Mar 02, 2017 03:52 PM

Opinion: Would Corporate Tax Reform in the United States Benefit Businesses?

One of the most significant economic policies that U.S. President Donald Trump might undertake is a radical reform of taxes on U.S. corporations. As a candidate, he promised to reduce the 35% rate on corporate profits to 15% — without explaining the implications of the loss of revenue, or how it would be compensated. There is wide consensus, especially among Republicans, that income taxes are too high, too complex, and too burdensome to file with the U.S. Internal Revenue Service.

Under the U.S. Constitution, all tax legislation must originate in the lower house of Congress, the House of Representatives — taxation being perhaps the most sensitive point of contact between a government and its citizens. It then must be passed by the Senate and signed by the president, which he can decline to do if he does not approve, which gives him some leverage over the deliberations.

Kevin Brady, chairman of the House of Representatives committee responsible for tax policy, has proposed a major overhaul of corporate taxation, the first since 1986, and it has been endorsed by Paul Ryan, Republican leader of the House of Representatives and his party’s unsuccessful candidate for U.S. vice president in 2012. The proposal has not been endorsed by Trump and is highly controversial within the business community, so it may not come to pass. It has five major features:

1. It would reduce the top tax on corporate profits from 35% to 20%.

2. It would allow capital expenditures to be deducted from income in the year in which they took place, rather than being amortized over the life of the investment.

3. It would tax income earned only in the United States, not that earned abroad; and it would tax past overseas earnings stashed overseas at only 8.75% rather than 35%.

4. It would deny deductibility of interest expense for firms (presumably except for interest rates paid by banks to their depositors).

5. It would deny deductibility of imported products, and, in parallel, would allow exports to be deducted — that is, only profits on sales in the U.S. would in effect be taxed.

The first two provisions would be welcome by all U.S. businesses. The third would be welcomed by those businesses, such as Apple Inc. and Google Inc., which have held abroad earnings on overseas sales to avoid paying the 35% tax (less any foreign taxes paid) when they remit the earnings to their U.S. corporate headquarters, an amount estimated to be around $2.3 trillion.

The last two provisions are hugely controversial within the business community and will generate great political resistance. The fourth provision is designed to eliminate the tax advantage of borrowing as opposed to raising equity, but it would be especially hard on real estate firms that borrow against property and on private equity firms that buy shares with borrowed funds, including those aimed at hostile takeovers.

The fifth provision is also hugely controversial, pitting many retail firms, such as Wal-Mart Stores Inc., Target Corp. and The Gap Inc., against mainly exporting firms, such as Caterpillar Inc., The Boeing Co., The Dow Chemical Co., Pfizer Inc. and General Electric Co. It would mark a major change in international trading arrangements. At least on the surface it seems to violate the rules of the World Trade Organization, which in general calls for the same treatment of foreign and domestic goods, apart from explicit tariffs on imports or exports and apart from government procurement (which is subject to separate rules).

One of the attractions of this provision to its congressional sponsors — perhaps its main attraction — is that it would raise much revenue (an estimated $1.1 trillion over the 10 years the Congress uses to assess budgetary provisions) to help pay for the loss of revenue from the first two provisions. This arises because of the large U.S. trade deficit, so taxes gained on imports would more than offset those lost on exports.

It is unclear to what extent congressional sponsors — and the Trump administration (which has not yet appointed its senior tax policy officials) — will take into account economic effects from the changes in the tax law, beyond arguing that it will stimulate growth, which is always invoked by politicians in support of their proposals. Three come to mind: foreign retaliation, further appreciation of the U.S. dollar against foreign currencies, and foreign emulation of a radical new practice. Taken together, these would paradoxically worsen the U.S. trade deficit, contrary to Trump’s expressed desires.

If this plan were to be adopted, U.S. trading partners would presumably complain to the WTO about U.S. violation of its rules, and they would probably win, but that would take many months. Before then, they might impose countervailing duties on U.S. exports on the grounds they were being given a tax subsidy through the deduction of exports from taxable earnings. (Under the WTO rules, the importing country would have to show injury to domestic production.) Or they might emulate the U.S. revolutionary tax practice by also denying the deductibility of inputs and allowing deductibility for their own exports, although it would take time in most countries to change and implement their tax laws.

Finally, the U.S. dollar, which under U.S. policy floats without official intervention, would very likely appreciate against other currencies under this new tax regime, at least in the absence of retaliation or emulation. Indeed, that is seen as an advantage by some adherents, since otherwise the price of imported goods, including many consumer goods, would rise sharply, by up to 20% (the loss of deductibility under the new tax rate). A 20% appreciation of the dollar would offset this prospective rise in consumer prices, and would also make newly deductible exports more expensive for foreign buyers.

But there is no reason to expect that the dollar would appreciate by even roughly 20% following such a change in taxes. If it were likely to pass, the dollar could appreciate well before the new taxes went into effect, which is likely not before 2018 at the earliest; and it could appreciate much more than 20%, as foreign firms invested more in the U.S. to assure their retention of U.S. sales, thus actually worsening the U.S. trade deficit for several years.

Richard N. Cooper is the Maurits C. Boas professor of international economics at Harvard University.

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