How Biden and Congress could improve business taxation

The Tax Cut and Jobs Act (TCJA) of 2017 created the most substantial changes in business taxation in decades. But in a new analysis, published in today’s issue of Tax Notes and cowritten with my Tax Policy Center colleague Claire Haldeman, we find that, while the law promoted efficiency by reducing the level and dispersion of marginal effective tax rates on new investments, it also included many poorly designed provisions, especially in the treatment of income by multinational corporations and pass-through businesses such as partnerships. We propose several ways to fix these problems, in some cases reforming the changes and in some cases going back to the old, pre-TCJA approach.

The TCJA created a 20% deduction for certain forms of income earned through unincorporated businesses, cut the corporate income tax rate from 35% to 21%, and made a variety of changes that shifted the tax base toward cash-flow taxation for both corporations and pass-through businesses.

The newly created 20% deduction for pass-through income makes arbitrary distinctions among different forms of business ownership and is far more beneficial to high-income households than others. It is also unlikely to stimulate investment by existing firms or the creation of new businesses. By cutting the tax rate on income, the deduction finances windfall gains to business owners who are profiting from investments made in the past.

As a result, the tax subsidy generates a smaller “bang for the buck” than if it were targeted to new investment. Repealing the pass-through deduction and moving toward universal expensing and elimination of the interest deduction would be better for stimulating investment.

On the international front, TCJA eliminated the tax on repatriations of actively earned profits by foreign affiliates of U.S. parent companies (coupled with a one-time transition tax on previously accumulated but unrepatriated foreign profits). To help stop profit shifting and encourage domestic activity, TCJA also created an alphabet soup of tax changes including a minimum tax on global intangible low-taxed income (GILTI), a base-erosion anti-abuse tax (BEAT) and a companion deduction for foreign-derived intangible income (FDII).

TCJA’s increase in repatriations, however, did nothing to stimulate investment, as corporations that held a lot of funds offshore also tended to have large domestic cash balances.

Going forward, Congress could tighten GILTI’s minimum tax provisions considerably by requiring taxes be based on country-by-country profits rather than global profits. There are many arguments for repealing FDII provisions, most notably that they subsidize monopoly profits and encourage exodus of physical capital, not to mention that they probably violate World Trade Organization standards. The BEAT provision is also flawed and burdensome compared to alternatives such as the SHIELD program proposed by the Biden administration.

While all tax laws require Treasury and IRS guidance, regulations played an outsized role in the implementation of TCJA. Because Congress passed the law so quickly, TCJA contained many mistakes and ambiguities. In addition, provisions such as the pass-through deduction and many of the international provisions had no precedent in prior law. We find that the Treasury Department overstepped its authority in several regulatory rulings. As a result, the 2017 law in practice provides bigger tax cuts than Congress indicated, especially for banks and real estate.

Our proposals are similar to those in President Biden’s budget but do not raise corporate tax rates by as much, focus more on reforming the corporate base, and explicitly acknowledge that the pass-through provisions were a mistake. One potential challenge to our proposals: the President’s pledge to avoid tax increases on households with income below $400,000. A potential compromise would be to remove the pass-through deduction only for higher-income households. Even this limited change would substantially reduce the cost, regressivity, and complexity of the provision.

By repealing or reforming many business tax provisions of TCJA, Congress could raise revenues while making business taxation more efficient, more equitable, and more resistant to profit shifting. Business taxes would be more neutral–across industries, business forms, and financing methods–as well as more certain, less complex, and better enforced.

Read the full report here.