Anatomy of a Special Tax Break and The Case for Broad Corporate Tax Reform

By / 3.20.2013

Washington policymakers turn to broad tax reform perhaps once in a generation, and now may be such a time. Today’s focus is on the corporate code, the source of most of the complexity and many of the economic problems associated with the U.S. tax system. There are many views about what aspects of the corporate code require reform and how to do it. Nevertheless, a consensus has formed that the reforms should simplify the corporate code by phasing out many special preferences and using some or all of the revenues to lower the
corporate tax rate.

This consensus reflects a growing recognition by policymakers and business people of how certain features of the corporate tax code impose burdens on American competitiveness. The feature noted most often is our 35 percent marginal tax rate on corporate profits, the highest of any developed country. The impact of this high marginal rate on competitiveness is exacerbated by the worldwide character of the U.S. tax system: We apply that rate to the worldwide profits of U.S.- based companies, while all but five other nations have territorial tax systems that tax businesses only on the profits earned in their domestic markets. Finally, over many decades, policymakers have created scores of special tax deductions, tax credits and tax exemptions for designated business activities, products or industries. These provisions not only entail costly administrative and compliance burdens for the companies that use them. They also interfere with our markets’ ability to allocate capital and other economic resources to their most productive uses, leaving the overall economy less efficient and productive. Phasing out special tax preferences and using all or most of the additional revenues to lower the corporate tax rate is the most reasonable response to these issues.

Here, we offer a case study of these dynamics using one of the larger and most recently-enacted special tax preferences, Section 199 of the corporate tax  code. Since 2005, this provision has provided a special deduction for some of the profits arising from certain designated “domestic production activities.” As we will see, the provision, originally designed for domestic manufacturing, now covers an estimated one-third of corporate economic activities. For example, food processing qualifies, but not retail food businesses—unless the food establishment roasts beans used to brew coffee. That exception allowed Starbucks, for example, to cut its effective tax rate by more than 2 percentage points in 2009. At the same time, the complex terms of Section 199 limit its value to most industries and companies. So, while the provision lowers the effective tax rate of those firms that can claim it – and no one faults a company for taking advantage of a badly-crafted policy – it also induces them to channel their investment and other business decisions in the particular ways required to claim the deduction. As a result, Section 199 distorts the allocation of capital and other critical resources, including entrepreneurial activity, both within and across industries, and for the economy as a whole.

Download the policy memo.