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The myth of corporate tax reform

By Robert Pozen,

House Speaker John Boehner recently joined the chorus of notables calling for corporate tax reform in any deficit-reduction package. Both Democrats and Republicans want to reduce the corporate tax rate from 35 percent to 25 percent, in return for eliminating the tax credits and deductions available primarily to U.S. corporations.

The rationale behind the proposal is sound in theory — a lower tax rate would help all profitable corporations. By contrast, Congress often bestows tax benefits on industries that are perceived as potential winners or those wielding political clout.

In theory, this proposal would also be revenue-neutral. The rate reduction would decrease U.S. tax revenue by approximately $600 billion during the next five years, but this would be offset by the additional tax revenue gained with the elimination of corporate tax “loopholes.”

But the chances of this proposal passing Congress on a revenue-neutral basis are slim. Most of the corporate tax benefits that would need to be repealed have both a significant positive effect on economic growth and deep political support among powerful constituencies. Moreover, repeal would hurt many non-corporate entities, such as local governments and partnerships running operating businesses, that would gain nothing from a lower corporate tax rate.

The biggest portion of tax benefits to be eliminated, more than $200 billion over five years, encourages U.S. companies to expand their activities in the United States — just what we need in these slow economic times. Examples include:

●$109 billion for accelerated depreciation that encourages U.S. corporations to buy machinery or equipment.

●$62.4 billion for U.S. corporations that locate their manufacturing facilities here, rather than abroad.

●$43.4 billion for U.S. corporations that increase their research activities and expense their experiments.

A second large chunk of corporate tax benefits, almost $100 billion over five years, supports the issuance of state and local bonds. Of this total, $73 billion is for the interest exemption on bonds for “public purposes” — which reduces the borrowing costs of cash-strapped states and cities. The rest is for the interest exemption on “special purpose” bonds — used to construct airports, docks and hospitals as well as water and sewage facilities. Such construction generates jobs and lays the foundation for future economic growth.

A third category, worth $54 billion over five years, provides tax benefits to specific industries. Some of these might seem vulnerable because they support industries under political attack, such as oil and gas, coal and other minerals. However, the total value of tax benefits to these industries that focus on extraction is less than $12 billion over five years — a minute portion of the $600 billion needed to finance the proposed reduction in corporate tax rates. Most industry-specific benefits go to less controversial businesses, such as $18 billion for non-taxed earnings by credit unions, mutual savings banks, nonprofit health insurers and other types of cooperatives.

A fourth category of tax benefits, worth about $50 billion over five years, promotes various social causes. The two largest in this category are tax credits for low-income housing ($34 billion) and tax deductions for corporate charitable contributions ($13.4 billion). Both of these tax benefits have a well-developed rationale and a well-organized group of political supporters.

The final category is the most complex — $213 billion for taxes deferred over the next five years on foreign profits of U.S. corporations. Although such corporate profits are officially subject to a 35 percent U.S. tax rate, this tax can be avoided as long as those profits are held by U.S. corporations in foreign bank accounts.

In other words, corporate tax reform can be achieved on a revenue-neutral basis only if Congress decides to raise $213 billion by repealing the current ability of U.S. corporations to defer indefinitely the 35 percent U.S. tax on their foreign profits. Instead, Congress is considering a proposal that would temporarily allow U.S. corporations to repatriate their foreign profits at a tax rate below 6 percent.

Of course, a compromise could be reached by lowering the corporate tax rate to 30 percent and retaining half of the current tax benefits for U.S. corporations. In a recent Grant Thornton survey, however, most corporate executives said that they would be unwilling to give up their tax credits and deductions unless Congress reduced the corporate tax rate to 25 percent or lower.

In short, corporate tax reform on a revenue-neutral basis would be politically unrealistic. Quick action to achieve this end is also likely, without careful management, to have an adverse impact on our fragile economy. Congress should focus its tax reform efforts on other dysfunctional aspects of the U.S. tax system.

Robert Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. His latest book is “The Fund Industry: How Your Money Is Managed.” He can be followed on Twitter: @pozen.

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