The Corporate Tax Simplification Delusion

02/17/2011 01:13 pm ET | Updated May 25, 2011

When President Obama, in his State of the Union, called on Congress to join with him to, "get rid of the loopholes. Level the playing field. And use the savings to lower the corporate tax rate for the first time in 25 years -- without adding to our deficit," he was echoing the groupthink on tax policy that has prevailed in Washington for a generation. The groupthink says that the optimal reform is to purge the federal corporate tax code of the myriad of credits and deductions and use the resulting savings to lower the rate. But the groupthink around simplification is based not on evidence; but on ideology. What's more, Washington often gets simplification wrong.

Look no further than the 1986 Tax Reform Act, which today's economists look to as the Holy Grail. It eliminated exemptions while lowering the corporate rate. The impetus for President Obama's call for and the bipartisan interest in tax reform is that while the '86 Act cleaned out the Augean stables, over the years lobbyists have mucked it back up and so it's time for another Herculean stable cleaning. But with a little more scrutiny the Holy Grail loses its luster.

One of the seminal articles that laid the intellectual groundwork for the '86 Act was by Larry Summers, former head of President Obama's National Economic Council, and Alan Auerbach. In an article evaluating the economic impact of an investment tax credit they found, not surprisingly, that a credit would spur more equipment investment. They even found that it would expand GDP compared to no credit. Sounds good, right? Wrong. Summers and Auerbach voted thumbs down on a growth-inducing investment tax credit because it crowded out "non- favored investment." And what was this non-favored investment? Housing. As they wrote, "The credit will bid up interest rates... discouraging purchase of non-favored capital goods, principally structures." For the Washington economics priesthood, this is the worst possible sin for it violates their 1st Commandment: "Thou Shall Not Distort Allocation Efficiency."

For most economists the ideal tax code is one that raises the necessary amount of revenue in the least distorting way. They hold this view because they believe that markets effectively allocate investment, that there are no market failures, and that taxes should have a minimal influence on the economy. If only the market were as simplistic as these assumptions.

Mistaking such assumptions as analysis, Congress passed the 1986 Act, which not only raised taxes on corporations while lowering them on individuals (exactly the opposite of what should have been done given increasing global competition) it eliminated the investment tax credit while expanding housing incentives. This contributed to the subsequent housing bubble and the decline in investment by manufacturers in equipment (down 31 percent over the last decade), one reason why the U.S. has lost over 30 percent of its manufacturing jobs. So a reform based on the idea of simplifying the tax code contributed to reduced investment in equipment, U.S. industrial decline, and the housing bubble and financial crisis.

Contrary to the counsel of the economics priesthood, we should in fact embrace tax code distortions that encourage pro-growth investment. As Canadian government economist Aleb ab Iorwerth wrote, "there is no presumption that distortions are necessarily welfare-reducing. Distortions that favor the contributors to long-run growth will be welfare-enhancing." That's why the Canadian government recently "distorted" their tax code to spur more capital expenditures by companies. That's why other nations have put place an array of tax incentives to spur investment in machinery and equipment (including software) and research and development.

But in the U.S. economists continue to call for getting rid of these pro-growth distortions. In their own failed effort at tax stable cleaning, the Bush administration actually proposed eliminating the R&D credit to use the savings to lower the rate, even though virtually every academic study on the matter has shown that the R&D credit spurs growth and investment. In fact, raising the Alternative Simplified R&D credit from 12 percent to 20 percent would create over 130,000 jobs, increase GDP by $90 billion, and pay for itself through increased tax revenues. But for the tax simplifiers, the R&D credit is an example of government picking winners.

This is not to say that tax reform should not work to reduce special deductions, exemptions and credits that cannot be justified on a competitiveness, productivity or innovation basis. Indeed, a reconstituted corporate tax code which closes parochial loopholes might have some positive impacts on growth, however, modest they might be. But if the dogged faith in simplicity ends up trumping efforts to reshape the code as a driver of innovation and U.S. competitiveness, it will result in less, not more growth and jobs. So the choice should not be between a corporate tax code riddled with particular exemptions and a completely neutral code. Rather the code should focus on expanding exemptions and incentives focused on spurring innovation and growth-enhancing activities like R&D and investments in new machinery and equipment, while eliminating ineffective ones.

Robert D. Atkinson, Ph.D. is founder and president of the Information Technology and Innovation Foundation, a non-profit, non-partisan economic and technology policy think tank based in Washington, DC.