Lawrence Summers is a professor at and past president of Harvard University. He was treasury secretary from 1999 to 2001 and an economic adviser to President Obama from 2009 through 2010.
Corporate tax reform has rightly been identified by the president-elect and congressional majority as an immediate priority. There is no question that the status quo — with the United States having the highest statutory corporate-tax rate among major countries and companies holding huge cash hoards abroad while awaiting a break on repatriation — can be improved. Unfortunately, the potential reforms identified by House Speaker Paul D. Ryan (R-Wis.) and President-elect Donald Trump appear likely to do significant damage to the tax base and to the U.S. and global economies.
The central concept put forward by Ryan — which appears to have Trump’s support — is to change the corporate income tax from a tax on the return to capital into one only on extraordinary profits and to accomplish this by taxing corporate cash flows. This would be done by changing the current corporate tax in three fundamental ways, in addition to a major reduction in the rate.
First, all investment outlays could be written off in the year they are undertaken, rather than over time according to a depreciation schedule. Second, interest payments to bondholders or banks that finance inventory, or to other creditors, would no longer be tax deductible. Third, to promote U.S. competitiveness, firms would be permitted to exclude receipts from exports in calculating their taxable income and would not be permitted to deduct from their income payments to foreign suppliers or affiliates.
Unlike some of the other economic ideas put forward by the president-elect, a corporate cash-flow tax is supported by some experts in both political parties. However, at least as the approach has been explained so far, it has four major flaws — each of which would likely be fatal.
First, the tax change would substantially exacerbate inequality, with more than half the benefits going to the top 1 percent of Americans. Eliminating the requirement that investments be depreciated over time and substantially scaling back the rate on extraordinary profits would be a radical step that might be defensible on grounds of eliminating double taxation in a world where capital returns are effectively taxed at the individual level. But it is hard to justify in the current world, where pensions, 401(k)s, life insurance, holdings by foreigners and the like render most individual capital income-tax free, where the remainder is taxed at highly preferential capital gains and dividend rates, and where the estate tax is easily avoided and likely to be eliminated.
Second, the tax change would capriciously redistribute income, increase uncertainty and place punitive burdens on some sectors. Think of a retailer who imports goods from abroad for 60 cents, incurs 30 cents in labor and interest costs and then earns a 5-cent margin. With a 20 percent tax, and no deductibility of import or interest costs, the taxes will substantially exceed 100 percent of profits, even if there is some offset from a stronger dollar. Businesses that invest heavily, hire extensively and export a large part of their product would have negative taxable income on a chronic basis; it is hard to imagine that the political process would allow annual multibillion-dollar refunds, and so these too may be victimized. Then there are the still unresolved questions of what the rules will be on interest deductibility for banks and of the treatment of businesses organized as partnerships that do not pay corporate taxes.
Third, the tax change would likely harm the global economy in ways that reverberate back to the United States. It would be seen by other countries and the World Trade Organization as a protectionist act that violates U.S. treaty obligations. While proponents argue that such an approach should be legal because it would be like a value-added tax, the WTO has been clear that income taxes cannot discriminate to favor exports. While the WTO process would grind on, protectionist responses by others would be licensed immediately. Moreover, proponents of the plan anticipate a rise in the dollar by an amount equal to the 15 to 20 percent tax rate. This would do huge damage to dollar debtors all over the world and provoke financial crises in some emerging markets. Because U.S. foreign assets are mostly held in foreign currencies whereas debts are largely in dollars, U.S. losses with even a partial appreciation would be in the trillions. Ironically, China, with its huge reserve hoard, would be a major winner.
Fourth, the cost over time of the tax change would force burdensome tax hikes or spending reductions on the federal government. The combination of a sharply lower rate, new opportunities for tax arbitrage created by the taxing of cash flows, the likely adverse effects of increased uncertainty and the fact that any revenue gains from bringing overseas cash home would be one-shots means that the reform would likely erode the federal revenue base. This would eventually mean reductions in entitlement payments, tax increases on individuals and reductions in government spending. All of this would slow economic growth and burden the middle class.
There is no need to reinvent the corporate tax wheel. Let’s fix the tax we have by reducing rates, closing shelters and broadening the base, and cracking down on profit shifting to tax havens. That would be an important step to making our economy grow faster and be fairer.