Corporate Taxation: Historic Reform Awaits 2017

September 19, 2014 9:45 AM

In summer of 1975, J. L. Kramer and I published an article in the International Tax Journal entitled "Higher U.S. Taxation Could Prompt Changes in Multinational Corporate Structure." Nearly four decades later, our Delphic predictions may be coming true—evidenced by the widespread phenomenon of corporate "inversions." Inversions—whereby US corporations acquire a legal citizenship abroad by merging with a foreign company—occur not because US corporate rates have risen since 1975 (in fact they fell from 48 percent then to the current level of 35 percent). Rather, they occur because foreign countries have sensibly cut their corporate tax rates further and faster while the United States clings to what is called the "worldwide" tax norm as other countries have shifted to a "territorial" norm.

The recent spate of inversions has upset the conceit that the US corporate tax system can stand the test of time and international competition. The fact that US-based multinational corporations (MNCs) are holding north of $2 trillion of their earnings and profits (E&P) in their subsidiaries abroad proves the US policy failure. Even the Washington Post editorial writers realize that all is not well. The question is what to do about this problem.

The Jack Lew Solution: Plug the Dike Today, Fix the Structure Tomorrow

Treasury Secretary Jacob Lew, echoing Secretary of State John F. Kerry—who castigated "Benedict Arnold" corporations in his 2004 presidential campaign—has assailed the loyalty of any US firm that thinks about relocating corporate headquarters in a friendly foreign climate. President Barack Obama speaks of "economic patriotism." Accordingly, Senator Bob Casey (D-PA) and others seek to close the "loopholes," administratively if possible, legislatively if necessary. These officials focus on imaginary tax revenue, ignoring the larger destructive consequences of the US corporate tax system.

One proposed remedy would raise the threshold of foreign ownership from 20 percent to perhaps 50 percent before an erstwhile US corporation could acquire the citizenship of a foreign country. Another remedy would limit deductions in the United States for interest paid to related firms abroad. Still other remedies would impose extra tax burdens on US shareholders or executives if their firms invert. Such remedies can be enacted only by Congress, and it's almost certain that Congress will not enact such measures in the next two years. Using existing legislative authority, it's not clear what the Treasury can do, but Secretary Lew has tasked his officials to scour the Internal Revenue Code for options. Assistant Secretary for Tax Policy Mark Mazur is reported to have an imaginative list. The Internal Revenue Service could certainly step up its audits of departing firms.

Lew and his allies recognize that the US corporate rate is out of line but fail to recognize how far out of line. And they are in no hurry to cut a deal with Congress. The administration has suggested a 28 percent rate, well above the OECD average and not in shouting distance of China, which has a 15 percent rate for high-technology firms. By contrast, Michael Graetz, professor of tax law at Columbia University, has recommended a 15 percent rate and I have suggested a 20 percent rate. In Treasury's view, lowering the corporate rate should be accompanied by closing other "loopholes," including accelerated depreciation, requiring firms to use "first-in first-out" accounting for inventory profits, rather than "last-in first-out" (LIFO), and eliminating the immediate deduction for intangible drilling costs in the oil patch. Such steps would amount to no real relief at all—just shifting the tax burden between corporate sectors.

Meanwhile, Lew completely ignores the second major defect in the US corporate tax system: its worldwide reach, which inspires US-based MNCs to retain more than $2 trillion of E&P abroad. Instead of advocating a territorial system, in which profits earned abroad would be taxed only by the country in which they were earned, the administration has essentially called for immediate US taxation of foreign profits (ending the long-standing practice known as "deferral"). Ways & Means Chairman David Camp (R-MI) unfortunately embraced this part of the administration's agenda in his own discussion draft. If these proposals ever came close to being enacted, US firms would move in droves to change their corporate citizenship.

Secretary Lew and his allies do not have the answer. They do not even understand the problem. If they were coal mining safety engineers in any earlier era, they would have strangled the canaries.

Basic Principles

Public Finance 101 teaches that taxes should be levied on immobile factors of production. When taxes are instead imposed on mobile factors, some of those resources leave the jurisdiction of the taxing authority. The late professor Charles Tiebout is not known in the public at large but he is rightly famous among economists for emphasizing that corporations, like people, can "vote with their feet." When mobile factors leave the jurisdiction, the income of immobile factors also drops, because they work with fewer mobile resources. Applying this insight in a simple model, Professor Arnold Harberger of the University of Chicago and the University of California calculated that $100 billion raised in corporate taxes could reduce the income of US workers by more than $100 billion if enough capital and intellectual property move abroad.

US business tax policy has turned these simple but powerful precepts on their head. In the global economy, capital is highly mobile. Ideas, embodied in intellectual property rights and trade secrets, are even more mobile. Relatively immobile are natural persons (only about 1,000 Americans renounce their citizenship annually for tax reasons) and various forms of real estate (buildings, farmland, oil, and lumber properties, etc.).

The federal government raises most of its revenue through personal income taxes and Social Security taxes, both imposed on factors that are relatively immobile across the US border. But the US business tax system also taxes immobile real estate fairly lightly: In fact, a mélange of "pass-through entities" account for about half of US business revenue. At the same time, the system tries to tax corporations at a statutory 35 percent rate, even though capital and ideas are highly mobile. To be sure, the effective federal tax rate is lower than 35 percent but still significantly higher than the effective tax rates in other OECD countries. If all the "loopholes" that government specialists in the Congressional Budget Office (CBO), Treasury, and Joint Committee on Taxation (JCT) dream of closing are eliminated, a massive loss of productive capacity within the United States would likely result as companies migrate abroad, taking both capital and ideas from US soil. Fortunately, the K Street legal community has so far thwarted these government tax specialists.

Missing from the inversion debate is the bigger prize: making the United States a world-class location for corporate headquarters and the conduct of all aspects of business—production, sales, exports, management, and R&D. Unlike political leaders elsewhere, who cheer and nourish their "national champions," most US leaders either take large successful firms for granted or scold them for imagined deficiencies. The revenue estimates of the CBO and the JCT fail to reflect the long-term benefits to the United States of retaining and attracting world-class corporations.

The Next Two Congresses, the 45th President, and the Business Community

The jury is out on the path ahead. Much will depend on the 2014 and 2016 elections and the strength of populist anger over the tax issue. Journalists and congressional members insist on confusing the "top one percent" with large corporations. Their goal, as Senator Russell Long of Louisiana used to say, is to avoid taxes that would hurt constituents and instead "tax the fellow behind the tree"—in contemporary parlance, MNCs with operations abroad. Variations on this theme are prominent in the inversion debate. According to President Obama, the costs of inversions are put upon a "bunch of hard working Americans who either pay through higher taxes themselves or reduced services." This is economic nonsense, but apparently the president's pollsters think the rhetoric wins votes. How the president will deal with the inversion engineered by his favorite economic advisor, Warren Buffet, who is now moving Burger King to Canada under the leadership of the Tim Hortons company based in Toronto, remains to be seen.

Even more disturbing are articles published in business press, such as the recent essay by Allan Sloan in the pages of Fortune, titled "Positively Un-American tax dodges." When knowledgeable observers miss the important point—the utter destructiveness of the US corporate tax system—it's no wonder that politicians and the public are confused.

The Senate Finance Committee and the House Ways & Means Committee will probably seek to link reform (territorial taxation and a 20 percent or lower rate) to anti-inversion penalties. Without meaningful reform, penalties alone will simply motivate firms to find other ways to migrate the productive corporate tax base abroad. The United States would become the least favored location for the Googles of tomorrow.

Reform legislation is a remote bet in the next Congress, but after 2016 Senate Finance and House Ways & Means may be able to work with the 45th president to enact a historic reform legislation.

The Business Roundtable, the National Foreign Trade Council, and other leading business groups should help by publishing their own estimates of additional investment, employment, and repatriated profits over the next five years if Congress reduces the corporate tax rate to 20 percent (without damaging offsets to raise revenues in other areas) and enacts a territorial system. It's not enough to oppose the current administration's misguided policies. The positive case for reform must be enunciated in a way that American workers can understand.