Policy Analysis No. 484

Replacing the Scandal-Plagued Corporate Income Tax with a Cash-Flow Tax

Executive Summary

Americans have been inundated with financial scandals at large corporations during the past two years. In many cases, unethical behavior and poor oversight of corporate management are to blame. But a deeper look reveals that the flawed structure of the corporate income tax has been a key driver of corporate waste and inefficiency. The tax code distorts financial and investment decisions and spurs executives to hunt for tax shelters.

Three fundamental flaws in the corporate income tax are behind the distortions and tax shelters. The first flaw is that the corporate income tax rate is very high. Currently, the U.S. statutory corporate rate is the second highest among the 30 major industrial countries. That high rate reduces investment, encourages firms to move profits abroad, and provides incentives to push the legal margins of the tax code.

The second flaw is that the corporate tax base of net income or profits is inherently complex because it relies on concepts such as capital gains and capitalization of long-lived assets that are difficult to consistently account for in a tax system. Costs of capitalized assets are deducted through depreciation, amortization, and other rules. The tax rules for capitalized assets and capital gains are repeatedly exploited in corporate tax shelters. These rules also cause economic distortions as they interfere with capital investment, business reorganizations, and other decisions. Capital gains taxation and capitalization would be eliminated under a replacement “cash-flow” tax system.

The third flaw is the gratuitous inconsistency of the tax code. Examples include the different tax treatment given to debt and equity and the different rules imposed on corporations and the half dozen other types of businesses. Such inconsistencies played a key role in the tax shelters exploited by Enron and other firms. Worse, they have created large costs to the economy by distorting capital markets and channeling investment into less productive uses. A cash-flow tax would eliminate these distortions and put all businesses and investments on an equal footing.

This study discusses the most serious corporate tax distortions and examines fundamental reforms to fix them. One option examined is a full repeal of the corporate tax. Another option is replacing the corporate income tax with a cash-flow tax. The study concludes that implementing a cash-flow business tax would build on President Bush’s tax cuts, help prevent future Enron-style scandals, and permanently boost the economy.

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