There's a battle brewing on Capitol Hill over whether or not to lower the corporate tax rate for U.S. companies. History shows that lower taxes do little to help most Americans.
FORTUNE -- In a budget plan called The Path to Prosperity: Restoring America's Promise, Rep. Paul Ryan of Wisconsin earlier this week laid out proposals to slash government spending on everything from health care for the poor to retirement cushions for the elderly. It's easy to see why the Republican congressman is being praised -- if not for being big on details, then at least for being bold. America's massive debt has reached unnerving levels. And at a time when parts of Europe struggle to avoid bankruptcy, the tone on Capitol Hill has quickly switched from a call for stimulus to a battle cry for austerity.
But who will actually prosper under Ryan's plan?
One of his key proposals is to lower the income tax rate paid by corporations, from 35% to 25%, by eliminating several tax loopholes and deductions. Simplifying the tax code would certainly remove a lot of uncertainties from today's highly complex tax system. Executives have often complained that one of the reasons they've been holding off on new investments and more hiring is the unpredictable tax environment. But how will lowering the tax burden for companies that are already flushed with record levels of cash really going to make the average American better off?
Compared with other advanced economies, companies doing business in the U.S. already pay low taxes. It's true that at 35% the corporate tax rate is technically higher than most major economies. But because of loopholes and other deductions, most companies pay significantly less – so the effective rate (or the percentage of corporate profits that is paid in federal corporate taxes) is about 13% to 15%, which is relatively low even by international standards.
General Electric (GE) has been the latest poster child of this phenomenon. Although it says it will have a small tax liability for 2010, the tax burden is tiny considering it made a profit in the U.S. last year of $5.1 billion, thanks to deductions, adjustments, offshore profit centers, and a 1,000-person tax team. However legal this might be, there's something unsettling about it all, especially at a time when millions of Americans are out of work and our state and federal governments wrangle over budget cuts that include slicing funding for everything from education to public safety.
Where's the benefit?
Ryan's plan to eliminate loopholes (although the plan doesn't specify which) is needed, but what will lowering the corporate tax do?
For one, it likely won't create much more investment or create many more jobs, says Robert Lynch, economics professor at Washington College, who has done extensive research into taxation and economic development. In a 2004 study, Lynch found that firms don't necessarily relocate or expand to an area more just because it has lower taxes. What's more, while a lower tax rate reduces costs for companies and creates some positive effects on local economies, it doesn't necessarily create substantial jobs. Just take a look at South Dakota, which currently has no corporate income tax and ranks first in the Tax Foundation's Business Climate index. Even its governor acknowledges that the sparsely-populated state has had a tough time attracting household names.
Lynch says the same holds true at the federal level. What worries the economist is that any cuts to corporate taxes would take funding away from other public services such as education, new roads and infrastructure projects that companies and the overall economy might gain more from.
"Companies aren't suffering from a lack of investment funds," Lynch says, pointing to record cash levels held by America's biggest companies. "What they're suffering from is lack of profitable investment opportunities."
Even as many non-financial companies sit on an estimated $2 trillion at a time when interest rates have remained at nearly 0%, executives still aren't hiring much. Indeed, much of that capital is sitting overseas and there's a coordinated push among some of America's biggest companies to bring those funds home at lower costs. Cisco (CSCO), Apple (AAPL), Duke Energy (DUK) and Pfizer (PFE) are leading an effort for a one-year tax holiday on foreign earnings that would allow companies to repatriate money at a much lower tax rate of about 5%.
But while the idea of bringing more capital into the domestic economy sounds like a good thing, it won't likely mean much for the average American. In 2004, Congress approved a one-year tax holiday as part of a jobs package, resulting in companies bringing back $362 billion. But, as Fortune's Tory Newmyer pointed out in February, studies have shown that most of the funds went to shareholders. Even while Congress passed several rules to make sure the funds would get invested back into the companies, not very much went to research, investment or hiring.
If the cost savings from lower taxes don't go to new investments or more jobs, could they at least lead to higher wages for workers, as Ryan's plan suggests?
If history tells us anything, that's unlikely. The effective corporate tax rate has been steadily declining for decades. Corporations paid more than 49% of their profits in federal taxes in the 1950s, 38% in the 1960s, 33% in the 1970s and 25% in the 1980s. All the while, U.S. wages have been stagnant for years even as productivity has risen. Between 1989 and 2010, U.S. productivity grew by 62.5% -- far outpacing wages, which grew by only 12% during the same period, according to a March 2011 study by the Economic Policy Institute.
So what will a lower corporate tax rate do?
Needless to say, there are more than a few bumps in Ryan's Path to Prosperity.
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