Implement Corporate Tax Reform to Incentivize Investment

This brief is part of “Election 2024: Policy Playbook,” a series by Rice University and the Baker Institute that offers critical context, analysis, and recommendations to inform policymaking in the United States and Texas.

The Big Picture

The corporate income tax in the United States is currently in a state of flux:

• Provisions of the Tax Cuts and Jobs Act (TCJA) of 2017 that allow expensing or immediate deductibility of equipment purchases are being phased out and will expire after 2026.
• At that point, purchases of equipment will be depreciated under the modified accelerated cost recovery system (MACRS), as are purchases of business structures currently.
• Similarly, research and development (R&D) expenditures are currently amortized over a five-year period although they were historically allowed full expensing.
• This situation provides an opportunity to enact corporate income tax reform that would improve investment incentives and move the U.S. toward a roughly neutral business tax system.

Summarizing the Issue

The time has come to enact corporate income tax reform using two key building blocks:

1. Reinstating expensing of equipment and eliminate most interest deductions.
2. Strengthening provisions designed to reduce income shifting.

Expert Analysis

Reinstate Expensing and Eliminate Most Interest Deductions

The first proposed building block involves moving to an income tax system with a primary goal of creating a roughly neutral business tax system that eliminates tax on — but does not subsidize — marginal investments, while taxing “above-normal” returns or “economic rents” at the statutory corporate income tax rate. Such a tax system does not discourage investments at the margin (the “marginal effective tax rate” is zero), but raises revenue from the taxation of inframarginal returns. These results can in principle be achieved with expensing, coupled with the complete elimination of interest deductions. Under the current tax system, interest deductions are limited to a moderate extent but not eliminated entirely, which implies that the current tax system subsidizes investments that benefit from expensing.

Accordingly, all investments in equipment and R&D should be expensed, with no deductions for the interest expenses associated with such purchases. Note that, in principle, expensing should also be allowed for investments in business structures. However, such treatment would be costly and could create the potential for significant tax evasion; it has thus generally been avoided, including under the TCJA. Following this convention, investment in structures should continue to receive deductions for depreciation. In this case, deductions for interest expenses are also appropriate, so interest on loans directly tied to investment in structures should be fully deductible. This would result in a marginal effective tax rate of zero on debt-financed investment in structures. In addition, deductions for depreciation on structures should be accelerated to offset the effects of inflation at a 2% rate (the inflation target rate specified by the Federal Reserve Board) and could be accelerated slightly further to partially offset the taxation of equity-financed investment in structures.

The net result would be a tax system that would be quite favorable to investment at the margin — an overall marginal effective tax rate roughly approaching zero, especially to the extent investment in structures is heavily debt-financed — while taxing the above-normal returns earned by such investments at the statutory corporate income tax rate. Indeed, since the majority of tax revenues would be raised from a largely non-distortionary tax on above-normal returns, a modest increase in the corporate statutory rate to 25% is also recommended. This represents an increase in the corporate tax rate of approximately 20%, which should be accompanied by the elimination of the current special 20% deduction for certain forms of noncorporate business income.

This approach would keep the corporate and noncorporate tax rates in rough parity and eliminate one of the provisions of the TCJA that most increased the complexity of the income tax system.

No further increase in the corporate tax rate is advised (nor an increase in the corporate tax rate that is not accompanied by full expensing for investments in equipment and R&D), as rate increases encourage multinational enterprises (MNEs) to move investments abroad and/or attempt to shift income to lower-tax jurisdictions, including tax havens.

Strengthen Provisions Designed to Reduce Income Shifting

The problem of income shifting would be addressed by the second building block of the proposal. The TCJA attempted to deal with the problem of income shifting by creating a separate minimum tax on what it defined as “global intangible low-taxed income” (GILTI). However, numerous analyses, reviewed by Dharmapala (2024), suggest that the GILTI provisions have largely been ineffective, as income shifting has not decreased any more than would be expected simply from the reduction in the U.S. corporate income tax rate to 21% under the TCJA. The effectiveness of the GILTI provisions in reducing income shifting by MNEs could be increased by imposing the tax on GILTI on a country-by-country basis, rather than on an aggregate basis as under current law. This would prevent taxes on income earned in high-tax countries from being used to offset tax liability on income shifted to low-tax countries, including tax havens, and should result in a further reduction in income shifting.

Policy Actions

To summarize, the following policy actions would move the U.S. toward a roughly neutral business income tax system: 

• Eliminate tax on — but do not subsidize — marginal investments, while taxing “above-normal” returns or “economic rents” at the statutory corporate income tax rate.
• Allow for the expensing of all investments in equipment and R&D, with no deductions for the interest expenses associated with such purchases.
• Make interest on loans directly tied to investment in structures fully deductible.
• Accelerate deductions for depreciation on structures to roughly offset the effects of inflation at a 2% rate.
• Increase the corporate tax rate to 25%, accompanied by the elimination of the current 20% deduction for certain forms of noncorporate business income.
• Reduce income shifting by imposing the existing tax on GILTI on a country-by-country basis, rather than on an aggregate basis as under current law.

The Bottom Line

Many additional reforms could, of course, also be part of a thorough overhaul of the income tax system. The main message of this brief is that the reinstatement of expensing of equipment coupled with changes in the limits on interest deductions as well as the strengthening of current provisions designed to reduce income shifting should be part of any corporate tax reform package that maintains the current tax structure. In addition, consideration should be given to more fundamental tax reform approaches, such as moving to a destination-based business cash flow tax.

This material may be quoted or reproduced without prior permission, provided appropriate credit is given to the author and Rice University’s Baker Institute for Public Policy. The views expressed herein are those of the individual author(s), and do not necessarily represent the views of Rice University’s Baker Institute for Public Policy.