International Corporate Tax Rate Comparisons and Policy Implications
Released: 2014-01-06T00:00:00

Advocates of cutting corporate tax rates frequently make their argument based on the higher statutory rate observed in the United States as compared with the rest of the world. Sometimes the higher rate alone is used as an argument, and in other cases the arguments include claims that cutting corporate taxes would induce large investment flows into the United States, which would create jobs or expand the base enough to raise revenue.

President Barack Obama has supported a rate cut if the revenue loss can be offset with corporate base broadening, while the Citizens for Tax Justice has urged a revenue raising reform and business leaders have urged setting deficit concerns aside. House Majority Leader Eric Cantor has also proposed a 25% corporate rate in the context of tax reform and Ways and Means Chairman Dave Camp has proposed a 25% combined with a move to a territorial tax system.

Many issues arise regarding the corporate tax outside of the global perspective addressed in other reports. This report focuses on the global issue relating to tax rate differentials between the United States and other countries. The first section provides tax rate comparisons. The second section discusses policy implications, including the effect of a corporate rate cut on revenue, output, and national welfare; the possibility that a rate cut may induce reactions from other countries; and the outlook for and consequences of a revenue-neutral corporate tax reform.

Effective Tax Rate Comparisons

Several important features affect the interpretation of the comparative tax rates: the type of rate, what taxes are included, and the use of weighted measures to adjust for size differences. A number of tax rate comparisons follow the discussion of these features.

Types of Tax Rates

Three basic types of tax rates are reported: the statutory rate, the effective rate, and the marginal effective rate. The statutory rate is the rate in the tax statute; in the case of the United States, it is the top marginal corporate tax rate of 35%. The effective rate is determined by the ratio of taxes paid divided by profits. The effective rate captures the tax benefits that reduce the taxable income base relative to financial profits. The marginal tax rate is calculated from a projected investment project: it estimates the share of the pre-tax return that is paid in taxes.

Each type of tax rate has its advantages and disadvantages, and is useful for considering certain types of behavior. For example, the statutory rate would potentially affect firms' attempts to shift profits by altering the source of borrowing or transferring assets or products at prices that are not arm's length. Even the statutory rate, however, needs some adjustments for this purpose. For example, most multinational firms in the United States are eligible for the production activities deduction, which reduces the U.S. statutory tax rate by 9%, from 35% to 31.85%.

The effective tax rate is taxes paid divided by profits. The effective tax rate captures some of the tax benefits and subsidies, reducing the tax paid per dollar of profit. This measure can make a country with a high statutory rate but narrow base more comparable to a country with a low tax rate and broad base. It is probably more suited to assessing the true relative burdens on investment than the statutory tax rate. However, these types of tax rates may not capture timing effects (such as accelerated depreciation) very well and generally depend on accounting measures of profit that may vary across countries.

The marginal effective tax rate is, in theory, the appropriate measure for determining the effects of tax rate differentials on investment. However, in some cases marginal tax rates do not include all of the components of investment; frequently, they are restricted to investment in fixed assets or fixed assets and inventory. This report estimates an overall marginal effective tax rate that includes inventories and intangibles as well as buildings and equipment. Marginal tax rates also depend on estimates of economic depreciation, expected inflation, and rates of return.

Also briefly discussed is a measure referred to as the effective average tax rate. The implications of this tax rate, which combines statutory and marginal effective rates, are not clear.

Types of Taxes Included

Most tax measures reflect the effect of both national and sub-national corporate income taxes. Of the 31 Organisation for Economic Co-operation and Development (OECD) countries, 8 countries (Canada, Germany, Japan, South Korea, Luxembourg, Portugal, Switzerland, and the United States) have sub-national corporate taxes. In some cases, these sub-national taxes are more significant than those in the United States. In the case of the United States, these corporate income taxes imposed by the state increase the statutory rate (without the production activities deduction) to 39.2%. With the production activities deduction, the combined rate is 36.3%.

Countries can also have other taxes that impose a burden on capital. In the United States, these taxes are imposed by the states and localities, and they include property taxes, franchise taxes, and retail sales taxes that apply to capital goods. These taxes are much more difficult to measure and are generally not included in comparative tax rate measures, although one study (discussed below) includes franchise, and transfer and sales taxes, but not property or wealth taxes.

Simple (Unweighted) versus Weighted Averages of Tax Rates

Another issue that affects the comparisons between U.S. and worldwide tax rates is whether tax rates are simple (unweighted) averages or whether they are weighted in some fashion to indicate their relative importance. If tax rates are not weighted, then a small economy, such as Iceland, can have the same effect on the average of international rates as a large economy, such as Germany or Japan. In general, smaller countries tend to have lower tax rates and thus unweighted averages are lower than weighted averages in most cases. In the results presented in this report, both weighted and unweighted averages are reported, but weighted averages are more relevant to making comparisons of measures of the tax burden on capital deployed around the world.

Tax Rate Comparisons: United States Compared with OECD and Large Economies

Table 1 reports the three measures of effective tax rates, with marginal rates restricted to equipment and structures separately, for the United States and the OECD excluding the United States. The statutory rate is reported with and without the production activities deduction.

The overall statutory rates in the OECD are slightly lower for 2013, with the rate in the OECD excluding the United States falling a little over a half to one percentage point. The U.S. rate is estimated at 39.1%, whereas the OECD weighted average is 28.4% and the unweighted average is 25.1%. The weighted rate was influenced by rate reductions in Japan and the United Kingdom.

The marginal tax rates do not reflect the effect of the production activities deduction that likely applies to most multinational corporations and would decrease these tax rates by 2-3 percentage points as of 2010. (The deduction was 3% in 2005-2006 and 6% for 2007-2009.) Thus while the difference between the statutory rate and the simple average—a difference of 13.7 percentage points—is frequently reported, a difference of about half that much—or 6.6 percentage points—occurs when the adjusted statutory rate of 36.2% is compared with the weighted average of 29.6%. The effective tax rate (which would automatically capture the production activities deduction and other provisions) is about the same. The marginal effective rate rates are also about the same when adjusted. Thus the tax rate most relevant for the purpose of incentives to invest is similar for the United States and the rest of the OECD with respect to equipment and structures investment.

The marginal tax rates do not reflect the temporary bonus depreciation in effect for 2008-2010 in the United States, which allowed 50% of the cost of equipment to be deducted. A provision allowing 100% of the cost to be deducted is in place for 2011. Because these are temporary provisions, it seems appropriate to exclude them. Whether these measures are captured in the effective tax rate depends on the treatment of deferred taxes, but measures from different years appear similar.

The OECD excludes some large countries, such as China and Brazil. Table 2 provides the statutory and effective tax rate comparisons for the 15 largest countries, which account for three-quarters of world gross domestic product (GDP). The results are similar to those in Table 1 with the weighted average about 1 percentage point higher. With the production activities deduction the rates differ by 5.6 percentage points. The effective rate is the same.

Tax rates have declined slightly, to a weighted average of 30 and an unweighted average of 29.2.

Table 3 , Table 4 , and Table 5 provide results for effective tax rates from other studies. Table 3 reports the Markle and Shackleford study that estimates the effective tax rate of domestic firms in different countries. Because a smaller number of countries are examined, Table 3 compares the U.S. rate with that of the six large countries.

Table 4 and Table 5 report the Swenson and Lee study that estimated effective rates for firms headquartered in various countries for 2006 and 2007. The tables report for 2006 pre-dated the start of the recession and do not include years with bonus depreciation. Both results confirm the findings of other studies: effective tax rates in the United States and in other countries are similar.

Table 6 returns to the estimates of marginal effective tax rates, and expands the marginal rate analysis to reflect the other categories of assets, inventories, and intangibles. It provides a weighted average of these tax rates, using data on capital stock shares from the United States but applying the same shares to other countries. Note that intangibles are generally taxed at negative tax rates both in the United States and abroad. Expenditures on research, advertising, and human capital investment are generally deducted when incurred, which leads to a zero effective tax rate, and most countries (including the United States) have additional subsidies or credits for research expenditures.

As Table 6 indicates, the overall marginal effective tax rates for the United States accounting for the production activities deduction and for the OECD countries weighted by GDP are similar, 20% and 18%. The differences are larger if the OECD rate is adjusted by average statutory rate changes that have occurred in these OECD countries since 2005, although base broadening could offset that reduction. Marginal tax rates are also significantly lower than the statutory rates: the U.S. rate is about half the statutory rate and the weighted OECD rate is about 60% of the statutory rate.

The next measure is another marginal tax rate measure (Chen and Mintz). This measure has a number of differences from those in Table 1 and Table 4 . It includes equipment, structures, inventories, and land, but not intangibles. It also includes the effects of transfer taxes that fall on capital and debt finance. In the United States, these taxes are primarily state and local retail sales taxes that apply to capital goods purchases or inputs into construction and are quite large. It also includes franchise taxes. It does not, however, include wealth, capital stock, or property taxes. The measure also allows for debt finance and uses capital stock weights for Canada.

Table 7 reports these estimates for the OECD. Based on comments made in a previous analysis, indicating the size of these additional state and local taxes, the table reports a number with these additional taxes subtracted out to allow more comparability to other results. As compared with the numbers in Table 6 , the discrepancy in the weighted OECD and the United States is larger. If the adjusted rates in Table 6 are recomputed to exclude intangibles, they would be 28.7% for the United States and 23% for the OECD (weighted). This differential of 5.7 points shrinks to 3.8 points when intangibles are included. The only other differential is that these rates should be lowered to reflect the effects of debt finance. Normally, higher statutory tax rates result in a larger negative tax rate on debt, so the United States rate should fall more for this reason (although this effect can vary with inflation).

The differential between the United State and the OECD as reported in the original study is 16.2 percentage points (34.6% minus 18.4%). Out of that differential, 5.2 points are due to using an unweighted average, 5.0 points are due to including transfer taxes, 1.9 points are due to excluding intangibles, and the remaining 4.1 points are similar to the difference found in Table 6 .

An updated study for 2012 shows similar relationships. The United States tax rate was 35.6%, the OECD excluding the United States was 24.0% weighted and 19.6% unweighted.

Table 8 reports the comparative rates for the 15 largest countries. These rates are closer together, and quite close when adjusted for transfer taxes.

The Chen and Mintz study makes an important point, namely that other taxes outside of the corporate tax can affect the relative burden of tax in a way that could affect investment. (These types of taxes would not be relevant for profit shifting.) The main reservation about this finding is that the inclusion of these other capital taxes is partial. The other main capital tax in the United States is the property tax, which probably adds another 3 percentage points to the rate, but other countries also have property taxes as well as wealth taxes.

Table 9 reports a fourth type of tax rate measure, which is named by its developers the "effective average tax rate." Estimates using this method differentiate between a normal (or riskless) return, which is taxed at an effective rate that reflects the various tax benefits such as accelerated depreciation, and the excess return, which is taxed at the statutory rate. Thus, it is a mix of marginal tax rates and statutory tax rates. This measure is reported because it is available and cited by some researchers. Some evidence suggests that it is a better predictor of location than other measures. It shows U.S. taxes to be significantly higher than OECD rates, but the implications of such a measure for economic behavior are not clear.

Economists sometimes, when examining investment subsidies, differentiate between the normal and excess return. The normal return's tax burden is affected by items such as accelerated depreciation and investment subsidies, whereas the excess profit is subject to the statutory rate. In these views, however, it is the tax on normal return that would, in any case, affect economic behavior. The excess return is generally seen as bearing little or no tax burden because the reduction in expected return due to tax is offset by the reduction in variance of after tax return (i.e., the tax reduces gains and losses).

One reason that a combination of statutory and effective marginal rates might have an effect on location is that firms may locate some physical activity in a country to facilitate profit shifting associated with setting up subsidiaries to exploit developed intangibles.

Summing Up

This comparison suggests some important precautions in comparing tax rates. First, it is important when forming a composite rate for the rest of the world to weight the tax rates by output or some other measure of economic importance. Because small countries tend to have lower rates than large ones, comparing rates using simple averages across countries exaggerates the differential between the United States and tax burdens elsewhere in the world. Second, weighted statutory tax rates differ but effective tax rates do not. Marginal effective tax rates have small differences. Third, in comparing the differences in statutory rates, the effect of the production activities deduction narrows the differential by close to half. Finally, although the role of subnational taxes outside of the corporate tax appears to be important for investment decisions, a full comparison has yet to be made. This analysis suggests that reform of state and local sales taxes could contribute to a more efficient system.

Economic Effects of a U.S. Rate Cut

The previous analysis has shown that U.S. statutory corporate tax rates are about 10 percentage points higher than a weighted average of the OECD or the large countries that account for most of output (7 percentage points when including the production activities deduction). Effective tax rates are about the same, and marginal effective tax rates are only slightly larger in the United States. The effects of including other capital taxes have not yet been explored on a comprehensive basis, although U.S. retail sales taxes on capital goods and franchise taxes are estimated to create an additional 5 percentage point differential.

This section explores the effects of a U.S. rate cut on the United States. The first subsection examines the effects on revenue, output, and national income for a corporate rate cut in isolation, only looking at capital flows. The second subsection discusses potential implications for profit shifting. The third subsection considers the possibility that other countries would react to a U.S. rate cut by cutting their rates as well. Finally, discussions of outlook for and consequences of a revenue neutral corporate tax reform are presented.

Effects on Revenue, Output, and National Welfare, Assuming No Tax Rate Changes by Other Countries or Offsetting Base Broadening in the United States

This section examines the effects of a corporate rate cut from 35% to 25% on revenues and international capital flows, and their effects on the U.S. economy (including feedback effects on revenues and effects on national welfare). It focuses on issues specific to global economy considerations of the corporate tax, not the traditional corporate tax issues that would also occur in a closed economy.

Revenues

The Congressional Budget Office (CBO) projected a 10-year corporate revenue of $4,360 billion from FY2013 to FY20221. If this number were multiplied by 10/35 to estimate the revenue loss, the result would be $1,245 billion per year, on average. The loss, however, is likely to be larger because net tax liability is the tax rate times taxable income, minus credits. Rate changes would not normally affect credits, and, if not, the revenue loss would be projected based on tax liability before credits. According to Internal Revenue Service (IRS) data, corporate tax before credits is 134% of corporate tax after credits.

One of the major credits, the foreign tax credit, would be affected, in some cases, by a rate cut. The foreign tax credit is limited to the U.S. tax because of foreign source income, so as the U.S. rate falls, the limit on credits also falls. In some cases, the credit would not be affected, or not affected proportionally, because the foreign tax credits are less than the limit and a change in the limit would not necessarily change foreign tax credits. (These firms are termed excess limit firms.) In other cases, firms have creditable taxes above the limit; with credits equal to the limit, a reduction in the limit would reduce foreign tax credits proportionally. (These firms are termed excess credit firms.)

Tax liability after the foreign tax credit but before other credits (general business credits and the alternative minimum tax credit) is 105.7% of tax liability after all credits. If foreign tax credits are reduced proportionally, the average loss is almost $132 billion. If foreign tax credits are not affected at all, the average loss per year is $168 billion.

These estimates suggest that over the 10-year period, $1.3 trillion to $1.7 trillion would be lost in revenues due to the proposed rate cut. This number does not include any behavioral feedback effects, which could reduce the cost, but also does not include debt service or crowding out of private capital, which would increase the cost.

Estimates implied by this calculation are larger than projections based on a percentage point rate increase contained in CBO's Budget Options which, applying the percentage loss to the new baseline suggests revenue losses of about $1,113 trillion. Some part of the discrepancy may reflect the fact that liabilities lag collections and that the first full year does not apply because estimates are based on fiscal years. In addition, to the extent that firms have unused foreign credits, a rate increase would raise less than reduction of the same size would cost. Other behavioral effects may occur as well.

Regardless of the precise estimate, a revenue loss in excess of $1 trillion and in excess of $100 billion a year would be expected over the next 10 years.

Effects on U.S. Output and Wages

What about the effects on the U.S. economy? The discussion sometimes focuses on job creation. Job creation is an important issue for the government to address during cyclical downturns. Standard economic theory suggests such policies should be temporary; in contrast, advocates of corporate rate cuts are proposing permanent cuts. In any case, temporary or permanent corporate rate cuts are unlikely to be very effective stimulus policies.

Economic theory suggests that there is no reason to view general job creation as a long-run objective of government policies. The economy can generate the jobs needed by the natural process of growth and market adjustment. In 1961 and 1991, the unemployment rate was the same, 6.7%. Employment, however, rose from 66 million to 117 million. Employment tends to grow steadily; the unemployment rate fluctuates. Long-term jobs policies, according to economic theory, therefore, should not be aimed at increasing jobs, although they can be designed to reduce structural or frictional unemployment (such as improving the skills of disadvantaged workers).

Rather, the capital flows induced by a corporate rate cut generally have effects on the level of output and on wage levels, rather than the number of workers. Despite the claimed effects of cutting the corporate tax on encouraging the flow of foreign-owned capital into the country from abroad (inbound capital) or discouraging the flow of U.S. capital to other countries (outbound capital), there are many forces that constrain the movement of capital. As capital flows into a country, its greater abundance coupled with a fixed amount of labor drives the wage rate up and the rate of return down, so that the pre-tax return to capital falls. If the economy is large enough to affect the rest of the world's returns, the proportional flow of capital is lessened further, because shift of capital from abroad (with no change in taxes) raises the after tax return abroad and draws some of the capital back. Capital flows are further reduced if there are significant non-corporate sectors (because a rate cut would draw capital from the unincorporated sectors of the economy as well as from abroad). Finally, the flow of capital would be further limited if capital is not perfectly mobile or products are not perfect substitutes.

A study by Gravelle and Smetters used a general equilibrium model to capture the effects of imposing a 35% tax, allowing for four sectors in the U.S. economy and a mirror foreign economy. The estimated change in the capital stock, assuming the conditions most conducive to capital inflows, was 4.5%. (This scenario assumes that individuals and firms view investments in different locations as perfect substitutes and consumers view foreign and domestic products as perfect substitutes; these are referred to as the portfolio and product substitution elasticities and are set, effectively, at infinity.) This effect implies a 4.7% increase from eliminating the tax (4.5/(1-4.5)). To convert a percentage change in the capital stock to a percentage change in output, multiply by the capital share of income, which was 0.29, to get a 1.36% increase in output. Because a partial change is proposed, multiply by 10/35 to obtain an estimated percentage change in output of 0.39%. With constant factor shares, which are assumed in this model, wages will also increase by this percentage.

A similar magnitude of effects can be obtained by examining revenue reductions and incidence estimates for this same perfectly mobile case. CBO projects the corporate tax at 2% of GDP. This revenue is as a percentage of gross output (which includes output that replaces capital and thus is not a part of an income concept). To convert it to a percentage of net of depreciation output (which is 82% of gross output ), divide by 0.82, for corporate revenues that are 2.27% of domestically generated income. To capture the effect of reducing the tax by 10 percentage points, multiply by 10/35, to obtain a tax cut of 0.65% of income. Incidence studies indicate that about 73% of the burden of the corporate tax falls on labor under this perfectly mobile assumption, so this number is multiplied by 0.73 to obtain an increase in labor income of 0.47% of total income. Based on national income accounts, the share of labor income is 76%, so dividing 0.47 by 0.76 yields a 0.62% increase in output and in wages.

Both estimates suggest a relatively small effect on output, of around 0.5%, but this estimate is too large. Perfect product substitution is not possible in a multi-good economy. Moreover, empirical evidence suggests elasticities that are smaller. Gravelle and Smetters propose as a more reasonable case a model with portfolio and product substitution elasticities of 3. This assumption yields a 1.6% change in the capital stock. Following the methodology outlined above, the effect on output and wages is 0.13%, rather than 0.4%. These elasticities reduce the share of the burden borne by labor to 21% and, again, following the same methodology would cause an output and wage effect of about 0.18% rather than 0.62%.

Two other aspects might make these effects even lower or perhaps reverse the sign. First, the effect of debt capital is not incorporated into any of these models. Because about a third of the capital stock is financed by debt, the magnitude of the first set of estimates (using capital stock estimates) should be reduced by about one-third to account for the presence of debt. This would be the expected outcome if returns to debt-financed investment were taxed at a zero rate, as would be the case if there were no inflation and no accelerated depreciation. However, since both of these conditions exist in the U.S. tax code, debt is subsidized at the corporate level because inflation is generally positive and the effective marginal tax rate is below the statutory rate. Lowering the statutory rate reduces these subsidies and discourages debt. This effect may be desirable for issues such as the debt-equity distortion, but can actually discourage capital inflows, as suggested in one study.

Second, the estimates of capital stock assume that the United States has a territorial tax (i.e., the only tax due is on domestic profits). Although a relatively small share of foreign source income is taxed, the U.S. system is not fully territorial, but rather defers the tax until income is repatriated (except for branch income and some passive income that is easily shifted). Under the U.S. system, the tax on income that is repatriated or currently taxed can be partially or fully offset by credits for foreign taxes paid. Most foreign source income is not taxed either because it is not repatriated or because credits are used to offset the tax; in addition to credits for tax paid in a country, unused credits from countries with higher taxes than the United States can be used to offset tax on income repatriated from low tax countries (called cross crediting).

Effects on National Income and National Welfare

Even though output (or domestically generated income) increases by small amounts, that output gain does not represent a gain in U.S.-worldwide income. The gains that labor experiences are offset by the losses in the pre-tax return by the existing domestic capital, reducing the benefits of these firms. For example, in the case where labor income increases by 21% of the tax, existing capital, which absent capital flows would have had income increase by 100% of the tax cut, now has that increase offset roughly by 21% of the tax due to the lower pretax return. Although both labor and capital have higher after tax income, there is a transfer between the government and individuals, which must be offset by other tax increases or reduced spending either now or in the future.

Although there will be some gains in national welfare, they are likely to be only a small fraction of the revenue change. They would arise from income that transfers from foreigners to U.S. persons. For thinking about this effect, consider separately inbound capital (capital owned by foreigners and invested in the United States) and outbound capital (capital owned by U.S. persons and invested abroad). The increase in inbound capital generates returns, but those returns are the income of the foreign investors. Thus, the only gain for the United States is the change in taxes, and the lower pre-tax rate of return on inbound investment. For outbound capital, the returns already belong to U.S. firms, and the gain is from moving capital back into the United States where taxes formerly paid to foreign governments are paid to the United States.

A recent study examined these effects, using data on foreign and domestic tax rates from a 2008 GAO study and estimates of inbound and outbound capital from the National Income and Product Accounts and found modest effects. The estimated output effects in this study were larger than those calculated above because the study used a partial equilibrium framework with a simplified single sector model designed to distinguish between outbound and inbound capital flows. The purpose, however, was to consider the general magnitude of welfare effects. The estimates found that there was a slight loss (3% of the additional output) for inbound capital because the reduction in the tax rate on existing capital inflows was less than fully offset by taxes on induced capital flows and the small reduction in pre-tax returns. For outbound capital, the main source of increased capital, there was a gain of 12% of output because taxes on this capital were paid to the United States rather than foreign governments. Overall, only about 9% of the output increase was a benefit to the United States which, for the magnitude of effects calculated, is less than two-hundredth of 1% of output and less than 3% of revenue.

These findings are quite consistent with optimal tax theories. For inbound capital, the optimal tax rate should be 1/(1+e) where e is the elasticity of the flow of inbound capital. Because the study used an estimated effective tax rate of 25% and the optimal tax rate is 25% when e is 3, a negligible effect on welfare would be expected. For outbound capital, the optimality rule is to tax foreign source income net of foreign taxes for a small country, with a slightly higher rate on outbound capital returns for a large country. Because current tax rules impose taxes much smaller than this rate and cause too much capital to be allocated abroad, cutting the U.S. tax rate improves welfare. However, the effects are small compared with either the U.S. economy or revenue.

Revenue Feedback Effects

A final issue is the magnitude of revenue feedbacks from the output increase. Recall that the corporate tax cut discussed is about 0.65% of net output.

This increase in output is taxed with a mix of both labor and capital taxes. The marginal tax rate on labor income is estimated by CBO at 28.4% and the capital income tax rate is estimated at 11.5%. The 11.5% is further reduced by 2 percentage points to account for the reduction in the corporate rate, to 9.5%. The overall marginal tax rate is 23.7%. Multiplying the 0.13% and the 0.18% increases in output by 23.7% yields an offset of 4.7% to 6.6%. (If infinite elasticities were assumed and the output effects of 0.4% and 0.62% were considered the feedback effects would be from 14% to 23% of revenue.)

There are three reasons this feedback effect is probably too large (aside from the reservations about output effects due to debt finance discussed above). First, this tax on labor income does not account for the expectation that increases in labor income might be partially received through tax exempt employee fringe benefits or partially spent on tax favored purchases (such as charitable contributions). Second, absent other changes the share of individual taxes collected as payroll taxes would eventually lead to increased outlays for Social Security. Finally, the transition to the new capital stock will not be immediate.

In all the scenarios, these revenue offsets from behavioral changes would likely be smaller than the increase in revenue due to debt service, which is estimated at 25% on average over the 10-year period. In addition, if the increase in the debt displaces the capital stock, output would be reduced by 2021 enough to reduce revenues by 15% to 23% of the static cost. If revenues are not offset, and the increased debt crowds out the U.S. capital stock, output would be reduced about, 0.4% by 2021, an effect more than twice as large as the effects estimated from international capital inflows.

Profit Shifting and Revenue Effects

Another aspect of behavior that is of concern for revenue is the possibility of profit shifting. It is more difficult to judge this effect. Because the evidence discussed above suggests that the revenue offset from corporate rate changes due to investment flows is likely in the neighborhood of 5%, real output effects do not appear large enough to make a corporate rate cut pay for itself in increased revenues, as some advocates claim.

Before examining profit shifting directly, consider the evidence cited to support the argument that there is a significant revenue shift. First, proponents point to studies that indicate a "Laffer curve" with a revenue maximizing tax rate of around 30%, using cross country panel data. These four studies were reviewed in a CRS report that found, due to both interpretation of the studies by proponents and statistical problems, these studies did not appear to support a gain in revenue from a cut in the U.S. tax rate.

Proponents also make the general argument that the United States collects a smaller share of revenue relative to GDP than other countries, even though its rate is higher. For example, Hassett points out that the U.S. corporate revenue is 2% of GDP whereas the revenue of most other countries is 3%, and that the share has grown in some countries as rates have decreased. Two factors other than profit shifting affect corporate revenues and their changes as a percent of GDP, the size of the base and the share of business income (and income in general) that is corporate source. Data shown earlier indicates that although the statutory rate is higher in the United States, the effective rate is not. Revenues patterns over time will reflect a combination of rate changes and base changes, and some countries financed some or all of their recent rate reductions with base broadening. In addition, the size of the corporate sector will be affected by the ability of firms to operate in noncorporate form. A 2007 study by the U.S. Department of Treasury indicates that the U.S. rules allowing large firms to operate in noncorporate form are more generous than those of other countries. It also documented that the share of business income received by corporations in the United States had declined from 80% to 50% as more generous limits of the number of shareholders small corporations could have to elect taxation as unincorporated businesses were adopted and special forms of business such a limited liability corporations, taxed as partnerships, grew. A recent OECD study indicated that corporate tax revenues, in addition to offsetting base changes, were increased by incentives to operate firms in corporate form and additional compliance measures.

It is possible to consider the effect of profit shifting by examining direct estimates of the cost of profit shifting. These estimates of profit shifting suggest that they amount to 14% to 20% of total corporate tax revenue, which would not be enough to offset the revenue loss even if profit shifting disappeared entirely. How much of a reduction in profit shifting might reasonably be expected? Because the profit shifting clearly occurs to the very low tax rate countries, even a cut to 25% would leave a large benefit to profit shifting (it would lead to a combined federal and state rate of 29.8%, and 27.7% for eligible firms if the production activities deduction were retained). Recent discussions of a plan referred to as the double-Irish, Dutch sandwich showed two companies that, having moved profits to Ireland (with a 12.5% rate), took further steps to shift profits to Bermuda (with a 0% rate). Because the cost in most cases is small, most firms would probably continue to shift profits to the limit currently allowed by law as interpreted by the courts, and probably considerably less than proportionally to the tax rate change.

As discussed below, reforms to the tax treatment of foreign source income, by eliminating deferral and by restricting the foreign tax credit, or by focusing on limiting profit shifting techniques, might reduce the ability or benefits of profit-shifting and raise revenues.

Other Countries' Reactions to a U.S. Rate Reduction

An important policy issue for the United States is whether other countries might react to a U.S. rate reduction. Evidence shows that the initial cut in corporate tax rates around the world may have been triggered by the cut in the U.S. corporate tax rate from 48% to 35% from 1986 to 1988 as a result of the Tax Reform Act of 1986. Figure 1 shows the statutory tax rates, beginning in 1981, for the United States and for the remainder of the OECD. The U.S. combined state and federal tax rate was about 50% and fell to just below 40% over those two years. Except for a slight rise in 1993, the tax rate has remained constant ever since. Two OECD numbers are provided: the unweighted numbers varying with the admission of new OECD members as well as tax rates and the GDP weighted tax rates of the OECD nations (outside the United States) in 1981. (Tax rates are shown in the Appendix , and they also indicate that the weighted average holding member country constant is about a percentage point higher.)

The tax rates for 2012 are similar to those for 2010: the unweighted average fell slightly from 25.5 to 24.9, but the weighted average was slightly higher, 29.8 compared to 29.6. The U.S. rate fell from 39.2% to 39.1%.

While the simple (unweighted) average, which includes new entrants to the OECD, suggests a relatively continuous decline in rates, the weighted average indicates a more discrete pattern of tax cuts. As indicated by the graph, tax rates on average were close together before 1987 but rates of other countries began dropping in the next few years. For the weighted OECD average, the first drop followed the U.S. tax cut, but subsequently, rates were relatively constant over the next several years (and still slightly above U.S. rates). Tax rates then fell again, but stabilized around 2002 and were relatively unchanged until 2007, when Germany began cutting its tax rate. The fall beginning in the late 1990s may have been associated with the lower tax rates of the emerging former eastern bloc countries.

If one country cuts its tax rate, it attracts capital from other countries, which benefits labor and possibly overall national welfare, at the expense of other countries, as discussed above. However, if all countries cut their tax rates, none will gain capital but all will lose revenue. The observation of rate cuts in the rest of the world in the wake of the U.S. tax cut is not proof that countries will cut their rates again if the United States does, but it does provide some support for that expectation.

It is also possible that a smaller rate cut that does not move the United States to rates below those of other large countries would be less likely to trigger a response. For 2010, statutory tax rates for the next two largest countries in the remaining OECD, Japan and Germany, were 39.54% and 30.18% respectively, although Japan is proposing a 5 percentage point rate cut. The United Kingdom and France are respectively 28% and 34.4%, although the United Kingdom is planning further cuts to 24%. If the United States cut its federal rate to 25% its rate would be 29.8%; with the production activities deduction it would be 27.7%. A rate cut to 30% would result in a 34.5% rate (32% with the production activities deduction). That rate would be similar to the rates in France, Japan, and Germany.

Revenue-Neutral Rate Reduction and Corporate Reform

If revenue concerns require offsetting corporate base broadening, what changes might be made and what are the consequences for international capital flows and profit shifting? This section discusses base broadening options, focusing on the largest corporate tax expenditures. The base broadening provisions are listed in Table 10 , along with the reduction in the corporate rate the revenue change would allow for. Note that while each proposal is stated in terms of the rate reduction its revision would permit, the rate reductions for several provisions taken together are slightly smaller than the sum of their individual rate reductions because the progressively lower rates make base broadening less valuable.

Accelerated Depreciation

Of the items listed among corporate tax expenditures, the single largest provision outside of deferral, is accelerated depreciation for equipment which, abstracting from the effect of temporary bonus depreciation, would allow a rate reduction of about 2 percentage points. This measure is based on an alternative depreciation system. (Much more revenue would be raised in the short run, but revenue neutrality based on a 10-year budget window would lead to a long-run loss, because slowing depreciation leads to much larger revenue gains in the short run compared with the long run.) Equipment, in particular, is taxed at rates well below the statutory rate, at least at current inflation rates. Nevertheless, the desirability of restricting depreciation is unclear. A revenue neutral revision that cuts the rate in exchange for higher taxation of new investment would raise the marginal effective tax rate, because the rate reduction would apply to the return to existing capital. Moreover, estimates suggest that the value of depreciation under the alternative system would be too small and would tax investments at effective rates in excess of the statutory rates. This provision would also raise revenues on unincorporated businesses, equivalent to about 30% of the corporate loss, which would permit a larger corporate rate reduction, by 3.3 percentage points.

In addition, there is some accelerated depreciation for buildings, primarily rental housing, but the revenue losses are largely for unincorporated businesses.

The Senate Finance Committee has released discussion drafts on cost recovery and accounting that relate to corporate taxation as well as a draft on international corporate tax issues. These proposals have not been scored. The cost recovery provisions would introduce a new depreciation system that would slow depreciation and approximate the present value of economic depreciation. Assets would be added to general pools rather than each vintage of investments being depreciated separately. Real property would be depreciated over 43 years. Research and development expenses would be deducted in equal increments over five years, as would half of advertising expenditures (the remainder would continue to be deducted when incurred). Oil extraction expenses would be recovered over five years and percentage depletion would be repealed. LIFO and lower of cost of market inventory would be repealed (see discussion of LIFO below).

Production Activities Deduction

One of the larger tax expenditures outside of deferral is the production activities deduction, which allows a deduction of 9% of taxable income for domestic production for certain industries, primarily manufacturing, electricity and natural gas production, and construction. This provision would allow a corporate tax rate reduction of 0.7 percentage points. This provision has been criticized as distorting the tax treatment of different industries by granting differential tax rates. In addition, it creates administrative and compliance problems in both distinguishing domestic content and identifying eligible activities. About a quarter of the cost benefits unincorporated businesses and these revenues are included in the above estimate; without those revenues the reduction would be under a percentage point.

The only reservation about this deduction is that it is more likely to apply to multinationals because of the industry restrictions and a revenue neutral substitution could raise the true statutory rate. For example, a 0.7 percentage point reduction in the federal rate would allow, after interacting with state taxes, a reduction from 39.2% to 38.5%, whereas firms with the production activities deduction have a rate of 36.3%. One option would be to tailor the provision more closely to the characteristics of multinationals, including disallowing the deduction for unincorporated businesses and further restricting the eligible activities (e.g., disallow electricity production as a qualified activity), and use those revenues to cut the rate, while retaining the deduction. If restricted to corporate manufacturing most than half of revenues would be recouped.

Tax Treatment of Foreign Source Income

The largest tax expenditure is the deferral of tax on foreign source income, which would permit a corporate tax rate reduction of 3.1 percentage points. This move toward worldwide tax would also, independently, increase the amount of capital in the United States by discouraging outbound capital and would reduce the benefit of profit shifting mechanisms, perhaps significantly. A larger reduction would be possible, by about 4 percentage points or more if the foreign tax credit were limited to offsetting tax only on income earned in that country as was proposed in S. 3018 , 111 th Congress. This change would eliminate most cross-crediting and raise more revenue; it would also be projected to gain a similar amount in welfare gain to the rate cut itself.

Other revenue raising alternatives affecting taxation of foreign source income have been proposed. President Obama has proposed a set of revisions that is estimated to raise $157 billion over 10 years: the major proposals are disallowing interest and certain other deductions of the parent company to the extent income abroad is not taxed currently ($37 billion), limiting foreign tax credits that can offset income to the same share as the share of income repatriated ($66 billion), a provision to tax excess returns of intangibles ($26 billion), and limiting foreign tax credits for certain extractive companies ($10 billion). These provisions would allow a rate cut of about a percentage point. An alternative would be to move to an actual territorial tax that exempts all active income earned abroad but disallows part of overhead expenses of parent companies, which is estimated to raise $76 billion and allow a rate cut of 0.5 percentage points. There are many other revisions to the treatment of foreign source income that would raise varying amounts of revenue.

House Ways and Means Chairman Camp has proposed a territorial tax (revenue neutral) that would preclude any revenue gains from the tax treatment of foreign source income. The Senate Finance Committee has released d a discussion draft on international corporate tax issue. All foreign source income would be subject to tax (equivalent to repealing deferral) but some income would be taxed at a lower rate than the statutory rate (i.e., a minimum tax would be imposed). This proposal has not been scored but could raise revenue, depending on the minimum tax rate.

Revenue offsets that increase the taxation of foreign source income can be significant and reinforce the capital flow and welfare effects of a rate cut in a global economy. Whether revenue increases from the treatment of foreign source income can be used as revenue offsets is unclear. Most proponents of rate reductions are also strong opponents of increasing the tax on foreign source income, and indeed favor lowering that tax burden, perhaps by moving to a territorial system without cost allocation, which would likely lose a small amount of revenue. Such a change would reduce capital investment in the United States, although probably slightly, and offset the capital flow and welfare gains of a rate cut.

The estimate in Table 10 does not include the effect of deferral of active financing income, which is a temporary provision but has been extended for many years. It would increase the cost of deferral by about 10%.

LIFO Inventory Accounting

Another option is the repeal of LIFO (last in, first out) accounting, which allows firms to treat goods sold as the latest acquired; eliminating this provision would raise $97.5 billion over 10 years and allow a 0.8 percentage point reduction in the corporate rate. Most firms do not use LIFO because they must conform tax and book methods. There is, however, a justification for LIFO, in that, on average, it eliminates the tax on inflationary gains.

Other Tax Expenditures and Base Broadening Provisions66

There are several remaining tax expenditures but most are either small or would be questionable as offsets for a variety of reasons. If every corporate tax expenditure were repealed, including those mentioned previously, the corporate rate could be cut by 7.9 percentage points, to 27.1%, assuming no behavioral responses. (In the category addressing the treatment of foreign source income, only the deferral provision is a tax expenditure.) Larger cuts could occur if the repeal of benefits for unincorporated businesses were used to cut corporate rates. Without revenue from the repeal of deferral, the rate would fall by approximately 5.5 percentage points, or to 29.5%

The Joint Committee on Taxation estimates a rate of 28% for repeal of corporate preferences excluding deferral, but this estimate allows for higher gains from depreciation and expensing of research and development during the budget horizon. (They note this rate would not be revenue neutral in the long run).

The incentives for research and development are popular provisions that have some economic justification, and, in the case of expensing, would be extremely difficult to administer. Only the expensing provision is reflected in Table 10 , but the research credit, which is temporary (and which the President proposes to make permanent, is actually larger. Special provisions for insurance companies are almost the size of the title passage rule, and would be an option as would the relatively smaller provisions for fossil fuels. The President's budget proposals would restrict insurance company provisions for a $14 billion gain (0.1 percentage point) and benefits for fossil fuels for a $43.6 billion gain (0.3 percentage points). Provisions such as tax-exempt bonds or the low-income housing credit are, however, designed to benefit others (state and local governments or low-income tenants) and if the corporate benefit were removed, these activities would largely migrate to the unincorporated sector. Lower rates for small corporations would allow a 0.3 percentage point reduction. Taxing income of credit unions would allow less than 0.1 percentage points. There are a number of energy subsidies that are directed at conservation whose repeal is not generally considered, as is the case for corporate charitable deductions.

In addition, there are also some tax reform possibilities that are not in the tax expenditure budget. For example, a tax reform bill introduced by then-Chairman of the Ways and Means Committee Rangel in the 110 th Congress ( H.R. 3970 ) included a provision extending the write period for acquired intangibles that raised $20 billion over 10 years.

Limits on Interest Deductions

Restricting the deduction of interest would permit a significant reduction in rates. Although the benefits vary with expected inflation, disallowing the deduction for the inflation portion of interest is estimated to allow a reduction of the tax rate in the neighborhood of 2.5 percentage points and, in a closed economy, would be an efficient reform. It might also reduce the use of debt as a method of profit shifting (by borrowing in high tax countries).

There is, however, a reservation about this change when considering international capital flows: a revenue neutral change could decrease the net inflow of capital if debt is more mobile than equity.

Shifts Between Individual and Corporate Taxes: Restrictions on Using the Non-Corporate Form, and Shifting Tax Burdens to the Shareholder Level

According to a Treasury study, the share of business income that is in corporate form has declined from 80% to 50% since the early 1980s, primarily through the increase in the number of shareholders for small corporations that are allowed to elect partnership treatment (Subchapter S corporations) and the growth in new organizational forms such as limited liability corporations that are taxed as partnerships. Using the tax rates currently in effect, if all business owners moving to this form are in the top 35% tax bracket, and if dividends and capital gains are distributed and realized based on economy wide averages as well as being subject to the current 15% rate, returning to the early 1980s share would allow a rate cut of 3 percentage points without altering overall individual and corporate revenue. Note, however, that the contribution to rate reduction declines rapidly as the corporate rate is cut. For example, a base broadening provision, such as those discussed above, that allowed a 3 percentage point rate cut starting at a 35% rate would allow a 2.6 percentage point reduction applying to a 30% rate and a 2.3 percentage point reduction starting at a 25% rate. The effect of moving operations to corporate form depends on the differential between the individual and corporate tax, and would reduce the rate by 1.3 percentage points starting at a 30% corporate rate, and actually raise the corporate rate if starting at a 25% rate.

This potential rate reduction is larger, however, if the individual rate is lower. According to estimates, the average tax rate for all partnership and Subchapter S income is 30%. In that case, the percentage point reductions are 5, 2.3, and 1.5, respectively, beginning at a 35%, 30%, and 25% corporate tax rate. Because these shifts into the noncorporate sector are driven by new forms of large companies, it is likely that the tax rate is higher than average for partnership and Subchapter S income (many partnerships, for example, are no different from proprietorships except they have two owners instead of one), but probably lower than the top rate.

In a global economy, it is better to allow tax cuts within the corporate sector at the corporate rather than the individual level. One option is rolling back the 2003 cuts in dividends and capital gains, which would allow a rate cut of about 2.5 percentage points, and perhaps as much as 4 percentage points. These increases in rates are scheduled to occur after 2012 when the Bush tax cuts expire, however, and whether they can be counted as revenue raisers depends on scoring options.

The last two options interact, however. The more taxes are collected at the individual level by raising taxes on dividends and capital gains, the larger a rate reduction from shifting income into the corporate sectors. If dividends were taxed at full rates and capital gains at 20%, then at a 30% individual tax rate and a 35% corporate rate, the reduction is 6.5 percentage points. These effects depend as well, of course, on how the individual tax rate on ordinary income develops, which is currently scheduled to rise.

Summing Up

This section has identified enough provisions to allow the corporate tax rate to be reduced to 25% without losing revenue over the long run (i.e., that do not depend on large short-run gains, such as those from reducing accelerated depreciation), but that would require going beyond corporate tax expenditures (which would account for only 5 percentage points) to business preferences associated with unincorporated businesses, foreign tax credit restrictions, or more fundamental reforms.

Appendix. Statutory Tax Rates, 1981-2010