Cut the Corporate Tax Rate; Drop the BAT.

We will never achieve a good tax reform by trusting bad revenue estimates.

According to Wall Street Journal reporter Richard Rubin, “Each percentage-point reduction in the 35% corporate tax rate cuts federal revenue by about $100 billion over a decade, and independent analyses show economic growth can’t cover all the costs of rate cuts.”

Economic growth does not have to "cover all the cost" to make that $100 billion-per-point rule of thumb almost all wrong.  If extra growth covered only 70% the cost of a lower rate, the static estimates would be 70% wrong.  Yet the other 30% would be wrong too, because it ignores reduced tax avoidance.  Mr. Rubin’s bookkeepers’’ rule-of-thumb implicitly assumes zero “elasticity” of reported taxable profits. Corporations supposedly make no more effort to avoid a 35% tax than to avoid a 25% tax.

Acceptance of this simplistic thumb rule – which imagines a 35% corporate rate could raise $1 trillion more over a decade than a 25% rate – explains why Ways and Means Committee Chairman Kevin Brady still insists a big new import tax is needed to “pay for” a lower corporate tax rate. 

In this view, a border adjustment tax (BAT) is depicted as a tax increase for some companies to offset a tax cut for others.  No wonder the idea has been ruinously divisive – with major exporters lobbying hard for a BAT and major retailers, refiners and automakers vehemently opposed.  Mr. Rubin declares the BAT “dead or on political life support,” while nevertheless accepting that it would and should raise an extra $1 trillion over a decade – assuming no harm to the economy and no effect on trade deficits.

Like Mr. Rubin, Reuters claims “Trump could have trouble getting the rate much below 30 percent without border adjustability.”  That is false even on its own terms because the Ryan-Brady plan would eliminate deductibility of interest expense, which is enough to “pay for” cutting the rate to 25% on a static basis.  Adding a BAT appears to cut the rate further to 20%, but the effective Ryan-Brady rate is really closer to 25% because the import tax and lost interest deduction are not a free lunch.

In any case, the entire premise is wrong. There is no need to “pay for” cutting a 35% corporate “much below 30 percent” because nearly every major country has already done that and ended up with far more corporate tax revenue than the U.S. collects with its 35% tax.  

The average OECD corporate tax rate has been near 25% since 2008, and revenue from that tax averaged 2.9% of GDP.  The U.S. federal tax rate is 35% and revenue averaged just 1.9% of GDP.  Ireland’s 12.5% corporate rate, by contrast, brought in 2.4% of GDP from 2008 to 2015.

Sweden cut the corporate tax rate from 28% to 22% since 2013 and corporate tax revenues rose from 2.6% of GDP in 2012 to 3% in 2015 according to the OECD. Britain’s new 20% corporate tax in 2015 brought in 2.5% of GDP according the same source, unchanged from 2013 when the rate was 23%. 

Many countries have deeply reduced corporate tax rates including Germany, Russia, Israel, Indonesia, Taiwan, Thailand, Mauritius, Vietnam and more.  And they didn’t raise VAT or other taxes to “pay for” lower corporate rates, because corporate revenues didn’t fall. Canada cut the corporate rate from 36.5% to 26.5% since 2006 while also cutting VAT from 7% to 5%.  

AEI Economist Alex Brill surveyed several studies that used experience of other countries to estimate what U.S. corporate tax rate would bring in the most revenue over time.  Among recent studies, the revenue-maximizing tax rate was found to range from 23.2% to 29.1%.  Contrary to The Wall Street Journal, each percentage point cut in the 35% rate raises revenue up to a point.   To cut the rate below 25%, simply cap interest deductions.  Expensing ends up raising more revenue after 20 years, so Congress could extend the window if they want expensing.

So, the first way to pay for a tax rate below 30% is to lower the rate. And that has nothing to do with whether or not a lower corporate tax rate raises economic growth, thought it would.  

The “Laffer Curve” revenue gains from cutting a 35% corporate tax rate are not due to faster economic growth, but reduced tax avoidance. Revenue gains from cutting the 35% rate to about 25% (23-29%) are not about macroeconomics but microeconomics.

The Joint Tax Committee makes this distinction: “A conventional [‘static’] JCT estimate incorporates behavioral responses in projecting tax revenues, but assumes that these tax and behavioral changes do not change the size of the US economy.”  

Less-conventional “dynamic” estimates from The Tax Foundation do allow behavioral changes to change the size of the US economy, but do not usually incorporate “microeconomic” behavioral responses that the JCT includes.  By combining the macroeconomic responses of the Tax Foundation with the microeconomic details of the JCT we could get closer to the truth.  

When the tax rate goes up, corporations find ways to report less taxable income. They do that by moving profitable activities other countries, by booking expenses in the U.S. and revenues abroad, by diverting profitable activities to pass-through entities, and by taking-on more tax-deductible debt and maximizing other deductible expenses such as travel and entertainment.

Economists have begun to estimate the “elasticity of taxable income” (ETI) for corporate marginal tax rates, as they have for individual tax rates on salaries and capital gains.  A joint paper by the Congressional Budget Office and Joint Committee on Taxation, for example, found the elasticity of realized capital gains to be arguably high enough for a lower tax rate to generate more revenue.  That is not because a lower capital gains rate raises GDP growth (though it does), but because it tax raises the volume and frequency of asset sales.

Similarly, a lower tax rate on corporate income can increase the amount of reported taxable income by reducing accounting gimmicks, corporate relocation, partial or complete conversion to unincorporated status, and superfluous deductions (e.g., interest expense on Apple’s needless borrowing).

Elena Patel and Matt Smith from the Treasury Department’s Office of Tax Analysis wrote a 2014 study about the Elasticity of Corporate Income. They include only taxable domestic income and focus on 2 million smaller C-corporations (83% of the total).  This study’s “baseline estimate of the corporate elasticity is 0.5, suggesting the corporate income tax distorts behavior and may cause substantial deadweight loss.”  

Such high elasticity of reported corporate earnings is quite consistent with Brill’s estimates of a revenue-maximizing tax rate.

If we also take account of faster growth of investment and GDP, of course, the case for lower tax rates becomes even stronger.

Phil Gramm and Michael Solon noted that even if lower marginal tax rates on labor and capital “closed only half the gap between the current [CBO projection of a ]1.8% GDP growth rate and the 3.4% GDP growth rate that the economy averaged for the previous 64 years, that alone would deliver $2.3 trillion in new revenues due to higher growth over the next 10 years.”  That sum is twice as large as those doubtful back-of-the-envelope estimates of a 10-year $1 trillion revenue windfall from a BAT, which blithely assume nothing bad happens – such as mass layoffs among afflicted retailers, automakers and refiners.