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Hassett Defends Deficits, Predicts Transfer Pricing Drop

Posted on February 20, 2018 by Jonathan Curry

The White House’s chief economist stepped up to bat for President Trump’s deficit priorities, arguing that the tax cuts’ $1.5 trillion price tag was needed to improve U.S. tax competitiveness. 

Trump and Congress were right to prioritize the tax cuts, particularly on the corporate side, Council of Economic Advisers Chair Kevin Hassett said February 16 during an onstage interview at a Tax Council Policy Institute conference in Washington. “I think that the noncompetitive corporate code really was harmful to productivity growth and wage growth and capital formation in the U.S.,” he said.

Hassett argued that while the tax cuts may increase the federal budget deficit, they would help offset a different kind of deficit.

Largely because of the lower corporate tax rate and the Tax Cuts and Jobs Act’s international tax changes, “we think that there’s gonna be a dramatic reduction in transfer pricing of profits to foreign locations,” Hassett said. The CEA estimated that over half of the United States’ trade deficit could be attributed to transfer pricing by U.S. multinationals, but because of the TCJA (P.L. 115-97), “transfer pricing has just become a lot less attractive,” he said.

Hassett also contended that the pre-TCJA tax code disproportionately harmed intangible capital. “You can see that when you look at trade imbalances for goods versus services, and I think we’re leveling the playing field,” Hassett said. He attributed that imbalance to former requirements concerning a worldwide system of international taxation, the high statutory corporate tax rate, and “our bad rule for transfer pricing that allowed firms to locate profits where they want.”

Economic Bogeymen

The tax cuts are already working as expected, but the associated economic gains could be jeopardized if Democrats regain control of Congress or the White House, according to Hassett.

“The main risk to our economic outlook is a political one,” he said. If Democrats succeed in undoing the TCJA, it would subtract half a percentage point from the administration’s economic growth forecast, Hassett said. That risk, however, is mitigated by the unlikelihood of the TCJA being rolled back until after the next presidential election at the earliest, he added.

Hassett said that although the technical international tax reforms on the corporate side could remain mostly unchanged, Democrats would likely try to raise the corporate income tax rate to around 28 percent, as well as target tax increases on higher-income individuals.

“The Democrats’ definition of who’s rich seems to be a moving target, but let’s say above $250,000. If you’re up above that, you could probably be assured that your marginal tax rate would go up,” he said.

Vanishing Advantage

Earlier that day, panelists at the conference suggested that the TCJA’s improvements to the United States’ competitive advantage would be short-lived.

The TCJA’s 14 percentage point corporate rate reduction was a “remarkable accomplishment,” said Drew Lyon of PwC. The law shifted the United States from having the highest combined statutory corporate tax rate in the OECD to now “roughly in the median” at 25.75 percent when the average state corporate tax rate is included. And although there is still a substantial share of OECD countries with lower corporate rates, most of the larger developed economies have rates around 30 percent.

But, he added, “even before the ink was dry on the bill,” other countries were making plans to reduce their tax rates, citing 10 countries that have already reduced or proposed to reduce their corporate rate for 2018 to 26 percent or below.

According to Lyon, the United States’ competitive advantage is further short-lived by the temporary nature of the full expensing provision, which is set to expire at the end of 2022, and the five-year amortization of research and development expenses, which doesn’t take effect until after 2021.

Using the OECD’s measures of incentives for research, the lower corporate rate and full expensing gives the United States a small boost in the rankings. “However, if we move to a world post-2021 when we’re amortizing research expenses over five years, or furthermore, no longer expensing equipment-related research activities, we’re actually slightly worse off than we were under prior law,” Lyon said.

Fellow panelist Jason Furman, former chair of President Obama’s CEA, echoed Lyon’s concerns, saying that equipment capital would likewise see disappointing results under the new law. The marginal tax rate on equipment investment will initially drop from 8 percent to 2 percent, but in 2027, after the expensing provision expires, it is higher than it was pre-TCJA, Furman said. He explained that a 21 percent corporate rate with normal depreciation results in a higher marginal tax rate than a 35 percent rate with 50 percent bonus depreciation.

“In other words, we would have had a lower tax rate on equipment if we had just made bonus [depreciation] permanent instead of doing everything else that we did in this law,” Furman said.

But the “real terrible, terrible thing that would happen in this bill that’s gotten too little attention . . . is what would happen to R&D if we took this bill literally,” said Furman.

The effective marginal rate on R&D activities is already higher in 2018 compared to 2017 because the interest expense deduction is worth less after the corporate rate reduction, Furman said. Allowing the 5-year amortization of research expenses to take effect would raise it even more, he said, though he added that many tax observers don’t expect lawmakers to allow that provision to take effect.

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