It's Official!

As of yesterday, April 1, 2012, the United States officially has the highest combined federal and state corporate tax rate among industrialized nations at 39.2%. We finally made number one and now we must face the consequences. Japan lowered their rate yesterday from 39.5% total corporate taxes to 38.01%. This is only a minor reduction; however, it’s enough to have us rethink our twenty-six year old corporate tax structure.

Thomson Reuters reported that of the 30 companies in the Dow Jones industrial average, 19 told shareholders their effective rate for their 2011 fiscal years, mostly ending December 31, was below Obama's proposed new tax rate. For the other twenty-seven companies, effective rates reported ranged from 2.7 percent to 43.3 percent. Clearly the tax breaks provided in the tax code have clearly disrupted the efficiency of the entire system. These convoluted tax breaks can cause high compliance costs—at times an estimated $40 billion per year or more than 12 percent of the revenues collected according to the President’s Economic Advisory Board.

Now is the time we start thinking about more progressive tax reform. How progressive should we be? The more I discuss the issue with fellow economists the more I realize there is a potential solution that would lower the tax on corporations, reduce complexities in the current tax system, increase opportunity for jobs and wage increases, incentivize the American population to save money which would also strengthen the dollar’s value, and create economic prosperity.  It’s time to incorporate a consumption tax.

There are several types of consumption taxes. Sales tax, for instance, is a type of consumption tax. A value added tax or VAT tax is the more popular form of a consumption tax on corporations and most commonly used among industrialized nations. Then there is something referred to as a BAT tax, or business activities tax—an idea brought to light by a corporate tax reform paper by the U.S. Department of the Treasury in a 2007. The idea behind a consumption tax is that, in its most basic form, it taxes the difference between sales and purchases (the value added). This tax occurs at every step of the process in the exchange of goods. The difference between this and a sales tax is that a sales tax is only levied on the final sale.

A consumption tax has several benefits and one major problem. The benefits are easy. It broadens the tax base which lowers the tax on saving and investment; encourages capital investment which helps spur job growth and labor productivity; and also greatly decreases the compliance costs. A consumption tax has no effect on when money is used to consume a good, thereby encouraging people to save; however, an income tax creates a bias towards spending right away to avoid higher taxation on consumption in the future. Compliance costs for firms would also greatly decrease. The Congressional Budget Office estimates that the cost for businesses of complying with a VAT with a $25,000 small business exemption would have been from $4 billion to $7 billion in 1988. As previously mentioned, these costs are currently about $40 billion annually. The major issue and concern with a consumption tax is the cost of implementing it. Implementing a consumption tax would take time, patience, and a small hit to firms during the transition period but it would be worth it afterwards.

I do not expect a consumption tax to be talked about and implemented for at least another five years, but I do believe it is worth keeping an eye on. Twenty-nine of the thirty OECD countries have VATs. The United States is the exception. In a modern world where we are trying to encourage saving and investment whilst competing globally for economic expansion, we cannot continue with a twenty-six year old tax system. The time for thinking about innovative ideas for implementing a pro-growth tax system is upon us. There are options and there are solutions, but we must be open to all possibilities.