I'm very leery of corporate tax reform, largely because I don't think there are enough genuine loopholes on the business side of the tax code to finance a meaningful reduction in the corporate tax rate.
That leads me to worry that politicians might try to "pay for" lower rates by forcing companies to overstate their income.
Based on a new study about so-called corporate tax expenditures from the Government Accountability Office, my concerns are quite warranted.
The vast majority of the $181 billion in annual "tax expenditures" listed by the GAO are not loopholes. Instead, they are provisions designed to mitigate mistakes in the tax code that force firms to exaggerate their income.
Here are the key findings.
In 2011, the Department of the Treasury estimated 80 tax expenditures resulted in the government forgoing corporate tax revenue totaling more than $181 billion. ...approximately the same size as the amount of corporate income tax revenue the federal government collected that year. ...According to Treasury’s 2011 estimates, 80 tax expenditures had corporate revenue losses. Of those, two expenditures accounted for 65 percent of all estimated corporate revenues losses in 2011 while another five tax expenditures—each with at least $5 billion or more in estimated revenue loss for 2011—accounted for an additional 21 percent of corporate revenue loss estimates.
To be blunt, there's a huge problem in the GAO analysis. Neither depreciation nor deferral are loopholes.
I wrote a detailed post explaining depreciation earlier this month, citing three different experts on the issue. But if you want a short-and-sweet description, here’s how I described depreciation in my post on corporate jets.
If a company purchases a jet for $20 million, they should be able to deduct – or expense – that $20 million when calculating that year’s taxable income… A sensible tax system defines profit as total revenue minus total costs – including purchases of private jets. But today’s screwy tax code forces them to wait five years before fully deducting the cost of the jet (a process known as depreciation). Given that money today has more value than money in the future, this is a penalty that creates a tax bias against investment (the tax code also requires depreciation for purchases of machines, structures, and other forms of investment).
In other words, businesses should be allowed to immediately "expense" investment expenditures. What the GAO refers to as "accelerated depreciation" is simply the partial mitigation of a penalty, not a loophole.
The same is true about "deferral." Here's what I wrote about that issue in February 2010.
Under current law, the “foreign-source” income of multinationals is subject to tax by the IRS even though it already is subject to all applicable tax where it is earned (just as the IRS taxes foreign companies on income they earn in America). But at least companies have the ability to sometimes delay when this double taxation occurs, thanks to a policy known as deferral.
I added to those remarks later in the year.
From a tax policy perspective, the right approach is “territorial” taxation, which is the common-sense notion of only taxing activity inside national borders. It’s no coincidence that all pro-growth tax reform plans, such as the flat tax and national sales tax, use this approach. Unfortunately, America is one of the world’s few nations to utilize the opposite approach of “worldwide” taxation, which means that U.S. companies face the competitive disadvantage of having two nations tax the same income. Fortunately, the damaging impact of worldwide taxation is mitigated by a policy known as deferral, which allows multinationals to postpone the second layer of tax.
Simply stated, the U.S. government should not be trying to tax income earned in other countries. "Deferral" is the mitigation of a penalty, not a loophole.
So why would the GAO make these mistakes? Well, to be fair to the bureaucrats, they simply relied on the analysis of the Treasury Department.
But why does Treasury (and the Joint Committee on Taxation) make these mistakes? The answer is that they use the "Haig-Simons" tax base as a benchmark, and that approach assumes bad policies such as the double taxation of income that is saved and invested. If you want to get deep in the weeds of tax policy, I shared late last year some good analysis on Haig-Simons produced by my colleague Chris Edwards.
By the way, properly defining loopholes also is an issue for reform on the individual portions of the tax code. I've previously pointed out the flawed analysis of the Tax Policy Center, which put together a list of the 12 largest "tax expenditure" and included six items that don't belong.
To conclude, the right tax base is what's called "consumed income." But that's simply another way of saying that the system should only tax income one time, and it's how income is defined for both the flat tax and national sales tax.
One final comment about GAO. It's understandable that they used the Treasury Department's methodology, but they also should have produced a list of tax expenditures based on a consumed-income tax base. That's basic competence and fairness.
I've been very critical of the Organization for Economic Cooperation and Development. Most recently, I criticized the Paris-based bureaucracy for making the rather remarkable assertion that a value-added tax would boost growth and employment.
But that's just the tip of the iceberg.
- The OECD has allied itself with the so-called Occupy movement to push for bigger government and higher taxes.
- The OECD, in an effort to promote redistributionism, has concocted absurdly misleading statistics claiming that there is more poverty in the US than in Greece, Hungary, Portugal, or Turkey.
- The OECD is pushing a “Multilateral Convention” that is designed to become something akin to a World Tax Organization, with the power to persecute nations with free-market tax policy.
- The OECD supports Obama’s class-warfare agenda, publishing documents endorsing “higher marginal tax rates” so that the so-called rich “contribute their fair share.”
Now the bureaucrats have concocted another scheme to increase the size and scape of government. The OECD just published a study on "Addressing Base Erosion and Profit Shifting" that seemingly is designed to lay the groundwork for a radical rewrite of business taxation.
In a new Tax & Budget Bulletin for Cato, I outline some of my concerns with this new "BEPS" initiative.
...the BEPS report...calls for dramatic changes in corporate tax policy based on the presumption that governments are not seizing enough revenue from multinational companies. The OECD essentially argues that it is illegitimate for businesses to shift economic activity to jurisdictions that have more favorable tax laws. ...The core accusation in the OECD report is that firms systematically—but legally—reduce their tax burdens by taking advantage of differences in national tax policies.
Ironically, the OECD admits in the report that revenues have been trending upwards.
...the report acknowledges that “… revenues from corporate income taxes as a share of gross domestic product have increased over time. ...Other than offering anecdotes, the OECD provides no evidence that a revenue problem exists. In this sense, the BEPS report is very similar to the OECD’s 1998 “Harmful Tax Competition” report, which asserted that so-called tax havens were causing damage but did not offer any hard evidence of any actual damage.
To elaborate, the BEPS scheme should be considered Part II of the OECD's anti-tax competition project. Part I was the attack on so-called tax havens, which began back in the mid- to late-1990s.
The OECD justified that campaign by asserting there was a need to fight illegal tax evasion (conveniently overlooking, of course, the fact that nations should not have the right to impose their laws on what happens in other countries).
The BEPS initiative is remarkable because it is going after legal tax avoidance. Even though governments already have carte blanche to change business tax policy.
...governments already have immense powers to restrict corporate tax planning through “transfer pricing” rules and other regulations. Moreover, there is barely any mention of the huge number of tax treaties between nations that further regulate multinational taxation.
So what does the OECD want?
...the OECD hints at its intended outcome when it says that the effort “will require some ‘out of the box’ thinking” and that business activity could be “identified through elements such as sales, workforce, payroll, and fixed assets.” That language suggests that the OECD intends to push global formula apportionment, which means that governments would have the power to reallocate corporate income regardless of where it is actually earned.
And what does this mean? Nothing good, unless you think governments should have more money and investment should be further penalized.
Formula apportionment is attractive to governments that have punitive tax regimes, and it would be a blow to nations with more sensible low-tax systems. ...business income currently earned in tax-friendly countries, such as Ireland and the Netherlands, would be reclassified as French-source income or German-source income based on arbitrary calculations of company sales and other factors. ...nations with high tax rates would likely gain revenue, while jurisdictions with pro-growth systems would be losers, including Ireland, Hong Kong, Switzerland, Estonia, Luxembourg, Singapore, and the Netherlands.
Since the United States is a high-tax nation for corporations, why should Americans care?
For several reasons, including the fact that it wouldn't be a good idea to give politicians more revenue that will be used to increase the burden of government spending.
But most important, tax policy will get worse everywhere if tax competition is undermined.
...formula apportionment would be worse than a zero-sum game because it would create a web of regulations that would undermine tax competition and become increasingly onerous over time. Consider that tax competition has spurred OECD governments to cut their corporate tax rates from an average of 48 percent in the early 1980s to 24 percent today. If a formula apportionment system had been in place, the world would have been left with much higher tax rates, and thus less investment and economic growth. ...If governments gain the power to define global taxable income, they will have incentives to rig the rules to unfairly gain more revenue. For example, governments could move toward less favorable, anti-investment depreciation schedules, which would harm global growth.
You don't have to believe me that the BEPS project is designed to further increase the tax burden. The OECD admits that higher taxes are the intended outcome.
The OECD complains that “… governments are often under pressure to offer a competitive tax environment,” and that “failure to collaborate … could be damaging in terms of … a race to the bottom with respect to corporate income taxes.” In other words, the OECD is admitting that the BEPS project seeks higher tax burdens and the curtailment of tax competition.
Writing for Forbes, Andy Quinlan of the Center for Freedom and Prosperity highlights how the BEPS scheme will undermine tax competition and enable higher taxes.
...the OECD wants to undo taxpayer gains made in recent decades thanks to tax competition. Since the 1980′s, average global income taxes on both individuals and corporations have dropped significantly, improving incentives in the productive sector of the economy to generate economic growth. These pro-growth reforms are the result of tax competition, or the pressure to adopt competitive economic policies that is put on governments by an increasingly globalized society where both labor and capital are mobile. Tax competition is the only force working on the side of taxpayers, which explains the organized campaign by global elite to defeat it. ...If taxpayers want to preserve gains made thanks to tax competition, they must be weary of the threat posed by global tax cartels though organizations such as the OECD.
Speaking of the OECD, this video tells you everything you need to know.
The final kicker is that the bureaucrats at the OECD get tax-free salaries, so they're insulated from the negative impact of the bad policies they want to impose on everyone else.
That's even more outrageous than the fact that the OECD tried to have me thrown in a Mexican jail for the supposed crime of standing in the public lobby of a public hotel.
In a violation of the 8th Amendment's prohibition against cruel and unusual punishment, my brutal overseers at the Cato Institute required me to watch last night's debate (you can see what Cato scholars said by clicking here).
But I will admit that it was good to see Obama finally put on the defensive, something that almost never happens since the press protects him (with one key exception, as shown in this cartoon).
This doesn't mean I like Romney, who would probably be another Bush if he got to the White House.
On the specifics, I obviously didn't like Obama's predictable push for class warfare tax policy, but I've addressed that issue often enough that I don't have anything new to add.
I was irked, though, by Obama's illiteracy on the matter of business deductions for corporate jets, oil companies, and firms that "ship jobs overseas."
Let's start by reiterating what I wrote last year about how to define corporate income: At the risk of stating the obvious, profit is total revenues minus total costs. Unfortunately, that's not how the corporate tax system works.
Sometimes the government allows a company to have special tax breaks that reduce tax liabilities (such as the ethanol credit) and sometimes the government makes a company overstate its profits by not allowing it to fully deduct costs.
During the debate, Obama was endorsing policies that would prevent companies from doing the latter.
The irreplaceable Tim Carney explains in today's Washington Examiner. Let's start with what he wrote about oil companies.
...the “oil subsidies” Obama points to are broad-based tax deductions that oil companies also happen to get. I wrote last year about Democratic rhetoric on this issue: “tax provisions that treat oil companies like other companies become a ‘giveaway,’...”
I thought Romney's response about corrupt Solyndra-type preferences was quite strong.
Here's what Tim wrote about corporate jets.
...there’s no big giveaway to corporate jets. Instead, some jets are depreciated over five years and others are depreciated over seven years. I explained it last year. When it comes to actual corporate welfare for corporate jets, the Obama administration wants to ramp it up — his Export-Import Bank chief has explicitly stated he wants to subsidize more corporate-jet sales.
By the way, depreciation is a penalty against companies, not a preference, since it means they can't fully deduct costs in the year they are incurred.
On another matter, kudos to Tim for mentioning corrupt Export-Import Bank subsidies. Too bad Romney, like Obama, isn't on the right side of that issue.
And here's what Tim wrote about "shipping jobs overseas."
Obama rolled out the canard about tax breaks for “companies that ship jobs overseas.” Romney was right to fire back that this tax break doesn’t exist. Instead, all ordinary business expenses are deductible — that is, you are only taxed on profits, which are revenues minus expenses.
Tim's actually too generous in his analysis of this issue, which deals with Obama's proposal to end "deferral." I explain in this post how the President's policy would undermine the ability of American companies to earn market share when competing abroad - and how this would harm American exports and reduce American jobs.
To close on a broader point, I've written before about the principles of tax reform and explained that it's important to have a low tax rate.
But I've also noted that it's equally important to have a non-distortionary tax code so that taxpayers aren't lured into making economically inefficient choices solely for tax reasons.
That's why there shouldn't be double taxation of income that is saved and invested, and it's also why there shouldn't be loopholes that favor some forms of economic activity.
Too bad the folks in government have such a hard time even measuring what's a loophole and what isn't.
Mitt Romney is being criticized for supporting "territorial taxation," which is the common-sense notion that each nation gets to control the taxation of economic activity inside its borders.
While promoting his own class-warfare agenda, President Obama recently condemned Romney's approach. His views, unsurprisingly, were echoed in a New York Times editorial.
President Obama raised ... his proposals for tax credits for manufacturers in the United States to encourage the creation of new jobs. He said this was greatly preferable to Mitt Romney’s support for a so-called territorial tax system, in which the overseas profits of American corporations would escape United States taxation altogether. It’s not surprising that large multinational corporations strongly support a territorial tax system, which, they say, would make them more competitive with foreign rivals. What they don’t say, and what Mr. Obama stressed, is that eliminating federal taxes on foreign profits would create a powerful incentive for companies to shift even more jobs and investment overseas---the opposite of what the economy needs.
Since even left-leaning economists generally agree that tax credits for manufacturers are ineffective gimmicks proposed for political purposes, let's set that topic aside and focus on the issue of territorial taxation.
Or, to be more specific, let's compare the proposed system of territorial taxation to the current U.S. system of "worldwide taxation."
Worldwide taxation means that a company is taxed not only on its domestic earnings, but also on its foreign earnings. Yet the "foreign-source income" of U.S. companies is "domestic-source income" in the nations where those earnings are generated, so that income already is subject to tax by those other governments.
In other words, worldwide taxation results in a version of double taxation.
The U.S. system seeks to mitigate this bad effect by allowing American-based companies a "credit" for some of the taxes they pay to foreign governments, but that system is very incomplete.
And even if it worked perfectly, America's high corporate tax rate still puts U.S. companies in a very disadvantageous position. If an American firm, Dutch firm, and Irish firm are competing for business in Ireland, the latter two only pay the 12.5 percent Irish corporate tax on any profits they earn. The U.S. company also pays that tax, but then also pays an additional 22.5 percent to the IRS (the 35 percent U.S. tax rate minus a credit for the 12.5 percent Irish tax).
In an attempt to deal with this self-imposed disadvantage, the U.S. tax system also has something called "deferral," which allows American companies to delay the extra tax (though the Obama administration has proposed to eliminate that provision).
Romney proposes to put American companies on a level playing field by going in the other direction. Instead of immediate worldwide taxation, as Obama wants, Romney wants to implement territorial taxation.
But what about the accusation from the New York Times that territorial taxation "would create a powerful incentive for companies to shift even more jobs and investment overseas"?
Well, they're somewhat right ... and yet they're totally wrong. Here's what I've said about that issue:
If a company can save money by building widgets in Ireland and selling them to the US market, then we shouldn’t be surprised that some of them will consider that option. So does this mean the President’s proposal might save some American jobs? Definitely not. If deferral is curtailed, that may prevent an American company from taking advantage of a profitable opportunity to build a factory in some place like Ireland. But U.S. tax law does not constrain foreign companies operating in foreign countries. So there would be nothing to prevent a Dutch company from taking advantage of that profitable Irish opportunity. And since a foreign-based company can ship goods into the U.S. market under the same rules as a U.S. company's foreign subsidiary, worldwide taxation does not insulate America from overseas competition. It simply means that foreign companies get the business and earn the profits.
To put it bluntly, America's tax code is driving jobs and investment to other nations. America's high corporate tax rate is a huge self-inflected wound for American competitiveness.
Getting rid of deferral doesn't solve any problems, as I explain in this video. Indeed, Obama's policy would make a bad system even worse.
But, it's also important to admit that shifting to territorial taxation isn't a complete solution. Yes, it will help American-based companies compete for market share abroad by creating a level playing field. But if policymakers want to make the United States a more attractive location for jobs and investment, then a big cut in the corporate tax rate should be the next step.
American companies are hindered by what is arguably the world's most punitive corporate tax system. The federal corporate rate is 35 percent, which climbs to more than 39 percent when you add state corporate taxes. Among developed nations, only Japan is in the same ballpark, and that country is hardly a role model of economic dynamism.
But the tax rate is just one piece of the puzzle. It's also critically important to look at the government's definition of taxable income. If there are lots of corrupt loopholes -- such as ethanol -- that enable some income to escape taxation, then the "effective" tax rate might be rather modest.
On the other hand, if the government forces companies to overstate their income with policies such as worldwide taxation and depreciation, then the statutory tax rate understates the actual tax burden.
The U.S. tax system, as the chart suggests, is riddled with both types of provisions.
This information is important because there are good and not-so-good ways of lowering tax rates as part of corporate tax reform. If politicians decide to "pay for" lower rates by eliminating loopholes, that creates a win-win situation for the economy since the penalty on productive behavior is reduced and a tax preference that distorts economic choices is removed.
But if politicians "pay for" the lower rates by expanding the second layer of tax on U.S. companies competing in foreign markets or by changing depreciation rules to make firms pretend that investment expenditures are actually net income, then the reform is nothing but a re-shuffling of the deck chairs on the Titanic.
Now let's look at President Obama's plan for corporate tax reform.
- The good news is that he reduces the tax rate on companies from 35 percent to 28 percent (still more than 32 percent when state corporate taxes are added to the mix).
- The bad news is that he exacerbates the tax burden on new investment and increases the second layer of taxation imposed on American companies competing for market share overseas.
In other words, to paraphrase the Bible, the President giveth and the President taketh away.
This doesn't mean the proposal would be a step in the wrong direction. There are some loopholes, properly understood, that are scaled back.
But when you add up all the pieces, it is largely a kiss-your-sister package. Some companies would come out ahead and others would lose.
Unfortunately, that's not enough to measurably improve incomes for American workers. In a competitive global economy, where even Europe's welfare states recognize reality and have lowered their corporate tax rates, on average, to 23 percent, the President's proposal at best is a tiny step in the right direction.
Another American company has decided to expatriate for tax reasons. This process has been going on for decades, with companies giving up their U.S. charters (a form of business citizenship) and redomiciling in low-tax jurisdictions such as Bermuda, Ireland, Switzerland, Panama, Hong Kong, and the Cayman Islands.
The companies that choose to expatriate usually fit a certain profile (this applies to individuals as well). They earn a substantial share of their income in other countries and they are put at a competitive disadvantage because of America's "worldwide" tax system.
More specifically, worldwide taxation requires firms to not only pay tax to foreign governments on their foreign-source income, but they are also supposed to pay additional tax on this income to the IRS — even though the money was not earned in America and even though their foreign-based competitors rarely are subject to this type of double taxation.
In this most recent example, an energy company with substantial operations in Asia moved its charter to the Cayman Islands, as reported by digitaljournal.com:
Greenfields Petroleum Corporation..., an independent exploration and production company with assets in Azerbaijan, is pleased to announce that the previously announced corporate redomestication ... from Delaware to the Cayman Islands has been successfully completed.
Because it is a small firm, the move by GPC probably won't attract much attention from the politicians. But "corporate expatriation" has generated considerable controversy in recent years when involving big companies such as Ingersoll-Rand, Transocean, and Stanley Works (now Stanley Black & Decker).
Statists argue that it is unpatriotic for companies to redomicile, and they changed the law last decade to make it more difficult for companies to escape the clutches of the IRS. In addition to blaming "Benedict Arnold" corporations, leftists also attack low-tax jurisdictions for "poaching" companies.
Libertarians and conservatives, by contrast, explain that expatriation is the result of an onerous tax system that imposes high tax rates and requires the double taxation of foreign-source income. Expatriation is the only logical approach if companies want a level playing field when competing in global markets.
I cover this issue (and also explain that the Obama administration is trying to make a bad system even worse) in the video below.
My recommendation, not surprisingly, is that politicians fix the tax code. Unfortunately, politicians prefer the blame-the-victim game, so they attack the companies instead of solving the underlying problem (and then they wonder why job creation is anemic).
The big-government advocates at the Center for American Progress recently released a series of charts designed to prove America is a low-tax nation. I wish this was the case.
The United States does have a lower overall tax burden than Europe, which is shown in one of the CAP charts, but that doesn’t exactly demonstrate that taxes are low in America. Unless, of course, you think weighing less than an offensive lineman in the NFL is proof of being skinny.
But the one chart that jumped out at me was the one showing that the United States collects less corporate tax revenue than other developed nations. The CAP document states, with obvious disapproval, that “Corporate income tax revenue in the United States is about 25 percent below the OECD average.”
The obvious implication, at least for the uninformed reader, is that the United States should increase the corporate tax burden.
But here’s some information that CAP didn’t bother to include in the study. The U.S. corporate tax rate is more than 39 percent and the average corporate tax rate in Europe is less than 25 percent.
So let’s ponder these interesting facts. CAP is right that the U.S. collects less tax revenue from corporations, but even they would be forced to admit (though they omit the info from their report) that the U.S. corporate tax rate is much higher. Let’s see…higher tax rate-lower revenue…lower tax rate-higher revenue…this seems vaguely familiar.
Could this possibly be an example of that “crazy” concept of (gasp!) a Laffer Curve? To be sure, it is only in rare cases, when tax rates get very high, that researchers find that high tax rates lose revenue. In most cases, the Laffer Curve simply implies that higher tax rates won’t raise as much money as politicians want.
But have our friends at CAP inadvertently identified one of those cases where a tax cut (i.e., a lower corporate tax rate) would “pay for itself”?
There certainly is strong evidence for this proposition. In a 2007 study, Alex Brill and Kevin Hassett of the American Enterprise Institute found that the revenue-maximizing corporate tax rate is about 25 percent (click chart to enlarge).
Somehow, I suspect this wasn’t their intention, but I want to thank the statists at CAP for reminding us about the self-destructive impact of high tax rates.
For those who want to learn more about the Laffer Curve, these three videos will make you more knowledgeable than 99 percent of people in Washington (not a big achievement, I realize, but the information is still useful).