Obama wanted a corporate tax cut, too

The new tax reform bill includes a dramatic reduction in the US corporate tax rate. Is it a handout to the rich, or vital for spurring job growth and investment?

Jan 04, 2018

Sections Economics

The new tax reform bill includes a dramatic reduction in the US corporate tax rate. Is this a handout to the rich or a necessary measure to spur the economy? On this episode of the Capitalisn’t podcast, Luigi and Kate debate the pros and cons and break down the law’s impact on pass-through businesses.

Kate: Hi, I’m Kate Waldock, a professor at Georgetown University.

Luigi: And I’m Luigi Zingales, a professor at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

Donald Trump: I’m giving the largest tax cuts in the history of this country.

Speaker 4: Everyone else has cut their corporate taxes dramatically in the world, and we haven’t.

Speaker 5: The tax cut is longer than the Bible, and not quite as inspirational.

Speaker 6: Big, wealthy corporations count far more than kids.

Speaker 7: This is our opportunity to make tax reform a reality, and deliver the most transformational tax cuts in a generation.

Speaker 8: The big winners are clearly corporations.

Kate: On today’s episode we’re going to talk about the recent tax reform. In particular, the reduction of corporate tax rates from 35 percent to closer to 20 percent. You’ve probably been hearing a ton of fiery rhetoric from both sides of the aisle about how this is just a handout to the rich. Or this is going to solve all of our economic problems and lead to 6 percent growth.

It’s all over the place, but we want to cut through all of that and focus on the economic issues here, in particular the economic issues surrounding corporate tax rates and international competition. So, Luigi, do you think that this is really a handout to the rich, or it’s going to solve all of our economic problems?

Luigi: Let me start actually with a story. In 2014 a group of economists of different persuasions were invited to the White House. I was lucky enough to be one of those.

After being in very pleasant conversation, President Obama said, “You know, I invited you here to have ideas. What are you proposing?” And Kevin Hassett, who is now the head of the Council of Economic Advisers, stepped up and said, “I think that we should cut the tax rates of corporations.” The reaction of President Obama was not, “This is a handout to the rich. It’s a terrible idea.” He said, “Oh, I know we need to cut the corporate tax rate. But, in order to make this effective and important, it needs to be a large tax cut. Where do I get the money to do so?” Then we had a conversation on how he could get the money. But, the important thing here is even President Obama recognized that a reduction of the corporate tax rate was due. And the question was not if, it was only how.

Kate: I am super jealous that you got to hang out with Obama and a bunch of economists and just shoot the shit on how to generally solve our economic problems. But, before we launch into further discussion about this, I just wanted to insert the quick disclaimer that this recent tax reform act is really huge. It covers all manner of sins.

It covers the mortgage interest deduction, and it covers state and local tax deductions, and it covers individual income taxes. But, we’re here specifically to talk about the business element of it. In particular, how corporate tax rates have changed. But, also what goes on with pass-throughs.

Luigi: Absolutely. Let’s start actually by having a pretty important conversation, which is why do we have corporate taxes to begin with?

Kate: Corporations are subject to what economists call double taxation. So, if you’re a corporation and you earn some profits, then after certain deductions you have to pay taxes on those profits. Then, if the owners of that corporation want to then receive that cash afterwards, they need to pay an additional tax. Either through capital gains or through dividends on what’s dispersed to them in cash.

So, there’s sort of this two-layer process. First, you’re taxed at the corporate level. And then you’re taxed on the cash that’s given back to you as a shareholder. So, Luigi, why should we even have these corporate taxes?

Luigi: It’s actually kind of a theoretical puzzle why we have an additional layer of taxes on corporations. There are three main explanations. One interpretation is we want to avoid that people will postpone paying taxes forever. So, if I am an owner of a corporation I can divert my income into a corporation, and if this corporation is not taxed, I can postpone paying my personal income tax for many years with clear advantages because paying a tax later is better than paying today.

The second idea is you want to tax rents. You want to tax not the normal return to capital, but the return to some form of monopoly.

The third interpretation, which is one I tend to espouse, is historically there was an easier way to collect taxes. Whether we like it or not, governments need to collect taxes, and they always prefer an easier way rather than a more complicated way. In the old days, tracing down individuals was very difficult. And just assessing a tax at the level of corporation, especially when it’s a big corporation, is relatively easy.

Kate: There’s this excerpt that I want to read from the Council of Economic Advisers, this report they came out with on taxes back in October. They start with a summary. And the first sentence of the summary is, “Wage growth in America has stagnated. Over the past eight years ...” So, that’s sort of a direct dig on Obama, saying that this is his fault for stagnation.

The first sentence of the second paragraph is, “The deteriorating relationship between wages of American workers and US corporate profits reflects the state of international tax competition.” So, they’re saying this is an international issue.

And then the first sentence of the introduction is, “An extensive literature on corporate tax policy documents that reducing the corporate tax rate results in increased capital formation and economic output.”

So, there’s these three different ideas that they are glomming together. In particular, there’s two separate ones that I think we should talk about.

One is that, we need to reduce taxes because we just can’t compete with other countries versus we need to reduce taxes because that boosts economic output. We need to recognize that those are two distinct ideas. I agree with the idea that we’re facing international tax competition. I’m not so sure what I think about the supply side argument that cutting taxes always boosts output.

Luigi: I don’t want to sound like a Trump defender, but I don’t think that what you read is so crazy. In the sense that, it is true that higher taxes lead to low investments. Imagine that I need to decide whether to create a plant in Michigan, or on the other side of the border in Canada. If I create this plant in Michigan, I end up paying 39 percent: 35 at the federal level, plus some other stuff at the Michigan level. Thirty-nine percent of my profits in taxes.

If I go to Canada, which is not exactly sort of a tax haven, I end up paying only 27 percent in taxes. If you, Kate, want to start a business, and you’re in doubt, and you know, they speak English on both sides, they basically have similar laws—we’re not going to an underdeveloped country where we cannot get what we get in the United States—at the end of the day, everything is similar except in one place you pay 39 percent, in the other 27. Which one do you choose?

Kate: I’m a goddamn proud American citizen, so I would stay over here.

Luigi: I’m glad that you have this sense of patriotism. I guess not everybody has the same sense of patriotism They might decide to go on the other side of the border.

Kate: Actually, I think that that sense of patriotism is important to this argument here because if enough people do think there’s a premium to staying in the United States, either through a sense of patriotism or, just because they just think that US workers are better trained, or because there is some benefit to being in the US for whatever reason, maybe it has to do with education, then we don’t need to worry as much about cutting taxes because we don’t actually face as much international competition.

Luigi: I think you have an image of the 1950s where the United States was so ahead of everybody else, that setting a plant anywhere else was basically going to no man’s land. First of all, the interesting thing is even if the United States has a higher statutory tax rate than Canada, it actually raises less taxes from corporations than Canada. Only 2.3 percent of GDP in the United States and 3.1 percent in Canada. How is that possible?

The answer is because in spite of having a high statutory tax rate there are so many loopholes that de facto you end up raising much less taxes. That’s what I would like to change. What I was hoping this reform would change.

Kate: But, now I feel like you’re contradicting yourself. If companies aren’t actually paying the statutory tax rate of what used to be 35 percent, then we shouldn’t care as much. I mean, going back to your Canadian example, if Canadian legislatures are actually making their corporations pay 27 percent, whereas in the US it’s higher but our corporations have ways of dodging it, then it shouldn’t matter.

Luigi: Actually, it does matter a lot because there are two things. Number one, only the connected and the big companies with big lawyers can exploit the system. So, you’re making it difficult for a new guy who starts a company to actually start a company. But, if you’re an established company with all your connections, etc., you end up paying much less, number one.

Number two, this is a huge subsidy for lobbyists, lawyers, and last time I checked, these are not really productive activities. These are just sort of what we call in economics “rent-seeking activities.” You spend resources to increase your share of the pie, but you’re not increasing the size of the pie for everybody.

Kate: I agree with what you’re saying, but I think that this current tax reform act makes things even worse for small businesses relative to large businesses. So, here, I think it’s important that we get into the rules about pass-throughs. I think that this word has been thrown around a lot in the past couple weeks. But, I’d like to just try and explain this as simply as possible.

So, we’ve been talking about the corporate tax rate. This applies to corporations. Corporations are just one sort of company. There’s a lot of different companies out there. So, if you’re walking down the street wherever you live, chances are if you’re looking left and right and you’re seeing restaurants, if you’re seeing dentist’s offices, if you’re seeing law offices, none of those are corporations, they’re probably LLC’s, some of them are probably sole proprietorships. There’s various different types of businesses that you can form, and only corporations are subject to this corporate tax cut.

Everything else is called a pass-through. So, what a pass-through means is any profits that the business makes, those profits ... No matter how they’re distributed back to who owns the business. So, let’s say you both own and manage your business. So, you’re paying yourself a salary like the manager, or if you’re paying yourself dividends as the owner, it doesn’t matter. Any profits that go back to you, they’re taxed at your personal income tax rate. Not a corporate tax rate, even though they’re coming from a business. So, this income that you’re earning from your own smaller business is called pass-through income.

Now, note that pass-through businesses don’t have this double-taxation problem. Income from a pass-through business is only taxed once at the individual level. Even so, corporations would have been getting this big tax cut, while smaller businesses or smaller business forms would have gotten nothing. So, to help pass-throughs, the tax plan cuts the pass-through rate. But, it does this in a really convoluted way.

So, only 20 percent of your income is eligible for these lower rates, in the form of a deduction. And for businesses in the service sector, which by the way is most small businesses, you’re only eligible for the deduction if your income is on the pretty low end. And for non-service businesses, the deduction is tied to your payroll.

So, overall, I think that it favors some industries over others. And also, many small businesses won’t be eligible for this deduction at all.

Luigi: Kate, I completely agree with you that having these favored industries is terrible because the moment you start picking and choosing the winner, the favored one and the unfavored one, then you generate incentives for people to try to become the favored one. So, a lot of money, effort is spent in distorting the tax system, rather than fixing. I was hoping that this tax reform was a possibility and opportunity to actually make the tax code simpler. And more fair.

To lower the tax rate, but increase the tax base. It does go in part in that direction. For example, you cannot deduct all the interest expenses from your bill. Before you’re treating profits and interest payment as two different things. We know in finance that they shouldn’t be taxed in a different way. By eliminating this distortion, and increasing the base, the tax reform goes a bit in that direction.

Kate: Also, another way that people can exploit the system is that individuals who used to be compensated as employees can establish their own pass-through businesses now and call themselves consultants. And still do essentially the same job, but now, potentially, take advantage of this pass-through deduction. There are apparently some safeguards put in place to prevent this.

But, a bunch of tax professionals got together and published this report that was basically like, “No, there’s still loopholes.”

Luigi: I agree. I’m not trying to defend the Trump tax reform. What I’m trying to highlight is the motivations behind this reform were not as crazy as they appear. The idea of decreasing the corporate tax rate to make more attractive doing business in the United States I don’t think is a bad idea.

I think that decreasing the rates, and increasing the base, the taxable base, is actually an excellent idea. And making this more homogenous and less differentiated across sectors, I grant you that they didn’t, but I think that that is a great idea.

Unfortunately, the implementation was far away from the principle. I think that you’re living in a world in which companies have a choice on where to locate. If you don’t treat them nicely, they don’t locate here.

Kate: I just want to touch on one thing you said, that it’s increasing the taxable base. So, I want to clarify that. Do you mean that because they eliminated certain deductions like interest deductions, or state and local taxes, that there will be a larger subset of businesses that now have to pay taxes in the first place?

Luigi: It’s not a large set of businesses that pay taxes. But, every business will pay taxes on a larger base because they cannot exclude from the taxation this item or this other item. But, at the lower rate. As economists, we know that what matters is the marginal tax rate. What you pay on the last dollar, because if you make an investment decision, you don’t look at how much you pay on average, because you’re going to keep paying that whether you make that investment or not. You look at how much you pay on the last dollar that you invest, or the last dollar that you produce.

That’s the reason why, as economists, we tend to like reforms that lower the rates and increase the base because they have the potential to raise the same amount of money with lower tax rates, and by the way, lower expenses for lawyers.

Kate: I think this is going to create a lot more work for lawyers. I think we should talk a little bit about another element of this, something that seems particularly sneaky and potentially harmful for future accountability, which is that a large component of this tax cut has to do with repatriation of profits that have been sitting abroad for a long time.

That just seems to me like it’s inconsistent with the message of past and potentially future administrations that you need to respect what tax rates are. If you have earned profits abroad, and if you want those profits to be distributed back to the US owners of a corporation, then you need to repatriate it and pay a higher tax. In particular, you need to pay the difference between the US corporate tax rate and wherever those profits were made in a foreign country.

What companies have been doing is just holding that money offshore, waiting for tax rates to go down. Or waiting for some sort of tax holiday, and that’s exactly what they got. I mean, they were rewarded for their bad behavior.

Luigi: I agree with this, but part of the problem is not only that there was this differential taxation, but as sort of Kate said that in 2004 George W. Bush passed the American Jobs Creation Act. Basically, it was a tax holiday to bring that money back. Once you pass the tax holiday once, then corporations are rational. They expect another tax holiday.

Kate: What did he say about fool me once?

Luigi: Yes. So, they understood. And as a result, the accumulation of cash grew to $2.7 trillion. Unfortunately, the problem was already done by the Bush administration. I think that this reform is better than what Bush did because had they done another tax holiday, it would have been a disaster.

So, what they’re doing is they’re trying to homogenize the tax rates so that in the future the incentives to accumulate sort of cash abroad go down.

Kate: It seems to me like there’s a much simpler solution to this, which is that you have to pay your taxes when you make the money. In the US, if you are a regular person earning income you have to pay those taxes every year. It’s not like April comes around and you’re like, I’m just going to shift these taxes into the future just because I feel like it because the income tax rate may go down in the future.

Corporations abroad, when they earn money abroad there’s no limit on how long they can just park it abroad. To be fair, I mean, there’s a reason for that. That’s because they may use that cash abroad to reinvest in their foreign subsidiaries. But, there’s got to be a period of time in which they can’t just keep holding onto it in the hopes that it can be repatriated.

I think that, instead, an easy solution is just to put a two- or three-year clock on how long you can keep those profits abroad before it has to be repatriated or reinvested. You can’t just hold onto it for forever.

Luigi: Again, you don’t realize that corporations have a choice of where to locate. And most countries don’t use this worldwide definition of income. They use only the territorial definition of income.

So, in 2006 at some point Pfizer was considering transforming itself into an Irish company. Buying an Irish subsidiary. That’s called corporate inversion. And corporate inversions are going up precisely because corporations see the advantage of being located somewhere else.

So, if you want all the major multi-nationals to be located in Ireland rather than the United States go ahead. I think that introducing a rule like that is sort of the perfect rule to lose all the major corporations to Ireland.

Kate: Yeah, but we can also take separate measures to try and prevent corporate tax inversions, which is what we’ve been trying to do. I think that we could go even further and say, that if you start out as a US multi-national, and you invert to essentially become a foreign company, and pay lower tax rates abroad, that means you can no longer do business here in the United States.

Luigi: Great. You’re going to make Facebook and Pfizer, etc., not able to do business in the United States.

Kate: If those are the rules, and we enforce them, they’re not going to invert.

Luigi: Look, you can certainly use, if you want, the brute force of the government to keep people in.

Kate: Yes.

Luigi: I prefer to have people attracted here rather than constrained here. I think that having lower tax rates, but with a bigger base, is one way to do it. The second way to do it, which is relatively easy, is at the end of the day what matters is the overall tax burden that you pay. Or the overall tax that you raise. If you reduce the corporate tax rate, but you increase the tax at the personal level on dividend incomes and capital gains, you’re going to by and large recover many of the corporate taxes you lose at the corporate tax level.

I’m not trying to say we need to transfer money to the rich here. There are plenty of ways at which we can avoid that, but still make America a better place to do business in.

Kate: The problem is that everything is going down. It’s not just corporate tax rates and favored pass-through rates that are going down. It’s also estate taxes, and a number of other taxes that benefit the rich.

Luigi: I agree. I think that reducing estate taxes is a problem, especially these days. I think that the perception that this is a handout to the rich is not just a perception. I think that because it lacks the other components, it is a big handout to the rich. But, what I would like to ... our listeners to understand, is that we’re not here to throw away the baby with the bathwater. We want to separate.

And as economists, we just say, look there are some aspects that are reasonable. In fact, probably necessary. And other aspects that are not only not necessary, but I think going the opposite direction of what should take place.

Unfortunately, this tax reform is a combination of the two.

Kate: If it were up to me, I’m not entirely ruling out the idea that cutting corporate taxes by a little bit could be OK. I mean, I understand that we face stiff foreign competition. I understand that we want to keep jobs here in the US. But, I think that the right thing to do is to move it incrementally, not by like 15 percent all at once. Also, to try and use the stick a little bit more. I don’t see what’s wrong with being more punitive to companies that try and dodge taxes.

I think that should be the first step, combined with maybe a very small decrease in corporate tax rates. But, there’s plenty more that we can do in enforcing not necessarily fraud, but tax-avoidance strategies.

Luigi: The United States are a major player. So, they should not compete with Ireland. They should not try to reach the Irish tax rates. But, we are in a competitive world. And you might want to discuss whether you want to change this at the global level, but good luck, because before the United Nations will decide this will be before your grandchildren are dead. But, I think it is important for the United States to understand that as you said, they should go gradual. I think that maybe this tax reform has been too aggressive in cutting corporate tax rates.

Kate: I don’t know why you’re so pessimistic about the prospect of international coordination on tax reform. I mean, yes, there is a premium to locating in the United States. It’s not like the corporate tax rate in the US is ever going to go to zero. But, you could imagine a world in which there is all of a sudden this fierce race to the bottom. Where a bunch of countries are competing with each other, just to keep cutting their corporate tax rates to attract more investment, and more jobs. This seems to me like a really dangerous negative spiral. And we should be coordinating on this issue the same way that we should be coordinating on environmental issues.

Luigi: We should definitely consider that. But, we are in a world in which we are competing on taxes. And my lack of faith in coordination derives from the European experience. In the European Union, allegedly, they have a way to coordinate at the European level. In spite of that, Ireland is playing the deviant with just a 12.5 percent tax rate.

Even within a union, or an alleged union, you can’t get this done. Imagine across countries that have no institution in common except maybe the United Nations.

Kate: Actually, this raises a good point, this kind of reminds me of Switzerland back in the ’70s and ’80s, when the Swiss bank account was a way for rich people to essentially just hide their money. That eventually ticked off a lot of US authorities, so we started trying to ask them whether they would share information with the IRS about who had bank accounts in Switzerland.

Of course, they didn’t want to do that because they wanted to protect their precious secretive Swiss bank account status. So, the way that we eventually got Switzerland to change the rules and start reporting these accounts to the IRS was to be mean. Whatever banks were doing this, we stopped letting them operate here. We started imposing these harsh penalties to coming over to the US.

We could do the same thing with Irish companies that are operating in the US.

Luigi: First of all, much of that effort led to the movement of the money laundering industry from Switzerland to Singapore.

Kate: Then we should be doing it to Singapore too.

Luigi: What I’m saying is it’s not easy. I agree with you. Especially, I’m much more in favor of doing that against the money laundering industry than I am against the tax component. But, I think in a short period, we’re not going to change dramatically this. So, the right strategy for the United States, as you said, is two parts.

One is cut the rates, but not too much. And two, use a little bit more of the stick, rather than the carrot. But, from here to say that we should not do anything on the corporate tax rate front I think is too much.

Kate: Maybe a small decrease could be in order. I would have much preferred to have seen a decrease from like 35 percent to like 32 percent. Not much below that.

Luigi: I think a reduction from 35 percent to 32.5 is not going to accomplish anything. It’s going to reduce some revenues without really making doing business in America more attractive. I think that if you do, you have to do it in a significant way. By the way, this was also what Obama said. He said, “I know I’m not going to stop corporate tax inversions with a small reduction. I need to have a big reduction, where do I get the money for the big reduction?” I think that’s still a problem. One other thing I don’t like of this particular tax reform is that it creates a big hole in the budget. It will add to the debt. At a time when this is not necessary, and not desirable.

Kate: So, Luigi, when are you going to lunch with Trump next?

Luigi: He did not invite me. I’m not sure he ever will.