Commentary

Reducing Business Tax Penalties to Spur Growth

For better or worse, efforts to pass an economic stimulus package appear to be dead. But the stimulus debate did raise some important issues about how the tax code puts barriers in front of capital investment through such provisions as depreciation and the alternative minimum tax. Business tax reform continues to be needed in these areas.

Business tax reform is being put on the agenda again with a recent ruling by the World Trade Organization against a $4 billion tax break provided to U.S. exporting companies, variously called “FSC” or “ETI.” This ruling has provided policymakers another opportunity to move ahead with business tax reforms to spur U.S. economic growth.

Some recent studies also indicate that we need to focus more on improving the U.S. business climate. London’s Economist Intelligence Unit placed the U.S. second, behind the Netherlands, for the “best place in the world to conduct business” in a recent study. And a study by GrowthPlus, a European think tank, compared ten major countries to determine which had the best environment for entrepreneurial growth companies. Again, the U.S. finished second, this time behind Britain.

Coming in second isn’t bad, but we don’t have an automatic claim on the highest living standard in the world unless we have the best possible tax climate. In recent years we’ve done little to improve that climate. For example, while the U.S. was a world leader in tax cuts in the 1980s, we hiked taxes in the 1990s. The average corporate tax rate in Organization for Economic Cooperation and Development (OECD) countries fell from 41 percent in 1986 to 31 percent today. That means our 35-percent corporate rate is now 4 percentage points higher than the average of our main trading partners. Britain’s corporate rate is now 30 percent, and even Sweden has a corporate tax rate of just 28 percent.

Tax rates are being cut because there is growing appreciation that high rates reduce savings, investment, and economic growth. Governments are also feeling the squeeze from globalization, which is increasing “tax competition” between countries. During the past decade, global direct investment flows rose from $204 billion to $1.3 trillion, and portfolio flows rose from $219 billion to $1.4 trillion. If countries don’t get their tax rates down to competitive levels, these huge flows of capital will flee to more attractive economic climates.

Right now the U.S. tax system is a negative factor in attracting inflows of business investment. Not only do we have a high corporate tax rate, but also the complex way that the federal government taxes corporations puts U.S. firms at a disadvantage in world markets. For example, because federal tax rules burden the foreign earnings of U.S. companies, the U.S. is not a good place to establish headquarters of a global company. Uncompetitive U.S. tax rules played a role in the merged Daimler-Chrysler choosing Germany for its headquarters rather than Michigan. The solution is to move toward a “territorial” tax system whereby U.S. firms could compete in overseas markets on an equal footing with foreign companies.

The WTO decision against the FSC tax break is a setback to U.S. companies competing in world markets. If we move to repeal FSC, we should also remove the substantial tax penalties that U.S. firms face. These include the high corporate tax rate, complex and unfair taxation of foreign business operations, and outdated depreciation rules.

All these measures would move us toward adoption of a low-rate consumption-based tax. Ultimately, that’s where international tax competition pressures are leading every country that wants to maximize growth. The United States should get out in front of the trend and lead world tax reform as it did in the 1980s.

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