(First Published in Tax Notes Viewpoint:Volume 127, Number 11 • December 11, 2017 )
University of Michigan professor Reuven S. Avi-Yonah recently published a very competent analysis of the current Senate and House tax bills.1 His assessment goes far beyond my ability to comment on the intricacies of the bills. However, the proposals he has put forth are another matter.
For starters, he argues that U.S. companies are not disadvantaged because their average tax rates are within the range of those in other developed countries. But that misses the point of a greater challenge facing many domestic companies. A corporation that sells only in California might be paying a corporate tax rate of 34 percent federal plus 8.84 percent state. At the same time, a multinational might pay little or nothing because it reports little income on a federal return that is also used to compute California tax. The idea that ending deferral will stop stripping income out of the United States is naïve given the income currently ducking state corporate tax. And that’s in addition to the foreign multinational enterprises that will still pay much less tax in any of Avi-Yonah’s solutions.
The real area of contention is whether income earned outside the United States should be taxed in the United States. Perhaps those allied with Avi-Yonah still believe in taxation based on residence instead of destination. But we’ve already had 100 years of residence taxation — and that has worked out poorly. How can anyone accept the merits of a residence-based tax given its history of helping strip income out of high-tax countries and redirecting it into tax havens?
Countries have tried various strategies to counter income stripping, but it’s unlikely that any of those efforts could be deemed successful. It’s time to give up on a residence tax that allows foreign MNEs to virtually always pay less tax than their domestic U.S. counterparts in identical circumstances.
Last year the Republican House leadership noted: “This Blueprint eliminates the existing self- imposed export penalty and import subsidy by moving to a destination-basis tax system. Under a destination basis approach, tax jurisdiction follows the location of consumption rather than the location of production.”2 That is a recipe for a fair tax system that would tax all income associated with consumption while exempting all income from foreign sales.
Avi-Yonah first considers earnings from past sales that are now held in accounts outside the United States. He says that because taxing that money will not affect current actions, it should be taxed at 35 percent. He says that because money is fungible, the distinction between cash and other assets is artificial. However, if the United States had previously embraced a sales factor apportionment (SFA) tax, there never would have been more than $2.6 trillion in deferred earnings. My basic disagreement with Avi-Yonah really comes down to his inexplicably abandoning his earlier work, of which I am a dedicated disciple. That work, which Avi-Yonah put together with economics professor Kimberly A. Clausing, made a powerful argument for changing to a destination-based corporate tax.3 Such an SFA tax works because it is smart, tamper-proof, and territorial — rather than the easily gamed system the United States has implicitly followed for more than 90 years through the permanent deferral loophole.
It’s not difficult to assess the income being lost through lack of an SFA tax on an individual company. If a company with revenue of $10 billion in a recent year and $1 billion in pretax profits had 40 percent foreign sales and 80 percent foreign profits, it would make sense to tax the real domestic profits of $600 million instead of $200 million. One could legitimately tax the $400 million in stripped profits at a high rate, perhaps even as much as 35 percent. The other $200 million in foreign profits might not be taxed at all or taxed at a low rate. And although it wouldn’t raise the more than $900 billion under Avi- Yonah’s proposal, the additional revenue would be far more than in the current Republican proposal — which can only be described as a giveaway.
We can disagree on how to tax funds previously earned overseas, but to me it seems only fair to differentiate between profits legitimately earned outside the United States and those stripped out of the United States. We should agree that there will be minimal effect on the actions of those taxed because the tax is on past actions.
Taxing all earnings without deferral is a proposal from more than 50 years ago, yet this perennial suggestion — mostly from liberals — is truly a bad idea. It makes foreign MNEs even more competitive. It also does nothing to keep
U.S. MNEs from continuing to strip earnings out of the United States to avoid state income taxes. And now seems to be the most inopportune time to bring it up again.
I share Avi-Yonah’s frustration, but promoting something highly unlikely to prevail is counterproductive. Why not propose something that has a chance of success and might open up a dialogue on how to fix the system? Taxing earnings that have been stripped out of the United States should have wider appeal than taxing all earnings held outside the United States. And this change in Avi-Yonah’s tax proposal might still yield substantial revenue. The United States has had multiple chances to move to a destination- based corporate tax, as Avi-Yonah has advocated in the past. So why does he advocate for something with virtually no chance to succeed while ignoring a potential solution?
The Senate bill explores global intangible low- taxed income (GILTI) — which is primarily income shifted out of the United States — but it suggests only a minimal tax. According to Avi- Yonah, the Senate bill’s remedy for income stripping is worse than the disease. Since the disease was so bad and the remedies are worse, why not render them all moot with an SFA tax? This would have been an obvious place for Avi- Yonah to advocate for SFA.
SFA is a far simpler and more effective way to counter income stripping because it avoids a destructive race to the bottom and is the most competitive tax system at any reasonable rate.4 Conversely, Avi-Yonah suggests that at least some of the anti-base-erosion provisions in the current bills would likely run afoul of WTO obligations and cause the EU to sue the United States and impose sanctions that would lose revenue and nullify the effects of the law.
To address potential WTO complications, Avi- Yonah suggests abandoning the House and Senate versions of the Tax Cuts and Jobs Act, except for the 20 percent corporate tax rate, and ending deferral by taxing all future offshore earnings at 20 percent. But ending deferral is a bad solution5 — as both Avi-Yonah and Clausing demonstrated 10 years ago. It is understandable but unfortunate that Avi-Yonah has abandoned his earlier work in favor of making different suggestions for tax reform. You can’t get a paper published that says “Remember that idea I had 10 years ago? I still like it!”
Now we are dealing with changes in our corporate tax laws that could have a profound effect on our future economy. So let’s look at priorities for a corporate tax system.
“First do no harm” to the American economy.
Do not disadvantage any U.S.-based company both in the United States and in world markets. The tax system shouldn’t play favorites.
Minimize the deficit, be revenue neutral, or increase revenue.
Gives businesses an incentive to grow and invest.
A lower tax rate will likely result in little extra investment or hiring for most companies. Instead, cash-rich, oligopolistic behemoths are going to increase dividends, stock buybacks, and CEO compensation. None of that will add to growth.
The Economist calls lower rate proposals “Grow Nothings,” as if to point out that lower rates will have minimal economic effect.6
But there is a way to help companies grow: Start at the bottom rung of the ladder instead of the top. Although the giants of Silicon Valley create growth for a segment of the economy, they do little or nothing for Main Street. Main Street businesses that could grow and create jobs often lack capital. Also, because of the punitive nature of the corporate tax schedule,7 these companies are always counseled to become S corporations or limited liability companies so that their earnings can be passed on to the owners without the imposition of a corporate tax. That may be the appropriate business form for a local dental practice or dry cleaner, but what about a company that dreams of growth?
For those companies, the current system facilitates overconsumption — particularly at year-end — because when facing a big tax bill, local businesses buy something to expense, such as one or two $60,000 pickup trucks for company use. The House and Senate bills are big on expensing. And while underinvesting in fixed assets can be a problem, overinvesting is often more damaging for many small companies.
The virtually unanimous choice of businesses to become passthroughs is an unanticipated consequence of the Tax Reform Act of 1986. It charges small businesses high rates and minimizes graduation, causing virtually all existing small businesses to change from being taxed as C corporations to becoming passthrough entities as soon as possible.
The damage being done to new and small businesses is not apparent, particularly to economists, who do not routinely interact with small businesses. In a 1905 Bernard Shaw play, Man and Superman, a young man of means talks about how he most intensely believes in the dignity of labor. A mechanic crawls out from under the car on stage and says: “Sir, that’s because you never done any.” Martin A. Sullivan said in his otherwise excellent book on corporate tax reform, “These special low tax rates . . . are a simple and clear giveaway to one privileged class of businesses.”8
It is unfortunate that most observers don’t understand the key difference between money in a business and money in one’s pocket: Money in a business can be used to fuel growth. The lack of small business growth after the Great Recession was brought home to me by a local bank commercial lending officer who said local businesses were coming to her in 2009 saying, “I’ve got trouble and I need a loan.” She had to tell them, “You don’t have any equity. There is no collateral in your business.” They were often passthrough businesses with big expensive pickups. Some of those businesses would have become C corporations and retained earnings if the corporate tax schedule had been favorable instead of punitive.
How could the current legislation be improved? If deficits do matter, a revenue-neutral or even revenue-positive corporate tax system could provide both growth and revenue. The first requirement would be to get Avi-Yonah and other naysayers to accept that a destination-based corporate tax such as SFA is not only the long- term solution but today’s best solution as well.
Just implementing SFA for corporate taxes along with the Tax Cuts and Jobs Act would increase revenue by more than $600 billion over 10 years and reduce the proposed deficit from $1.5 trillion to about $900 million — and that is at the 20 percent rate. Higher rates could raise substantially more revenue.
But that is not all. SFA is estimated to raise more than $17 billion a year for states — all generated from currently tax-avoiding MNEs. And SFA would greatly increase the efficiency of our corporate tax system, likely resulting in the release of many highly skilled individuals who could then do productive, value-added work.
But what if the Republican tax bills fail? That would still be a good time to create a better corporate tax bill that would provide a truly pro- growth rate schedule that could be revenue neutral or even revenue positive. I find it hard to believe that highly skilled and intelligent experts would be OK with foreign MNEs paying far less in taxes than U.S. companies in identical circumstances. But that would be the consequence of ending deferral. Perhaps those experts simply don’t understand that states are suffering from a lack of revenue from foreign MNEs.
Domestic companies are also terribly disadvantaged in competing with those MNEs. Although ending deferral would level the playing field between domestic companies and U.S. MNEs regarding federal taxes, it wouldn’t do a thing for state tax disparity. If the experts understand the problem, how can they sleep at night after advocating for any plan that would severely disadvantage domestic companies?
Today’s healthy economy presents a time for reducing instead of increasing the deficit.
Therefore, it is helpful to show a tax schedule that could be approximately revenue neutral yet lower the tax rate from 35 percent to 28 percent while encouraging growth-oriented small businesses to be taxed as corporations. The suggested rate schedule would be:
|$0 to $500,000||
|$500,000 to $1 million||
|$1 million to $5 million||
|Above $5 million||
Some have suggested that now is the time in the business cycle when the tax rate should raise revenue. The above schedule could be modified to increase revenue from our largest corporations, many of which are the result of mergers that never would have been approved years ago but are now everyday occurrences.
Tax schedules could perform a dual purpose: raising revenue and reducing the lure of mergers. Adding to the above schedule with perhaps a 32 percent rate above $100 million in pretax profit and a 35 percent rate above $1 billion in pretax profit would add more than $600 billion in revenue over 10 years. It might also cause some companies to reconsider their merger plans. All companies would still benefit from the schedules because SFA is territorial, and by not taxing exports or foreign sales, it would make
U.S. companies highly competitive in world markets.
It’s clear that the United States is facing a real opportunity for dynamic tax reform. But little will be accomplished if Washington keeps repeating the same basic pattern of quibbling around the margins of tax rates. What’s needed now is a simple, bold move. Adopting a destination-based tax is something that almost all Americans would support because they grasp the inherent inequity of a system that continues to allow jobs and
capital to move overseas. Instead, what voters want is for Washington to hunker down and finally take steps to ensure that tax reform is truly effective and will help to shore up domestic companies. Anything less is just window dressing — and a wasted opportunity.