Cut the Corporate Tax Rate? Representative Ryan’s 8.5% Business Consumption Tax

President Obama did not offer much in the way of specifics in his State of the Union address this week, so one thing that did stand out was his specific recommendation that we lower the tax rate on corporate income. A Republican response to the president’s speech was given by Wisconsin Representative Paul Ryan, and while Ryan didn’t mention it in his response, he has recommended replacing the corporate income tax with a “Business Consumption Tax” at an 8.5% rate.

Ryan’s Business Consumption Tax is a Value Added Tax (VAT).  I have argued against creating a VAT in the United States, but Ryan’s Business Consumption Tax avoids many of the negative factors that would make a VAT undesirable here.

The compliance costs on taxpayers would be less the way Ryan’s Business Consumption Tax computes value added for tax purposes than the system used for tax computation in the European Union, and while there is always a threat that this tax could open the door for a wider application of a VAT, the tax is limited in both a political and economic sense, and is designed as a replacement for the corporate income tax.

The Business Consumption Tax would have a broader tax base than the current corporate income tax (fewer loopholes), and that produces the tax’s biggest advantage: it allows the marginal tax rate to drop from the current 35% to 8.5%.

Perhaps the biggest change from the current tax system is that a firm’s labor costs are part of its value added, so firms that are labor intensive (for example, software companies) would find their tax bills rising relative to manufacturing firms that are capital intensive. This could create a political hurdle too high to clear, should Ryan’s plan ever be seriously considered.

Having listened to the State of the Union address, the intriguing thing is that President Obama says he wants to lower the corporate tax rate, and Representative Ryan has a plan to do it — big time. A drop from 35% to 8.5% would make tax considerations a minor issue in new investment compared to the penalty of over a third of corporate income that now is levied on corporate profits that firms are unable to drop through the loopholes. Obviously, businesses will be more productive when they make their resource allocation decisions on how profitable they will be rather than on whether they can avoid taxes.

I’ve heard Obama critics say that he has no intention of following through on his rhetoric on limiting government. But the president did say he wants to cut the corporate tax rate, and the Ryan plan is an interesting starting point for answering the president’s rhetoric, if for no other reason than that it would reduce the corporate tax rate to a quarter of its present level.