Tax Analysts Blog

The Unspoken Tax Expenditure

Posted on Jan 3, 2013

There's a lot of talk in Washington about scaling back tax expenditures for the sake of lowering marginal rates — or preventing future rate increases. Most economists agree that lowering rates, while broadening the base, is the gold standard for tax reform. This explains the chatter about eliminating the deduction for state and local taxes, or limiting the deductions for mortgage interest expense and charitable donations. There's even discussion about modifying the exclusion for employer-provided health insurance. I can remember when such talk was considered heresy. But we're now told that everything must be on the table in order to keep rates down.

The underlying rationale for cutting tax expenditures is perfectly sound, but there's an obvious political problem. Generations of Americans have come to rely on these measures and they don't want them taken away. The burning issue that Congress will face in 2013 is whether there are any preferences buried in the Internal Revenue Code which are, at once, substantial enough to pay for a rate reduction while not being culturally hard-wired into voters' minds.

I recently stumbled upon a position paper from Citizens for Tax Justice which identifies numerous tax expenditures that could be tapped to pay for a rate reduction. The big-ticket item on their list is something that nobody is talking about: the deferral of foreign corporate income. The CTJ scores the elimination of deferral at $583 billion over 10 years. You can see the CTJ paper by clicking here. If lawmakers are serious about taking an axe to tax expenditures, one wonders how long deferral can escape their attention.

Deferral of corporate profits is a subtle concept that merits some explanation. Viewed most plainly, deferral is the ability to earn income in the current year but not pay the related tax until a subsequent year. It's a timing differential, nothing more. Yet, it lies at the very heart of corporate tax planning. Corporations can often delay the U.S. tax hit on foreign profits until those earnings are repatriated from overseas affiliates. This benefit is not available for domestic earnings which are taxed currently — that is, on an accrual basis. Earn a profit in Detroit and it's taxable now. Earn a profit in Dubai and it's taxable when (or if) the firm brings the money back into the country. Keep those profits offshore indefinitely and you may never pay U.S. tax on them. Thus the stories one hears about vast corporate treasuries being parked offshore in places like the Cayman Islands. That's deferral at work.

Deferral is perfectly legal, and has been for a long time. Back in 1962 Congress saw fit to enact a set of anti-deferral rules. The idea was to permit deferral for active income while restricting deferral for passive income. Fifty years on, those rules don't have much teeth. Multinational firms can side-step our anti-deferral laws with relative ease. Tax attorneys joke that "a tax deferred is a tax avoided."

And no discussion of deferral is complete without mentioning the economic incentives it creates. Deferral results in capital invested abroad enjoying higher after-tax returns than capital deployed domestically, other things being equal. In effect, deferral subsidizes foreign investment relative to domestic investment. (Opinions differ on whether deferral also subsidizes foreign employment relative to domestic employment.)

Several observations come to mind here.

First is the price tag. Eliminating deferral gets Congress well over half a trillion dollars. That's real money. Second, I suspect the general public doesn't really care about deferral — certainly not to the same extent they care about the deduction for mortgage interest or the exclusion for health insurance. Most Americans are unaware that deferral even exists, which by implication means they wouldn't be dismayed by its repeal. Third, the business sector will cling to deferral like a mama grizzly bear clings to her cubs. And with good reason. Eliminating deferral would effectively kill transfer pricing as we know it today. That would translate to a major increase in effective tax rates for businesses with foreign operations, although the statutory tax rate (35%) would never change. There's no chance Corporate America allows that to happen without one heck of a fight.

Deferral's revenue score (and dubious economic incentives) doom it to life with a bull's-eye on its back. That's just the way it is. The challenge ahead for the business lobby in 2013 is to keep deferral off the negotiating table when a wide range of political voices are telling us that everything must be on the table for the sake of keeping down rates. Nobody in Congress is mentioning deferral just yet, but you can be darn sure they're thinking about it.

Read Comments (5)

J. B. GustJan 2, 2013

No, the real unspoken tax expenditure, the one that isn't even scored, is the
total exclusion from taxes (not just a deferral) of the billions of investment
income of foundations and endowments. Harvard has literally billions of
investment income every year, with zero taxes. If you are serious about taxing
the truly rich, tax them.

amt buffJan 5, 2013

Ending deferrals (such as 401k deductibility) is scored very inaccurately, only
counting the effects over 10 years.

In fact, more revenue is collected now but less revenue is collected later,
e.g. after retirement for 401k withdrawals of pre-tax contributions. That
revenue cost is beyond the 10-year horizon and doesn't show up in the scoring.
This makes ending deferral look much more profitable for the government than it
really is.

Every study of tax expenditures uses this same completely misleading scoring.
Don't expect the press to discover the hidden revenue cost of ending deferral
until after the legislation is enacted.

Rick GundlachJan 6, 2013

I think that both are areas of reform, in what is clearly a "target-rich
environment" of dodges and loopholes.

vivian darkbloomJan 7, 2013

Anyone who has closely followed the etymology of the term "tax expenditure"
knows that the term was originally defined (by Stanley Surrey) to include those
tax deductions, exclusions, credits and other "preferences" that deviate from
a baseline "normative income tax system". The latter is particularly
subjective. What, exactly, is the baseline "norm"?

For example, if one considers that the "normal" income tax system in the rest
of the developed world taxes domestic corporations on a territorial basis, the
idea that an *exclusion* of the foreign profits of a domestic corporation, much
less the *deferral* of those profits is a "tax expenditure" becomes a bit more
difficult to accept.

Perhaps that is one reason why this "tax expenditure" is largely "unspoken"?

Most of this "tax expenditure" could be eliminated overnight if the United
States would adopt a system under which active foreign profits are exempt from
domestic tax when repatriated (or not) under, say, a system such as the
"participation exemption" that is used by backward and uncivilized countries
such as the Netherlands.

anna nycJan 7, 2013

Consider these:

1. Exploitation of Offshore Tax Havens by Wealthy Individuals & Corporations /
US PIRG Report
$150 Billion
bit.ly/WpF4wR

2. CEO Executive Pay Tax Loopholes / IPS Report
$14.4 Billion
http://www.ips-dc.org/resources/executive_excess_2012.pdf

3. Tax Write-offs for Corporate Legal Settlements of Cases Involving Harming
the Public / US PIRG Report
$ Billions Annually
BP $10B Tax Credit from $37.2B Gulf Spill
UBS $245M Tax Credit from $1.5B Settlement
http://www.uspirg.org/reports/usp/subsidizing-bad-behavior

4.Income Shifting by US Multinationals / Tax analysts Report
$90
Billionhttp://www.taxanalysts.com/www/website.nsf/Web/HomePage/$file/clausing.pd
f

I haven't found an annual estimate for cost to US Treasury/Taypayers of ALL
Corporate Legal Settlement Tax Credits, but if I estimate at $15B, say, a low
total from 5 above would be $269.4 Billion collectible corporate tax,
equivalent of $2.7 trillion Deficit reduction over a decade.

$2.7 trillion over a decade and it's incomplete. Just add 100 yr old $3.5B Oil
Drilling Tax Credit...up to $300B - $3 trillion Deficit reduction!

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