With so much attention focused on whether 2013 will bring tax increases to the rich (it will) and small businesses (it won’t), the corporate tax system, as broken as any in our 70,000 page Internal Revenue Code, goes unnoticed.
Aside from their shared love of John Hughes movies, the need for corporate tax overhaul was the one item President Obama and Mitt Romney agreed upon, as they both recognized that the combination of a high tax rate and a narrow tax base has left U.S. corporations struggling to compete on an unbalanced international playing field.
The ideal corporate tax system, most would agree, would be defined by three key characteristics:
1. Has a low maximum tax rate,
2. Contains limited deductions and preferences,
3. Is fairly simple for corporations to implement and for the IRS to monitor.
Such a system is generally favorable because it encourages hiring, does not distort a corporation’s choices over where to produce or how to finance its operations, and it does not appreciably favor one industry over another.
Needless to say, this is NOT our current system. At the moment, U.S. corporations are subject to a maximum 35% rate, the highest of any advanced nation. It should be noted, however, that the effective marginal tax rate – or the rate a business would actually expect to pay on a marginal investment — is only 26%.
While that reduced effective rate may sound like a good thing, it’s important to understand what makes up the difference: the effective rate is lower than the maximum rate of 35% because of the abundance of deductions and preferences that litter the current law and narrow our tax base. And while those loopholes may reduce a corporation’s tax liability, they also serve to add considerable complexity and increase a corporation’s compliance burden. In fact, it’s estimated that U.S. corporations pay over $40 billion per year on administrative and compliance costs; enough to fund the L.A. Dodgers’ payroll for three full months.
To his credit, the President appears to recognize the shortcomings of the current regime. Last February, he published his creatively named “The President’s Framework for Business Tax Reform,” which represents a decent jumping off point for any future discussion on an overhaul of the corporate tax system. The President’s plan can be separated into three distinct categories: general corporate reform, manufacturing industry reform, and international reform.
General Corporate Reform
President Obama has proposed lowering the maximum corporate tax rate from 35% to 28%. Understand, however, that this lost revenue is to be paid for by broadening the tax base, i.e.., eliminating deductions. Part of the goal of the base broadening would be to eliminate the preferential treatment enjoyed by some industries under the current system. Take a gander at the following table, which illustrates the effective tax rate paid by different industries in 2007 and 2008, even though they were all subject to the same top marginal rate of 35% (CLICK TO ENLARGE):
Clearly, there’s something wrong with a tax system that forces the manufacturing and construction industries — among the leaders in job creation — to pay tax at an effective rate of nearly twice the mining industry. To fix this discrepancy, the President’s framework would level the playing field by starting with the presumption that all tax expenditures for specific industries should be eliminated, with a few exceptions that are critical to growth (see manufacturing discussion, below). The framework highlights a few examples:
In addition to these industry-specific changes, the President’s framework for corporate reform would make permanent 100% bonus depreciation for “small businesses” and allow C corporations with up to $10,000,000 of average gross receipts to use the cash method of accounting (the current limit is $5,000,000).
Manufacturing Industry Reform
While the President asserts that all industries should be treated equally, some will be treated a little more equally than others, as the plan goes on to bestow certain preferences specifically on manufacturers by proposing the following:
International Reform
No discussion regarding corporate tax reform is complete without addressing the international tax regime, but in reality, this discussion likely warrants a post of its own. In short, however, President Obama has a drastically different view of the appropriate tax treatment of the international operations of U.S. corporations than many international tax experts.
Under the current system, the profits of a foreign affiliate of a U.S. corporation are taxed when they are repatriated to the U.S. While many international policy gurus favor a move to a “territorial” tax system — whereby foreign profits would only be taxed once, by the foreign country — the President wants to expand the current corporate tax regime to a “worldwide system” in which profits earned by foreign affiliates of U.S. corporations would be taxed even before they are repatriated to the U.S. This is sure to be a sticking point in any future negotiations, as some powerful lobbies (read: Apple, Google) will not take kindly to the idea of a minimum international tax rate.
The president’s proposals include the following:
The lesson, of course, is that proposed corporate tax reform — like a carburetor or a swingers’ party — has a lot of moving parts. And as we’ve witnessed over the past six weeks, getting Congress to agree on anything is not an easy task. But if there’s one thing both parties can agree upon, it’s that something needs to be done to fix our broken corporate tax system, and soon.
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