I won't try to summarize what Marty and Itai had to say, although frankly I'd be glad if their comments got wider distribution. (And not just because all publicity is good publicity.) But here is a written version of my remarks at the session, putting the book in context and offering a quick overview:
This book is in
some ways a sequel to an earlier book that I wrote, called Decoding the U.S. Corporate Tax.
Now, of course you know the iron law of movie sequels. With just one exception, they’re never as
good as the original.
The exception
isn’t The Godfather, Part 2, which is
too slow-moving and self-important. It’s
Gremlins 2, which was better than the
original for a reason. It was more of a
horror-comedy than the original Gremlins.
Fixing U.S. International Taxation isn’t
comedy – for that, you’d have to try my novel, Getting It. But it does do
one thing that’s different from its precursor.
Decoding mainly just summarizes the existing
economics literature on corporate taxation, trying to make it more accessible. I got frustrated when I couldn’t find
suitable accounts of the literature for my tax policy classes. Plus, I figured that, if I wrote the guide
myself, I’d probably agree with most of it, even a couple of years later.
With Fixing, I initially wanted to do much
the same thing for international tax. But
there was a problem. I had to adjust for what I considered the
sorry state of the literature. As I say
in the book, despite more than 50 years of analysis by really good people, at
some point it went badly off the rails.
I’m
not alone in thinking this. For example,
Michael Graetz gave a Tillinghast Lecture here some years back entitled “Taxing
International Income: Inadequate Principles, Outdated Concepts, and
Unsatisfactory Policies.”
So I concluded
that I needed to reinvent the wheel a bit, albeit using familiar public
economics ideas. And not to be
grandiose, many others have been moving in the same direction as I have. But there was certainly nothing out there
putting it all together in a way that I considered suitable.
Let me start with
a simple illustration of the underlying problem. Say the U.S. corporate tax rate is 35%, while Germany’s
is whatever. So the U.S. taxes all
corporate income that’s earned here at 35% , whether it’s earned by a U.S. company,
a German company, or anyone else.
If we want, we
can also tax U.S. firms’ German income at 35%, or indeed at any other rate we
like. But we simply can’t impose any tax on the German income of German
firms – or on any other foreign source income of non-U.S. firms.
If only we could tax foreign companies’ foreign
source income, that would actually be great for us. Foreigners who owned those companies would in
effect be making large tax payments to the U.S. Treasury, which we would get to
spend as we liked. And no one would be
able to avoid the source-based U.S. tax by investing outside the U.S., rather
than here.
But even Dick
Cheney, or Vladimir Putin if he were American, would know better than to try
taxing foreign firms’ foreign source income.
So we face a constraint. There‘s
a 2-by-2 grid yielding 4 boxes – the U.S. and foreign source income of U.S. and
foreign firms. But the income in one of
the boxes we simply can’t tax.
This brings us to
one of the key points at which the international tax literature went off the
rails. In tax policy thinking, we tend
to like neutrality, because, while
taxes are a private cost to the taxpayer, they aren’t a social cost. Rather, they’re
a transfer from one person to others. If
you have two or more choices and the tax system treats them neutrally, it can
keep the choices’ relative payoffs in the same order, so it doesn’t induce
inefficient behavioral changes that reflect treating taxes as a cost rather
than a transfer.
But given the
four boxes and the one we can’t reach, there are two different ways we could be
neutral here between adjacent boxes: by equalizing U.S. versus foreign investment by U.S. firms, or U.S. versus foreign firms making foreign
investments. We can’t be neutral at
both margins.
A big mistake has
been to assume we should pick one or the other neutrality, and push it all the
way while ignoring the other margin.
That’s generally not good thinking.
When you can avoid making
all-or-nothing choices, why wouldn’t you?
Chocolate brownies or cheesecake?
I think I’ll have a little of each.
For more of a
formal economics example, say there are just 3 drinks – milk, juice, and water
– and that we want to tax them in connection with raising revenue as
efficiently as possible. Suppose that we
simply can’t tax water, and that we’re taxing milk at a high rate, because it’s
not very price-elastic – the people who like it will mainly keep on drinking
it. Finally, suppose that if we raise
the price of juice by taxing it, people will switch into water relatively fast. There’s actually a literature, called optimal
commodity taxation or Ramsey pricing, which shows that we shouldn’t choose
between milk-juice neutrality, by taxing juice at the milk rate, and
water-juice neutrality, by not taxing juice at all. Instead, if we want to raise revenue as
efficiently as possible, we should tax juice at an intermediate rate, somewhere
between that for the other 2 commodities.
In terms of
international tax policy, U.S. source income is milk, foreign firms’ foreign
source income is water, and U.S. firms’ foreign source income is juice. We have more market power over investing in
the U.S. than over using U.S. firms to invest abroad. Perhaps this helps explain why almost
everyone agrees that we shouldn’t actually tax U.S. companies’ foreign source
income at the U.S. effective rate. It
also helps to show the likely undesirability of setting the U.S. tax rate for
U.S. firms’ foreign source income as low as zero.
Let me turn to
another big piece of the puzzle which I have ignored so far. When U.S. and German firms earn income in
Germany, presumably they will face German taxes. How should we think about that, from a U.S.
standpoint? Unfortunately, this is a
second place in which the international tax policy literature has gone off the
rails.
Suppose the U.S.
and Germany both tax U.S. firms’ German source income at 35% (although
Germany’s actual corporate rate is lower).
And suppose both countries likewise tax the U.S. source income of German
firms. Even with foreign taxes being
deductible in the residence countries, cross-border investment would face a
combined tax rate of almost 60%. Wouldn’t
that unduly discourage it, probably to the detriment of people in both
countries?
The answer is
yes. But the literature made 2 main
mistakes in analyzing this concern.
First, it defined the problem as double
taxation of cross-border investment, rather than as overly high taxation.
Focusing on the number of taxes
levied, rather than on the overall tax burden imposed, is unhelpful. Personally, I would rather be taxed twenty
times at a 1% rate each time, than once at 50%.
Second, the
analysis assumed too quickly that, in deciding what to do about the problem,
U.S. and German taxes should automatically be viewed as equivalent. From a U.S. standpoint, they are not
equivalent. We get the money from our
own taxes, but not from theirs. And of
course the Germans should think the same way from their perspective.
Now, there may be
room for the U.S. and Germany to cooperate by reciprocally deferring to some of
each other’s tax claims, to mutual advantage.
But you have to actually look
at the strategic interactions, not just assume that German and U.S. taxes are
the same from a U.S. standpoint. And in
fact today we provide a foreign tax credit for German taxes, but they don’t reciprocate. Instead, they generally exempt German
companies’ U.S. income. This equally
avoids “double taxation,” but it means that German firms in the U.S. will
always want to minimize their U.S. taxes, whereas U.S. firms in Germany won’t
care about their German taxes if they anticipate claiming immediate U.S.
foreign tax credits.
This brings me to
the broader problem of how the literature has analyzed the choices that a
country has when deciding how to tax resident companies’ foreign source
income. Supposedly, there are just 2
respectable options: exempting foreign source income, or having a worldwide
system with foreign tax credits.
The problem, from
the standpoint of clear thinking, is that these are compound choices. They differ at two margins, not just one.
First, exemption
taxes U.S. companies’ foreign source income at a zero rate, while worldwide
uses the full domestic statutory rate.
Apparently, intermediate statutory rates for foreign source income are
verboten.
Second, the two
systems differ in their marginal reimbursement rates, or MRRs, for foreign taxes
paid. Exemption has a zero MRR – paying
foreign taxes has no effect on your U.S. tax liability. However, since this matches the approach’s
zero marginal tax rate for foreign
source income, exemption is what I call an implicit deductibility system for
foreign taxes. Under exemption, U.S.
taxpayers want to maximize their after-foreign-tax foreign source income, just
as they would with foreign tax deductibility and any positive U.S. tax rate
below 100%.
What about a
typical worldwide system? In principle,
foreign tax credits create a 100 percent MRR for foreign taxes paid on foreign
source income. You get every penny back,
barring the application of foreign tax credit limits. If this were the entire story, U.S. companies
would generally be indifferent to whether the foreign taxes they paid were low
or high.
As it happens, in
practice U.S. companies are usually anything but indifferent to their foreign
taxes. They want to minimize those
taxes, just like our taxes, and they are very good at doing it. This reflects the real world consequences of
another important U.S. international tax rule, called deferral, under which you
don’t have to pay U.S. taxes on your foreign subsidiaries’ earnings until you’ve
officially brought the money home, which you may never actually need to do.
In Fixing, I analyze how deferral and
foreign tax credits interact to affect U.S. taxpayers’ incentives. In short, each rule has bad incentive effects
when considered in isolation, but somewhat reduces the other’s bad effects.
Deferral
encourages costly tax planning maneuvers, in lieu of just using internal funds
efficiently. But if you have enough
foreign tax credits, you can bring your foreign earnings home tax-free. So foreign tax credits can reduce deferral’s
undesirable incentive effects.
On the other side
of the ledger, consider again the effect of foreign tax credits in reducing
cost-consciousness with respect to foreign taxes. If you anticipate either permanent deferral
or a future reduction in the tax rate on repatriations, you may be highly
foreign tax cost-conscious after all.
Still, a system
with both rules is guaranteed to have high tax planning costs and other
deadweight loss relative to the revenue actually raised. So having both deferral and foreign tax
credits, as we do today, is definitely not a good answer.
The interaction
between these two bad rules puts us in what I call an “iron box.” Scale back deferral and you worsen the
problems caused by the foreign tax credit.
Scale back foreign tax credits and you worsen deferral. Change either or both of them and you alter
the overall effective U.S. tax rate on foreign source income – the merits of
which have nothing to do with deferral and foreign tax credits in particular.
Let me just
mention two more themes from the book.
First, on a more theoretical note, I spend a lot of time devising what I’d
like to hope were final burial rites for a set of concepts that have played
much too large a role in international tax policy debate. These are single-bullet global or national welfare
norms such as capital export neutrality, capital import neutrality, capital
ownership neutrality, national neutrality, and national ownership
neutrality. Each of these concepts has
an acronym, such as CEN or CIN, so I deride using any of them as the “battle of
the acronyms” or “alphabet soup.”
Lawyers have tended to over-use these terms more than economists, but
plenty in both groups have come to realize that they don’t help much. I just try to summarize and spell out a case
against them that was already well-known in the best circles.
Second, the
international tax issue that has rightly gotten the largest headlines in recent
years is rampant base erosion and profit-shifting by numerous well-known
companies. This reflects the tax
planning opportunities that the companies have in the present environment, what
with high global capital mobility and the huge economic role of
intangibles. I don’t have as much that’s
new to say about these problems as I do about the basic structural elements of
our international tax system, which is why I don’t emphasize them more. But two points about them that I do make in Fixing are the following.
First, it’s
well-known that we can’t actually get the source rules right, because source is
not a well-defined economic idea. But we
can try to make it costlier for multinationals, in a business and planning
sense, to treat so much of their income as arising in tax havens. This is exactly how economic substance rules
limit aggressive tax sheltering – for example, by requiring undesired downside
economic risk as the price for successfully claiming huge artificial losses. In the international tax realm, this approach
is likely to require paying far less heed than we currently do to the formal
legal lines between commonly owned entities.
Second, all else
equal, it’s actually a good thing, from the U.S. standpoint, if a U.S. company
pays less foreign taxes, rather than more.
Again, the foreign taxes are just a cost from our standpoint, because we
don’t get the money. But the
complicating problem, which helps to explain why exemption countries have
anti-tax haven rules, is that, when we see significant income being attributed
to a haven, and we know that it couldn’t actually have been earned there, we
have reason to suspect that we, and not just foreign governments, may be among
the losers. In effect, income’s being
reported in a tax haven is a tag that indicates its potentially suspect status
from the standpoint of protecting our domestic tax base.
A reasonable
response to this concern may involve treating the foreign taxes that our
companies pay as effectively better than just deductible, but worse than fully
creditable. The Baucus international tax
reform plan in Washington actually takes a stab at doing this, in an apparently
treaty-compliant way.
There’s a lot
more I could say – the book is about 200 pages long, after all – but instead why
don’t I stop here, and listen with interest to what Marty and Itai have to say.
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