Tax Analysts Blog

JCT Report Provides New Insight on Competitiveness

Posted on Feb 3, 2015

Do U.S. businesses suffer a disadvantage relative to competitors in other major economies? Usually the debate features conservatives pointing to the high U.S. statutory rate (Figure 1), while liberals focus on the effective corporate tax rate as a percentage of GDP (Figure 2).





These data are far from perfect indicators of U.S. tax competitiveness, so they do little to resolve the debate. They only reason they are so often cited is that they are readily available -- unlike more ideal measures of corporate burdens. And besides, better indicators of business tax competitiveness -- such as effective tax rates, whether marginal effective tax rates on investment for representative investments (calculated by economists) or effective tax rates from financial statements of individual corporations (calculated by accountants) -- are subject to their own problems of aggregation and interpretation.

One major shortcoming with using the data in the figures as indicators of business tax burdens stems from the fact that not all businesses are taxed as corporations and that the share of passthrough businesses may vary widely across nations. So, for example, a country may have a low corporate rate but, if it subjects all of its businesses to corporate tax, it may be less competitive than a country with a high corporate rate and a small corporate sector. Also, a country with a relatively low ratio of corporate revenue to GDP may still be taxing its corporations more heavily than its competitors if a larger portion of its business is conducted though partnerships.

JCT Passthrough Study

An unpublished study by the Joint Committee on Taxation recently made available to Tax Analysts allows us to address these potential biases in interpreting cross-country comparison of statutory corporate tax rates and ratio of corporate revenue to GDP. The October 2013 study was requested by the Democratic staff of the Senate Finance Committee in April 2012. It compares the corporate share of total business income in the United States with that of five other major economies -- Australia, Canada, Japan, Germany, and the United Kingdom. Figure 3 summarizes the major quantitative findings. It shows that Australia has the largest corporate share of total business income (81.9 percent). It is followed by Canada (74.5 percent), the United Kingdom (67.5 percent), and Japan (50.1 percent). The United States (42.1 percent) is fifth of six. Only Germany’s corporate share (34.1 percent) is smaller.



Four factors described in the report help explain why these differences exist. First, there is variation in the availability of limited liability to owners of passthrough businesses. We know that over time, the increasingly widespread and now universal availability of limited liability companies in the United States has greatly contributed to the shrinkage of the corporate share of U.S. business. The JCT report tells us that of the six countries studied, only Australia restricts the privilege of limited liability to businesses that pay entity-level tax. That probably explains why Australia has the largest corporate share of the six countries.

Second, the relative tax burden of corporate versus passthrough business will affect the choice of entity. And again, the experience of the United States demonstrates this. The 1986 Tax Reform Act reduced the difference between the top individual rate and the corporate rate from positive 4 percent to negative 6 percent. After its enactment, there was a marked shift in the choice of entity in favor of passthroughs.

Figure 4 shows the differential between the statutory corporate rate and the top individual tax rate in the six countries studied. Although it hardly tells the whole story (because the relative tax attractiveness depends on a whole slew of factors, including the tax rate on dividends, the tax treatment of capital gains, and payroll taxes), the differential plays a significant role in how businesses choose to organize themselves. Figure 4 shows that the difference is substantially smaller in the United States than in the other five countries. Excluding the United States, the differential for the group is between 13 and 27 percentage points. The differential in the United States is 3 percentage points. No doubt, this is one reason why passthrough status is more prevalent in the United States than in all of the other countries save Germany.



Third, different countries have different restrictions of ownership of entities that qualify for passthrough tax treatment. In general, the study reports that in countries other than the United States, passthrough entities that provide limited liability to owners often have significant restrictions on the number or the nationality of owners. For example, in Australia, partnerships generally cannot have more than 20 partners without incorporating. In Canada, partnerships that are passthrough entities cannot have partners who are not residents of Canada.

Finally, in other countries passthrough ownership interests generally may not be publicly traded. In the United States, however, there are over 100 publicly traded partnerships that qualify for passthrough treatment under section 7704. According to the National Association of Publicly Traded Partnerships, the market capitalization of these partnerships, the majority in industries related to energy and natural resources, was about $450 billion at the end of March 2013.

Wrinkles

It is unclear from the information in the report why Germany has such a small corporate share. Germany does provide limited liability to partnerships. And, as shown in Figure 4, the top individual rate is substantially higher that the corporate rate, as in all the other counties except the United States. One partial explanation might be that in 2007, the year for which the JCT made its estimate of the size of Germany’s corporate section, the corporate rate was nearly 39 percent (before dropping to 30.2 percent in 2008), so the tax disincentive to forming a taxable corporation was larger than it is now. The JCT mentioned two other possible tax factors that make passthrough status more attractive than corporate status in Germany: the ability of partnerships to pass through losses, and more favorable treatment of repatriated foreign earnings by partnerships than corporations.

It is important to understand the potential shortcomings of these data. Business profits are volatile, especially during the last decade. And all of these data are for a single year. So the reported corporate shares of total business income may not be representative of long-term trends. Without further analysis of additional years of data, we cannot take any conclusions drawn from the JCT study as absolute. But it is also important to remember that it is extremely difficult to make good cross-country comparisons of tax burdens, and that one year of data is far better than none. The JCT has made a prodigious effort that provides us, at a minimum, with a more nuanced understanding of differences in business tax burdens across countries.

Implications

Assuming the JCT’s numerical findings (shown in Figure 3) for single years are indicative of long-term trends, they have three important implications for the debate about the tax competitiveness of U.S. businesses.

About the competitiveness of passthrough business: More than in other countries, the United States tilts the playing field more in favor of passthroughs over taxable corporations. The excess of the top individual rate over the corporate statutory rate is smaller (as shown in Figure 4). Limited liability is more broadly available to owners of passthrough entities. And with the widespread availability of LLCs in the United States, businesses can easily attain limited liability and passthrough treatment without the restrictions on ownership in other countries.

About the competitiveness of corporate business: A simple comparison of the U.S. ratio of corporate tax revenue to GDP to the same ratio in other countries (like that shown in figure 2) leaves a biased impression of the relative tax burden on the U.S. corporate sector. As previously pointed out by Peter Merrill of PwC, the low ratio of corporate revenue to GDP in the United States compared with other countries is in part because of the relatively small share of its business conducted in corporate form (Tax Notes, Oct. 8, 2007, p. 174,). To correct for this bias, Figure 5 presents estimates of the ratio of corporate revenue to GDP, assuming all six countries had the same corporate share as the United States. With this adjustment, the United States’ corporate revenue as a percentage of GDP moves from 0.6 percentage points below average to 0.2 percentage points above average.


About the overall competiveness of U.S. business: Although the U.S. corporate tax rate is high, that rate applies to less than half of total U.S. business income. The U.S. corporate tax may be burdensome on corporations subject to the tax, but because a disproportionately large share of business can entirely escape the tax, the impact of the corporate tax on business overall is relatively small compared with other countries. To illustrate this point, Figure 6 calculates an average statutory corporate rate on all business income. This is an average rate where the statutory rate applies to taxable corporations and a zero rate applies to passthrough business. According to this measure, the U.S. corporate tax is no longer the most burdensome, but the fourth most burdensome of the six countries studied.


Read Comments (4)

robert goulderFeb 2, 2015

Very useful summary, Marty. Clearly there's a need to look beyond statutory
rates when evaluating relative competitiveness. Context is everything, as they
say.

But even if we accept that the U.S. doesn't have the least competitive
corporate tax system on the planet, isn't there still a case for making our tax
system more competitive than it currently is? Certainly the status quo can be
improved on, quite substantially one would think.

I don't view the JCT report as sayings "competitiveness is irrelevant, don't
bother chasing it." It's just saying "where we're currently at isn't all that
bad." While that observation cuts against claims of U.S. exceptionalism, it
doesn't (at least to me) negate the case for comprehensive tax reform that
lowers marginal rates.

vivian darkbloomFeb 2, 2015

This is an interesting collection of information; however, for this reader it
raises as many questions as answers.

In particular, I have difficulties in assessing the relevance of Figure 2
"Corporate Tax Revenue as Percentage of GDP". I assume that the corporate tax
revenue side of the comparison is the amount of tax collected by the IRS from
US resident corporations and non-US resident corporations doing business in the
US. However, the tax on "US resident corporations" would include any US tax
collected that is attributable to the non-US operations of such corporations
(either through branches or repatriated or deemed repatriated earnings of
foreign subsidiaries). This seems, however, inapposite to the comparison to
*GDP* which is generally a measure of only domestic production. The more
appropriate comparison might be to *GNP* even though depending on the year and
country, those measures may or may not have wide divergence.

Also, such comparisons do not take into account other important aspects of
corporate "tax competitiveness". This would include the comparative costs,
both in terms of the costs of compliance and planning and the costs of
structuring business operations in such a matter that is competitive from the
tax standpoint (in the sense that the tax burden can be reduced to comparable
levels) but, as a result, which is also non-competitive from the strictly
business standpoint. Pundits often complain about the degree of tax planning
engaged in by US multinationals. However, to a great extent, such planning,
and the cost thereof, is simply due to the need to bring them into a greater
competitive position from a non-competitive starting point.

Finally, I found Figure 6 more much more misleading than helpful and I'm
waiting to see a general media outlet cite this as evidence that the US
corporate tax system is more competitive than Australia, Canada or Japan and
nearly as competitive as the UK and Germany. It is an oxymoron to to say that
there is an "average corporate tax rate" if the income against which it is
calculated is both corporate and non-corporate business income. It is
particularly inappropriate given the fact that the very reason much US business
income is not earned through corporations in the first place is that it is
comparatively unattractive! I should think a more relevant statistic would
attempt to arrive at an "average tax rate on business income". This would
entail applying a statutory or effective tax rate on non-corporate business
income and corporate business income by applying individual and corporate
rates, respectively, and then using a weighted average.

emsig beobachterFeb 2, 2015

Marty: Why should the U.S. adopt a territorial tax to redress a competitive
disadvantage that may not exist? These charts certainly do not show that U.S.
firms are at a major tax disadvantage vis a vis firms domiciled in other
countries.

One question that usually goes unasked is: why should U.S. tax policy provide
incentives for U.S. firms to invest in foreign countries rather than in the
U.S.? The worldwide system was designed to be tax neutral -- U.S. firms could
invest in the U.S. or overseas and face the same tax rate.

I understand that adoption of a territorial tax may reduce the rate of
corporate inversions. The inversions allow the so-called permanently reinvested
earnings currently assigned to tax haven subsidiaries to escape tax completely.

Perhaps the U.S. should reduce marginal tax rates, eliminate some specialized
deductions and credits, and end deferral.

vivian darkbloomFeb 3, 2015

"One question that usually goes unasked is: why should U.S. tax policy provide
incentives for U.S. firms to invest in foreign countries rather than in the
U.S.?"

Ernsig,

The issue of international tax neutrality is difficult and conceptually
debatable. Your view of "tax neutrality" looks only at one side of the
equation. This side is known as "capital export neutrality". The other side,
however, is "capital import neutrality". Most "experts" believe that achieving
both simultaneously is not possible. Your view also seems to suggest that it
is the responsibility of the US to "correct" the lower tax rates offered by
foreign jurisdictions by imposing a "soak-up tax" on US multinationals. One
aspect of "neutrality" is that countries do not discriminate between in-bound
and domestic investors doing business within the same territory.
Non-discrimination provisions in tax treaties generally serve to enforce this.
If a US subsidiary of a US corporation is competing in, say, the UK, with a
UK-owned business, that is, in a sense, "neutral". Is it the obligation of the
US to eliminate that aspect of territorial neutrality? By failing to do so,
are they actually providing an "incentive" as you put it?

There is, I think, another issue with your point of view. It seems to suggest
that if the US companies are able to compete on equal terms in the territories
of foreign countries, that somehow detracts from the US domestic economy. I
disagree that, from a US domestic perspective, this is a "zero sum"
proposition. In fact, persuasive arguments can be made that by allowing US
multinationals to compete on equal terms abroad enhances our domestic economy.

Also,

"The worldwide system was designed to be tax neutral -- U.S. firms could invest
in the U.S. or overseas and face the same tax rate."

The "worldwide system" was never designed. If tax rates and rules were uniform
throughout the world, we would not be having this discussion.

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