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If there is one policy agreement between Republicans and Democrats, it is that the 35 percent corporate tax rate in the United States should be reduced to 28 or 25 percent.

Brookings Economist Looks at the High Corporate Tax Rate

  • 2/6/2013

Brookings Economist Looks at the High Corporate Tax Rate

If there is one policy agreement between Republicans and Democrats, it is that the 35 percent corporate tax rate in the United States should be reduced to 28 or 25 percent. The current rate, highest in the advanced industrial world, is a disincentive to investment and encourages corporations to relocate overseas, according to Robert C. Pozen, an economist at the Brookings Institute in Washington, D.C.

Interest deductions and tax expenditures

Pozen thinks he has a solution: a modest limit to the deductions that corporations claim for the interest they pay on bonds and other debt.

“Admittedly, interest deductions probably won't be the first target for politicians,” said Pozen. “Most likely, politicians will first take a close look at the myriad of provisions designed to benefit specific industries.” He cited the fiscal cliff deal, which extended tax benefits for car-racing facilities, railroads, mining companies, and various alternative energy companies.

“Indeed, many of these preferences have highly suspect economic justifications; unfortunately, these special deals are too small for their repeal to raise a significant amount of revenue,” acknowledged Pozen. He also warned lawmakers against turning to some of the larger tax preferences that corporations enjoy, collectively known as “tax expenditures.”

Pozen said lawmakers would likely find it unwise, or politically infeasible, to repeal any of these large tax expenditures, such as accelerated depreciation or the research and development credit. Most Democrats and Republicans view these policies as being essential to economic growth. In addition, the bipartisan Joint Committee on Taxation has estimated that the elimination of virtually all corporate tax expenditures would not be sufficient to reduce the corporate tax rate to 25 percent.

Interest cap

Another approach, according to Pozen, would be to change how the U.S. taxes the foreign profits of U.S. corporations. Currently, U.S. corporations do not pay U.S. tax on foreign profits so long as they keep those profits overseas. Congress could raise a significant amount of revenue if it required U.S. corporations to immediately pay U.S. taxes on their foreign profits — beyond the foreign taxes they already pay. That could pose further problems, however, as the change would make the U.S. corporate tax system even more out of step with the rest of the world; most foreign countries require corporations to pay tax only on profits that were earned in that country (with exceptions designed to prevent abusive tax shifting).

Pozen proposes what he terms an "interest cap," which would also reduce a significant distortion in the tax code. Currently, if a corporation finances an investment with debt, it can deduct the interest that it pays on that debt. If a corporation finances an investment by issuing new shares of stock, or by using money in the bank, there is no equivalent deduction. As a result, the tax code effectively encourages corporations to load up on debt. This makes companies more vulnerable to downturns, exposing their employees to a greater risk of layoffs, and prolonging recessions in the broader economy.

To balance these competing demands, Pozen says his proposal would apply the interest cap to financial institutions, but at a lower rate. They would be allowed to deduct 79 percent of their interest expense, which is less than the 100 percent that they may deduct currently, but more than the 65 percent that nonfinancial corporations could deduct.

“Undoubtedly, certain debt-intensive industries will lobby against my proposed cap on interest deductions,” said Pozen, but he encourages lawmakers to resist such pressure.

“Policymakers should focus on setting the stage for broad-based economic growth by reducing the distortions in favor of debt-finance, and by bringing our corporate tax rate in line with the rest of the world,” he added.

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