Overhauling the Old Jalopy

Tax competition is starting to hurt America. But can Uncle Sam muster the political will to fight back against his tax-cutting foreign rivals?

It is more than two decades since America led the world in tax reform, and what Ronald Reagan called “that old jalopy of our tax system” is looking in need of a lot more than a new spray of paint. Last week Hank Paulson, the treasury secretary, held a summit in Washington, DC, to address the part of the system that is most visibly lagging behind best practice in the rest of the world—the taxation of firms.

The gathering of tax experts, business leaders and other heavy-hitters, including Alan Greenspan, former chairman of the Federal Reserve, agreed with Mr Paulson that Uncle Sam was “undermining the competitiveness of American workers” with high corporate tax rates. However, nobody at the summit expected Congress to do much about it, especially given its current preoccupation with easing taxes on the middle class and increasing them on the rich, particularly those who have made their fortunes in private equity.

America’s competitiveness problem has been a constant theme of Mr Paulson’s time at the Treasury, which he joined a year ago after running Goldman Sachs. As well as taxes, he is worried that America’s capital markets are struggling to hold their own against resurgent financial centres such as London and Hong Kong.

Corporate-tax reform was a key part of the Reagan blitz, too. Following the Tax Reform Act of 1986, the base of the corporate income tax was broadened but the top rate was slashed by 12 percentage points, from 46% to 34%, the biggest cut since the tax was introduced in 1909. Thus began a trend of reducing the tax rate on companies that has spread across the globe. However, whilst countries from Ireland (with a rate of 13%) to China—which recently passed a law cutting the rate to 25%—have continued to lower corporate taxes, American rates have edged back up, to 35%, in 1993. Adding state taxes to federal ones gives an overall rate of 39%. That is the second highest in the OECD, in which the average rate is 31% (see chart).

In a world of multinational firms and mobile capital, tax rates can make a significant difference to where profits are recorded and business is done, though economists disagree on how much. Governments outside America have long worried that competition between countries to attract international businesses creates pressure to lower corporate tax rates. America is now belatedly starting to agree with them.

If headline tax rates were all that mattered, America would be an unattractive place for companies to locate. In fact, tax is not the only thing firms take into account when deciding where to locate. And companies care less about the official tax rate than what they actually pay after taking into account the various allowances and breaks that countries offer. Ranked by this “effective marginal tax rate”, America lags behind by less, though its rate of 24% is well above the OECD average of 20%.

The big gap between the headline and effective marginal tax rates reflects the large number of allowances given to firms for doing particular activities, such as research and development. Many of these allowances are fiendishly complicated; they distort business decisions and raise the cost of tax compliance.

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