Wednesday, March 14, 2012
The one thing on which our political leaders seem to agree is the need for corporate tax reform. Barack Obama and Mitt Romney unveiled new proposals on the same day last month, with President Obama cutting the top corporate tax rate to 28% and Mr. Romney reducing it to 25%. Rick Santorum would cut the rate to 17.5%, and to zero for manufacturing. Congressional action is bubbling below the surface as well.
This flurry of proposals is a result of increased awareness of how out of step America is with the rest of the world. The U.S. is currently an outlier within the 34-member Organization for Economic Cooperation and Development, with a combined state and local corporate tax rate that is about 15 percentage points higher than the average of our trading partners.
But amid all of the promising rhetoric there is significant cause for concern. Many proposals, particularly those of Messrs. Obama and Santorum, seem to have unlearned many of the lessons of modern economics. Three shifts in the economic environment since the 1960s, each recognized by most economists, provide an essential guide to reform.
First, U.S. tax policy can no longer treat the U.S. as a closed economy. Capital and business activity are increasingly mobile across national boundaries and highly responsive to variation in the net tax paid across locations. Second, the word "business" is not synonymous with "corporation"—pass-through (noncorporate) businesses are almost as important in the aggregate as old-fashioned corporations. Third, economic research has stressed that both corporate taxes and investor-level taxes on dividends and capital gains contribute to the tax burden on corporate equity. Investors factor in the total capital tax, both individual and firm level, when making decisions. ...
Mr. Obama's plan, as if designed by Rip Van Winkle, is blind to this major shift and is thus a weak tonic for the flagging economic recovery. While the president proposes reducing the corporate tax rate, other changes that are portrayed as "loophole closing" on multinational firms make his plan a net increase in corporate taxes collected.
Mr. Obama, ignoring the second reality, would also raise taxes on noncorporate business, in the interest of requiring the "rich" to pay for the "privilege" of being an American, to paraphrase a recent statement by Treasury Secretary Tim Geithner. ...While cutting corporate tax rates with his left hand, Mr. Obama would increase tax rates with his right by radically increasing tax rates on dividends and capital gains. Modern economic theory and empirical evidence—including a series of papers by one of us (Hassett) and Alan Auerbach of the University of California, Berkeley—show that raising taxes on dividends at the individual level increases the cost of equity capital and lowers asset prices, harming consumers while hindering firms' ability to hire workers.
The plans of Messrs. Romney and Santorum have significantly more promise. Both would bring down rates on corporate and noncorporate income, though only Mr. Romney would do so in a revenue-neutral way (the Santorum plan adds greatly to federal deficits). According to one study, a top marginal tax rate on individual incomes of 28% as proposed by Mr. Romney, compared with Mr. Obama's proposed top marginal rate of 39.6%, would increase the wage bill of noncorporate businesses by over 6%, raise investment by 10%, and push business receipts up by 16%.
And by proposing special tax breaks for manufacturing, Mr. Santorum follows Mr. Obama's incorrect lead and introduces a significant economic distortion. In a world with highly mobile capital, tax policy needs to be neutral toward different forms of business activity and not succumb to the temptation to pick winners and losers. We are aware of no serious economic argument to support such a policy direction. ...
Mr. Obama's tax reform proposal takes a wrong turn in each area and appears motivated by a poor understanding of the impact of capital taxation on business behavior and the welfare of middle-class Americans.