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August 31, 2011
Tax Reform: Reduce the Corporate Income Tax Rate and More

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By Eric M. Zolt

Eric M. Zolt is the Michael H. Schill Distinguished Professor of Law at UCLA School of Law. This article is based on remarks given at the National Tax Association Conference "Tax Reform in an Age of Uncertainty and Deficits" in May. He is also on the Tax Analysts board of directors.

A potential reduction in corporate income tax rates could be a catalyst for fundamental changes in the tax regime for business income and the relative contribution of tax revenue from different types of taxes.

Eric Zolt

The U.S. corporate income tax rate is too high. In an increasingly global economy, we are the odd man out. Among all the OECD countries, we have the second highest nominal marginal tax rate.1 With non-OECD countries, the gap is often even larger. Because we tax U.S. corporations on their worldwide income, we make it hard for U.S. multinational enterprises to compete against foreign corporations in foreign markets. We also make it unattractive for foreign corporations to invest in the United States.

While most scholars and practitioners agree that the nominal corporate tax rate is too high, the consensus breaks down on a variety of important issues.2 These include whether actual effective marginal tax rates paid by U.S. corporations are substantially higher than those imposed by other countries, who bears the economic incidence of the corporate tax, how to pay for the tax cuts, and whether to extend the rate cuts to businesses operating in noncorporate form. The lack of consensus makes it challenging to generate support for a rate reduction.

The purpose of this article is to highlight the option of using the possible reduction in corporate tax rates as a catalyst for broader tax reform. Focusing on high corporate tax rates may provide an opportunity to reexamine two important parts of our tax system: the tax regime for business income, and the relative contribution of tax revenue from different types of taxes (such as personal and corporate income taxes, payroll taxes, and different types of consumption taxes).

A. Background for Rate Reduction

It seems simple. All Congress has to do is lower the corporate income tax rate by 5 to 15 percentage points. We will then be competitive with other developed countries. But any corporate rate reduction will have ripple effects throughout the tax system, some intended and some not. Prof. Dan Halperin provides a useful overview of how changing the corporate tax rate will change incentives as to choice of entity and also the timing and form of distributions, particularly for high-income taxpayers.3

To those who work, teach, or legislate in the corporate tax field, those interrelationships are not surprising. Changing one piece of the tax puzzle (in this case, reducing the corporate income tax rate) will change incentives and affect behavior. We have seen this before, with the changes in the relative individual income taxes, corporate tax rates, and capital gains rates in the Tax Reform Act of 1986,4 and in 2003, with the transition to a flat schedular tax on dividend distributions (rather than taxing dividends at ordinary income tax rates).5

But more generally, changing the corporate tax rate could also get us thinking about several fundamental policy choices we have made in designing our tax system. This is exactly what happened during the George H.W. Bush administration, when Treasury considered alternatives to reduce the double taxation of distributed corporate income. The study of corporate integration began as a review of different ways to reduce the potential double taxation of distributed corporate income. However, it quickly required an understanding of how integration affects several related issues, such as the treatment of distributed income from tax preferences, of tax-exempt and tax-favored investors, and of foreign-source income.6

Competing pressures influence tax reform choices, particularly in an increasingly global economy. Prof. Steffen Ganghof provides a useful framework that demonstrates the competing considerations a country may face in designing an income tax system.7 He starts by examining three domestic policy goals:

  • tax progressivity (this goal addresses concerns of vertical equity by requiring high-income recipients to pay a higher proportion of their income in tax);
  • comprehensiveness (this goal provides for equal treatment of income from capital and income from labor); and
  • symmetry (this goal provides for equal treatment of income from different types of capital).

The goals of comprehensiveness and symmetry address concerns of horizontal equity, and together with the first goal, result in taxing individuals in accordance with "ability to pay" principles. Additionally, the goal of symmetry addresses concerns of allocative efficiency and tax-induced distortions in investment and savings decisions.

In a closed economy, a global, progressive income tax can theoretically satisfy these three objectives. At least in its ideal form, a global, progressive income tax achieves all three goals by taxing income from all sources equally, according to a taxpayer's ability to pay. Put aside that no country has anything close to a comprehensive income tax.8

With the competitive pressures in an open economy, however, something has to give. When international competitiveness is added to the three domestic tax policy goals, governments may no longer be able to satisfy all goals, particularly if the cross-border mobility of capital varies both between types of capital and types of countries. In Ganghof's terminology, governments face an income tax quadrilemma: The only choice open to them is which goal is to be sacrificed -- progressivity, comprehensiveness, symmetry, or competitiveness.

Supporters of reducing the corporate income tax rate value competitiveness. The issue for them is then which other goal or goals the United States should sacrifice to have a tax system that allows U.S. businesses to compete in a global economy. Countries in a similar position have made different choices.9

B. Opportunity to Reexamine Basic Positions

A reduction in the corporate tax rate may provide an opportunity to consider more fundamental changes to the U.S. tax system. This part examines proposals to reform the tax regime for business income and to change the relative revenue contribution from different tax instruments.

1. Reform tax regime for business income.10 I am pro-choice: Folks should be allowed to choose their friends, sports teams to support, and type of cola. But freedom to choose, especially within our tax system, brings costs as well as benefits. With apologies to Yogi Berra, whenever taxpayers get to a fork in the road, they take it.

The tax code is chock-full of implicit and explicit elections that contribute to the complexity and inefficiencies of the tax system.11 It is impossible to eliminate all choices in the tax system. It is possible, however, to reduce substantially the number of implicit and explicit elections.

The business tax system provides individuals and business entities many opportunities to customize a tax regime to minimize potential tax liability. Taxpayers can choose their form of organization and linked tax regime. They can structure their investment as debt or equity and then decide the form and timing of distributions (as dividends or redemptions). They can fashion distributions of profits of closely held entities as dividends, salary, or rents. Taxpayers can also elect whether to consolidate with related entities or treat each as a separate entity for tax purposes.

Because form rules in the tax regime covering cross-border transactions, the choices in the international tax regime are even greater than choices in the domestic context.12 Taxpayers can structure their foreign operations as U.S. or foreign entities13 and in noncorporate or corporate form. By extending the 1996 adoption of the check-the-box regulations to foreign entities, the tax law often allows taxpayers to elect hybrid treatment so that they can choose one form of organization for U.S. tax purposes and another form for foreign tax purposes.14

The form of income is also subject to simple modification -- often with different tax consequences. The same basic transaction can be structured as a license or sale, payments for compensation, or payments for royalties; even better, the same transaction can be treated one way in one tax jurisdiction and another way in a different jurisdiction. It is also easy to change the location of the income. International tax planning is relatively straightforward in a world of intracompany transactions: simply create or move high-value intangibles in or to low- or no-tax jurisdictions and place debt in high-tax jurisdictions to suck out any profits at little or no U.S. or foreign tax liability. Prof. Edward Kleinbard is exactly right when he says we have arrived at a world of stateless income.15

Our system of taxing foreign-source income from active business operations provides taxpayers many choices.16 Taxpayers can decide when and how much tax to pay on income earned outside the United States simply by deciding when to repatriate foreign income. Strong arguments exist for either adopting a territorial system or a worldwide tax system for U.S. businesses with active business operations. But the current system of deferring tax until repatriation is hard to justify on economic, fairness, revenue, or administrative grounds.

By eliminating many elections, we could simplify the tax law, make it more efficient, and likely raise substantially the same revenues at lower tax rates. A good place to start is reexamining decisions that allow taxpayers to choose the tax regime that applies to business income and to their investment in the business enterprise.

a. Single tax regime for business income. Our legal system provides many choices as to organizational form to conduct business activity. They differ in many respects in state law consequences, such as ownership and governance structures and liability rules. Similarly, our tax system allows taxpayers to choose which tax regime applies to their business operations -- such as sole proprietorships, partnerships (general and limited), cooperatives, S corporations, and C corporations.

So individuals balance the nontax costs and benefits of adopting a particular business form against the costs and benefits of the tax regimes tied to the particular business form. But as William Klein and I noted in a 1995 article,17 there is no reason to link business form and tax regime. Why should taxpayers have to choose a suboptimal organizational form to achieve a favorable tax regime? This was the logic behind Treasury's check-the-box rules adopted in 1996. While the federal government dithered on proposals to integrate the individual and corporate tax system, this reasoning also led state legislatures to adopt the limited liability company regimes that paired limited liability status with single-level passthrough taxation.

But why allow taxpayers to choose their tax regime? Why not just adopt a single set of tax rules that apply to all business income? Several reform proposals for taxing business income would apply without regard to business form (perhaps with exclusions for very small businesses operating as sole proprietorships). Some tax the full return on equity capital, some tax the full return of both debt and equity capital, and others seek to tax only economic rents. These include proposals by President George W. Bush's advisory panel on tax reform,18 the comprehensive business income tax (CBIT) from Treasury's 1992 integration study, and the business enterprise income tax.19 They are all steps in the right direction. If we want a tax system that is neutral as to business form, then one size fits all.

b. Treat debt and equity the same for tax purposes. The classic corporate income tax distorts decisions on organizational form, decisions to retain or distribute corporate earnings, and decisions to use debt or equity in the firm's capital structure. Of these three distortions, the preferential tax treatment of debt over equity is the most troubling.

Why allow taxpayers to choose the tax treatment applicable to their investment in a firm? Debt and equity are just different financial claims on the same enterprise. And thanks to the efforts of lawyers, accountants, and investment bankers, it is increasingly difficult to distinguish between them.

Treating debt and equity the same way requires either extending the deductibility of interest to dividends or denying the tax deduction to interest payments. Both approaches have merit. In 1992 Treasury put forth a proposal to tax business income once by providing for no corporate-level deduction for dividend and interest paid and no inclusion into income at the investor level for any dividend or interest received. As discussed below, this CBIT proposal is simply a form of dual income taxation, a schedular tax on dividend and interest with final withholding at the entity level.

I appreciate that it will not be easy to make fundamental changes in the taxing of debt and equity. There would have to be a period of transition. It would also require coordination with other developed countries to have source-based taxation of interest and dividends. But I think it would substantially improve how we tax business income.

But now back to tax competition. How can we have a tax system that encourages economic growth and is more in line with the tax system of other developed countries? The key may be in returning to schedular taxation, whereby we adopt separate tax regimes for income from labor and income from capital.

c. De-link the taxation of income from labor and capital and tax capital income at a single flat rate. The conventional wisdom is that good tax systems are based on a comprehensive income tax model in which capital and labor income are treated equally and the combined income is taxed at progressive rates. In reality, income tax systems often turn out to be neither very comprehensive nor very progressive. Different types and forms of capital bear different tax burdens.20

One response would be to continue the slog toward the ideal comprehensive income tax model. This has not been particularly effective. Another approach would de-link the taxation of income from labor and the taxation of income from capital, retaining progressive tax rates for labor income and taxing capital income at a flat rate. With increasing globalization and tax competition, this dual income tax approach may have greater appeal because countries could reduce tax rates on more mobile capital income while retaining higher and more progressive tax rates on less mobile labor income.

A flat tax regime for capital income would have several advantages over the current regime.21 First, it would simplify the tax rules that apply to income from capital, especially if reforms also eliminated or reduced existing tax preferences (including the reduced tax rates for capital gains) and exemptions. Second, it would make the taxation of capital income more uniform and less distortive. Third, a single tax regime could lead to substantial enforcement and administrative gains through provisional and final withholding regimes. But perhaps the most important advantage would be the flexibility in setting tax rates for income from capital apart from income from labor. It would allow the United States to have a tax regime for income from capital that is competitive with that of the rest of the world and still retain a progressive tax system for labor income.

There are also several disadvantages with a dual income tax regime. First, it would be difficult to justify on equity grounds why one type of income is taxed at a single tax rate (and likely a relatively low rate) and another type of income is subject to progressive tax rates. It is only a slightly satisfactory response to note that we have similar disparities between labor and capital income under the current tax system. Second, any tax system that provides for a lower rate for one type of income will create incentives for taxpayers to structure their activities to qualify for the lower tax rates. Thus, if income from capital is taxed at a lower rate than income from labor, taxpayers will try to convert labor income into capital income. The Nordic countries have devised different approaches to limit these arbitrage opportunities with only modest success.22 While the likely differential in tax rates under a U.S. dual income tax system would be substantially smaller than the rate differential in Nordic countries, taxpayers would no doubt attempt to transmute their labor income into income from capital.

Several options exist for designing a dual income tax system for the United States. We would have to make decisions on such issues as the relative tax rates for capital and labor income, whether to provide for differential treatment of portfolio investment income and income related to active businesses, whether to provide differential treatment to the "normal" return on capital and to "excess" returns, and whether to use the dual income tax reform as an opportunity to integrate the individual and corporate tax system. We did not appreciate it at the time, but the CBIT model with final withholding on dividends and interest provides an excellent start in designing a dual income tax.

2. Change the relative contribution of tax revenue from different tax instruments. Forget politics for a moment. The United States is in an enviable tax position compared with other countries. Putting aside some oil-rich countries, the United States has more flexibility in considering tax reform alternatives than almost any other country. This favorable position results from four factors: (1) a relatively low tax burden (measured as a percentage of GDP) compared with that of other developed countries; (2) a tax burden on consumption that is much lower than other countries'; (3) an economic structure that facilitates relatively high levels of tax compliance23; and (4) a relatively effective tax administration system. I am not saying that we should increase tax burdens, but I am saying that we have greater tax capacity and flexibility in reforming our tax system than almost any other country.

In a world of tax competition, it makes sense to reexamine the relative revenue contributions from different types of taxes. Despite having one of the lowest overall tax burdens in the world, the United States has one of the highest income tax burdens. We can rebalance the tax mix by adopting a broad-based consumption tax (a VAT) that would substantially reduce the revenue required to be raised from individual and corporate income taxes.24 As Prof. Michael J. Graetz and others have noted, we could go from being a high-income tax country to a medium- to low-income tax country by adopting a VAT and using a substantial part of the tax revenue to cut income taxes.25

But increasing taxes on consumption and decreasing taxes on income would shift part of the existing tax burden from the rich (particularly the very rich) to the middle- and lower-income groups. Amid increasing poverty and income inequality, it seems like we would be going in exactly the wrong direction. The key is if the United States moves to more regressive taxes, the case for more progressive spending programs is even stronger.26 This is not news. It is something that Scandinavian countries and Western European countries figured out many years ago. We are again the odd man out compared with other developed countries.

In his State of the Union address, President Obama called for the United States to out-educate, out-innovate, and out-build other countries.27 For the United States to do any of that, we need a tax system that provides substantial revenue without impeding growth. We also must get out of the partisan rut in which the only way to increase funding to social programs is through higher taxes on the wealthy.

Adopting a VAT to supplement, rather than replace, income taxes would facilitate reform of the type that has gained modest momentum over the last couple of years. Lowering tax rates under the individual and corporate tax systems should reduce both the need and political support for the host of special preferences and exclusions that riddle the income tax system. Broadening the base would likely have efficiency, equity, and administrative gains and yield additional revenue that would support further reductions in marginal tax rates. It may also allow us to quit running social spending through the tax system (such as tax benefits for housing, retirement savings, healthcare, and education), which makes the benefits available only to those paying income taxes (perhaps those who need the benefits least) and ties the amount of benefits to the individual tax rate.

C. Reform Proposal

It makes good sense to reduce the corporate income tax rate. But we should not stop there. There are many tax reform proposals floating around. So to the stack, I add the following:

    1. Adopt a VAT to raise revenue and dramatically reduce the revenue requirements from the individual and corporate income tax.

    2. Reduce electivity in the tax law by providing a single tax regime for business income regardless of organizational form, and equalize the tax treatment of debt and equity.

    3. De-link the taxation of labor and capital income and provide for a single tax on capital income and a progressive tax on labor income.

    4. Reduce individual income tax rates and reform the individual income tax by expanding the tax base through the elimination of many of the individual deductions and special incentives.

    5. Reduce corporate tax rates and reform the corporate tax by expanding the tax base through the removal of many exemptions and special preferences, including changing the regime so that U.S. corporations are taxed currently on their worldwide income.

    6. Stop running social spending programs through the tax system.

    7. Commit to social programs that will make some progress in equalizing opportunities for all Americans and address the basic needs of those who are economically at the very bottom of our society.


1 "Tax Policy Reform and Economic Growth," OECD Tax Policy Studies No. 20 (2010), at 24; OECD Tax Database, Basic (Non-Targeted) Corporate Income Tax Rates (Table II.1), available at Japan's corporate tax rate would be lower than the U.S. rate, but the scheduled tax reduction was delayed because of the March tsunami. Kyoko Shimodoi and Toru Fujioka, "Japan Considers Scrapping Planned Corporate Tax Reduction," Bloomberg, Mar. 29, 2011, available at

2 See Peter R. Merrill, "Competitive Tax Rates for U.S. Companies: How Low to Go?" Tax Notes, Feb. 23, 2009, p. 1009, Doc 2009-258, or 2009 TNT 34-45; Jane G. Gravelle and Thomas L. Hungerford, "Corporate Tax Reform: Should We Really Believe the Research?" Tax Notes, Oct. 27, 2008, p. 419, Doc 2008-18748, or 2008 TNT 209-18; Matthew H. Jensen and Aparna Mathur, "Corporate Tax Burden on Labor: Theory and Empirical Evidence," Tax Notes, June 6, 2011, p. 1083, Doc 2011-10018, or 2011 TNT 111-13; Jeremy A. Leonard, "A Closer Look at the U.S. Corporate Tax Burden," Tax Notes, Nov. 17, 2008, p. 849, Doc 2008-22936, or 2008 TNT 223-38.

3 Daniel Halperin, "Mitigating the Potential Inequity of Reducing Corporate Rates," Tax Notes, Feb. 1, 2010, p. 641, Doc 2010-261, 2010 TNT 34-10.

4 Eric M. Zolt, "Corporate Taxation after the Tax Reform Act of 1986: A State of Disequilibrium," 66 N.C. L. Rev. 839 (1988).

5 Raj Chetty and Emmanuel Saez, "Dividend Taxes and Corporate Behavior: Evidence From the 2003 Dividend Tax Cut," 120 Q. J. Econ. 791 (2005).

6 Treasury, "A Recommendation for the Integration of the Individual and Corporate Tax Systems" (1992), available at I was one of the principal authors of this Treasury report.

7 Steffen Ganghof, The Politics of Income Taxation: A Comprehensive Analysis (2006); Ganghof, "Global Markets, National Tax Systems, and Domestic Politics: Rebalancing Efficiency and Equity in Open States' Income Taxation," Max Planck Institute Discussion Paper 01/9 (2001).

8 Boris I. Bittker, "Comprehensive Income Taxation: A Response," 81 Harv. L. Rev. 1032 (1968); Edward J. McCaffery, "Tax Policy Under a Hybrid Income-Consumption Tax," 70 Tex. L. Rev. 1145 (1992).

9 The Nordic countries sacrificed comprehensiveness by providing different treatment for capital and labor income. Denmark also chose to sacrifice symmetry by imposing differential tax rates on capital income. Australia sacrificed symmetry but in a different way: by electing to cut only the corporate income tax rate. New Zealand chose instead to cut all income tax rates, thus sacrificing progressivity. See Steffen Ganghof and Richard Eccleston, "Globalization and the Dilemmas of Income Taxation in Australia," 39 Aust. J. Polit. Sci. 519, 530 (2006). In contrast, Germany, until its most recent reforms, sacrificed competitiveness to retain the other three objectives.

10 This section borrows heavily from Zolt, "Reform the Taxation of Business Income," in Toward Tax Reform: Recommendations for President Obama's Task Force (2009), Doc 2009-13595, 2009 TNT 172-40 .

11 Heather M. Field, "Choosing Tax: Explicit Elections as an Element of Design in the Federal Income Tax System," 47 Harv. J. on Legis. 21, 22 (2010).

12 Philip R. West, "Across the Great Divide: A Centrist Tax Reform Proposal," Tax Notes, Feb. 28, 2011, p. 1025, Doc 2011-2086, 2011 TNT 40-7.

13 Daniel Shaviro, "The Rising Tax-Electivity of U.S. Corporate Residence," NYU Law and Economics Research Paper No. 10-45, 2010, available at

14 Reg. section 301.7701-3.

15 Edward D. Kleinbard, "Stateless Income's Challenge to Tax Policy," Tax Notes (forthcoming).

16 H. David Rosenbloom, "From the Bottom Up: Taxing the Income of Controlled Foreign Corporations," 26 Brook. J. Int'l L. 1525 (2001).

17 William A. Klein and Zolt, "Business Form, Limited Liability, and Tax Regimes: Lurching Toward a Coherent Outcome?" 66 U. Colo. L. Rev. 1001 (1995).

18 President's Advisory Panel on Federal Tax Reform, "Simple, Fair, and Pro-Growth: Proposals to Fix America's Tax System" (Nov. 1, 2005), Doc 2005-22112, 2005 TNT 211-14.

19 Kleinbard, "The Business Enterprise Income Tax: A Prospectus," Tax Notes, Jan. 3, 2005, p. 97, Doc 2004-23324, 2005 TNT 2-37.

20 Zolt, "The Uneasy Case for Uniform Taxation," 16 Va. Tax Rev. 39 (1996).

21 See Richard M. Bird and Zolt, "Dual Income Taxation: A Promising Path to Tax Reform for Developing Countries," in World Development (forthcoming); Bird and Zolt, "Dual Income Taxation and Developing Countries," 1 Colum. J. Tax L. 174 (2010); Kleinbard, "An American Dual Income Tax: Nordic Precedents," 5 Nw. J. L. & Soc. Pol'y 41 (2010).

22 Peter Birch Sorensen, "Dual Income Taxation: Why and How?" 61 FinanzArchiv: Pub. Fin. Archive 559 (2005).

23 Despite what is a significant tax compliance gap, the United States has a relatively small informal economy compared with most other developed and developing countries; a still large (although shrinking) portion of workers in formal employment arrangements; and an economy in which most transactions go through the financial system.

24 Eric Toder and Joseph Rosenberg, "Effects of Imposing a Value-Added Tax to Replace Payroll Taxes or Corporate Taxes," Tax Policy Center (Mar. 18, 2010), Doc 2010-7657, 2010 TNT 67-31.

25 Michael J. Graetz, 100 Million Unnecessary Returns: A Simple, Fair, and Competitive Tax Plan for the United States (2008); Toder and Rosenberg, supra note 24.

26 Zolt, "Time for a Postpartisan Tax Policy," Tax Notes, Sept. 15, 2008, p. 1082, Doc 2008-18712, 2008 TNT 180-41.

27 President Barack Obama, State of the Union Address (Jan. 25, 2011), available at


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