Senator Warren’s Corporate Book Tax Is Wrong Way to Fund New Spending

August 11, 2021

Now that Senate Budget Chairman Bernie Sanders (I-VT) has kicked off the budget reconciliation process to advance President Biden’s agenda, Senators Elizabeth Warren (D-MA) and Angus King (I-ME) and Representative Don Beyer (D-VA) are pushing to create a new surtax on corporate book income. However, their arguments for the policy misconstrue why there are differences between a corporation’s taxable income and book income. The reason why: lawmakers have enacted specific policies that mean tax laws differ from accounting standards.

Sen. Warren’s proposal would place a 7 percent tax on book income above $100 million on top of the current corporate income tax. It would not be a minimum tax, but instead would be a second, more harmful tax running parallel to the existing corporate income tax.

Sen. Warren insists that corporations exploit loopholes to lower their taxable income and effective tax rates, and so she wants to place a tax on the income that corporations report to their shareholders on their financial statements. As we’ve reviewed previously:

According to Senator Warren, the goal of this policy is to prevent companies that report profits to their shareholders in a given year from paying little to no federal income tax. The senator’s aim is to close the “book-tax” gap in profits. Under current law, companies have an incentive to report high profits to their shareholders while reporting low profits to the IRS. This tax would be based entirely on book profits to reduce this incentive.

A company not paying taxes in a given year despite having earned a financial profit usually means they have used standard tax provisions Congress passed. Companies may have taken deductions for making investments or reduced their tax liability by taking business tax credits for activities such as research & development (R&D) spending or renewable energy production that the government believes deserve special support through the tax code. Some corporations pay zero corporate income taxes because they were carrying forward past losses, a normal feature of the U.S. tax code that protects against business cycle volatility. Over longer time horizons, book-tax gaps fade as they are often driven by timing differences between the two sets of rules.

These underlying policies that lead to book-tax gaps could be debated and changed. Closing the gap directly would require revoking existing policies like the R&D tax credit, tax credits for green energy, write-offs for R&D expenses and other physical investments that benefit workers and drive long-term productivity growth, and net operating loss provisions that smooth out the effects of business cycles.

Instead of being direct, however, Warren’s proposal would create two sets of tax rules for companies, one in which the structure has been designed by lawmakers to calculate taxable income and provide for incentives they deem appropriate, and another which claws back such provisions for certain companies.

Tax Foundation analysis shows that Sen. Warren’s proposal would have a larger negative impact on the incentive to invest in the United States than a 7 percentage point increase in the corporate income tax rate. In other words, the 7 percent tax she proposes would result in a larger drop in economic output, full-time equivalent jobs, and wages than a 7 percentage point corporate tax increase. This is chiefly because companies would not be able to use expensing or accelerated depreciation for their capital investments.

Under corporate book income rules, companies spread out the cost of investments across roughly its useful life, also known as economic depreciation. The purpose of this rule is to match costs to the revenues they generate to best inform creditors and shareholders: deducting, say, the entire cost of a new factory the year it’s constructed could make it seem like a company is unprofitable to shareholders. While the economic depreciation approach makes some sense for accounting purposes, it’s a bad framework for tax policy.  

Spreading out the deductions over time creates a tax bias against investment. Deductions in future years are worth less than deductions in the current year, thanks to the time value of money and inflation. It also creates a bias against companies that rely heavily on physical capital (think energy production and high-tech manufacturing), and towards companies that mostly rely on labor (think financial services or fast food). Depreciation makes it cost more to invest, which reduces investment and capital accumulation and ultimately hurts workers relative to a full expensing system where investments can be deducted immediately.

Sen. Warren’s proposal could also mean clawing back new tax credits that the Biden administration has proposed as part of the Build Back Better agenda, such as manufacturing and transportation tax credits. The tax has other problems too, as our former colleague Kyle Pomerleau argues:

Other aspects of the surtax would also distort corporate investment behavior. It appears that companies would not be able to carry forward losses into future years. As a result, investments that might lose money for several years before turning a profit could face high effective tax rates. Based on descriptions of the plan, the surtax also would include foreign income in its tax base with no deduction or credit for foreign taxes. This would make it less likely for U.S. companies to own foreign investments and would ultimately reduce national income.

The proposal would also violate the promise to not raise taxes on households earning under $400,000. While it would increase the progressivity of the tax code, it would reduce after-tax incomes for taxpayers of all income levels, according to standard analysis that distributes the corporate tax burden to owners and workers. We should expect that the surtax would fall more heavily on workers, through lower wages, than the current corporate tax because the surtax would fall more heavily on investment than the current corporate tax.

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A surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services.

The 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.

Full expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs.

Depreciation 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.

A 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.

Book income is the amount of income corporations publicly report on their financial statements to shareholders. This measure is useful for assessing the financial health of a business but often does not reflect economic reality and can result in a firm appearing profitable while paying little or no income tax.

A 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.

Taxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income.