Corporate Tax Reform Without Tears

Economists have long recognized the damaging effects of the high U.S. corporate tax—at 35%, the rate is the highest in the industrialized world. Over the past few years, politicians in both parties have come to understand that the corporate tax system itself is dysfunctional, causing resources to be misallocated and encouraging corporations to invest overseas.

In February 2012, President Obama proposed a substantial reduction in the corporate tax rate to 28% from 35%. This year, the president has spoken positively about corporate tax reform if it is revenue-neutral, meaning the rate cut should be paid for by broadening the corporate tax base.

This is progress toward a bipartisan solution. Lowering tax rates and broadening the tax base is a central tenet of conservative economic philosophy. High tax rates distort decisions on the margin, as do many specific deductions, exclusions and deferrals. Lower tax rates and a broader base allow the market to allocate resources with less interference from the government.

But what is the best way to meaningfully broaden the corporate tax base? Eliminating tax credits to specific industries, such as green energy, is a good place to start. Unfortunately, repealing these provisions wouldn’t raise enough revenue to make a significant dent in the corporate tax rate. Larger corporate tax expenditures, such as the research and development credit, have strong political support on both sides of the aisle.

Congress could also raise revenue by requiring U.S. corporations to immediately pay tax on all of their foreign profits. Currently, corporations may defer taxation on their foreign profits until they bring them back into the U.S. However, almost all Republicans would prefer for the U.S. tax system to move in the other direction: taxing only those profits earned in the U.S. (with some exceptions to prevent such abuses as shifting profits abroad to take advantage of lower rates).

Given the importance of reducing the corporate rate—and the infeasability of the other options for paying for it—Rep. Kenny Marchant (R., Texas) and Rep. Jim McDermott (D., Wash.) are floating a proposal to modestly restrict the deductibility of gross interest expense for corporations. This change would meet two crucial criteria: It would raise a significant amount of revenue and significantly reduce economic distortions caused by the tax code.

Based on Internal Revenue Service data from 2000 to 2009 (the most recent available), I estimate that disallowing roughly 30% of interest deductions (that is, allowing for a 70% deduction for gross interest expense) would have fully paid for a reduction in the corporate tax rate to 25% from 35%.

Limiting interest deductions for corporations would also correct, to a degree, a serious imbalance. When a corporation finances an investment by issuing debt, the interest payments generate a stream of tax deductions. When a corporation finances an investment by using its cash on hand or by issuing new shares of stock, there are no analogous tax deductions.

Because of this difference, many corporations choose to maintain a debt-intensive capital structure—primarily for tax reasons instead of underlying economics. As a result, the economy will tend to be overly leveraged relative to a true free market. This makes corporations overly at risk of going bankrupt, increasing the fragility of the economy.

Some corporate officials have criticized such a limit on interest deductions based on the fear that it would increase their tax burden. This is false, on average, since the proposal would be structured to be revenue neutral.

Here’s a simple example. Consider a corporation with taxable income of $100 million, calculated after deducting interest expense of $90 million. Currently, it would pay $35 million in corporate tax—35% of its $100 million taxable income. If interest deductions were capped at 70%, $27 million of interest expense would become nondeductible, increasing the corporation’s taxable income to $127 million from $100 million. At a 25% tax rate, it would pay $31.75 million in corporate tax—slightly lower than under current law. In other words, because the proposal would be revenue-neutral, some corporations will pay a little more and others a little less.

A more legitimate concern is how existing debt would be treated under this proposal. Corporate executives have made financing decisions based on good-faith beliefs about the tax law going forward, so it might be unfair to deny a full deduction for interest payments on existing debt. Any restrictions to interest deductions should be phased in very slowly and should not apply to debt issued before some relevant date.

Congress need not finance the entire rate reduction by restricting interest deductions. For instance, Congress could cap interest deductions at a higher level—say, 80%—and finance the rest by limiting other deductions and credits now available to corporations.

But there’s a particularly strong case in favor of restricting interest deductions: It could raise significant amounts of revenue while at the same time reducing economic distortions. This proposed change should be the core of any revenue-neutral legislation to reduce the corporate tax rate to 25% from 35%.