This content is provided by Americans for Tax Reform Foundation.
When Japan cut its corporate tax rate in April, the United States became the nation with the highest corporate tax rate in the OECD. The current rate of 35 percent makes American businesses less competitive in the global market and clashes with America’s proud tradition of limited government. Former Massachusetts Governor Mitt Romney, the presumptive Republican nominee for president, has made reducing the corporate tax rate a central part of his tax plan.
A study by Democrats on the House Ways and Means Committee found that cutting the corporate tax rate to 28 percent would reduce the tax burden on American businesses by $717.5 billion over 10 years. While the Ways and Means Democrats believe the loss of revenue represents an argument against corporate tax reform, in reality it strengthens the case for cutting the corporate tax rate because doing so would remove some of the burdens unfairly imposed on free enterprise.
However, the Ways and Means Democrats’ study is deeply flawed for a crucial reason: it fails to account for the increase in growth that a corporate tax cut would cause. When the economy expands, everyone is better off as the economic pie grows and revenues (a fixed portion of income) rise as well.
As Congressman Paul Ryan notes in his excellent long-term budget plan, the Path to Prosperity, revenues are more closely correlated with GDP than tax rates. He points to an important 2005 study in the Journal of Public Economics entitled “Tax Structure and Economic Growth”; the study finds that a 10 percentage point reduction in the corporate tax rate increases annual GDP by 1.1 to 1.8 percentage points.
An analysis of economic projections from the Congressional Budget Office (CBO) with and without a corporate tax cut shows that the impact of a 2013 rate cut on the American economy would be dramatic. Assuming an annual increase in real GDP of 1.45 percentage points (midway between the 2005 study’s authors’ estimates), the difference in annual real GDP would reach $2.732 trillion by 2022. Over the course of ten years, the total increase in economic activity would be a whopping $13.635 trillion.
Moreover, the increase in growth generated by a corporate income tax cut would have massive effects on unemployment. The relationship between unemployment and real output is called Okun’s Law. In its most basic form, it holds that a decrease in unemployment is correlated with an increase in real GDP. An interesting formulation of this law, developed by economist Edward Knotek of the Federal Reserve Bank of Kansas City, states that the annual change in unemployment is equal to 1.20-(0.35 x annual change in real output).
This model of unemployment shows that cutting the corporate tax rate would provide a massive boost to America’s labor market. Without a corporate tax cut, the American labor market would remain mired in the malaise of the Obama recovery: the unemployment rate would stay above 8 percent for the next ten years. However, a reduction in the corporate tax rate would allow the unemployment to fall steadily and drop below 5 percent in 2020. In short, cutting the corporate tax rate would lead to full employment.
Such a significant increase in output would also lead to a growth of revenue. The CBO reasonably estimates revenue to average around 20 percent of GDP for the next ten years. Under this scenario, the annual 1.45 percent boost to GDP resulting from a 10 percentage point reduction in the corporate income tax rate would generate $2.814 trillion in surplus revenue over a ten-year period.
The gains in economic activity that would result from a ten point corporate tax cut would likely offset the lower rate and lead to a net increase in corporate tax revenue; any reduction in corporate income tax revenue would likely be insignificant. Yet even if one accepts the Ways and Means Democrats’ dubious estimates of a $717.5 billion reduction in revenue resulting directly from rate cuts and the $243 billion loss of revenue that they ascribe to “interaction with corporate rate change,” a staggering $1.854 trillion in revenue above baseline levels remains over the ten-year window. That revenue could be used to reduce other tax rates such as marginal income tax rates, which would further grow the economy, put Americans back to work, and reduce the scope of government’s intrusion into the lives of private citizens.
Cutting the corporate tax rate is a win-win proposition: it will provide a huge boost to the economy and generate surplus revenue to be used for further tax reductions. Governor Romney ought to emphasize this plan on the campaign trail, and President Obama would be wise to adopt it as well.