US tax reform: badly needed, but is the destination right?

Back in 1988, the economist Larry Summers explained why the US had no VAT: ”Liberals think it’s regressive and conservatives think it’s a money machine. If they reverse their positions, the VAT may happen.” Nearly 30 years later, the US still doesn’t have a VAT. But recent tax reform proposals by the Republican party would bring many of the features of VAT into the corporate tax system.

There are good reasons to for the US to consider corporate tax reform. At 35%, its statutory federal rate of corporation tax is the highest in the G20 – indeed one of the highest in the world. The US clings to a system of worldwide taxation, attempting to tax groups headquartered there on their worldwide income. At the same time, it provides easy ways to step around the system (such as the “check-the-box” election, allowing groups to decide whether companies should be treated as separate entities or not), with the result that US groups now keep over $2tn of cash in offshore jurisdictions. The EU Competition Commissioner’s recent State aid ruling on Apple provides ample evidence of the need to reform the US system, beyond what it says about Apple and Ireland.

The Republican proposals would reduce the federal rate to 20%, and would move away from the principle of taxing US groups on their worldwide income towards a corporation tax based on sales in the US. The cash-flow principle would give companies immediate relief for capital expenditure, while the “destination basis” would exempt income from exports while giving no relief for expenditure on imports (the so-called “border adjustments”). But is this “destination-based cash-flow tax” (DBCFT) the right direction for reform?

From an economically purist standpoint, it has advantages. Corporation tax, as usually implemented as a tax on a company’s return on its economic activity, distorts a company’s finance and investment behaviour (see for example this 2007 OECD study, chapter 4), so that decisions are at least partly driven by tax considerations. A DBCFT would remove distortions in two respects. Firstly, being a cash-flow tax giving immediate relief for capital expenditure, it would tax only economic rent: that is, it would tax only profit earned above the “normal return to capital” (broadly, what the company could earn simply by putting its money in a bank account). This has long been established (see the 1978 Meade report, chapter 12) as a non-distortive way of taxing corporate income.

Secondly, it taxes corporate profits in the country where sales are made – rather than the country where the “economic activity” takes place (a notoriously hard concept to pin down given today’s global supply chains). As set out in an Oxford Centre for Business Taxation (OUCBT) paper published last month by Auerbach, Devereux, Keen and Vella, this means it doesn’t distort the location of investment decisions – subject to an important proviso, to which I will return below …

Economic principle versus tax policy practice

These are attractive economic properties, and it’s not surprising that a number of economic commentators have favoured the reform. However, while economics is a vital ingredient in tax policy, I’m instinctively sceptical of radical tax reform based on economically pure rationale. The reasons behind this instinct could fill a whole article, but I’ll mention just two. A key point is that I’m a pragmatist when it comes to tax policy: political acceptability, which is an essential underpinning of any tax system, is at least as important as economic purity. So economists would say that a destination-based cash-flow corporate tax is in principle equivalent to a VAT plus a labour subsidy, and could be implemented in either way. But from a political perspective the two are very different: to see this, try suggesting to the UK Parliament that they should abolish corporation tax and increase VAT to compensate – even with a labour subsidy it’s unlikely to be politically palatable.

A further reason – which economists might have more sympathy with – is that an economically pure system is rarely achieved in practice, and this risks undermining the economic rationale for the reform in the first place. So, for example, the OUCBT paper is at pains to emphasise that the economic properties of their proposed DBCFT are only realised if relief for losses is absolutely symmetric with the treatment of profits.

The US reform proposals would implement this by indexing carry-forward losses to retain their economic value. But what of companies that are in a permanent loss-making position? This could arise from either of the defining features of the proposed reform. Immediate write-off of capital expenditure was effectively a feature of the UK corporate tax system prior to 1984, with its 100% capital allowances, and left many small companies in a permanent tax loss position after the deduction of the owner’s salary. It’s not clear how great a concern this would be to economists – a business not earning an economic rent might arguably be better off simply leaving its money in the bank – though the DBCFT isn’t fully delivering its “labour subsidy” element in that case.

The case of companies that would show a permanent loss under the destination basis is interesting. They could include those who look most like winners from the reform – companies such as Boeing, for example, which have high expenses in the US but export most of their product. Under the new regime, they would get a massive reduction in tax and might not be inclined to campaign for a payable loss relief credit on top of this. For economists, however, if losses are not treated symmetrically with profits, and relieved in the same way as profits are taxed, the system becomes distortive and loses the very economic efficiency properties that motivated the reform.

The proviso – multilateral versus unilateral adoption

The recent OUCBT paper includes this important finding: “In principle, the DBCFT has remarkable properties in terms of economic efficiency. In particular, it should not distort the scale or location of investment, nor forms of financing choices.”

The finding, however – particularly in relation to the location of investment – is based on an assumption of universal adoption of DBCFT. That is, it assumes a world in which all countries have adopted the destination-based cash-flow tax, in a fundamental reform of the international tax system (going way beyond the recent OECD Base Erosion and Profit-Shifting project). The US proposal, however, is for unilateral adoption. In such an environment of unilateral adoption, the OUCBT paper finds that a DBCFT would distort the location of investment decisions. Specifically, it would encourage companies to locate production activities in the country adopting unilateral DBCFT, and would represent “an aggressive move in the existing tax competition game”.

On top of that incentive to locate real activities, unilateral adoption of DBCFT would create an incentive for artificial profit-shifting, to the detriment of the rest of the world. Effectively, the DBCFT country would become like a tax-haven, encouraging companies to over-price non-taxed exports and under-price unrelievable imports, shifting income into the DBCFT regime from other countries, and expenses out of the regime into countries with a more traditional international tax system. Again this would be a highly aggressive move in terms of the overall balance of the international tax regime.

Note that these distortions are distinct from the effect of encouraging exports and discouraging imports, which the OUCBT paper describes as at most temporary. A currency appreciation is then postulated, cancelling out this effect – though economists such as Willem Buiter have argued the currency could just as well move the other way.

The distortion in investment location and profit-shifting incentive are enduring features of unilateral adoption, which would only be whittled away if and when more countries followed suit. And while the destination-based approach has some attractions as a general system for developed, high-tech economies, it is less convincing as a global model of international taxation: the sections of the OUCBT paper dealing with “inter-nation equity” and developing country issues (pp.34-38) seemed the least persuasive, and they accept that developing countries would likely need resource taxes to supplement a DBCFT.

WTO challenge?

We could therefore expect any country unilaterally adopting a DBCFT to attract condemnation from trading partners. The EU has already fired a warning shot against the US tax reforms, arguing the “border adjustments” breach WTO rules. This is an untested area of law, but Wolfgang Schön, of the Max Planck Institute for Tax Law and Public Finance in Munich, argued last year that, while border adjustments are a standard feature of VAT systems and accepted as such under WTO rules, they would be a prohibited “export subsidy” if implemented as part of a direct corporate tax – which is what the US proposals seek to do.

The Republican’s tax reform blueprint argues that other countries, with their VATs, obtain the same effect and hence gain an unfair advantage over the US. But, according to the logic of Schön’s paper, if the US wants to level the playing field, it must either adopt a VAT, or persuade the rest of the world that the destination basis should be adopted as the new norm of international corporate tax. [Update 28 March: see also Dan Neidle’s recent Tax Journal article, which includes a useful info-graphic illustrating the difference between the positions for a VAT and a DBCFT.]

The last word …

Larry Summers has recently argued against the corporate tax reform proposals – partly on the grounds that they would exacerbate inequality, which might seem ironic given his comments 30 years ago. He argues the US corporate tax system is badly in need of reform, but that it needs to be fixed within the normal parameters of international tax – for example, by closing shelters and cracking down on tax havens.

From the stand-point of the rest of the world, that view is certainly attractive. International tax has for years had to contend with a leaky US tax regime which encourages profit-shifting across the world (and to a large extent this was what triggered the OECD’s BEPS project). A unilateral move to a position where the US was effectively a tax haven would create instability, new opportunities for multinationals to exploit, and headaches for tax collectors across the world.


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