The right way to cut corporate taxes
By Robert Pozen
Published: Saturday, Oct. 6, 2012, 9:00 p.m.
Amid all the division on Capitol Hill, both parties generally agree that the corporate tax rate, which at 35 percent is among the highest in the world, needs to be cut. During Wednesday's presidential debate, both candidates advocated a significant reduction in the corporate tax rate.
Yet the federal budget's unsustainable fiscal path should preclude a large unfunded tax cut. Given these competing demands, policymakers have been searching for revenue-neutral reforms that reduce the corporate tax rate and broaden the corporate tax base.
Few politicians have offered sufficient details about how they would pay for a reduction in the corporate tax rate. Politically vulnerable tax breaks, such as special treatment of corporate jets and “green” energy, are small relative to total corporate tax receipts. And large tax breaks, such as those for research and development, are considered essential to economic growth.
So if Congress wants to finance a meaningful reduction of the corporate tax rate, it will need to find other base-broadening measures that meet two criteria: a solid policy rationale and the potential for significant new revenue. Fortunately, there is a base-broadening reform that fits both: limiting corporate interest deductions.
Currently, when a corporation pays interest, it may deduct that interest on its tax return. By contrast, a corporation may not deduct its dividend payments to shareholders. This bias distorts the financing decisions of corporate managers, who might choose, solely for tax reasons, to finance a certain project with debt instead of equity.
This bias also distorts investment decisions in favor of easily collateralized equipment suitable for debt finance at the expense of investments better suited for equity finance, such as capital raising by small business.
The tax code's bias for debt is even more worrying because excess leverage often imposes costs on external parties other than the debt issuer. For instance, a highly indebted company is more likely to go bankrupt, which can seriously harm its employees, customers and suppliers. Companies are unlikely to fully consider those external costs when deciding how much debt to take on.
Furthermore, reforming the treatment of interest expenses can raise a large amount of revenue and thus pay for a significant reduction of the corporate tax rate. In 2007, corporations with net income paid $294 billion in corporate taxes and claimed $1.37 trillion in gross interest deductions, according to the Internal Revenue Service.
From 2000 to 2009 — the most recent years with relevant data — a reduction of the corporate tax rate from 35 percent to 25 percent could have been financed solely by disallowing the deductibility of roughly 30 percent of corporations' gross interest expenses — that is, by allowing corporations to deduct only 70 percent of their gross interest expenses, rather than 100 percent, as they can now.
Although this would increase the effective tax rate on debt-financed investment, the overall cost of capital would remain roughly the same because equity returns would be taxed at 25 percent instead of 35 percent.
Future revenue estimates would have to take into account the lower interest rates and lower corporate leverage expected over the next decade. Also, debt issued by the financial sector is likely to need special treatment, because the profits of a financial institution depend largely on the spread between the interest rates at which they borrow and the rates at which they lend.
Modifications to the treatment of corporate interest expense should be a key component of bipartisan corporate tax reform. Such a restriction could finance a significant reduction in the corporate tax rate and greatly reduce the tax code's implicit subsidy to debt-financed investment.
This would make the United States a more competitive place to do business, reduce distortions in corporate decision-making and help foster a more stable financial system.
Robert C. Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution.
Show commenting policy
TribLive commenting policy
You are solely responsible for your comments and by using TribLive.com you agree to our Terms of Service.
We moderate comments. Our goal is to provide substantive commentary for a general readership. By screening submissions, we provide a space where readers can share intelligent and informed commentary that enhances the quality of our news and information.
While most comments will be posted if they are on-topic and not abusive, moderating decisions are subjective. We will make them as carefully and consistently as we can. Because of the volume of reader comments, we cannot review individual moderation decisions with readers.
We value thoughtful comments representing a range of views that make their point quickly and politely. We make an effort to protect discussions from repeated comments either by the same reader or different readers.
We follow the same standards for taste as the daily newspaper. A few things we won't tolerate: personal attacks, obscenity, vulgarity, profanity (including expletives and letters followed by dashes), commercial promotion, impersonations, incoherence, proselytizing and SHOUTING. Don't include URLs to Web sites.
We do not edit comments. They are either approved or deleted. We reserve the right to edit a comment that is quoted or excerpted in an article. In this case, we may fix spelling and punctuation.
We welcome strong opinions and criticism of our work, but we don't want comments to become bogged down with discussions of our policies and we will moderate accordingly.
We appreciate it when readers and people quoted in articles or blog posts point out errors of fact or emphasis and will investigate all assertions. But these suggestions should be sent via e-mail. To avoid distracting other readers, we won't publish comments that suggest a correction. Instead, corrections will be made in a blog post or in an article.
- Penguins insider: Malkin found confidence in Game 3
- Switch in pairings helps Penguins defensemen find groove in Game 3
- Former PPG executive indicted in fatal NH crash
- Kovacevic: No science to solving power play
- Wilkinsburg woman, 24, dies in crash
- SCI-Pittsburgh inmate taken to AGH after ‘severe beating’
- Alaska’s Iditarod Trail challenges Unity couple
- Heyl: Even crooks know UPMC’s full of it
- Eddie Merlot’s steakhouse attracts with menu, wines, decor
- Pennsylvania Gov. Corbett wants candidate Wolf to release tax records
- Maatta not a top rookie finalist