How will Trump pay for needed corporate tax cut? With other taxes.

President Trump is reportedly set to propose cutting the federal corporate income tax rate from 35 to 15 percent. Slashing the corporate rate will deliver big economic payoffs if it is done without adding to the deficit, but achieving that goal will require hard choices by the president and Congress.

The distortions caused by the corporate income tax in today’s globalized economy are legion. Because the corporate income tax primarily applies to profits earned in the United States, companies have an incentive to avoid U.S. tax by earning profits overseas. Companies may move capital investment abroad, which makes American workers less productive and drives down their wages.

{mosads}Or, companies may use accounting gimmicks to book profits abroad rather than in the United States. The corporate income tax also gives foreign-chartered companies an artificial competitive advantage over American-chartered companies and encourages companies to switch their charters through inversions. 

Slashing the corporate rate from 35 to 15 percent would shrink all of those distortions in one fell swoop. But such a large rate cut would cause a significant revenue shortfall. If the lost revenue was not replaced, the larger deficit would crowd out investment, undermining the tax cut’s economic gains and would impose new burdens on future taxpayers. 

Although making up the revenue loss by removing corporate tax “loopholes” sounds appealing, it wouldn’t work. Repealing special-interest provisions would yield only enough revenue to pay for a couple percentage points of rate reduction. Even slowing down depreciation schedules, which would discourage investment, wouldn’t be enough to get the rate close to 15 percent.

Fortunately, other options for making up the lost revenue are available.

One approach would be to offset the lower corporate rate by raising taxes on dividends and capital gains received by American shareholders. Dividends and gains would be taxed at ordinary rates rather than the preferential rates that now apply. Because the taxes paid by the shareholders would not depend on where the corporation invested, booked its profits, or was chartered, shareholder taxation would avoid the harmful incentives of the corporate income tax.

Taxing capital gains at higher rates would pose challenges. Because gains are taxed only when shareholders sell their stock under today’s rules, higher tax rates would give shareholders a stronger incentive to postpone taxes by hanging on to their shares. That incentive could be eliminated by taxing shareholders each year on the rise in the value of their stock holdings, whether or not they sell.

Gains could be averaged over a number of years to smooth out stock market volatility and small shareholders could be exempted from tax. Eric Toder of the Urban Institute and I recently developed a plan that would lower the corporate tax rate to 15 percent and offset the revenue loss with higher shareholder taxes.

A more sweeping approach would seek bigger economic gains by moving toward consumption taxation. Consumption taxes are more growth-friendly than income taxes because they do not penalize saving and investment.

Most consumption tax plans involve some form of value-added tax (VAT) — a consumption tax used in 160 countries that involves taxing the value added at each stage of production. The tax blueprint that House Republicans presented last year would replace the conventional corporate income tax with a business cash flow tax, a modified VAT that allows firms to deduct their wage costs.

The Republican blueprint has encountered roadblocks because the cash-flow tax is not well understood and because it would not fit well with the rest of the federal tax system nor with international trade rules.

A more straightforward approach would adopt a full-fledged VAT. By itself, using a VAT to pay for corporate rate reduction would shift the tax burden toward middle-income and lower-income households. To address that problem, the change should be part of a bigger reform that includes individual income tax cuts and rebates or tax credits for low-income households. Several proposals along these lines have been put forward.

Of course, moving to a VAT would raise many design and transition issues. For example, the VAT should be prominently listed on customer receipts to keep it from becoming a stealth tax that politicians could repeatedly raise without public scrutiny.  

Cutting the corporate tax rate to 15 percent in a fiscally responsible manner would provide a powerful boost to the American economy. But getting there will require some hard decisions.

Alan D. Viard is a resident scholar at the American Enterprise Institute, where he studies federal tax and budget policy. Prior to joining AEI, Viard was a senior economist at the Federal Reserve Bank of Dallas and an assistant professor of economics at Ohio State University.

The views expressed by contributors are their own and not the views of The Hill.