The base of the federal corporate income tax includes net income from business operations (receipts, minus the costs of purchased goods, labor, interest, and other expenses). It also includes net income that corporations earn in the form of interest, dividends, rent, royalties, and realized capital gains. The statutory rate of tax on net corporate income ranges from 15 to 35 percent, depending on the amount of income earned. The United States taxes the worldwide income of domestic corporations, regardless of where the income is earned, with a foreign tax credit for certain taxes paid to other countries. However, the timing of the tax liability depends on several factors, including whether the income is from a U.S. or foreign source and, if it is from a foreign source, whether it is earned through direct operations or through a subsidiary. Statutory and effective tax rates are not necessarily the same. An effective tax rate, which is often lower—even substantially lower—than the statutory rate, measures the amount of tax that a corporation actually pays on a dollar of its economic income, when all aspects of the tax (deductions, credits, deferrals, etc.) are taken into account. Statutory and effective rates may differ, for example, because depreciation allowances for specific types of capital investments exceed (or fall short of) the true (economic) depreciation. Other differences arise because income from foreign subsidiaries is generally not taxed until it is repatriated to the United States. Special incentives, such as the research tax credit, that are designed to encourage certain behavior, also cause the effective rate of the tax to differ from its statutory rate. A recent Congressional Budget Office (CBO) study found that the United States’ statutory corporate tax rates are high relative to Organization for Economic Cooperation and Development (OECD) countries but comparable with the rates for what were then the G- 7 countries. Comparisons of effective rates depend on the type of investment and the type of financing. According to CBO, U.S. effective corporate tax rates in 2003 were the G-7 median for equity-financed investments in machinery, second lowest for debt-financed investment in machinery, and second highest for equity-financed investment in industrial structures. Differences in effective tax rates across types and sources of income are pervasive, reflecting the complexity of the tax code. The corporate income tax (1) reduces the after tax return on capital income and, therefore, affects the incentive individuals have to save and invest; (2) taxes corporations differently than partnerships and sole proprietorships; (3) taxes U.S. corporations operating in foreign countries differently than those operating domestically and differently than foreign governments tax corporations; (4) taxes different types of corporate investments, such as machinery or structures, unevenly; and (5) taxes debt-financed investment at lower rates than equity-financed investment. These differences in effective tax rates alter both investment decisions and the reporting of corporate income as firms try to minimize their taxes. Such tax avoidance, much of it legal but some illegal, reduces tax revenue. Guiding investments to lightly taxed activities rather than those with high before tax productivity may reduce economic growth, further reducing tax revenue from what it otherwise would have been. At about $277 billion, corporate income taxes are far smaller than the $841 billion in social insurance taxes and $998 billion in individual income taxes that OMB estimates will be paid in fiscal year 2006 to fund the federal government. Figure 1 shows the relative importance of federal taxes. Figures 1 and 2 show the trend in corporate tax revenues since 1962. Tax experts have written that corporate tax revenues fell from the 1960s to the early 1980s for several reasons. For example, corporate income became a smaller share of national income during these years, partly due to the fact that corporate debt, and therefore deductible interest payments, increased relative to corporate equity, reducing the tax base. In addition, tax expenditures, such as more generous depreciation rules and corporate tax rate reductions lowered corporate taxes. Since the early 1980s corporate tax revenues have fluctuated in a narrower range, reflecting changes in corporate profits, tax laws, and other factors. Since the early 1980s the corporate tax has accounted for from about 6 to 13 percent of federal revenue, as shown in figure 2. Consequently, although not the largest, it remains an important source of federal revenue. Relative to the gross domestic product (GDP), the corporate tax has ranged from a little over 1 percent to just under 2.5 percent during those same years. CBO has recently projected that despite the recent uptick, corporate tax revenue for the next 10 years as a percentage of GDP is expected to stay within this same range. Corporate tax revenues of the magnitude shown in figure 2 make them relevant to considerations about how to address the nation’s long-term fiscal imbalance. Over the long term, the United States faces a large and growing structural budget deficit primarily caused by demographic trends and rising health care costs as shown in figure 3, and exacerbated over time by growing interest on the ever larger federal debt. Continuing on this imprudent and unsustainable fiscal path will gradually erode, if not suddenly damage, our economy, our standard of living, and ultimately our national security. We cannot grow our way out of this long-term fiscal challenge because the imbalance between spending and revenue is so large. We will need to make tough choices using a multipronged approach: (1) revise budget processes and financial reporting requirements; (2) restructure entitlement programs; (3) reexamine the base of discretionary spending and other spending; and (4) review and revise tax policy, including tax expenditures, and tax enforcement programs. Corporate tax policy, corporate tax expenditures, and corporate tax enforcement need to be part of the overall tax review because of the amount of revenue at stake. Corporate tax expenditures reduce the revenue that would otherwise be raised from the corporate income tax. As already noted, to reduce their tax liabilities, corporations can take advantage of preferential provisions in the tax code, such as exclusions, exemptions, deductions, credits, preferential rates, and deferral of tax liability. Tax preferences—which are legally known as tax expenditures—are often aimed at policy goals similar to those of federal spending programs. For example, there are different tax expenditures intended to encourage economic development in disadvantaged areas and stimulate research and development, while there are also federal spending programs that have similar purposes. Also, by narrowing the tax base, corporate tax expenditures have the effect of raising either corporate tax rates or the rates on other taxpayers in order to generate a given amount of revenue. The sum of estimated forgone revenue for the federal government because of corporate tax expenditures was $80 billion for fiscal year 2005. In its most recent report, the Department of the Treasury (Treasury) listed 27 tax expenditures for corporate taxpayers only and another 52 provisions available to both corporations and other businesses. As of fiscal year 2005, the two largest tax expenditures used by corporations were the accelerated depreciation of machinery and equipment ($15.9 billion) and the deferral of income of controlled foreign corporations ($10.5 billion); these two accounted for a third of the sum of corporate revenue losses estimated by Treasury. We reported in September 2005 that the effectiveness of many tax expenditures is not subject to a level of review similar to that of programs that spend money directly. Although some corporate income tax expenditures are reviewed by government agencies, academics, and others, all should be reviewed periodically to ensure they have not outlived their usefulness, are not redundant, or are not inefficient in accomplishing their intended purpose. In that report, we recommended that the OMB and Treasury take steps to ensure regular reexamination of tax expenditures, including the corporate provisions. OMB disagreed with the recommendations, citing methodological and conceptual issues. Our report discusses in detail the issues that OMB raised and why we continue to believe that our recommendations are valid. Also, as far back as 1994, we have suggested that Congress should review these tax expenditures, considering such things as how well the corporate tax expenditures are achieving their purposes and whether they should remain, given the potential benefits of a simpler corporate tax code, possibly with reduced tax rates. Ensuring corporate income tax compliance is challenging because much corporate tax avoidance is legal and the true tax liability for large corporations is difficult to determine. A wide variety of strategies will undoubtedly be needed to address corporate tax compliance. Opportunities to pursue include simplifying the tax code, obtaining better data to the extent feasible on noncompliance, continuing to oversee the effectiveness of IRS’s efforts, continuing to leverage technology, and sending sound compliance signals through such things as increased effectiveness in collecting taxes owed. The amount of corporate tax avoidance is unknown. A complex tax code, complicated business transactions, and often multinational corporate structures make determining corporate tax liabilities and the extent of corporate tax avoidance a challenge. Tax avoidance has become such a concern that some tax experts say corporate tax departments have become “profit centers” as corporations seek to take advantage of the tax laws in order to maximize shareholder value. Some corporate tax avoidance is clearly legal, some falls in gray areas of the tax code, and some is clearly noncompliance or illegal. Tax code simplification has the potential to reduce at least some of this avoidance. Often corporate tax avoidance is legal. For example, multinational corporations can locate active trade or business operations in jurisdictions that have lower effective tax rates than does the United States and, unless and until they repatriate the income, defer taxation in the United States on that income, thus reducing their effective tax rate. Similarly, making investments that qualify for accelerated depreciation can lower a corporation’s current effective tax rate, although in the future its rate would be higher. Corporate tax planners may find legal ways to exploit tax code complexity to play one provision of the code off another in ways that Congress never intended. In response, Congress has sometimes acted to address what it considered to be abusive tax shelters.