Take the Odds on Corporate Tax Reform

The smart money always wagers against tax reform, but 2015 may be the year the sucker bet pays off, at least for business taxes.

A corporation of one.

Photographer: David Paul Morris/Bloomberg

The smart money always wagers against tax reform, but 2015 may be the year that the sucker bet pays off, at least for business taxes. The driver could be the outdated corporate tax system: The current 35 percent rate is out of step with world norms and holds back investment in the U.S. 

There is general agreement that the corporate tax rate should be in the mid-20s. There is also near-consensus that most tax incentives and subsidies should be thrown out to free up the revenue needed for lower rates. 

Two big hurdles remain. The more intractable one involves so-called pass-through entities. These firms -- sole proprietorships, partnerships, limited liability companies and S corporations -- are often conflated with small businesses and entrepreneurs, even though many of them are well-heeled hedge funds, law firms and private-equity shops. 

Collectively, pass-throughs earn about half the U.S.'s domestic business income, yet they pay no corporate tax. Instead, profits flow to their owners, where they are taxed at ordinary income rates. 

Here's the rub: Pass-through owners would get no benefit if business tax subsidies are ended in exchange for a lower corporate tax rate. Pass-through owners would, in effect, get a tax increase. They would naturally balk at such a deal. 

Reducing top individual tax rates is a nonstarter. The Barack Obama administration would be adamantly opposed, and the revenue drain would be unacceptable. Many affluent individuals, after all, earn large salaries working for big companies. Lowering individual rates in the purported service of “small business” would bestow windfalls on these fortunate owners and employees. 

A better strategy would encourage pass-throughs to incorporate. Incorporating is tax-free, so that isn't a problem. If dividend and capital gains tax rates stay where they are, then the all-in tax burden on future corporate profits distributed to owners wouldn't differ materially from the top marginal rate (about 40 percent) that owners of successful pass-through firms face today. 

Herding more business income into the corporate tax system would have important policy and political payoffs. Congress and the Internal Revenue Service today must maintain two different business-tax systems. The U.S. should make one system work well, rather than muddling along with competing regimes. By picking one tax system, the U.S. could reduce taxpayer gaming and the wide disparity in effective tax burdens on business income. 

The second hurdle is figuring out what to do about the international income of U.S. multinationals. Here, Republican leaders in Congress and the administration are within striking distance of a deal. It would call for the U.S. to move to a so-called territorial tax, backstopped by a strong anti-abuse rule (probably a minimum tax), under which profits escaping any serious foreign taxation would be taxed in the U.S.

Companies would also be required to pay tax at a negotiated rate on their $2 trillion-plus stockpile of offshore earnings. The result would be a more neutral and stable system in which big U.S. multinationals pay more tax on their foreign operations than they do today.

The great fear of U.S. multinationals is that Congress will play them for fools: A few years after surrendering business tax subsidies in return for lower corporate tax rates, Congress will jack up the rates again. The best insurance against this is for the corporate-tax rolls to swell with tens of thousands of successful small- and medium-sized businesses, as found in every congressional district. They would serve as the enforcers of tax reform’s bargain. 

But what should be done about genuinely small businesses? The corporate tax can accommodate them, too, by offering graduated rates on corporate incomes, just as the U.S. does for individuals. For example, Congress could offer preferential rates on the first $2 million of corporate income each year. 

The tax code nominally does this today, but the reduced tax brackets are set to absurdly low income levels. And in a particularly cruel twist, the code immediately takes away the benefit of lower brackets with a surtax on the next few higher dollars of corporate income. 

The U.S. could encourage the incorporation of domestic businesses by letting firms keep the benefit of graduated corporate tax rates, perhaps until earnings reach $10 million. 

Offering bargain corporate-tax rates to induce small- and medium-sized companies to accept tax reform might seem distasteful to some, but it’s a good deal for America. One comprehensive and sensible tax system for all businesses above a certain size should be the ultimate objective.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.