Why Corporate Tax Reform Is So Tricky

The U.S. corporate tax code is an opaque morass of special-interest giveaways. It distorts investment decisions, fuels CEOs' addiction to debt, and discourages corporations from settling in the U.S. Oh, and its 35 percent statutory rate is the highest in the world.

The need to lose this albatross is the rare area of agreement uniting President Barack Obama, his Republican adversaries, and Big Business. All say that lowering the corporate tax rate while closing industry-specific loopholes could give the U.S. economy a jolt of adrenaline and make life easier for corporate treasurers.

So why do tax experts doubt things will change any time soon? A quarter-century after the last overhaul of the tax code under President Ronald Reagan, would-be reformers confront interlocking political and financial dilemmas that will only become more vexing as the 2012 Presidential campaign approaches. "There's an illusion of consensus. Everybody's view of tax reform is different," says Martin A. Sullivan, a contributing editor at Tax Analysts, a nonprofit organization in Falls Church, Va. "I don't expect any real movement."

Few undertakings are more politically difficult than tax reform. Worse, economists say the lower-rates/broader-base concept now being floated by the Administration and lawmakers would likely have little immediate impact on the nation's principal economic headaches: the $1.6 trillion federal budget deficit and the 8.8 percent jobless rate.

In December, the bipartisan panel appointed by Obama, the National Commission on Fiscal Responsibility and Reform, recommended using the proceeds from rewriting the tax code to pare the annual deficit by $80 billion in 2015 and $180 billion in 2020. Bowing to political reality, the Administration says it wants a revamp that would be "revenue neutral," meaning it wouldn't change the amount of cash coming into government coffers—or help close the deficit. Republicans have made no promises but reject any talk of increasing the government's tax take.

In any case, the immediate economic payoff from a new corporate tax code would be modest. "That's not where we should be looking in terms of employment effects," says Nariman Behravesh, chief economist for IHS Global Insight, who pegs the annual output gain from an overhaul at less than $100 billion. Mark Zandi, chief economist for Moody's Analytics (MCO), says a more competitive tax code would promote job growth over a decade or longer. "It takes time for the effects to be felt," he says.

For all its free-market brio, the U.S. has stayed on the sidelines of a global trend to cut corporate tax rates. From 2000 to 2010, the average statutory corporate rate among members of the Organization for Economic Co-operation and Development fell from 32.8 percent to 25.7 percent. Including subnational-level taxes, Japan's 39.5 percent rate is the world's highest. Prior to the earthquake, the Japanese government had announced plans to lop 4.5 percentage points off that rate in April, which would leave the U.S.'s 39.2 percent combined federal-and-state tax take as the globe's highest. Still, the U.S. now gets just 9 percent of federal tax receipts from companies, down from 32 percent in 1952.

Unlike most other industrialized nations, which tax corporations only on income earned in their native land, the U.S. taxes corporate income earned anywhere when it is repatriated. In a world of highly mobile capital, the American approach encourages companies to invest overseas and deters them from bringing home the profits from those operations. That explains why Corporate America is sitting on an estimated $1 trillion-plus in cash in offshore accounts. "The U.S. is an outlier on the corporate rate and the corporate tax system," says Alan J. Auerbach, a tax policy expert at the University of California, Berkeley. "On the other hand, it's not that easy to see how to change the corporate tax in ways people like to see."

Lawmakers on both sides of Capitol Hill have begun hearings on potential reforms. Yet unlike in 1986, when Reagan threw his full weight behind a tax-code makeover, no champion has emerged to drive the process. In his January State of the Union address, Obama said of the corporate code: "It makes no sense and it has to change." But he has yet to offer a specific proposal.

Obama's fiscal commission recommended comprehensive change that would lower rates and eliminate "tax expenditures," the special deals—including some gift-wrapped for specific industries—that lower corporations' tax burdens. Such provisions cost the Treasury about $102 billion each year, according to the Tax Foundation, a nonpartisan group in D.C. A deduction for domestic production activities that especially benefits the oil, gas, and coal industries—just one of the myriad tax breaks—will lower corporate tax bills by more than $10 billion this year. Yet even if lawmakers could summon the political will to kill every one, the corporate rate would only drop to 28 percent in a revenue-neutral plan, according to Sullivan.

Business advocacy groups such as the Business Roundtable and U.S. Chamber of Commerce back a move to lower rates. CEOs such as Robert A. McDonald of Procter & Gamble (PG) complain that the current tax code puts the company at a disadvantage in global markets. "We pay about two percentage points higher corporate tax" than international competitors, McDonald told a House hearing in January. About 40 percent of P&G's total sales are in the U.S., yet the company makes 60 percent of its global tax payments to the Internal Revenue Service. In the quarter ended Dec. 31, P&G paid an effective tax rate of 17.9 percent.

Not all members of America Inc. are equally enthusiastic. One reason: The 35 percent rate only hits some industries. Computer and pharmaceutical companies, which can shift profitable operations to low-tax jurisdictions such as Ireland, pay much less. Over the past three years, General Electric (GE), which has vast non-U.S. holdings, paid an effective tax rate of 3.6 percent, while retailer Wal-Mart Stores (WMT) paid 33.6 percent.

Any move to lower rates by eliminating widely used deductions would arouse the ire of businesses that aren't structured as conventional corporations and pay taxes instead at individual rates. Partnerships and other businesses that file as S corporations—including hedge funds, law firms, and sole proprietorships—wouldn't benefit from a lower rate on corporate income, and they would lose valuable tax breaks for expenses such as interest payments and accelerated depreciation.

"With a revenue-neutral approach, you always have the problem that there are winners and losers," says Joel B. Slemrod, an economics professor at the University of Michigan's business school and a former senior tax economist on Reagan's Council of Economic Advisers. "And losers always shout louder than winners applaud."

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