There is a serious danger that tax reform will soon degenerate into noth label for an increase in business taxes used to finance another cut in individual tax rates. The wrong kind of business tax increase could reduce the incentive to invest in plant and equipment, precipitating an economic downturn in the near future and leading to a decline in our rate of economic growth in years ahead.
The Treasury's proposal, even with its drastic changes in the tax treatment of charitable contributions, of state and local taxes and of various fringe benefits, calls for a corporate tax increase of more than 35 percent to finance a 7 percent cut in personal taxes. If political pressures eventually cause Congress to drop most of the major revenue-raising changes in personal tax rules, achieving a significant cut in personal tax rates would require an even larger rise in corporate taxes.
The advocates of raising business taxes ignore the adverse effects on investment and growth and focus on the fact that corporate taxes now provide a much smaller share of total federal tax revenue than they did in previous decades. Corporate income-tax revenues were 23 percent of total federal taxes in 1960, 17 percent in 1970 and only 9 percent in 1984.
But this comparison gives the misleading impression that the fall in the corporate tax share of total federal revenue is the result of continually more favorable tax treatment of business income. In reality, the business tax share has declined year after year because of other changes that have been taking place in the economy.
One important reason has been the rapid growth of the Social Security programs and therefore of the earmarked taxes that are used to pay for them. Between 1960 and 1984, the taxes needed to pay for those programs rose from 3 percent of GNP to nearly 7 percent of GNP. That increase raised social insurance taxes from 16 percent of total federal revenue in 1960 to 36 percent in 1984 and brought with it a corresponding reduction in the tax share provided by corporate taxes.
The major explanation for the decline of corporate taxes has been a shifting of some of the tax on business income from the corporations themselves to the individuals who provide the capital for those corporations. That has occurred because corporate interest payments have been rising continuously over the past quarter century. Those interest payments are tax-deductible expenses of the corporations that pay them and are part of the taxable income of the individuals who receive that interest either directly or through financial intermediaries, such as banks. To get a meaningful picture of what's been happening to the tax burden on corporate capital, we have to adjust the raw figures for this shifting of the tax from the corporations to the individuals who provide the capital.
A study published a few years ago shows that the federal taxes paid by nonfinancial corporations, their creditors and their shareholders were 62 percent of the real capital income for those corporations in 1960, declined to 48 percent in 1965 and then rose to 66 percent in 1979. Unfortunately, more recent evidence is not available. But we can look at how the rise in interest costs has been a major cause of the decline in the taxes paid directly by corporations.
The average interest rates that corporations paid on their bonds tripled between 1960 and 1984, and the net interest expenses of nonfinancial corporations rose from 9 percent of their pretax profits in 1960 to 44 percent in 1984. If interest payments had been as large a share of profits in 1960 as they became in 1984, the corporations' 1960 tax liabilities would have been cut by 36 percent.
As a rough approximation, adjusting for the rise in interest expenses in this way would reduce the 1960 corporate taxes to 15 percent of total federal tax revenue and 17.5 percent of the total federal revenue other than the earmarked Social Security taxes. By contrast, 1984 corporate taxes were 13.3 percent of federal revenue other than Social Security taxes. And the Congressional Budget Office now estimates that their share will rise to nearly 16 percent by the end of the decade. In short, adjusting for the increased importance of Social Security and the rise in corporate interest outlays explains almost all of the decline in the corporate tax share of federal revenue.
By the late 1970s, Congress became aware that rising interest rates had substantially eroded the value of the business depreciation allowance and had thereby significantly reduced the incentive to invest. It responded by enacting the Accelerated Cost Recovery System, which has substantially improved investment incentives and has probably been responsible for the recent strength of private investment in the face of unprecedently high real interest rates.
Treasury Secretary James Baker has already indicated that he is rethinking the business side of the tax reform proposal. As he does so, we think he should bear two principles in mind: First, any change in corporate taxes should maintain or strengthen the overall incentive to invest in new plant and equipment. If business taxes are to be increased, that can be done in a way that not only enhances the perceived fairness of the tax system, but also improves the incentive to use capital productively.
Second, any increase in tax revenues should be used to finance a reduction in the budget deficit. There is surely no reason under current conditions to raise taxes on business just to give a further tax cut to individuals.