The Cato Institute has organized an online forum to debate pro-growth economic policy reforms. Tax Policy Center scholars Bill Gale, Donald Marron, and Eric Toder have each contributed to the discussion. The U.S. corporate tax system is broken. The current method of taxing the profits of large, publicly traded corporations was designed for an economy in which international investment was relatively unimportant and most corporate profits were produced by tangible assets, such as machinery and buildings. It doesn’t work well in today’s economy, which features increasing globalization and a rising share of profits coming from patents, brand reputation, and other intangible property. Until now, lawmakers have debated ways that the United States could reform its corporate tax while retaining its basic structure. But that will not be sufficient to address fundamental flaws in the law. As a result the United States should consider more significant reforms, such as leading an international effort to develop new rules to allocate corporate profits among countries or scrapping the corporate income tax entirely and replacing it with a direct tax on shareholders. The corporate income tax has always distorted economic choices in important ways. By taxing corporate income at both the corporate and shareholder level, it encourages businesses to organize themselves as limited partnerships or subchapter S corporations so that they face only a single level of tax and favors sectors, such as agriculture and real estate, in which non-corporate structures have been prevalent. It favors the use of debt over equity, encouraging corporations to become overleveraged, and favors retained earnings over distributions, keeping capital locked in to existing businesses. Depreciation rules and other special provisions favor investment in some industries over others for both taxable corporations and other businesses, causing capital to flow to less productive uses than they would with neutral tax rules. All of these distortions reduce economic output. These long-standing problems are only the tip of the iceberg, however. The biggest problems come from the interaction of the U.S. tax system with the global economy. At roughly 39 percent (including state taxes), the top statutory U.S. corporate tax rate is the highest among developed countries. This discourages investment in the United States by both U.S.—and foreign-owned corporations and encourages companies to report taxable profits elsewhere. Also, the United States is one of the few countries that still taxes active foreign-source income of its resident corporations, although the tax liability is deferred until foreign profits are repatriated to the U.S. parent. These rules encourage U.S., but not foreign-owned corporations, to retain profits overseas and may place U.S. companies at a disadvantage compared with their foreign competitors who do not pay home-country tax on their foreign profits. Besides distorting investment flows, keeping capital of U.S. multinationals “locked-out” overseas, and in many circumstances favoring foreign over U.S.-chartered multinationals, corporate tax rules also encourage firms to manipulate the way they report income and where they locate their legal residence. These tax avoidance activities are rampant because the concepts of residence and source that determine who gets to tax corporate profits make little economic sense. Both U.S.- and foreign-resident multinationals have investors, employees, and shareholders throughout the world, and intangible property contributes to a firm’s output throughout the world. Corporations can avoid residence-based taxation by incorporating elsewhere. They can avoid source-based taxation by shifting reported income overseas, often into tax havens. Recent events have highlighted how U.S. corporations can avoid both residence-based and source-based taxation without changing real decisions about investment and employment. Efforts by major corporations such as Medtronic, Mylar, AbbVie, and Burger King to merge with foreign firms and move their corporate residence overseas to reduce their U.S. tax liability have sparked outrage and prompted proposals to curb such transactions. Earlier this year, congressional hearings highlighted the ways other major U.S. firms, including Apple, Microsoft, and Caterpillar, shift reported profits from intangible assets, mostly developed in the United States, to affiliates in low-tax foreign countries where the companies undertake little real economic activity. Last month, the Treasury Department announced new rules to reduce the tax benefits from corporate expatriations, and President Obama and Senators Levin and Schumer have advanced legislative proposals that would remove tax benefits from recent inversions and deter future ones. Both the president and Ways and Means Chairman Dave Camp have endorsed broader reforms that would lower the top corporate rate and eliminate or reduce many business tax preferences. Obama and Camp would also limit the ability of U.S. multinationals to benefit from shifting reported profits to tax havens, and Camp has in addition proposed eliminating 95 percent of the tax on repatriations of dividends to U.S. companies from their foreign affiliates. Camp’s proposal would move our corporate tax more in line with most of our trading partners by removing most of the repatriation tax, retaining only a small tax to correct for the continued deductibility of some costs of generating foreign income against U.S. profits. These reforms would improve the allocation of domestic investment and tax foreign-source income of U.S. corporations in a more efficient way. But in a recent paper, Alan Viard of the American Enterprise Institute and I argued that these reforms don’t go far enough because they continue to rely on the flawed concepts of corporate residence and source to assess corporate tax liability. We offer two more fundamental reforms that would get at the root of the problem. The first option would seek international cooperation on defining the source of corporate income, building on the ongoing Base Erosion and Profit Shifting (BEPS) Project being undertaken by the Organization of Economic Cooperation and Development (OECD). The OECD has advanced a number of important proposals to encourage countries to limit common tax avoidance techniques and to require better information reporting on where multinationals generate profits. The current measures are important first steps, but fall short of an international agreement on allocating corporate income. Viard and I would go further, urging countries to adopt common rules for allocating income. This could stop firms from shifting profits to tax havens without putting U.S. multinationals at a competitive disadvantage. Such allocation rules would still allow countries to compete for real capital investment by cutting rates. But they would stop countries from efforts to attract and retain corporate headquarters by turning a blind eye to how their home-based companies shift profits to tax havens. Although it would be very difficult for nations to reach consensus on how to allocate profits, all of our leading trading partners have a common interest in preventing the diversion of profits to tax havens. A second and even more far-reaching reform option would scrap the U.S. corporate income tax entirely and replace it by taxing shareholders under the individual income tax on the annual increase in the value of their corporate equity holdings. American shareholders in all publicly traded companies, domestic and foreign, would be fully taxed, at ordinary-income rates, on their dividends and the annual increases in the value of their shares, whether or not they’ve sold the shares and would be allowed to claim a full deduction for any annual declines in share values. Current law rules provide a preferential rate for capital gains realizations to prevent lock-in and impose limits on realized losses to prevent shareholders with net gains from selectively claiming losses. These rules would no longer be necessary in a system that taxes all gains or losses, whether realized or not. U.S. tax liability would depend only on the individual shareholder’s residence, not on the corporation’s legal residence or the source of its income. The U.S. tax system would no longer discourage domestic investment, reward companies that shift reported income elsewhere, or favor foreign over U.S.-resident companies. These rules would apply only to publicly-traded corporations, for which it is possible to observe changes in a company’s market value. Other companies would continue to be taxed as most businesses are today, with income allocated to owners or partners in proportion to their ownership shares and taxed once under the individual income tax. Owners of these businesses would continue to pay capital gains tax upon realization, with current law preferred rates and limits on capital losses. The removal of the corporate double tax, however, would substantially reduce the benefit that tax law now provides to these “flow-through” enterprises, compared with firms with similar activities that are organized as taxable corporations. Both these options would confront difficult design choices and significant political obstacles. There is no agreed upon way to allocate corporate profits among jurisdictions and different formulaic approaches have strengths and weakness and produce different divisions of the tax base among countries. International agreement on how to allocate multinational profits would therefore be hard to achieve, even though all of the major and emerging economies would benefit from halting the use of tax havens to strip their tax bases. And it will be difficult to persuade Americans to accept more international constraints on our tax system. Replacing the corporate tax with an accrual tax on corporate shareholders would also be challenging. Congress would have to resolve major issues, such as how to address the effects of market volatility on individual tax liability, and whether and how to impose an offsetting levy on non-profit institutions and retirement plans that would benefit from removal of the corporate level tax. Lawmakers would also have to decide whether to retain tax preferences that benefit flow-through businesses such as partnerships, even though these subsidies would be effectively eliminated for publicly-traded corporations. And a major educational campaign would be necessary to address the concern that the proposal is taxing people instead of corporations, even though economists agree that people ultimately bear the burden of the corporate income tax. Neither option is likely to be enacted before the next presidential election. But the current method of taxing corporate income is eroding quickly and is not sustainable in the long run. Tinkering with the current system won’t fix the problems. We need a system for taxing corporate income that works in our current globalized economy, allowing us to retain the benefits of free trade and capital movements and improving incentives to invest in the United States, while ensuring that corporate shareholders pay taxes commensurate with their incomes. The time to start developing practical reforms to accomplish these goals is now.