Introduction

The corporate income tax has been levied on a permanent basis in the United States since 1909, when it was introduced at the rate of 1 percent. Almost one hundred years later, the U.S. federal tax rate for most corporations is 35 percent, and state taxes on average add another 4 percent tax. When corporate income is delivered to shareholders, it then faces a dividend tax. With combined federal and state personal income tax rates ranging above 40 percent for many shareholders in 2002, the overall marginal tax rate on distributed corporate income is likely above 60 percent, making corporate income the highest taxed form of income in the United States.

The high rates of taxation on capital income in the United States stand in marked contrast to the implications of optimal tax theory in the economics literature. Over the past three decades, numerous studies--including Diamond (1973); Feldstein (1978); Auerbach (1979); Atkinson and Sandmo (1980); Judd (1985, 1999); Chamley (1985, 1986); Lucas (1990); Bull (1993); Chari, Christiano, and Kehoe (1994); and Jones, Manuelli, and Rossi (1993, 1997) --have concluded that an optimal tax system in most cases will not include a tax on capital. Judd (2001) provides a useful intuition for the result. A capital tax introduces a distortion into an economy, a distortion that "explodes" over time. Hence, even a small capital tax will not be optimal.

When capital accumulation and economic growth suffer, it is not just high-income individuals that pay the price. Mankiw (2001) developed an interesting model that shows that this zero capital tax result is not solely a consequence of models where a benevolent social planner concerned with Pareto optimality decides on tax policy. In Mankiw's model there are two distinct types of agents: workers and capitalists. Capitalists chose the capital stock in order to maximize profits; workers supply labor. In Mankiw's model there can be a tax on capital and a tax on labor. Because workers outnumber capitalists, and the hypothesized economy is a democracy, workers effectively get to dictate the tax on capital and labor to maximize their own welfare. Mankiw shows that even in this context, workers would rationally choose to set the capital tax to zero. The intuition here is that workers are better off--their wages are higher--when the capital stock is higher, which makes workers more productive and feeds through to wages.

The U.S. income tax system is, of course, far from the optimal tax suggested by
economic studies. Yet on the personal income side, the tax treatment of owneroccupied housing, IRAs, 401(k) accounts, and various types of pensions has lowered the effective tax on some capital income, effectively moving the system in the direction of a consumption tax. It might therefore behoove tax-reform-minded specialists to focus their efforts on quantifying the economic benefits associated with corporate tax reform, since the present system appears farthest from the optimum in that arena.

Charged as we are with gazing into a crystal ball, the forward-looking thesis of this paper is that pressure for fundamental corporate tax reform in the U.S. is emerging with or without the assistance of economists. Indeed, the interaction between corporate taxation and international competitiveness has become so striking in the "casual" data that a fierce international tax competition is raging. For example, it does not take a rocket scientist to recognize that between 1991 and 2000, Ireland, which has a corporate tax rate on profits from manufacturing activities of only 10 percent, posted an average growth rate of real GDP that was almost three times the average of other countries in the European Union (EU). While the U.S. has avoided engaging in this corporate tax competition over the past decade, the positive experience of those countries that have cut corporate taxes--and negative experience of those that have not —will likely have a significant impact on the U.S. tax policy debate in the coming years. Put differently, while the high tax on corporate income makes little sense from an optimal tax perspective, it makes even less sense from the perspective of international competitiveness. When capital accumulation and economic growth suffer, it is not just high-income individuals that pay the price.

We begin by documenting the evolution of the relative position of the U.S. corporate tax system since the mid-1980s and show that the United States, mostly through inaction during the 1990s, has become one of the least favorable corporate tax climates among industrialized economies. We then turn to exploring the economics of tax competition and recent efforts to identify the areas of the tax code that have been most affected by it. We conclude with policy recommendations.

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