The Challenges of Corporate-Only Revenue Neutral Tax Reform

June 18, 2015

Download FISCAL FACT No. 471: The Challenges of Corporate-Only Revenue Neutral Tax Reform (PDF)Download FISCAL FACT No. 471: The Challenges of Corporate-Only Revenue Neutral Tax Reform (PDF)

Key Findings:

  • Policymakers are currently focused on corporate tax reform to bring down the high statutory corporate income tax rate from 35 percent to 25 percent.
  • A pure 25 percent corporate tax cut would increase the size of the economy by at least 2 percent.
  • However, many lawmakers want to reduce the corporate income tax rate in a revenue neutral manner.
  • There are not enough corporate-only tax expenditures that could be eliminated to pay for a full corporate income tax cut to 25 percent.
  • Many corporate tax expenditures are also used by pass-through businesses. Eliminating them will increase taxes on pass-through businesses without giving them a lower tax rate.
  • According to the Tax Foundation Taxes and Growth Dynamic Model, eliminating corporate tax expenditures in order to pay for a lower corporate rate would fully negate the expected growth from the rate cut itself.

Introduction

There is universal recognition in Washington that the 35 percent federal corporate tax rate is out of step with our global competitors and should be lowered in order to improve U.S. competitiveness and economic growth, with a common target of 25 percent. And while there is a need for comprehensive tax reform, many have suggested that lawmakers move forward with corporate-only reform, provided that it be accomplished in a revenue neutral manner by broadening the corporate tax base.

While corporate-only tax reform may appear to be less complicated and more expeditious than comprehensive reform, there are reasons to believe that the goal of revenue neutrality and economic growth are at odds with each other. For example:

  1. People overestimate the number of “loopholes” in the corporate tax code. The static cost of cutting the corporate tax rate to 25 percent averages about $126 billion per year over ten years. However, the total amount of corporate tax expenditures averages about $180 billion per year, $80 billion of which is the cost of deferral—which ought to be reserved for international tax reform, not used for reforming the domestic corporate code. Thus, the numbers suggest that to cut the corporate rate to 25 percent in a statically measured, revenue neutral manner would require eliminating every other corporate tax expenditure—good and bad.
  2. Many corporate tax expenditures are also available to pass-through businesses such as S-corporations and partnerships. Eliminating these provisions to finance corporate-only reform would effectively raise taxes on pass-through firms without any corresponding reduction in their tax rates. Even if lawmakers were to attempt to hold pass-throughs harmless, it would require complicating the code by creating one set of rules for C-corporations and another for pass-throughs.
  3. Cutting the corporate tax rate to 25 percent would certainly boost economic growth—by at least 2 percent over the next decade or so according to the Tax Foundation’s TAG model. However, our model also shows that the negative economic effects of eliminating many of these corporate tax preferences would negate all of the growth generated by the rate cut.

Considering these issues, lawmakers would do well to rethink the self-imposed restriction of revenue neutrality, and focus on creating the maximum amount of economic growth, even if that comes at the expense of federal revenues. While there are certainly some base broadeners within the corporate code that won’t dampen the growth effects of the rate cut, there are not nearly enough of these to fund a rate cut on a static basis.

On the other hand, lawmakers could take into account the long-run effects on tax revenues from the additional growth generated by the corporate rate cut. Simply cutting the corporate tax rate would generate enough economic growth to eliminate much of the long-run revenue loss. Any short-term deficits could be covered by eliminating the least harmful tax expenditures or spending cuts.

So, lawmakers have a choice: they can eliminate most corporate tax expenditures and risk eliminating the growth effects of the rate cut; they can find offsets outside of the corporate code to maintain overall budget neutrality; or, they can relax the constraint of revenue neutrality and either accept a transitory deficit or look to spending restraint to cover the revenue gap. Given these choices, growth should always win out.

Corporate Tax Expenditures in Context

The corporate tax code is not riddled with as many “loopholes” as conventional wisdom would have it. According to the latest federal budget, there are roughly 80 corporate tax expenditures that have a total budgetary value in 2015 of $118 billion. By contrast, there are roughly 100 tax expenditures in the individual income tax code with a total budgetary value of $1.1 trillion.

Furthermore, the majority of these corporate provisions perform important functions, such as ameliorating double taxation, correcting what would otherwise be an overstatement of income, or moving the code toward a less distorting tax base. Examples include: the deferral of income from controlled foreign corporations; accelerated depreciation (known as MACRS, the Modified Accelerated Cost Recovery System); expensing of research and experimentation (R&E) expenditures; and excess of percentage over cost depletion.

Provisions such as these promote economic growth by reducing the cost of capital and, thus, encouraging more investment and the efficient use of business resources. As we will see below, the economic effects of eliminating these provisions can cancel out the positive effects of reducing the corporate tax rate.

Chart 1 shows the mathematical challenge of eliminating corporate tax preferences in order to offset the static cost of cutting the corporate tax rate. The bars illustrate the value and composition of tax expenditures in each of the next ten years, as is projected in the 2016 Federal Budget, while the line illustrates the approximate cost of cutting the corporate tax rate to 25 percent.

In 2015, corporate tax expenditures purportedly “cost” the Treasury $118 billion, a cost which is projected to grow to $239 billion by 2024. Over the next ten years, the total budgetary cost of all corporate tax expenditures is $1.8 trillion, an average of roughly $180 billion per year.

As the chart illustrates, the two biggest factors in the growth of corporate tax expenditures are the projected cost of deferral and the cost of accelerated depreciation. Deferral is the largest single corporate tax expenditure, with a total ten-year cost of $800 billion. Accelerated depreciation is the next largest, with a ten-year cost of $194 billion, followed by the Section 199 manufacturing deduction at $140 billion. The R&E tax credit has a ten-year budgetary cost of $18 billion (compared to the $70 billion cost of the R&E expensing provision). That leaves the cost of all other provisions at $674 billion.

In contrast to this menu of available base broadeners, the ten-year cost of cutting the corporate tax rate to 25 percent is roughly $1.26 trillion ($1.32 trillion including the elimination of the corporate AMT), or $126 billion per year.[1] As is illustrated here, the cost of an immediate rate cut would start at $94 billion in the first year and gradually grow to $140 billion annually by the end of the decade.

It is also very clear from the chart that offsetting the cost of the rate cut would require eliminating every corporate tax expenditure except for deferral. Indeed, the value of all tax expenditures aside from deferral is roughly $1.1 trillion over ten years—nearly $200 billion short of offsetting the $1.26 trillion cost of cutting the corporate tax rate to 25 percent.

Since there is a very strong case to be made that any changes to deferral should be reserved for international tax reform, the math would seem to indicate that lawmakers will have to reach out beyond the corporate tax system if they intend to enact revenue neutral, or even budget neutral, corporate-only tax reform.

Corporate Tax Expenditures Are Shared with Pass-Throughs

Another complicating factor in attempting to broaden the corporate tax base to finance corporate-only tax reform is the fact that non-corporate businesses, such as S-corporations and partnerships, can also take advantage of many of the same tax expenditures as traditional C-corporations.

Chart 2 shows that 59 of the 79 corporate tax expenditures also benefit pass-through businesses. These provisions include a wide variety of items such as the R&E tax credit, the Section 199 manufacturing deduction, accelerated depreciation, the tax credit for low-income housing, and the charitable deduction. The value to C-corporations of these widely available provisions is $43 billion, whereas the value to pass-throughs of those same provisions is $92 billion,[2] more than twice as much.

Considering the disparity in how much each sector benefits from these provisions, it seems impossible for lawmakers to broaden the corporate tax base and not have pass-throughs suffer some collateral damage. Indeed, doing so would create two vastly different tax codes for corporations and noncorporations, resulting in an even more complicated tax code.

By contrast, only 20 provisions apply solely to C-corporations and they have a total budgetary value of $76 billion in 2015. As Chart 2 indicates, deferral comprises 85 percent of the total budgetary cost of these 20 provisions. The rest, including inventory sales source rules, the exemption of credit unions from tax, and the lower graduated income tax rates for corporations, total just $11 billion. Therefore, even if lawmakers were to repeal all of these items in an attempt to broaden the corporate tax base in a way that didn’t affect pass-throughs, there is still not enough savings here to offset the full cost of a 10 percentage point reduction in the corporate tax rate.

The Economic Effects of Corporate Base Broadening

Setting aside the challenging static mathematics of broadening the corporate tax base in order to finance a rate cut, it is even more important for lawmakers to understand the different economic effects of eliminating various corporate tax expenditures as offsets. As we’ll see, exchanging some tax expenditures for rate cuts can have a positive effect on economic growth while trading other provisions for rate cuts can negate any of the economic growth generated by the lower rates.

In order to establish a benchmark, we used the Tax Foundation’s TAG model to first simulate the economic effects of cutting the corporate tax rate with no offsets to see how much growth a “pure” policy would generate. We cut the corporate income tax to 26.3 percent, which is as far as the corporate rate can be cut with the elimination of available corporate-only tax expenditures.[3] As Chart 3 indicates, cutting the corporate rate to 26.3 percent with no offsets can boost the level of GDP by 2 percent over roughly a decade. The challenge to those who insist that corporate tax reform be revenue neutral is to find offsets that don’t diminish the growth potential of a pure rate cut.

Rather than model the economic effects of all 79 different corporate tax expenditures, we instead separated them into four groups based on their characteristics, then used the model to estimate what the economic effects would be if these provisions were eliminated and the static savings was used to lower the corporate rate by an equivalent amount.

There are certainly many different ways to group these very different provisions, but we’ve chosen to split them along these main characteristics (the full list is included in the appendix):

Group 1: Provisions that move toward a cash flow base or prevent double taxation. This group includes deferral—which is intended to prevent the double taxation of foreign profits—and 15 provisions that offer firms a fuller, more accurate measure of their costs of production, including expensing, accelerated depreciation, or the proper treatment of inventories (such as LIFO—Last In, First Out). Eliminating them would raise the cost of capital by more than the corresponding tax rate reduction would reduce it.

Group 2: Provisions that affect business activity at the margin but don’t move toward a cash flow base. The main component of this group is the Section 199 manufacturing deduction. This measure does impact a targeted sector of businesses at the margin, effectively lowering their corporate tax rate, but does not move the system toward a consumption base. Eliminating these provisions is the equivalent of a rate increase.

Group 3: Provisions that have social policy objectives and those that have minimal economic effects. There are more than 20 provisions that can generally be considered social policy in nature, but which don’t distort the market. These include the special Blue Cross/Blue Shield deduction, the deductibility of charitable contributions, the work opportunity tax credit, and the credit for low-income housing investments. Repealing these provisions would have little impact on economic activity.

Group 4: Provisions that involve subsidies or those which distort the market in some fashion. There are more than 30 provisions that are generally intended to benefit a specific sector, industry, or policy objective. What makes these different from Group 3 is that these can be considered more of a direct subsidy to an industry or tend to distort the market in some way. These items include the exclusion of interest on public purpose State and local bonds, the exemption of credit union income from tax, the energy production credit, the new markets credit, and the credit for energy efficient appliances. Repealing these provisions would eliminate the distortions caused by them and would add to economic efficiency and growth.

Simulation Results

Group 1 Simulations:

The tax expenditures in Group 1 have a ten-year budgetary value of roughly $1.2 trillion, or an average of about $120 billion per year. However, deferral is the largest component of this group with a ten-year value of $812 billion and, for the purposes of this simulation, we are assuming deferral is reserved for any reform of the international tax system. MACRS has the second-highest value at roughly $200 billion over ten years and the remaining provisions have a value of $161 billion over ten years.[4]

For illustrative purposes, we simulated MACRS and the remaining expensing provisions separately:

Simulation 1: Change from MACRS to the Alternative Depreciation System (ADS).

In Simulation 1, we modeled a change in the depreciation regime from MACRS to ADS. As Chart 3 shows, this lowered the level of GDP by 1.46 percent by the end of the adjustment period. The main cause of the decline in GDP is the fact that the policy increases the cost of capital (the “service price”) by 2.7 percent. Moreover, the policy reduces business stocks by 4.1 percent and the wage rate by 1.2 percent.

Simulation 2: Eliminate LIFO and the remaining expensing provisions.

As with the move from MACRS to ADS, eliminating these provisions also increases the cost of capital and affects businesses’ investment decisions at the margin. As a result, the net effect of these changes reduces GDP by 0.49 percent.

Group 2 Simulation:

The elimination of the Section 199 manufacturing deduction is also at the margin. As a result, this trade has a net negative economic effect. GDP is reduced by 0.4 percent.

Group 3 Simulation:

As stated above, provisions in Group 3 are social policy provisions that do not impact investment decisions at the margin. When we enter the elimination of these expenditures into the model we find that it does not impact aggregate economic activity. There is no change to GDP.

Group 4 Simulation:

Group 4 provisions are considered corporate subsidies and also do not impact aggregate economic activity. As is shown in Chart 3, when we enter the elimination of these expenditures into the model we find that it has no long-term impact on GDP.

Final Simulation:

For the final simulation, we entered into the model all of the rate changes afforded by the elimination of these provisions, as well as the change in depreciation schedules.

As Chart 3 illustrates, the result of this summary simulation shows that the effect of broadening the corporate tax base completely negates the economic growth generated by the pure rate cut. The net effect of cutting the corporate tax rate to 26.3 percent while eliminating every corporate tax expenditure (except for deferral) decreases GDP by 0.05 percent over the adjustment period.

Indeed, no growth means no added investment or jobs, and no long-term recovery of federal revenue. It means that all the political pain of broadening the corporate tax base is for naught.

Conclusion

Lowering the 35 percent federal corporate tax rate is essential to making the U.S. more competitive and boosting long-term economic growth. Indeed, the Tax Foundation’s TAG model finds that a rate cut to 26.3 percent with no offsets would increase the level of GDP by more than 2 percent over the next decade and, over the long-term, would also recover much of the static revenue loss.

However, while there is a strong desire among many lawmakers to offset a rate cut with a broadening of the corporate tax base, there are both practical and economic challenges with such a tradeoff.

First, if we set aside deferral, there simply are not enough “loopholes” in the corporate tax code to fully offset the ten year cost of cutting the corporate tax rate to 25 percent. Moreover, the majority of corporate tax provisions are shared with pass-through businesses such as S-corporations and LLCs. Eliminating these tax breaks indiscriminately would inadvertently increase the effective tax rates born by these noncorporation businesses with no corresponding reduction in their marginal tax rates. This should clearly be avoided.

Finally, our TAG model shows that the economic effects of broadening the corporate tax base fully negates the positive growth resulting from the rate cut itself. These results are consistent with similar exercises performed by economists at the Joint Committee on Taxation[5] and others at Rice University.[6]

The lesson from this is that lawmakers would do well to put a priority on generating economic growth and improving U.S. competitiveness rather than maintaining static revenue neutrality.

Corporate Income Tax Expenditures For Fiscal Years 2014-2024

In millions of dollars, based on assumptions from the Mid-Session Review of the 2015 Budget.

2015-24

Group 1: Provisions that move toward a consumption base or prevent double taxation

Deferral of income from controlled
foreign corporations (normal tax method)

$811,980

Accelerated depreciation of
machinery and equipment
(normal tax method)

$194,820

Expensing of research and
experimentation expenditures (normal tax method)

$70,250

Inventory property sales source rules
exception

$58,480

Excess of percentage over cost
depletion, fuels

$10,900

Last In, First Out

$18,700

Excess of percentage over cost
depletion, nonfuel minerals

$6,170

Accelerated depreciation on rental
housing (normal tax method)

$5,690

Expensing of exploration and
development costs, fuels

$4,990

Expensing of multiperiod timber
growing costs

$2,590

Natural gas distribution pipelines
treated as 15-year property

$980

Amortize all geological and
geophysical expenditures over 2
years

$930

Expensing of certain small
investments (normal tax method)

$640

Expensing of certain multiperiod
production costs

$330

Expensing of reforestation
expenditures

$320

Expensing of certain capital outlays

$190

Expensing of exploration and
development costs, nonfuel
minerals

$100

Total =

$1,188,060

Total minus deferral & MACRS

$175,570

Group 2: Provisions at the margin, but not toward a consumption base

Deduction for US production activities

$140,090

Tonnage tax

$880

Total=

$140,970

Group 3: Provisions with nominal economic effects

Credit for low-income housing
investments

$83,610

Exclusion of interest on life insurance
savings

$81,370

Tax credit for orphan drug research

$38,870

Graduated corporate income tax rate
(normal tax method)

$38,300

Deductibility of charitable
contributions, other than education
and health

$21,170

Deductibility of charitable contributions
(education)

$10,100

Tax incentives for preservation of
historic structures

$5,590

Exclusion of interest on rental housing
bonds

$4,910

Special Blue Cross/Blue Shield
deduction

$3,550

Deductibility of charitable contributions
(health)

$2,850

Exclusion of interest on student-loan
bonds

$2,450

Credit to holders of Gulf Tax Credit
Bonds

$1,100

Credit for employee health insurance
expenses of small business

$1,080

Work opportunity tax credit

$960

Small life insurance company
deduction

$430

Tribal Economic Development Bonds

$190

Special alternative tax on small
property and casualty insurance
companies

$180

Credit for disabled access

expenditures

$170

Deduction for endangered species
recovery expenditures

$150

Employer-provided child care credit

$100

Empowerment zones

$70

Indian employment credit

$30

Total =

$295,910

Group 4: Targeted provisions with distortionary economic effects

Exclusion of interest on public
purpose State and local bonds

$139,170

Exemption of credit union income

$25,390

Special ESOP rules

$21,520

Credit for increasing research
activities

$18,300

Exclusion of interest on hospital
construction bonds

$16,730

Energy production credit

$12,100

Exclusion of interest on bonds for
private nonprofit educational
facilities

$10,980

Tax exemption of certain insurance
companies owned by tax-exempt
organizations

$8,460

Exclusion of interest on owner-
occupied mortgage subsidy bonds

$6,030

Advanced nuclear power production
credit

$5,210

New markets tax credit

$4,630

Exclusion of interest for airport, dock,
and similar bonds

$3,630

Energy investment credit

$3,330

Exclusion of interest on bonds for
water, sewage, and hazardous
waste facilities

$2,200

Qualified school construction bonds

$1,440

Exemption of certain mutuals’ and
cooperatives’ income

$1,340

Credit for holders of zone academy
bonds

$1,060

Tax credits for clean-fuel burning
vehicles and refueling property

$880

Exclusion of interest on small issue
bonds

$810

Credit for investment in clean coal
facilities

$760

Recovery Zone Bonds

$590

Industrial CO2 capture and
sequestration tax credit

$460

Exclusion of interest on bonds for
Highway Projects and rail-truck
transfer facilities

$420

Exclusion of utility conservation
subsidies

$300

Credit for energy efficient appliances

$270

Deferral of gain on sale of farm
refiners

$250

Credit for holding clean renewable
energy bonds

$200

Special rules for certain film and TV
production

$160

Exclusion of interest on energy facility
bonds

$100

Qualified energy conservation bonds

$100

Investment credit for rehabilitation of
structures (other than historic)

$100

Exclusion of interest on veterans
housing bonds

$40

Credit for construction of new energy
efficient homes

$30

Bio-Diesel and small agri-biodiesel
producer tax credits

$20

Total =

$287,010


[1] Tax Foundation Taxes and Growth Model and Joint Committee on Taxation.

[2] Much of the $92 billion available to pass-through businesses is also available to individuals with nonbusiness income.

[3] For simplicity, we assumed a revenue loss of $12.6 billion for every 1 point reduction in the corporate rate. This is based on the roughly $1.26 trillion ten-year cost of cutting the corporate rate to 25 percent, or $126 billion per year. The $1.1 trillion in corporate-only tax expenditures (excluding) deferral allows for an 8.7 percent corporate tax rate cut.

[4] Office of Management and Budget, Fiscal Year 2016 Budget of the U.S. Government, Feb. 2, 2015, https://www.whitehouse.gov/sites/default/files/omb/budget/fy2016/assets/budget.pdf.

[5] Nicholas Bull, Tim Dowd, and Pamela Moomau, Corporate Tax Reform: A Macroeconomic Perspective, 64 (4), 923-942, National Tax Journal, Dec. 2011, http://www.ntanet.org/NTJ/64/4/ntj-v64n04p923-41-corporate-tax-reform-macroeconomic.pdf.

[6] John W. Diamond, Thomas S. Neubig, and George R. Zodrow, The Dynamic Economic Effects of a US Corporate Income Tax Rate Reduction, Oxford University Centre for Business Taxation, June 17, 2011.


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