Treasury Secretary Henry M. Paulson Jr. recently briefed President Bush on various possibilities for overhauling a corporate tax structure that he considers disadvantageous for U.S. business. A study that the Treasury Department released on July 23, 2007, said the corporate tax rate could be reduced from 35 percent to 27 percent by eliminating the research-and-development tax credit, the deduction for domestic production, breaks for interest on state and local bonds, the deferral of income from controlled corporations and various other “special provisions.” Alternately, the eliminated provisions could be replaced with expensing of 40 percent of the cost of new tangible investments and the system still would raise current levels of revenue.

Key Considerations

From the Treasury’s viewpoint, these are the key considerations for corporate tax reform: 

  • Ideally the United States needs a broader tax base and lower rates to avoid the distorting effects of preferences and high rates.
  • The recently enacted domestic production activities deduction is distorting and is the most costly corporate tax preference. 
  • The study includes a confusing discussion of unincorporated businesses, the import of which appears to be that individual tax rates also need to be lowered, particularly if corporate rates are lowered, so as not to create an artificial impetus to incorporate.
  • Tax on capital income reduces savings and investment and that reduces real income.
  • Debt financed corporate business effectively pays no corporate tax.
  • The double tax on corporate income is distorting.
  • The current asset depreciation system is not sufficiently generous.
  • Expensing of new capital investment can be viewed as an equivalent alternative to lowering the tax rate in terms of encouraging business investment in capital assets.
  • But, expensing offers substantially more “bang for the buck” due to concentrating on the encouragement of new investment..
  • Compared to other countries the U.S. corporate tax rate is high, but the relation of the total corporate tax collected to GDP is low, suggesting that the United States has abnormally high corporate tax preferences.

What does this mean?

The Treasury study is fairly careful not to make specific proposals. Many of its observations are so common as to be platitudes: broaden the base and lower the rate, and reduce tax on capital so as to encourage investment. However, it may be possible to tease out some indications of the administration’s inclinations. First, what is not emphasized may be important. Although the study identified deferral of foreign income as a tax preference, it did not dwell on that point. To the extent it did discuss it, the study applied the general observation that lowering marginal rates would decrease the pressure to push income offshore

Second, the domestic production deduction turns out to be what it appeared to be from the outset: a stalking horse for a general corporate rate reduction.

Third, the study does not heavily emphasize what has long been the showcase corporate tax reform: integration. However, it does starkly illustrate that debt financed business investment basically pays no corporate tax. Perhaps the reason why the study does not focus more on a solution to this problem is the complex interrelationship between any fix and the entire income tax system.

Fourth, the real message of the study seems to be expensing.


The theory of expensing is completely different from the theory of depreciation, which it would replace. Expensing abandons any attempt to accurately measure income on a current basis.

The study cites the economic argument that a front-end deduction of an asset’s cost has the same present value as eliminating a future tax on the “normal” riskless return on such an investment. That sounds like, but is not the same as, saying that front-end expensing produces the same present value tax reduction as future depreciation. When you talk about eliminating tax on riskless return, you are not talking about properly measuring income in order to tax income: you are talking about taxing consumption rather than investment. Indeed, expensing is a key component of a consumption tax at the business level, for example a subtraction method VAT.

Of course, from the corporate taxpayer viewpoint there is nothing not to like about expensing. It allows an immediate current tax reduction, and forgetting about tomorrow is not an unusual world view for tax planning. The code already contains an entering wedge of expensing. The problem is paying for it.

The chart of “special provisions” in the study offers a ready menu for paying for it, starting with the largest revenue loser — the deduction for domestic production. Presumably, most of the taxpayers that would suffer from the loss of that deduction would benefit from expensing. The study introduces the concept of partial expensing, such as expensing 40 percent of a new asset’s cost. Picking the percentage would make it relatively easy to match the revenue loss from eliminating the domestic production deduction. And most taxpayers that have benefited from that deduction probably did not think it would last forever, so the political fallout should be manageable. Finally, it should be noted that the study’s list of preferences is limited to corporate preferences. It completely ignores the huge preference resulting from the deduction and simultaneous exclusion of employee health benefits.

A way station to a consumption tax?

As the study states in a footnote, expensing is a key component of a cash flow or consumption tax. Under a subtraction method VAT, businesses collectively pay a VAT that approximates the results of the more common credit method VAT. The businesses compute their tax base by, among other things, deducting all purchases (i.e., expensing) and in theory including all cash sources, including net borrowings.

There is the rub. The study made no mention of including net borrowings in the tax base. That and many other problems would have to be addressed before a VAT could be adopted. And yet, it has long been observed that a VAT added onto the income tax system is probably the only way the United States can increase its revenue, as many claim is needed. As to revenue needs, see Testimony of Controller General David A. Walker (July 25, 2007) and Center on Budget and Policy Priorities, Historical Averages Not a Meaningful Benchmark for Future Revenues (August 22, 2007).


The Treasury study suggests that the administration has some interest in moving substantial tax changes prior to the end of President Bush’s term. Despite the difficult political climate, perhaps the administration feels that it is now or nearly never. And trading the domestic production deduction for partial expensing in a revenue neutral change could be a relatively easy step that could be viewed as a placeholder for adoption of a consumption tax when the time is right.