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Don’t Put the Cart Before the Horse by Prematurely Setting a Top Corporate Tax Rate

Many policymakers are tempted to specify in advance the tax rate cuts that tax reform can achieve, while saying much less about the specific cuts in tax expenditures (deductions, credits, and other preferences) needed to pay for the rate cuts.  This year’s Ryan budget is the classic example, proposing more than $5 trillion in tax cuts (see estimates from the Joint Committee on Taxation [JCT] here and here) without specifying a dime in offsets.

President Obama called last week for cutting the corporate tax rate to 28 percent (and 25 percent for manufacturing) and broadening the corporate tax base enough to offset the costs not just in the first decade but in future decades as well.  To his credit, the President has consistently proposed some specific corporate tax expenditures curbs, though not enough to pay for this deep a rate cut.  The President also has issued a “menu of options” of additional corporate tax offsets, discussed below, to help achieve revenue neutrality.

We have long argued that policymakers should not set specific targets for new, lower tax rates until they can match the rates with specific tax subsidy cuts needed both to cover the cost of the rate cuts and to meet deficit-reduction targets.  Closing “loopholes,” as a generic concept, sounds attractive.  But, convincing lawmakers to scale back specific, large tax expenditures that have powerful and motivated constituencies is very difficult politically.

In addition, curbing some tax expenditures — especially in the corporate area — saves much less money over the long term than in the initial years.  In 2011, JCT estimated that policymakers could cut the corporate tax rate to 28 percent, without making deficits worse over the first decade, by eliminating most corporate tax expenditures.  But that package would produce annual revenue losses before the end of the decade that would grow over time, thus making long-term deficits worse.

To its credit, the President’s new proposal recognizes this timing problem and addresses it by requiring corporate tax reform to show no revenue loss not only in the first decade, but at least through the second decade as well.  It devotes the temporary revenue gains in the initial years to timely, temporary infrastructure investments, using only the permanent revenue gains for permanent rate cuts.  This is a sound and essential idea.

This also means that the temporary portion of proposals that the Administration has advanced to raise revenues by eliminating certain corporate tax subsidies — such as accelerated depreciation and what’s known as “last-in, first-out accounting” — would not be available to finance corporate rate cuts.

That fact underscores the difficulty of enacting enough permanent tax-expenditure savings to pay for lowering the corporate rate all of the way to 28 percent.  For example, the JCT exercise assumed that the tax credit for research and development would expire, which is very unlikely politically, although not inconceivable.

But the JCT exercise also assumed that companies would no longer be allowed to deduct their research and development costs for tax purposes in full in the year they incur those costs; they would instead have to depreciate those costs over time.  There is virtually no chance politically this change will occur.  Yet in the JCT exercise, it paid for 15 percent of the cost of lowering the corporate rate to 28 percent.

To be sure, there are other sources of corporate tax revenue beyond eliminating the specific tax expenditures that JCT examined.  JCT’s exercise did not include savings from curbing certain international corporate tax expenditures, such as deferral of taxes on overseas profits.  In addition, there are ways to raise substantial corporate revenue that go beyond the traditional “tax expenditure” designation.

The “menu of options” the Obama Administration has provided includes examples of two such approaches:  cutting the tax subsidy for debt financing and taxing large businesses that now escape the corporate tax entirely (i.e., large “pass-throughs”).  Both are excellent ideas, although they aren’t yet specific proposals.  The President has also proposed a minimum tax on foreign profits, though the rate remains unspecified.

The President’s proposal thus combines a specific corporate tax rate with a menu of possible financing options, some of which aren’t yet very specific, and without a reality check on what the political process will bear.  Cutting tax subsidies is hard, and the danger is that lawmakers get attached to a specific rate they ultimately are unable to reach without adding to the deficit.

The best course would be for policymakers first to agree on a framework for a balanced package of spending cuts and tax increases to help address the nation’s long-term fiscal problems — a package that includes a revenue target for tax reform.  The size of the rate cut would then depend on the amount of tax-expenditure savings, beyond those needed to hit the revenue target, on which policymakers can agree.

Chuck Marr
Vice President for Federal Tax Policy