A Case for Higher Corporate Tax Rates

I. Introduction

Many commentators have claimed that increased international tax competition means that the United States should have lower corporate tax rates.¹ As a result, while tax scholars were broadly critical of the Tax Cut and Jobs Act, most were sympathetic to the perceived need to lower the corporate tax rate, reflected in the TCJA’s reduction of the rate from 35 percent to 21 percent.² The preponderance of voices in favor of lower rates is likely compounded by skepticism among many that a corporate-level tax makes any sense at all.³

We argue, by contrast, that too little attention has been paid to factors that favor higher rather than lower rates. Some of the reasons favoring higher rates are long-standing, but others, which we focus on here, result from structural changes in the American economy and the corporate tax itself over recent decades.

Our case for higher corporate tax rates goes as follows: Entity-level taxes,⁴ like the corporate tax, are well suited to target the supersized returns that accrue to capital owners when their companies enjoy market power or other non-reproducible advantages. Hitting these supernormal returns — usually known as “economic rents” — is a sweet spot because taxing them is likely to be both economically efficient⁵ and distributionally progressive.

Two big changes mean that corporate taxes increasingly target rents, militating in favor of higher rates. First, shifts in the legal structure of the corporate tax, alongside subtler changes in the composition of American business investment over the past few decades, have focused the existing corporate tax on economic rents. In particular, the U.S. corporate tax has come over time to resemble a cash flow tax, under which all business investments can be immediately deducted from taxable income, in contrast to the historical norm in which investments could be deducted only gradually over time.⁶ Immediate deductions are appealing to businesses because they would rather reduce their taxes today than in the future. These changes have been criticized as corporate giveaways by progressives,⁷ but we instead celebrate them for making the tax more efficient and thereby allowing higher rates.

In particular, economic theory implies that a cash flow tax raises considerable revenue by taxing economic rents at the statutory rate without discouraging efficient investments.⁸ The reason is that, for investments without rents, the subsidy implicit in deductions at the time of investment essentially nets out with the taxes on income from the investment, resulting in a net tax rate of zero. Because the tax rate is zero, investors will make all the investments in projects without rents that they would make if there were no taxes. This in turn means that investors will still make even more appealing investments — those with rents — even though the government collects substantial tax revenue from those rents. Modest additional reforms could conform the corporate tax even more closely to a cash flow tax. These reforms include providing a more generous treatment of tax losses as well as structures and inventory, while ending the forgiving treatment of interest under the current code.⁹ These changes would further sharpen the corporate tax’s focus on economic rents and make higher rates less distortive.

Second, a variety of empirical work suggests that economic rents play an increasing role in the American economy, partly because of growing market power.¹⁰ The rise in economic rents is therefore another reason to look again at the potential of the corporate tax. Properly structured, this tax can both efficiently raise revenue and combat behaviors — like lobbying governments to get or maintain economic dominance — that can give rise to rents in the first place and cause their own ill effects.

These arguments help answer a major question in taxation — why we should have corporate-level taxes (or, more precisely, taxes on business entities, to which these arguments equally apply¹¹) at all, beyond administrative convenience.¹² These taxes make it feasible to tax economic rents accruing to capital at higher rates than the ordinary returns to capital (or labor income).¹³ As a matter of both equity and efficiency, this entity-level tax is likely to be desirable. Taxing rents likely distorts economic activity less than taxing labor income or the ordinary returns to capital, and thus efficiency counsels taxing rents at higher rates. Likewise, taxing rents likely has very progressive distributional effects.

Moreover, a corporate tax could raise significant additional revenue with higher rates. We estimate below that the government would be levying from a huge tax base — at least $900 billion per year — even after further focusing the tax on rents.

Our argument for higher rates is not a slam-dunk, however. After we make our prima facie case for higher rates, we review the arguments favoring lower rates and discuss problems with cash flow taxation in the real world, as well as how these problems might be ameliorated. The most prominent factor favoring lower rates is the international mobility of profits, business activity, and corporate residency. However, given the brief length of this report, we mostly put this essential issue to the side, because it has been extensively discussed elsewhere.¹⁴ Instead, our argument is an important, but partial, counterbalance to the debate, which has overwhelmingly focused on international mobility. And, in considering the relative importance of domestic considerations, it is important to keep in mind how much revenue the corporate tax can raise despite these international concerns. Even with international mobility and a 35 percent rate that exceeded that of much of the world, the U.S. corporate tax still raised more than $300 billion annually before the TCJA came into effect.¹⁵

Although we don’t present an unblemished case for higher rates, the question of the right corporate tax rate remains critically important. This is especially true given the widespread desire among Democrats to repeal the TCJA; any such repeal requires taking a position on what the new rate should be.¹⁶ Even under the new 21 percent rate, the corporate tax raised more than $200 billion of revenue last year, with the potential to raise much more.¹⁷ And let’s state the obvious here: We need the money if it can be raised efficiently and fairly. Even before COVID-19 hit, the United States was running a deficit of about $1 trillion per year, which is projected to increase in the medium and long run.¹⁸ Of course, there are strong reasons to not raise taxes during a severe recession, but — once the most urgent period is over — higher corporate taxes could be offset by lower taxes elsewhere or, if needed, pay back some of the borrowing undertaken to combat the recession spurred by COVID-19. Moreover, there remain many worthy investments the government could make that remain unfunded.¹⁹

Our goal in this report is to provide policymakers trying to make Americans better off with a missing piece of the puzzle: There are good reasons for having higher corporate rates. We are not wedded to a conclusion about the right rate, but rather to the idea that the arguments favoring lower rates (and dominating the current discussion) are incomplete. Instead, we also need to grapple with the factors that have changed in favor of higher rates.

II. The Case for Higher Corporate Taxes

Two important but overlooked changes favor higher corporate tax rates. First, changes in the structure of the corporate tax, reinforced by changes in the nature of business investment, have made the tax more efficient. Second, evidence suggests that there has been a significant rise in economic rents, which are non-distortionary (and, indeed, perhaps beneficial) to tax.

A. Corporate Tax Has Become More Efficient

The prima facie case in favor of raising revenue through high capital taxes at the entity level is straightforward if the tax is levied through a cash flow tax. Under a cash flow tax, businesses can immediately deduct the costs of purchasing long-lived assets, like equipment and structures. Under a standard “income tax” (a term of art here), in contrast, these expenses would need to be capitalized and thus deducted only over time as they depreciate in value. Taxpayers, of course, prefer immediate deductions to capitalized expenses because they can reduce their tax liability sooner.

For a risk-free investment, companies receive two types of returns. The first is the normal return. The normal return is the premium that savers demand in exchange for forgoing current consumption and instead allowing their savings to be used for investment. Thus, the normal return is the amount that a company must pay to obtain capital from savers to fund its investments. The second is the “supernormal” return to capital, also known as economic rents. Economic rents are payments to a factor of production that exceed the return necessary to induce the contribution of that factor. This factor could be labor, land, or capital, but here we’re concerned with capital. For example, if a company borrows $100 to invest, paying a 3 percent interest rate, and it gets returns of $110 the next year, its rents are $7: It pays back the $100 loan and the $3 of interest, and has $7 of rents to spare. And a result that will be crucial going forward is that, if the rent had been only $6, or $1, or 1 cent, the company would still have made the investment, since it still comes out ahead after paying the interest.

We have long known that cash flow taxes levied on business entities exempt the normal return to capital from taxation.²⁰ With a cash flow tax, the government effectively becomes an equity partner in the venture, giving the company part of the capital it needs upfront in exchange for a share of the future profits (through taxes). The cost to the government of providing that capital is the opportunity cost of forgoing other investment opportunities, which is the normal rate of return.²¹ If the normal return is all that the government recovers when it taxes the profits, then it’s really just getting paid back exactly what it provided, and the company is effectively untaxed. And (putting aside market failures) untaxed companies produce efficient amounts of investment. Thus, by exempting this normal return to capital, a cash flow tax leaves companies investing the efficient amount, even at high rates. Importantly, however, if the company earns rents, a cash flow tax still hits those rents at the statutory rates.

An example, summarized in the table, may clarify things. Take a company that has $300 of taxable income when the corporate tax rate is 40 percent. If the company does nothing else, it’ll owe $120 in taxes ($300 * 40 percent). Under a cash flow tax, if the company invests $100 in Project A, it can take an immediate $100 deduction, leaving it now with $200 of taxable income and $80 of tax owed. Note that nothing would change economically if the government collected the full $120 tax originally owed and then mailed the business a $40 check labeled “Government investment in Project A.”²² Thus, the company has to put up only 60 percent of the cost of the project, with the government putting up the other 40 percent. In return, however, the government collects 40 percent of any returns from the project, just like an equity investor.²³ So, as shown in column (i), if Project A lasts one year and earns the normal return (3 percent), that means it’ll be worth $103 at the close of the project, with the company owing the government $41.20 ($103 * 40 percent). The government put up $40 and got $41.20 back — which might sound good for the government and bad for the company — but effectively, the government didn’t raise any tax. This is easiest to see by imagining the government borrowed the $40 at a 3 percent interest rate at the outset to fund the “check” it sent. At the end of the year, it has $41.20 and owes its lenders $41.20 ($40 + $40 * 3 percent). As a result, the company is effectively untaxed on projects earning the normal return.

However, if Project A also earns rents, the story is different, as shown in column (ii). Suppose that the project yields $110. The government now collects $44 ($110 * 40 percent), leaving the government with $2.80 after paying off its lenders. Notice that this is 40 percent of the $7 of rents earned by the company.

Example of Cashflow Taxation of Projects Without and With Rents

	(i) Without Rents	(ii) With Rents
Year 1:
(1) Cost of Project A	-$100	-$100
(2) Change in tax collected Row (1) * 40% tax rate	-$40	-$40
Year 2:
(3) Return on investment	$103	$110
(4) Rent	$0	$7
Total:
(5) Value in year 2 of year 1 tax reduction Row (2) * 1.03 (because of 3% interest rate)	-$41.20	-$41.20
(6) Change in year 2 tax collected Row (3) * 40% tax rate	$41.20	$44.00
Effective government tax collection
Row (5) + Row (6)	$0.00	$2.80

Thus, for projects that earn rents, becoming a full equity partner is valuable to the government: It raises a tax on the economic rents (here at a 40 percent rate). The government earns enough to cover the costs of its initial investment and captures some of the project’s upside, which takes the form of rents. Importantly, however, the government raises the money without discouraging companies from making any efficient investments. Recall that a company already engages in the efficient level of investment, as long as it gets back the normal return. Everything beyond that is just gravy, and taxing it won’t distort the company’s incentives.

A tax that raises revenue only from economic rents is extremely attractive. A true rent is such a good return that investors will choose to invest in it even with a very high tax rate. As a result, these returns are not sensitive to marginal tax rates. Because a normal return is sufficient to induce an investor to invest, the loss of any return above that (the rent) will not discourage the investment. Thus, a tax that hits only these excess returns is extremely efficient — indeed, as efficient as a lump sum head tax²⁴ — and thus, under some assumptions, will have an optimal rate of nearly 100 percent. That is, a cash flow tax on rents is a way of raising revenue essentially without economic costs — a remarkable result, the complications of which we return to later.

Thus far, we have considered a project with a known return. But these results stay the same when projects are risky. Savers demand higher returns for investing in projects whose risk cannot be diversified away. In the same way that the government can invest in a risk-free venture, it can also invest in a risky venture. It just has a higher opportunity cost when it picks the risky venture because the government could also invest in another higher-risk, higher-return opportunity. So only the rents are not part of the cost to the government of investing, and thus are a return above and beyond what it cost the government to invest in the first place.²⁵

Recent changes in tax law and investment patterns have brought business taxes closer to the cash flow tax ideal. First, regarding changes in tax law, in 13 of the 15 years before the TCJA, the code offered bonus depreciation, allowing companies to immediately deduct a large proportion of the cost of purchasing long-lived equipment.²⁶ The TCJA goes further,²⁷ allowing the immediate deduction of the full costs of purchasing equipment, precisely as a cash flow tax would.²⁸

Second, changes in investment patterns have increasingly moved the corporate tax toward a cash flow tax. The tax code has always allowed for the immediate deduction of most kinds of self-developed intangible capital (for example, employee training, long-range planning done by executives, advertising, and so forth).²⁹ This type of investment makes up a substantial and increasing share of business investment. Consider the increasing importance of intellectual property produced by (usually) immediately deductible salaries paid to workers, versus the declining importance of machines in factories. One estimate is that intangible investment has risen from 30 percent of total investment in the 1970s to 60 percent today.³⁰ As a result, the corporate tax already looked quite a bit like a cash flow tax even before considering the full expensing of equipment provided by the TCJA.³¹

The net result is that the corporate tax now resembles a cash flow tax. Indeed, the size of the corporate tax base has converged to that of the cash flow tax base over time. The figure shows our estimates of the actual corporate tax base (in dark bars) and the corporate cash flow tax base (in light bars). As is clear from the figure, whereas the two bases were quite different in the 1970s, more recently, the size of the bases has been essentially the same.³² Although the current tax base could be both over- and underinclusive relative to a cash flow tax, these data show quantitatively what our description of the history of the corporate tax suggested: The size of the current corporate tax base is close to the size of the cash flow tax base.³³

One might worry that as the corporate tax comes to mirror a cash flow tax, it will become more efficient but cease to be an important source of revenue as we shrink the tax base by adding lots of new deductions. We don’t find this to be true. The money we could raise from a corporate cash flow tax is large, with a likely tax base of about $900 billion today solely from domestic operations.³⁴ The figure shows this result graphically. Over the past half-century, the cash flow tax base has always been at least 5 percent of GDP. And, if anything, the corporate cash flow tax base has risen over time: from about 5.4 percent of GDP in 1970-2001 to about 6.4 percent in 2002-2013.

To be clear, nothing in our argument suggests that there should not also be taxes on the normal return to capital at the shareholder level. We merely argue for a higher rate on corporate cash flows than on the normal return, because the corporate cash flow tax approximates an efficient rents tax.³⁵ If we were to fully convert the corporate tax into a cash flow tax, the normal return to capital (invested in corporate equity) would be taxed only through shareholder-level taxes on dividends and capital gains. Rents, by contrast, would be taxed at both the corporate and shareholder level, and thus at a higher rate.³⁶

B. Rising Rents

A second important change favoring higher rates is a significant rise of rents in the U.S. economy. Indeed, these rents are what allow a cash flow tax to raise significant revenue. Because taxing rents is not distortionary and is perhaps even beneficial since doing so reduces rent-seeking behavior, this shift presents a golden opportunity for raising high revenue at a low efficiency cost.

Economic rents can accrue to capital providers for a variety of reasons, any of which are efficient to tax.³⁷ Even in competitive industries, companies with lower costs — for example, because of an advantageous site unavailable to other companies — earn economic rents. We focus here more on rents earned through monopoly or other market power. Rents attributable to market power are signals of a loss of economic efficiency. Because the company with market power charges a supercompetitive price, too few units are sold, leading to inefficiency.

Evidence increasingly suggests that the U.S. economy suffers from growing rents,³⁸ whether because of larger network effects and other returns to scale,³⁹ increasing industry concentration,⁴⁰ increases in common ownership,⁴¹ reduced antitrust enforcement,⁴² or other factors. The rise of intellectual property and other intangible investment has helped move the corporate tax toward a cash flow tax and, at the same time, plays an important role in the many explanations for increasing rents.

An economist’s instinctive answer to a rise in economic rents attributable to market power is that antitrust enforcement should be increased to make the industry more competitive or that public utilities-type regulation be imposed to restrict prices to the competitive level. If these strategies could be perfectly implemented, this is the first-best solution: These actions reduce the price to the competitive level, eliminating the social loss from market power. Taxing these rents, by contrast, affects the distribution of the monopoly profits but does not eliminate the efficiency costs of market power. Nevertheless, in the real world in which antitrust enforcement is imperfect, taxing rents may be a good option alongside antitrust.⁴³ Indeed, as Reuven S. Avi-Yonah has pointed out, the modern corporate tax was enacted in the early 20th century in part as an anti-monopoly tool.⁴⁴

In particular, companies with powerful network effects⁴⁵ or positive returns to scale⁴⁶ may limit the usefulness of traditional antitrust remedies like breaking up dominant companies and, to a lesser extent, even blocking mergers. If the returns to scale or network effects are large enough, breaking up the company can make consumers worse, rather than better, off. Put differently, a productively efficient monopolist that can take advantage of scale will charge less than a bunch of competitive but productively inefficient small companies. This issue of “natural monopolies” is not new. Traditionally, these kinds of companies are regulated as public utilities with regulators trying to set the price charged at the competitive level. It is outside the scope of the report to consider whether regulating technology companies like Google or Facebook like a public utility⁴⁷ or generally stepping up antitrust enforcement are good ideas; for now, we just note that current competition policy appears to allow broad potential scope for earning rents.⁴⁸

Thus, a rents-focused corporate tax with a high rate may be a good option to raise revenue and provide for a more progressive distribution of those rents than in the absence of the tax. In terms of efficiency, although it does not combat monopoly pricing, the tax avoids some of the problems created by either antitrust or economic regulation.⁴⁹ It is relatively simple to administer and does not require measuring relevant markets or directly intervening in businesses. Indeed, although the tax would leave in place the inefficiency associated with market power, it would still have its own efficiency benefits: Because the tax is highly efficient, it would allow for the reduction in other distortionary taxes.

And finally, higher taxes on rents discourage some inefficient rent-seeking behavior, such as lobbying to get laws changed to allow businesses to gain monopolies or otherwise drive out competition. If the returns to that behavior are taxed at high rates, the behavior itself should decline. For rent-seeking to be deterred, however, the rent-seeking expenses must be nondeductible from taxes. Otherwise, for the same reason that other investment behavior will not be discouraged by a tax on rents, that tax will not discourage rent-seeking behavior. But many such costs are nondeductible, such as lobbying,⁵⁰ bribes and kickbacks, fines and fees for breaking laws and regulations,⁵¹ and nonfinancial costs of rent-seeking like criminal penalties for violating antitrust laws or simply feelings of guilt or unease.⁵² So, even independent of the revenue raised from the tax on rents, such a tax has salutary effects. And as the corporate tax has increasingly targeted rents, the potential importance of this rent-seeking deterrent has increased.

Before moving on, one may wonder how the two big reasons suggesting higher rates relate to each other. In particular, if — in a simple world — rents should be taxed at 100 percent, and we say that the first reason for higher corporate tax rates is that “the corporate tax base is now focused on rents,” who cares about this second reason, rising rents? It may seem that if rents are a small part of the economy or a big part, the first reason implies that we should have a high corporate tax rate because it’s good to get (as close to) 100 percent of those rents as possible, small or large as they may be.

If readers consider the first reason sufficient for us to have made our case, we do not object. However, we think that a more nuanced analysis shows that the two reasons reinforce each other. First, although the corporate tax has moved closer to a cash flow tax focused on rents, it is not the case that the corporate income tax purely targets rents, so a larger share of profits going to rents will make this imperfectly targeted tax more concentrated on rents, which we should tax at a higher rate. Second, given this imperfect targeting and the effect of taxing rents on discouraging rent-seeking, greater rents mean more benefits from higher rates. Third, policy changes typically require overcoming political inertia and allocating scarce domestic political capital. And more rents mean that the gains to overcoming that inertia and taxing rents at higher rates are greater.

C. Other Reasons

Apart from these two changes, three other factors militate in favor of higher corporate tax rates.

1. Distribution.

Taxes levied on economic rents accruing to capital are likely to be highly progressive, because the incidence of taxes on these rents will probably be borne primarily by the providers of business capital.⁵³ The debate about the incidence of the corporate tax is old,⁵⁴ with some saying that much is borne by labor.⁵⁵ That analysis is different from ours, since it did not concern a tax on rents but rather a tax on normal returns to capital. Because a tax on rents does not change incentives on the margin, it is less likely to be passed on to other parties than a tax on normal returns, driving its progressive distribution.⁵⁶

2. Labor income masquerading as capital.

Currently, an entrepreneur or other business owner is eligible for favorable tax treatment at capital rates for what was arguably a labor endeavor. For example, Facebook CEO Mark Zuckerberg is one of the world’s richest people primarily because of his labor contribution, not because of a capital contribution with a gigantic risk premium. He now owns stock worth more than $67 billion on which he is eligible for indefinite deferral of personal taxes through the corporate form and capital gains rates if he ever realizes income.⁵⁷ Raising taxes on businesses would encourage entrepreneurs to take salaries that matched their labor contributions, equalizing taxes on all forms of labor income. Likewise, it would stop tax shelters in which individuals with sufficiently long time horizons can incorporate their businesses, retain earnings (including what should be labor income), and reduce their tax burdens. This phenomenon was common in past eras,⁵⁸ and given the relationship between the top individual rate and the new 21 percent corporate rate, it may well return.⁵⁹

3. Second-best taxes and politics.

Even if a corporate tax were not the most efficient tax, it is arguably one of the best available second-best taxes. Voters tend to believe that taxes or subsidies benefit or harm the party on whom they are statutorily incident.⁶⁰ Overwhelmingly, middle-class Americans get their income from their labor, not ownership of corporations. So corporate taxes tend to be relatively popular.⁶¹ At the same time, there is widespread resistance to the kind of redistribution through taxes on labor that might maximize welfare because people have strong intuitions that people deserve to keep a substantial share of the income that they earn, making taxing away a very large share of labor earnings challenging.⁶² Thus, at least to the extent that corporate taxation is at least as efficient (for a given level of progressivity) as directly raising taxes on labor income, this factor favors higher corporate taxes.

Thus far, we have an argument for taxing corporations on a cash flow basis at a very high rate. But the argument is not so simple; we turn next to counterarguments.

III. Potential Drawbacks

We have described several reasons to support higher corporate tax rates. But we do not want to lose sight of the arguments on the other side — favoring lower corporate tax rates — that need to be weighed against these new and preexisting reasons to support higher corporate taxes. We divide these responses into two parts. First, we briefly discuss international mobility. These concerns have been well explored elsewhere, but we briefly review them here.⁶³ Our point is not to rehash the merits and demerits of the international mobility debate. Rather, we largely put that issue to the side and focus our discussion on the domestic issues in a corporate tax designed to target rents.

A. International Mobility

As mentioned in the introduction, current thinking emphasizes international competition in setting corporate tax rates, which Section II ignored. International mobility allows companies to move activities abroad to avoid high domestic tax rates. Of course, some economic activity cannot be moved — such as activity benefiting from a natural resource or particularly advantageous location. Similarly, if a company is considering investing in a project likely to earn the normal return so that effectively no tax will be levied through a cash flow tax, companies would not seek to shift that project to a jurisdiction with a lower statutory rate.

But there are at least three types of ways in which companies may shift activity or profits abroad in response to a high cash flow tax. First, companies may shift more of their profits abroad without moving “real activity” (that is, employment and capital investment on the ground). Common methods are mispricing transactions between subsidiaries,⁶⁴ strategic use and mispricing of debt among subsidiaries,⁶⁵ or other accounting tricks that shift measured income from high-tax jurisdictions to low-tax ones. Another step to avoid high U.S. taxes without shifting real activity — and one with high political salience — is moving the corporate domicile abroad, known as inversion.⁶⁶ Second, even projects earning the normal return might be shifted abroad in response to a high cash flow tax, if doing so makes it easier to shift existing rents to low-tax jurisdictions. Third, some projects may have the potential to earn rents in multiple locales. For those projects, high taxes on rents encourage moving real activity abroad.⁶⁷ As a result, companies sometimes consider the statutory rate, even under a cash flow tax, leading them to potentially avoid locating rent-earning projects in a jurisdiction with a high cash flow tax rate, especially if the source of the rent is relatively mobile (for example, intellectual property).

Thus, a cash flow tax with a high rate is likely to put pressure on the tax system’s ability to contain profit shifting and inversions, and to some extent encourage multinationals to locate real activity abroad. We do not take issue with these well-worn arguments, which we take as a baseline. We merely wish to note important arguments pointing in the other direction. We also discuss potential reforms to limit these pressures in Section IV.

B. Domestic Taxation Issues

1. Inability to provide full refundability.

Under the theory discussed in Section II, a cash flow tax does not distort investment decisions if, at the time of the investment, companies are provided a tax benefit whose value matches the tax rate multiplied by the investment amount. So if the rate is 21 percent, and a company invests $1,000, the company must receive a benefit from the government upfront of $210. If the company has positive net income, a deduction works fine. But if the company is in a loss position, receiving a deduction of $1,000 will have a present value of less than $210 because the government does not refund the loss; instead, the company is only allowed to deduct the loss against income in future years.⁶⁸ Indeed, the leading study suggests that these net operating losses are worth only about 50 percent of their face value because they are not indexed for interest or inflation, and the company may never earn enough taxable income to use them.⁶⁹ Further, the absence of full refundability also threatens the neutrality of taxes nominally falling on the return to risk. This problem would be exacerbated by a cash flow tax at a high rate because the government would tax the upside when projects succeed but not fully refund losses on the downside when projects fail. Companies facing a regime with high rates and low-value NOLs may avoid risky projects that, even after adjusting for risk, have a higher pretax net present value, thus raising the social cost of taxes.

2. Distorting organizational form.

Applying a full cash flow tax at a relatively high rate to C corporations without changing passthrough taxation would provide an incentive for companies to organize as passthroughs, unless they need access to public securities markets. In some ways, this would mimic the incentives before the TCJA, except more so. We believe this is less of a problem than one might at first think. Acknowledging that there has been significant erosion in the share of income earned by C corporations over time,⁷⁰ there is a relatively inelastic group of very large companies that need to access public markets and thus be C corporations.⁷¹ This can make it efficient — if we must have two different tax regimes, and there’s a reason (perhaps a political one) to have a higher rate for public corporations — to set the C corporation rate higher and use public trading as the dividing line.⁷²

A more comprehensive solution to this problem would involve unifying the regime facing all but the smallest businesses, using an entity-level cash flow tax. As noted earlier, the arguments in favor of a cash flow tax at the entity level apply to nearly all businesses, not just C corporations.⁷³ Indeed, the arguments are potentially stronger for passthroughs, which are less likely to shift projects abroad in reaction to the tax because they are less likely to be international in scope.⁷⁴ There is also some evidence that the rise in inequality is linked to the increasing use of passthrough taxation, providing further support for higher tax rates on them.⁷⁵ Further, for privately held businesses, cash flow taxation may help share risk by absorbing some of the upside and downside of businesses with few owners.⁷⁶ At minimum, there are good reasons, in addition to the administrability concerns,⁷⁷ to repeal the new 20 percent passthrough deduction in the TCJA.⁷⁸

3. Other potential issues.

Here, we briefly consider some other potential drawbacks to high cash flow taxation. First, as Lily Batchelder points out, business executives untutored in the mechanics of cash flow taxation may be attentive to the full statutory rate, acting as if they will have to pay it even if they actually effectively pay no taxes on their investments that earn the normal return.⁷⁹ Although executives may adjust over time, especially in a system with high rates and full expensing, this factor still gives us some pause. Second, in some cases, high-rate cash flow taxes may worsen agency problems within companies, reducing principals’ incentives to monitor the companies’ agents — for example, when the monitoring costs are not tax deductible (for example, at a nonprofit) but profits are taxed at a high rate.⁸⁰ Note though that this effect is limited by the fact that the cost of much monitoring, such as the wages paid at taxable companies to employees who monitor portfolio performance, is tax deductible and thus not subject to this concern. Third, the one-time introduction of this system has the potential to substantially reduce the value of business equity, which will likely be unpopular with important parts of the electorate, particularly, but not limited to, retirees and soon-to-be retirees, who hold large amounts of this equity as savings. If the policy is revenue-neutral⁸¹ — that is, accompanied by reductions in other distortionary taxes — there could be at least as many winners as losers from the change, but an attempt to compensate some middle-income investors and retirees might well be warranted.⁸²

IV. What to Do?

Basic theory suggests that rents accruing to capital providers should be taxed at a very high rate through a cash flow tax. However, the theory has holes. What are policymakers looking at the current corporate tax to do? We argue that there are strong reasons to have higher corporate rates, especially if issues of international avoidance are further addressed and the tax is even more closely targeted at economic rents. We discuss ways to do so here. We fully acknowledge, however, that we are operating in an arena with great uncertainty — regarding both the ways to improve the corporate tax, especially to reduce international avoidance, as well as weighing the pros and cons of a higher tax rate.

A. International Avoidance

In light of the concern that higher taxes would lead to an increase in shifting profits or economic activity abroad or outright corporate inversions, Congress could adopt other measures aimed at these issues. We do not intend here to list all possible options or all the upsides and downsides of the options we discuss, but rather to show that options remain on the table for combating international avoidance.

The TCJA made substantial changes to the international side of U.S. corporate taxation, including introducing the base erosion and antiabuse tax and the global intangible low-taxed income regime. The BEAT is designed to combat profit shifting from U.S. operations of foreign and domestic multinationals by creating a minimum tax based on payments made to foreign related parties.⁸³ At a high level, the BEAT can be thought of as partly denying deductions for payments made to foreign related parties (usually subsidiaries) for rent, interest, royalties, and many services because those deductions may be inflated by profit shifting.⁸⁴

The GILTI provision is a global minimum tax that is applied to a specific tax base, after excluding a 10 percent return on physical assets, to focus on income derived from intangibles.⁸⁵ GILTI, like the BEAT, is largely designed to prevent profit shifting from higher-corporate-tax countries. It is too soon to know with much certainty how well these changes are working to limit the effective mobility of various kinds of rents under the current rate structure.⁸⁶ Increasing the statutory corporate tax rate without increasing the BEAT and GILTI rates would increase the incentive for shifting profits abroad. So, to the extent these provisions are working well, it would make sense to increase those rates commensurately with the increase in the statutory rate.

One potential broader reform might move us back to(ward) a worldwide tax regime, but with no deferral, a somewhat lower rate for some kinds of foreign cash flows, and with foreign taxes that are only partially credited.⁸⁷ As part of that move,⁸⁸ Congress could do more to restrain inversions — for example, by not allowing larger U.S. companies to invert by merging into smaller foreign companies, as under the Obama administration’s proposed toughening of section 7874, although there are questions about how effective that would be.⁸⁹ Moreover, the existence of large economic rents raises the potential gains from international cooperation on profit shifting and reduces the likelihood that international tax competition is beneficial.⁹⁰ It therefore reinforces the potential gains from the recent OECD initiative for a global minimum tax to deter avoidance, which would in turn make the use of a worldwide source-based regime more practical.⁹¹ At a minimum, as Dani Rodrik points out, international treaties could focus more on the coordination of tax rates.⁹²

Another reform would turn the corporate tax into a destination-based cash flow tax (DBCFT), under which the inclusion of revenue and allowability of deductions are determined by the location of the final sale of the good or service. Proponents of this reform argue that it would end inversions and profit shifting by changing the focus of sourcing rules to the location of customers, which is hard for businesses to manipulate.⁹³ A DBCFT may address many concerns with profit shifting,⁹⁴ but there remain potential problems, including inducing large shifts in U.S. currency (which should be proportional to the rate of the DBCFT) and treaty compliance.⁹⁵

It is also worth noting that fears over the negative effects of the United States having a higher corporate rate than other countries are sometimes overblown. Corporations locate places for many reasons, including the wages that they must pay (which depends in part on other types of taxes, like income taxes) and the benefits yielded from higher taxes, like more educated workers and better infrastructure. There is little special about the corporate tax rate as part of this bundle, except for changing corporate residency and profit shifting among locations. This reality is part of why, at the pre-TCJA 35 percent rate, the corporate tax still raised a lot of revenue — on average more than $300 billion per year in the five years before the TCJA came into effect — even without further antiavoidance measures.⁹⁶ And although debate continues over what would be most effective, many agree that more can be done to mitigate international avoidance.⁹⁷

B. Refining the Focus on Economic Rents

Policy changes can also help address a variety of concerns about how the corporate tax targets rents.

In response to the concern that imperfect loss offsets mean that a corporate cash flow tax is no longer primarily a tax on rents, the tax code could provide more generous NOLs — first undoing the less generous treatment enacted in the TCJA,⁹⁸ but then going beyond that, such as by adjusting for inflation and possibly providing interest on NOL recovery. The code could make immediate refunds easier, for example, by allowing refunds against payroll or other taxes, as the research tax credit does.⁹⁹ Or the code could simply allow the sale of NOLs, which would be akin to full refundability, although it might be politically unpopular or lead to concerns about fraud.

Most basically, expensing could also extend to structures, inventory, and the types of self-developed intangible property that are now capitalized.¹⁰⁰ Doing so would help finish the transformation of the corporate tax into a cash flow tax.

If we do move to full expensing (and probably also under the status quo), we would want to curtail interest deductions. With full expensing, allowing interest deductions can result in a negative tax rate, causing projects with negative pretax value being funded — for example, if the loan comes from a tax-exempt party that will not pay tax that corresponds to the deduction received by the loan recipient.¹⁰¹ To avoid this undesirable result, interest deductions and inclusions for nonfinancial companies¹⁰² should be eliminated in keeping with cash flow tax principles.¹⁰³

In response to the concern that entrepreneurial laborers would have their labor taxed at inappropriately high capital rates, there are two responses. First, entrepreneurs could actually receive income from their labor in the form of labor income! In other words, higher corporate tax rates could simply cause a more appropriate labeling of income. One may respond, quite sensibly, however, that small companies are liquidity-constrained, necessitating payment in equity. In response to that, the tax law could give companies, say, five years to become liquid enough to pay a higher salary to the entrepreneur. In other words, the code could give small companies five years to recharacterize income to the company as labor costs, allowing time for the company to gain more liquidity and pay a reasonable salary to entrepreneurs. If a company opts to pay these larger salaries ex post, the code could tax the entrepreneur and provide a refund to the company.

C. What Rate?

Ultimately, policymakers must decide what the corporate tax rate will be. We cannot tell them exactly what that rate should be. But we can offer both guidance and the caution that, just as we do not know, neither do those who suggest low rates largely on grounds of international competition.¹⁰⁴

If there were no issues of international competition, we would suggest high rates under a cash flow tax. For example, proponents of moving to a destination basis have argued that it would eliminate nearly all incentives for shifting profits and real activity.¹⁰⁵ If this is true — and we could also carry out the domestic reforms discussed earlier — we would suggest a rate of at least 50 percent. This is about the statutory rate that the United States had from the 1950s to 1970s, a time of high economic growth but also limited international competition.¹⁰⁶ Notably, the corporate tax was considerably less focused on rents during that period compared with today, so these high rates would probably be more efficient now than they were at midcentury.¹⁰⁷ Even though the most basic theory might imply it, we would not suggest a corporate tax rate of nearly 100 percent because the corporate tax is not — and is not likely to ever be, even after further honing the tax — a tax purely on rents because of the concerns about nonrefundable losses and distorting risk-taking, issues in conforming the taxation of what are now passthroughs, recharacterization of income as salaries, effects on entrepreneurship, agency problems, and other domestic policy design issues. Further, if we cannot tackle the domestic reforms suggested in this report, we would suggest rates somewhat less than 50 percent, even if the international side was largely “solved.”

But in fact, many of the most important issues now are international. In general, the higher the corporate tax rate goes, the stronger the intensity of profit shifting, changes in the location of real activity or who owns that activity, and incentives to invert. We could therefore keep our 21 percent rate, which is in line with or below that of most other industrialized countries.¹⁰⁸ But that decision would risk ignoring the strong reasons to have higher rates that we describe in this report. Ultimately, the right rate depends significantly on our ability to address international concerns: The better the system deters shifting of profits and real activity, the more coordination across countries there is, etc., the higher the tax rate should go. But neither we nor others are in a great position to weigh the factors.

We end with a hunch: that a sensible approach, at least if some of the international issues could be dealt with, would be to set the corporate tax rate about equal to the top labor tax rate. Doing so would at least simplify the taxation of corporations by reducing — although not eliminating — the incentive to recharacterize labor income as capital income or vice versa. Equalizing the tax on income earned through labor and corporate equity for high earners is complicated, in part because of the shareholder-level taxes on dividends and capital gains, which increase the effective rate on returns to corporate equity. However, three-quarters of corporate equity is owned by those who do not pay taxes on dividends, whether because they are owned through charities, pensions, or other tax-preferred savings accounts like section 401(k) plans or IRAs, or pay minimal taxes like foreign owners.¹⁰⁹ This reduces the importance of these shareholder-level taxes in roughly equalizing the treatment of labor and corporate equities.

V. Conclusion

Policymakers have overwhelmingly focused on how international competition means that the United States should lower its corporate tax rates. In this report, we have tried to add some balance to the debate, arguing that this conclusion is far from obvious and, in fact, that important factors point in the opposite direction — toward higher rates. We note a major tension at the heart of recent corporate tax policy: Policy and economic changes have made the tax more efficient, and further changes that we discuss could make it more so. All else equal, that efficiency justifies a higher rate, yet the rate has instead decreased considerably. At the same time, the increase of rents in the American economy further justifies higher rates. We cannot say what the optimal rate is; in particular, there are major unresolved issues with international competition. We can say that recent legal and economic changes, the rise of rents, and our proposed tweaks suggest that the rate should be higher than the current policy discussion suggests.