TCS Daily

Consumption Function

By Kevin Hassett - June 12, 2003 12:00 AM

Now that the dividend tax reduction is law, Republicans are already beginning to discuss their tax plans for next year. Such a rapid change in focus is likely to become part of the landscape in Washington each June for as long as the Republicans hold power. The new Republican strategy is clearly to address a pressing tax problem each year, rather than to try to construct the mother of all tax reforms and ram it through in a single year. Each new move, however, will likely capture territory in the march toward the ultimate objective, a consumption based tax.

It is interesting to review the dividend story one last time in order to search for clues about next year's likely tax story. As can be seen in the accompanying chart, the United States began the year with the second highest tax on dividends in the developed world.

This high "double" tax distorted all sorts of behavior - inducing heavy reliance on risky debt finance, for example - and likely caused more economic damage dollar-for-dollar than any other part of our tax code. After the dust settled and the dividend tax rate was cut about in half, the combined tax on dividends in the U.S. dropped considerably compared to that in other countries. Under the new law, as can be seen in the next chart, the U.S. now has the 10th highest combined tax on dividends.

We are hardly a paradise at this point, but our head is no longer sticking out above the others.

So what is next? The next chart suggests one possible target. The U.S. currently has one of the highest corporate tax rates in the world. Because of this high tax rate, U.S. firms have a very strong incentive to locate operations (and profits) abroad. The reason is simple. If a dollar is earned by a foreign subsidiary, a firm does not have to pay U.S. tax until the dollar is mailed back home. So a little relocation abroad can save a company millions in taxes.

As can be seen from the chart, many countries have figured out that firms are so clever at locating operations and profits around the globe that it is counterproductive to have a large tax rate on corporate income. Indeed, countries with lower corporate rates have generally grown faster than countries with higher corporate rates. The dividend tax reduction is certainly part of the solution, but firms that intend to grow their operations significantly still have a strong incentive to locate their new plants overseas. If they do that, shareholders gain because after tax profits are higher, but U.S. workers suffer.

So there is already a pretty sound case that the corporate tax rate should be reduced. There is also another factor to consider. Next year, Congress and the President will have to extend the provision passed last year that allowed firms to expense a portion of their capital investment. This "expensing" provision was a favorite of consumption tax theorists, and became part of the stimulus bill because its designers hoped to eventually make expensing full and permanent. The latest dividend tax bill included a provision that made the expensing bigger, next year you can be sure that attempts will be made to extend it.

So there has to be corporate tax action anyway next year in order to keep the tax code on the path to a consumption tax, and the as-yet untouched corporate tax rate looks too high by international comparison and is a tempting target. Neither of those moves is a "big idea," but politicians generally like to save their best stuff for the campaign. Thus the odds have to be very high indeed that the main focus next year will be in this area.

What could stop such a bill? The tax reduction this year was so difficult because measures of the deficit soared and fiscal conservatives became extremely wary of additional cuts. One can be sure that the same individuals will be reluctant to extend corporate tax reductions past next year, and that they might even see political advantage in letting the debate over corporate tax cuts last until the election. After all, if deficits are high, voters will be nervous about it and tax cut opponents will tell voters that "the Republicans are bankrupting America in order to give fat-cat corporations a big tax cut."

If political strategists believe that this oversimplified argument will appeal to voters, corporate tax relief may be delayed. On the other hand, it is almost impossible to conceive of a scenario where Republicans let expanded expensing expire without a fight. Thus, the odds of a corporate tax bill being at the top of the agenda next year seem pretty good.

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