Tax reform Overhauling the old jalopy

Tax competition is starting to hurt America. But can Uncle Sam muster the political will to fight back against his tax-cutting foreign rivals? IT IS more than two decades since America led the world in tax reform, and what Ronald Reagan called “that old jalopy of our tax system” is looking in need of a lot more than a new spray of paint. Last week Hank Paulson, the treasury secretary, held a summit in Washington, DC, to address the part of the system that is most visibly lagging behind best practice in the rest of the world—the taxation of firms.The gathering of tax experts, business leaders and other heavy-hitters, including Alan Greenspan, former chairman of the Federal Reserve, agreed with Mr Paulson that Uncle Sam was “undermining the competitiveness of American workers” with high corporate tax rates. However, nobody at the summit expected Congress to do much about it, especially given its current preoccupation with easing taxes on the middle class and increasing them on the rich, particularly those who have made their fortunes in private equity.
America's competitiveness problem has been a constant theme of Mr Paulson's time at the Treasury, which he joined a year ago after running Goldman Sachs. As well as taxes, he is worried that America's capital markets are struggling to hold their own against resurgent financial centres such as London and Hong Kong.

Corporate-tax reform was a key part of the Reagan blitz, too. Following the Tax Reform Act of 1986, the base of the corporate income tax was broadened but the top rate was slashed by 12 percentage points, from 46% to 34%, the biggest cut since the tax was introduced in 1909. Thus began a trend of reducing the tax rate on companies that has spread across the globe. However, whilst countries from Ireland (with a rate of 13%) to China—which recently passed a law cutting the rate to 25%—have continued to lower corporate taxes, American rates have edged back up, to 35%, in 1993. Adding state taxes to federal ones gives an overall rate of 39%. That is the second highest in the OECD, in which the average rate is 31% (see chart).

In a world of multinational firms and mobile capital, tax rates can make a significant difference to where profits are recorded and business is done, though economists disagree on how much. Governments outside America have long worried that competition between countries to attract international businesses creates pressure to lower corporate tax rates. America is now belatedly starting to agree with them.
If headline tax rates were all that mattered, America would be an unattractive place for companies to locate. In fact, tax is not the only thing firms take into account when deciding where to locate. And companies care less about the official tax rate than what they actually pay after taking into account the various allowances and breaks that countries offer. Ranked by this “effective marginal tax rate”, America lags behind by less, though its rate of 24% is well above the OECD average of 20%.

The big gap between the headline and effective marginal tax rates reflects the large number of allowances given to firms for doing particular activities, such as research and development. Many of these allowances are fiendishly complicated; they distort business decisions and raise the cost of tax compliance.

The Treasury is also worried about another big distortion caused by the corporate tax system—the incentive it gives to use debt rather than equity finance. Equity capital is subject to double taxation. It is taxed first when the company declares a profit, and again when it is paid to shareholders as dividends or capital gains. Money paid out by the firm as interest is taxed only once, as income to the investors who receive the interest.

Companies can avoid this double taxation either by setting themselves up as partnerships, or by becoming an “S corporation”, a unique creation of America's tax code which gives a business limited liability without incorporating. An S corporation's profits are taxed just once, as the income of its shareholders. The number of these entities has soared in recent years, and they now account for about half of the income earned by American businesses.

This is business voting with its feet on a grand scale—but many of America's largest and most internationally mobile firms are unable to become S corporations, which have tight rules, not least being limited to a handful of shareholders. Congress is considering a law that will require private-equity firms that go public to start paying corporate tax—thanks to the furore over Blackstone's initial public offering in June, which the private-equity giant structured to avoid corporate tax. This law could perhaps be justified on grounds of equal treatment: the private-equity firms would be on a more even footing with other listed companies. But it would extend the scope of double taxation.

Congress is also considering taxing the carried interest of partners in private-equity firms as income rather than capital gains, which are taxed at a lower rate. The idea has merits—carried interest does indeed look more like income than equity. But Glenn Hubbard, dean of Columbia Business School and a former chairman of George Bush's Council of Economic Advisers, notes that private-equity partners, given the sort of accountants that they can afford, would no doubt find a way to avoid the higher tax.

Mr Hubbard thinks that America should now cut the corporate tax rate. Such a cut could be partly paid for by removing some of today's allowances. The Treasury calculates that getting rid of all existing allowances would broaden the tax base enough to allow the rate to be cut to 27%—though Mr Hubbard is sceptical that such a wholesale reform would be politically feasible, as some allowances, such as the research tax credit, are too popular with business. Instead, he wants America to raise money elsewhere, perhaps through consumption taxes as in Europe.

How much should the corporate tax rate be cut? Alan Auerbach of the University of California, Berkeley, says it would make sense for America to move more in line with other countries. Unfortunately, in the current political climate, even that idea seems outlandish. But Mr Hubbard, for one, thinks things would be different if voters realised who actually pays the tax. The evidence, he says, suggests that the burden of the corporate tax falls disproportionately on workers. For instance, a study by Kevin Hassett and Aparna Mathur of the American Enterprise Institute, looking at 72 countries over 22 years, suggests that a 1% increase in corporate tax rates results in a 0.8% reduction in manufacturing wage rates. Other studies paint a similar picture. If workers understood that corporate taxes are a toll on the common man, wouldn't they clamour for a rate cut?

Unlikelier things have happened, even in tax reform. As President Reagan observed when introducing his pioneering measures, “there are three stages of reaction to a new idea like our tax proposal. First stage is: ‘It's crazy. It'll never work. Don't waste my time.' The second: ‘It's possible, but it's not worth doing.' And finally: ‘I've always said it was a good idea. I'm glad I thought of it'.”