Economists have always been somewhat dubious about the corporate income tax and
historically the reason just has been because of some flaws that it has
even in a closed economy.
Flaws that continue certainly in an open economy
but that would occur even if it was closed.
So I'll just say a word about those quickly and then turn it back over to you
to discuss the flaws that particularly arise in an open economy, because that's what really
drove us to this project.
But even in a closed economy, corporate income tax would be kind of problematic.
It has a number of economic distortions where it encourages people to do things for tax reasons
that they wouldn't do for good business reasons.
There's a number of things that could be mentioned, but I'll just focus on two big ones.
The distinction between debt and equity and
the distinction between corporate and pass-through businesses.
As you've already explained, Eric, the corporations are allowed to deduct the interest payments
they make to their bondholders and then the bondholders pay taxes only one level of tax,
when the corporation uses debt.
But then if they use equity, there's two levels of tax, the double taxation you mentioned
earlier where the corporation pays tax and then the individual stockholders pay tax on
their dividends and capital gains.
They do get a preferential rate and the capital gains tax is deferred until they sell
but still there's a second level of tax there.
And so that artificially encourages companies to use debt when there might be good business
reasons to issue stock or equity instead, so it would encourage companies to engage
in more borrowing than they otherwise would do and that's been a longstanding distortion
of the corporate income tax.
Another distortion is just how you set up your business because the corporate income
tax only does apply to corporations and it doesn't apply to all of those pass-throughs
and so it gives an artificial tax advantage to the pass-throughs, causing them to become
a bigger share of the economy and corporations a smaller share of the economy than your business
logic might otherwise dictate.
It's particularly odd to see that because as you mentioned, some of the pass-through
businesses actually have characteristics that are very similar to corporations in terms
of the liability protections for their owners.
And so even when people weren't really worried about international investment
and cross border activity, economists had said these are real problems with the corporate
income tax and it'd be good if a reform could be done that would address them.
That's in and of itself, I think, a pretty decent reason to be thinking about corporate
tax reform, but I think it's really overshadowed by the bigger problems that are layered on
top of these distortions once you think about the open economy.
Maybe you can say a bit about that.
Eric: Well, I can, but before I do that, I want to ask you one question.
Alan: Sure.
Eric: And that is, given all the bad things you've described about the
corporate income tax, why don't we just get rid of it?
Yeah, so there's certainly...it's an issue that you and I have certainly wrestled with
and it's an issue economists have long wrestled with.
There's obviously some popularity from a political standpoint of taxing corporations because
people tend to think nobody's paying that tax.
That's of course a bad reason.
There are some good reasons though why people have been reluctant to just scrap the corporate
income tax.
Reasons why you need to think about any action that you take: it does bring in revenue and
also if you're not collecting the tax at the corporate level, you probably do want to make
sure that that income is going to be fully taxed at the shareholder level.
Of course, that's the direction our reform plan ended up taking.
Eric: Okay, so let me go on to the issues of international again...we're going back and forth
but as I said before, we tax companies on two bases.
Where the profits come from and where the company is resident.
Now from an economist's point of view, both of those criteria have problems.
If we only tax profits that come from the United States and don't tax profits that are
earned overseas, we give U.S. companies an incentive to earn profits overseas
to push investment and jobs away from the United States.
That's been a theme of much of the Democratic oratory in campaigns.
However we could solve that by having a worldwide tax.
If we had a worldwide tax and didn't have deferral, we taxed everything as it was earned
wherever it was earned, then we wouldn't be treating foreign and domestic profits differently,
but we would be vastly treating U.S. chartered companies different from foreign chartered
companies and we'd give foreign companies a tremendous competitive advantage, as many
of the business people frequently point out.
So there's no good solution.
The problem is when independent countries are trying to have separate tax rules to meet
their own needs and trying to address businesses that are global in nature.
It's very hard for separate countries to do that and they can't do it in a perfect way.
Now I've described the problem as a theoretical economist would talk about it.
Now let's get to the real world.
Theoretical economists talk as if there was such a thing as the source of corporate profits
and the residence of corporations.
However when you think about it, those are not easy concepts and they're not clear concepts.
Now you could say if you have a factory here, profits produced by the workers in that factory
are profits that come from the United States.
That is a pretty clear standard and when these rules were developed 100 years ago and source
was the main basis for international tax rules, that was really where people...what people
thought of permanent establishments generating businesses, but today things are different.
The real generator of value is not the manufacturing itself.
It's the know how that enables the manufacturing.
It's the patents.
It's the techniques.
It's the brand name reputation that allows you to sell things.
It's all of the collection of things that we call intellectual property
and intangible property.
Apple has developed the skills and the techniques to produce an iPad.
The profits from actually manufacturing the iPad are not that great.
The profits come from the iPad itself, the technology, and the technology can be owned
by a company anywhere in the world.
The technology contributes to production anywhere in the world
There is no clear place to say that technology is here. Technology is everywhere.
So the concept of source falls down when companies are exchanging intellectual property for which
you can't tell what the right price is and putting intellectual property in all kinds
of different locations, usually low tax locations.
Second issue: residence.
As I said before, as we've discussed in our paper
residence is not really connected to anything real about the company's activity.
Not to its sales, not to its production, not to where its shareholders are.
So what is residence?
It's where they have a piece of paper.
If you try to tax residence...and granted there are a lot of frictions in our system
companies can't change residence easily all the time...but if there is an incentive to
put your residence somewhere else for tax reasons, you can be sure
that smart people will figure out how to do it.
Alan: We've certainly seen it happen, yeah.
Eric: It happens and we've certainly seen it happen just as we've seen the location
of profits move.
So we have a system that's really based on sand and this is the reason why we're seeing
an erosion of the corporate tax base, not only in the United States, but throughout the world.
So, our view is we have this erosion of the corporate tax base at the same time we have high rates
that discourage certain kinds of businesses, particularly domestic businesses and businesses
that don't have that much intellectual capital
and cause residence of companies to move outside of the United States.
None of this is good.
Alan: A lot of the attention has been paid to the so-called inversion transactions
where an existing company basically swaps its U.S. charter for a foreign charter, arranges it
so the parent of a corporate group has a piece of paper from a foreign country instead of
a U.S. company.
And of course as you might expect, Congress and the IRS have adopted rules to try to stop
those transactions.
Really a very partial remedy though, because none of this stops a newly established company
from starting life with a foreign charter instead of a U.S. charter, even if it plans
to have most of its actual activities managed out of the United States.
Certainly none of this stops the fact of business opportunities flowing away from the heavily
taxed U.S. chartered companies and going to the foreign chartered companies, even if none
of the individual companies can change their charters.
None of it stops a U.S. chartered company from being acquired by a large foreign chartered company
which has some of the same benefits as an inversion
but doesn't get subjected to the restrictions that we've tried to put on inversions.
We really see a lot of steps being taken.
The companies are saying, "Okay, you're gonna tax us based on where our source is
and where our residence is.
Let's do everything we can to change the source and change the residence based on how easy
it is to manipulate those things."
Eric: As Alan has said, we've had a series of rules to stop inversion, starting in the
1980s and moving forward or maybe starting in the 1990s.
Each time we adopt a rule, we think we've solved the problem and then new transactions
pop up that are within the rules.
Alan: It really is, we've concluded it's really a losing battle if you're trying to just tinker
with those rules.
That's why we decided to do something more fundamental.
We should talk I guess just briefly about the other reforms that are out there
which I think we've already covered a lot.
There's some proposals that even don't really look at the open economy issues at all or
even really at most of the closed economy distortions that I've mentioned.
Instead, they just try to slow down the depreciation allowances and take away some of the special credits.
That means that there are companies that have more income to be taxed on and then you could
lower the rate.
Instead of it being 35%, you could take that down by several percentage points.
Now that could be a good idea, but it actually might not be either.
It depends on the details of how you do it.
The hope would be that by changing the rules that way, you'd make the playing field more
level, that you no longer would have certain kinds of investments and certain kinds of
industries tax preferred over others.
If so, that could make things more efficient, but you've got to realize a couple things on this.
First of all, some people have really optimistic expectations about how low you can get that
corporate rate down by taking away these preferences and still bring in the same revenue as today.
Realistically, there's not that much to bring the rates down all that much.
Furthermore, bringing the rate down is not an end in itself.
Some of these plans actually are counterproductive.
They take away tax preferences for new investments that haven't been made, but not from the old
investments that are already there.
When you lower the rate, you end up discovering that what you've done is you've given this
unexpected windfall gain to the investments that have already been made, that clearly
don't need any extra incentive since they've already been done, but meanwhile you've actually
raised the tax penalty on people trying to make or thinking about making the new investments.
Those kind of reforms really seem pretty limited.
Even if they're done in a way that works well, they're only going to produce a modest gain
and leave all these basic problems unchanged.
Then the other set of reforms of course try to tinker with the source and the residence.
I guess you've already mentioned those, Eric.
Some of them say, let's tax U.S. chartered companies more heavily on their overseas profits
so they won't have as much of an incentive to take investments abroad, but then as you've
said, that just aggravates the problem of the disincentive of being a U.S. chartered
company.
Then other people say, "Well, let's go the other direction then.
Let's lower or eliminate the taxes on U.S. chartered companies' overseas profits, so
then there's no penalty on being a U.S. chartered company and companies won't have an incentive
to get rid of the U.S. charters, but then of course they've got an even bigger incentive
if you are U.S. chartered to do your investments abroad.
By any time they try to ease one problem, they make the other worse.
Of course they're relying still on those two concepts that we just can't really define very well
Where are the profits being earned and where does this company supposedly live?
Eric: So I guess I would add a little to that because there are some international reform
proposals out there today which I think are constructive and my only criticism is not
a criticism of them because I'm in favor of everything that's constructive, but that they
really don't solve the fundamental problem.
Alan: Don't go far enough, yeah.
Eric: So let me just talk a little bit about what those are and what's driven the impetus
for some of these proposals and that is, because U.S. companies can shift profits to low tax
countries to get tax savings and they've been doing it more and because foreign countries
have been lowering their tax rates, even in the so-called high tax foreign countries...their
rates are now below the U.S. rate and they've been falling over the last two decades
We have a situation where U.S. companies are accumulating large profits overseas which
have not paid any foreign income tax or paid very little foreign income tax.
So before if the profits had paid foreign income tax, they could bring them back and
get a foreign tax credit that would offset much of the U.S. income tax, but now the foreign
tax credits are not going to be enough.
And so companies are stuck in the situation where their profits are locked out overseas.
They've accrued over 2 trillion of assets, U.S. companies have in overseas subsidiaries.
Now they're actually not really physically overseas.
They might be in U.S. banks, but they are overseas in the sense that what they can't
do is use those profits for investments in the U.S. or use it to pay dividends to U.S.
shareholders without incurring a 35% tax when they bring the profits back.
So companies are...this is a situation which has caused a lot of disquiet and so what some
of the reformers had said, "Hey, if we're going to have a preference for foreign income,
which we now have through deferral, let's do it in a different way.
Let's not tax the money when it's repatriated.
Let's eliminate this repatriation tax and replace it with two things.
The first thing is we're gonna say, there's all this money that companies have already
accrued under the old rules and they expected to pay some tax.
We'll impose some low rate tax on the money that they've had overseas, just a onetime
tax on those accrued profits.
We'd let them pay it out over 10 years or 8 years or 10 years so there's not too much
of a sticker shock.
The second thing is going forward, we would actually take some of their profits from intangible
assets and subject to current U.S. taxation...it's been called a minimum tax...at some low rate.
So they would continue to have their foreign income preferentially taxed, but we wouldn't
discourage them from bringing money back.
We would impose this tax at a low rate, whether they bring the money back or not.
I think that's a constructive reform, but I think both of us would say, this doesn't
solve the basic problem.
It doesn't prevent the incentive to book profits.
There'll still be an incentive to have profits overseas because the overseas rate is lower
than the U.S. rate.
There will still be an incentive for U.S. companies to invert because there is a positive
overseas rate, which will be greater than what other countries are imposing.
So while we like these reforms, it's a better way of making the existing system work.
It is not the solution and we need to look at something more fundamental.