There’s little dispute that the United States has a high corporate tax rate. At 35 percent, it is, nominally, higher than rates in other advanced economies – a factor that companies consider when they select where to invest. Include state taxes, and the rate is, on average, 39.1 percent, according to the Congressional Budget Office. But the reality is more complicated, and easily misrepresented.
Corporations, like individuals, can make deductions. These loopholes allow them to lower their “effective tax rate” substantially. After deductions, the average American corporation pays 18.6 percent in federal tax, according to the Congressional Budget Office. By comparison, Germany’s effective corporate tax rate is 15.5 percent; the United Kingdom’s 18.7.
Reducing the corporate rate to 20 percent while dropping some deductions is one of Republican leaders’ top policy priorities: It is the bedrock underpinning a 429-page tax plan House Republicans announced on November 2, 2017, the Tax Cuts and Jobs Act.
Many Democrats agree that tax reform is imperative to compete in the global economy. But reformers who believe tax cuts will stimulate the economy by encouraging consumers to spend may be disappointed. “Claims that behavioral responses could cause revenues to rise if rates were cut do not hold up on either a theoretical or an empirical basis,” argues a September 2017 report from the Congressional Research Service.
To help journalists navigate the debate, this briefing will explain how the corporate tax rate works, proposals for reform, and frame some economics questions that will be useful to your reporting. It will also look at controversial pass-through taxation that critics of the Republican plan fear will be abused by the rich.
To recoup revenues lost when the corporate tax rate is lowered, Congressional Republicans have proposed to drop several deductions. Known as “loopholes” or “tax expenditures,” deductions are expenses that a company can deduct from its earnings, reducing its tax liability. One of the largest is the deduction of debt interest, which allows firms to deduct the interest they pay on loans before paying taxes.
For more on deductions, see
“Closing tax loopholes: Explainer and reporting resources.”
An example: After expenses – including payroll, costs of goods sold, utilities, etc. – a company earned a profit of $100 million last year. But its interest payments totaled $40 million. Under the current tax code, the firm deducts the interest from its taxable income and pays tax only on $60 million – its profits after interest payments. This encourages firms to borrow. The draft House Republican plan targets such large companies by capping the interest deduction at 30 percent of the firm’s taxable income. This cap would not affect companies with less than $25 million in gross revenues.
In total, corporate deductions amount to over $180 billion a year, the Government Accountability Office has estimated. In other words, they cost the federal government $180 billion in lost revenue.
The Internal Revenue Service (IRS) describes corporate expenses that can be deducted, including the controversial interest deduction, here. Other deductions added to the tax code over the years are designed to help, among others, dairy farmers, oil producers and space-technology researchers. Each has its own constituency, making reform tricky. Banks like the deduction of debt interest, for example, because it encourages firms to borrow money from them.
The Peterson Institute for International Economics, a non-profit, non-partisan Washington think tank, reckons dropping the rate below 23 percent is unfeasible; though that’s in line with other advanced economies, it is still higher than the rates in some advanced economies like Ireland and The Netherlands, meaning the incentive remains for American companies to register themselves in foreign companies for tax purposes – a strategy known as inversion.
Foreign earnings and corporate inversions
U.S. firms are holding as much as $2.6 trillion offshore, according to statistics released by the House Ways and Means Committee in 2016. Why? It’s cheaper. They don’t have to pay taxes on the profits they earn abroad, which they would if they returned the money to the U.S.
As business has become globalized, some U.S.-based companies have moved overseas, or set up foreign partners, to reduce the tax burden on their international income. Corporate inversion works when the foreign jurisdiction has a lower corporate tax rate. This is not happening only in offshore tax havens like Cyprus. Ireland’s 12.5 percent corporate tax rate has attracted the likes of Google, Facebook and a number of U.S. drug companies, which have registered local entities.
The Obama administration struggled to stop corporate inversions, with little success. “If Washington wants to stop companies from taking advantage of tax-friendly environments overseas, or relocating altogether, it can start by making the United States a place where companies want to conduct business,” wrote Gary Clyde Hufbauer, a senior fellow at the Peterson Institute for International Economics, after Donald Trump won the presidential election in 2016.
One solution is a “territorial system,” where U.S.-based corporations would only owe U.S. tax on profits earned in the U.S. This would lower the amount Uncle Sam collects, but also encourage profits to be shipped home and reinvested, potentially creating jobs and strengthening the U.S. economy, says a 2016 report by the Congressional Research Service.
Supporters of the November 2017 Republican tax plan hope the lower corporate rate would discourage inversions. The plan also exempts some profits earned abroad.
What’s pass-through taxation?
Most businesses in the U.S. are not corporations required to pay corporate tax. The majority, according to Treasury Department data, are known as “pass-through” entities, which pass their profits to their individual owners to be taxed as personal income. There are many different types of pass-throughs – such as sole proprietorships, partnerships and S-corporations – depending on the size of the business and its ownership structure.
Currently, the pass-through tax rate is the same as the income tax rate. If you own a shoe store that earns $100,000 per year in profits, you pay taxes on the $100,000 as if it were your own income (if you’re single, that’s a rate of 28 percent according to the 2017 IRS tax schedule). If business is good and your shoe store earns you over $418,401, you are liable for a marginal rate of up to 39.6 percent.
A 2015 report by the Treasury Department found the richest Americans benefit disproportionately from pass-through entities: “69 percent of pass-through income earned by individuals accrues to the top 1 percent.” Matthew Weinzierl of Harvard Business School has linked the pass-through rate to growing income inequality in America: “If you cut the tax rate on pass-throughs from 39.6 to 25 [percent], and you cut top rates […] the vast majority of this tax cut goes to people in the top 1 percent.”
In their November 2017 draft tax bill, House Republicans proposed changing the pass-through rate to 25 percent. For the richest Americans, those currently paying 39.6 percent on their income, this could amount to a substantial break. Indeed, critics assail the Republican plan as creating a new loophole that will further enrich the richest.
The Republican plan addresses this concern by excluding some types of businesses. But these provisions have sown confusion and appear unpopular among business lobbyists. Rather than encourage the pass-through loophole, in fact, the Congressional Research Service recommends taxing more pass-through entities at corporate rates.
Another tax that benefits the wealthy is the lower rates applied to capital gains – the income derived from selling stocks or receiving dividends. These are often taxed at no more than 20 percent, no matter how much you earn. Since the poorest Americans tend not to hold stocks and dividends, the capital gains tax rate is widely seen as a boon to the rich. Similar is the carried interest provision, wherein the manager of a private investment fund pays a beneficial rate on income from the fund.
See our other tax explainers:
The Organization for Economic Cooperation and Development, a multilateral think tank, has a rich database of comparative tax data. The World Bank, a multilateral lender, also compares taxation in different countries. A March 2017 paper from the Congressional Budget Office discusses corporate tax rates internationally. And the National Bureau of Economic Research’s December 2011 paper on the effect of corporate taxes on investment around the world continues to be widely cited.
The House Ways and Means Committee drafts tax legislation. The November 2017 plan with section summaries written by the plan’s advocates is available here.
The Brookings Institution, a non-partisan think tank in Washington, has published two explainers on pass-through taxation: one here and one, at Brookings’ Tax Policy Center, here. The Tax Policy Center also has data on corporate tax rates in the U.S.