By Byron Pelton
Tax policy is the difficult, yet crucial balancing act that every government faces between raising revenue for public institutions and fostering productive economic activity. While public institutions are essential for the basic functioning of any economy, funding them through taxes distorts some people’s incentives on the margin, meaning that those who were on the fence about a decision will choose not to pursue such a decision due to the penalty that taxation imposes. The key question is as follows: does the rate of taxation and the method(s) of collection together raise sufficient revenue for the government’s function while minimizing distortions in people’s decision making? Currently, the United States’ corporate income tax (CIT), does not. Efforts to correct the negative consequences have fallen short, and the damage to economic growth and workers’ wages continues to compound.
As a primer, modern economic theory contends that output comes from some combination of the four factors of production: land, labor, capital, and ideas. The returns that factor owners receive in exchange for the use of their input in the production process are called economic rents. Some rents, such as those on capital and land, require little or no effort on the part of their owners to enjoy. On the other hand, those with neither capital nor land are prohibited from receiving those kinds of passive returns, and are instead forced to work for a wage (often for some capital and/or landowner). Thus, due to fairness concerns, wages (labor rents) are taxed differently than corporate profits—which are effectively rents on the other factors. The individual income tax targets the former, while the corporate income tax targets the latter.
Rents on non-labor factors become corporate profits, defined as revenues minus costs (one of the costs being wages). However, not all expenses can be fully deducted from taxable income in the same year they are incurred. Capital investment - the purchase of assets like machinery or buildings to be used in the production process - is not fully deductible. Instead, its value is deducted over several years in a process known as expensing. This is problematic, as there is evidence that this lowers workers’ productivity, leading to decreased wages. Further, this process creates a bias toward borrowing to fund capital investment. Both problems can be avoided, however, if the right tax provisions are adopted.
Value-added taxes (VATs) have become popular in the European Union. One of their virtues is that they treat costs equally, rather than forcing some to be written off over many years. This equal treatment mends the issues facing growth and wages, and eliminates the bias toward borrowing. But must the United States copy such a tax in order to reap these benefits? Not according to former House Speaker Paul Ryan, who proposed a solution in 2016. The plan would have converted the CIT into what is called a destination-based cash flow tax (DBCFT). This new tax would solve the expensing problem present in the CIT, while also streamlining the mode of enforcement.
The first change a DCBFT would make is to authorize the full expensing of capital investment (like a VAT, unlike the CIT), while allowing for the deduction of worker wages (unlike the VAT, like the CIT). This would mean that rents on labor are excluded, but rents on capital are not—since rents are returns above the cost of providing the input, and the value of the input is fully deductible. The tax applies solely to cash flows toward non-labor factor owners without the reckless damage to wages and growth that the CIT generates. And hence, the cash flow aspect of its name.
The second characteristic of a DBCFT is that it includes what is called a border adjustment, meaning that the tax applies to the consumption of people within the United States’ borders, rather than from companies who, by convoluted accounting and legal definitions, originate from the U.S. This would prevent profit-shifting by companies that claim higher profits in low-tax countries and excessive costs in high-tax countries.
While Ryan’s version involved tax cuts, it is not clear that such cuts were necessary or desirable, as these do not solve the underlying problems. Instead, leaving the rate as it is and removing the aforementioned inefficiencies that plague the tax code would alleviate the issues Republicans raise, while also allowing for redistribution of non-labor rents to the less fortunate. Making the wealthy pay their fair share and reducing the complexity of the tax code are both popular causes which a DBCFT would simultaneously achieve by more effectively targeting capital income, while simplifying the process of calculation.
A transparent, streamlined approach to corporate taxation is widely desirable and important for a country that values growth and opportunity for all of its people, regardless of economic status. As a worker-protected corporate tax, a DBCFT can garner support from policymakers on both sides of the aisle. The debate over whether the corporate income tax should increase or decrease is tired and unproductive. It is vital that the United States’ Congress shake the dust off of this proposal and renew an American dream that is an attractive and equitable offer to businesses and workers alike.
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