Analysis of US Corporate Income Tax Reform
A tax system should meet its objective of raising revenue for a government in a manner that meets the principles of equity, efficiency as well as complexity. Consequently, the essence of these principles is to ensure that any tax policy promotes economic growth as well as seeking to improve individuals’ social welfare. However, US corporate tax rate has been one of the highest even in comparison with the other OECD countries hence a need to reform it to meet the above principles as well as serve its key purpose of raising revenue. In this respect, this analysis seeks to analyze and present the desirability of a specific reform that seeks to lower the current corporate tax rate; noting its effect on corporate businesses and individuals’ behavior through its impact on corporations’ efficiency and the social welfare.
- Current corporate tax system
The US Corporations pays tax on the taxable income which is their total receipts less the cost of business and other costs like depreciation, wages, interest expenses and supplies. The tax is on a progressive scale where the top statutory rate is 35%. With the average OECD corporate rate being 28%, the US has a corporate income tax rate that is among the highest in the Organizations for Economic Corporation and Development (OECD) countries only being second to Japan. However the current rate raises low revenue compared with other OECD countries with US being ranked fourth lowest in terms of the tax revenue as a share or percentage of GDP. This results from the relatively narrow tax base in comparison with the size of the business sector as well as the numerous special deductions provisions including tax exceptions and credits which usually reduce the effective tax rate way below the statutory rate. (The president’s, 66)
Equity: Tax equity principle dictates that those with same ability to pay should pay the same amount of tax while those with different ability should pay different amount of tax. In addition, the principle requires that those benefiting from the government services need to pay taxes. (Deaton, 301) In this respect, the US Corporate tax system charges corporations an income tax as they benefit from the government’s services, infrastructure, regulations as well as policies and laws that seek to protect them and their operations. However, the current system has a weakness when it comes to the tax base on the ability to pay as corporate businesses are usually charged a higher tax rate compared to their counterparts in the non corporate business sector. (The president’s, 66)
Efficiency: The efficiency principle requires that a tax system has an objective of promoting efficient allocation of resources. However some tax systems like the US corporate tax tends to inherently disrupt such allocation with its high tax rate promotion of investments in the non corporate businesses. (The president’s, 67) Tax on a business affects demand and supply through the tax incidence which determines the bearer of the tax burden. In that respect, a tax placed on efficient market creates a wedge between supply and demand price disrupting efficient market operations. (Harberger, 220)
Complexity: The current tax system is complex imposing significant costs on tax payers in terms of money and time spent in preparing and filling for taxes. (Kaplow, “How Tax Complexity”) The complexity of the tax system is also presumed to result from the one by one adoption of new provisions seeking to enhance tax policy goals without a consideration or with little attention to their interaction with the existing policy provisions. (The president’s, 66) In addition, to the direct costs of the current complex tax system, it also results into frustrations with tax payers resulting to reduced transparency as well as underlying the system’s fairness and trust. The complex tax system also increases mistakes and errors adversely affecting compliance while adding more enforcement and administrative costs. (The president’s, 67)
The key justification that could be fronted for the current corporate income tax rate sustenance would only be the significant revenue that it provides for the US government.
Current system drawbacks
The current high corporate income tax rate reduces returns on investments hence discouraging savings while reducing aggregate investments. In addition, the narrow tax base creates incentives favoring debt over equity while encouraging investments in the tax favored assets and equipments in non corporate businesses more than corporate investments driving capital away from corporate to non corporate businesses. Due to deductibility of interest, corporations are also induced to use debt for investments financing. (The president’s, 66)
- Proposed Corporate income tax reform
The tax reforms proposed seeks to achieve goals including the simplification of the tax system ensuring compliance with the current existing tax laws as well as reforming corporate tax system. `One of the specific key reforms that the wider reform proposes is the reduction of statutory Corporate rate which involve reducing the corporate tax rate from the current 35% is the subject of this analysis. (The President’s, 66)
The structure of the reform proposed in respect to its relation with the principles of equity, efficiency as well and complexity is as discuses below.
Equity: The policy reform seeks to enhance equity and efficiency by establishing a policy that treats different businesses structures and industries equally. This would be achieved through an equal or low tax rate allowing markets to allocate resources to highest value use hence increasing national output. (Deaton, 302)
Efficiency: The tax reform would result to an increased level playing ground for non business corporations and corporate businesses by making the non corporate businesses relatively less attractive compared with the high attractiveness that they command with the current high corporate rate tax. This would consequently result to more efficient resources allocation. (Deaton, 305)
The graphs below illustrate the welfare effect of a reduction of the corporate tax rate.
Source: Frank & Bernanke, 170.
An efficient market without a tax should operate at an equilibrium point E. However, the current corporate tax means that businesses charges a higher price to consumers hence the market operating at point Qt and Pt showing less output and high prices. At this point, consumer surplus which is the difference between their reservation price and the actual price they pay is the green shaded region while producer surplus is the yellow shaded region. In addition, the tax also results to a deadweight loss equivalent to the red shaded region showing the inefficiencies resulting in the market due to the corporate tax where there is low output and high prices. (Frank & Bernanke, 170)
Source: Frank & Bernanke, 170.
With a tax reduction, there will be an effect in that businesses will reduce prices to a new price level Pt* where output will increase to Qt* from the initial Qt. This results to increased output and a reduction of prices which is an improvement in the society’s welfare. In addition, consumer’s surplus that was initially the green shaded region increases by the blue shaded region while the deadweight loss reduces to the new red shaded region C*D*E which is less than the CDE loss before the reform. Therefore, a reduction in the corporate tax would result to increased efficiency in the society improving welfare through increased output Qt*-Qt and lower prices Pt*. (Frank & Bernanke, 170)
Complexity: The reduction of the corporate income tax rate will not have a significant impact on solving complexity facing the current corporate income tax system. (Kaplow, “How Tax Complexity”)
The reform would result to a tax revenue loss of $120 billion over 10 years, but the situation can be offset or addressed by broadening the tax base; a reform that is also provided by the wider tax reform proposal. The corporate tax rate reduction would also result to a low incentive on new investments for every dollar of tax revenue that the government loses as reduction on tax would be on investments that are already made by the corporations. (The president’s, 69)
Tax policies affect individuals’ utility depending on how they are affected by relevant tax policy variables. Therefore, the corporate income tax rate reform would have some effects on individuals with the comparison of the individuals’ behavior prior and after the reform as well as the desirability of such behavior change and the empirical evidence for such expected change being provided below. (Edwards, “Income Tax”)
Individual’s behaviors difference
Some of the individual behaviors as a result of the current tax system include individual’s reallocation of resources to non corporate businesses investments rather than investing in corporate businesses. With a tax rate reduction, the reallocation is expected to be reduced due to the attractiveness that will come with the lower corporate tax rate. The current tax system also favors some unproductive activities like tax avoidance as well as individual’s lobby for loopholes in a bid to reduce their tax liability. With a tax rate reduction, the tax payers are expected to reduce those unproductive activities of tax avoidance and lobbying for loopholes. (The President’s, 70) Compared to the current system where individuals have no incentive to shelter their income under the corporate business system, the reform is also expected to result into a shift of income from individual income tax base into corporate income tax base as individuals seek to shelter their income under the lower corporate taxes. This would result from the fact that the corporate tax rate would be lower than the highest individual income tax rate. The market would also experience increased consumption by consumers whose surplus increases with the low tax rate. (Edwards, “Income Tax”)
Behaviors’ change desirability
The reform would have a number of effects on individual behaviors that are desirable such as increased compliance with tax payments resulting from reduced tax avoidance as well as reduced lobbying for loopholes by the tax payers. Consumers would also increase their spending with the increased purchasing power derived from low prices. (Harberger, 225)
The evidence that would point to the expected change in individual behavior and increased efficiency would be the 2003 congress’ reform which cut the top rate on the dividends to 15% from 35% as a means of spurring investments and market efficiency. The reform resulted to a 50% increase of the average per-share dividend payout by corporations in the Standard and Poor’s 500. This resulted to improved welfare hence individuals spending increase with a higher disposable income. (Edwards, “Income Tax”)
The comparison of the current corporate tax system with the proposed reform concludes that a reform on the corporate tax is paramount for the purpose of achieving equity, efficiency and simplicity in the tax system that favors corporate operations and desirable individual behaviors. Although a corporate tax rate reduction from the current 35% which is too high even compared to the other OECD countries would have an incentive of individuals shifting their tax base to corporations to shelter their income, it would have numerous benefits for the economy and individuals including increased US corporations competitiveness, efficient allocation of resources between corporate and non corporate businesses as well as reducing undesirable individual behaviors like tax avoidance and relocation of resources. It would also increase market efficiency by increasing output while lowering prices to increase total market welfare.
Deaton, Angus. “Equity, Efficiency and the Structure of Indirect Taxation.” Journal of Public
Economics (1977): 8, pp. 299-312. Web. 04 March 2013.
Edwards, Chris. “Income tax rife with complexity and inefficiency.” Cato Institute Tax &
Budget Bulletin No 23 (April 2006). Web. 04 March 2013.
Frank, Robert & Bernanke Ben. Principles of Micro-Economics. New York: McGraw-
Hill/Irwin, 2001. Print.
Harberger, Arnold. “Corporation Income Tax Incidence.” Journal of
Political Economy (1962): 70 (3), pp. 215-240. Web. 03 March 2013.
Kaplow, Louis. “How tax complexity and enforcement affects income tax efficiency and
equity.” National Tax Journal (1996): 49, pp. 135-150. Web. 03 March 2013.
The president’s Economic Recovery Advice Board. “The report on Tax Reform options:
Simplifications, compliance and corporate taxation” (August 2010). Web. 04 March 2013.