June 14, 2007

June 14, 2007 | Commentary on Taxes

Cutting Corporate Taxes to Save America

Prospects for the U.S. economy are bright. Inflation and taxes are moderate; interest rates are low; the S&P 500 is repeatedly setting record highs; and growth is accelerating toward 3 percent despite the housing slump. Both the Bush administration and the Congressional Budget Office forecast the economy to grow at 2.5 percent annually or better for the next five to 10 years.

So why are the stock market bulls and our international competitiveness about to take a long vacation? It's all a matter of shares.

Government forecasters analyze the share of income derived from each major category of the tax base. They divvy up total income according to taxable and non-taxable labor compensation, corporate income, sole-proprietorships, interest income and some smaller categories. Each category of income has its own effective tax rate. The tax rate on non-taxable labor compensation is zero, obviously, while that on corporate income is typically among the highest.

Because its effective tax rate is so high, the corporate income share is especially important to the receipts forecast. And here a shadow looms over the equity markets and the competitiveness of American companies.

Government forecasters expect corporate receipts to fall from current levels and not recover for five years. (See the graph below.) The explanation is mostly good news.

The recent recovery and expansion occurred in stages. First, growth in GDP resumed in late fall of 2001. Then GDP growth accelerated, but job growth remained tepid as higher productivity generated additional output. With GDP growth accelerating and job and wage growth stalled, corporate profits began to rise rapidly.

In summer of 2003, strong job growth resumed. But labor markets remained soft and so wage growth remained anemic; corporate profits continued to rise. By 2006, corporate profits reached an extraordinary 13.7 percent of gross domestic income. This compares to a 50-year average of 9.3 percent. During the 1990s the share never exceeded 9.7 percent. History and theory suggest the corporate profit share will decline toward something more consistent with the historical average.

Sustained firmness in labor markets since late fall of 2005 is leading to stronger nominal wage growth, up 4.3 percent in 2006 and faster than the best years of the 1990s. The recent bump in inflation diminished real wages gains and so the corporate profits share remained elevated. But in the years ahead, administration and CBO forecasters believe nominal wage growth will remain strong, inflation will subside, and so real wage growth will accelerate. That's the good news.

The bad news is that labor's rising income share is likely to come out of corporate profits. Corporate profits in nominal terms are forecast to be flat even as the economy expands. The flattening of corporate profits may not occur in the next quarter, but it will almost surely occur before long. Flat corporate profits means flat corporate tax receipts.

A sustained period of flat corporate earnings also implies generally flat stock prices. It also suggests American companies could be in for rough times on the international stage.

After-tax corporate profits are the mother's milk of companies investing for the future. If profits flatten, Congress will need to seriously consider cutting the corporate tax rate. At 40 percent, according to KPMG, the total U.S. corporate tax rate is higher than that of every other major industrialized country save Japan. A corporate tax-rate cut may soon be essential to sustain our international competitiveness.

High employment rates combined with solid real wage growth will be great for American workers, spreading the benefits of prosperity widely. However, the shift in income shares from the corporate sector to workers may come as an unpleasant surprise to the stock market and to our competitiveness. The effects of that surprise are likely to linger for a few years.

JD Foster is the Norman B. Ture Senior Fellow in the Economics of Fiscal Policy at The Heritage Foundation.

About the Author

J.D. Foster, Ph.D. Norman B. Ture Senior Fellow in the Economics of Fiscal Policy
Thomas A. Roe Institute for Economic Policy Studies

First appeared in the Washington Post