As Foreign Profits Rise, Corporate Tax Rates Fall
Globalization is creating two misleading impressions about corporate taxes in the U.S.
First, corporate-tax revenue is keeping up with recent historical averages as a share of gross domestic product. However, that’s only because globalization has raised the corporate-profit share of GDP, while reducing the share of labor compensation.
Second, both Democrats and Republicans in Congress are committed to corporate-tax reform in response to globalization. Yet they are unlikely to accomplish much, because each party’s desired reforms are pretty much the opposite of the other’s.
Consider the state of corporate taxes. In the final quarter of fiscal year 2012, corporate income taxes amounted to 1.7 percent of GDP -- exactly their quarterly average over the past three decades. A closer look, though, reveals that this pattern reflects two contrasting trends.
The effective tax rate -- the share of corporate profits actually paid in taxes -- averaged 19 percent over the past three decades. That is much lower than the top corporate statutory rate, currently 35 percent, because of the various deductions and exclusions that corporations claim.
Over the past few years, this effective tax rate has plummeted. In the final quarter of fiscal year 2012, it was only 13 percent. That’s not necessarily a problem, if it is temporary. About half the recent decline in effective rates, for instance, can be explained by the temporary bonus-depreciation provisions that have subsidized corporate investment, and expanded use of loss carryforwards.
Yet there is a more permanent reason for the decline that has to do with globalization: an increasing share of profits is now earned abroad and taxed more lightly than domestic profits, as Edward Kleinbard of the University of Southern California has underscored. Relative to domestic profits, foreign profits have been rising for several decades, and that trend is likely to continue.
Globalization is thus reducing the effective corporate-tax rate as the share of profits earned abroad increases. At the same time, however, by raising the corporate-profit share it is also increasing corporate-tax revenue as a percentage of GDP.
Over the past three decades, profits averaged 9 percent of gross domestic income. In the final quarter of fiscal year 2012, though, they amounted to 12 percent. That increase amounts to an extra $450 billion a year in profits. Those extra profits were enough to lift corporate taxes to 1.7 percent of GDP despite the low effective tax rate.
Meanwhile, as I have written previously, the decline in labor compensation as a share of national income has suppressed income growth for the typical worker.
Globalization is also the main reason why corporate-tax reform is harder than most people think. Under the current complicated system, as a recent Congressional Budget Office report explains, U.S. multinationals are partially taxed on the profits they earn abroad.
Republicans and the Business Roundtable generally favor moving away from this system and toward a territorial one, in which companies would be taxed only on the profits they earn within the U.S.
The Barack Obama administration, in contrast, is concerned about companies shifting profits and jobs overseas, an activity that a territorial system would only encourage. (As the CBO report highlights, other countries with so-called territorial systems, such as France and Japan, typically have anti-abuse provisions to keep companies from shifting profits to tax havens. Pure territorial systems are much less common than some advocates in the U.S. suggest.)
Another reason that corporate-tax reform is so hard is that tax rates vary significantly across and within industries. Consider, for example, a comparison of rates made in a National Bureau of Economic Research paper by Kevin Markle of Dartmouth College and Douglas Shackelford of the University of North Carolina at Chapel Hill: From 2005 to 2009, the effective corporate-tax rate in mining amounted to just 6 percent, while in manufacturing it was 26 percent and in retail trade, 31 percent.
All companies are in favor of coupling lower statutory-tax rates with a broader tax base -- unless the base broadens so much that it undercuts their lower rates. It is mathematically impossible, furthermore, to keep the overall effective tax rate constant while cutting that rate for some companies, unless the overall effective rate increases for others.
Globalization is putting increasing pressure on the corporate-tax system. But with diametrically opposed visions on how to adapt the system, the likelihood that reform will happen is very small.
(Peter Orszag is vice chairman of corporate and investment banking at Citigroup Inc. and a former director of the Office of Management and Budget in the Obama administration. The opinions expressed are his own.)
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