Given that President Joe Biden’s administration has so much on the table for big ticket spending, lawmakers understandably are looking for ways to pay for it all. One proposal is to increase corporate tax. Some fear this would make the US an uncompetitive place to do business, but there is a way to adjust the tax to give US workers the edge.
While we don’t actually need tax hikes to fund many infrastructure ideas (since the investment brings positive returns over time), the U.S. generally needs higher taxes to fund ongoing welfare programs like child support, alleviating fears of long-term structural deficits. Because of this, Biden is now expanding the number of tax increases included in its infrastructure proposal.
The proposals include an increase in corporate tax. As my colleague from Bloomberg Opinion, Justin Fox, reports, corporate tax revenues have been falling for decades. Former President Donald Trump’s 2017 tax cuts were just the final step in rendering corporate tax revenues insignificant.
Higher corporate taxes have disadvantages. While it mostly doesn’t come out of the middle-class pockets, it tends to reduce corporate investment. This is a disadvantage at a time when businesses generally need to invest less and invest more to take advantage of the new technologies. Therefore, every corporate tax increase should be accompanied by tax exemptions – for example, accelerated depreciation allowances.
Another common problem is that a higher corporate income tax could make the US less attractive as an investment destination. The US used to have what is known as a “worldwide” tax system in which companies headquartered here pay the same taxes regardless of where they earn their money. Trump’s reform has led us to a “territorial” system where companies are only taxed on what they earn in the US. However, if US corporate taxes rise, it will be a powerful incentive for companies to move factories and offices offshore to avoid the high US rate. This is definitely not the result Biden is hoping for.
Fortunately, there is a solution to this problem as well. It’s something that Congress considered in the run-up to Trump’s tax reform, but – unfortunately – ultimately decided not to try. It goes by the awkward name of Destination-Based Cash Flow Tax (DBCFT).
This tax, conceived by Berkeley economist Alan Auerbach, would target cash flows, not profits. This would be preferable for several reasons. First, companies could spend investments when they made them, not when they devalue – a great incentive to invest! Second, it would automatically remove the tax deductibility of interest, which would cease the favor of leverage and put the financial system on a solid footing.
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Third, companies would be taxed based on where sales are made rather than where production takes place. That said, when a company makes a car in China and sells it in the US, it pays some taxes to the US instead of just China. This is sometimes called “marginal adjustment,” but it does not require any adjustment at all – it is just a natural feature of how a cash flow tax works.
Obviously, this removes a reason for companies to move manufacturing overseas and would add to Biden’s efforts to rebuild U.S. supply chains. It’s not a big deal now because corporate taxes are so low following Trump’s tax cuts, but if Biden is looking to reclaim some of that revenue, the cash flow tax would be a very useful tool in preventing US industry from eroding.
There are some legal objections to this type of tax; Some believe that doing so would violate certain arcane rules of the World Trade Organization. However, in a 2017 paper, Auerbach showed that a destination cash flow tax is mathematically equivalent to value added tax (VAT) with wage deduction.
A sales tax is like a sales tax, and cash flow is basically sales minus wages. So taxing cash flow is the same as taxing companies’ sales while deducting the amount they pay their workers.
VAT is widely used across Europe and has the advantage of being easy to collect and difficult to avoid. VAT is sometimes criticized as regressive because it affects all people equally, regardless of their solvency. Deducting wages from tax would make them progressive because when wages are tax-free, companies have an incentive to pay their workers more. And if the tax revenue were used to fund measures like child benefits, the whole package would be even more progressive.
In other words, such a package – replacing corporate income tax with VAT plus a wage subsidy – could actually be a simple sale to voters. It would allow Americans to get a raise while corporations would be taxed to support social programs. It would be a big reform, but Congress should think about it.
Noah Smith is a columnist for the Bloomberg Opinion. He was an assistant professor of finance at Stony Brook University and blogs for Noahpinion.