Sunday, January 23, 2011

Corporate tax reform

The newspapers are full of public statements as well as trial balloons concerning the Administration's possible plans on corporate tax reform.

Judging from the public statements and reported musings that I've seen (e.g., Obama's address from Schenectady lauding GE investment in low-tax countries abroad that created complementary jobs in the U.S.), I imagine that, under the right circumstances, they would be delighted to propose significantly reducing domestic corporate tax rates AND exempting U.S. companies' foreign source active business income. But the right circumstances might have to include (a) revenue-neutrality from the corporate and/or broader business sector, (b) a strong consensus in the tax policy community that the proposal is a big winner in a policy sense, contributing to growth, jobs, efficiency, etc., and (c) presumably some sort of positive judgment about the proposal's political prospects, though I have no idea whether this would mean potential for 2011 enactment or merely that it was a good marker to place down showing where the Administration would like to go over the next 6 years.

Can one significantly reduce corporate tax rates on a revenue-neutral basis? Yes if you repeal enough items - for example, accelerated depreciation, LIFO rules for inventory, the tax break for domestic production, various energy tax breaks for oil and gas, coal, ethanol, alternative fuels, etcetera.

Some of this would be hard to do politically. Energy tax breaks, obviously, are about as sacred as you can get in the political world, though I doubt that more than one in a thousand academics would object to repealing them. My favorite term for oil drilling incentives is that they epitomize a "drain America first" strategy of using up our oil while the foreign flow is still reasonably robust. But I digress.

Accelerated depreciation poses a bit of a dilemma. Even if one in principle likes a consumption tax approach in which everything would be expensed, there is something to be said for moving towards true economic depreciation. Pairing accelerated depreciation with deductible interest expense can lead to better-than-exempt treatment. And having the degree of generosity vary by asset and industry contributes to a poorly designed U.S. industrial policy that distorts resource allocation in the economy. But on the other hand, if you are thinking in terms of stimulating new economic activity in the short term, offering incentives for new investment (such as rapid depreciation) is better-targeted than lowering the rate, which partly gets "wasted" on old investments, or those that were made before the new initiative was announced.

Even if the politics somehow took care of itself, a fundamental problem with the idea of lowering the corporate rate in exchange for broadening the base is the lack of general consensus in the tax policy community regarding where we should head on these matters. There is broad agreement about a lot of things - for example, that the tax rules should not distort debt versus equity choices, or the use of a corporate versus a non-corporate entity. But experts differ considerably about the relative magnitude of various problems, and thus about which should be addressed first and at the expense of addressing others.

In the run-up to 1986 tax reform, there was far more expert consensus. Generally everyone (though perhaps not, say, Boris Bittker) liked the idea of lowering the rates significantly while broadening the base. There were also conflicting choices and directions back then. For example, 1986-era reformers (starting with Bill Bradley in 1983) decided not to aim for a consumption tax instead of an income tax, or to seek corporate integration. But at that time the consensus really was for an income tax, and corporate integration (while widely accepted in principle) didn't have the level of intellectual support it attracted later on.

Today, by contrast, how relatively concerned we should be about (a) the double corporate tax versus (b) the debt-equity distortion versus (c) the line between corporate and non-corporate business taxation - which ones to take on first, and which ones to sacrifice for now - are not comparably subjects of agreement. As a consequence, there is little consensus about how to evaluate relatively large-scale but still incremental (rather than fundamental) changes.

Suppose, therefore, that we have a proposal to lower the corporate rate to 25 percent. How much does it matter if unincorporated businesses don't get the rate reduction? Or if the tax-exempt sector and foreign investors, which indirectly pay tax at the corporate level via their ownership of corporate equity, thereby benefit? Or if the use of corporations becomes a tax shelter for high-income individuals, who then could lower their tax rates from 35% to 25% by incorporating and under-paying themselves as owner-employees?

Again, my point is not just that these issues are hard, but that expert consensus about them is lower than it was for the comparably main-stage issues in 1986. In some respects, the 1986 consensus may have been wrong - readers of this blog or my work may know, for example, that I'd prefer a progressive consumption tax to an income tax (though in 1986 I of course accepted the era's consensus). Today's situation makes it harder to decide what to do & then do it, even if the party and interest group problems of legislative politics can be solved.

BTW, I've mentioned in earlier posts my extreme skepticism about the general desirability these days of 1986-style tax reform, in which the budgetary gain from eliminating tax expenditures is given away via lower rates, rather than being used to improve the long-term fiscal situation. Is corporate tax reform of the sort that the Obama Administration is reportedly contemplating any different?

Yes and no. It's no different in principle. If the tax expenditures that we repeal are really "disguised spending," in the words of the Bowles-Simpson Commission, then "revenue neutrality" is a nonsensical concept - taxes are being reduced in exchange for reducing disguised spending, and standalone preference repeal wouldn't actually be a "tax increase," the optics notwithstanding. And in terms of budget neutrality, when we are so far in the hole fiscally over the long run, why give away any low-hanging fruit without getting any overall budgetary relief from the exercise?

But the case for reducing corporate rates is stronger than that for reducing individual rates, due to pressures of global tax competition (U.S. individuals are not as mobile, or likely to leave for tax reasons, as capital that can go anywhere). So at least the budgetary loss that offsets the budgetary gain from repealing corporate tax preferences has a stronger underlying policy rationale than cutting the individual rates, given where we stand currently.

On international tax issues, there is even less of a consensus than on the domestic tax base. These days, I hear scarcely any support (other than the most tepid) for worldwide taxation of U.S. companies as an end in itself. But there is still strong support for it as a back-up system for defending the domestic tax base, by impeding U.S. companies' efforts to tax-plan their way out of treating income as earned in the U.S. For example, you can build a trap for yourself by reporting all of your income as earned in the Caymans, but then finding that you cannot cheaply access it for other uses without paying a U.S. repatriation tax.

There is simply no consensus at the expert level, at this point, about what would be needed to address this problem sufficiently to make exemption of foreign source active business income a clearly good (or at least innocuous) move.

I myself do feel fairly confident regarding how to do this. My plan is (a) exemption for foreign source active business income - though not for the usual reasons; instead, the main rationale would be that exemption is the only practical way to repeal the hideous Scylla and Charybdis of U.S. international and taxation, which are deferral and foreign tax credits, plus (b) a transition tax on the $1.2 trillion of foreign earnings that U.S. companies have already accumulated abroad, plus (c) unitary business rules for both U.S. and foreign-headed multinationals - that is, we ignore formal entity lines between the U.S. and foreign members of commonly controlled groups, and use some sort of "objective" approach (whether or not it is called or indeed constitutes formulary apportionment) to apportion taxable income between home and abroad. This means no more transfer pricing, at least in a "comparable arm's length price" sense, and it means not caring about intra-group debt or about which members of a worldwide corporate group borrowed from third-party lenders.

But there's as yet no consensus regarding this view. And even if there were, we'd have a lack of consensus about the desirability of doing some parts of my 3-part plan without others (e.g., A from above without B and with only a tincture of C).

Certainly, in terms of anything the Administration could propose this year that bundles a shift to exempting foreign source income with Package X to make the overall international proposal revenue-neutral, there is no realistic Package X that would attract consensus expert support for the overall proposal. And even if there were, the business community would not get behind it, due to the combination of (1) the hope of doing a lot better by eliminating most or all of Package X, and (2) the fact that, even if the net winners from the proposal could be reconciled to accepting it rather than trying to do even better, the net losers are bound to squawk.

For these reasons, I was talking to someone the other day about the prospects for international tax reform, and said that I was getting a bit worried, since I really wish they'd let me complete and publish my international tax book before anything big happens. (For the record, my position is that I was at least half-joking, though I would rather not take a lie detector test on the subject.) He or she replied, in effect: Don't worry, and take all the time you like. This ain't happening any time soon.

That said, I suppose it's not inconceivable that we will go to a 25 percent domestic corporate rate and exemption of foreign source active business income WITHOUT any pay-fors, and thus without any serious effort to address the broader issues. You don't need to rely on broader intellectual consensus if you are simply handing out goodies, rather than mixing them with sour medicine. Obviously, this would totally contradict long-term budgetary concerns, but those concerns don't always constrain political actors, to say the least.

One could certainly imagine a Republican Administration in 2013 doing this - though it seems likely to be a lower priority than their stance on the Bush tax cuts. But is there any chance it could happen sooner? Certainly not if the Obama Administration sticks to what I believe is their current position about doing these things responsibly or not at all. But strange things can happen in politics, unforeseen by the actors and suppressed from speech and consciousness (like a good poker player's awareness that he may need to fold his hand soon) even if subliminally suspected.

1 comment:

Tyler said...

There are ways to reform the corporate tax code that would encourage investment in the USA and not be a windfall for corporations...

http://www.tylernewton.com/blog/2010/12/how-to-reform-the-corporate-tax-code.html