If Democrats raise the corporate tax rate, here's what else they should do
A higher corporate tax rate comes with predictable negative consequences, but these can be mitigated
Welcome to No Withholding! This is the first issue of the newsletter. Several times a month, I’ll be sending out an opinion column on a federal tax policy issue. If you have thoughts or disagreements, feel free to chime in on Twitter or in the comments.
Many Democratic lawmakers are interested in raising the U.S. corporate tax rate. Presidential candidate Joe Biden has proposed raising the federal statutory rate to 28 percent, up from the current 21 percent. And some Democratic lawmakers are interested in bringing the rate back to 35 percent, where it was before 2017.
There’s been a lot written about whether hiking the corporate rate would be a good idea. But here, I’m interested in a different question: If Democrats are already set on raising the corporate tax rate, what’s the best way to go about it?
One option for Democrats is to increase the corporate tax rate without making any other changes to the corporate tax code. This would be simple and would accomplish Democrats’ goal of raising revenue from big businesses. But it would also come with tradeoffs. Some of the predictable downsides of a higher corporate rate (which I’ll discuss in more detail below) include:
Increasing the tax code’s bias towards debt
Widening the tax code’s preference for non-corporate businesses
Raising the tax code’s penalty on business investment
That said, each of consequences can be mitigated. Instead of enacting a standalone corporate tax rate increase, Democrats should consider the following policies to accompany a corporate rate hike:
Restrict the business interest deduction further
Eliminate the pass-through deduction (§199A)
Expand the availability of expensing for investments
I’ll go through each of these policy suggestions, explaining how they can help address some of the predictable (and, in my opinion, negative) consequences of raising the corporate tax rate.
1. Raising the corporate tax rate increases the tax code’s bias toward debt over equity.
One of the longstanding issues with the U.S. tax code is that it encourages businesses to load up on debt. This is a problem because high levels of private debt can create macroeconomic instability — and also because it’s generally bad for the tax code to arbitrarily favor certain business decisions over others.
The basic reason why the U.S. tax code is biased toward debt is 1) business are allowed to deduct most interest payments to debt-holders and 2) businesses are not allowed to deduct most payments to equity-holders.
Importantly, raising the corporate tax rate would increase the tax code’s bias towards debt over equity. When the corporate tax rate is higher, corporations’ interest deductions become more valuable, lowering the effective tax rate on debt. At the same time, a higher corporate tax rate means lower profits, raising the effective tax rate on equity.
The 2017 tax law made significant progress in reducing the tax code’s bias toward debt, for two reasons. First, it lowered the corporate rate. Second, it enacted a new version of §163(j), which restricts the ability of heavily leveraged businesses to deduct interest payments. These changes substantially diminished the discrepancy between the tax treatment of corporate debt and corporate equity - as shown by the Congressional Budget Office data I’ve put in this chart:
If Democrats are interested in raising the corporate rate, they should also take steps to ensure that the tax code’s bias toward debt does not grow larger again.
One way to do this would be by strengthening §163(j), to further restrict the deduction for business interest payments. For instance, lawmakers could lower the provision’s threshold, and could also remove carveouts for real estate businesses and auto dealers.
2. Raising the corporate tax rate would create a preference for pass-through businesses over corporations.
Many businesses in the United States are not corporations and are not subject to the corporate tax. Instead, most companies are pass-through businesses, whose taxes are paid by the business owners rather than by the business entity.
For many years, corporations were taxed at a higher total rate than pass-through businesses. But the 2017 tax act changed the game by enacting a large cut to the corporate tax rate. It also enacted a controversial provision, §199A, which lowered taxes on pass-through businesses. As a result of all these changes, corporations and pass-through businesses are roughly at tax parity, as as shown by data from the Congressional Budget Office:
Ideally, the tax code should tax pass-through business income at roughly the same rate as corporate income. A large spread between the tax rates on corporations and on pass-throughs encourages tax planning and leads to allocations of capital based on tax considerations rather than economic merit. Fundamentally, there’s no good reason to favor some businesses over others simply because of their legal form.
If Democrats are interested in raising the corporate rate, they should take steps to ensure that tax parity between corporate businesses and pass-through businesses is preserved.
One way to do this would be by repealing §199A, which was really only enacted because the corporate tax was being cut so sharply in 2017 and Congress wanted to offer something to the pass-through businesses as well. If Democrats reverse the corporate rate cut, they should reverse §199A as well.
3. Raising the corporate tax rate increases the tax code’s penalty on business investment.
Businesses spend their money on all sorts of different things: wages, rent, raw materials, and more. Most of these business expenses can be deducted fully and immediately. But one category of business expenses is not always immediately deductible — business investments such as equipment, machines, buildings, and research. This feature of the tax code creates a penalty for businesses that invest.
Raising the corporate tax rate would exacerbate this penalty on business investment. Whether or not you think that this would have a big effect on the American economy, you might still think it’s unfair. It is unintuitive that tax code should place a higher burden on businesses that build factories, purchase machines, and conduct research. This disparate treatment of businesses that make investments would become even more pronounced with a higher corporate tax rate.
If Democrats are interested in raising the corporate rate, they should take steps to ensure that this doesn’t add further tax burdens to the decision to invest.
One way to do this would be to expand the availability of immediate expensing for investments. Lawmakers could do this by 1) making 100% expensing for short-lived investments permanent, 2) expanding cost recovery for structures, and 3) reversing the provision of the 2017 tax law that would require research and development investments to be amortized beginning in 2022.
Conclusion
The tradeoffs that come with the corporate income tax have been well-known for a long time. As Democrats seek to increase corporate taxes, one approach might be to pretend that these tradeoffs don’t exist, in order to pass a standalone rate increase. But if Democrats are willing to put together a somewhat more complicated legislative package, they could mitigate some of the bigger issues that result from increasing the corporate tax rate.