A tax rate in the range of 20% to 25% should make the United States an attractive destination for capital investments and help to align the fortunes of the overall economy with those of the stock market and corporations.
U.S. equities recently have been trading at all-time highs, and American corporations are earning record profits. Yet, overall economic growth has been lackluster. In the first quarter of 2017, the U.S. economy grew at a meager annual rate of 1.2%.
The culprit for this disparity between the fortunes of corporations and the overall economy appears to be, at least partly, the U.S. corporate tax system in general and the corporate tax rate in particular.
The system is unique. First, the statutory corporate tax rate is among the highest in the world. Of the 34 member countries of the Organization for Economic Co-operation and Development (OECD), a group comprising the most advanced, industrial nations in the world, the U.S. corporate tax rate is at the very top, at about 39%, factoring in both federal and state taxes. The average corporate tax rate for the OECD countries is significantly lower at about 25%.
Second, the U.S. has a worldwide tax system. That is, a corporation headquartered here must pay taxes on all its profits, regardless of where they were earned. The rules require U.S. corporations to pay any incremental taxes due when foreign profits are repatriated to the United States.
Taxes influence how much and where corporations invest, because taxes affect both the after-tax cost and return on investments. The high U.S. corporate tax rate incentivizes corporations to reduce their after-tax cost of investments and increase after-tax return by diverting investments to jurisdictions with lower corporate taxes. Further, the worldwide tax system provides incentives for corporations to invest profits abroad or hold them as cash outside the United States.
My research, conducted in collaboration with Suresh Nallareddy at Duke University and Ethan Rouen at Harvard University, finds that as the difference between the U.S. corporate tax rate and that in the OECD countries grew, growth of the overall economy lagged behind the growth in corporate profits. The underlying driver: fewer profits of U.S. corporations are translating into subsequent capital investments in the United States.
Using data from 1975 to 2013, we find that when the difference between the U.S. corporate tax rate and the average OECD rate is below its time-series median, a 1% increase in corporate profits is associated with a 0.24% increase in one-quarter-ahead domestic investments. In contrast, when the difference between the U.S. corporate tax rate and the OECD average is above its median, which has been the case for at least the past two decades, a 1% increase in corporate profits translates into only a 0.03% increase in next-quarter domestic investments.
With potentially historic tax reform looming on the horizon, the question of what corporate tax rate is best for the U.S. economy. While the exact rate can be debated, it is clear that a reduced rate of 20% to 25% should make the U.S. competitive with other countries to attract and retain investment dollars.
Urooj Khan is a professor of accounting at Columbia Business School.