BY DR. SETH H. GIERTZ
Among developed nations, the United States stands out with the highest corporate tax rate. President Donald Trump plans to change that by lowering the federal corporate tax rate to 15 percent. Profits from unincorporated businesses would also be taxed at 15 percent, in place of the taxpayer’s regular income tax bracket.
The last time the United States overhauled its tax system, President Ronald Reagan’s Treasury Department kicked off two years of debate by releasing a three-volume treatise. This time, Trump started the process by releasing a one-page schematic.
While details are sparse, the proposed changes to the corporate tax are encouraging. The U.S. corporate tax is woefully out of date, having failed to adapt to shifts in the economy away from manufacturing and toward services and technology.
The proposed changes for unincorporated businesses, not subject to the corporate tax, are more problematic. Setting the tax rate on unincorporated businesses much lower than the top federal income tax rate (proposed at 35 percent) creates huge opportunities to game the tax system by reclassifying labor income as profits.
While our tax system is a drag on the economy, it has fueled one sector: tax avoidance. As evidence, consider the spate of corporate inversions in recent years, as well as the arcane maneuvers used to avoid or delay paying corporate taxes.
One such innovation is the Double Irish with a Dutch sandwich. No, this is not Starbucks’ latest offering. Rather, this is a tax strategy that some of the world’s richest firms have used to pay little or no taxes on much of their corporate profits.
Apple Inc., uses such techniques to lower its corporate tax burden from over 43 percent, the statutory corporate tax rate for corporations in California, to under 3 percent. Apple is not alone. Google Corp., Microsoft and many other tech companies also enjoy the Double Irish. More traditional firms, relying less on intellectual property, are less able to shift profits.
Schemes like the Double Irish exploit idiosyncrasies in some countries’ tax systems in order to escape paying corporate taxes. These profits may be taxed in the future, if they are repatriated. U.S. firms hold well over $2 trillion in profits overseas. Many firms are leaving profits outside the U.S. seemingly in perpetuity, or until the U.S. makes repatriation less onerous.
Cutting corporate tax rates won’t eliminate tax avoidance schemes. Other reforms are needed to curb the practice. However, lower rates alone will go a long way toward reducing the practice.
Firms employ high-priced accountants and lawyers to devise and carry out their tax strategies — not to mention lobbying efforts to keep such maneuvers legal. A nearly 60 percent cut in the corporate tax rate will lead firms to shift from costly avoidance strategies and toward investment in socially productive activities.
Extending the 15 percent rate to unincorporated businesses is intended to spur economic growth and jobs. It is more likely to spur accounting chicanery, with firms reclassifying labor income as profits.
Consider a surgeon with $800,000 in taxable wages. For simplicity, assume this entire amount is taxed at 35 percent. The doctor would owe $280,000 in taxes. Instead, suppose she reported $400,000 of this income as wages and the other $400,000 as business income. She would now owe $140,000 in taxes on wages and $60,000 in taxes on business income. This would save $80,000 in taxes, lowering her tax rate on the shifted income by 30 percent. Any unincorporated business could exploit this practice. And, efforts by the IRS to curtail this behavior would be costly and invasive.
The United States has much to gain from lowering its corporate tax rate, but extending this rate to unincorporated businesses is more problematic. My hope is that the president’s bullet points serve as a clarion call for the desperate need for fundamental tax reform.