Support For Lowering The Corporate Tax Rate Comes From Unlikely Quarter

https://www.forbes.com/sites/hershshefrin/2017/04/26/support-from-unlikely-quarter-for-lowering-the-corporate-tax-rate/#6780a1e2cba3

President Trump is proposing to reduce the corporate tax rate to 15 percent from its current 35 percent.  Some will be surprised to learn that not only lowering the corporate rate, but eliminating it altogether, is one of the reforms proposed by economist Hyman Minsky, whose ideas about the impact of psychological traits on financial instability have gained much attention since the global financial crisis.

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Minsky recommended eliminating the corporate income tax because it encourages companies to take on excessive debt. He made the forceful argument, which recent events have supported, that excessive leverage makes the economy fragile and vulnerable to instability. In his view, overvalued debt, not overvalued equity, presents the biggest threat to stability. Corporate debt is part of the picture, as is of course mortgage debt, student loans, and sovereign debt.

The link between corporate debt and the corporate income tax involves the tax deductibility of corporate interest payments. This is the so-called “tax shield” effect. Every dollar of interest paid reduces the corporate tax liability by the tax rate. By lowering the tax rate from 35 percent to 15 percent, the tax shield per dollar of interest drops from 35 cents to 15 cents. That drop represents a 20 cent per dollar decrease in the incentive to issue corporate debt. According to traditional corporate finance theory, a lower corporate tax rate encourages corporations to raise more external funds using equity rather than debt. Minsky’s perspective was that equity is less of a threat to economic instability than is debt.

Two issues complicate the analysis. The first issue pertains to total tax revenue. Lost corporate tax revenue not replaced by some other form of tax revenue increases the federal deficit. The second issue is that many corporations do not fully exploit tax shield opportunities. In fact, there is a phenomenon called the “debt puzzle” in which the corporations most likely to use high debt in order to exploit tax shields refrain from doing so. These reluctant corporations are the most able to withstand the shock of unfavorable events, and as a result the ones that fully exploit tax shields are the least able to withstand those shocks.

Psychological forces operate at both ends. Loss aversion, meaning the oversensitivity to potentially incurring losses, leads stable companies to hold the lid on debt, while excessive optimism and overconfidence lead fragile companies to take on too much debt. This is not the greatest prescription for financial stability.

Other elements in President Trump’s proposal are worth mentioning. Economic theory has long supported the idea of a simple flat tax. In contrast, the President’s proposal features a top bracket of 35 percent along with lower brackets of 10 percent and 25 percent.  The proposal also features eliminating the deductibility of state and local tax and the elimination of the alternative minimum tax.

If we are going to redo the tax code, why not use the opportunity to make the entire tax code simpler and fairer? There is good reason to eliminate corporate income tax altogether, make individual income tax very simple with few or no deductions, and to consider instituting a value added tax for raising revenues.