Historically, the drive for tax reform in the US has focused on the individual income tax. The ideal, epitomised by the Tax Reform Act of 1986, has been to broaden the tax base and thereby reduce statutory tax rates in a revenue-neutral manner.
American observers, however, now believe that the so-called fiscal cliff deal that President Barack Obama and congressional Republicans agreed to on the first day of the year has in effect taken individual income tax reform off the table indefinitely.
The reason is that the fiscal cliff deal raised the top individual income tax rate from 35 per cent to 39.6 per cent and raised the maximum rate on dividends and capital gains from 15 per cent to 20 per cent. Having just expended enormous political capital to raise rates, it is exceedingly unlikely that Mr Obama would then turn round and agree to cut them again in some sort of tax reform.
Moreover, the improving but still large federal budget deficit means there is going to be continuing political pressure to raise revenues. Both Republicans and Democrats agree that higher rates are off the table and that new revenues must come from closing tax expenditures, which will make them unavailable to finance rate reductions.
Thus it appears that there is no potential for a tax reform deal in the traditional sense. But there is a growing need for it on the corporate side of the ledger that may yet become a vehicle for meaningful tax reform.
Members of both political parties are keen to reduce the statutory corporate tax rate from 35 per cent, which is high by international standards, to perhaps 25 per cent. The problem is that if revenue neutrality is demanded, no new revenue source such as a financial transactions tax is permitted, and the base-broadening is confined to the corporate side, there is a problem. There are not enough corporate tax expenditures available to finance the rate reduction that everyone thinks is necessary.
The Congressional Research Service has estimated that the lowest statutory corporate tax rate possible that is financed entirely by closing corporate tax expenditures is 29.4 per cent in the long run. And this is a very optimistic calculation because it would require the elimination of accelerated depreciation, a very popular tax preference that has long enjoyed bipartisan support.
Getting the rate that low would also require treating the large and growing unincorporated business sector the same way as traditional C corporations. Such companies are often assumed to be small businesses that are large job generators. Under current economic and political circumstances, it is highly unlikely that Congress would do anything deemed to raise taxes on small businesses.
The one big tax preference theoretically available to finance a rate reduction is deferral on foreign source income. Presently, the US taxes the income of foreign subsidiaries of US-based multinational corporations, but only when repatriated to America. Income remaining offshore is untaxed by the US.
This tax regime obviously makes it expeditious for multinational corporations to realise their profits offshore and keep them there, neither taxed by the US nor available to shareholders as dividends. This often involves legally dubious techniques such as selling intellectual property like patents to foreign subsidiaries at a price far below market value.
By borrowing in high-tax jurisdictions, thus maximising the deduction for interest expense, and realising profits in low-tax jurisdictions to the greatest extent possible, US-based multinational corporations can defer a vast amount of taxation indefinitely. Another Congressional Research Service report estimates that US-based multinationals realise about $1tn of profits a year in foreign jurisdictions.
The following chart from the CRS report illustrates the extent to which US-based multinational corporations have shifted their profits from relatively high-tax jurisdictions such as Australia, Canada, Germany, Mexico and the UK to low-tax jurisdictions such as Bermuda, Ireland, Luxembourg, the Netherlands and Switzerland.
Profits of US multinational corporations in selected country groups as a percentage of total profits reported abroad by American MNCs
Source: Congressional Research Service analysis of US Department of Commerce data
It is important to emphasise that little in the way of real economic activity, such as jobs or tangible investment, has shifted anywhere. All that has shifted is the tax base.
The Internal Revenue Service and the OECD have struggled for some years to deal with the problem of income shifting and tax avoidance, to little avail.
This makes the international tax regime a ripe target for reformers. Some type of one-off reform that lowers rates and eliminates deferral is theoretically achievable. The payoff would be taxation of the vast hoard of liquid assets estimated to be held in foreign accounts by US-based multinationals, estimated by the Pulitzer Prize-winning journalist David Cay Johnston at $3.4tn.
With reports of low domestic taxes paid by large profitable corporations such as Starbucks in the UK, the time may also be ripe for an international agreement to curb tax shifting. The US has recently implemented a law called the Extractive Industries Transparency Initiative that requires companies to disclose their payments to governments from oil, gas and mining assets. Allison Christians of McGill University argues that the expansion of such information reporting to the transfer pricing of all multinationals is the first step towards capturing the revenue now lost to the shifting of business costs to high-tax jurisdictions and revenues to low-tax jurisdictions.
There is growing evidence that corporations are sensitive to the public outcry when they are caught avoiding taxation excessively. Starbucks, for example, recently agreed to pay more taxes in the UK than legally required to quell the controversy over its virtually nonexistent tax bill. The same shaming technique may have broader application to multinationals generally.
As Justice Louis Brandeis of the US Supreme Court once put it, “publicity is justly recommended as the remedy for social and industrial diseases”.
The writer is a former senior economist at the White House, US Congress and Treasury. He is author of ‘The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take’