Tax reform will be the major domestic policy issue of 2017. Although the public debate will no doubt focus on the cuts in personal taxes, overhauling the corporate tax code is economically more important. A well-designed reform of business taxes can raise productivity and real wages, increasing the quality of jobs available in the U.S. The way to achieve this is twofold.
First, lower the corporate tax rate. The U.S. taxes corporate profitsat 35%, the highest rate in the industrial world. Companies reduce their taxable profits using deductions for interest and accelerated depreciation. But the high overall rate raises the cost of capital and reduces the net after-tax return on investment in the corporate sector.
That drives money out of industrial corporations and into real estate, unincorporated businesses and foreign investments. As a result, American workers have less equipment, and older equipment, than their competitors in other countries. That lowers their productivity and therefore their real wages.
Second, eliminate the tax penalty on American firms that repatriate profits earned by their foreign subsidiaries. The current tax code penalizes American firms that repatriate profits earned overseas. An American company that operates in a foreign country pays that country’s corporate tax, and it can then reinvest the profits abroad without penalty. But if the firm brings those profits back home, it must pay the 35% U.S. rate on the total profits, offset by a credit for the foreign tax paid.
For example, an American firm that repatriates profits from a country with a 20% corporate tax would have to pay an extra 15% of the pretax profits to the U.S. That penalty explains why American companies hold about $2.5 trillion abroad—money that could otherwise be invested in the U.S. Other countries use the “territorial system” that allows companies to repatriate earnings by paying at most a very small additional tax.
On both of these points, Mr. Trump and Republicans in Congress agree. The tax plan released by the Trump campaign would sharply reduce the corporate rate to 15%. This would also effectively eliminate the penalty on repatriated profits: To use the example from above, an American subsidiary in a country with a 20% corporate tax could bring that money back to the U.S. with no extra tax. Under Mr. Trump’s plan, the $2.5 trillion that American firms currently hold overseas would be subject to a one-time 10% tax and could then be repatriated tax-free.
But something resembling the Trump plan can become law only if it is passed by Congress. It is significant, therefore, that the corporate tax changes proposed by House Republicans are similar to Mr. Trump’s. The plan announced by Speaker Paul Ryan would cut the corporate rate to 20%. It would also shift the U.S. to a full territorial system by exempting 100% of dividends repatriated from foreign subsidiaries. Profits currently held abroad would be subject to a one-time tax of 8.75% for cash and 3.5% for other profits. They could then be brought home tax-free. The two plans are clearly similar enough to permit a legislative compromise.
Critics of the Trump and Ryan plans say they would increase the budget deficit and the national debt. Since the corporate tax raises 1.8% of GDP, cutting the corporate tax rate in half would boost the annual deficit by 0.9% of GDP. But that’s true only if there are no offsetting revenue increases.
In the short run, the revenue loss could be more than offset by taxing the $2.5 trillion held abroad, since Mr. Trump’s proposed 10% tax would raise more than 1% of GDP. In the longer run, the tax cut will increase corporate capital investment, leading to higher real wages and pretax profits—and therefore higher tax revenue. Federal taxes now collect 18% of GDP. So boosting GDP over time by about 5% is enough to offset the revenue lost by cutting the corporate rate in half. To the extent that the actual growth falls short, additional steps, such as cutting tax expenditures and other government spending, would be needed.
It is difficult to know how these plans will affect individual households at different income levels. But it is a mistake to say that the benefits of cutting corporate tax rates flow only to share owners and not to wage earners. The plans offered by Mr. Trump and the GOP Congress would increase business investment in the U.S. That would raise real wages and reduce real pretax rates of return. While I cannot estimate how the resulting gains would be distributed, I can say that the conventional measures attribute too much to share owners and not enough to wage earners.
The Trump and Ryan tax plans also include major changes that would improve individual incentives by lowering tax rates, thus rolling back the sharp rise in the tax rate on high-income taxpayers that has occurred since the Reagan reform of 1986. But I leave that subject for another day.
Mr. Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, is a professor at Harvard and a member of the Journal’s board of contributors.