Replacing the Corporate Income Tax with a Cash-Flow Tax
Edwards, Chris, The Cato Journal
Americans have been inundated with financial scandals at large corporations during the past two years. In many cases, unethical behavior and poor oversight of corporate management are to blame. But the corporate income tax has also been a key source of corporate inefficiency and scandal. The tax code distorts financial and investment decisions, and spurs executives to hunt for tax shelters.
These tax problems are highlighted in the 2,700-page report on Enron Corporation by the congressional Joint Committee on Taxation (JCT 2003a). Enron is just one company, but it took a team of JCT investigators a year to figure out how all its tax shelters worked. The JCT's efforts were a mirror image of the efforts of Enron, the accounting firms, and investment banks that put Enron's tax shelters into place originally. The JCT (2003a:16) concluded that Enron "excelled at making complexity an ally." While an ally to Enron, tax complexity is an enemy to productive corporate management and efficient investment decisionmaking.
Enron-style tax sheltering has not been the only type of corporate tax scandal in the news. Attention has also focused on the growing number of U.S. companies reincorporating in low-tax jurisdictions, such as Bermuda. U.S. firms can save taxes on their foreign operations by creating a foreign parent company for their worldwide operations. At the same time, there are growing concerns about the uncompetitiveness of the U.S. corporate tax because of the high statutory rate of 35 percent and the complex rules on foreign investment (Edwards and de Rugy 2002).
The corporate income tax is also feeling pressure from financial innovation on Wall Street. A recently decided case in the U.S. Tax Court, which involved Bank One's use of derivatives, was an 8-year battle with a trial that produced a 3,500-page transcript and 10,000 exhibits (Simpson 2003: C1). The corporate tax system is having trouble keeping up with today's complex and globalized economy.
The corporate income tax has three fundamental flaws. The first flaw is that the U.S. statutory tax rate is the second highest among the 30 major industrial countries (KPMG 2003). That high rate reduces investment, encourages firms to move profits abroad, and provides incentives to push the legal margins with complex tax shelters.
The second flaw is that the corporate tax base of net income or profits is inherently complex because it relies on concepts, such as capital gains and capitalization of long-lived assets, that are difficult to consistently account for in a tax system. Costs of capitalized assets are deducted through depreciation, amortization, and other rules. The income tax rules for capitalized assets and capital gains are repeatedly exploited in tax shelters, and they distort capital investment, business reorganizations, and other decisions.
The third fundamental flaw is the gratuitous inconsistency that Congress has injected into the tax code. One example is the different treatment given to corporate debt and equity. Another example is the different tax rules imposed on corporations and the half dozen other types of businesses. Such inconsistencies have played a key role in the tax shelters exploited by Enron and other firms. Worse, they distort capital markets and channel investment into less productive uses.
This article discusses the most serious corporate tax distortions and examines fundamental reforms to fix them. One option examined is full repeal of the corporate tax. Alternately, the replacement of the corporate income tax with a cash-flow tax is discussed. A cash-flow tax would eliminate most of the serious distortions in the corporate tax system by eliminating capital gains taxation, replacing capitalization with expensing, and creating financial neutrality between debt and equity. By cutting individual dividend and capital gains tax rates and providing partial expensing treatment for business investment, the 2003 tax law was a good first step toward corporate tax reform (see JCT 2003b). …