You've heard it a thousand times: The United States has the highest statutory corporate tax rate in the world. No surprise, then, that everybody wants to lower it.
President Obama's framework for business tax reform would reduce the corporate rate from 35 percent to 28 percent. Departing House Ways & Means Committee Chair Dave Camp, R-Michigan, does Obama one better, offering a plan that cuts the rate to 25 percent.
Both Obama and Camp cite "global competitiveness" as the principal justification for their reforms. Yet neither proposal is especially competitive by international standards. The average corporate rate among OECD nations is 24 percent. If tax reform is worth doing, why not aim high?
Earlier this month Sen. Ben Cardin, D-Maryland, introduced tax reform legislation that is decidedly different -- and sure to provoke strong reactions from stakeholders. His bill, the Progressive Consumption Tax (PCT) Act of 2014, attempts the unthinkable. It would slash the corporate rate to 17 percent without adding to the deficit or altering the distributional profile of our current tax system. Spoiler alert: Cardin pays for the impressive rate reduction with a broad-based federal consumption tax. Make no mistake -- this is a VAT.
The details of the PCT Act sound vaguely familiar. That's because the bill bears a strong resemblance to ideas proposed by professor Michael Graetz in his book, 100 Million Unnecessary Returns: A Simple, Fair, Competitive Tax Plan for the United States. The crux of both the PCT Act and the Graetz plan is that a VAT would generate enough revenue to sharply reduce the corporate rate and radically alter the individual income tax by exempting most American households. The change would be dramatic and transformative. This is big-picture stuff.
Here are a few salient discussion points.
Corporations: As mentioned, the PCT Act would reduce the corporate rate by more than half, from 35 percent to 17 percent, and America would enjoy one of the most competitive tax environments in the world. Our corporate tax rate would be well below that of trade partners like Japan (35 percent), Germany (29 percent), and the United Kingdom (21 percent), and it would match the rates in Singapore and Taiwan.
Given the rate differentials, the PCT Act would have major implications for transfer pricing and earnings stripping. Since it would be considered a low-tax country, the United States might become a favorite destination for foreign profits shifted away from high-tax source countries. This would be a bizarre reversal of the prevailing behavioral incentives. We could become the poacher rather than being preyed upon. Our tax code would attract, not repel.
Single Rate: The PCT would apply at a single rate. Unlike European VATs, there would be no reduced rate for necessities (e.g., medicines, children's clothing, unprepared food). That makes sense. A bifurcated rate structure is not optimal for addressing the regressive aspects of taxing consumption. The existence of multiple rates also greatly complicates compliance. Merchants would face endless confusion about which goods and services qualify for which rates. Roughly half of all VAT litigation in other countries concerns eligibility for reduced rates. A single rate avoids these headaches.
Goods and Services: Like other VAT regimes around the world, the PCT would apply to both goods and services. This is preferable to our retail sales taxes that generally focus on goods. Let's face it -- retail sales taxes are not terribly helpful in the modern service economy. The concept here is that broader is better.
Financial Services: One notable exclusion from the PCT would be the financial sector. This isn’t because Cardin is yielding to pressure from Wall Street. Applying a VAT to banks necessarily involves technical difficulties. European VATs similarly exempt the financial sector. That's because the business model of banks intertwines savings and investment (exempt activities) with the provision of services (taxable activities). For VAT purposes, financial institutions generally prefer inclusion -- with zero rating -- to exemption. This enables them to claim valuable input credits. Interestingly, an explanatory statement from Cardin's office hints at flexibility on this issue and points to the systems in Australia and New Zealand as possible alternatives.
Setting the Rate: As drafted, the PCT rate would preliminarily be set at 10 percent. Cardin acknowledges that it could change depending on how the legislation is scored. The Joint Committee on Taxation has not yet estimated its budgetary effects. A revenue scoring of the Graetz plan by the Tax Policy Center found that a 12.9 percent VAT achieved revenue neutrality. These rates seem high compared with retail sales taxes, but they're low by international VAT standards. The average VAT rate among EU nations is around 20 percent.
Business Inputs: Like most VAT systems around the world, the PCT would operate on a transactional basis. No surprise there. Given the almost universal adoption of the credit invoice method, it would have been highly unusual to opt for the subtraction method. The PCT allows a full credit for business inputs. As many readers know, my biggest gripe with retail sales taxes is that they fail to exclude business inputs and result in cascading. It's been estimated that something like one-third of all retail sales tax charges in the United States relate to business inputs. That's outrageous. Any consumption tax that doesn’t address cascading is deeply flawed. The PCT avoids that problem.
Border Adjustment: The PCT is destination based, rather than origin based. That means the applicable rate is determined by the location of sale rather than the location of production. No remote vender problem here. (That means you, Alibaba.) As a result, U.S. exports would be eligible for a border adjustment. If you think that sounds like an export-contingent tax incentive, you are correct. It's also an export subsidy that's expressly authorized by the WTO. The WTO has rejected Congress's attempts to apply export subsidies through the corporate income tax on many occasions. (Longtime readers may recall the domestic international sales corporation, foreign sales corporation, and extraterritorial income fiascos.) Because the PCT is an indirect tax, the border adjustment is WTO-compliant. Other nations with VATs already benefit from these export subsidies. A decade ago the U.S. trade representative estimated the value of the subsidy, just for the European Union, at $4 trillion per year. An export subsidy of roughly comparable size is implicit in the PCT, leveling the playing field (finally) between domestic firms and foreign rivals.
Progressivity: Everyone knows a VAT is regressive. Consumption taxes, by definition, do not reach personal savings. Because the poor save much less of their earnings, they will inevitably pay more VAT (proportionally) than the wealthy. This is true even though affluent households outspend poorer households and pay more VAT on a gross basis.
The PCT mitigates the regressive nature of a VAT in two ways. First, it includes a "family allowance" that exempts the first $100,000 of income for joint filers ($50,000 for single filers and $75,000 for head of household filers). This would relieve about 90 percent of the American public from any federal income tax liability whatsoever. Second, the PCT offers a rebate to compensate poor families for the loss of income tax benefits (such as the earned income tax credit and the child tax credit) that would be functionally eliminated for households no longer subject to income tax.
Income Tax: What about the remaining 10 percent of Americans with annual earnings in excess of $100,000? They would continue to pay income tax, but only on amounts exceeding the threshold. The PCT proposes three brackets with marginal rates of 15, 25, and 28 percent. That's a significant rate cut for the wealthiest taxpayers, who are now taxed at 39.6 percent. The current tax code is rife with tax expenditures, many of dubious merit. The PCT jettisons all but five : (1) charitable contributions, (2) state and local taxes, (3) home mortgage interest expense, (4) employer-provided healthcare, and (5) retirement benefits.
The Circuit-Breaker: Many conservatives favor the concept of a consumption tax, but oppose it for fear it will lead to an uncontrollable expansion of government. These are reasonable concerns. The PCT addresses them with a "revenue circuit-breaker." If revenues grow too large (as gauged by a numerical target), the surplus cash must be returned to taxpayers. This could take the form of direct refunds mailed out by the IRS, or credits to be applied against the following year's income tax. Several state governments already do something similar. The circuit-breaker is untested at the federal level but would seem to address GOP fears.
The VAT Haters Club: I have no doubt that many in Washington will oppose Cardin's bill. The Ralph Nader crowd surely will, because the PCT, like any VAT system, is regressive. These folks are unlikely to be swayed by measures that preserve our system's overall progressivity. This group also sees little value in reducing the corporate tax rate so dramatically. They don't lose any sleep over the loss of global competitiveness. At the opposite end of the political spectrum, staunch conservatives are just as certain to object to the PCT because they wish to starve the beast. These folks generally buy the sloganeering pitch that "VAT is French for big government." True, they're keenly aware of the international trend to reduce corporate rates. In fact, they frequently trumpet this fact. But they selectively ignore that those same rate reductions are almost uniformly paid for with a broad-based consumption tax. I suspect they will not be calmed by Cardin's revenue circuit breaker.
At the end of the day, a VAT isn't going anywhere in Congress. We understand that. But Cardin's PCT legislation nevertheless makes for some compelling discussion.