Candidate Trump called for a significant reduction in the corporate tax rate to aid the competitiveness of U.S. firms. The U.S. has the highest statutory corporate tax rate among advanced nations at 35 percent or nearly 40 percent when you include state and local business taxes. Trump called for cutting the federal rate to 15 percent. Moreover, the current corporate tax system encourages U.S. multi-nationals to defer taxes on foreign income indefinitely rather than return some home for investment. The system has encouraged U.S.-based firms to acquire foreign firms and do an “inversion” to avoid the pernicious business tax code. We need to address the causes of these actions rather than the symptoms.
Speaker Ryan and his colleagues have proposed sweeping reform of the business tax code by recommending a destination-based cash-flow tax system “DBCFT.” While there are legitimate concerns association with some of the features of this bold plan, it is a good place to start the discussion on modernizing the business tax system.
Globalization has forever changed the international competitive landscape, but U.S. corporate tax policy has not kept up. Because manufacturing investment is now highly mobile across borders, U.S. manufacturers and their workers have borne the brunt of this outdated thinking on corporate tax policy. The efficiency of investment is reduced as businesses allocate capital investment in specific projects across the globe based largely on tax considerations.
Lower tax rates on businesses will led to higher levels of domestic investment and a greater accumulation of productive capital. Having more capital stock available per worker augments productivity and improves long-run economic growth, leading to more jobs and a higher standard of living for those workers. Industries exporting a greater share of the goods and services that they produce pay higher wages than those that don’t. As exports rise from an improved competitive position, good middle-class jobs are created. In short, businesses will unleash their “animal spirits.”
The basic tenet of the DBCFT is that tax jurisdiction is based upon where consumption occurs rather than the location of production with the rate pegged at 20 percent for corporations and 25 percent for partnerships and proprietorships. This new tax system would provide for border adjustment by exempting exports and taxing imports. The DBCFT becomes in essence, a value-added tax (VAT) but with a deduction for wages and doesn’t tax income. This plan would reduce distortions by eliminating the deduction for interest payments on debt and place equity on an equal footing.
Another benefit is that it moves the U.S to a territorial tax system similar to most of our trading partners. The DBCFT would tax business earnings derived from domestic production in the U.S. rather than the current system which taxes U.S. multinational corporations on their worldwide earnings. Additionally, it allows for an immediate expensing for investment in equipment, structures and intellectual property rather than a depreciation schedule. This would end the accounting debate on how quickly a building should be depreciated as opposed to a software system.
The DBCFT would eliminate special interest provisions on deductions and credits. These provisions incentivize firms to make decisions largely based on tax considerations rather than on sound investment principles. Eliminating these tax expenditures would improve the public’s perception of fairness in the tax system. However, it would retain an important credit: the R&D tax credit. America’s future is based upon being the most innovative nation in the world. Further, the DBCFT would provide rules to allow foreign earning held abroad to be repatriated at a one-time rate of 8.75 percent. The plan doesn’t stipulate this, but some proportion of those repatriated earnings could be invested in infrastructure, something the President campaigned on.
There are some challenges that must be addressed to implement a DBCFT. The special interests that benefit from the current tax expenditure model will arm themselves with lobbyists to protect the status quo or at least their prized tax expenditure. Further, many industries that are large importers, such as petroleum refiners, retailers and auto manufacturers, will suffer in the short-term. Consumers might see prices rise for some products which are heavily imported. Another politically thorny issue is that some big corporate exporters may have a negative net tax liability. This could be addressed by provisioning the net tax liability forward for future use, but eliminate the government providing a current year payment.
Another issue is whether the WTO would see the DBCFT as a direct VAT or an income tax. Under the latter, wages would not be allowed to be deducted which is contained in the Ryan Plan. However, this could be overcome by creating a credit for wages paid somewhere else in the tax code. The border adjustment does offset some of the lost revenue from reducing the rate to 20 percent from a static analysis because of the U.S runs a large trade deficit, but the DBCFT would still likely reduce federal revenues by $500 to $800 billion over the next ten years even under dynamic scoring.
If President Trump is serious about leveling the playing field on trade for U.S. based manufacturers and other businesses, the DBCFT plan offers some appealing features. It rewards firms producing goods and services in the U.S. Although this feature may appear somewhat protectionist in nature, it permits the president to keep his promise on trade but not moving to impose new tariffs.
It should be pushed through Congress with bipartisan support because it will require seven Democratic votes in the Senate to pass. Now is the time for presidential leadership and a collaborative spirit to infuse Washington for the good of businesses, large and small, and most importantly, American workers.
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