Fourth Highest Corporate Tax Rate Means Time for Reform

This article was first published in National Review Online, April 1, 2002.

Congress finally passed a stimulus package after making sure to strip out elements that would benefit the economy over the long run. The plan includeed an accelerated depreciation provision that will be beneficial if it is later made permanent. But a new corporate tax survey by KPMG makes clear that this is only the first of many needed business tax reforms in the United States.

KPMG found that the United States has the fourth highest corporate income tax rate in the 30-nation Organisation for Economic Co-operation and Development (OECD). The combined U.S. federal and average state rate of 40 percent is almost 9 percentage points higher than the average OECD top corporate rate of 31.4 percent.

This is a dramatic reversal of the U.S. tax situation. After cutting the federal corporate rate from 46 percent to 34 percent in 1986, policymakers fell asleep at the switch, perhaps assuming that we had claimed a low-tax advantage permanently. But most industrial countries followed the U.S. lead and cut tax rates in the late 1980s. Then another round of tax rate cuts began in the late 1990s, with the result that the average OECD corporate rate fell from 37.6 percent in 1996 to just 31.4 percent by January 2002 (see chart). The average corporate rate in the European Union is now 32.5 percent, down from 38.2 percent in 1996.

Average Top Corporate Rate in the OECD

We sometimes write-off European economies as uncompetitive welfare states, and ignore that many countries have improved their business climates. In fact, a recent study by the Economist Intelligence Unit placed the United States second, behind the Netherlands, for the “best place in the world to conduct business.” And a study by GrowthPlus, a European think tank, compared 10 major countries to determine which had the best environment for entrepreneurial growth companies. Again, the United States finished second, this time behind Britain.

In the last few years, the corporate tax rate was cut in Denmark, France, Ireland, Germany, Poland, and Portugal, and in many countries outside of Europe. Even socialist Sweden has a top corporate tax rate of just 28 percent. It is certainly true that overall European taxes, as a share of gross domestic product, are much higher than in the United States. But Europe has shifted about one-third of its overall tax burden to less distortionary consumption taxes.

What the Europeans and others are realizing is that countries shoot themselves in the foot by imposing high tax rates on mobile capital. IMF data show that annual global portfolio capital flows rose six-fold during the past decade. United Nations data show that global direct investment also rose six-fold during this period. The U.S. attracts a big share of these flows because of its large economy, stable currency, and strong growth. But investment flows are increasingly sensitive to taxes, so it makes less and less sense to have a high corporate rate. After all, last year’s recession, the Enron collapse, and the high-tech bust all show that the U.S. business sector is not as invincible as it seemed in the late 1990s.

A high statutory rate isn’t the only aspect of U.S. business taxation that needs reform. Aside from making the new depreciation rules permanent, we need to switch to a territorial tax system from the complex worldwide system that makes U.S. firms less competitive abroad. Glenn Hubbard, chairman of the Council of Economic Advisers, has noted that “from an income tax perspective, the United States has become one of the least attractive industrial countries in which to locate the headquarters of a multinational corporation.” As a consequence, there has been a “marked increase” in the number of U.S. firms reincorporating abroad, according to a new U.S. Treasury analysis. Shouldn’t the U.S. be trying to attract business rather than drive it away?

The critics of course will say that big corporations and their shareholders should pay their “fair share” of taxes, and that the government needs to crack down on tax-avoiders like Enron. Such views ignore big picture realities. First, the huge rise in global capital flows means that the corporate tax burden probably falls more on immobile workers, and less on the mobile capital income it is ostensibly placed on. Second, the high corporate tax rate is the reason why Enron and other firms go to such wasteful lengths to avoid and evade taxes. If the U.S. cut its corporate rate to say 20 percent, not only would real capital investment increase, but firms would financially restructure in order to shift more of their global tax base into this country.

As the world economy changes, so must U.S. tax policy. Pressures to attract mobile capital through international “tax competition” will continue to increase. These trends dictate that we reform our tax system by moving away from a high-rate income tax system to a low-rate consumption-based tax system.

Chris Edwards is director of fiscal policy studies at the Cato Institute.