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Frequently Asked Questions on Business Taxes

9 min read

Q: Do businesses really decide where to locate based on taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. es? How important is this compared to other factors, such as wages, cost of living, and travel costs?

A. Taxes do factor into business location decisions. For example, a growing body of academic research indicates that foreign direct investment (FDI) can be quite sensitive to the corporate tax rates imposed by a state or country. One recent study of the effects of corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. es on the location of foreign direct investment in the United States found a strong relationship between state corporate tax rates and FDI—for every 1 percent increase in a state’s corporate tax rate, FDI can be expected to fall by 1 percent.1

A new study of income tax rates in 85 countries by economists at the World Bank and Harvard University found a strong effect of both statutory and effective corporate tax rates on FDI as well as entrepreneurship. For example, the average rate of FDI as a share of GDP is 3.36 percent. But a 10 percentage point increase in the statutory corporate rate can be expected to reduce FDI by nearly 2 percentage points.2

Q: How do corporate income taxes affect wages and living standards?

A. Corporate income taxes raise the cost of capital firms must pay when investing. A higher corporate tax translates into less investment and capital formation. Lower capital formation means that workers have less capital to work with, which lowers their productivity. Lower labor productivity translates into lower real wages and living standards.

One factor that affects capital formation are differences in the cost of capital between nations. In today’s global marketplace, capital increasingly flows freely across borders. When a country lowers corporate taxes, it attracts capital.

Recent research has focused on the lower corporate tax rates enacted by OECD nations over the past two decades to explore the link between corporate taxes and wages. This research has found that wage rates have gone up the most in countries with the largest reduction in corporate taxes. This finding is important because is tells a story whereby the corporate tax is borne by workers, through lower real wages, rather than by owners of capital. The intuition is simple: a tax will generally be borne by the input that is the least mobile. In today’s world economy, capital flows freely across borders, while labor does. Thus, the corporate tax lowers workers’ real wages relative to where they would be set otherwise.

Q: What can the U.S. expect if it chooses not to reform its business tax system?

A. In a world of greater economic integration and increased trade and capital flows, a firm’s decision about where to locate and expand its operations is increasingly influenced by factors such as a country’s business tax system and investment climate. In the past, U.S. levels of education and training provided distinct advantages to the United States. As emerging countries begin to approach U.S. levels of education and training, other imbalances, such as a business tax system that is out of line with other nations, becomes more important.

By standing still, the United States can expect to see reduced inflows of foreign capital and investment because the United States will be a less attractive place in which to invest, innovate and grow. U.S. firms will face a higher cost of capital than foreign firms, making it more difficult to compete in foreign markets.

Taxes also influence the level and location of investment decisions made by foreign firms. Research has suggested that a 10 percent increase in taxes reduces a country’s inflow of foreign direct investment (FDI) by 6 percent. One might expect multinationals’ location decisions to be similarly sensitive to tax rates, but the economic literature on that issue is mixed.

A more disturbing possibility emerges as the disparity grows between corporate taxation in the United States and its trading partners: a slower pace of innovation in the United States. A key determinant of economic growth, innovation tends to take place where the investment climate is best. Firms and their workers reap no benefits from technological advances until they’re brought into production. For example, new technologies are often “embedded” in new types of capital; an important innovation such as a faster computer chip does not confer any benefit on firms until they purchase new computers. Higher investment spurs innovation by raising the demand for these new technologies. This interplay between innovation and capital accumulation makes failure to reform the U.S. business tax system more damaging to the economy. As the U.S. corporate tax becomes ever more burdensome, the United States may fall behind in innovation and productive capacity.

What are the potential economic benefits of reform? The recent Treasury report, Approaches to Reform of the U.S. Business Tax System for the 21st Century, found that wholesale replacement of the U.S. corporate income tax with a consumption-based tax would increase economic output by between 2.0 percent and 2.5 percent in the long-run.

Importantly, because this estimate does not fully capture the positive effects of free-flowing capital in a global setting or technological change, it is likely to be a conservative estimate of the potential benefits of reforming the U.S. business tax system.

Q: Is it reasonable to focus on the statutory corporate tax rate when the U.S. has an average tax rateThe average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes. well below the average among OECD member nations?

A. Reform should focus on the entire U.S. business tax system. One key problem with the U.S. business tax system is that the U.S. statutory corporate tax rate is high relative to other industrialized nations, exceeded only by Japan. But, this comparison only tells part of the story.

Another problem is that that the effective marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. on investment, a measure which captures most of the features of a tax system— the corporate tax rate, the tax depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. systems, tax treatment of debt, investor level taxes, etc.—is also somewhat higher in the U.S. as compared with G-7 countries. This more complete measure suggests there are broader aspects of the tax system that need to be considered as part of a reform. Also, in some respects, the comparison to the G-7 may be more important from an economic perspective because the U.S. has very large capital and trade flows with these larger economies.

Finally, what drives the average corporate rate in the Unites States below the average for the OECD or the G-7 is that the U.S. corporate tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. tends to be more narrow than in these other countries. Two types of provisions explain the more narrow U.S. corporate tax base. First, the United States provides accelerated depreciation for business investment. According to a recent Treasury report, Approaches to Reform of the U.S. Business Tax System for the 21st Century, accelerated deprecation accounts for roughly one-half of the more narrow tax base. Importantly, accelerated depreciation helps mimic an important aspect of the consumption-based VATs prevalent in other countries: removing the tax penalty on saving and investment.

Second, the U.S. tax base includes myriad special tax provisions from the research and experimentation tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. to the new markets tax credit that are targeted to specific types of projects and corporate activities. While these provisions lower the average corporate tax rate, they only do so only for firms engaged in these particular activities. Because of these targeted provisions, other taxpayers must face higher taxes to raise a given amount of revenue.

Q. Virtually all countries, but the United States, have a value-added tax. Isn’t that the direction the United States should be taking?

A. More than 120 countries around the world have value-added taxes (VATs). Most countries with VATs have also retained their income tax systems, in part, to address concerns over the regressivity of VAT systems and, in part, to finance government sectors that tend to be larger than in the United States. VATs also have the advantage of being more conducive to economic growth by, unlike the income tax, not imposing a penalty on saving.

An often underappreciated feature of the U.S. income tax system is that it shares, to some degree, a key aspect of VATs: a lower tax on the return to saving and investment. Tax-free saving accounts (e.g., IRAs, 401(k)-type plans, pension plans, etc) eliminate or reduce investor level taxes on the return to saving and accelerated depreciation for business investment lowers the effective tax rate on business investment. Indeed, the U.S. income tax is not an income tax at all, but a hybrid income-consumption based tax system.

The key to making the United States more competitive in the global market place is making the U.S. a more attractive place to invest. This can be accomplished through various types of reforms, such as allowing faster write-off of business investment, which also makes the U.S. tax system more VAT-like, or lowering the corporate tax rate. Thus, some types of business tax reforms that would help improve the competitiveness of the United States are also consistent with the trend elsewhere of increasing the emphasis on consumption-based taxes.

Q. Is a reduction in the corporate tax rate the best approach for the U.S. business tax system?

A. The fact that in the past twenty years the United States has gone from a high tax rate to a low tax rate country is emblematic of the challenges the United States faces in an increasingly global market place. The U.S. business tax system was developed at a time when the United States was the primary source of capital investment and dominated world economic markets. Now, the United States’ position of economic preeminence is increasingly being challenged. The United States is now a net recipient of foreign investment rather than the largest source.

There are a number of approaches to reform of the business tax system that would make the United States more competitive in the global market place. Reducing the cost of capital for business investment is crucial for enhancing the competitiveness of the United States. This can be accomplished through a combination of lowering the corporate tax rate, allowing faster write-off of business investment and keeping investor level taxes on returns low.

1. Claudio A. Agostini, “The Impact of State Corporate Taxes on FDI Location,” Public Finance Review 2007; 35; 335.

2. Sineon Djankov, Tim Ganser, Caralee McLiesh, Rita Ramalho, and Andrei Shleifer, “The Effect of Corporate Taxes on Investment and Entrepreneurship,” National Bureau of Economic Research, Working Paper 13756, January 2008.