How to reform the corporate tax code

There has been alot of talk recently in Washington about reforming and simplifying the tax code, trading lower rates for fewer deductions. Frankly, I'm all for that, particularly with regard to the corporate tax code. My general view is that governments (federal, state and local) should concentrate more on creating conditions that are business-friendly in general, rather than friendly to specific businesses. Our current corporate tax system embodies the worst in special-interest politics. It has the second-highest statutory rate in the world, but the effective corporate tax rate is much lower. My studies have shown that we collect about the same percent of GDP in corporate taxes as other countries. That said, just about everything you find on the internet covering this topic is written by someone with an agenda, so it's hard to get it all straight.

Cutting through all the gobbelygook, there are two clear reasons why our current corporate tax system is bad for America.

  • By having a higher statutory rate we discourage non-favored business from establishing productive capacity in the Unites States. There are many areas in which the United States could be a big exporter of durable manufactured goods (where the cost of labor is small relative to the cost of capital), but the tax code basically discourages it.
  • We have a worldwide tax system. Most countries have a territorial tax system. In a worldwide system we tax American multinational profits no matter where they are earned, but allow companies to defer paying taxes earned on income abroad until those earnings are repatriated to the United States. Because we have a higher tax rate, multinational companies are basically encouraged to reinvest that cash abroad.

Thankfully, Obama seems to be moving in the direction of lowering the statutory rate, eliminating loopholes and moving to a territorial tax system. This is far better than the campaign position he took, which was to end corporate tax deferral and encourage companies to reincorporate and move their headquarters to places like Bermuda, Ireland and Switzerland so they could be taxed in a territorial system at a lower rate.

While moving to a territorial tax system would discourage the cash hoarding by companies abroad that has occurred since the end of the recession, there are two other changes that I recommend to encourage domestic investment (and the job creation that coincides with domestic investment):

  • Immediate expensing of R&D and investment. Companies are the most rational actors in the economy, so you can't really encourage investment that companies wouldn't make otherwise. You can, however, encourage them to pull investment forward by increasing investments' net present value by postponing tax expense, particularly for growing companies that are investing heavily. Such a change would also encourage foreign companies to invest in the United States. Obama has included a temporary proposal for investment expensing as part of a stimulus plan, and I would recommend making it permanent.
  • Expensing of dividend payments. The tax code encourages executives to receive option compensation as opposed to cash compensation. Options increase in value when the stock price per share goes up. Thus, when option-rich executives have extra cash, they favor conducting share buybacks over paying dividends. (The reason for this is that share buybacks reduce the number of shares outstanding while increasing demand for the stock. Dividends do neither of these things, but are more directly remunerative to shareholders.) In addition, companies tend to have extra cash when times are good and the stock price is high. If the company overpays for the stock, they are destroying shareholder value. Encouraging dividends would also reduce the tendency for companies to build up cash that they then burn on value-destroying, empire-building acquisitions. Companies should have to convince the capital markets to fund their acquisitions, as a matter of discipline. If we moved to allowing the deduction of dividend payments, the individual tax rate on dividends should be moved back to the income tax rate.

Making these two changes would encourage companies to either use profits for investment or dividends, and would discourage share buybacks, self-funded acquisitions and the needless hoarding of cash that is conducted particularly by so many US technology companies.

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