The Trump administration’s “unified framework for fixing our broken tax code” is a breathtakingly thin document. But one can draw conclusions: it is regressive; the reductions in business taxation are huge; and the opportunity for desirable reform of the corporate tax regime has been lost.
The Tax Policy Center estimates that the proposals would lower federal revenues by $2.4 trillion over the first 10 years: $2.6 trillion in cuts in taxation of corporations and another $240 billion lost through elimination of the estate and gift taxes, offset by about $470 billion in increased revenues from individual income tax.
In all, it estimates: “Taxpayers in the top 1 per cent (incomes above $730,000) would receive about 50 per cent of the total tax benefit; their after-tax income would increase an average of 8.5 per cent.”
Those in the top 0.1 per cent would gain by 10.2 per cent. But “taxpayers in the bottom 95 per cent of the income distribution would see average after-tax incomes increase between 0.5 and 1.2 per cent”. This is a regressive plan misrepresented as the opposite.
Income
The most important change, by far, is in corporate taxation. At present, the US taxes the worldwide income of US corporations at a 35 per cent rate, albeit with many deductions and loopholes (as well as an average state tax of 9 per cent, itself deductible from federal tax). These are the highest rates of any significant high-income country. But US companies pay this rate on income earned abroad (with a deduction for foreign tax paid) only when it is repatriated. According to the US Treasury, some $2.5 trillion in profits of US-owned subsidiaries is parked abroad, as a result.
In the language of experts on corporate taxation, the US has a residence-based corporate tax system. But it is (deliberately) leaky. One way of fixing this would be to lower the rate, but apply it to worldwide income, as it is earned.
Since the administration is proposing a cut to a 20 per cent rate, that seems a sensible way to go. The proposal is, instead, to move to a “territorial” or “source-based” system: it suggests a “100 per cent exemption for dividends from foreign subsidiaries (in which the US parent owns at least a 10 per cent stake)”. But it retains aspects of a residence-based system, since it will continue to tax foreign profits of US multinational companies at a reduced rate.
That reform is needed is clear. Despite having such a high marginal tax rate, the US does not generate much revenue by the standards of other big, high-income countries. The combination of high rates, with weak revenues and huge incentives to leave money abroad is impossible to defend.
Yet an opportunity is being missed to improve the taxation of corporations in more fundamental ways. Instead, the US will reinforce the highly problematic global shift towards territorial taxation.
Residence
In a globalised economy, such taxation creates a huge incentive to shift purported production to low – (or zero) – tax jurisdictions. Yet, with residence-based taxation on worldwide income, instead, there is an incentive for companies to shift their residence: that has created “tax inversions” – the artificial shifting of corporate domicile.
To be fair, globalisation has made the taxation of corporations very hard: it makes it difficult to determine where profit is generated; it facilitates shifts in the location of production and corporate domicile; and it separates the location of companies from that of their shareholders.
All this encourages a competitive race to the bottom among governments. In addition, technological developments have created huge companies that own little fixed capital and whose production can barely be located. Where is a search engine?
For such reasons, experts have proposed the idea of a “destination tax”, instead of one on source or residence. This would, in effect, be a tax on the value added generated by capital in sales in a given jurisdiction.
Paul Ryan, speaker of the House of Representatives, supported this novel idea earlier in the year. Unfortunately, it has since been buried. Yet it has big advantages. It would obliterate the fiscal advantages of locating in tax havens and it would put the big economies back in the driving seat.
Moreover, the US could impose the change on its own. A business may produce wherever it likes, but few large ones can avoid selling there.
One objection to this proposal is that the tax would be imposed on imports, with a parallel deduction on exports. Some argue this would be illegal under World Trade Organization rules, since, legally, corporation tax is a direct tax and not, like the VAT, an indirect one.
Labour
There are also questions about the treatment of labour costs, which would be exempted from the domestic tax, but not from imports. These difficulties might have been resolved. But the domestic political opposition to the tax on imports, principally from US retailers, seems to have proved decisive.
That is a great pity, since the destination principle is attractive. An alternative could have been to stick with taxation on worldwide income, with no exemption for unrepatriated income, but at the reduced rate of tax. This would make movement into tax havens for US resident companies fruitless. The US is also powerful enough to prevent companies shifting domicile for tax reasons alone.
As it is, however, the planned US shift to a territorial system will surely reinforce the global spiral towards ever-lower corporate taxes, spurred on by competition from low-tax countries and tax havens. When income inequality and “fairness” are such big issues, the perception that corporate income is increasingly untaxed is bound to be politically provocative. Unfortunately, the chance of radical change seems lost.
Copyright The Financial Times Limited 2017
