UniCredit Research: Trump’s corporate tax cut may prompt Europe to follow

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UniCredit Research

Economics Thinking No. 32 (UniCredit Research)

 Trump’s corporate tax cut may prompt Europe to follow

  • President Donald Trump has pledged to cut the corporate tax rate to 15% from 35%, while Republican congressmen are aiming at a drop to 20%. Both rates are below the European average of about 24%.
  • In the past, the corporate tax rates  set by European countries proved to be sensitive to policy changes in the United States. The Tax Reform Act adopted by Ronald Reagan in 1986 is a case in point.
  • Some European governments are already thinking about countermeasures to a potential tax regime change. And the risk of a race to the bottom in corporate tax rates is non-negligible.
  • However, historical patterns should be taken with a pinch of salt. The globalization reversal that is now underway, coupled with growing anti-establishment sentiments, might not trigger the same reaction observed over the last three decades.

1. Cutting the corporate tax rate

Within weeks, President Donald Trump will send Congress an outline for a comprehensive plan to overhaul the tax code for individuals and businesses. The details are not known yet, but the tax reform, especially on the corporate front, will likely be radical. In Trump’s words, “it will be phenomenal”. During his campaign, and as  part of his plan to “make America great again”,  Mr. Trump pledged to cut the corporate tax rate to 15% from the current 35%. The primary goal is to dissuade large corporations from moving their legal entities or even their operations to more convenient fiscal jurisdictions. Republicans in the House of Representatives, instead, favor a tax rate cut to 20%. There is clearly plenty of room to negotiate an agreement that suits both the executive and legislative branches of the Republican Party.

Regardless of the final outcome, the reform will likely reshape international capital markets and affect the investment decisions of several multinationals.  It will also inevitably trigger reactions from other advanced economies too. The prospect of losing tax revenues as a result of a less appealing tax system might induce other governments to revise their corporate taxation rules, in a sort of race to the bottom.  Wolfgang  Schäuble, Germany’s finance minister, recently argued that Berlin should simplify its complex corporate tax system, and Viktor Orbán, Hungary’s prime minister, went a step further. To lure foreign direct investment, he has promised to cut the rate to 9% from the current 19%, going even below Dublin’s 12.5%. But all European capitals are working out potential responses to Washington’s aggressive moves.

This is not the first time that a radical tax-regime change in the United States has forced European countries to adapt abruptly. Something similar happened in the  1980s under President Reagan. While today’s macroeconomic and political environment is radically different from then, with globalization being in retreat and with bilateralism replacing multilateralism, the corporate tax battle between America and Europe is likely to resurface. With an eye on the historical evidence, we will see how it could unfold.

2. The corporate tax rate over time

The debate about the reform of corporate taxation goes well beyond the setting of a new statutory tax rate. There are many issues on the table that complicate the negotiation. First, it remains to be seen whether the US will shift to a cash flow tax, which implies immediate deductions of capital spending and no deduction of net interest payments. This would be a far-reaching change that would make the tax system rather complicated, increasing the cost for firms to adjust. Second, there is the issue of border-adjustments  –  meaning whether  imports, but not exports, should be  included  in  the tax base.  Alternatively, Congress and the White House may ultimately decide to stick to the current tax system, with minor amendments. Each party involved in the negotiations has different views about each of these issues. Therefore, the reduction of the statutory tax rate, which  is widely supported within the Republican party, represents just a small part of the wider issue. Yet, the statutory rate gives a clear signal about the intrusiveness of corporate taxation, facilitating cross-country comparisons, without getting lost in the peculiar functioning of each tax system. And, despite all its technical limitations, this is the number that is more often discussed in international policy debates. For this reason, the rest of the analysis will take this specific angle.

Over the last three decades, corporate tax rates have been trending down across the advanced world. Chart 1 shows that the unweighted average corporate tax rates for a selected sample of advanced economies has softly declined from about 50% in 1981 to about 25% now, but the drop in the rate has not led to a fall in corporate tax revenues. These have actually increased slightly from 2% of GDP in 1981 to about 3%  now, thanks to base-broadening reforms  through reductions in incentives or other deductions as well as to the untamed increase in the GDP share of corporate profits across the advanced world.

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These diverging movements highlight the complexity of the corporate tax system. At a minimum, it comprises a statutory tax rate, which is applied to taxable profit. The definition of taxable profit, however, is typically far from being straightforward or homogenous across countries.



Source: OECD, UniCredit Research

Financial globalization, which has provided increased room for international tax arbitrage, is the prime suspect for the decline in the average corporate tax rate over this period. When capital became increasingly more mobile at the end of the 1980s and beginning of the 1990s, governments started to revise down their corporate tax rates for fear of losing investments, jobs and eventually more tax revenues. One trigger of the downward trend in corporate tax rate was the decision of the Reagan administration to adopt the Tax Reform Act of 1986, which slashed the corporate tax rate in the US from 46% to 34%. At that time, as shown in chart 2, the statutory tax rate in the United States was high in absolute terms but below the rates charged by other large European economies like Italy, Germany and France. Reagan’s decision was motivated more by ideological considerations aimed at boosting the economy through supply-side policies than by a desire to attract foreign investments or to retain domestic ones at the expense of other Western competitors.

The main European countries reacted to Washington’s decision by cutting their corporate tax rates as well, albeit in an uncoordinated manner. In 1985, when financial capital was not too mobile and the labor force was not globalized at all, it was still possible for economies that were smaller and less competitive than the United States to set corporate tax rates that were slightly above the American one, without experiencing major capital hemorrhages. Yet, the 25% reduction in the tax rate caused by the Tax Reform Act of 1986 demanded a response.



Source: OECD, UniCredit Research


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