Keith Mack
The United States' corporate tax system is a subject of frequent debate, with significant implications for the nation's economy and fiscal outlook. The lengthy and complex US tax code can be challenging to understand, and many argue that the system needs reform. The corporate tax rate in the US has been criticized for favoring corporations and the wealthy, allowing them to avoid paying their fair share. Tax breaks, tax credits, and accounting techniques enable corporations to reduce their tax liability and shift profits to offshore tax havens. In recent years, policymakers have attempted to address these issues and curb stock buybacks, while presidents Biden and Trump have implemented changes to the tax system with varying effects on corporations.
| Characteristics | Values |
|---|---|
| Tax cuts | In 2017, the corporate tax rate was cut from 35% to 21% |
| Tax credits | Research tax credit, stock options, accelerated depreciation |
| Tax breaks | Large tax breaks for companies paying taxes from previous years |
| Tax avoidance | Use of accounting techniques to record profits offshore in countries with lower tax rates |
| Inequality | Driven by executive compensation, with corporate executives comprising a sizeable share of the top 0.1% of earners |
| Stock buybacks | Used to distribute cash to shareholders and boost executives' pay rather than investing in the business |
| Tax preferences | Stock buybacks enjoy tax preferences, including relative to shareholder dividends |
| Tax reform | Need for substantial tax reform, including global minimum tax |
| Impact on revenue | Corporate income tax represents the third-largest category of federal tax revenue in the US |
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What You'll Learn
Tax breaks for stock options
The US tax code allows corporations to claim tax breaks for stock options. Stock options are employee benefits that enable an employee to buy their employer's stock at a discount to the stock's market price. These stock options can be statutory or non-statutory. Statutory options are granted as part of purchase or incentive plans, while non-statutory options are not granted by a plan.
The tax rules concerning stock options are complicated, and the amount of stock option tax breaks claimed each year varies widely. This variation depends on several factors, including the number of stock options granted in a given year, how they are valued on the grant dates, the number of highly compensated individuals exercising options, and changes in stock prices and volatility.
The stock option tax breaks allow corporations to report smaller profits to the IRS than they disclose to shareholders and investors in their 10-K filings. This results in a stock option book-tax gap, where costs are reported differently for financial accounting purposes and tax purposes. For instance, corporations can overstate their stock option expenses, enabling them to avoid paying billions in federal and state income taxes.
The research tax credit is the most significant tax credit utilized by corporations. It is intended to encourage innovation, but it often rewards companies for research they would have conducted without the tax break. For instance, Apple, Microsoft, and Meta collectively reported billions of dollars in research tax credits from 2018 to 2022.
To address the issue of stock option tax breaks, Congress could take several actions. One proposal is to require corporations to pay a low-rate excise tax on stock buybacks, as suggested by Senator Sherrod Brown (D-OH). Additionally, Congress could enact a global minimum tax, as negotiated by the Biden administration, to prevent corporations from shifting profits to offshore tax havens.
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Tax avoidance
The Trump administration's 2017 Tax Cuts and Jobs Act (TCJA) reduced the federal corporate income tax rate from 35% to 21%. However, during the first five years of its implementation, profitable corporations paid considerably less than that due to various tax breaks and loopholes. For instance, telecom giant AT&T reported a 2.6% federal tax rate over five years, while Comcast's tax rate was 15.8%. The TCJA also introduced favourable provisions for multinational corporations, allowing them to pay a reduced tax rate of 13.125% on certain qualified business asset investments.
Corporations also use complex accounting schemes to shift profits earned in the US to countries with lower or no corporate tax rates, such as Ireland, Bermuda, and the Cayman Islands. This practice, known as "profit-shifting," reduces their overall tax liability. Additionally, tax breaks for stock options and accelerated depreciation allow companies to report lower profits to the IRS than they disclose to shareholders, further reducing their tax burden.
To address these issues, President Biden signed into law a corporate minimum tax in 2022, which aims to ensure corporations pay their fair share of taxes. Additionally, states can implement "worldwide combined reporting" (WWCR), which treats a parent corporation and its subsidiaries as a single entity for tax purposes, reducing the effectiveness of profit-shifting strategies.
While efforts are being made to curb corporate tax avoidance, it remains a complex issue that requires continued attention and reform to ensure a fair and equitable tax system in the US.
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Low effective corporate tax rates
The United States imposes corporate tax at the federal, state, and local levels. The federal corporate tax rate in the US is currently 21%, following the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, which reduced the rate from 35%. This federal rate does not include the average of corporate taxes imposed at the state and local levels.
The US corporate tax rate is now lower than the top rate in all other leading economies except the United Kingdom. Corporate tax revenues in the US as a share of gross domestic product (GDP) have been lower than the average in other leading economies, even before the 2017 reduction. In 2021, the US corporate tax revenue accounted for just 1.6% of GDP.
The TCJA also made changes to the treatment of multinational corporations and their foreign-source income. Previously, dividends distributed by foreign subsidiaries to their US parent corporations were subject to US tax with a credit for foreign income taxes paid. Now, a 10% return on certain qualified business asset investments is exempt from further US tax. Additionally, the TCJA created a new domestic minimum tax, the Base Erosion and Anti-abuse Tax (BEAT), to prevent cross-border profit shifting.
Corporations in the US can take advantage of various tax breaks and tax credits to reduce their effective tax rates further. For example, tax breaks for stock options and accelerated depreciation allow companies to report smaller profits to the IRS than they disclose to shareholders. The most significant tax credit is the research tax credit, which often rewards companies for research they would have conducted without any tax break.
Furthermore, corporations can use complex accounting schemes to shift profits earned in the US to offshore tax havens, such as Ireland, Bermuda, or the Cayman Islands, where corporate tax rates are lower or non-existent. These practices contribute to the low effective corporate tax rates in the US and have led to calls for substantial tax reform.
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Tax preferences for buybacks
Stock buybacks are a way for corporations to distribute earnings to shareholders. Before 2023, the ability to defer capital gains taxes created a tax preference for buybacks over dividends. This was particularly beneficial for companies that were less concerned with signalling long-term entity strength. The Inflation Reduction Act of 2022 imposed a 1% excise tax on buybacks, but this is not enough to eliminate the tax advantage for buybacks.
Buybacks are taxed as capital gains, while dividends are taxed as income. This means that buybacks are often taxed at a lower rate than dividends, creating a tax preference for buybacks. For example, individuals pay income taxes on dividends, which can range from 15% to 23.8%. In contrast, corporations pay a lower excise tax on buybacks, which reduces the value of their shares. This preference for buybacks is particularly advantageous for foreign investors in countries with low capital gains tax rates.
To achieve tax parity between buybacks and dividends, some have proposed implementing an excise tax that generates the same amount of federal revenue as taxes on dividends. This would involve setting the excise tax on buybacks at a higher rate, such as 10 to 12%. While this may impact companies' financial performance, it would ensure that buybacks and dividends are taxed equally.
President Biden has proposed raising the excise tax rate on corporate stock buybacks from 1% to 4%. This increase is expected to eliminate about 85% of the current tax preference for dividends over stock repurchases. It is also projected to raise $265 billion over a 10-year budget window.
In conclusion, the tax preference for buybacks exists because of the lower tax rates applied to them compared to dividends. This preference can be reduced or eliminated by increasing the excise tax rate on buybacks, which would result in higher tax revenue for the government.
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Tax incentives for innovation
US tax laws have been criticised for favouring corporations and the wealthy. President Biden's plan aims to address this by repurposing revenue from the lower tax rate on Foreign-Derived Intangible Income (FDII) to fund new tax incentives for innovation.
State governments have increasingly used tax incentives to promote innovation investment. As of 2024, 35 states offer R&D tax credits, with the top 15 states contributing 78% of the nation's total R&D expenditure in 2022. R&D tax credits are a valuable tool for state policymakers to strengthen local innovation ecosystems, address regional needs, and encourage local skills and talent development.
The Research and Development (R&D) Tax Credit is a government-sponsored incentive that rewards companies for conducting R&D in the US. It grants funding to promote internal innovation and is accessible to businesses of all sizes, with a wide range of eligible activities. The R&D Tax Credit can be combined with federal credits, and companies can instantly offset up to $500,000 per year of their payroll taxes.
However, the 2017 Tax Cuts and Jobs Act included an amendment that changed how companies are taxed for their R&D spending. Previously, companies could deduct 100% of R&D expenses annually, but the amendment spread this deduction over five years, making R&D more expensive. This negatively impacted R&D investment, particularly for domestic, financially constrained, and research-intensive firms.
The House of Representatives approved legislation to repeal the amendment in January 2024, but the Senate voted it down in July. Companies can consider reclassifying expenses to maintain R&D investment, but a long-term solution requires legislative action.
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Frequently asked questions
Yes, the tax laws in the US do favor corporations. The US corporate tax system is a subject of frequent debate, with many arguing that the laws allow corporations to avoid paying their fair share.
The federal corporate tax rate in the US is 21%. However, corporations may also be taxed at the state and local levels, resulting in a combined tax rate that can exceed 21%.
Corporations use various legal methods to reduce their tax liability, including tax credits, deductions, and accounting techniques to shift profits to offshore tax havens.
Corporate tax avoidance results in a significant loss of revenue for the government, impacting the country's fiscal outlook and widening annual deficits.
Yes, there have been proposals for tax reforms, including the introduction of a corporate minimum tax and efforts to curb stock buybacks and executive compensation.
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