Introduction
The United States continues to experience tepid economic growth, despite the official end of the recession more than 5 years ago. The U.S. economy remains exposed to contraction – with negative growth rates seen in the first quarters of 2015 and 2014.  More worrisome is the U.S.’s projected growth rate of 2.3 percent over the next 10 years. Essential to improving this outlook is a pro-growth policy agenda that includes reforming the nation’s broken tax code.

The House and Senate are both in the early stages of considering tax reform, characterized by committee-level working groups, discussions, and hearings. The Senate Finance Committee recently released the results of a bipartisan effort to examine 5 separate elements of the tax code.[1] The congressional budget resolution also assumes a fundamental rewrite of the tax code. While promising, history indicates that there have only been a handful of tax overhauls of the modern tax regime, and a total overhaul remains a difficult policy goal. In the near-term, it will likely remain elusive, but reforms of a smaller scope, such as business-only reform, or reform that focuses only on taxation of U.S. multinational corporations, are more achievable. Of course this approach would also be less desirable in terms of the implications for overall growth and the manufacturing sector, which remains a vital component of the U.S. economy.

This analysis reviews the need for tax reform, characteristics of a successful tax reform, and the policy merits of recent tax proposals and concludes that comprehensive tax reform would offer the largest opportunity for U.S. firms, particularly domestic firms, to include domestic manufacturing firms, while a robust business tax reform that includes essential rate reduction, could yield 2.5 million new jobs and as much as $9,000 in additional annual income per American. Less optimal for the economy in general and manufacturing would be a narrower reform that does not include business pass-throughs, while still less optimal would be a reform that only addresses the international tax system.

The Need for Tax Reform: The Corporate Tax Rate
The single most important characteristic of the U.S. corporate tax is that the rate is too high. The combined federal-state U.S. corporate tax rate of 39 percent is the highest among all major developed economies.^[2] The high U.S. rate is seemingly not a matter of deliberate choice. Instead, it stems from a failure to acknowledge and keep abreast of broader global trends.

The U.S. corporate tax rate is essentially unchanged since 1986, when a significant rate reduction was enacted. Prior to 1986, the U.S. levied corporate taxes in excess of the Organization for Economic Cooperation and Development (OECD) average. By 1988, when the 1986 reform was fully implemented, the combined U.S. statutory rate had fallen below the OECD average.

Since 1988, however, the U.S. has again become a corporate tax outlier. According to OECD data from 1988-2011, every OECD nation, except the U.S., reduced its combined statutory corporate tax rate. On average, these nations saw a decline of 18 percentage points in combined statutory rates. The only OECD nation that saw a net increase in the combined statutory rate was the United States – the result of a 1-percentage point increase in 1993.

Additional Measures of the U.S. Tax Rate
Just as taxing wages creates a disincentive to work, taxing capital creates a disincentive to invest. The tax system that currently exists in the United States is full of these distortions, which leads to an inefficient amount and distribution of capital. But measuring the effect of taxes on capital investment is more difficult than just looking at the statutory rate found in the U.S. tax code. Instead, it is useful to consider two additional measures of taxation: the average effective tax rate and the effective marginal tax rate.

While statutory tax rates are critical to firm investment decisions, other measures of corporate taxation also warrant consideration.^[3] A firm’s average effective tax rate includes other facets of the corporate tax code, such as credits and deductions, which figure in the determination of a firm’s tax burden. While less stark than top statutory rates, an international comparison of effective corporate rates still paints the U.S. in an unfavorable light. According to a study by PricewaterhouseCoopers, “companies headquartered in the United States faced an average effective tax rate of 27.7 percent compared to a rate of 19.5 percent for their foreign-headquartered counterparts. By country, U.S.-headquartered companies faced a higher worldwide effective tax rate than their counterparts headquartered in 53 of the 58 foreign countries.”^[4]

The effective marginal tax rate measures the true value of taxes paid on each additional dollar of investment. Firms make their marginal investment decisions based on the expected return from that investment. A high effective marginal rate lowers that return, making investment less attractive.

Making investment even less attractive is the marginal tax distortions created by the U.S. tax code. For example, publicly traded C-corporations face a higher marginal rate than sole proprietorships and other S-corporations. Similarly disruptive, debt-financed investments face a lower rate than equity-financed investments. Finally, investments in assets such as inventory, computers, and manufacturing buildings typically face a higher effective marginal rate than investment in petroleum and natural gas structures.[5]

Because these rates vary based on asset type and financing structure, the U.S. tax code inadvertently incentivizes certain types of investment over others. This contributes to inefficient investment decisions and limits economic growth. Pro-growth tax reform would address these inefficiencies, which would include a lower rate and an associated diminution of distortions.

Alternative Approaches to Tax Reform

Comprehensive Tax Reform
A fundamental tax reform would address both business and individual tax systems, which have gone without a complete reform since 1986. Since then, rates and complexity in both systems have increased. A fundamental overhaul would likely face revenue-neutrality constraints as was the case in 1986. Such a constraint would require important tradeoffs, but it could still allow for a pro-growth tax reform, that could increase GDP growth, employment, wages, and could yield budgetary savings.[6]

Comprehensive tax reform, however, has proven to be an elusive public policy goal. The most recent attempt advanced by former Chairman of the Ways and Means Committee was met with restraint in Congress, while the administration has expressed little interest in pursuing a tax reform that would pair business and individual rate reduction.

Businesses-Only Reform
That United States has a highly uncompetitive tax code that harms growth and disadvantages U.S. firms at home and abroad. U.S. corporate tax reform therefore is essential, but any effort to attempt to reform “business” taxation that focused solely on the corporate code would fall short of taking full advantage of the chances for improved economic policy.

The code taxes businesses in two distinct ways: either at the entity level or the individual level. Whether the business is taxed directly or the taxable income is passed through and then taxed at the individual level is determined by the legal form that the business takes.

There are four major organizational forms available to non-farm businesses: C-corporations (named for subchapter C of the tax code), non-farm sole-proprietorships, S-corporations (subchapter S of tax code), and partnerships. A business may elect to organize as a particular type of entity for a number of reasons that are beyond the scope of this discussion.^[7] Broadly, these organizational forms can be separated by how related income is taxed. This division separates C-corporations, where income is taxed at the business or entity level (and again when passed along to shareholders as a dividend), and the other major forms of organization broadly referred to as pass-through entities because related business income is said to “pass-through” the organization to be taxed at the individual level through the personal income tax.

As of 2012, there were 32.8 million non-farm businesses filing tax returns: 1.6 million C-corporations, 23.6 million sole-proprietors, 4.2 million S-corporations, and 3.4 million partnerships (including LLCs). The past several decades have seen the relative growth of non-farm sole proprietors, S-corporations and partnerships, and the associated diminution of the C-corporation.[8]

This dates to tax reform legislation in 1986 that raised the corporate rate above the top individual rate. S-corps quickly gained popularity followed later by partnerships. As as the Joint Committee on Taxation notes, “1986 was the last year in which the number of C-corporation returns exceeded the number of returns from pass-through legal entities…. while the number of C-corporations has generally declined in the United States since 1986 by a third, the number of pass-through entities has nearly tripled.”^[9]

The tax code driving a firm’s organization produces an inefficient distortion, which ultimately is a drag on economic growth.^[10] There is evidence that the corporate tax code can reduce the incentive to organize business activity as a Schedule C corporation in favor of other forms of organization, this has been found to impose a cost by misallocating entrepreneurial talent in the economy.[11]

A sound tax reform would mitigate this effect. Any attempt to reform business taxation generally must therefore be neutral to legal form of organization. Pursuing corporate tax reform, to include needed rate reduction, while leaving the individual code untouched would exacerbate any existing distortions.

International-Only Reform
The U.S. corporation income tax applies to the worldwide earnings of U.S. headquartered firms. U.S. companies pay U.S. income taxes on income earned both domestically and abroad. Active income earned in foreign countries is generally only subject to U.S. income tax once it is repatriated, giving an incentive for companies to reinvest earnings anywhere but the U.S., owing to its high corporate tax rate.

This system distorts the international behavior of U.S. firms and essentially traps foreign earnings that might otherwise be repatriated back to the U.S.

While the U.S. has maintained an international tax system that disadvantages U.S. firms competing abroad, many U.S. trading partners have shifted toward a territorial system; that system exempts entirely, or to a large degree, foreign source income. Of the 34 economies in the OECD for example, 28 have adopted such systems, including recent adoption by Japan and the United Kingdom.

Maintaining the U.S. worldwide system compounds the incentive for firms to keep earnings offshore in the face of high domestic rates. The combination of high rates and an increasingly outmoded worldwide tax system disadvantages U.S. firms abroad, where market opportunities are growing.

The 1990’s and early 2000’s saw a series of corporate “expatriations” whereby U.S. firms re-domiciled abroad to reduce their tax burden, a phenomenon that has seen a recent resurgence. Maintaining, the U.S.’s antiquated tax system will, as previous research by the American Action Forum has demonstrated, will continue to put domestic headquarters at risk.[12] This activity has drawn attention to international inversions, and spurred potential reforms to address international tax policy as a revenue source for additional infrastructure policy.[13]

However, modernization that only includes an international reform would come at the expense of reforms that fundamentally address the primary failures of the U.S. business tax code – the rate. An international-only reform would not benefit C and S-Corporations with sole operations in the United States, including domestic manufacturing. Moreover, such a reform would not benefit the million of domestic S-Corporations that do not conduct overseas operations. An international-only reform falls well short of the goals of both comprehensive and an ideal business tax reform.

Benefits of Reform
Early research on the economic effects of corporate taxes was largely focused on closed economies.^[14] Despite this limitation, this early work revealed many of the pernicious effects of corporate taxes, and laid the foundation for better understanding of the tax’s effects. While the U.S. corporate tax code had remained largely unchanged for decades, there has been significant global economic and geopolitical change in the intervening years. In an increasingly interdependent global economy, corporate taxes must be considered in the context of high capital mobility, a world that only amplifies flaws observed in the early literature. In a global economy where investment can more easily shift, the implications for economic growth from corporate tax policy can be significant.

There is a strong body of research identifying the negative effect on investment and capital formation from corporate tax.^[15] Recent work has furthered the understanding that a high corporate tax rate increases the user cost of capital, which slows investment, productivity, and economic growth. Djanker et. al. present a robust finding that “the effective corporate tax rate [has] a large adverse impact on aggregate investment, FDI, and entrepreneurial activity.”^[16] Among the more telling examples is a recent study by the OECD that notes “corporate income taxes have the most negative effect on GDP per capita.”^[17]

Another OECD study found that reducing the statutory corporate tax rate from 35 percent to 30 percent increases the ratio of investment to capital by approximately 1.9 percent over the long term.^[18] This is also consistent with the finding from the JCT, which observed that reducing corporate income taxes have the greatest effect on long-term growth by increasing stock of productive capital, which leads to higher labor productivity.^[19]

In a 2008 OECD study of how corporate taxes affect investment decisions, Arnold and Schwellnus conclude that corporate taxes lower the rate of return for innovative-risky investments, reducing innovation and risk-taking.^[20] To the extent that the corporate income tax discourages risk-taking, this suggests that the corporate income tax is like a “success tax” that firms with higher than average productivity must face, which is consistent with Gentry and Hubbard.^[21]

Among the most clearly stated observation of the growth implications for corporate tax reform is from Gordon and Lee, who found that cutting the corporate tax rate by 10 percentage points can increase the annual growth rate by between 1.1 percent and 1.8 percentage points.^[22]

The Tax Foundation also recently published estimates of the potential growth effects from corporate rate reduction, finding that reducing the “federal corporate tax rate from 35 percent to 25 percent would raise GDP by 2.2 percent, increase the private-business capital stock by 6.2 percent, boost wages and hours of work by 1.9 percent and 0.3 percent, respectively, and increase total federal revenues by 0.8 percent.”^[23]

There is a clear consensus that the high U.S. corporate rate is a detriment to the economy and should be addressed through a reform that results in lower rates. As the research literature indicates, lower rates would have a significant and positive effect on economic growth, and therefore on employment and wage growth.

Employment and Income Effects
The American Action Forum has previously estimated that a pro-growth corporate reform could yield a significant improvement in annual economic growth.[24] This effect is predicated on the GDP effects of a lower corporate rate in keeping with findings in the economic literature. A reform that did not include these effects – such as an international only reform would therefore preclude these gains. Over the long-term, a 1 percent increase in trend economic growth would accrue to workers, first as the U.S. economy returns to full employment in the form of new jobs, then as wages. On recent estimate of an improvement in trend economic growth of the magnitude finds that such an improvement could yield 2.5 million new jobs and nearly $9,000 in annual income growth for Americans.[25]

Assessing the Benefits of Tax Reform for U.S. Manufacturing
The U.S. manufacturing sector is essential to a vibrant national economy over the long term and to a robust continued recovery in the near term. While a comprehensive tax reform is unlikely in the this Congress or the next, attention by policymakers to business tax reform is worth considering in its impact not just on the economy broadly, but in terms of the manufacturing sector specifically.

Ranking alternative approaches to tax reform requires assessing the impact of a given reform on a sector requires gauging the footprint of a sector on the overall economy. Manufacturing contributed $2.1 trillion to the U.S. economy on annual basis in the first quarter of 2015, or 12 percent of GDP.[26] Taken alone, the manufacturing sector would stand as the 9^th largest economy – surpassing the GDP of India.[27]  According to the U.S. census, 11.3 million Americans are employed in the manufacturing sector.[28] The manufacturing sector is thus a critical sector of the U.S. economy, and the incidence on manufacturing of any tax reform should be considered in this context.

As noted above, comprehensive tax reform is unlikely in the near-term, but a reform that focuses on business income has gained increased attention from lawmakers over the past year. U.S. firms face disproportionately high business tax rates compared to other economies – especially for manufacturers. Indeed, according to one study, compared to other large economies, U.S. manufacturing faces one of the highest effective tax rates, second only to Japan, compared to other large markets.[29] Rate reduction as part of a business tax reform is therefore essential to any tax reform that addresses the anticompetitive taxation of U.S. manufacturing.

The scope of any business tax reform is also essential. Corporations tend to be larger than other forms of organization in terms of payrolls. This also holds true in manufacturing, where 64 percent of manufacturing employment is concentrated among corporations. However, other forms of organization comprise the bulk of manufacturing employers in the U.S. Indeed, of the 292,094 manufacturing establishments in 2013, 63 percent were organized as S-corporations, sole proprietorships, partnerships, or other form of organizations.[30] Failure to address these pass-through entities as part of business tax reform would thus leave the bulk of U.S. manufacturing firms exposed to anticompetitive rates. Thus, the optimal tax reform approach for the manufacturing sector would achieve needed rate reduction that would be applied broadly to all firms – both C corporations as well as pass-through entities.

The least competitive tax reform approach for U.S. manufacturers would be a reform that left the statutory rate untouched, but would alter the taxation of foreign source income. Many U.S. manufacturers have robust overseas operations, and indeed, the majority of manufacturing employees in the U.S. are employed by U.S. multinational corporations.[31] These firms must confront a tax regime that is increasingly out of step with trading partners. While this includes the U.S. system of taxing worldwide profits, this system is exacerbated by the U.S. high statutory rate. Even a tax reform that incorporated some rate reduction could come at the expense of domestic manufacturers that do not have overseas operations, or would lose certain tax benefits in exchange for international reforms.[32] Indeed, some of the international tax reforms that have been considered as part of a financing mechanism for infrastructure spending could harm the pass-through entities that form the majority of manufacturing establishments in the U.S.[33]

Conclusion
The United States is on a pathway to grow at middling rates for the next decade. In the absence of major policy reforms, the U.S. will increasingly cede the global marketplace to foreign competitors. One essential area of reform is tax policy. The U.S. has not undertaken a major tax reform in nearly 30 years, while other major trading partners have pursued pro-growth reforms to attract new investment and opportunities. As a result the U.S. imposes an antiquated system of tax on its firms, which comprise over 10 percent of the nation’s income. Reforming the tax code to be more pro-growth  should be the goal of the policy-makers in the near-term. While a fundamental overhaul of the tax code is most desirable, alternative approaches to tax reform would have varying effects on the economy as a whole and the manufacturing sector in particular. A business tax reform that includes robust rate reduction and enhances the competitiveness of U.S. pass-through entities represents the optimal approach to a business tax reform for the U.S. economy – improving trend growth and incomes.

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