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Robert Pozen: What’s the Answer for Corporate Taxes?

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How do we reduce the corporate tax rate, currently at 39.1%, without adding to the deficit? That’s the question Robert Pozen tackles in an opinion piece posted to Yahoo! Finance on Tuesday. While the chairman emeritus of MFS Investments notes President Obama and Gov. Mitt Romney agree that the United States needs to cut its corporate tax rate, which is the highest in the industrialized world, he argues that any reductions should be paid for by broadening the tax base.

“Unfortunately, revenue-neutral corporate tax reform will prove very difficult for either candidate,” Pozen concedes. “Oft-mentioned tax breaks, such as those favoring hedge fund managers or green energy firms, are simply too small for their repeal to have a substantial effect on tax revenues. And both President Obama and Gov. Romney have called for the expansion of other, larger corporate tax breaks, such as the credit for increasing spending on research and development.”

Thus, Pozen adds, if either candidate wants to reduce the corporate tax rate, he will likely have to search for other revenue-raising measures.

However, he writes that one particular reform should get a “close look:” limiting the deductibility of corporate interest expense.

“Such a reform could raise a large amount of revenue and would improve economic efficiency by treating different investments more equally,” Pozen says. “President Obama has suggested this approach be ‘considered,’ as has Congressman Dave Camp (R-MI), the Chairman of the House Committee on Ways and Means.”

He notes that according to the IRS, corporations with net income paid $2.1 trillion in corporate tax between 2000 and 2009 (the most recent years with available data). During this same period, these corporations “claimed over $8.5 trillion in gross interest deductions—at a 35% tax rate, those deductions were worth almost $3 trillion.”

“Based on an analysis of data like these, I calculate that the corporate tax rate could have been reduced from 35% to 25% from 2000 to 2009, financed solely by disallowing roughly 30% of gross interest deductions. In other words, corporations would have been able to deduct nearly 70% of their gross interest expense, instead of 100% as under current law. The revenue raised from this limitation (at a 25% tax rate) would have been roughly equal to the revenue loss resulting from the rate cut.”

He adds that disallowing a modest portion of the interest deduction would also improve economic efficiency by reducing the tax code’s large bias toward debt-financed investment. Currently, corporations can deduct the returns to a debt-financed investment (interest expense), but not the returns to an equity-financed investment (dividends or stock appreciation).

“When a corporation takes on too much debt, it increases its risk of bankruptcy—an event which imposes significant costs on the corporation’s employees, customers, and suppliers.”

He concludes by reiterating that the country urgently needs a reduction in the corporate tax rate implemented on a revenue-neutral basis.

“As part of the tax package to achieve this goal, Congress should include some limits on the deductibility of corporate interest expense,” he said. “Such a limitation would raise enough revenue to allow a substantial reduction in the corporate tax rate, increasing the global competitiveness of the U.S. Such a limit would also reduce the tax bias in favor of debt by decreasing the effective tax rate on equity—without raising the average cost of capital in the U.S.”