No Longer a Chump

Richard Rubin of the Wall Street Journal quotes me in a new article noting that the U.S. is no longer going to be a chump in terms of profit shifting out of the U.S.  I like the vocabulary.com definition of chump:  Chump is a very informal word for someone who falls for every trick and scheme, or who believes everything you tell them. If you get an email from an African prince asking for your bank account information so he can give you a lot of money, and you respond excitedly, ready to collect the cash, you're a chump.  

The 2017 tax law change not only reduced the federal corporate tax rate to 21%, but also enacted a number of rules consistent with the OECD/G20 BEPS Project.  These include anti-hybrid rules (BEPS Action 2), the so-called GILTI alternative minimum tax (AMT) on foreign source income (tightening controlled foreign corporation (CFC) rules, BEPS Action 3), excess interest deduction limitation (BEPS Action 4), a tougher intangible transfer pricing rule (BEPS Action 8-10) and a new tax on certain related party payments susceptible to transfer mispricing.  These anti-BEPS provisions are estimated by the JCT to raise more than $600 billion over ten years.

The Congressional Budget Office’s April 2018 Budget and Economic Outlook estimates that the 2017 tax changes will reduce profit shifting out of the US by over 20% ($65 billion out of an annual $300 billion).  The lower tax rate reduces the incentive for many multinational enterprises (MNEs) to stop locating debt in their US subsidiaries or headquarters and reduces the incentive for transferring intellectual property (IP) out of the US.  The CBO claims that only “a small portion” of the reduced profit shifting is from transfer mispricing, although transfer mispricing occurs with debt as well as IP transfers.  At a 35% corporate tax rate, $300 billion of profit shifting resulted in a $105 billion annual revenue loss.  At a 21% rate, it falls to $63 billion.  A $65 billion reduction at 21% will increase US revenues by $14 billion annually.  

A $14 billion annual pickup seems low given the 21% corporate tax rate plus the other anti-BEPS provisions.  Ireland with a 12.5% corporate rate, countries with lower “patent box” tax rates, and Caribbean tax havens remain, and the move toward a territorial system (100% dividend exemption) even with the foreign source income AMT, means some companies at some margins will still have an incentive to shift taxable income out of the U.S.  In other cases, now there will be some companies at some margins shifting taxable income into the U.S.  Thus, I am more optimistic than the CBO is about the potential positive effects of the US tax changes on MNE economic decisions towards US activity once the uncertainty of the new rules is reduced and the positive effects on reduced profit shifting.

One reason that the $65 billion of reduced profit shifting might be reasonable is the US tax change is occurring after the meaningful changes following the OECD/G20 BEPS Project and its on-going implementation by the 113 country BEPS Inclusive Framework.  The Country-by-Country reporting by almost 10,000 MNEs of their profits, taxes and certain economic activities across countries provides important transparency to tax administrations, and is expected to reduce egregious transfer mispricing.  The revised OECD transfer pricing guidelines will eliminate the so-called “cash boxes”, where significant intangible income is assigned to a subsidiary in a low-tax-rate country despite minimal economic activity other than financing graciously provided by the parent.  The BEPS Inclusive Framework is enforcing one of the BEPS minimum standards requiring actual economic nexus to benefit from special low tax rate for “patent boxes” or other “tax subsidies”.  The U.S. continues to be an active participant in the OECD BEPS Inclusive Framework.

Even with a 21% corporate tax rate, the U.S. will need to be on close guard to combat continued attempts at profit shifting as well as closing new unintended tax minimization opportunities that will definitely arise.   Although new data to analyze the reduction in profit shifting won’t be available immediately, the playing field in international tax planning is no longer tilted strongly against the US.  The US is no longer easy picking for international tax planning.  The U.S. is not yet a champ in the international tax area, but it is no longer a chump.  

Tom Neubig 

Digital Taxation: EC proposal and OECD interim report

A new European Commission (EC) proposal to impose a temporary 3 percent excise tax on certain digital services “characterized by user value creation” of large social media and platform companies raises a number of important issues.  The EU proposal release comes a week after an excellent OECD interim report on Tax Challenges Arising from Digitalisation.    The OECD report notes the current lack of an international consensus on a long-term solution to international tax rules dealing with the ability of countries to tax (“nexus”) foreign companies and the attribution of global profit from certain digital activities between countries.

The EU proposal is intended to better measure the location of a multinational company’s income where “user generated contents and data collection have become core activities for the value creation of digital businesses.”  Although the OECD/G20 BEPS project addressed the potential of double non-taxation from digital services, the project did not address to which countries the appropriate income tax on digital services should be paid.  The new OECD report outlines a dozen countries, including the United States, that have imposed unilateral measures affecting cross-border digital services.  The 113 countries participating in the BEPS Inclusive Framework all agree to work towards a consensus based long-term agreement on the tax treatment of digital services but are currently split on whether and which type of long-term agreement is needed and whether interim steps are needed before a long-term agreement is reached.

The EU digital tax proposal is a further manifestation of tax policy arguments to allocate some global income based on the location of consumers.  The EU proposal for a Common Consolidated Corporate Tax Base would allocate corporate income tax within the EU based on the location of consumers, tangible assets and employees.  The EU comprehensive proposal on digital services suggests a different profit split allocation for function with a significant digital presence (e.g. R&D and marketing expenses, number of users and digital data collected).  The U.S. and Canada at the subnational level allocate corporate income between states and provinces based on sales, payroll, and/or tangible capital.  China has argued in transfer pricing cases that more income should be allocated based on the use of IP in the domestic market.  India was the first to introduce an equalization levy on digital advertising revenue attributable to Indian consumers. 

The OECD report provides a thorough analysis of the types of digitalization activities that give rise to both income and consumption tax issues.  These include two-sided markets, where a social media platform can earn additional advertising revenue as a result of the personal data provided by users benefiting from “free” digital services.  The user data is an important intangible capital asset of digital companies but is generally not recognized as a factor in whether a company has a “permanent establishment” in the country to justify being subject to tax.  The intangible capital from user data is not included in the current profit allocation of the arms’-length transfer pricing rules based on assets used, functions performed and risks assumed. 

Most of the focus on the BEPS project has been on its efforts to stop double non-taxation of corporate income.  In addition, the BEPS project included significant improvements in the consumption taxation of cross-border service supplies in both the business-to-business (B2B) and business-to-consumer (B2C) markets.  The EU is now collecting an additional 3 billion euros annually in Value-added Taxes (VAT) as a result of implementing the BEPS recommendations of revised International VAT/GST guidelines, which more effectively applies VAT to cross-border digital services. 

Neither the EC proposal nor the OECD report discuss lost consumption tax revenues from the significant value of “free” digital services.  Lost VAT revenue at an average EU OECD members’ VAT rate of 22% on gross receipts is significantly greater than any lost corporate income tax (CIT) revenue at an average EU OECD members’ CIT rate of 23% on net income (even if the net income is 40-50% of gross receipts).  No explanation for the EU’s choice of a 3% tax rate on gross receipts was provided.

Although it is difficult to impose tax directly on “free” services, such as employee fringe benefits or bank checking services, public finance economics concludes that in many cases it doesn’t matter whether the tax is imposed on or collected at the seller or consumer level.  Thus, a tax at the company level may be a rough proxy for the income tax and/or consumption tax that ideally would be collected on the barter income of digital users and/or on the value of “free” consumer services.  The August 9, 2016 blog described an appendix in the BEPS Action 1 report prepared by the Tax Sages on the incidence of taxes on foreign sellers (without permanent establishment) of digital services. 

A final OECD report on tax issues from digitalisation is due in 2020, with the goal of moving closer to a long-term international agreement to international tax rules for digital services.  The OECD/G20 BEPS Country-by-Country reports will also be reviewed and potentially changed in 2020.  Greater transparency on where companies are operating beyond total revenues, tangible capital and employees would help assess the location of income by country not only for tax administrations but for assessing cross-border digital services as well as national income statistics. 

Tom Neubig

Tax and the UN’s Sustainable Development Goals

A recent conference by The Platform for Collaboration on Tax was held on how taxation is an important part of the United Nations’ 17 Sustainable Development Goals (SDG).  World leaders adopted the goals at a UN summit in the fall of 2015.   The goals are to end all forms of poverty, reduce inequalities, while protecting the planet. 

The Platform is a collaboration of the International Monetary Fund (IMF), the Organization for Economic Co-operation and Development (OECD), the United Nations (UN) and the World Bank Group (WBG).   The conference highlighted that tax structures affect more than just financing government, but also affect equality, investment, growth, environment and other SDG goals (and their 230 indicators). 

It is exciting to hear about enhanced international cooperation in standard setting, capacity building and technical assistance.  Teaming among the key four international tax organizations, with several regional tax organizations, and the active involvement of developing and developed country tax policy officials and tax administrations, with business and civil society groups, is encouraging.  But it is only the beginning of a long and politically difficult journey. 

There is some positive progress. Now there are 112 countries participating in the base-erosion and profit-shifting (BEPS) Inclusive Framework, up from the initial 44 countries.  All 112 countries have signed on to implementing the four BEPS Project minimum standards, including country-by-country reporting of multinational enterprises.  Further progress on curtailing BEPS and providing technical assistance to implement anti-BEPS measures is a work-in-progress.  148 countries are participating in the Global Forum on Transparency and Exchange of Information for Tax Purposes, which not only has begun Automatic Exchange of Information between countries on financial assets held by their citizens in foreign countries, but also making progress on greater transparency on the underlying owners of different types of business arrangements.

A number of countries raise less than 15 percent of their GDP in taxes, which is considered insufficient to finance basic government services for their citizens.   Domestic resource mobilization requires increased tax administration capacity as well as properly designed tax structures.   Many countries have large “informal” sectors, which don’t participate in the tax system or other government programs.  Corruption and bribery undermine trust in governments and contribute to large illicit financial flows out of many countries. 

While focusing on multinational corporations and reducing BEPS is important, the stakeholders need to recognize that corporate income tax and legal tax avoidance is only one of many tax policy and tax administration issues that need addressing for developing countries’ domestic resource mobilization.  Issues of taxing rights of individual countries is not just a developing country concern, but also of developed countries, as seen in the emerging debate on the international tax effects of digitalization of the global economy.   The race to the bottom in tax incentives, base erosion through tax expenditures, and significant tax gaps from non-compliance and evasion need addressing.  Higher levels of tax must be achieved in the context of promoting economic growth, reducing tax uncertainty, and reducing inequality.  Designing better tax structures, strengthening tax administration capabilities, and supporting statistics and analysis for continuous improvement are foundational.

There is no shortage of important tax policy and tax administration issues for all stakeholders (and young tax professionals) to work together in making progress toward the critical sustainable development goals.  There is also no time like the present to start taking specific actions by individual countries.   The Platform’s first global conference is a useful first step, and hopefully the next conference will report even greater progress by the Platform and individual countries. 

Tom Neubig

Stop wasting tax dollars

All government spending and tax incentive programs provide some benefits to economic activity that would take place without the incentive.  I'm skeptical of attempts to increase the "bang for the buck" with so-called incremental tax incentives.  I disagree with critics of general tax rate changes who prefer special incentives rather than general tax rate changes.

But giving tax money away for activity which has already taken place, with no positive future economic benefits, is a waste of badly needed tax dollars.  The Bipartisan Budget Act of 2018, extended 29 tax provisions through the end of 2017, after they had already expired.  The Joint Committee on Taxation estimates these retroactive windfalls cost $10 billion over the next 10 years.  It would have been better to provide a one year extension for activity taking place in 2018 so at least some marginal incentive effect to change behavior would have been possible.  

Many economists noted that the reduced tax rate on the deemed repatriation of previously deferred foreign source income upon moving toward a territorial tax regime provided a windfall to multinational corporations that had already benefitted from significant US tax deferral.  Instead of being taxed at the prior 35% corporate tax rate, they were not even taxed at the new 21% corporate tax rate.  The deferred income is taxed at 8% if held in illiquid assets and 15.5% if held in liquid assets, plus can be paid in installment payments over the next eight years.  At a five percent discount rate, the installment payment option reduces the effective tax rate by an additional 17 percent.  Although the partial recapture of previously untaxed foreign income is estimated to raise $339 billion over 10 years, the revenue gain could have been considerably more without adverse economic effects.  

With the U.S. now entering a period of annual trillion dollar deficits yet still facing significant social needs, including funding opioid treatment and prevention and deteriorating public infrastructure, policymakers should make every effort not to waste tax dollars with retroactive windfalls.  Unfortunately, the recent tax and budget bills are examples of distorted and wasteful priorities of our politicians providing windfalls to special interest groups.  

Tom Neubig

1980’s Redux? Tax cuts followed by deficit concerns

The Tax Cuts and Jobs Act (TCJA) of 2017 is often compared to the Economic Recovery Tax Act with respect to major reductions in individual and corporate income tax rates plus accelerated depreciation. 

The 1981 tax cuts averaged -2.9% of GDP during the next four years.  President Reagan and the Republican Senate became concerned with large future deficits just the following year.  During the remainder of President Reagan’s term, five tax bills increased revenues by 1.85% of GDP, offsetting 64% of the 1981 tax cuts.   

Two more tax increases along with spending reductions addressed projected deficits in 1990 and 1993.  Since 1993, there have been tax increases in the US, except the Affordable Health Care Act of 2010, and then only 0.2% of GDP. 

The 1980s’ tax increases preserved the lower individual and corporate tax rates, and in particular inflation indexing of the individual income tax brackets.  The tax bills reduced tax expenditures as well improved tax administration enforcement and information reporting, and included scheduled payroll tax increases as part of protecting the solvency of Social Security. 

In a balanced approach to reducing the potentially trillion dollar annual deficits, Congress has many tax options remaining.  The TCJA embraced anti-base erosion and profit shifting (BEPS) protections as part of the international changes, and scaled back itemized deductions.  However, the TCJA did not limit the many types of exempt and deferred investment income.  The TCJA gave a pass to the oil and gas and real estate industries.  It provided a new deduction for pass-through business owners without any changes in enforcement tools to reduce the current high rates of non-compliance.   A limitation on multinational enterprises’ ability to overleverage their US affiliates was dropped in the final legislation. The tax benefits of LIFO and carried interest remain.

Although the 2017 tax cuts average only 1.06% of projected GDP (yes, less than 40% of the Gipper's tax cuts, and the percentage will be lower to the extent the 2017 tax cuts stimulate GDP in the initial years), concerns about the rising budget deficits at a time of low unemployment and an aging population are warranted.   Tax increases as part of meaningful deficit reduction are possible while still retaining the key features of the 2017 reforms.

Tom Neubig

BEPS After the 2017 US Tax Change

The US 2017 Tax Cut and Jobs Act (TCJA) made significant changes to the US international tax rules by lowering the federal corporate statutory tax rate to 21%, enacting a territorial dividend participation exemption, and including several anti-Base Erosion and Profit Shifting (BEPS) provisions.  Pascal Saint-Amans and I had previously called for a lower US corporate tax rate with a “tough” territorial regime.  This is my initial assessment of how the 2017 US tax change has addressed the significant profit shifting out of the U.S. 

The table below compares the 2017 US tax changes to the key G20/OECD BEPS Action recommendations.  The US rules closely followed the BEPS Action 2 (hybrids), Action 3 (CFCs), and Action 4 (Interest). 

Even more significant than these specific anti-BEPS provisions is the reduction in the US federal tax rate, which reduces the top combined federal and state statutory marginal corporate tax rate from 38.2% in 2017 to 25.8% in 2018.  Instead of the U.S. having the highest corporate tax rate among all developed countries and all OECD countries, the US general tax rate in 2018 will be lower than the tax rates of countries accounting for over 60% of non-US OECD countries’ GDP. 

Although the 2017 tax changes reduce the incentives and place limitations on profit shifting out of the U.S., US multinational enterprises (MNEs) will still have some incentive to shift some profits out of the U.S. to benefit from lower tax rates in some other foreign countries.   In particular, US transfer pricing rules were not significantly changed by the 2017 legislation, and remain a potential weak link in the tighter anti-BEPS rules. 

The GILTI and BEAT provisions were estimated to raise $262 billion over 10 years, and some of the $253 billion from the interest limitation would be from MNEs reducing overleveraging US affiliates with debt.  The Joint Committee on Taxation did not separately estimate the revenue effect of reducing BEPS due to lowering the US tax rate. 

One unintended effect of the anti-BEPS provisions will be an increase in measured US Gross Domestic Product.  BEPS has reduced measured US corporate profits, while increasing import prices into and lowered export prices out of the US due to transfer mispricing and other MNE tax planning.  The reduction of BEPS out of the U.S. will increase measured US GDP, even if there is no increase in real GDP from higher capital investment or increased labor supply.  

As a simple example, if the U.S. was losing $100 billion of corporate tax revenue annually, then BEPS could have reduced US GDP by 1.5%.  If the 2017 tax change reduces BEPS shifting out of the U.S. by one-third, this could increase measured GDP by roughly 0.5%.  If the lower US general and “patent box” tax rates encourage some shifting of BEPS into the U.S., then measured GDP could increase even more.  In comparison, the JCT estimated that the 2017 tax change would increase GDP by 0.8% over the 10-year period. 

I’ve updated the unweighted and GDP-weighted average OECD general corporate tax rates for 2018, including the lower US tax rate, in the table at the beginning of this blog.  The US change makes little difference in the unweighted OECD average tax rate, but results in a significant drop from 31.5% in 2017 to 26.3% in 2018 on a GDP-weighted basis.  The variation in general tax rates across countries falls sharply with the US tax rate reduction, which is a driver of overall BEPS shifting.  A similar reduction in the average and variation in “patent box” statutory tax rates also occurs between 2017 and 2018. 

Bottom-line: The US tax changes will reduce the incentives and opportunities for BEPS out of the U.S., but there will remain significant opportunities for MNEs to lower their overall effective tax rates through profit shifting.  Continued focus on harmful tax competition, greater transparency and tighter transfer pricing rules, and implementation of the G20/OECD BEPS minimum standards (and some of the other Actions) by all members of the BEPS Inclusive Framework are needed.   The fight against BEPS should remain a high priority of the international community, including the U.S. 

Tom Neubig

Tax reform or simply tax cuts?

The Tax Cuts and Jobs Act passed Congress yesterday.  As with any major legislation, the new law includes some beneficial changes, some bad tax policy, and especially missed opportunities.  It is not the last word on US federal tax policy.  After President Reagan’s 1981 tax cuts, he turned around and supported significant deficit reduction and loophole closing tax legislation in 1982 and 1984, and also a revenue-neutral tax reform in 1986.   

The bill’s ten-year revenue loss totals $1.5 trillion.  The modest positive economic effects from deficit spending and certain tax reductions could alternatively have been achieved with needed government infrastructure spending that would also reduce the costs of doing business in the US.  The beneficial tax reductions could have been financed with beneficial tax base broadening.

According to the Congressional Joint Committee on Taxation’s (JCT) revenue estimates, the bill includes provisions with $5.5 trillion of gross tax reductions and $4.0 trillion of gross tax increases.   The bill costs $2.5 trillion from reductions in individual (-$1.2T) and corporate (-$1.3T) statutory tax rates.   

Some people have asked whether this legislation should be called tax “reform”.   My answer is a qualified yes.  The move to a “territorial” tax system with recognition that tougher anti-base erosion and profit shifting rules, plus some reduction in the corporate tax rate, were badly needed and are a significant fundamental tax reform.  The increase in the standard deduction and tighter limitations on various itemized deductions is along the lines of lower rate, broader base reform.

The legislation, however, is a significant deficit-increasing tax cut, and creates several new tax expenditures (government subsidies provided through the tax system in the form of special lower tax rates or exemptions).  The 20% deduction for certain qualified pass-through business income and reduced rate on certain foreign-derived intangible income (e.g. type of “patent box”) are new and complex tax expenditures.  The legislation also moves away from a net income tax by adding further limitations on the use of business losses for both active partnerships and corporations.

The table below shows the legislation’s provisions with the largest tax reductions and tax increases.

Besides a tax cut disproportionately benefiting the well-to-do and which will burden our kids and grandkids with higher debt, the legislation missed an opportunity to do significant tax base broadening by reducing the largest tax expenditures.   If the legislation had been revenue neutral from additional base broadening, then it would clearly have been tax reform.   The legislation did not touch the three largest tax expenditures:  exclusion of employer-provided health insurance ($3.0T over ten years), exclusion of pension/IRA contributions and earnings ($2.5T), and lower rate on dividends and capital gains ($1.6T).  Meaningful reductions in any of those tax expenditures could have made the legislation revenue neutral and with a fairer distribution.

Tax expenditures in the US are very large, totaling as much as current income tax collections.  Lowering corporate and individual tax rates will reduce tax expenditures given in the form of lower rates, exemptions, exclusions and deductions.   Overall, I would expect the US tax expenditures on net to decline after the legislation from rate reduction, rather than from base broadening.

The US does a good job of measuring and monitoring income tax expenditures with annual reports by both the Congressional JCT and the US Treasury.   I’m pleased to be working with the Switzerland-based Council on Economic Policies (CEP) in an effort to improve tax expenditure reporting globally.  A new IMF blog with Agustin Redondo of the CEP presents some preliminary results from a new Global Tax Expenditure Database.

Tax cut vs. tax reform?  The new bill is both, but 2017 was a missed opportunity for more significant tax reform.  Future federal income tax reform is needed, and perhaps 1982 and1984-style loophole closing deficit reduction legislation will follow this new legislation.  Focus on future deficit reduction should not be limited to just direct spending reductions, particularly after this $1.5 trillion tax cut. 

Tom Neubig

Tax "reform" reflects politicians' social and economic values

I had the pleasure of speaking to students and faculty at Washington State University about federal tax reform, thanks to the Hoops Institute, the Foley Institute and the Carson School of Business.  The talk was Wednesday night when the Senate began its deliberations on tax reform.  The talk was very timely, and how sausage, I mean legislation, is made has been in clear view.

The one hour presentation and Q&A was videotaped and can be seen by clicking here.

Tax reform is still a moving target, but the House and Senate Finance Committee legislation have much in common so it is a highly likely that there will be tax "reform" in 2017.  Two key messages I hoped to leave with the students.  First, although the media and lots of people focus on the politics, process and personalities around tax reform, our tax system and tax reform legislation reflects our politicians' (and thus our country's) social and economic values.  Tax reform reflects the trade-offs between economic growth, efficiency, fairness, simplicity and certainty.  The Republican majority that is passing this tax legislation has made trade-offs with respect to current vs. future generations in terms of using deficit financing, between growth and fairness as shown in the JCT distributional tables, and between stability and uncertainty with its choice of sunsetting most of the individual tax changes.  Those values are different than mine.

Second, elections matter.  Our democratic process has provided us with the current President and current Congressional majorities that are voting for this particular type of tax legislation.  There will be elections in 2018 and 2020, and voters will be able to decide if this type of tax legislation reflects their social and economic values.  

In the presentation, I stress several positive features of the current tax bills, especially the need to have a more competitive corporate tax rate and strong anti-base erosion and profit rules.  However, the current legislation is a serous missed opportunity for our country, especially if we are going to use a trillion dollars in tax cuts instead investing in needed productive infrastructure, while doing minimal base broadening of the major tax expenditures on the individual side.  I stressed that each person has to make their own assessment of the trade-offs between growth, fairness, and simplicity, and then vote accordingly at the next opportunity.

Tom Neubig

Tax planning involving intangible capital distorts national statistics

The new World Intellectual Property Report 2017, by the World Intellectual Property Organization (WIP0), estimates that nearly one third of the value of manufactured products sold around the world comes from “intangible capital,” such as branding, design and technology.  The WIPO study of the global value chains companies use to produce their goods shows that intangible capital contributes twice as much as buildings, machinery and other forms of tangible capital to the total value of manufactured goods. This underscores the growing role of intellectual property, which is frequently used to protect intangible and related assets in the worldwide economy.

I was fortunate to work with Sacha Wunsch-Vincent, a WIPO senior economist, to analyze the effects of tax planning in multinational companies' value chains on countries' national income statistics.  Our new WIPO working paper explains how the current measures of intellectual property payments and receipts are distorted, and significantly understated in high-tax-rate countries.  Click here to the link to our working paper.

The phenomenon of global fragmented production and associated trade in intermediate products, including intangible assets, has changed how economists study globalization and how new public policies are shaped. Understanding cross-border flows of disembodied knowledge, often associated with intellectual property (IP), is essential to analyzing how modern economies operate. Available data to document these international IP-related knowledge flows – namely cross-border payments for IP - are distorted by various factors.

Tax planning by multinational enterprises has seriously distorted the measurement of cross-border IP flows, which affects national measurement of imports, exports, GDP and productivity.  Intangible assets and their income flows are a major source of profit-shifting across countries through transfer mis-pricing and other tax planning.  The tax-induced mismeasurement could be more than 35% of global Charges for Use of Intellectual Property (CUIP), and greater for individual countries, particularly high-tax-rate countries. International initiatives to address tax base erosion and profit shifting (BEPS) and other statistical initiatives on global value chains w ill improve future measurements of cross-border IP flows, improving the understanding of both the creation and uses of IP. 

Since the working paper, I did a simple regression of CUIP receipts as a percent of GDP in OECD countries in 2015, which finds that tax haven status (e.g. Ireland, Luxembourg, Netherlands and Switzerland) is a strong predictor of CUIP receipts, rather than R&D spending relative to GDP or patent box or ordinary corporate statutory tax rates.  Actual effective tax rates on much of intangible capital payments in these tax-haven countries are significantly lower than the statutory tax rates due to administrative rulings and special deals.  Most Caribbean islands don't report CUIP in the national statistics.  Tougher anti-BEPS rules as a result of the OECD/G20 BEPS Project and Inclusive Framework will reduce the tax distortions of national statistics on this important source of economic growth.

Tom Neubig

Progress on Evaluating Tax Incentives

In the midst of the rush to pass significant US tax reform, a conference on state and international tax incentives illustrated progress in the analysis and evaluation of government incentives.  The American Tax Policy Institute conference had panels on assessing state and local tax incentives, international tax incentives, tax competition, and using evidence-based tax incentive policymaking.

Tim Bartik of the Upjohn Institute presented a new database tracking five types of tax incentives over 26 years covering over 90% of the US economy.  This public database will be an invaluable resource for state and local tax policy analysts.  Other panelists noted that non-tax incentives also play a major role in state and local governments’ economic development efforts.  New data from state and local government financial reports will start being available shortly as a result of the Government Accounting Standard Board’s Statement 77 on tax abatement disclosures, which will help identify hidden tax incentives.

Jeff Chapman of The Pew Charitable Trust led a roundtable of three state officials responsible for evaluating state tax and non-tax incentives.  The Pew Charitable Trust project is providing states with best practices and evaluation tools, as well as a state tax incentive evaluation-rating tool. 

Tax competition for mobile investment, workers and tax revenues also is occurring at the country level.  This can take the form of competition in tax rates, patent boxes, tax incentives, as well as with base-erosion and profit-shifting facilitation.  The Platform for Collaboration on Tax, a joint effort by the IMF, OECD, UN and the World Bank Group, is providing capacity-building support to developing countries, including a toolkit for evaluating investment incentives.

More analysis and evaluation of existing tax incentives is needed at all levels of government.  The current US tax reform proposals repeal many tax expenditures, often with no empirical analysis or evaluation.   Repealing tax expenditures to lower individual and corporate tax rates has some appeal, and would make the federal tax code simpler.  However, government intervention for many socially-desired activities is done through tax expenditures or non-tax grants or subsidies.  The House bill repeals the exclusion of students’ qualified tuition reductions, without any hearing or empirical evaluation.  Reducing incentives for investment in human capital to pay for tax incentives for physical capital investment and general tax cuts should be analyzed and evaluated before such a change is considered.

Tom Neubig

Tax reform obstacles

Any major legislation will have obstacles and roadblocks, and in the case of tax reform likely some near-fatal experiences.  The media has focused on differences between the Ways and Means (W&M) Committee tax legislation and Senate Finance Committee (SFC) Chairman Hatch’s initial proposal, namely differences in the treatment of state and local property tax deductions and a one-year delay in the corporate 20% tax rate.

Those differences are relatively minor in the Republican Party’s desperate desire to have one major legislative victory before the 2018 elections.  Below are five more significant issues that could determine the fate and timing of federal tax reform in 2017 or 2018.

Deficit increases not offset significantly by economic growth.  The $1.5 trillion increase in deficit is a concern of several Republican senators, given low current unemployment and large future deficits from baby boomers’ retirement and health programs.  When JCT and CBO complete their dynamic fiscal estimate, it may show only a small reduction in the estimated static deficit.  This may be why the House will vote even before the dynamic score is finished. 

Byrd rule preventing long-term deficits.  Senate rules don’t allow a majority vote if legislation increases the deficit beyond 2027.  This required the Bush 2001 tax cuts to be sunset after 10 years.  The SFC Chairman’s mark has large deficits in 2027, so the Chairman’s mark will need to be changed drastically to comply with the Byrd rule.  Sun-setting corporate tax cuts will make the dynamic effects even weaker, and make the proposal less attractive to many.

Distributional issues and weak middle-class tax relief.  JCT estimates do not distribute the estate tax cuts (see 11/5/17 blog), thus understating the benefits to the wealthiest.  The JCT estimates that W&M legislation increases individual income taxes on average for the $10-40k income classes in years 2023-2027.  Is that tax relief for hard working, but lower income, Americans?

Business tax cuts may be whittled away as they try to make the package more appealing to households.  During the W&M Committee legislative changes, Republicans increased deemed repatriation tax rates and retightened the related party payment rule to reduce the business tax cut to provide more household tax cuts.  At some point, more of the business community might say it is not beneficial to their industry.

Refundable tax credits.  Several Republican Senators are not supporters of refundable tax credits (low-income “welfare” through the tax code, rather than corporate welfare).  Much of the tax reduction for some low and middle-income families is due to larger refundable tax credits.  With a narrow margin to get 50 Republicans, this could be the tipping issue for at least one Republican senator.

There will be other obstacles raised and pre-mature death warnings as the legislation goes through the SFC, the House and Senate, and a conference committee.  Still I predict legislation called tax “reform” will be enacted in early spring of 2018, although scaled back to a smaller version with more of the tax cuts going to non-business households.  Stay tuned. 

Tom Neubig

Distribute all the tax cuts!

I wrote on October 3rd about how the analysis of the 1986 tax act did not distribute its corporate income tax increases, thus showing all income groups getting tax cuts even in a revenue-neutral tax reform.  Now the Treasury, Joint Committee on Taxation, and Congressional Budget Office distribute corporate income tax changes to households.  However, the JCT and CBO still do not distribute estate tax changes.  [Fortunately, the Treasury and Urban/Brookings Tax Policy Center distributional analyses do include estate tax changes.]

Given that the eventual repeal of the estate tax in House Ways and Committee Chairman Brady's tax reform proposal accounts for 12% of its total net tax cut over ten years, and 29% of the total net tax cut in fiscal years 2025-27 when the estate tax is repealed, this is a serious omission from the JCT distribution tables.  

The IRS Statistics of Income has published tables linking estate tax returns with the income tax of married decedents in the prior year, which provides important information about the income of estate taxpayers.  The table above shows that decedents with taxable estates in excess of $10 million had an average income in excess of $1 million the year before their death.  Decedents with taxable estates over $20 million, accounting for over half of the estate tax paid, had an average income over $4 million.  

The description of the US Treasury distributional analysis, as of 2015, said that "Ninety-one percent of the estate and gift tax burden falls on the top 5 percent of families, with 43 percent on the top .1 percent of families." 

In addition to the $36.6 billion of income tax cuts millionaires would receive in 2027, they would also likely get another $28 billion (73% of the total $38 billion) of estate tax reduction, for a total of $64 billion tax cut accounting for almost 40% of the proposal's total tax reduction ($156 billion) in that year.  [Some might argue that heirs, rather than the decedents', income should be used in the distribution table.  However, even with large families, heirs of $10+ million estates would also likely be millionaires under a Haig-Simons definition of income.]

Revenue and distribution tables are based on estimates and projections by career professional staffs.  If the Congressional government staffs can distribute corporate income taxes and make 10-year revenue projections, their distributional tables can also include estimates of the distribution of estate taxes.

Tom Neubig

Brady's tax reform plan: kudos and caveats

House Ways and Means Committee Chairman Brady's tax reform proposal deserves kudos for lowering the federal corporate income tax rate with significant base-broadening and base erosion protections.  As the chart above shows, two-thirds of the static revenue loss is from business income tax provisions.  

Of course with any major tax reform proposal, many issues are important and need extensive debate.  The $1.5 trillion of additional deficit-financed tax cuts will only be partially offset by potential future economic growth, particularly when the US economy is at or near full employment and with large projected future deficits from the baby-boomers' "entitlements".

To fit under the budget reconciliation limits of $1.5 trillion, typical budget gimmicks are included, such as delayed elimination of the estate tax, temporary capital expensing provisions, temporary extra personal tax credits, and one-time revenue from recapture of previously untaxed foreign source income.  

Important issues are raised, such as the extent of government (tax) subsidies for high-priced residential housing, and the treatment of non-corporate business income.  Other tax issues are missing from the plan, such as potential limitations on excessive retirement plan savings and employer provided medical insurance expenditure.  The role of refundable tax credits and the payroll tax as part of the overall US federal tax system is largely absent.  

Nonetheless, the Brady proposal is a good start to meaningful tax reform which would lower marginal tax rates and broaden the income tax base in ways to reduce economic distortions, promote economic growth, and treat similarly situated people more fairly.  Hopefully further improvements, particularly in terms of reduced deficits and fairness, will result during the deliberative process. 

The table below shows the major elements of the Brady plan based on the Joint Committee on Taxation's revenue estimates, rearranged by the author. 

Tom Neubig

Which comparative corporate statutory tax rates?

The US policy debate on international tax reform often includes comparisons to an OECD average of 24% for non-US corporate statutory top tax rates.  Yet many of the US exports, imports and foreign direct investment are with non-OECD countries such as Brazil, China, India, Singapore, Taiwan and tax havens.  The 24% average tax rate is unweighted, so counts Estonia and Slovenia with the same weight as Germany and Japan. 

The Tax Foundation did a good analysis of statutory corporate tax rates in over 200 countries.  They present an unweighted average (23.0%), but also an average weighted by countries’ Gross Domestic Product (29.4%).  Clearly a weighted average is more appropriate for a comparative analysis, but I don’t think GDP is the best weight for analyses of international business competitiveness or base erosion and profit shifting.  Domestic consumption accounts for most of GDP and government spending is another significant percentage. 

Four measures focused on international business activity are exports and imports, outbound and inbound foreign direct investment (FDI).  These measures are specific to U.S. multinational business activity.  For convenience, I calculate the weighted average corporate statutory tax rate for the top 15 countries which account for 66% of US exports, 72% of US imports, 81% of the assets of US multinational enterprises’ affiliates, and 91% of the assets of foreign-owned US affiliates.

The weighted average of the top 15 countries that are US major trading partners is 27%, using 2017 top statutory corporate tax rates.   The weighted average of the top 15 countries with FDI into the US is 26%.  The weighted average of the top 15 countries where US multinationals have affiliates is 20.5%, since a significant share of US outbound FDI is in 0% tax rate havens.  The outbound US FDI rate would be even lower if intangible assets, often placed in tax havens, was included in total assets.  

A federal corporate tax rate of 20% combined with state corporate income tax would be slightly under 25%, so the US would no longer be an outlier.  Of course, many multinational corporations are able to avoid state corporate income taxes on their foreign source income, so a 20% rate would be below the current averages for exports, imports and inbound FDI. 

Statutory marginal tax rates are important determinants of base erosion and profit shifting (BEPS).  Tough anti-BEPS tax rules are also important.  Average effective tax rates reflecting not only the statutory tax rate, but also the tax base and tax credits, affect foreign direct investment.   Reducing the US statutory tax rate is important to curtail a number of economic distortions, but other dimensions, such as territorial and anti-BEPS rules, are also key elements of a balanced international tax system for the U.S. 

Tom Neubig

Improve, not hide, tax research on corporate taxes

What were they thinking?  The US Treasury Department removed from the Treasury website a 2012 Treasury staff technical paper which reported on an improved approach to distributing the corporate income tax.  (Kudos to Richard Rubin of the WSJ for breaking the story.) Instead of assuming that 100% of the corporate income tax (CIT) is borne by capital owners in the form of lower capital returns, the paper estimated that some of the CIT is borne by workers in the form of lower wages or reduced employment opportunities.

The analysis estimated that about one-fifth of the CIT is borne by workers.  That apparently is contrary to the belief of the current Treasury Secretary who cites other empirical studies that workers could bear 70% or more of the CIT.  Some academic studies have claimed that workers bear more than 100% of the CIT due to significant shifts in global capital.  The Joint Committee on Taxation and the Congressional Budget Office have been using estimates of 20-25% shifting to workers in their analyses.

If current Treasury officials have information to improve the distribution of CIT across households, then they should publish that analysis so it can be reviewed, debated and critiqued.  Removing the 2012 analysis from the list of Treasury Office of Tax Analysis technical studies does not help the policy debate about this important issue.  The 2012 analysis included the usual disclaimer:  The papers are works in progress and subject to revision. Views and opinions expressed are those of the authors and do not necessarily represent official Treasury positions or policy. OTA Technical Papers are distributed in order to document OTA analytic methods and data and invite discussion and suggestions for revision and improvement.  The analysis remains available as a publication in the National Tax Journal.  

Any empirical analysis can be critiqued and improved on, so instead of trying to hide the prior analysis, Treasury should provide its current analysis.  The 2012 analysis relies heavily on a distinction between "normal" and "supernormal" returns, which a prior blog questions.  The analysis assumes that "supernormal" returns are borne 100% by capital owners, despite empirical research that average effective tax rates, which fall on "supernormal" returns, affect foreign direct investment, and thus could result in lower capital investment in the US with a negative effect on total US wage compensation.  The distributional effect of any proposal could depend on the specific policy changes.  Changes in average effective tax rates (i.e. lower statutory tax rates) have a larger effect on foreign direct investment than changes in marginal tax rates (i.e. expensing) on investment. (DeMooij/Ederveen 2008).  The distributional effects likely differ between small very open economies and the US.

Removing the technical working paper from the Treasury website has given the analysis more prominence.  That is probably a positive development, since distributional consequences should be weighed against economic growth, economic efficiency and simplicity.

Distributing the CIT among households is an improvement from the last US tax reform in 1986.  At that time, uncertainty about how to distribute the CIT meant it was not included in the distributional tables.  That is why President Reagan's 1985 tax reform proposal could be revenue neutral while showing every income group getting a sizable tax cut.  See 1985 table below.  The 1986 tax act was revenue neutral, but raised CIT revenues to finance individual income tax reductions.  

Let's have an open and honest debate about the distributional burden of the corporate income tax, recognizing that the economics profession is still uncertain about its exact shifting to capital owners, workers and consumers.  

Tom Neubig

Tax reform is hard choices and heavy lifting

With the imminent release of the next variant of the Trump/GDP tax reform plan, the last rate reduction/base broadening tax reform in 1986 can provide some insights on the hard choices and heavy lifting politically that true reform takes.  The above chart shows that significant tax base broadening in both individual and corporate income taxes occurred to finance lower tax rates and low- and middle-income tax relief.  

The closest thing to a silver bullet in base broadening was the repeal of the investment tax credit, which accounted for slightly less than one-quarter of the revenue increases.  After that, tax reform required detailed, while still significant, tax law changes closing loopholes, removing industrial policy-type subsidies, and limiting special rules that benefited small groups and complicated the tax code.  The table below shows the major revenue raisers.

It was not easy taking on all of the interest groups that benefited from these specific tax provisions, but the principle of lower marginal tax rates and their benefits of greater efficiency, growth, and simplicity won the day, with the strong support of the President and Congressional leaders, particularly the tax-writing committee chairmen.  Base-broadening also helped improve horizontal equity, treating households in similar situations similarly.  Closing loopholes benefiting the well-to-do and small groups improved the perception of a fairer tax system.

The tax and economic issues are different now than in 1986, but lower marginal tax rates, closing loopholes, and removing special provisions benefiting small groups will have similar benefits.  Reducing taxes is easy; tax reform is hard choices and taking on many different vested interests in order to achieve a principled outcome.  The final outcome was far from perfect, but was a major policy improvement.

I went to the OECD in Paris in 2014 to work on tax reform since I had waited 28 years for the next US federal tax reform. The OECD/G20 Base Erosion and Profit Shifting project was and still is global tax reform in progress.  Hopefully, the President and Congress will work toward true US tax reform. 

Tom Neubig

Changing Global Headquarters Locations, 2000-2017

The composition of the Fortune Global 500 (FG500) companies by headquarters location has changed as developing countries’ economies have grown to more than half of world GDP.  The number of US-headquartered companies among the largest 500 companies, ranked by revenue, has fallen from 179 in 2000 to 132 in 2017.  At the same time, the number of China-headquartered companies grew from 10 in 2000 to 109 in 2017.

The 26% drop in the share of US-headquartered companies in the FG500 is due to many factors, and often cited in calls for US corporate income tax reform.  Countries’ tax systems play a role in the success of their headquartered companies and can affect the choice of headquarter location, particularly following mergers.

The table below shows a strong positive correlation between the change in a country’s share of FG500 company headquarters and the change in its share of global GDP.  While the US share of FG500 companies declined 26% between 2000 and 2017, the US share of world GDP declined by 19% between 2000 and 2016.  The other G-7 countries (Japan, Germany, France, the UK, Italy and Canada) also experienced a similar decline in both their share of the FG500 and world GDP.  As China, India and other developing economies have grown faster, their economies have been able to support larger companies, both multinational and purely domestic companies. 

Most of the decline in the US share of the FG500 occurred between 2000 and 2009.  Since 2009, the decline in US-headquartered FG500 companies slowed considerably as the US share of world GDP stabilized and actually increased slightly.  Two of the eight “lost” companies since 2009 were “inversions” of Johnson Controls and Medtronic to Ireland between 2016 and 2017, both tax-driven.

Japan and the UK moved from worldwide to territorial tax systems in 2010.  As shown in the table, the switch to territorial did not stop the decline in their share of FG500 companies since enactment.  The U.S., China and South Korea have worldwide tax systems, although some academics have said the US system is “dumb” territorial with significant tax planning around deferral and foreign tax credits, and also significant base erosion from profit shifting out of the U.S. 

Corporate headquarter are important as the location for executive decision making, highly paid executives and other headquarter staff, associated service providers, and prestige for the country and city.  Most of the companies' employment and investment may not be at the headquarters location, rather located at regional headquarters, research labs or large operating facilities. 

Overall tax systems, including tax rates, tax bases, and tax uncertainty, matter in headquarter and other location decisions.  But so do the overall size and growth of the domestic economy, public infrastructure, skilled labor force, and fiscal and economic policies and their stability.

Tom Neubig

Tax Expensing Favors Long-Lived and Risky Investments

Immediate deduction of the full cost of business investments (“expensing”) is an integral part of a consumption tax.  Expensing, however, is not consistent with an income tax.  Expensing creates major economic distortions within an income tax.

Measuring economic depreciation, similar to any valuation procedure, is specific to the facts and circumstances of the particular investment, and is not easy.  So tax depreciation has used rules of thumb in the trade-off between administrability, simplicity and economic efficiency.  Expensing would be simple, but results in significant erosion of the tax on capital income, particularly if expensed investments can be debt financed with deductible interest. 

Economists calculate that expensing results in a zero marginal effective tax rate (METR) on the marginal (last dollar) zero-profit investment.  Since the vast majority of investment is not marginal, nor earns the minimum required return of the investor, expensing only reduces businesses’ average effective tax rate on investment.  But the tax benefit can be quite large, particularly for long-lived assets and risky borrowers.

Expensing accelerates the timing of tax deductions compared to economic depreciation.  Investors benefit from having more cash (less tax paid) when they take the deduction, but repay the cash (more taxes paid) later since they don’t have the future deductions they would have had with economic depreciation.  This is the equivalent of the Federal government giving investors an interest-free loan. 

The Federal Credit Reform Act (FCRA) of 1990 requires calculation of Federal interest subsidies through below-market interest rates, guarantees or loan forgiveness.  Zero-interest loans from accelerated tax depreciation and other tax deferral provisions aren’t covered under the FCRA.   

Zero-interest loans from tax expensing vary by the life of the capital investment and the riskiness of the investor (borrower) as shown in the table below.  Corporate bond interest rates vary from 2.9% for AAA borrowers to over 10% for CCC or below rated borrowers.  The table below shows how the benefit of zero-interest rate loans from expensing vary, from 5% of the cost of the investment for a 5-year asset by AAA borrower to 53% for a 20-year investment by a high-risk borrower. 

Historically, the US tax code has tried to provide more incentive for shorter-lived equipment rather than longer-lived assets.  This would be reversed with expensing.  Subsidizing high-risk borrowers or risky investments should be done directly through programs, such as the Small Business Administration programs, rather than hidden in tax provisions.

Considering tax expensing as a zero-interest lending program is helpful in understanding the real economic effects of such a proposal.  Reducing the tax rates on business income would provide an investment incentive in a uniform way to all types of investments and investors.

Tom Neubig