The much anticipated corporate tax reform framework released last week by President Obama hit the right notes but lacked the details to know if it can fully realize it's potential.
While it's unclear if it would generate enough new revenue given high deficits and severe program cuts we face, the framework has the potential to be much more. It is path-breaking in diagnosing problems with business taxes. Moreover the reforms could improve the integrity of the tax system in ways that help redeem how American politics deals with taxes.
First, Obama's framework zeros in on why America's system of business taxes is so dysfunctional. Corporate taxes generate far less revenue as a percent of the U.S. economy than most other wealthy nations, while the official 35 percent rate is higher than almost any other country. Special tax preferences and loopholes reduce the actual tax rate to far less. A recent study of profitable Fortune 500 companies found they pay only about half the legal rate and many companies pay more on lobbying than on taxes.
As a result, businesses that can't afford fancy tax lawyers end up paying close to the official 35 percent rate, while many of the nation's largest corporations get away tax free. It isn't just unfair. Productivity suffers when companies succeed based on the abilities of their lobbyists and lawyers, rather than their innovation and efficiency. We won't outcompete China by having the world's best tax-avoidance lawyers.
Obama's framework would close some of the worst loopholes in the tax code, such as ending unjustified subsidies for oil companies, hedge fund managers, and corporate jets. Perhaps most important, the White House's plan would end some incentives for companies to shift their profits to offshore tax havens. Companies with the ability to employ big legal and tax departments increasingly use sophisticated tax dodges that shift profits earned in the United States to places like the Cayman Islands that levy little or no taxes and disclose almost no information to American tax authorities. The Obama framework proposes a number of possible measures, including a minimum tax on American subsidiaries that transfer profits overseas to tax havens.
The last major tax reform, which happened in 1986, offers a cautionary tale. Although corporate tax rates would be lowered across the board, might reforms set off a new round of loopholes and tax avoidance strategies?
The answer depends partly on whether enhanced reporting requirements will be introduced to ensure that companies truly managed and controlled from the U.S. will be treated for tax purposes as domestic corporations. Regardless of where they register, companies active in the U.S. that send profits to offshore companies that don't comply with American financial disclosure laws should pay taxes on those profits. Legislation such as the Cut Loopholes Act, recently introduced by Senators Levin and Conrad, would strengthen reporting and disclosure requirements to advance those goals.
More profoundly, a look at the experience of other nations suggests that redeeming America's tax system over the long term will only be possible if taxpayers trust that others similarly pay their full tax bill. One reason that a country like Sweden sustains political support for high taxes is that Swedes trust that their compatriots contribute just as much as they do to supporting public structures. Eliminating loopholes and leveling the playing field among businesses can boost confidence over time in the capacity of government. Again, this will depend a lot on whether a new tax framework is accompanied by enhanced reporting requirements.
Obama's framework also takes an important step toward creating integrity for the tax system by proposing to end the practice of introducing "temporary" tax breaks, which get continually reapproved and enlarged over the years by Congress without regard to how they will pay for them. Politicians maintain this fiction because it allows them to show savings in their future budgets by assuming the tax breaks will expire, while deferring those difficult decisions into the future. The Obama framework instead calls for tying future corporate tax breaks to the closing of other loophole closing or the introduction of higher rates. If you want to create a new corporate tax loophole, you'd need to close an existing tax break of equal size. This would rein in special-interest tax preferences.
The president's framework has elevated the conversation over business taxes. It will mean a lot more if the White House fills in the details in ways that advance what's already promising in their plan.