Tax fairness or a new unfairness

Here is an interesting idea from my friend Rob Atkinson over at ITIF: a one-size-fits-all tax code is not one-size-fit-all. In a new report, (U.S. Corporate Tax Reform: Groupthink or Rational Debate?), he points out that the push for tax simplification will actually harm economic competitiveness.

The current thinking in Washington is that the tax code impedes economic competitiveness because of high tax rates. In order to lower rates, the tax code should be "simplified", i.e. eliminate many tax deductions and credits. Increased revenues from tax simplification would offset revenues lost from lowering the corporate rate.

The other part of tax simplification is a call for fairness. Many see these tax deductions and credits (aka loopholes) as breaks for special interests. Others argue that they are expenditures in discipline, not subject to budgetary discipline.

Both of these arguments contain more than a grain of truth. I have long argued that, contrary to popular perception, the United States has long had a (dis?)functioning industrial policy: the tax code. It is a de-facto policy hidden from public (and most policymaker's) sight.

The problem with the tax code is not that it introduces economic distortions, but that we have the wrong set of incentives built into the system. The idea of a sectors or industry neutral tax code is a chimera. By the mere nature of the different businesses, a unitary tax code will impact sectors differently. Instead of the current ad-hoc system of tax incentives, we need a guiding set of principles for evaluating each incentive. One overall principle should be to provide incentives for production and investment and not for consumption. [Having said that, I recognize the need for some consumption incentives to both stimulate the economy during economic downturns and provide a boost of purchasing of certain sectors to spur innovation, such as tax incentives for purchase of alternative energy production equipment.]

Atkinson adds a new element to the discussion by showing that tax simplification would effectively raising taxes on sectors that are subject to international competition (such as steel, pharmaceuticals and electronics), while lowering taxes on non-tradable sectors (grocery stores, electric utilities and car dealers). That would have the opposite effect on competitiveness:

While the former [grocery stores, electric utilities and car dealers] provide needed services, if their taxes increase they are not going to build fewer grocery stores, electric wires, or car dealerships since those investments are largely based on levels of consumer demand. But if the taxes on steel companies, drug companies and electronics companies are raised, they will act as any rational company would by moving some production to nations that tax them less.

He argues that the tax code should be designed so that it achieves three goals:

1. Provides direct incentives for U.S.-based enterprises to invest in the building blocks of innovation, productivity and competitiveness: research and development and innovation commercialization, workforce training, and machinery and equipment (including computers and software);
2. Taxes firms in internationally traded industries at a lower rate than firms in non-traded industries; and
3. Lowers the average effective corporate tax rate from its current levels.

One of Atkinson's recommendation is a version of something he and I have been advocating for years - a knowledge tax credit:

Congress should enact an American Innovation and Competitiveness Tax credit that provides a credit of 30 percent on expenditures on R&D and workforce training and a credit of 15 percent on machinery and equipment (including software) in excess of 50 percent of base period expenditures. For business to get the full benefits from new equipment, they need higher-skilled workers. Allowing employee training expenditures to be counted as qualified expenditures for the credit would help correct the problem that workforce training in the United States has fallen by approximately half as a share of GDP over the last decade.

As I noted in my recent comment in the journal Economists' Voice ("Invest in Intangibles")(see also earlier posting), we should be focusing on incentives for investments in intangible assets as well as equipment.

I don't know if in the current budgetary climate of austerity such a tax credit is politically feasible. But it makes sense from an economic and competitiveness point of view. The issue of corporate tax reform will clearly be on the political agenda for some time. Let us hope this idea manages to get into the mix.