Economic Intelligence (U.S. News & World Report), February 24, 2012
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President Obama announced plans on Wednesday to reform the corporate tax code to make it simpler and fairer. The plan would reduce the top corporate tax rate substantially from 35 percent to 28 percent (25 percent for manufacturing) without increasing the deficit, a tall order indeed. Eliminating special interest tax breaks for business is an obvious quid pro quo for a lower tax rate and has the added benefits that it reduces the complexity and increases the fairness of the tax system. But this will not be sufficient.
To achieve a tax cut that is revenue neutral, the president has proposed eliminating three provisions in the tax code that create significant inequities and economic distortion. He proposes limiting the tax deductibility of interest, eliminating the special tax treatment of earnings of hedge fund and private equity managers, and reducing incentives for companies to offshore profits in tax havens.
Currently businesses can deduct interest payments on all of their debt no matter how highly leveraged they are. This leads companies to assume high debt-to-equity ratios not justified by business requirements. This makes companies vulnerable to financial distress in an economic downturn. A recent study of 2,156 highly leveraged companies found that a stunningly high 25 percent of them went bankrupt between 2007 and 2011. The tax deductibility of interest also encourages businesses to use complex financial instruments whose only purpose is to reduce the company's taxes. Finally, the disparate treatment of interest on debt and earnings retained by the corporation discriminates against innovative firms that want to use their profits to invest in technology or R&D, since retained profits are taxed, while profits used to pay interest are not. This is economically inefficient as it leads to too little investment and impedes growth.
The ratio of debt to the enterprise value of publicly traded companies is typically 14 percent, while companies acquired in leveraged buyouts have a debt-to-enterprise value of 67 percent. The president hasn't proposed a specific limit on the interest deduction, but limiting interest on the first 35 percent of debt would improve economic efficiency without affecting most companies.
The special carried-interest tax break for private equity and hedge fund managers has become familiar to most people through Warren Buffett's complaint that rich people often pay lower taxes than their secretaries and through the revelation that Mitt Romney's tax rate is less than 15 percent. When these managers earn profits for their investors, they receive 20 percent of these profits as compensation for good performance. But unlike other types of performance–based pay, this income is taxed at a 15 percent rate rather than the higher tax rate that most of us pay on our earnings. The president proposes eliminating this special tax break.
Finally, the president proposes reducing the incentive for profitable companies to park their profits in offshore tax havens. Businesses are estimated to have $958 billion held offshore. U.S. corporations can set up a holding company in locations where corporate taxes are low. They can then transfer ownership of trademarks, patents, copyrights, and other assets that yield royalties or interest payments to the holding company. U.S. taxes on these profits are not paid until the profits are repatriated. This is especially useful to financial services firms, to IT companies like Apple, Google, and Microsoft, and to pharmaceutical companies like Pfizer. Companies that use offshore manufacturing in low-tax regions are also able to defer payments on profits. This reduces investment in domestic productive capacity not for business reasons but simply to avoid taxes. The president's proposal will require companies to pay a minimum corporate tax on all offshore profits, thus reducing the incentive for offshore production and parking profits in a tax haven.
While it is unlikely that corporate tax reform can be accomplished in an election year, President Obama has sharpened the distinction between his proposals and those of the Republicans. Proposals from Mitt Romney, Rick Santorum, Newt Gingrich, and Ron Paul advocate a tax holiday for businesses that repatriate offshore profits and a "territorial system" that would exempt these profits from U.S. taxes permanently. They favor reducing the top corporate tax rate, from 25 percent (Romney) to as low as 12.5 percent (Gingrich), regardless of the huge increase in the federal deficit that would result. Americans will have the opportunity in November to decide what kind of corporate tax reform they favor.
Eileen Appelbaum is a senior economist at the Center for Economic and Policy Research.