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Federal Business Taxation: The Current System, Its Effects, and Options for Reform

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Publication Date: November 2005

Publisher(s): Library of Congress. Congressional Research Service

Series: RL33171

Topic: Banking and finance (Taxation and tax policy)
Business (Business finance)

Abstract:

A foundation of the broad tax revisions implemented almost 20 years ago by the Tax Reform Act of 1986 was tax "neutrality" -- the idea that economic efficiency and economic welfare are promoted if the distorting impact of taxes on business and other economic decisions is minimized. Based on this principle, the 1986 act broadened the tax base and reduced statutory tax rates set forth by the tax code. In time, however, the underlying thrust of tax policy has changed. Rather than neutrality and efficiency, recent business tax legislation has been guided more by a concern for promoting investment and capital formation, and by attention to the perceived impact of taxes on the ability of U.S. firms to compete with foreign companies. Further, recent interest in fundamental tax reform has been partly stimulated by these same concerns for capital formation and competitiveness.

As 2005 closes, business tax policy is thus potentially at a crossroads, and it is useful to take stock of where the system stands, the economic effects it is known to have, and the principal options for reform. Several data series show a similar pattern in the level of corporate taxes: corporate income taxes have generally declined over the post-World War II period. At the same time, however, significant disparities in the structure of business taxes have remained, suggesting a persistence of distortions caused by the tax system: corporate-sector investment remains heavily taxed compared to non-corporate business and owner-occupied housing; debt is treated more favorably than equity; and equipment more favorably than structures.

The base of business taxation is the return to business investment; business taxes thus influence the economy through their impact on investment. In broad terms, business taxes can, at least in principle, reduce capital formation and thus impair long-term economic growth by making saving and investment less attractive. This effect, however, depends on a robust response of saving to taxes, whose presence is uncertain. Another impact is on the allocation of investment among different sectors and asset types. Here, business taxes likely distort investment decisions, reducing economic efficiency and economic welfare. In the case of equity, economic theory suggests that in the long run, the burden of business taxation is shared among all owners of capital and has a progressive effect on the tax system.

Various hypothetical alternatives exist for reforming the business tax system. One possibility is to move in the direction of the 1986 Tax Reform Act by broadening the existing tax base -- that is, by eliminating tax benefits and preferences. Another possibility -- and one that is favored by many economists -- is to adopt some form of tax integration that would eliminate the double taxation of corporate income. A third option is to adopt a form of consumption tax, under which new business investment would be exempt from tax. Either corporate tax integration or a consumption tax could improve economic efficiency, but only if the design were to avoid the types of distortions present in the current system.

This report will be updated only in the event of major changes in the business tax system.