The tax treatment of U.S. businesses is a complicated and onerous process for tax preparers, revenue officials, and business owners alike. The tax system treats businesses differently based on their legal form, produces economic distortions, taxes income multiple times, and creates complexity and uncertainty for taxpayers. Even though business taxation has changed in the last decade, significant opportunity for further reform remains.
A bold reform option to transform how U.S. businesses are taxed follows the lead of Estonia, which ranks number one in Tax Foundation’s International Tax Competitiveness Index. Estonia taxes business profits when they are distributed under a flat, simple tax rate of 20 percent for all businesses. Adopting a distributed profits tax is a major pillar of Tax Foundation’s Growth & Opportunity tax reform agenda.
Estonia’s simple, transparent, and neutral tax system is a major success story, resulting in low compliance costs, efficient tax collection, and positive economic outcomes.
For businesses, the total time to comply in Estonia is lower than in almost any country on earth. The World Bank estimates that a typical business spends about five hours a year complying with corporate taxes in Estonia, compared to 87 hours in the U.S., and another 31 hours to comply with labor taxes in Estonia, compared to 55 hours in the U.S.
Estonian taxpayers have a relatively positive view of its tax administration, and officials indicate there is relatively little in the way of taxpayer uncertainty and questions relating to its business tax system.
In terms of economic effects, while all the Baltic countries have relatively competitive tax systems, Estonia’s original transition to a distributed profits tax paved the way, with research indicating this led to outperformance on investment, labor productivity, firm resiliency, and other measures.
Estonia’s economy is among the most entrepreneurial and dynamic in Europe, thanks in part to its tax system. For example, Estonia leads Europe in terms of startups per capita (including “unicorns” or startups valued at $1 billion or more), venture capital funding per capita, and capital investment per capita. Since the financial crisis in 2009, Estonia has recovered strongly, positioning itself as a center of innovation and startups in Europe. Venture capital invested in early-stage startups grew from $4 million in 2009 to almost $1 billion in 2021.
Over that 12-year span, real GDP per capita in Estonia has grown 53 percent, compared to 19 percent in the U.S. and 17 percent on average across the Organisation for Economic Co-operation and Development (OECD). Since the tax reform in 2000, Estonia’s GDP per capita has grown 119 percent, while U.S. GDP per capita has grown 27 percent and the OECD average has grown 26 percent.
A distinctive element of the Estonian tax system is the distributed profits tax paid by all businesses. Under the current U.S. corporate income tax, businesses calculate taxable income by accounting for deductible expenses, depreciation, amortization, limitations on deductions, exclusions, exemptions, credits, and especially complex rules for foreign income on an annual basis. By contrast, instead of annually paying taxes on business profits, Estonian companies only pay a tax when they distribute profits to shareholders, including dividends and net share repurchases (stock buybacks). To avoid double-taxation, dividends received by shareholders are exempt from individual income tax.
The distributed profits tax is a cash-flow tax model for business taxation. If a business makes a profit in a certain year, its owners can choose to invest the profits in growing the business without facing a tax because retained earnings are exempt.
For example, if a fast-growing startup needs to reinvest all its earnings in the business by raising wages, hiring, and buying new equipment, it can do so without paying the 20 percent tax on its earnings. Such treatment is particularly beneficial to small business entrepreneurs. Many lack liquidity and access to credit, depend on retained earnings to grow their small business, and do not have the time or resources to deal with our complicated business tax code.
In the U.S. context, a distributed profits tax would treat passthrough firms, such as partnerships, sole proprietorships, and S corporations, identically to C corporations. Equalizing the tax treatment between all business forms greatly simplifies the tax system. Equal treatment also reduces economic distortions and eliminates incentives for tax avoidance as well as the need for related anti-avoidance rules.
Relative to the current U.S. tax system, the proposed reform would reduce, but not zero out, the tax burden on new investments. A business only faces tax when it distributes profits to its shareholders. In practice, equity-financed investment doesn’t face tax if it is financed with retained earnings. If a firm plans to distribute the profits of a new investment, however, it will face the full 20 percent tax at the margin, regardless of how the profits are distributed (dividends or stock buybacks).
The tax would effectively ignore interest at the business level. As a result, it eliminates the tax subsidy for borrowing that exists in the current tax system, treating debt-financed investment the same way as an investment financed by retained earnings. The treatment of interest under the proposal would also be much simpler than the current system, where interest is partially deductible under a complicated and internationally unconventional limitation.
The distributed profits tax is equivalent to providing full expensing for new investments and unlimited net operating loss (NOL) carryforwards and carrybacks. Estonia and Latvia, two countries with distributed profits taxes, are two of only three countries in the OECD to provide 100 percent cost recovery for all major types of capital investment and the only two to provide unlimited carryback of losses. The U.S. tax system provides a patchwork of accelerated cost recovery for certain types of investments and permits limited NOL carryforwards. Rather than explicit provisions for each, the proposal provides full cost recovery and NOL provisions by avoiding the traditional calculation of taxable business income and instead simply taxing distributed profits.
The tax generally only applies to profit distributions from domestic companies. Profits earned abroad are generally only subject to applicable foreign taxes. As such, U.S. multinational companies would avoid the morass and double taxation inherent in our current international code that taxes Global Intangible Low-Taxed Income (GILTI) and other foreign income while crediting some foreign taxes paid.
The proposal also takes a simple approach to the global minimum tax for large multinational companies under negotiation by the OECD and some 140 countries. Companies could avoid a top-up tax from the minimum tax rules if their profit distributions are sufficiently high to satisfy the 15 percent minimum tax relative to the income definition in the model rules. This is similar to the reality that Estonian businesses will face when the minimum tax rules are adopted.
The relative simplicity and pro-growth potential of a distributed profits tax should be readily apparent to U.S. business owners, decision makers, and all who have had to file a corporate or passthrough income tax return.
We estimate the reform would reduce business tax compliance costs by more than $70 billion each year and expand the size of the U.S. economy by 1.7 percent in the long run. Further, we estimate the capital stock would increase by 3.1 percent, wages by 1.3 percent, and employment by 412,000 full-time equivalent jobs.
The lower marginal tax rate on business investment drives the economic benefit by making more investments economically feasible. A higher level of investment in turn leads to higher worker productivity, spurring higher output, jobs, and wages over time.
Adopting a distributed profits tax would greatly simplify U.S. business taxes, reduce marginal tax rates on investment, and renew our country’s commitment to pro-growth tax policy.