that Washington does not need to actively shape the structure and performance of the U.S. economy, the United States needs a corporate tax code that achieves three key things:

  1. provides direct incentives for U.S.-based enterprises to invest in the building blocks of innovation, productivity and competitiveness: research and development and innovation commercialization, workforce training, and machinery and equipment (including computers and software);
  2. taxes firms in internationally traded industries at a lower rate than firms in non- traded industries; and
  3. lowers the average effective corporate tax rate from its current levels.

Unfortunately, the conventional wisdom on tax reform, if followed, would lead to none of this. It would likely cut, not expand, key incentives that spur enterprises to invest more in the building blocks of growth and competitiveness, including the three most “costly” incentives, the deduction for domestic production, the R&D tax credit and accelerated depreciation. However, these are among the most pro-growth in the tax code. Reform would also likely raise taxes on traded sectors (sectors that compete globally such as vehicle production as opposed to those that do not such as barbershops) relative to their current rates (while lowering taxes on non-traded sectors), making them even less competitive than their competitors in other nations. And finally, if it is revenue neutral it would do nothing to lower the overall level of corporate taxation, thereby failing to address a key U.S. economic competitiveness challenge. American workers deserve better. At the very least, they should know that policymakers have heard and fairly considered all relevant arguments before deciding on a new tax policy.