Tuesday, July 05, 2016

Cleaned-up version of my remarks at AEI on June 17 concerning corporate integration

As noted in earlier posts, just under three weeks ago I participated in a panel discussion at the American Enterprise Institute of the corporate tax reform plan recently disseminated by Eric Toder and Alan Viard.  You can find a video of the session here, and view my slides for the talk here.

AEI subsequently posted a transcript of the event.  Here is a significantly cleaned-up version of my remarks as transcribed:

Thank you for inviting me, and for coming up with a very interesting plan. Why don’t I start by clarifying that the title or my talk [“Tower of Babel or Smorgasbord?: Comments on Toder-Viard 2016]  is not a characterization of the plan itself, but rather of something broader.

The Toder-Viard plan has a lot of very interesting details one could delve into.  For today, however, I thought it would be more interesting to put it into the context of other tax reform plans. So my title refers to the corporate tax reform field generally.

When you look at fundamental tax reform relating to individuals, there is a surprisingly high level of consensus. Now, it’s true that Diamond and Saez argue for a top individual rate as high as 70 percent. Most people in Washington don’t subscribe to that, so there’s an area of disagreement. There also is a longstanding debate (such as that between income tax and consumption tax advocates), concerning how one should tax the “normal” rate of return of saving.

Apart from these issues, however, there is considerable agreement regarding what the tax system for individuals ought to look like.  But in corporate and other business tax reform, it almost seems as if everyone has his or her own plan.  Here are just a few examples from the last thirty-plus years:

--William Andrews’s ALI plan, involving dividend exemption,

--Alvin Warren’s ALI plan, involving imputation credits.

--the comprehensive business income tax (CBIT) plan, basically an entity-level income tax,

--Edward Kleinbard’s dual business enterprise income tax (dual BEIT),

--Alan Auerbach’s modern corporate tax,

--Michael Graetz’s recent proposals,

--the recent corporate tax reform plan by Harry Grubert and Rosanne Altshuler.

So there are just a lot of plans out there.  Indeed, the main reason I don’t have my own plan is that I am still holding out.  I will issue it as soon as Congress promises to enact it immediately with no changes – an offer that no one has made to me just yet.

Now, even if all experts agreed about how to do corporate or broader business tax reform – that is, even if we didn’t have this Tower of Babel where everyone has his or her own plan - it’s still not clear Congress would listen. Experts really don’t have that sort of clout here. But since it might conceivably help, it’s worth asking: Why do so many eminent, intelligent, leading academics and think- tank people have such different plans for corporate and broader business tax reform?

The reason, I think, is that there’s really no perfect answer to the issues presented.  Thus, reform turns into a game of pick your poison, about which there is naturally disagreement.

Lewis Carroll’s Red Queen said that she could believe six impossible things before breakfast.  It was just a matter of practice. For corporate tax reform to have a single slam-dunk, clearly-best answer, one would need to believe just two impossible things.

The first impossible thing one would have to believe is that perfect flow-through of corporate income to the shareholders or other owners is feasible. I say owners, by the way, because there are different types of financial instruments with varyingly stock-like economics.

The second impossible thing one would have to believe is that taxing owners indirectly at the entity level rather than directly at the owner level, isn’t going to make any difference, even for administrative or political economy reasons.

If just those two impossible things were true, corporate tax reform would be easy. You’d just figure out how much corporate income pertained to each owner, and then you would tax that person or not tax that person exactly as you wished.

But of course it’s not so easy in practice. The first problem pertains to perfect flow-through.  Toder and Viard have a mechanism that would do this for publicly traded stock.  But in all other cases, it’s problematic.  You may have valuation difficulties.  Then there are non-pro rata deals among the owners.  Finally, when you have taxable income at the entity level that isn’t equal to economic income (for example, due to realization issues or deliberate tax preferences), it’s just very hard to come up with a good answer as to how the divergences should be allocated among the owners.

This is why partnership taxation is such a nightmare, both in the U.S. and elsewhere. Once economic income doesn’t equal taxable income, and even if you perfectly understand the deal between the owners, there’s no good answer to the question of who should get the tax benefits, especially in the face of some effort to limit the extent to which they are effectively  tradable.

Now consider tax-exempts and foreigners.  It seems clear that the extent to which we’re going to tax either Harvard University, a pension fund, or foreigners on income that any of them earned through a corporate entity has a very good chance of being affected in practice by whether we are imposing taxation at the entity level or at the owner level.  Taxing these persons indirectly, at the entity level, via a tax on companies in which they own shares, is at a minimum optically different than imposing the same tax, say, on corporate distributions to these persons.

This can motivate wanting to retain some degree of entity-level taxation. But once you do that, a number of design problems may emerge. One is that the entity rate doesn’t always equal the owner rate. A second is that, if you’re taxing on a residence basis, then U.S. entities that are subject to the U.S. corporate tax are not equivalent to U.S. individuals. There is cross-border shareholding.

Then, of course, you have the problem that all of these plans deal with in different ways: if you’re imposing tax at both the entity level and the owner level, how are you going to coordinate those two taxes in order to get the right overall answer, while also minimizing the various distortions that may be created?

I’m not saying that these challenges are unsolvable. Various plans address them in different ways.  But it’s going to be difficult in any event, and there are bound to be tradeoffs and imperfections, leading to different design preferences among corporate and business tax reform advocates.

Let’s just briefly ask, how do we want to tax foreigners who invest in or through companies that are subject to U.S. federal income taxation?  Under present law, we are clearly taxing them to some extent (whether or not they ultimately bear the incidence of this tax) when they own stock in U.S. or other companies that pay tax here.

Suppose we think of the U.S. tax system as aiming to maximize national welfare for U.S. citizens or residents (however we might choose to define the “us” that we distinguish from the rest of the world’s “them”).  This would imply that we might want to revenue-maximize with regard to foreigners — getting as much money from them as we could – subject to a few caveats.  The first is, of course we’re concerned with economic incidence, not nominal incidence . It may not be that easy to make foreigners bear a U.S. tax, given that they can invest elsewhere.  So this depends on our having market power of some kind, such as by reason of their earning location-specific rents here.

Second, one needs to take into account any adverse effects that taxing them might have on us. For example, if their investing here makes us richer (such as by reason of its raising labor productivity and thus wages), then that’s an indirect effect that you have to think about.

Finally, there are issues of comity and feasibility. There’s a Monty Python episode in which a man in a bowler hat says: “I think we should tax foreigners living abroad.”  That’s the perfect plan for any country that both can actually do it and does not need worry about retaliation of any kind.  In practice, however, it may not be so easy.

The result is that we have a very complex situation, with regard to how much we should try to tax foreigners.  There’s no simple formula that gives us the right answer.

Tax-exempts add another layer of complication. Consider tax subsidies for charities. It’s not clear how big these subsidies should be. Nor is there a consensus in the charitable field regarding how we should treat the entities’ intertemporal choices.  Then consider retirement savings vehicles.  Even some of the people who favor income taxation may view their reasons for having this policy preference as consistent with allowing individuals who save for retirement to exempt the normal rate of return on at least some of this saving.  But for extra-normal returns we may reach a different conclusion.

In sum, it’s quite reasonable to think that, even insofar as we have reasons for reducing entity-level corporate income taxation, that doesn’t necessarily mean that we want to lighten the tax burdens currently borne with respect to corporate income by tax-exempts and foreigners.  Instead, a ceasefire-in-place approach might make sense until such time as those distinct policy questions are separately examined.

OK, I just want to briefly mention the latest twist on corporate tax reform. An earlier speaker mentioned the Hatch plan, which would make dividends deductible but subject to withholding tax.  This could end up being the same as imputation, because in effect it ends up substituting the shareholder’s marginal tax rate for that of the entity.

Under the Hatch plan as I understand it, suppose a U.S. company repatriated $1 billion from tax havens.  Under current law, this might cost the company $350 million of U.S. tax, a price that the company may not be willing to pay.  In effect, the Hatch plan says, so long as you pay the entire intra-company dividend to shareholders, who will get it tax free, we’ll relabel the $350 million of tax that you must pay as a withholding tax on them, rather than as an entity-level tax on you. Therefore, the financial accountants won’t make you deduct the $350 million tax cost from financial accounting income.

The implicit claim is that this relabeling would make the company willing to bring the money home, on the view that its managers only cared about accounting income and earnings per share, not about shareholder welfare.  Mere relabeling of the $350 million remitted to the Treasury by the company therefore ends up making an enormous difference.

The Hatch plan would be a real acid test of that view, so I don’t know whether or not the proponents’ apparent expectation regarding managerial behavior would actually end up being borne out.  But it’s certainly bold and interesting, not to mention cynical.

Okay, turning to the Toder-Viard plan in particular, the 2014 version clearly was true corporate integration.  But Eric and Alan realized that it raised some issues requiring further thought.  One was the distinction between publicly traded and other businesses.  Another was the overall revenue loss, and a third (related to the second) was the big gains effectively offered to foreigners and tax exempts.

They’ve made some big changes in Toder-Viard 2016. The entity-level corporate tax rate is 15 percent, rather than zero.  This gives rise to a credit. The 15 percent withholding tax for interest paid to tax exempts is a feature that I like, for the reasons they give for it.  However, while I agree that these changes needed to be made, in some ways it’s less pure a corporate (and business) tax reform plan than it was in the 2014 version. Thus, admittedly arbitrarily, I’m going to reclassify it a bit.

There can often be a surprising degree of overlap between (A) “corporate integration” plans and (B) other “corporate tax reform” proposals that may be either broader or narrower in scope.  Suppose we put Toder-Viard 2016 in Group B, rather than in Group A, even though it could really be put in either. 

In any plan that lowers the entity-level corporate rate, one faces the question of whether, and if so how, to try to pay for it.  If one pays for it on the tax side, one needs to determine the source of the offsetting revenues.  This can be from either inside or outside the broader category of corporate and business taxation generally.

“Inside” funding models include Toder-Viard, Grubert-Altshuler, and 1986-style corporate tax reform, in which you lower the rate and broaden the base. “Outside” funding models might rely on, say, enactment of either a VAT or a carbon tax.

Let’s narrow the field a bit. I don’t think 1986-style corporate tax reform is the answer here. I had a piece in Tax Notes a couple of years ago called “1986-Style Tax Reform: A Good Idea Whose Times Has Passed.”  When you’re looking at corporate tax reform in particular, however, the case for this type of approach is especially weak.  There’s really not enough potential base-broadening to pay for much of a cut in the entity-level corporate rate.  Also, you may end up benefiting old investment, relative to new investment, unless you put in transition rules that are theoretically feasible but probably wouldn’t happen as a practical matter.  Plus, you face the question of whether the base-broadening applies (but without a rate cut) to non-corporate businesses. Also, if the corporate rate is lower, you have the problem of owner-employees underpaying themselves so that their labor income will be taxed at the lower entity rate, rather than the higher individual rate.  While that can be addressed, such as by enacting a Scandinavian-style dual income tax, it often hasn’t been in 1986-style proposals.

I’m also skeptical about the outside funding proposals that rely on enacting a VAT or a carbon tax. The problem is that, even if we should and do enact one or both of these taxes, the revenues will have rival claimants.  If I am designing my own corporate integration or rate reduction proposal, it’s tempting for me to say: I want those revenues for my plan. But other people with their own proposals of any kind (whether tax-related or not), along with people who are concerned about the long-term U.S. fiscal gap, might reply: Great, but what about us?  We would like to claim those revenues, too.

So I have two in-category finalists of credible inside-funding proposals: Toder-Viard and Grubert-Altshuler.  Both involve lowering the corporate rate, but financing it within the broader system of corporate and business taxation.

There’s a lot to like in Toder-Viard 2016. For example, I like the fact that you’re collecting the tax annually, but also with the averaging proposal that they describe.  In addition, they’re doing something about debt versus equity, including through their proposal with regard to tax-exempts.  But I remain concerned that the plan may discourage going public, although they offer a transition rule that may help to a significant degree with regard to people’s timing in going public.  And relatedly, I do still worry about the publicly traded versus non-publicly traded divide. I think that’s clearly the core problem.

With regard to narrowing that divide, they emphasize realization at death, which would be desirable even absent their proposal, but arguably becomes more urgent with it. Politically, however, realization at death is a hard sell that hasn’t happened yet, and that possibly never will.

Turning to Grubert-Altshuler, I like that plan too, and I’m not here to adjudicate which of the two plans is better.  But there I worry about the deferred tax.  As they concede, their interest charge doesn’t compleetly solve the lock-in issue, because of the problem when you get a big value jump in one year, followed by expected reversion to the normal rate of return.  Their point is that they would nonetheless significantly reduce lock-in relative to present law, a point that is certainly correct.

The big problem with their averaging / interest charge proposal is that of so-called sticker shock. Say Mark Zuckerberg had an enormous early value jump with respect to Facebook, after which his stock reverted to earning just a normal annual rate of return, and that he continued holding the stock until he died. The tax that was due at this time (what with interest on deemed past years’ accruals) could be a hard sell politically. Also, suppose the deferred tax is just out there, waiting. You would have people lobbying Congress to urge that it be eased or eliminated.  So I worry about the deferred tax collection as a potential major sticking point in practice, even though in principle, the plan is a good one.

One last final note on which I’ll close: One of the great tragedies of popular music history was that the Beach Boys’ “Smile” album never came out in 1967.  The version that finally came out in 2003 proved it to be a brilliant song cycle. At the time, however, the Beach Boys just put out a 29-minute micro-version, called “Smiley Smile,” that was pretty much garbage. One of the Beach Boys commented at the time: “We settled for a bunt, instead of trying to hit a grand slam.”

Now, the Beach Boys really blew it.  But corporate tax reform is different. Sometimes it’s better to settle for a bunt than to try to hit a grand slam.  So, while there are multiple ambitious plans out there, including Toder-Viard and Grubert-Altshuler, whose enactment I would welcome, skepticism about the political prospects might motivate trying to proceed more modestly.

One could simply ask: What are the worst problems we face in corporate and business taxation today, and how might these problems be addressed more narrowly?

My big three might be, first, problems with debt – including, not just debt versus equity, but also the use of interest deductions in base erosion and profit-shifting.  Second, disguised labor income of owner-employees if we significantly lower the corporate rate.  Third, international tax policy, which almost everyone agrees is an enormous mess.

So my narrow or “bunt” option might involve the following.  First, stronger thin capitalization rules or other limits on interest deductions.  Second, something addressing the distinction between normal returns and extra-normal returns, and taxing the latter at a higher effective rate than the former.  And, finally, international tax reform, although I won’t further abuse my time limit here by saying anything particular about that.

In sum, there are a lot of good corporate tax reform plans out there.  I’d prefer most of them to present law.  And perhaps we should think of the existing cacophony as offering Congress an empowering smorgasbord, rather than a dissuading Tower of Babel.  But it might conceivably be more promising to proceed more narrowly.  Even narrower changes, if well-chosen, could leave the overall system in considerably better shape than it is today.

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