Rehabilitating the Business Income Tax

By Kleinbard, Edward D. | Policy Brief Series (Hamilton Project), June 2007 | Go to article overview

Rehabilitating the Business Income Tax


Kleinbard, Edward D., Policy Brief Series (Hamilton Project)


THE AMERICAN SYSTEM for taxing business income is broken. Business tax laws and regulations are tremendously complicated, lead to inefficient choices by business leaders and investors, and raise much less revenue than might be expected given statutory tax rates. This complexity forces businesses to spend tens of billions of dollars on tax compliance and creates myriad opportunities for tax avoidance. Furthermore, inefficient choices result from tax rates that differ arbitrarily depending on the type of income-earning asset, how the asset is financed, where it is located, and how the business is organized. Consequently, U.S. corporate tax revenue is the fourth lowest as a share of CtDP among the Organization for Economic Cooperation and Development (OECD) member countries, although the U.S. statutory corporate tax rate is the second highest in the OECD.

In a new discussion paper released by The Hamilton Project, Edward Kleinbard of Cleary Gottlieb Steen & Hamilton LLP proposes a comprehensive reform of the business income tax. Kleinbard s proposed Business Enterprise Income Tax, or BEIT, uses a consistent, logical framework to make the tax system simpler, fairer, and more efficient. Under the BEIT, the tax code for the first time would impose a constant burden on returns from investing capital in a business operation. In addition, many of the arbitrary distinctions between various forms of business organization or investment would cease to have tax implications. The result would be a system integrated at the corporate and the individual levels that taxes all business income once and only once.

THE CHALLENGE

A successful system for taxing business income would measure income comprehensively and tax that income consistently, regardless oi whether that income is reinvested in the business or distributed to investors and regardless of the form in which that business is organized or in which an investment is made. The current system falls short on all of these counts. Because the system lacks a coherent logical structure grounded in economic principles, it is vulnerable to manipulation and creates significant economic distortions. Scattered attempts have been made over time to remedy the system's shortcomings, resulting in a patchwork of rules that is increasingly complex, unpredictable, and inefficient. At the same time, globalization and the increased sophistication of the financial system have accentuated the system's intrinsic shortcomings.

The failings of the current business tax code include the following:

Distortion of business decisionmaking. By imposing different tax rates for similar economic outcomes, the system distorts business decisionmaking, as tax strategy takes priority over assessing market risks and returns. Kxamples include:

* Financing methods. Under current law, business interest payments on debt are tax deductible while dividends on equity are not. With interest and dividend receipts taxable for some investors and not others (such as tax-exempt institutions), debt-financed investments may escape tax entirely and equity-financed investments may be double-taxed. The result is a dramatic disparityaccording to the Congressional Budget Office, corporate investments financed with equity are effectively taxed at 36 percent while those financed with debt face a negative effective rate. To the extent this leads corporations to over leverage themselves, it can increase financial fragility throughout the economy and worsen corporate governance.

* Organizational forms. Today's tax code imposes different rules on businesses with different organizational forms, largely on the basis of nineteen th-cen tu ry legal and social norms. In particular, corporations are taxed at a higher rate than partnerships, which are viewed as passthrough vehicles rather than as independent taxable entities.

* Asset markets. Owing primarily to problems in measuring depreciation, the current system imposes very different tax rates on income earned by different types of physical assets. …

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