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Hughes: Corporate calculations and the gamble on growth

By Kent Hughes

Woodrow Wilson Center

Published on December 29, 2017 11:03AM

Last changed on January 2, 2018 10:50AM

Kent Hughes

Kent Hughes

Santa came to President Trump early this year. He left a big tax cut bill under the White House Christmas Tree, the first major rewrite of the national tax code since the Reagan era tax reform in 1986.

Tax rates were cut for most Americans and most businesses. Cuts in individual rates will put more money in consumers’ pockets and cuts in business taxes will lead to added profits and some new investment. While the individual rate cuts will expire in 2025, Republicans point to the temporary tax cuts under President George W. Bush that, except for the top rate, were made permanent under President Obama. Of course, the debate will continue over the actual effects of the tax cuts.

Betting on corporations: Cuts were provided for both corporations and pass through businesses (those where profits are not taxed as corporations but are ‘passed through’ and taxed as individual income). For the long-term, the most important changes are the sharp drop in the rate on corporate profits (from 35 percent to 21 percent) and the shift from a global tax system (U.S. companies are liable for taxes whether or not income is earned in the United States) to a territorial system (corporations are taxed where they earned the profit). There are a number of special provisions but the shift to a territorial system is the basic story.

The cut in the corporate rate is coupled with five years of allowing an immediate deduction of the cost of capital investments (or expensing) against business taxes. Also, the new law eliminated the corporate version (not the individual variant) of the alternative minimum tax, a tax adopted several years ago in reaction to years when profitable corporations managed to pay no tax at all.

In addition, the new law deals with U.S. corporate earnings made since 1986 and held abroad. Current law has encouraged companies to keep overseas profits overseas to avoid paying the statutory 35 percent rate (there is a credit for taxes paid to foreign governments). Real money is at stake. Estimates vary, but many put U.S. overseas corporate holdings at $2.5 trillion. The new tax law treats the overseas earnings as if they had been repatriated and subjects them to a tax of 15.5 percent for cash and other liquid assets and 8 percent for real estate, factories and other physical assets.

How much money will return? Estimating how much will actually return to the United States is complicated. If the overseas funds are held in foreign currencies, future repatriation will require the purchase of dollars, which will drive up the value of the dollar and make U.S. exports less competitive. And there is another complexity. Even under the old law, some of the overseas funds could avoid the tax by investing in the U.S. but outside the headquarters company. These funds would have already been converted into dollars so there would be no added negative effect on exports. One is tempted to borrow President Trump’s comment on health care to ask “who would think taxes were that complicated.”

In a world where countries compete to attract investment, the lower corporate tax rate should also make the U.S. a more attractive investment target. That was one reason for the 1986 reform, where the 35 percent rate put the U.S. ahead of most of its industrial competitors. Over time, however, countries reduced their corporate tax so that by 2017, the US had a higher rate than most of our competitors.

In looking to the future, the United States will need to keep at least three factors in mind. First, it is a fair bet that competing countries will start to lower their rates to compete with the new, lower U.S. rate. Second, with China offering an ever lower rate for priority industries, China would still have an edge when taxes are the only consideration. Finally, most companies do not look only at the tax rate — they also weigh the quality of the workforce, the presence of research universities, a supportive or antagonistic government, and whether health and other benefits are paid by the company or by the tax payers.

Will economic growth be stimulated? Most observers expect that individual and corporate rate cuts will provide an added impetus to growth. The President has already taken steps to pursue pro-growth regulatory reform and adopted an international economic policy that focuses on enforcing existing rules and creating new ones that will benefit the United States and much of the industrial world. If the President combines a trillion dollar infrastructure with increased investment in research and development, training and education, American industry will have many of the tools it needs to lead the international competition.

There are many questions about the new tax law. It adds another trillion dollars to the national debt.

While everyone will receive some benefit from the tax cut, the benefits are heavily weighted to those already at the top of the economic ladder. Current surveys of CEOs do not suggest that most corporations will increase their investments or raise wages. Of course that could change as the pace of current growth presses against existing capacity. The sheer complexity of the law will have tax accountants and tax lawyers working more than full time. Unlike the bipartisan tax reform of 1986, the current law was passed with only Republican votes. Any needed changes in the tax law could run into a partisan hurdle.

In America, there is always reason for optimism. America has a history of resilience in the face of economic as well as geopolitical challenges. If the President and the Congress adopt a pragmatic approach to the changes brought by globalization and technology and a flexible response to the growing challenge of mercantilism, America can again produce widely shared prosperity at home and leadership abroad.

Kent Hughes is a public policy fellow at the Woodrow Wilson Center in Washington, D.C. He is a 1958 graduate of Pendleton High School.


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