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The next president will have limited levers available for fixing the economy. Interest rates are already artificially low, despite the fact that we have consumer, business, and governmental debt of over $31,758,400,000,000 outstanding in our economy, a 75% increase over the course of the Bush administration. Our balance of payments with the rest of the world remains badly negative, over $700 billion in 2007 and running at close to that rate in 2008, despite the crash of the dollar against almost all other currencies. The collapse of the Ponzi schemes of subprime mortgage lending and wild consumer credit are removing a huge artificial stimulus from the economy. The government has tried shipping out cash to taxpayers with little effect, and the federal deficit of over $9.5 trillion (some $31,666 for every man, woman and child in America) makes it difficult to deficit spend. Meanwhile, between now and 2040 the retirement of the baby boom generation will put impossible strains on Social Security and Medicare (which are unfunded and therefore must be supported by a shrinking work force), and private pensions are unhealthy. We desperately need the economy to grow quickly, but the government has used up all of its traditional stimulus tools.

That leaves three basic avenues – efficiency, trade, and innovation. Either we remove drags on the efficiency of our economy, or we buy less from other countries and sell more to them, or we develop new growth engines. The federal government can influence each of these factors. As consumers of government, the American electorate will want to examine very carefully what the candidates have to say in regard to each of these areas. In this series of articles, I will examine each of the three areas and their interactions, and what the candidates have to say about them.

Efficiency and Corporate Tax Policy

Government can improve the efficiency of the economy in two ways. First, it can get out of the way. Through taxation and badly designed regulation, government creates distortions and impediments to efficiency. Second, government can use well designed regulations to grease the wheels of commerce, an area that I will address in my next piece.

But let’s start with the Hippocratic principle of “First, do no harm.” Taxes necessarily burden activities by making them less attractive, and this changes the ways in which people invest and do business. The U.S. 35% tax on corporate income creates several harmful distortions. First and worst, it pushes corporations to locate their high value activities – and good jobs – outside of the United States. Under the current system, if a corporation earns $100 in the U.S., $35 of that is taxed away, leaving only $65. If it earns the same $100 in the Dominican Republic and avoids bringing the cash home, it pays no tax and keeps the full $100. That’s a 54% improvement in net profit ($35/$65) by moving the activity. Its shareholders are happy to let it keep the cash because they can sell the stock (now worth an extra $100 because of the retained cash) either tax free or at low capital gains rates. So the corporation puts the activities abroad and does it best never to bring the cash profits back to the U.S. That means that the U.S. imports products rather than exporting them, damaging our balance of payments, and it means that U.S. employees get paid less because there is less demand for their services. That, in turn, reduces consumer demand.

Second, by encouraging corporations to hold on to all that cash, the tax system gives companies an excuse to invest in the best investment available to them rather than making the cash available to fund the best new, innovative investment available in the economy. That creates a large efficiency drag. A 4% after tax foreign return on $100 is equal to a 6% return on $65, i.e. on the earnings that would remain after repatriation. Add in tax on the earnings at a 35% U.S. rate versus 0% foreign, and a 4% foreign return = 9.5% U.S. return. So, our corporations are willing to make investments that are well under half as efficient as the ones they would choose in the absence of corporate tax.

Third, the tax system encourages companies to use debt rather than equity, because interest payments are deductible. That increases the risk of bankruptcy (a bad thing for those depending on corporate pensions) and contributes to the high total U.S. debt load.

Fourth, corporate tax discourages use of the corporate form, which is generally the most efficient way to raise capital. Between 1994 and 2004, the share of business other than sole proprietorships using corporate form declined from 40% to 25% This holds back business growth.

Corporate tax creates various other distortions and inefficiencies as well. It favors some investments over others, it facilitates diversion of profits to corporate insiders, and it involves large compliance costs.

In response to these concerns, Senator McCain has proposed reducing the corporate tax rate, which he acknowledges will reduce total revenue. Senator Obama has stated that he might be willing to reduce corporate rates and broaden the corporate tax base, but is studying the matter . Neither candidate has addressed the side effects of such a rate cut, including the incentive for wealthy individuals to reduce their taxes by using corporate shells. Further, 25% is not zero, and thus a rate reduction reduces but does not eliminate the distortions.

There are revenue neutral options for eliminating these inefficiencies that would actually help to tax high income individuals more effectively than the current system. However, such proposals are not in the interests of powerful corporate tax lobbyists, who make their living from the current system. Will either presidential candidate really prove immune to the lobbyists? Watch and listen.