How Will the Tax Overhaul Affect U.S. Competitiveness?

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Introduction

President Donald J. Trump and congressional Republicans have enacted the largest changes to the federal tax code in three decades. They say that steps such as lowering rates for corporations and individuals and reforming the taxation of foreign profits will boost the U.S. economy by increasing investment and productivity while making U.S. firms more competitive internationally. Economic analyses are divided over the likely macroeconomic effects of the tax plan, however, with some experts arguing that its impact on business decisionmaking and growth will be small and that the bill creates new incentives for offshoring. Experts also warn that the legislation will increase the budget deficit and add to the national debt, which could undermine economic performance and national security in the coming decades.

What’s the business tax landscape in the United States?

Only a small minority of businesses, known as C corporations, are subject to the corporate tax rate. Other forms of business organization—sole proprietorships, partnerships, S corporations, and limited liability companies (LLCs)—are known as pass-through businesses for the purpose of taxation. This is because, rather than paying the corporate rate, their business income passes through to the firm’s owner, who is taxed at the individual rate.

The role of C corporations in producing business income has declined in recent decades as pass-through businesses became more common, lowering their contribution to tax revenue. Currently, C corporations make up about 5 percent of total businesses in the United States, though they account for nearly forty percent of all business income.

What are the major tax changes for U.S. businesses?

It cuts the corporate rate. The rate for C corporations is reduced from 35 percent to 21 percent.

It largely ends the taxation of foreign profits. The bill shifts the United States from a worldwide taxation regime, in which U.S. companies are taxed on their global income, to a territorial system, in which earnings abroad are exempted, though the legislation introduces a minimum tax on some forms of foreign income. This aligns the United States more closely with other developed countries, most of which operate under a territorial system.The plan also imposes a one-time repatriation tax of up to 15 percent on companies’ currently tax-deferred foreign profits.

It gives pass-through businesses a large deduction. The legislation allows owners of certain pass-through firms to deduct 20 percent of their income. Most U.S. businesses are pass-throughs, in which owners are taxed at individual rates, which are generally much higher than the new corporate rate.

It allows for immediate expensing of capital expenditures. The legislation allows for the full up-front cost of capital investments to be deducted; the previous system required such deductions to be spaced out over several years. Some experts believe this will spur business investment.

It cuts the individual rate. The plan reduces individual income tax rates for most brackets, lowering the top marginal rate of 39.6 percent to 37 percent. It nearly doubles the standard deduction but eliminates many other deductions. Most changes to the individual rate are temporary, set to expire at the end of 2025 if they are not renewed.

What are the expected budgetary effects of the legislation?

The nonpartisan Congressional Budget Office projects that the tax code changes will add some $1.5 trillion to the federal deficit over the next ten years, not accounting for any macroeconomic effects the legislation could have over that period. As a point of contrast, the 1986 overhaul of the U.S. tax regime, signed by President Ronald Reagan, was deficit neutral.

What are the expected effects on growth?

Analyses from think tanks, academic economists, former policymakers, and research firms provide a mixed view of the likely effect of the tax bill on growth domestic product (GDP) growth. Some economists argue that such steep tax cuts inherently boost growth, and they credit Reagan’s 1986 reforms with boosting the economy and leading to a decade of more than 3 percent growth. A group of prominent economists who support the legislation argued in a November 2017 letter [PDF] that the current measures would have similar effects.

Many leading economists, however, including those in a recent University of Chicago survey, think that the administration’s claims about economic growth are overstated. The pro–tax reform Tax Foundation agrees with the White House that cutting taxes will raise growth, but their analysis finds the plan would increase GDP by an average of 1.7 percent a year over ten years. The more skeptical Tax Policy Center sees a smaller effect, finding an average boost to GDP of 0.42 percent a year over ten years. The Penn Wharton Budget Model, a nonpartisan public policy initiative, finds that U.S. GDP in 2027 will be between 0.4 and 0.9 percent higher as a result of the legislation.

How do proponents say the measures will improve U.S. competitiveness?

Proponents of the tax law, known as the Tax Cuts and Jobs Act, predict a number of economic benefits.

• The U.S. corporate rate of 35 percent was previously the highest among developed economies, which some economists say put many U.S. businesses at a disadvantage in competition with international firms. Reducing the statutory rate to 21 percent, proponents of the legislation say, will ease corporations’ tax burdens and allow U.S. firms to drive more revenue back into their businesses, hiring new workers, making capital investments, and the like.
• Supporters say that a lower corporate rate, combined with other measures in the bill, lowers the cost of capital investments, encouraging U.S. firms to invest and hire domestically.
• They also argue that lowering individual income taxes through 2025 will incentivize work and increase the labor supply.
• President Trump and his congressional allies say that a one-time tax holiday on foreign profits will lead large U.S. multinationals that have kept trillions of dollars in profits abroad to avoid U.S. taxes, including Apple, Starbucks, and General Electric, to repatriate that money and invest it domestically. Up to now, the United States has only collected taxes on firms’ foreign earnings when they are brought back to the United States.

What are the main criticisms of the plan?

Many economists are skeptical that corporate competitiveness hinges on tax rates. The United States neither can nor should match foreign jurisdictions that have extremely low or nonexistent tax rates, some argue, and policymakers should be wary of a “race to the bottom” in global taxation.

• A major concern of many economists is the projected increase in the budget deficit, especially with entitlement commitments, notably Medicare and Social Security, increasing and interest rates rising. It is a dangerous time to increase the U.S. debt, which has surpassed $20 trillion in total, they say. Some experts are concerned that growing costs of debt service could impinge on critical defense spending.
• Many experts warn that it is difficult to gauge if a lower corporate rate will improve U.S. firms’ competitive position, or whether it will incentivize more investment and hiring, given the many other intervening factors, such as the elimination of deductions and the fact that many companies already pay much less than the statutory rate.
• Some experts worry that the shift to a territorial tax system could encourage the offshoring of production, investment, and employment for tax-gaming purposes. Many jurisdictions, from Ireland to the Bahamas, have much lower rates than the new 21 percent rate, and anti–tax avoidance measures included in the legislation to discourage this, such as a tax on “intangible” foreign income, such as that from intellectual property, don’t go far enough, they say.
• Many analysts are skeptical about the purported benefits of the one-time tax holiday on foreign profits. U.S. companies are already booking record profits that they could use for investment. A 2017 Bank of America survey of more than three hundred large U.S. companies found that the vast majority plan to use the tax holiday to pay down corporate debt, carry out share buybacks that reward investors, or complete mergers, rather than make investments.
• Tax experts say that the new rules provide new opportunities for taxpayers to game the system, lowering tax revenue and likely creating economic inefficiencies. Some individuals will now be incentivized to incorporate as C corporations to take advantage of the lower rate, while others will opt to create pass-through businesses to pay rates much lower than they would on their individual income.

How will it affect different industries?

Tax experts say companies that do most or all of their business within the United States and aren’t able to move their operations abroad are likely to see the biggest boost. This is because such businesses have been subject to the full corporate rate, while large multinationals that can shift their production to other countries have already been paying much less than the new 21 percent level. Apple, for instance, pays as little as 2.5 percent on its foreign revenues by shifting most of its accounting to Ireland and other low-tax jurisdictions, according to CFR Senior Fellow Edward Alden.

Thus, analysts believe that retail, domestic manufacturing, transport, and some domestic service industries will benefit the most. According to research by PricewaterhouseCoopers, retailers pay the highest average tax rate of any industry, and so they stand the most to gain from a lower rate. The National Association of Manufacturers, a lobbying group, also sees both a lower rate and a new tax break for capital investments as making the manufacturing industry more competitive globally, with a majority of its members saying the tax changes will allow them to increase investment and hire new workers.