Corporate Taxes: The Basics and Paths to Reform

What is a corporate tax?

It is a tax on the profits made by a business. Profits are equal to revenue minus expenditures. There are a large variety of deductions or exceptions that companies can claim to lower their tax burden. A company with no profits – regardless of revenue – would pay no corporate taxes.

What is the US corporate tax rate – the “official” one and the “real” one?

The federal government imposes a 35% tax on corporate profits generated in the United States. On average, states impose an additional 4% corporate tax rate; thus, the average, or “top marginal” corporate tax rate in the United States is approximately 39%.1

However – theoretical tax rates are not the same as what businesses end up paying at the end of the day. Estimate of the “real” corporate tax rate suggests that business ultimately pay about half of the official US tax rate. Precise estimates using a variety of models range from 12-20%.2

There are a variety of mechanisms by which corporations avoid paying the corporate tax, the most common of which is listing their profits as “offshore.” For example, let’s say that General Motors makes a $100 million profit in a year; however, in their tax filings, they claim $20 million of the profit was generated in the United States and $80 million was generated in the Cayman Islands. GM would be immediately taxed on the $20 million in profits made in the US. However, they can “defer” tax payments on the $80 million made abroad until they “bring back” this money to the United States – known as repatriation. As a result, many top US companies are holding billions of dollars in “offshore” profits in countries with low tax rates. They will avoid paying US corporate taxes on these profits until they bring the money back into the US. This essentially incentivizes US companies to shift their profits to countries with low corporate tax rates – otherwise known as offshore “tax havens.” Corporations typically pay a tax rate between 3-7% in these countries.

By a process known as “income shifting,” companies can take advantage of tax havens by disguising profits earned in the US as profits earned abroad. There are many strategies companies can use to manipulate profits, including transfer pricing manipulation; this essentially allows a company to buy goods or services from an international subsidiary of the parent company. For example, Coca-Cola US could pay Coca-Cola Cayman Islands a “fee” for intellectual property. This way, the net profits of Coke US would fall, and the profits of Coke Cayman Islands would rise.3 Granted, this is an oversimplification of the legal strategies used to shift profits between corporate entities, but it serves as an example of how companies are able to transfer profits offshore. Somewhere between 60-70% of world trade transactions now occur within large companies rather than between companies with different ownership.4

To give you a sense of the scope, approximately $2.4 trillion in US corporate profits now reside in offshore accounts; if this money was brought back to the US, it would amount to nearly $700 billion in tax revenue at the current federal rate of 35%.5 There is a common misconception that this money is “trapped” overseas, disincentivizing companies from continuing to hold money abroad; this is misleading. Corporations are free to use overseas money to invest in securities or other investment options as long as they do not use the money to reinvest in the US parent company.

If you would like more information on transfer pricing, check out this video. Here is a real life example of shifting profits in the banana industry.6

How has the corporate tax rate changed over time?

The US corporate tax rate has varied substantially over the course of the last century. In the early 1900s, there was virtually no corporate tax. This changed when it was increased to around 10% in the 1920s. Between 1942-1986, the tax rate was fairly consistent, with a top bracket between 40 and 52%. The current rate of 35% was set in 1993.7

How does this compare to other countries?

The US has a comparatively high corporate tax rate – one of the highest among other industrialized nations. The average rate for 35 other OECD nations is ~25%. This has not been the case throughout history; rather, other nations have lowered their corporate tax rates over the last two decades as the US rate has remained unchanged. 8

How much of federal tax revenue comes from the corporate tax?

A very small percentage – only 11% — of the federal tax revenue comes from corporate taxes. In our piece on tax revenue, we cover other sources of tax revenue. 9

It is important to note that – while tax rates are higher than they have been in the past – the total contribution of corporate taxes to overall federal tax revenue has decreased sharply over time – down from 32.1% in the 1950s to 10.8% in 2015.  Though corporate taxes once accounted for 33% of all federal tax revenue, it now constitutes only 10%.

What is “double taxation”?

A company is taxed on its profits. If these profits are distributed to shareholders, recipients must pay additional taxes on these dividends that are treated as personal income. As a result, business profits are often taxed at both a corporate level and again at an individual level. There is a good argument that the tax code should be reformed to prevent this type of double taxation.

Why do people want to change it?

Many studies support the viewpoint that taxes hurt economic growth. Corporate taxes have been shown to have a particularly detrimental effect on economic growth and wages.10 Given that the US corporate tax rate is much higher than competing countries, it discourages companies from locating in the US and investing in capital development here. There is also good research to suggest that corporate taxes ultimately get passed on to workers in the form of decreased wages.11

It hurts small businesses

The complexity of the current corporate tax code ultimately harms small and mid-sized businesses that cannot hire specialized law firms to lower their effective corporate tax rate. Manipulating the tax law to achieve the lowest possible rate is challenging and requires significant legal expertise. Large companies have the ability to hire law firms that specialize in corporate tax law, whereas smaller and mid-sized companies do not have the same access to these services, putting them at a disadvantage. Between 2008 and 2012 – among 288 of the top Fortune 500 companies – nearly 40% paid no federal corporate tax for at least 1 year over a five-year period, and a third of companies paid less than a 10% effective tax rate over a five-year period.12

Fixing the corporate tax system: eliminate it altogether?

A lot of systems have been proposed to fix corporate tax law. For examples, some ideas include: limiting the mechanisms by which companies can move profits to offshore tax havens; incentivizing companies to repatriate money by creating a one-time, low-tax repatriation rate to bring back some of the $2.4 trillion in offshore accounts; moving to a “territorial” tax system that only collects taxes on income earned within the borders of the country; and lowering the corporate tax rate. Many other proposals have been suggested by academics and politicians.

Failures in corporate tax policy stem from the fact that corporations are – by definition –  fictitious entities. Corporate taxes are inherently different from income taxes because corporations, unlike individuals, are freely mobile, artificial financial entities. It is easy for companies to use a variety of legal and economic mechanisms to shift money between countries and tax jurisdictions in a way that limits their overall tax burden. This is much harder – if not impossible with proper legislation – to do as an individual. For this reason, corporate tax reformers often lag behind, playing “catch up” to limit creative corporate tactics to avoid taxation.

Given the inherent difficulty in corporate taxation, here is an idea: abolish the corporate tax. Although most people probably believe that the corporate tax burden falls on wealthy CEOs of large companies such as Apple and Walmart, this is not the reality of how the tax functions in practice. Instead, the corporate tax has merely encouraged companies to hire law firms, find innovative ways to shift money to low-tax jurisdictions and pass the remaining tax burdens onto workers and shareholders. Potential benefits of a lower corporate tax rate are numerous in academic literature.13

Successful tax reform must (1) assess how policy changes incentives and decision-making, and (2) offset tax cuts with new sources of revenue. In lieu of a high corporate tax, policy-makers should consider eliminating the tax and recouping revenue by increasing the personal income tax for the highest-earning brackets. In order to encourage companies to repatriate offshore holdings, companies would only be eligible for the new 0% corporate tax rate after bringing back money at a one-time 25% tax rate. This would generate $600 billion in federal tax revenue – money that could be reinvested in infrastructure programs or other areas of need. As a point of comparison, the US Department of Transportation estimated that improvements to the nation’s bridges and highways will cost an estimated $123.7 billion to $145.9 billion per year.14

With the abolishment of the tax, federal revenue would decrease by 10%; increases in the income taxes of the wealthiest citizens could offset this revenue loss. This would also require changes in the existing capital gains tax policy. With the elimination of a corporate tax, companies could funnel more money into compensation for workers and executives; increases in executive compensation would be offset by higher tax rates for the wealthy.

In summary:

  • Eliminate the corporate tax rate – from 35% to 0%
  • Offset the 10% loss in federal tax revenue with marginal increases in income taxes for the wealthiest wage-earners
  • The new 0% corporate tax rate will only be available to companies that choose to repatriate their offshore funds at a rate of 25%
  • Tax revenue generated by offshore repatriation will be reinvested into public infrastructure spending
  • Raise rates on dividends and capital gains so that profits made from investing in corporate growth will offset tax revenue losses from a lower corporate tax rate

Why not a territorial system? Some have proposed moving to a territorial corporate tax system. This means that companies would only be taxed on income generated within the United States. Profits made abroad would not be taxed. For example, Apple, which is based in the US, would not be taxed on profits made from the sale of iPhones in India.

The problem with a territorial system is that it does not solve the incentive issues that plague our current system – it would essential codify the existing repatriation system that allows countries to capitalize on low tax rates abroad. Countries would still be encouraged to transfer profits overseas. Not only would this shift investment out of the US to other countries with lower tax rates, it would also unfairly benefit companies with a large multinational presence.15

Other good reads:

U.S. Corporate Tax Reform – The Council on Foreign Relations

A Proposal to Reform the Taxation of Corporate Income – The Tax Policy Center

  1.  Corporate Income Tax Rates around the World, 2016. (2016, August 18). Retrieved February 19, 2017, from https://taxfoundation.org/corporate-income-tax-rates-around-world-2016/
  2. Corporate tax chartbook: How corporations rig the rules to dodge the taxes they owe. (n.d.). Retrieved from http://www.epi.org/publication/corporate-tax-chartbook-how-corporations-rig-the-rules-to-dodge-the-taxes-they-owe/
  3. Transfer Pricing. Retrieved from www.taxjustice.net/topics/corporate-tax/transfer-pricing/
  4. Transfer Pricing. Retrieved from www.taxjustice.net/topics/corporate-tax/transfer-pricing/
  5. Corporate tax chartbook: How corporations rig the rules to dodge the taxes they owe. Retrieved from http://www.epi.org/publication/corporate-tax-chartbook-how-corporations-rig-the-rules-to-dodge-the-taxes-they-owe/
  6. Lawrence, F., & Griffiths, I. (2007, November 5). Revealed: how multinational companies avoid the taxman. The Guardian. Retrieved from https://www.theguardian.com/business/2007/nov/06/19
  7. Corporate Top Tax Rate and Bracket. (2017, February 14). Retrieved February 19, 2017, from http://www.taxpolicycenter.org/statistics/corporate-top-tax-rate-and-bracket
  8. Corporate Income Tax Rates around the World, 2016. (2016, August 18). Retrieved February 19, 2017, from https://taxfoundation.org/corporate-income-tax-rates-around-world-2016/
  9. “Policy Basics: Where Do Federal Tax Revenues Come From? | Center on Budget and Policy Priorities.” Accessed February 19, 2017. http://www.cbpp.org/research/policy-basics-where-do-federal-tax-revenues-come-from.
  10. McBride, William. “What Is the Evidence on Taxes and Growth?” Tax Foundation, December 18, 2012. https://taxfoundation.org/what-evidence-taxes-and-growth/.
  11. “Fixing the Corporate Income Tax.” Mercatus Center, February 22, 2012. https://www.mercatus.org/publication/fixing-corporate-income-tax.
  12. “The Sorry State of Corporate Taxes.” Citizens for Tax Justice. Accessed February 26, 2017. http://ctj.org/corporatetaxdodgers/sorrystateofcorptaxes.php
  13. “Abolishing the Corporate Income Tax Could Be Good for Everyone.” Accessed February 19, 2017. http://www.ncpa.org/pub/ba799.
  14. “2013 Conditions and Performance – Policy | Federal Highway Administration.” Accessed February 19, 2017. https://www.fhwa.dot.gov/policy/2013cpr/
  15. “The Fiscal and Economic Risks of Territorial Taxation.” Center on Budget and Policy Priorities, January 30, 2013. http://www.cbpp.org/research/the-fiscal-and-economic-risks-of-territorial-taxation.