The biggest tax issue for big business is transfer pricing and various other methods of shifting profits from high-tax countries to low-tax countries. For the U.S. government this has resulted in huge revenue losses. Estimates vary between $30 billion and $60 billion annually. For multinationals the ability to easily move profits has been a major contributor to the decline over the last decade in the effective corporate tax rates they report to shareholders. This in turn increases reported profits which is very important for keeping stock price high. For many companies there is no need to engage in complex and questionable tax shelters when it is perfectly legal to shift profits and gain huge tax benefits through income shifting.
This post will focus on the question of whether the Congress and the IRS should crack down on aggressive transfer pricing practices. For some, the answer is: "of course." After all, the deliberate mismeasurement of income is "bad tax policy." Others, however, are guided by the notion that lowering taxes on foreign activities of U.S. multinationals improves their competitiveness. According to this view, because aggressive income shifting lowers taxes on foreign investment, we really should not be concerned. Aggressive income shifting, in this view, can be a good thing. It is not too often you hear this latter view explicitly stated, but I would wager a month's pay that this fundamental view keeps many members of Congress from really being concerned about the issue.
- Background: For the last fifty years or so there has been a great debate in academic and policy circles about the fundamental guiding principle of international tax policy. Liberal types favor what is called "capital export neutrality." (CEN) According to this view foreign profits of U.S. corporations should be taxed at the U.S. tax rate (currently 35 percent). Conservative types favor "capital import neutrality" (CIN) where foreign profits are taxed at the foreign tax rate (in the 25 to 30 percent range in most industrialized countries, in the teens in low-tax countries like Ireland, Switzerland, and Singapore, and zero in pure tax havens like Bermuda and the Cayman Islands).
In principle the U.S. taxes the worldwide income of U.S. based companies at the U.S. rate. This suggests conformity with CEN. Most of the rest of the world exempts foreign source income from home-country tax. (Japan and the U.K. just made this change in the last few years.) Exemption of foreign profits is consistent with CIN. Over last decade, CIN has displaced CEN as the guiding principle adopted by governments in the formulation of their international tax laws. One major exception to this trend is the stance adopted by the Obama Administration in its budget proposals released as part of its FY2010 and FY2011 budgets.
It is critical to understand that although the U.S tax structure is set up to implement CEN its practical effect is to leave most foreign income untaxed. The benefits of the current system are so large that proposals for the U.S. to replace its worldwide system with a territorial system are estimated to raise revenue.
Now let me explain why a lax attitude toward aggressive transfer pricing is not consistent with any principled approach to international tax policy. A small bit of economics terminology here can clear up a lot of confusion. The term I want to focus on is "effective tax rate." It is not usually used in policy analysis of transfer pricing. But it is really useful because it allows us to evaluate transfer pricing abuse from an economic perspective rather than from legal standards (like the "arm's length standard" that has been undeservedly enshrined as the guiding principle of transfer pricing).
Under an exemption system (or under the U.S. system which in effect replicates the benefits of exemption), when there is no inappropriate income shifting, the effective rate of tax on foreign investment is the foreign tax rate. Let's say that if income is measured correctly, a foreign subsidiary that records a before-tax rate profit of 200 and (because the foreign tax rate is 10 percent) has an after-tax profit of 180. The only tax on foreign income is the foreign tax of 20 so the effective tax rate (20/200) is the foreign rate of 10 percent.
Now let's suppose that under U.S. transfer pricing rules the U.S. corporation investing abroad is able to shift income from the United States into the foreign jurisdiction so that the foreign subsidiary has taxable profits of 400. Now, the multinational corporation pays 40 of foreign tax and 70 less of U.S. tax. The net tax burden of investing in the foreign jurisdiction is -30. Dividing that by economic income of 200 we get an effective tax rate of minus 15 percent. (A negative effective tax rate means that government is not taxing but subsidizing investment.)
Now let's take that -15 percent tax rate and put it into the standard economic framework. For adherents of CEN there is a big problem, they want the rate of tax on foreign investment to be 35% and it is -15%.
But even for adherents of CIN, there is a problem. They want the rate of tax on foreign investment to be 10% (the statutory foreign rate) and it is -15%. In this case, U.S. tax rules have not leveled the playing field for the U.S. multinationals vs. foreign competitors in their home markets. The rules provide a large subsidy to give U.S. companies an advantage over foreign companies competing in their home markets. If we take "multinational competitiveness" to mean the effective rate of tax on foreign investment should equal the actual foreign rate, generous transfer pricing rules go far beyond what is necessary.
Now, you cannot blame businesses or their lobbyists for pushing for the most advantageous tax rules possible. But make no mistake, pushing for transfer pricing rules that are more generous than those which correctly measure income is not a principled position. It is merely natural profit-maximizing business behavior to make tax as low as possible.
Or let's put it differently: Obviously there is no upper limit on how much benefit to provide foreign investment. This post is describing what that upper limit should be.
There are many who openly espouse CIN but really want much more. Obviously, lower taxes on U.S. multinationals make them more competitive (but not in the technical sense described above). Taking tax rates on foreign investment below foreign rates has no economic justification. First of all, it is unfair and inefficient because the tax-advantaged positions provided through transfer pricing are wildly uneven across industries and often within industries. But even if we could give all multinationals even tax-advantages from transfer pricing if tax rules more generous than CIN would allow, then we are entering into a dangerous, slippery-slope, industrial-policy, interventionist, non-market world where the government is effectively saying we need to subsidize multinational business because it is provides some sort of special economic benefit. Most every economist would agree taxes should be neutral and not pick winners and losers. And this is why I believe the Obama administration's proposals to prevent income shifting are good economics.