Tax Analysts Blog

Corporate Tax Reform Must Come at a Price

Posted on Jan 21, 2011

I had the privilege of testifying before the Ways and Means Committee yesterday. Below is the text of my oral testimony. The official witness testimony along with footnotes can be found here.

  Good morning, Chairman Camp, Ranking Member Levin, and other members of the Committee. Thank you for this opportunity to share my views on tax reform, a critically important issue for the future competitiveness of the American economy. My testimony will focus on a component of the U.S. tax system that is particularly in need of reform: the corporation income tax.

A quarter of a century ago, President Reagan defied all the skeptics and provided the leaderships for a bipartisan overhaul of the tax system that dramatically lowered tax rates and scaled back tax breaks that favored certain groups and activities over others. It was a victory for the public over the special interests.

Twenty-five years later the need for tax reform is greater than ever.

The complexity of the law costs businesses billions of dollars. Families endure endless hours of anxiety and paperwork.

The perception of unfairness—whether due to outright cheating by investors hiding funds on Caribbean islands or to special interests who can lobby their way to lower taxes—is an insult to the majority of taxpayers bearing their fair share.

And on top of all this our tax code is dead weight on the shoulders of the American economy. Its long list of subsidies and handouts defies any notion of a free market. The tax code’s interference with the free-market impedes the efficient allocation of capital, hampers productivity growth, and reduces international competitiveness. To promote job creation the tax code should minimize its role in the economy by rechanneling the revenues devoted to tax breaks into lower rates.

1. Reduction in the Corporate Tax Rate is a Necessity

In recent years the need for a significant reduction in the corporate statutory tax rate has moved from being just another good idea to being an absolute necessity for maintaining international competitiveness. Between 1995 and 2005, foreign statutory corporate tax rates have dropped on average about one percent per year, and since then rates have continued their decline. And just last month, the Japanese government announced its intention to reduce its corporate tax rate by 5 percentage points, effective April 1 of this year. This will leave the United States with the dubious distinction of having the highest statutory corporate tax rate in the world.

A high corporate tax rate is an invitation for a host of troubles. It encourages corporations to issue debt. It encourages corporations to engage in complicated and expensive tax planning. Most of all, it reduces investment and job creation in the United States.

2. Severe Budget Pressures Suggest Revenue-Neutral Corporate Reform

As already noted, base broadening corporate tax reforms are good in and of themselves because they remove market-distorting subsidies from the tax code. In this fiscal environment, base-broadening assumes additional importance.

We are on the road to fiscal catastrophe, and so far practically no action has been taken to remedy the problem. In order to put the nation’s finances on a sustainable path—that is, just to get our debt-to-GDP level to stabilize (far short of balancing the budget)—will require annual deficit reductions of approximately $500 billion.

With these enormous and unprecedented budget pressures, it seems reasonable to assume necessary corporate tax cuts must be accompanied by corporate base broadening. This is the view of the White House, as articulated by Treasury Secretary Geithner on January 12: “We are going to take a look at whether we can find political support for a reform of the corporate tax code that would lower rates by broadening the base but not lose revenue on net.” Rate reductions in the United Kingdom, Germany, and Japan have been accompanied by significant expansions of the corporate tax base.

3. The Current Corporate Tax Favors Some Business Sectors over Others

The essence of an efficient and competitive tax system is a level playing field. Government should not attempt to outguess the market and pick winners and losers. Unfortunately, there is a wide disparity in the tax treatment of businesses under current law.

The table below provides some examples of this disparity. While many corporations have effective tax rates approximately equal to the 35 percent statutory rate, other corporations have effective rates in the low twenties, the teens, and even the single digits. The major reason for these low effective tax rates is the ability of some corporations to shift a significant portion of their profits into low-tax jurisdictions.

Winners and Losers Under Current Code

Table 1.pdf

As the table shows, low effective tax rates are common in industries like pharmaceuticals and computer equipment where it is easy to shift technology and manufacturing to low-tax jurisdictions. In industries where customer markets and the provision of services are largely domestic, the opportunities for reducing taxes through cross-border profit shifting are limited.

4. International Tax Rules Favor Foreign Over Domestic Job Creation

Under current law, if an American corporation opens a factory in Indiana, the profits of that factory are subject to the 35 percent U.S. corporate tax rate. If the same corporation instead opens a similar factory in Ireland, the profits from that factory are subject to a 12.5 percent tax rate. If that factory generates a profit of $100, the choice is between an after-tax profit of $65 in the United States and $87.50 in Ireland. Obviously, U.S. tax law provides a large tax advantage for building and moving factories to low-tax countries.

In their advocacy for relaxation of U.S. tax rules, U.S. multinational corporations like to ignore the possibility that foreign investment (provided incentive by U.S. tax laws) can substitute for U.S investment. They focus instead on the idea that foreign investment can complement U.S. investment. In other words, it is in the best interest of the United States to increase foreign investment and job creation because this will increase U.S. investment and job creation.

No doubt foreign investment by U.S. multinational corporations has both substitution and complementary effects on U.S. investment. Intuitively, you can think about substitution occurring when a U.S. multinational decides to open a factory abroad rather than in America. Complementary effects are likely to occur when a multinational opens a distribution and marketing affiliate that increases worldwide sales, which in turn increases demand for U.S. research and development and U.S. headquarters services.

U.S. Multinationals Job Creation, 1999-2008

Chart 1.pdf

The two effects are not mutually exclusive. They offset each other. One reduces U.S. job creation. The other increases it. Data from the U.S. Department of Commerce (in the figure above) shows that since 1999 U.S. multinational corporations have reduced domestic employment by 1.9 million while increasing foreign employment by 2.4 million. Whatever the positive effects of foreign operations may be on domestic employment, they have not offset the job losses. U.S. multinational corporations are not net domestic job creators.

5. Profit Shifting to Tax Havens Results in Large Revenue Loss

Data from a variety of sources indicate inappropriate profit shifting occurring on a large scale. By “inappropriate” I mean the perfectly legal but economically indefensible assignment of profits to subsidiaries in low-tax jurisdictions.

The table below presents the latest data on the profitability of affiliates of U.S. multinational corporations in five low-tax countries. In all these jurisdictions, the average effective tax rate of U.S. affiliates was below 10 percent. Although these are all small jurisdictions (with their economies equal to only about 2 percent of the world’s non-U.S. gross domestic product), they together account for 21 percent of foreign profits of U.S. multinationals. There is no perfect way to measure profitability, but by almost every measure these five tax havens have extraordinarily high rates of profit. These data strongly suggest U.S. multinationals are readily able to shift profits into tax havens and thereby significantly reduce taxes properly owed to the United States and other industrialized nations.

Profits and Profitability of Foreign Affiliates of U.S. Multinationals in 2008

Table 2.pdf

Over the last decade, the transfer pricing problem has gone from bad to worse. From 1999 through 2007, foreign profits of U.S. multinationals have increased by 163 percent, while over the same period, traditional indicators of economic activity have increased on average by only 97 percent. This excessive growth of foreign profits represents an annual revenue loss of $28 billion over and above the revenue loss if transfer pricing rules were as effective as they were in 1999. This is an estimate of the minimum annual revenue loss from inappropriate transfer pricing and income shifting.

6. Profit Shifting Turbo-charges the Incentive for Foreign Job Creation

But the growing problem of profit shifting to low-tax countries is about more than lost revenue. It is about turbo-charging the incentive to move operations offshore. The ease with which U.S. corporations can move profits makes it vitally important for U.S. corporations to invest outside of the United States.

The simple example presented earlier—comparing the U.S. 35 percent rate with the Irish 12.5 percent rate—is unrealistic and grossly understates the tax advantages of foreign over domestic investment. That’s because it does not take into account the enormous tax benefits derived from profit shifting through transfer pricing.

Not only can investment reduce tax on Irish profits, it reduces on taxes properly attributable to profits from high-tax countries, including the United States.

Building on the simple example described before, let’s suppose that for a nominal fee the U.S. parent company allows the Irish subsidiary to use valuable marketing and manufacturing intangibles. Without access to these intangibles the Irish subsidiary would only have $100 of profits. That $100 is the true economic income attributable to the activities in Ireland. Access to the parent company’s intangibles, however, allows the Irish subsidiary to book $300 of profit. The Irish subsidiary should be paying the U.S. parent $200 in royalties (or its equivalent), but because of lax transfer pricing rules it does not.

With a 12.5 percent tax rate, Irish tax liability on $300 of reported profits is $37.50. The shift of $200 of profits out of the United States reduces U.S. taxes by $70. The total tax effect of the investment in Ireland is an increase in Irish tax of $37.50 and a reduction in U.S. tax of $70. The net tax effect of investment in Ireland is a reduction in tax of $32.50.

Given the $100 of true economic profit in Ireland, the effective tax rate is negative 32.5 percent. Proponents of capital export neutrality and a worldwide system would argue the proper tax rate in this example is 35 percent (the U.S. rate). Proponents of capital import neutrality and a territorial system would argue the proper rate of tax in this example is 12.5 percent (the Irish rate). There is no principle of international taxation that can condone negative effective tax rates on foreign investment.

Because of legal transfer pricing practices, the U.S. Treasury is providing billions of dollars of subsidies for U.S. companies to invest in Ireland and other tax havens.

Irrespective of your views about whether the United State should move to a territorial system or not, we should all be able to agree that the inefficiency of subsidies, provided through aggressive transfer pricing, is a drag on economic growth and job creation.

7. Multinational Competiveness is not U.S. Competitiveness

Multinational corporations are important to the U.S. economy. They account for the bulk of our private-sector R&D. They are export-intensive—accounting for a proportionately larger share of exports than the rest of the economy. Of course, we want our multinationals to improve their competitiveness.

But support for U.S. multinational businesses should not come at the expense of other sectors. Yes, U.S. multinationals create jobs. But so do purely domestic corporations. So do small businesses. And so also do foreign-headquartered companies that invest in the United States. We must remember that multinationals’ competitiveness and overall US competitiveness are not always the same thing. Promoting overall—or “standard of living competitiveness,” as the Joint Committee on Taxation labels it —is the superior policy objective.

Favorable treatment of one sector over another generally hurts overall competitiveness because the free market allocation of capital is distorted.

To promote economic growth and maximum job creation all corporate business should be taxed evenly. Low rates of corporate tax are desirable for all these businesses. Any relaxation of current international rules would only increase disproportionate benefits for multinationals versus other businesses. To do this in the fairest and most efficient manner possible, we should minimize the enormous tax breaks for offshore job creation made possible by aggressive transfer pricing and use the revenue gains to lower corporate tax rates for all U.S. corporations.


8. Conclusion: Base-Broadening Should Begin with Reform of International Tax Rules

When the Bush Treasury Department listed ways to pay for lower corporate tax rates, the three largest revenue raisers were: (1) changes to the depreciation rules, (2) repeal of the section 199 domestic production credit, and (3) repeal of the research credit. These are direct incentives for domestic job creation. They are only available for business activity in the United States. In light of the current 9.4 percent unemployment rate, when we start broadening the tax base to pay for corporate rate reduction, we should cut incentives for foreign investment before we cut incentives for domestic investment. For obvious reasons, when Congress designs tax incentives it insists that they only be available for domestic activity. As so the tax benefits of accelerated depreciation and tax credits are only available for investment and job creation inside U.S. borders. Before we reduce depreciation allowances, or the domestic production credit, or the research credit, we should limit the ability of corporations to shift profits to low-tax countries and to take advantage of enormous incentives to create jobs offshore.

Whatever direction corporate reform takes—whether the United States moves to a territorial system or retains the current worldwide system--Congress must consider tougher measures to prevent transfer pricing abuse. Current statutes and regulations enshrine the arm’s-length standard. This standard gives primacy to the often futile search for comparable, unrelated-party transactions in the hope of using those transactions to determine the terms for related-party transactions.

The arm’s-length method is seriously flawed in both theory and practice. The theoretical problem is that because of synergies within large corporations—what economists call “economies of scope”—the economic relationship between entities within a corporate group are not the same as those between unrelated parties. The practical problem is the lack of truly comparable unrelated transactions that can be used to apply the arm’s-length method to related-party transactions. Modifying the arm’s-length standard will not get the job done.

The major alternative to the arm’s-length method for allocating income to locations is formulary apportionment. The major problem with a pure formulary approach is international coordination (including a lot of renegotiation of existing tax treaties). The major benefit would be the elimination of profit accumulation in tax havens with little or no real economic activity. Although proponents of the arm’s-length method hate to admit it, there are some formulary elements employed in current law. Profit-split methods widely used for allocating income from intangibles are a crude version of a formulary method.

Another method of attacking the transfer pricing problem would be to reduce the availability of deferral in situations where transfer pricing abuse is likely. Around the world and traditionally in the United States, anti-deferral rules (usually referred to as “Subpart F rules” in the United States or “controlled foreign corporation rules” in the rest of the world) are widely-used as a backstop to the transfer pricing rules.

Other major industrialized countries, most of whom have exemption systems, have anti-abuse rules that revoke the exemption privilege not only for passive income but also for active income where there is potential for transfer pricing abuse that threatens the domestic tax base. The rules vary widely and are highly complex. These rules struggle to maintain a balance between competitiveness (by providing a full exemption for properly measured foreign source income) and preventing tax avoidance (by preventing shifting of domestic income to tax havens).

In trying to identify situations where transfer pricing abuse is likely, these rules look at a number of factors. High on the list is the favorability of the tax system of the jurisdiction in which the foreign subsidiary operates. Some countries form “white lists” of jurisdictions that have sufficiently high levels of taxation or have treaties with the home country. Subsidiaries operating in white list countries automatically qualify for exemption or face less stringent anti-avoidance rules. Other countries have created “black lists” of tax havens where exemption is not permitted or is much more difficult to obtain. Still another method is to determine the effective tax rate of a subsidiary and only allow exemption if it exceeds some threshold. In addition to low tax rates, other factors that could trigger anti-avoidance treatment are lack of commercial activity or lack of local management and control in a subsidiary in a low-tax jurisdiction.

In its FY2011 budget, the Obama Administration proposed creating a new category of subpart F income. Under the proposal, the profits subject to Subpart F inclusion would be (1) from an intangible, (2) from a subsidiary paying low foreign taxes (suggested by the Treasury to be less than 10 percent), and (3) earning an excessive return (suggested by Treasury to be above 30 percent). All three of these characteristics are commonly found in inappropriate transfer pricing. The Obama proposal is in line with the well-established practice of using CFC/Subpart F rules as a backstop to transfer pricing rules. As such, if it is properly designed, it would be an important additional tool for IRS efforts to combat transfer pricing abuse.

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Mr. Chairman, thank you for the opportunity to share my views.

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