The dynamic economic effects of a US corporate income tax rate reduction

The U.S. corporate income tax system has not been changed significantly since the much celebrated Tax Reform Act of 1986 (TRA86). In the interim, most countries have dramatically reduced their statutory corporate income tax rates below the US rate, prompted in large part by the inexorable forces of globalization and increasing international tax competition (Zodrow, 2008). The U.S. statutory corporate income tax rate is now the highest in the world among the industrialized countries, sparking concerns about the extent to which the tax system makes it difficult for the U.S. to compete successfully in the modern world economy. These issues were the focus of a recent comprehensive report prepared by the U.S. Treasury (2007) entitled Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century.

Such concerns have prompted calls for reform, ranging from dramatic changes in the corporate income tax system to replacing the income tax system with some form of consumption-based taxation. This paper focuses on one such reform—a reduction in the statutory corporate income tax rate. Of course, a reduction in the corporate tax rate would have to be financed by expansion of the corporate tax base, an increase in other taxes, a reduction in spending, and/or an increase in the deficit. The analysis considers three potential financing alternatives: elimination of a wide range of business tax expenditures, an increase in individual income taxes on labor income, and a decrease in government expenditures in the form of income transfers. Each package is designed to be revenue neutral in a dynamic sense, that is, taking into account the effects of the reform over time on saving, investment, labor supply, and other macroeconomic variables. The dynamic analysis in the paper reflects simulations of the macroeconomic effects of reform using a modified version of a dynamic, overlapping generations, computable general equilibrium model developed by Diamond and Zodrow.