Order Code RL33171
CRS Report for Congress
Received through the CRS Web
Federal Business Taxation: The Current System,
Its Effects, and Options for Reform
November 30, 2005
David L. Brumbaugh
Specialist in Public Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Federal Business Taxation: The Current System, Its
Effects, and Options for Reform
Summary
A foundation of the broad tax revisions implemented almost 20 years ago by the
Tax Reform Act of 1986 was tax “neutrality” — the idea that economic efficiency
and economic welfare are promoted if the distorting impact of taxes on business and
other economic decisions is minimized. Based on this principle, the 1986 act
broadened the tax base and reduced statutory tax rates set forth by the tax code. In
time, however, the underlying thrust of tax policy has changed. Rather than
neutrality and efficiency, recent business tax legislation has been guided more by a
concern for promoting investment and capital formation, and by attention to the
perceived impact of taxes on the ability of U.S. firms to compete with foreign
companies. Further, recent interest in fundamental tax reform has been partly
stimulated by these same concerns for capital formation and competitiveness.
As 2005 closes, business tax policy is thus potentially at a crossroads, and it is
useful to take stock of where the system stands, the economic effects it is known to
have, and the principal options for reform. Several data series show a similar pattern
in the level of corporate taxes: corporate income taxes have generally declined over
the post-World War II period. At the same time, however, significant disparities in
the structure of business taxes have remained, suggesting a persistence of distortions
caused by the tax system: corporate-sector investment remains heavily taxed
compared to non-corporate business and owner-occupied housing; debt is treated
more favorably than equity; and equipment more favorably than structures.
The base of business taxation is the return to business investment; business
taxes thus influence the economy through their impact on investment. In broad
terms, business taxes can, at least in principle, reduce capital formation and thus
impair long-term economic growth by making saving and investment less attractive.
This effect, however, depends on a robust response of saving to taxes, whose
presence is uncertain. Another impact is on the allocation of investment among
different sectors and asset types. Here, business taxes likely distort investment
decisions, reducing economic efficiency and economic welfare. In the case of equity,
economic theory suggests that in the long run, the burden of business taxation is
shared among all owners of capital and has a progressive effect on the tax system.

Various hypothetical alternatives exist for reforming the business tax system.
One possibility is to move in the direction of the 1986 Tax Reform Act by
broadening the existing tax base — that is, by eliminating tax benefits and
preferences. Another possibility — and one that is favored by many economists —
is to adopt some form of tax integration that would eliminate the double taxation of
corporate income. A third option is to adopt a form of consumption tax, under which
new business investment would be exempt from tax. Either corporate tax integration
or a consumption tax could improve economic efficiency, but only if the design were
to avoid the types of distortions present in the current system.
This report will be updated only in the event of major changes in the business
tax system.

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Contents
Basic Structure of the Current System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Level of Corporate Taxes, Past and Present . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Economic Effects of Business Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Business Taxes and Capital Formation . . . . . . . . . . . . . . . . . . . . . . . . 10
Business Taxes and Economic Efficiency . . . . . . . . . . . . . . . . . . . . . . 11
Business Taxes and Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Business Taxes and Competitiveness . . . . . . . . . . . . . . . . . . . . . . . . . 13
Taxes and Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Taxes and International Business Investment . . . . . . . . . . . . . . . . . . . 15
Business Taxes and Tax Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Comprehensive Taxation of Business Income . . . . . . . . . . . . . . . . . . . 15
Corporate Tax Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Business Taxes under Consumption or Flat Taxes . . . . . . . . . . . . . . . 18
National Sales Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Value-Added Tax and “Flat” Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Consumed Income Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Effects of a Consumption Tax on Business . . . . . . . . . . . . . . . . . . . . . 21
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
List of Figures
Figure 1. Corporate Taxes as a Percentage of GDP, FY1934-FY2005 . . . . . . . . . 5
Figure 2. Corporate Tax Revenue as a Percentage of Total Federal
Tax Revenue, FY1934-FY2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Figure 3. Average Effective Corporate Tax Rates: Federal Corporate
Taxes as a Percentage of Corporate Profits, 1959-2000 . . . . . . . . . . . . . . . . 7
Figure 4. Marginal Effective Tax Rates on Corporate and Other Investment,
1953-2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

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Federal Business Taxation: The Current
System, Its Effects, and Options for Reform
Almost 20 years ago, the broad tax revisions implemented by the Tax Reform
Act of 1986 (P.L. 99-514) were based on tax “neutrality” — the idea that economic
efficiency and economic welfare are promoted if the distorting impact of taxes on
business and other economic decisions is minimized. To this end, the 1986 act
broadened the tax base for both businesses and individuals, scaling back various
narrowly-applicable tax preferences and benefits, and reduced the statutory tax rate.
In time, however, the general thrust of business-tax policy began to change, and
in recent years policy has been guided more by a concern for the level of investment
and capital formation, as well as the perceived impact of taxes on U.S.
competitiveness. Thus, measures designed to promote tax-consistency across
investments and activities have been supplanted by provisions designed to stimulate
investment and assist in the ability of U.S. firms to compete with foreign companies.
Cases in point are the temporary “bonus depreciation” provisions enacted in 2002
and 2003 and the broad tax deduction for domestic production included in the
omnibus business-tax bill passed in 2004.1 At the same time, there has recently been
renewed congressional and public interest in broad reform of the U.S. tax system.
In contrast to 1986, however, much of the recent interest in reform has centered on
a shift in the tax base to consumption rather than a comprehensive measure of income
— a change in focus that is based, in part, on the same concerns for capital formation
and competitiveness that underlie much of recent business-tax legislation.
Business taxation is thus potentially at a crossroads as 2005 draws to a close.
Will the thrust of tax policy continue to shift away from the principles of efficiency
and neutrality that guided tax reform two decades in the past? If fundamental tax
reform is adopted in the near future, would it include a revamped system of business
taxation? If so, what would business taxation look like? Regardless of the outcome,
it is useful at this point to take stock; to pause and review the current system and its
effects. The charts and discussions on the following pages are intended to assist in
that exercise. The report follows with a discussion of the principal economic effects
of business taxation. Its concluding sections review the various theoretical principles
on which fundamental reform of business taxation might be based.
1 Bonus depreciation was initially provided by the Job Creation and Worker Assistance Act
of 2002 (JCWA; P.L. 107-147). It was increased by the Jobs and Growth Tax Relief and
Reconciliation Act of 2003 (JGTRRA; P.L. 108-27) but generally does not apply to property
placed in service after 2004. The domestic production deduction was provided by the
American Job Creation Act of 2004 (AJCA; P.L. 108-357).

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Basic Structure of the Current System
Businesses can take a variety of forms, ranging from large, publicly held
corporations, to more closely held corporations, to partnerships (large and small), to
firms that are run by only a single self-employed owner. With some exceptions, the
rules for determining taxable income — for example, how to calculate depreciation
and other deductions — are the same, regardless of the type of business. The
particular manner in which that income is taxed, however, does vary, depending on
the type of business.
Income earned by large, publicly held corporations (“C” corporations, in tax
parlance) is generally subject to the corporate income tax — one of the principal
structural components of the federal tax system, along with the individual income
tax, the estate and gift tax, excise taxes, and social security taxes. In conceptual
terms, the present U.S. corporate income tax is sometimes described as a “classical”
system that applies as though corporations were entities with an existence separate
from their owners, the stockholders. The tax applies to taxable corporate income,
corporate profits (after deducting interest) as defined by the tax code. It applies
separately and in addition to the individual income tax’s applicability to
shareholder’s dividends and capital gains. As discussed in more detail below (see the
section on the economic effects of the tax), this means that income subject to the
corporate income tax is generally taxed twice — once under the corporate income tax
in the hands of corporations, and once under the individual income tax when
stockholders receive dividends or realize capital gains. The double taxation does not
occur, however, in the case of corporate income generated by debt-financed
investment, since the return to such investment is paid to creditors as interest and is
tax-deductible. Double taxation also does not apply in the case of income paid to
tax-exempt stockholders — for example, pension funds.
Income earned by relatively closely held corporations — termed “S
corporations” by the tax code — is not subject to the corporate income tax and so
also is not taxed twice. Instead, an S corporation’s income is “passed through” to the
firm’s stockholders and taxed to them under the individual income tax, regardless of
whether the income is actually distributed. To qualify as an S corporation, a firm can
have no more than 100 shareholders and must meet certain other requirements.
As with S-corporation profits, partnership taxable income is not subject to an
entity-level tax such as the corporate income tax. Instead, each partner is taxed under
the individual income tax on his or her share of the partnership’s profit.2 Individual
income taxes also apply to business income earned by self-employed persons who
operate sole proprietorships. As with partnerships and S corporations, no separate
tax is applied at the entity (i.e., business) level.
2 For a more detailed description of the taxation of passthrough entities, see CRS Report
RL31538, Passthrough Organizations Not Taxed As Corporations, by Jack H. Taylor. See
also CRS Report RL32254, Small Business Tax Benefits: Overview and Economic
Rationale, by Gary Guenther.

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According to recent estimates by the Congressional Budget Office, 62% of
tangible business assets are owned by C corporations; the remainder (48%) is owned
by other business entities (i.e., partnerships, sole proprietorships, and S
corporations).3
As noted above, rules for determining taxable income are generally the same,
regardless of the form of business organization.4 The base of federal business income
taxes is generally profits, net of interest payments. Profits, in turn, are gross receipts
— for example, sales — minus deductible costs. Important categories of deductible
costs include interest payments, wages, purchased materials and other inputs, and a
depreciation allowance for the decline in value of tangible capital. Importantly, the
tax code’s definition of these elements frequently differs from how an economist or
accountant might define them. For example, the tax code may fully or partly exempt
certain types of income from inclusion in taxable income — a specific example is the
partial deduction the tax code permits for income from domestic production
activities. Or, the tax code may require the recognition of income at a different point
in time than when economic theory indicates it is actually earned or permit a
deduction to be claimed at a different time from when the cost is actually incurred.
Regardless of the underlying provision, instances where taxable income differs from
economic income can provide either a tax benefit or tax penalty and (as described
more fully below) influence how the economy’s capital resources are allocated.
U.S. firms increasingly participate in international markets, and so an overview
of the U.S. structure would be incomplete without including its international
dimension. In the international context, the U.S. applies what is sometimes termed
a “residence” based tax system, but with important exceptions. The United States
generally applies its corporate income to the worldwide income of corporations
chartered in (i.e., “resident” in) the United States. At the same time, however, U.S.
firms can generally indefinitely postpone (defer) U.S. tax on foreign-source income
as long as the income is earned by foreign-chartered subsidiary corporations and
reinvested abroad. To alleviate double taxation, the United States permits its
taxpayers to credit foreign taxes they pay against U.S. taxes they would otherwise
owe, subject to the limitation that foreign taxes can only be credited against U.S.
foreign- (and not U.S.-) source income.
Foreign businesses in the United States are generally subject to U.S. business
taxes on their U.S.-source income. If a foreign firm operates in the United States
through a U.S.-chartered subsidiary corporation, the subsidiary is generally subject
to U.S. tax in its role as a resident U.S. corporation; like other U.S.-chartered
corporations, it is subject to U.S. tax on its worldwide income, regardless of the
nationality of its owner(s). If, on the other hand, the foreign firm operates in the
United States through a branch of the foreign-chartered parent corporation, the
foreign firm is subject to U.S. tax on its income from U.S., but not foreign, sources:
3 U.S. Congressional Budget Office, Taxing Capital Income: Effective Rates and
Approaches to Reform (Washington: GPO, 2005), p. 8.
4 An exception is income earned by corporations subject to the alternative minimum tax
(AMT). AMT rules in some cases apply differently to corporations compared to
individuals.

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the United States taxes foreign persons and corporations on their income from the
active conduct of a U.S. trade or business. (The economic effects of international
aspects of the federal tax system are discussed below.)
Another structural component of the system is the alternative minimum tax
(AMT). The tax code provides both a corporate AMT and an individual AMT; a
business may be subject to either, depending on whether it pays the corporate income
tax or is taxed under the individual income tax as a sole proprietorship or
passthrough entity. Both AMTs essentially require a taxpayer to pay either the
regular tax or the AMT, whichever is higher. The two liabilities will ordinarily differ
for a business because they are computed differently. The AMT is imposed at a
lower statutory rate than the regular tax, and the base of the AMT is more inclusive
than that of the regular tax, permitting fewer omissions and tax benefits. The purpose
of the AMT is to ensure that few truly profitable corporations escape paying at least
some tax.
The importance of the AMT in the structure is difficult to quantify. Recent data
on the share of corporate investment subject to the tax are not available. The
numbers that are available show that prior to 1999, the AMT was important: in 1998,
more than one-quarter of corporate assets were held by firms paying the AMT, and
within the manufacturing sector over one-half of firms were AMT firms. Beginning
in 1999, however, new, more generous AMT depreciation rules likely reduced the
portion of investment affected by the AMT.
Level of Corporate Taxes, Past and Present
What is the current level of business taxes, and how has it changed over time?
This review of the data focuses primarily on the corporate income tax; there are a
variety of ways to gauge its size. First, the general importance of the tax in terms of
any economic effects it has can be assessed by looking at the level of the tax
compared to the size of the economy — that is, by assessing corporate tax revenue
as a percent of gross domestic product (GDP). Figure 1, below, presents such data
for fiscal years 1934 to 2004, thus showing the position of corporate revenues from
well before World War II to the latest year available. Clearly, the chart shows that
corporate tax revenues have declined from their peak during World War II (7% in
FY1945) and from another peak that coincided with the Korean War (6.1% in
FY1952). The chart also shows that they have declined from what might be termed
an intermediate level of between 2% and 4% in the 1960s and 1970s to a level
between 1% and 2% in recent years.

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Figure 1. Corporate Taxes as a Percentage of
GDP, FY1934-FY2005
Source: U.S. Office of Management and Budget, Historical Tables: Budget of the U.S. Government,
Fiscal Year 2006 (Washington: GPO, 2005), pp. 31-32.
While corporate taxes have declined as a percentage of GDP, Figure 2, below,
shows that corporate income-tax revenue likewise declined as a share of total federal
revenue, and in roughly the same pattern. Corporate tax revenue’s share of total
federal revenue declined from a peak of 40% during World War II (FY1943), and a
somewhat lower peak of 32% during the Korean War (FY1952), to levels of slightly
above and below 10% after the late 1980s.

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Figure 2. Corporate Tax Revenue as a Percentage
of Total Federal Tax Revenue, FY1934-FY2004
Source: U.S. Office of Management and Budget, Historical Tables: Budget of the U.S. Government,
Fiscal Year 2006 (Washington: GPO, 2005), pp. 31-32.
These broad measures of corporate taxes are useful as rough indicators of how
the level of corporate taxes in the economy has changed, but lack precision in
showing the burden of corporate taxes and the causes of the taxes’ fluctuations. For
example, a decline in the share of national income comprising corporate profits is
partly responsible for the reductions shown in Figures 1 and 2. Figure 3, below,
corrects for this with a series that holds profits constant. It shows average effective
corporate tax rates (AETRs), which are the ratio of federal corporate income taxes
to before-tax corporate profits. According to the AETRs, the aggregate burden of
corporate taxes steadily declined during the 1960s and 1970s, reaching a low of about
20% of corporate profits during the early 1980s before rising to a plateau of around
25% that has generally prevailed from 1986 to the present. The anomalous year in
the last two decades was 2000, which registered a spike in the AETR to 34%.
Since AETRs hold the level of corporate profits constant, a principal
determinant of variations in the rates is legislated changes, and several can be linked
to the fluctuations in the AETRS. At least three factors are likely responsible for the
decline in rates during the 1960s, 1970s, and early 1980s. First, during the 1970s and
1980s, several reductions in the statutory corporate tax rate that applies to taxable
income were enacted. Second, while taxable corporate profits were artificially
inflated during the 1970s by a rising price level, firms were also permitted to claim
investment tax credits. Third, the Economic Recovery Tax Act of 1981 provided
accelerated depreciation deductions, which likely played a prominent role in the
sharp drop in tax rates in the early 1980s. Following the reduction, rates increased
again in the mid-1980s. Part of the increase was likely due to timing results from the

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1981 act, but the Tax Reform Act of 1986 was also likely responsible for part of the
increase. The act reduced statutory tax rates, but also repealed the investment credit
and scaled back depreciation allowances.
Figure 3. Average Effective Corporate Tax Rates:
Federal Corporate Taxes as a Percentage of
Corporate Profits, 1959-2000
Source: CRS Report RL30469, Average Effective Corporate Tax Rates,1950 to 2002, by Steven
Maguire.
AETRs have their own shortcoming as a gauge of the corporate tax burden.
They provide only one-year snapshots of a firm’s tax burden, while according to
economic theory, taxes impose a burden on capital income by reducing the expected
rate of return over the life of new investment. For example, the tax burden on an
investment consists not only of taxes paid in its first year, but also those paid in, say,
the fifth year of its life. In addition, because of discounting, the tax burden on
investment depends partly on how taxes are distributed over an investment’s life; a
given amount of taxes matters more to a firm the sooner it is paid. The same is true
of deductions, but in reverse; a given deduction is more valuable the sooner it is
claimed.
“Marginal” effective tax rates (METRs) take these factors into account,
measuring the impact of taxes over a representative investment’s entire lifetime as
well as the timing of payments and deductions. Unlike AETRs, METRs can thus
accurately register the impact of provisions such as accelerated depreciation, whose
value depends crucially on timing. METRs also take into account the interaction of
inflation and tax rules, statutory tax rates, and investment subsidies such as the
investment tax credit. In general, a marginal effective tax rate is the difference

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between the pre-tax and after-tax return on prospective investment, divided by the
pre-tax return.5
Figure 4, below, presents a set of METRs for the period 1953 through 2003.
The top line in the figure shows METRs for corporate investment. The second line
is rates for non-corporate business and moves in tandem with corporate rates, but at
a lower level. (The third line is the METR for the remaining broad category of
capital investment: owner-occupied housing.) The series shows a decline in rates
from the early 1950s to the mid-1960s — the result of accelerated depreciation,
introduction of an investment tax credit, and reduced statutory tax rates. Rates then
rose in the late 1960s and varied during the 1970s, a consequence of repeal and
reintroduction of the investment tax credit as well as inflation. Rates declined
sharply in 1981, reflecting the Economic Recovery Tax Act’s accelerated
depreciation provisions. METRs then remained relatively stable until 2001 to 2003,
when reductions in shareholder-level taxes (including reduced tax rates on capital
gains and dividends) as well as bonus depreciation caused a reduction in effective
rates. If the series had been carried out through 2005, the expiration of bonus
depreciation would cause the METR to rise again, but not all the way back to its level
in 2000.6
Figure 4. Marginal Effective Tax Rates
on Corporate and Other Investment,
1953-2003
Source: CRS Report RS21706, Historical Marginal Effective Tax Rates on Capital Income, by Jane
G. Gravelle.
5 More precisely, METRs begin by assuming that investments must earn a particular return,
after taxes, in order to attract funds from savers. The METR calculation then works
backwards, and derives a pre-tax return investments must earn in order to generate the after-
tax return required by savers. The difference between the pre-tax and after-tax returns is
sometimes referred to as the “tax wedge.” An investment’s METR consists of the tax wedge
divided by the pre-tax return.
6 For a discussion of factors underlying the variation in METRs, see CRS Report RS21706,
Historical Effective Tax Rates on Capital Income, by Jane G. Gravelle.

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The preceding charts show four different measures of corporate taxes: taxes as
a share of GDP, corporate tax revenues as a percentage of federal revenue, average
effective corporate tax rates, and marginal effective tax rates. Each series shows the
same general pattern in the period after World War II: a general decline in the level
of corporate taxes. But before accepting this broad pattern as the conclusion of this
look at corporate tax data, note the relative position of the three lines in Figure 4,
denoting METRs for corporate investment, for non-corporate business, and for
owner-occupied housing. In contrast to the general direction of each set of METRs
— they have all declined, showing a decline in capital taxes in general — their
relative position has remained the same. And importantly, it is the relative tax
treatment of investment that affects the allocation of investment among different
uses, and differences in the treatment of different investments that distort the
allocation of capital. Thus, to the conclusion that business taxes have generally
declined in the post-World War II period, there is an additional important result:
corporate investment remains relatively heavily taxed compared to non-corporate
business and (especially) owner-occupied housing.7 The report’s next section
explores the implications of this result by discussing the economic effects of business
taxes.
Economic Effects of Business Taxes
The base of the corporate income tax and of business taxes in general is income
from capital investment. It is thus not surprising that business taxes exert their most
direct effects through their impact on the return to new investment. By reducing the
return to capital investment, business taxes — at least in principle — can affect the
economy’s commitment of resources to capital formation in general, although this
effect may be muted. Business taxes can also affect the allocation of investment
funds among different sectors, as suggested at the end of the preceding section. And
while businesses are not people, the burden of business taxes is ultimately borne by
individuals; business taxes thus have an impact on the fairness of the tax system.
Business Taxes and Capital Formation. Because they apply to the return
to investment, business taxes can potentially reduce the economy’s overall level of
investment and its stock of capital. There are indeed some who advocate cutting
business taxes as a means of boosting capital formation: according to economic
theory, an increase in the capital stock boosts long run growth, which, in turn,
increases living standards and per capita income in the future.8
7 Tax distortions among assets also persist within the corporate sector. While differential
treatment of assets declined under the Tax Reform Act of 1986, subsequent changes in law
have reintroduced significant differences in the treatment of equipment, structures, and
inventories, with equipment being favored. See CRS Report RL32099, Capital Income Tax
Revisions and Effective Tax Rates, by Jane G. Gravelle. See also U.S. Congressional Budget
Office, Taxing Capital Income: Effective Rates and Approaches to Reform (Washington:
GPO, 2005), p. 8.
8 Some economists have concluded that the distortions from taxing capital are so great that
the optimal tax on capital from the point of view of economic efficiency and welfare is zero.
Acceptance of this analysis, even in principle, requires a particular theoretical construct that

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Yet business taxes do not necessarily have a pronounced effect on the aggregate
level of capital in the economy. A key element is the economy’s supply of saving,
and there are indications that individual savers may not respond robustly to tax cuts
by increasing their saving. Note first, however, that business taxes do likely have an
impact on firms’ investment demand. Taxes on business profits increase the rate of
return a given asset must earn, before taxes, in order to generate the rate of return
required to attract funds from savers. A tax on business investment thus encourages
firms to forgo a range of less profitable investments they might otherwise undertake.
And indeed, as described below, uneven application of business taxes results in less
investment in heavily taxed areas and more investment in lightly taxed projects.
But investment demand is just one side of the market for capital; the other side
is household saving. And if individual saving is unresponsive to changes in the after-
tax rate of return, then changes in investment demand will have little impact on the
overall stock of capital: boosts in demand will principally serve to increase the
economy’s real interest rate. For example, provision of a tax credit for businesses to
undertake investment may indeed boost business demand for the particular type of
investment in question, and firms may boost the rate of return they are willing to pay
savers for each quantity of investment. But unless savers are willing to increase the
quantity of funds they supply in response to the higher return, there will be no
increase in the capital stock.
Economic theory provides no unambiguous answer on how saving responds to
its rate of return, after taxes, and is subject to countervailing effects. In isolation, a
tax on investment income — that is, on saving — reduces the price of current
consumption compared to future consumption, and may thus reduce saving. On the
other hand, a tax on saving increases the amount of saving an individual must
undertake before taxes in order to achieve a particular dollar amount, after taxes, and
may thus increase saving. The answer to the question therefore depends on the
empirical evidence. And while there have been numerous econometric studies of
saving, their results differ.9 This has led some to suggest that instead of providing
tax incentives for saving and investment, a more certain approach to boosting
aggregate national saving would be reducing government dis-saving by reducing the
government’s budget deficit.10
includes, for example, an assumption that individuals have infinitely lived time horizons.
But even if this analysis is accepted, it does not necessarily recommend a repeal of capital
income taxation for a number of reasons: the unresponsiveness of saving may reduce any
distortions; any tax that replaces a tax on capital likely has its own distortions; and the
transition costs of moving to an alternative tax may be costly enough to offset any benefit.
9 For a thorough survey of the empirical studies that have been conducted, see B. Douglas
Bernheim, “Taxation and Saving,” Handbook of Public Economics, vol. 3, Alan J. Auerbach
and Martin Feldstein, eds., (Amsterdam: Elsevier, 2002), pp. 1173-1249. Note also that
while investment incentives may not result in additional domestic saving, they may attract
foreign capital into the domestic economy. The return to foreign capital, however, does not
accrue to domestic residents.
10 For a textbook presentation of this argument, see Andrew B. Abel and Ben S. Bernanke,
Macroeconomics, 3rd ed. (Reading, MA: Addison-Wesley, 1998), p. 210.

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Business Taxes and Economic Efficiency. Not only does the amount
of capital matter for economic performance, but so too does how that capital is
employed. And while business taxes likely have little impact on long-run growth and
capital formation, they do affect the allocation of investment among different uses
and thus affect economic efficiency. Because taxes affect investment demand, they
distort the allocation of investment where they apply unevenly, channeling funds to
tax-favored assets and away from more heavily taxed assets. The results for
economic efficiency follow: economic theory indicates that undistorted market prices
and investment returns generally allocate resources to their most productive use so
that capital and other resources produce the mix of output that consumers value most,
and economic welfare is maximized. To the extent business taxes distort the
allocation of resources, they reduce economic welfare.
One prominent distortion posed by the U.S. tax system results from the double-
taxation of corporate-source equity income — its taxation under both the corporate
income tax and the individual income tax. As a result, investment is channeled away
from the corporate sector into less heavily taxed areas such as owner-occupied
housing and non-corporate business (see the effective tax rates in Figure 4, above).
A second distortion posed by the corporate income tax is its favoring of debt over
equity in the financing of investment. The return to debt-financed investment
consists of corporate interest payments to creditors; the return to equity consists of
dividends and capital gains. Since interest is tax-deductible at the corporate level but
dividends and capital gains are not, firms are encouraged to use higher levels of debt
than they otherwise would, increasing the risk of bankruptcy to an inefficiently high
level.
Different types of business assets are also taxed at different rates, encouraging
firms to invest more heavily in favored assets than they otherwise would. The
depreciation allowances that apply to machines and equipment are relatively
generous compared to depreciation allowances for structures and capital-recovery
methods for inventory, leading to a relatively light tax burden for machines and
equipment. Thus, firms’ asset choices are distorted, encouraging more investment
in machines and equipment and less in structures and inventory than is economically
efficient. Prior to the Tax Reform of Act of 1986, the differential tax burdens among
assets were substantial — a consequence of a relatively high statutory tax rate,
relatively high inflation, uneven depreciation rules, and the availability of an
investment tax credit for equipment, but not other assets. The 1986 act altered
depreciation rules, repealed the investment credit, and reduced the statutory corporate
tax rate, thereby greatly diminishing inter-asset distortions. In recent years, however,
both legislation and economic developments have reintroduced differential tax
burdens, though not to the extent existent before 1986. Legislative changes included
introduction of less-favorable depreciation for structures, bonus depreciation for
equipment, and an increased statutory tax rate.11
As noted above, the corporate income tax distorts corporate financial policy,
favoring debt finance. Another distortion of corporate financial policy results from
11 Jane G. Gravelle, “The Corporate Tax: Where Has it Been and Where is it Going?”
National Tax Journal, vol. 57, Dec. 2004, p. 914.

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CRS-12
individual rather than corporate income taxation, and the preferential treatment of
capital gains. Specifically, since capital gains are not subject to individual income
taxes until a stockholder sells stock and the gains are realized, taxes favor the
corporate retention of earnings — which increases the value of corporate stock —
over payout of dividends. Recent legislation has reduced the statutory tax rate on
dividends to the same rate applicable to realized capital gains, which has reduced the
difference between the effective tax rates of retentions and payouts. Nonetheless, a
difference remains because capital gains are not taxed until realized while dividends
are taxed on a current basis.
Business Taxes and Equity. Corporations are not people; they are
economic entities (firms) taking a particular legal form (incorporation). Thus,
corporations cannot bear the burden of the corporate income tax in any real sense; it
ultimately is borne by individuals. In the short run — that is, before economic actors
have had a chance to adjust to the tax — the tax is thought to be borne by corporate
stockholders
The long-run burden of the tax is more uncertain. The standard and most
resilient economic model of the corporate income tax is that developed by Arnold
Harberger in 1962.12 While a number of challenges have been made to the model
since its inception, its results have generally proved resilient.13 The model concludes
that if capital investment funds and labor are free to flow from one economic sector
(e.g., the corporate sector) to another (and given certain other conditions), then
wages, prices, rates of return, and the allocation of capital and labor adjust, in the
long run, to the corporate income tax. Given the ability of economic actors to adjust,
the burden of the corporate income tax spreads beyond corporate shareholders’ sector
to all owners of capital, including owners of corporate debt, non-corporate business,
and owner-occupied housing.
This picture of the long-run burden of the corporate tax has implications for the
vertical equity of the tax system — that is, its distribution across income classes.
Because capital ownership is greater at upper-income levels, the corporate income
tax is itself progressive and makes the overall tax system more progressive than it
would otherwise be.
Business Taxes and Competitiveness. A widely cited reason for
reforming U.S. business taxation is to improve U.S. “competitiveness,” where
competitiveness is usually a loosely defined term generally meaning the ability of
U.S. firms to compete with foreign businesses, whether by means of export sales or
sales by U.S. firms who have invested abroad. Yet there are few areas in which
economic theory and popular beliefs diverge more widely than in international
economics and notions of “competitiveness.” Given the prominence of
12 Arnold H. Harberger, “The Incidence of the Corporation Income Tax,” Journal of
Political Economy, vol. 70, June 1962, pp. 215-240.
13 See the review of challenges to the Harberger model in Jane G. Gravelle, “The Corporate
Income Tax: Economic Issues and Policy Options,” National Tax Journal, vol. 48, June,
1995, pp. 267-277.

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CRS-13
competitiveness in the public debate, it is thus useful to examine the international
dimension of business taxes’ effects in some detail.
Taxes and Trade. Contrary to popular arguments that are sometimes made,
economic theory indicates that business taxes do not affect the nation’s balance of
trade — that is, the imposition of federal taxes on business profits does not increase
the U.S. trade deficit by reducing U.S. exports or increasing imports. This
conclusion may counter intuition at first — surely the imposition of a tax on the
profits of a U.S. exporting firm will reduce its sales to foreigners and thus reduce
aggregate U.S. exports. But economic theory’s rebuttal is equally intuitive: just as
an individual cannot consume more than he earns unless he borrows, a country
cannot use more than it produces — cannot import more than it exports — unless it
borrows to finance the difference by importing foreign investment. Thus, a country
can only increase its trade deficit if it imports some additional amount of foreign
investment; a country’s net exports only increase if its net overseas investment also
increases.14
In slightly more technical terms, a country’s balance of trade (its balance on
goods and services) mirrors its balance on capital account; the balance of trade
changes only if the balance on capital account likewise changes. This relationship
is an identity that holds whether or not the international economy is in equilibrium.
The particular economic mechanism that enforces the identity under the current
regime of flexible exchange rates is exchange rate adjustments. Even if a change in
an exogenous variable (e.g., taxes) would otherwise increase net exports, exchange
rates adjust to offset any change that would otherwise occur.
The implication of this analysis is that business taxes alter the balance of trade
only if they also alter net flows of international investment (the balance on capital
account). As an illustration, the United States recently repealed a tax benefit for
exporting known as the extraterritorial income (ETI) benefit. While some observers
feared that ETI’s repeal would harm U.S. competitiveness, economic theory indicates
its repeal will have no direct impact on the balance of trade. While some reduction
of exports may initially occur, that reduction will stimulate a fall in the price of the
dollar in currency markets below what would otherwise occur. The dollar’s
depreciation will mitigate the initial decline in exports and will also reduce imports.
There will be no change in the trade balance (exports minus imports).
While business taxes do not affect the trade balance, they can affect the
composition of its trade. This outcome follows from one of the foundations of
economic trade theory — the theory of comparative advantage. According to this
theory, the composition of a country’s exports and imports is determined not by how
the costs of domestic goods compare to those of foreign goods, but rather by how the
14 Note, however, that a country’s general fiscal position can alter the trade balance. For
example, if a country increases its government’s budget deficit, real interest rates may rise,
leading to an inflow of foreign capital and an expansion of its trade deficit. Thus, to the
extent business taxes contribute to total government revenue and the government’s overall
fiscal stance, they can be said to have an impact on the trade deficit. In this sense, however,
they are indistinguishable from other taxes.

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CRS-14
costs of domestic goods compare to each other. Under comparative advantage, a
country exports what it can produce at lowest cost. The particular composition of its
exports and imports thus depends on the particular pattern of costs across all of its
products and potential products. Business taxes can alter this pattern of costs and
thus alter the content of trade. For example, if taxes apply heavily to one item and
fall lightly on another, they encourage the import of the first product and the export
of the second.
But if business taxes cannot increase net exports and can only change the pattern
of trade, this is not necessarily bad news. Standard economic trade theory indicates
that countries gain economic welfare by exchanging exports for imports; the
exchange enables each trading country to specialize in producing what it produces
most efficiently while not sacrificing its use of the higher-cost goods that it imports.
In short, a country’s economic welfare is not enhanced by the mere act of exporting;
it is the ability to exchange exports for imports that makes a country better off (that
produces “gains from trade,” in economic parlance).
Taxes can reduce economic welfare through their impact on trade in a number
of ways. One is a reduction in economic efficiency similar to those described in
preceding section, but translated to the international economy. If taxes apply
unevenly, they may distort the pattern of costs within the economy and distort the
composition of trade, thus encouraging a country to specialize in activities at which
it is relatively inefficient. A second way taxes can reduce a country’s economic
welfare is to worsen its “terms of trade,” or the quantity (in real terms) of exports it
must give up to obtain a given quantity of imports. For example, if part of the benefit
of an export subsidy (e.g., ETI) is passed on to foreign consumers in the form of
lower prices, the subsidy worsens the subsidizing country’s terms of trade; its exports
are cheaper for foreign consumers. The subsidizing country’s economic welfare is
reduced because its own taxpayers are underwriting the price reduction for foreign
consumers.
Taxes and International Business Investment. Business taxes can have
a direct impact on the extent to which U.S. firms invest abroad, and also the extent
to which foreign firms invest in the United States. Here, the crucial factor is how
taxes (both U.S. and foreign) on an investment in a foreign location compare to taxes
on an identical investment undertaken in the United States. To the extent taxes in the
foreign location are lower than those on the U.S. project, taxes encourage overseas
investment; to the extent U.S. taxes are low relative to taxes on the overseas
investment, they encourage domestic, over foreign, investment. If taxes are the same
in either location, they have no impact (are “neutral” towards) on location choice.
According to traditional economic theory, taxes best promote economic
efficiency by not distorting the location of investment; neutrality between overseas
and domestic investment best promotes efficiency. But the overall impact of the
U.S. system is uncertain. As described above, the United States in some situations
taxes the overseas income of its firms on a current basis, while in other instances it
permits an indefinite deferral of taxes on foreign-source income; foreign tax credits
are provided to alleviate double taxation. The net result of this system for the relative
tax burden on foreign and domestic investment is mixed; the system produces a
patchwork of incentives, disincentives, and neutrality towards overseas investment

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CRS-15
that varies, depending on factors such as the level of foreign taxes applied to the
investment, the legal form of the investment, and the location and nature of a firm’s
other foreign investments. The efficiency effect of the system is thus not clear.
Business Taxes and Tax Reform
The first section of this report outlined the current structure of federal business
taxation — a separate tax on corporate profits imposed in addition to the individual
income tax and net of interest; and taxation of unincorporated business on a current
basis under the individual income tax. The report’s section on business tax data
indicated that while the level of business taxes has generally declined since World
War II, important divergences remain in the way different types of investment are
taxed. The section on economic effects indicated that these effects can impair
economic efficiency, although they likely do not hinder U.S. competitiveness. With
these pictures in mind, the report now turns to the principal options for reform that
have been developed for business tax policy.
Comprehensive Taxation of Business Income. Since corporations are
economic and legal entities and not people, the question might be raised: why
impose a separate corporate income tax at all? The question is made more pointed
when the detrimental efficiency effects of a separate tax on corporate income are
considered — effects such as the diversion of investment away from equity
investment in the corporate sector. A number of arguments, however, can be
mounted in favor of a separate tax on corporate income. First, since stock ownership
in particular, and ownership of capital in general, is more prevalent among upper-
income individuals, the corporate income tax adds an element of progressivity to the
tax system; its repeal — absent compensating changes elsewhere in the system —
would be, in isolation, a regressive policy change. Second, corporate managers may
be able to exercise considerable independence from stockholders in their decisions
about corporate investment. To the extent this occurs, corporations do have some
existence separate from their stockholders. Third, without a corporate income tax (or
tax integration plan, as outlined below), retained corporate earnings would receive
favorable tax treatment. And finally, even if corporations are not people and have
no existence separate from their stockholders, many individual taxpayers nonetheless
compare the taxes they pay with those paid by large corporations and draw
conclusions about fairness from that comparison. And even if such comparisons,
from an economic standpoint, are not appropriate, they do affect perceptions about
the fairness of the tax system — perceptions that are important to the acceptance of
the tax system by the public at large.
While the current system does tax corporations as though they were separate
entities, it does not do so on a comprehensive basis. Numerous important omissions
from the tax base would exist if all corporate profits were taxed on the same basis.
Thus, if the validity of a separate corporate income tax is accepted, one hypothetical
direction that tax reform might take is to move in the direction of a more pure version
of the “classical” system of taxing corporate income — to eliminate the various
omissions in the tax base and non-neutralities embedded in the current system.
Setting aside the distortions that result from the existence of the corporate income tax

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CRS-16
in the first place, such a reform would likely minimize the inefficiencies and
distortions that exist within the classical system. As noted at the outset of the report,
such was a guiding principle of the Tax Reform Act of 1986.
How much does the current system depart from a comprehensive tax on
corporate income? One considerable departure is the omission of income from debt-
financed investment from the tax base — an omission that occurs when interest
payments are deducted. Income generated by debt-financed investment is income
from capital just as surely as is income from equity investment. Debt’s omission
from the tax base distorts firms’ financing choices, favoring debt over equity and
enticing firms to accept a higher risk of bankruptcy than is economically efficient.
Nonetheless, simple elimination of interest deductibility has rarely been proposed
outside of a movement away from the classical system by adoption, for example, of
tax integration (discussed below).15
Another important determinant of the corporate tax base is depreciation. One
important element of the 1986 act’s reform was its evening-out of depreciation
allowances across assets. The act implemented depreciation allowances that were
more closely aligned with actual economic depreciation. Together with the act’s
repeal of the investment tax credit, the depreciation revisions reduced prior law’s
general preference for equipment and relatively short-lived assets over structures.
Since 1986, however, a wedge has reemerged between equipment and structures,
although — setting aside the temporary bonus depreciation for equipment — this has
been more a consequence of changed economic conditions (reduced inflation) and
a lengthening of depreciation allowances for structures than reintroduction of
accelerated depreciation.16 Nonetheless, a likely ingredient of tax reform based on
comprehensive income taxation would be a realignment of depreciation allowances
with economic depreciation.
Another prominent departure from comprehensive taxation is the deduction for
domestic production that was enacted by the American Jobs Creation Act of 2004
(P.L. 108-359). The deduction is 9% of income from domestic production activities;
it cannot be applied to income from overseas investment. Other omissions from the
tax base are more narrowly targeted tax benefits — for example, the section 179
expensing allowance from equipment investment of small businesses, the tax credit
for research and experimentation, and various provisions applicable to the oil and gas
industry. The Joint Committee on Taxation (JCT) maintains a list of “tax
expenditures” or provisions that carve out special tax treatment for particular
activities, income, or investments; a relatively comprehensive list of omissions from
the corporate tax base can be obtained by consulting the JCT list.17 A tax reform that
15 For example, even the initial, more theoretically pure, Treasury Department proposals that
preceded the 1986 Tax Reform Act stopped short of straightforward taxation of the return
to debt.
16 For estimates of disparities in tax burdens across assets under current law, see CRS Report
RL32099, Capital Income Tax Revisions and Effective Tax Rates, by Jane G. Gravelle.
17 CRS has prepared for the Senate Budget Committee a compendium containing
explanations and analyses of the various tax expenditures on a biannual basis. The most
recent version is U.S. Congress, Senate Committee on the Budget, Tax Expenditures:

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CRS-17
moves in the direction of comprehensive income taxation would presumably scale
back items included in the list of tax expenditures.
Corporate Tax Integration. As described above in the section on the
economic effects of business taxation, the current “classical” system of taxing
corporate income results in a number of distortions in the allocation of investment,
thus reducing economic efficiency and causing a concomitant reduction in economic
welfare. For this reason, economists have long advocated some form of tax
“integration” — a term that refers to eliminating double taxation of corporate income
by altering the general system of taxing corporate-source income.
Integration proposals vary, but fall into two broad categories: those that apply
to both retained earnings and dividends and thus all corporate profits (“full
integration”), and those that change the treatment only of earnings that are distributed
(“partial integration”).
There are three basic approaches to full integration, which differ in whether
double taxation is removed at the corporate level or at the individual level. The
“shareholder allocation” method is similar to partnership taxation. The corporate
income tax would be repealed, and corporate profits — whether retained or
distributed — would be allocated among the firm’s owners, who would pay
individual income taxes on the corporate income. Thus, corporate income would be
taxed once, in the hands of individuals.
A second approach is “shareholder credit” integration, under which the
corporate income tax would be retained, but corporate stockholders would receive
a tax credit for the corporate-level taxes paid by the paying corporation. An
adjustment to the capital gains portion of the credit would be made to account for the
capital gains resulting from both retained earnings (that have been subject to the
corporate income tax) and other price appreciation. Under this approach, while relief
would be provided at the individual level, taxes would be paid on the corporate
income tax at individual income tax rates. Thus, the corporate income tax would
function much like a withholding tax.
A third approach is to retain the corporate income tax, but exclude corporate-
source income from individual income taxes — a relatively simple method to
implement for distributed earnings, but difficult to administer for the portion of
capital gains attributable to reinvested earnings. In the latter case, stockholders’ basis
in stock would have to be adjusted to reflect retained earnings, so as to exclude only
gains attributable to retained earnings. In 1992, a U.S. Treasury report outlined a
variant of this method, termed a “comprehensive business income tax” (CBIT), under
which corporate-source income would not be taxed at the individual level. The
corporate income tax would be retained, and interest deductions would not be
permitted.
Compendium of Background Material on Indivdiual Provisions, committee print, 108th
Cong., 2nd sess. (Washington: GPO, Dec. 2004).

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CRS-18
Partial integration by means of an exclusion for dividends received by
stockholders would thus be relatively straightforward. Indeed, the reduced individual
income tax rate that the Jobs and Growth Tax Relief Act of 2003 (JGTRRA) applied
to dividend income can be viewed as a form of shareholder-level partial integration,
akin to a shareholder exclusion that applies to only part of received dividends.
Similarly, a shareholder-credit version of integration that would be restricted to
dividends paid would be more straightforward than the full-integration version of a
credit system. A partial-integration form of the shareholder credit method is the
system used most frequently by European and other foreign countries that have
adopted integration.
Each method of integration has its particular advantages and disadvantages. As
suggested in the preceding discussion, partial integration is simpler and easier to
administer than full integration; on the other hand, it does not achieve all the
efficiency gains under full integration, since a part of corporate income would still
be taxed twice. Also, the different plans differ in their revenue cost, with the full-
integration methods generally losing more revenue than partial integration plans, and
shareholder allocation methods reducing revenue more than other methods.18
Business Taxes under Consumption or Flat Taxes. Either tax
integration or a tax based on a comprehensive measure of income would qualify as
fundamental tax reform. Each would entail substantial changes to the current system
and would use a tax base supported by a relatively consistent concept of income. In
popular discussions, however, the term “fundamental tax reform” has frequently
referred to a different type of tax change: replacing the current federal individual and
corporate income taxes with a system that taxes consumption but exempts saving.
Most taxonomies list three basic types of national-level consumption taxes: value-
added taxes; a national sales tax; and a tax on individuals’ consumed income. In
addition, a prominent “flat tax” proposal would consist of a form of value-added tax
imposed at the corporate level and a wage tax at the individual level.
The different forms of consumption taxes differ chiefly in their methods of
collection and, as a result, their ease of administration and compliance costs. Their
general effect on business taxes, however, would be the same: income from new
business investment would be exempt from tax under each form. In the near term,
however, income from investment in place at the time of transition would generally
be taxed.
National Sales Tax. Turning to specifics, a national retail sales tax would
operate much as do the sales taxes imposed by most states: the tax would be imposed
on final sales from businesses to consumers; businesses would collect the tax and
remit it to the government. In general, business-to-business sales (sales of
intermediate goods) would be exempt from the tax; the levy would be applied to
imports, but exported goods would be exempt.
18 For a more comprehensive discussion and analysis of integration, see CRS Report
RL31597, The Taxation of Dividend Income: An Overview and Economic Analysis of the
Issues, by Gregg A. Esenwein and Jane G. Gravelle.

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CRS-19
To the extent that business inputs are included in the base of a national sales tax,
the product to which they contribute would be subject to multiple layers of tax; such
cascading would carry the potential of inefficient distortions, diverting resources
away from the heavily taxed products. Accordingly, an important task under a
national sales tax would be distinguishing between business and non-business uses
of purchased items, so as to exempt the former and tax the latter. One possible
method of doing so would be to issue exemption certificates to businesses so as to
remove their purchases from the tax base. Nonetheless, making the distinction would
likely present significant administrative and compliance problems, particularly in the
case of items that lend themselves to both business and personal use (e.g., many
services). Compliance might also present a problem, given the high tax rate that
would likely be necessary to avoid a revenue loss if income taxes were abolished.19
Value-Added Tax and “Flat” Tax. As the term implies, value-added taxes
(VAT) are levied on the value added by each firm in a good’s production process.
VATs thus differ in their point of collection from retail sales taxes, but by the final
stage of production the cumulative rate of the VAT on an item is the same as that of
a sales tax (assuming each is applied uniformly).
There are two general methods by which VATs are administered: credit-invoice
and subtraction. Under a credit-invoice method, a business is assessed VAT on its
gross receipts, regardless of whether its sales are made to another business or to a
final consumer. At the same time, the firms from which it has purchased its inputs
provide it with invoices showing the VAT the suppliers have already paid with
respect to the inputs. The purchasing firm claims the VAT shown on the invoice as
a credit against the VAT on its own sales. As a result, for each firm, the VAT applies
only to value added. Under a subtraction-method VAT, tax is levied on a firm’s
gross receipts after subtracting purchases from other firms. What is left, then, as the
base of the tax is the return to capital (profits) and the return to labor (wages) — the
value added by the taxed firm. Despite the difference in administration, a
subtraction-method VAT and a credit-invoice VAT produce the same tax, assuming
they are levied at the same rate. It should also be noted that, as with a sales tax, each
is levied on imports, but exports are not included in taxable gross receipts. In the
case of the credit-invoice method, an exporting firm receives a tax rebate for taxes
paid with respect to its inputs.
A variation on the subtraction-method VAT is the so-called “flat tax” —
sometimes termed the Hall-Rabushka proposal after its designers. Under the flat tax,
a subtraction-method VAT would be imposed on business — that is, firms would pay
a tax on gross receipts minus items purchased from other firms. In contrast to a pure
VAT, however, firms would also be permitted to subtract wages from gross income,
thus removing from the business-level tax base that portion of the firm’s value-added
19 For more detailed discussions of how a national sales tax might operate in practice, see
John L. Mikesell, “The American Retail Sales Tax: Considerations on Their Structure,
Operations, and Potential as a Foundation for a Federal Sales Tax,” National Tax Journal,
vol. 50, Mar. 1997, pp. 149-165, and Martin Sullivan, Flat Taxes and Consumption Taxes:
A Guide to the Debate (Washington: American Institute of Certified Public Accountants,
1995), pp. 11-18.

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CRS-20
contributed by labor. Individuals, however, would be assessed a tax on wages
received, thus bringing the value added by labor back into the tax base, albeit at the
individual level.
By the final stage of production, the cumulative rate of a VAT on an item is the
same as that of a sales tax, assuming neither contains special allowances and benefits.
Thus, their broad economic effects are the same. But since the two types of tax differ
in how they are collected, there are differences in compliance and ease of
administration. A VAT would impose a higher compliance burden on businesses in
general than a retail sales tax; under a VAT, every business would be required to file
a tax return, not just businesses in the retail sector. At the same time, a VAT avoids
the administrative problem of distinguishing business use of items from personal use.
Further, some analysts have argued that small businesses would likely encounter high
compliance costs under a national sales tax, and small businesses are relatively
numerous in the retail sector. Thus, compliance rates may be higher under a VAT.

Consumed Income Tax. A third type of consumption tax is a tax on
consumed income imposed at the individual rather than business level. Individual
income consists of consumption plus saving. Thus, individuals would calculate their
tax by subtracting saving from their income and paying tax on the residual. Business
investments made by individuals would be characterized as saving, and thus an
exempt use of income. Thus, for example, an individual’s purchases of stock would
be deducted from taxable income, as would, say, the purchase of a new machine by
a small business owner. Note that an individual consumption tax is defined in terms
of the uses of income rather than its source. Thus, it is business investment that is
deductible rather than income generated by businesses. However, arithmetic dictates
that deducting the cost of a capital investment at the time it is made (“expensing” the
investment) produces a tax saving that is identical in present-value terms to
exempting the net income the investment produces as it is generated over the
investment’s lifetime. Thus, deducting business investment on the uses side of the
income ledger is the same as exempting income from new investment on the sources
side. New business investment bears no burden under an individual consumption
tax.
Effects of a Consumption Tax on Business. A consumption tax
exempts from its coverage income that is saved, which is the equivalent of exempting
investment income. In short, under any form of pure consumption tax — be it a sales
tax, a VAT, or an individual consumption tax — business profits are ultimately
exempt from tax. As a result, if it is assumed that a consumption tax would not
contain its own preferences for special goods or services (an assumption that is
perhaps heroic), the various non-neutralities existing under the current system of
business taxation would be eliminated. As described in the preceding section on
economic efficiency, these include current law’s preference of non-corporate
investment over the corporate sector, of corporate debt over equity, and of machines
and equipment over inventory and structures. If these non-neutralities were
eliminated under a consumption tax, business investment — especially corporate
investment — could be expected to increase under a consumption tax, as well as
equity finance and investment in assets other than equipment. Economic efficiency
could potentially increase.

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CRS-21
It is worth underlining, however, that it is not the taxation of capital per se that
produces these non-neutralities, but the particular shape of capital income taxation
that has gradually come into being in the current system. Under a consumption tax,
non-neutralities affecting business might be implemented in a different way, but the
result might still be distortions in the allocation in business investment. For example,
a sales tax or VAT might exempt a particular type of good from taxation, which
would favor investment in the sector producing that type of good.
The transition to a consumption tax would likely include significant effects in
the short and medium term. Perhaps most importantly, a consumption tax would
exempt the return to new investment, but would still apply to income produced by
investment in place at the time of the tax’s implementation. Note that under none of
the types of consumption taxes outlined above would a firm be able to continue to
recover the cost of capital in place at the time of transition, either through
depreciation or other deductions. At the same time, revenue produced by old
investments would be included in the tax base, producing a windfall loss for owners
of existing capital. Firms affected most heavily by the taxation of old capital would
be older, slow-growing firms. Also, if a uniform consumption tax were adopted and
existing business distortions were consequently eliminated, as described above,
transition effects would include a shift of resources away from previously favored
investment. For example, business sectors where corporate production is intensive
would benefit, as would firms with low debt-to-equity ratios and production
processes favoring machines and equipment over structures.20
A frequently made popular argument for a consumption tax relates to its
purported beneficial effects on competitiveness. As described above under the
heading “Taxes and Trade,” economic theory indicates taxes have little impact on
competitiveness as it is popularly understood. However, a specific argument relating
to “border tax adjustments” is frequently made in support of consumption taxes, so
the argument is worth describing here. The argument — frequently made by
businesses — focuses on the fact that foreign firms in VAT countries receive a rebate
of the VAT on exports to the United States and elsewhere. Thus, it is argued, foreign
firms from VAT countries have a cost advantage over competing U.S. firms. As
described in the section on competitiveness, however, taxes or tax-related
mechanisms such as VAT rebates do not directly alter the balance of trade. In the
particular case of VAT rebates, exchange rate adjustments in response to the rebates
act to eliminate any impact on the balance of trade or “competitiveness.”
Conclusion
While the charts presented earlier in this report show that the level of the
corporate tax has generally fallen in the decades since World War II, the basic
structure has remained the same: a “classical” system under which the corporate
income tax is superimposed on the individual income tax. In 1986, the far-reaching
20 For a more detailed analysis of the impact of fundamental tax reform on business, see
CRS Report RL32603, The Flat Tax, Value-Added Tax, and National Retail Sales Tax:
Overview of the Issues, by Gregg A. Esenwein and Jane G. Gravelle.

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Tax Reform Act implemented reforms within the context of the existing system,
broadening its base and reducing rates. In recent years, however, concern about the
impact of the system on capital formation and U.S. performance in international
markets has stimulated interest in a more substantial structural change, either by
adopting tax integration or moving towards a consumption tax.

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