Thursday, February 15, 2018

The Republican Tax Reform: Part 11—The Corporate Income Tax Rate Reduction

This post is not done yet, but this is what I’m working on for after the long weekend.


I think control issues are a general problem with politicians and bureaucrats. I’m speculating, but I think that jobs where you can conceivably control some things attract people who believe controlling things is important.

A problem with that is if controllers believe they can control something that they can’t.

This comes up a lot in tax policy. There’s a real economic problem with tax labeling and tax incidence that no one should ignore. But political processes often focus on labeling exclusively, or as a matter of convenience. There’s also an issue that you can target a certain tax base, but you always need some element of buy-in from the parties being taxed. It’s perfectly legal for people to avoid being included in the tax base, and if buy-in is weak you may get some tax cheating on top of the avoidance.

Which brings us to the problem of multinational corporations. These don’t face one corporate tax rate. They face a bunch. And it’s reasonable and legal to expect them to pick and choose where to place the tax base they create.†

Here’s how that might work out. Country A has a corporate income tax rate of 10% and country B has a corporate income tax rate of 20%. Multinational firms from both countries then do everything they can to shift costs to country B (as a practical matter of tax planning, if not so much an ethical one, costs you measure internally are easier to move around than revenues that others might be able to measure externally to the firm) . Income is revenue minus costs, so the goal is to cancel out all the revenue from country B with costs from country B but also costs from country A that have been shifted over. If they do this perfectly, they end up with their income all taxed at 10%. This makes good financial sense, and going further, it is the fiduciary duty of corporate officers to make sure this happens. Now suppose the politicians in country B want to increase taxes. They raise their rate to 21%, and still collect nothing. Even worse, they may not be able to admit how it is possible for country A to raise their rates even more, say to 12%, and have their tax revenue go up by 20%.

Part of me does not believe that politicians can be that dumb.

But a different part of me is certain that they are that dumb. Here’s why. If country B really wants to increase tax revenues (instead of just labeling themselves as tough on business) they should undercut country A’s rate. Perhaps country B should try 9%. But if they do country A should try 8%. That game ends with both of them charging a 0% rate. At first glance, this outcome might seem implausible, but governments do this all the time when they compete with each other to offer tax breaks to get first to locate within their jurisdiction. In public finance there’s actually evidence of governments going past zero and offering packages that amount to negative tax rates on net. That’s what can happen if governments are not that dumb. If they are dumb, they might not go that far, and end up with a positive rate, but one that is different from other countries. This is actually what we observe in the real world, which makes me thing there are a lot of politicians who really don’t get the economics.

Which brings us to the U.S. corporate tax rate. The OECD says that, yes, the U.S. did have the highest statutory corporate tax rate (the right column at this site). Those are marginal rates, so there will be some weirdness to judging our system when all we’ll have is average rates from the data. Also, when we talk about the statutory rate, this is before deductions, exemptions, credits and so on. The effective tax rate might be much lower. The Congressional Budget Office (CBO) researched that for G-20 countries, and found that in 2012 … our marginal corporate rate was the highest, our average corporate tax rates were still the third highest, and our effective corporate rate was the fourth highest (see Table I here). That’s better, but not good. The change in positions also indicates that our system has a lot of complexity to it.

So yes, it is reasonable to think that high U.S. corporate tax rates were causing multinational firms to shift their costs around the world. How recent a phenomenon is that? Well, historical panel data sets on that are both complex and sketchy, but the OECD data for earlier periods shows the U.S. did not used to be at the top of the list. What’s happened is that many other large and/or rich countries have reduced their corporate tax rates over the last generation or so. This is because the wave towards lower tax rates that hit the U.S. starting in the 1980’s was a global phenomenon. It just did not hit our corporate income tax rate.

After all this, the U.S. was doing one more dumb thing. Well, smart from the perspective of collecting revenue, but dumb from the perspective of reducing tax distortions. The U.S. had been running a non-territorial tax system. In a territorial tax system, a U.S. multinational would pay tax on its income in each country that it operates, at the tax rate for that country … and then you were done. But this is not the system the U.S. had. Instead, if the tax owed in the foreign country was lower than what would have been paid if that operation was in the U.S., the firm owed the different too. Except that a U.S. firm could claim that the foreign income on which that extra tax was owed was still needed or active in that foreign country, say for future investments. In this case, that tax liability could be deferred indefinitely. And obviously, it could be invested in financial investments from the foreign country and earn even more income that could also be deferred.

But wait! There’s one more big distortion. The “Americanness” of a firm was judged on the basis of its headquarters’ location. And some countries had territorial tax systems in place. This led to inversions: move the headquarters to a lower tax country with a territorial tax system and completely avoid rather than defer some U.S. corporate taxes.

† Thomas Piketty’s Capital in the 21st Century made a big splash a few years ago. There’s evidence that many non-economists didn’t read much past the first chapter. But economists did (Piketty is a big name guy on our field’s political left). Piketty wants big government. He doesn’t hide that. But big government requires big taxes. Multi-national corporations can short-circuit that by moving their income around to lower tax jurisdictions. Not surprisingly, Piketty suggested that we need a single global tax system and rate to apply to corporations, with a bureaucracy to distribute the proceeds down to individual countries.

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