Replacing the Scandal‐​Plagued Corporate Income Tax with a Cash‐​Flow Tax

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Americans have been inundated with financialscandals at large corporations during the past twoyears. In many cases, unethical behavior and pooroversight of corporate management are to blame.But a deeper look reveals that the flawed structureof the corporate income tax has been a key driver ofcorporate waste and inefficiency. The tax code distortsfinancial and investment decisions and spursexecutives to hunt for tax shelters.

Three fundamental flaws in the corporateincome tax are behind the distortions and taxshelters. The first flaw is that the corporateincome tax rate is very high. Currently, the U.S.statutory corporate rate is the second highestamong the 30 major industrial countries. Thathigh rate reduces investment, encourages firmsto move profits abroad, and provides incentivesto push the legal margins of the tax code.

The second flaw is that the corporate tax base ofnet income or profits is inherently complex becauseit relies on concepts such as capital gains and capitalizationof long-lived assets that are difficult toconsistently account for in a tax system. Costs ofcapitalized assets are deducted through depreciation,amortization, and other rules. The tax rulesfor capitalized assets and capital gains are repeatedlyexploited in corporate tax shelters. These rulesalso cause economic distortions as they interferewith capital investment, business reorganizations,and other decisions. Capital gains taxation and capitalizationwould be eliminated under a replacement"cash-flow" tax system.

The third flaw is the gratuitous inconsistencyof the tax code. Examples include the differenttax treatment given to debt and equity and thedifferent rules imposed on corporations and thehalf dozen other types of businesses. Such inconsistenciesplayed a key role in the tax sheltersexploited by Enron and other firms. Worse, theyhave created large costs to the economy by distortingcapital markets and channeling investmentinto less productive uses. A cash-flow taxwould eliminate these distortions and put allbusinesses and investments on an equal footing.

This study discusses the most serious corporatetax distortions and examines fundamentalreforms to fix them. One option examined is afull repeal of the corporate tax. Another option isreplacing the corporate income tax with a cash-flowtax. The study concludes that implementinga cash-flow business tax would build onPresident Bush's tax cuts, help prevent futureEnron-style scandals, and permanently boost theeconomy.

Chris Edwards

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