What’s the Answer for Corporate Taxes?

President Obama and Governor Romney may have their differences on tax policy, but both candidates agree that the United States needs to cut its corporate tax rate. Including federal, state, and local taxes, corporate profits are currently taxed at 39.1 percent, the highest rate in the industrial world. This high corporate tax rate distorts investment decisions and encourages corporations to relocate overseas.

However, given the federal government’s large deficits, any reductions in corporate tax rates should be paid for by broadening the tax base. In February, President Obama released a corporate tax reform framework that endeavored to do just that.  Although Governor Romney is less specific, he has suggested a willingness to broaden the corporate tax base to pay for rate reduction.

An Imperfect Solution

Unfortunately, revenue-neutral corporate tax reform will prove very difficult for either candidate. Oft-mentioned tax breaks, such as those favoring hedge fund managers or green energy firms, are simply too small for their repeal to have a substantial effect on tax revenues. And both President Obama and Governor Romney have called for the expansion of other, larger corporate tax breaks, such as the credit for increasing spending on research and development. Thus, if either candidate wants to reduce the corporate tax rate, he will likely have to search for other revenue-raising measures.

One particular reform should get a close look: limiting the deductibility of corporate interest expense. Such a reform could raise a large amount of revenue and would improve economic efficiency by treating different investments more equally. President Obama has suggested this approach be “considered,” as has Congressman Dave Camp (R-MI), the Chairman of the House Committee on Ways & Means.

Significant New Revenue

According to the IRS, corporations with net income paid $2.1 trillion in corporate tax between 2000 and 2009 (the most recent years with available data). During this same period, these corporations claimed over $8.5 trillion in gross interest deductions—at a 35 percent tax rate, those deductions were worth almost $3 trillion.

Based on an analysis of data like these, I calculate that the corporate tax rate could have been reduced from 35 to 25 percent from 2000 to 2009, financed solely by disallowing roughly 30 percent of gross interest deductions. In other words, corporations would have been able to deduct nearly 70 percent of their gross interest expense, instead of 100 percent as under current law. The revenue raised from this limitation (at a 25 percent tax rate) would have been roughly equal to the revenue loss resulting from the rate cut.

Of course, this simple estimate misses some key factors. First, interest rates and corporate leverage will likely be lower over the next 10 years than over the past 10 years, reducing the value of interest deductions. Second, such a reform would need to give special treatment to the financial sector, which would face a large burden under this proposal. Nevertheless, this back-of-the-envelope calculation shows that limiting the deductibility of corporate interest expense could play a large role in rate-reducing corporate tax reform.

Reducing the Bias Toward Debt

Disallowing a modest portion of the interest deduction would also improve economic efficiency by reducing the tax code’s large bias toward debt-financed investment. Currently, corporations can deduct the returns to a debt-financed investment (interest expense), but not the returns to an equity-financed investment (dividends or stock appreciation). This differential treatment leads some corporate managers to make financing and investment decisions for tax reasons, instead of economics.

Even worse, when a corporation takes on too much debt, it increases its risk of bankruptcy—an event which imposes significant costs on the corporation’s employees, customers, and suppliers. Because these costs affect external parties, corporate managers won’t be sufficiently motivated to take these costs into account when deciding how much debt to take on. Thus, these managers are likely to choose a level of debt that is too high from the standpoint of society as a whole.

Banks will argue that limits on interest deductions should not apply to them because borrowing money is the “raw material” in the lending process. However, as recent history has demonstrated, the demise of one large bank can trigger a cycle of panic, fire sales, and more bank failures. So, while the financial sector should be given special treatment under this type of reform, it should not be exempted entirely.

In short, the U.S. urgently needs a reduction in the corporate tax rate implemented on a revenue neutral basis. As part of the tax package to achieve this goal, Congress should include some limits on the deductibility of corporate interest expense. Such a limitation would raise enough revenue to allow a substantial reduction in the corporate tax rate, increasing the global competitiveness of the U.S. Such a limit would also reduce the tax bias in favor of debt by decreasing the effective tax rate on equity—without raising the average cost of capital in the U.S.