If there's one policy agreement between Republicans and Democrats, it's that the 35% corporate tax rate in the United States should be reduced to 28% or 25%. The current rate, highest in the advanced industrial world, disincentivizes investment and encourages corporations to relocate overseas.
Unfortunately, the deficit is a major hurdle facing any proposal to reduce the corporate tax rate. Because of the fiscal pressures facing the government, most politicians recognize that any corporate tax rate cut must be paid for by eliminating tax preferences and "loopholes." But few politicians have identified enough revenue-raising measures to offset the cost of a significant reduction of the corporate tax rate-cutting the rate from 35% to 25% would cost roughly $1.2 trillion over ten years.
I believe that there is a sensible answer: a modest limit to the deductions that corporations claim for the interest they pay on their bonds and other debt.
Admittedly, interest deductions probably won't be the first target for politicians. Most likely, politicians will first take a close look at the myriad of provisions designed to benefit specific industries. For instance, the fiscal cliff deal 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.
Politicians might then turn to some of the larger tax preferences that corporations enjoy, collectively known as "tax expenditures." However, they will 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 any case, 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%.
Another approach would be to change how the U.S. taxes the foreign profits of U.S. corporations. Currently, U.S. corporations can avoid paying 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 that they already pay. However, this change would make our 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).
Thus, if policymakers are serious about reducing the corporate tax rate, they will need to consider other revenue-raising measures. To merit serious consideration, such reforms should offer the potential for meaningful new revenue, and they should also make sense from a policy standpoint.
My proposed limits to interest deductions (which I call the "interest cap") would meet both criteria. Currently, corporations may fully deduct the interest they pay on their bonds and other forms of debt. This deduction costs the Treasury a significant amount of money, and encourages corporations to take on too much debt, increasing the fragility of the economy.
Using data from 2000 to 2009 (the most recent available), I estimate that a 65% cap on deductions for gross interest would have paid for a reduction in the corporate tax rate from 35% to 25% over those ten years. In other words, corporations would be able to deduct 65% of their gross interest expense, rather than 100%; from 2000 to 2009, this modest restriction would have been enough to finance the entire rate reduction to 25%.
My proposed "interest cap" 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.
I acknowledge that the treatment of financial institutions under my proposal is a tricky issue. Financial institutions typically borrow significant amounts of money in their daily operations. On the one hand, a vibrant financial sector is a critical component of a healthy, growing economy, and the "interest cap" could constrain these daily operations. On the other hand, excess debt within the financial sector can be especially damaging, as it has the potential to increase the severity of financial crises.
To balance these competing demands, my proposal would apply the interest cap to financial institutions, but at a lower rate. They would be allowed to deduct 79% of their interest expense-less than the 100% that they may deduct currently, but more than the 65% that nonfinancial corporations could deduct.
Undoubtedly, certain debt-intensive industries will lobby against my proposed cap on interest deductions. But policymakers should resist such pressure: any revenue-neutral tax reform must necessarily create winners and losers. Instead, 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.