I'd like to use Friday to discuss an interesting article that was published in Tax Notes during the week.
On August 15, Bill Parks offered a set of principles to guide corporate tax reform (For Corporate Taxes: Lower Rates, Raise Revenues, 132 Tax Notes 745).
Our tax system is broken, and the best way forward would be a Big Reform which substantially changes existing tax rules and regulations. In the United States, the taxation of business income has become increasingly skewed between multinational "princes" and domestic "paupers." What do I mean by "princes" and "paupers"? Let's examine two hypothetical businesses.
Assume that ToolCo manufactures specialized parts and equipment for U.S. industrial clients. The business is medium-sized (less than 500 employees), located in the Midwest, and generates solid but unspectacular profits for its owners. ToolCo uses state-of-art engineering software, including some applications (intellectual property) designed by its resourceful technology group, in the manufacturing process. Because ToolCo is a domestic business with domestic IP development, manufacturing and sales, ToolCo's effective tax rate for a multi-year period is consistently in the range of 40%.
Compare ToolCo to BigTool Inc. Like its smaller competitor, BigTool manufactures specialized parts and equipment. However, BigTool is a U.S. based multinational, with thousands of employees located in the U.S. and foreign countries. Through transfer pricing and cost sharing arrangements, BigTool shifts much of the intellectual property for its operations to low-tax foreign jurisdictions. Consequently, BigTool pays the U.S. tax rate (40%) on a relatively small proportion of its worldwide profit. Its global effective tax rate for a multi-year period is consistently in the range of 20%.
In my simple examples, BigTool is the multinational "prince," and ToolCo is the domestic "pauper." The U.S. tax system imposes higher costs on purely domestic businesses, compared to multinational business that can develop intangibles offshore and use transfer pricing to shift income to low-tax jurisdictions.
I am not alleging that U.S.-based multinationals are "avoiding" tax or engaging in otherwise unscrupulous behavior. In fact, large public multinationals are subject to extremely rigorous accounting and financial reporting requirements. They are simply capitalizing on a structural advantage permitted by the existing tax system. The bottom line result, however, is perverse. Capital will flow away from domestic businesses (where after-tax returns are lower) towards multinational businesses (where after-tax returns are higher).
As noted, Bill Parks's recent article offers a set of principles to guide corporate tax reform. I've been noodling on Big Reform ideas lately, and Bill nails one of them on the head:
The proposal has an intuitive appeal based on its simplicity. It would eliminate our reliance on transfer pricing rules to define and protect the U.S. tax base. Less is more when it comes to transfer pricing: the existing rules are porous, ineffective and impose daunting costs on taxpayers and the IRS.
Let's revisit my example in light of Bill's proposal. ToolCo (the mid-size, purely U.S. business) would be a winner. By broadening the base and lowering rates, domestic manufacturers and service providers (like ToolCo) will have increasingly competitive cost structures. BigTool (the large, multinational business) could be a winner or a loser, depending on its mix of U.S. and foreign sales. If, say, 80% of its sales were made in the United States, it would pay more U.S. tax. On balance, it seems likely that Bill's idea would result in a fairer tax distribution between domestic and foreign businesses. In other words, multinationals would pay more tax under Bill's proposal, because income would no longer flush down the cracks of a leaky transfer pricing system.
Bill's article provides a reminder about tax reform. Reform should be guided by fairness and simplicity. Policymakers should weigh both virtues when designing an improved tax system. Incremental reforms that add complexity are probably worse than no reform at all.
On August 15, Bill Parks offered a set of principles to guide corporate tax reform (For Corporate Taxes: Lower Rates, Raise Revenues, 132 Tax Notes 745).
Our tax system is broken, and the best way forward would be a Big Reform which substantially changes existing tax rules and regulations. In the United States, the taxation of business income has become increasingly skewed between multinational "princes" and domestic "paupers." What do I mean by "princes" and "paupers"? Let's examine two hypothetical businesses.
Assume that ToolCo manufactures specialized parts and equipment for U.S. industrial clients. The business is medium-sized (less than 500 employees), located in the Midwest, and generates solid but unspectacular profits for its owners. ToolCo uses state-of-art engineering software, including some applications (intellectual property) designed by its resourceful technology group, in the manufacturing process. Because ToolCo is a domestic business with domestic IP development, manufacturing and sales, ToolCo's effective tax rate for a multi-year period is consistently in the range of 40%.
Compare ToolCo to BigTool Inc. Like its smaller competitor, BigTool manufactures specialized parts and equipment. However, BigTool is a U.S. based multinational, with thousands of employees located in the U.S. and foreign countries. Through transfer pricing and cost sharing arrangements, BigTool shifts much of the intellectual property for its operations to low-tax foreign jurisdictions. Consequently, BigTool pays the U.S. tax rate (40%) on a relatively small proportion of its worldwide profit. Its global effective tax rate for a multi-year period is consistently in the range of 20%.
In my simple examples, BigTool is the multinational "prince," and ToolCo is the domestic "pauper." The U.S. tax system imposes higher costs on purely domestic businesses, compared to multinational business that can develop intangibles offshore and use transfer pricing to shift income to low-tax jurisdictions.
I am not alleging that U.S.-based multinationals are "avoiding" tax or engaging in otherwise unscrupulous behavior. In fact, large public multinationals are subject to extremely rigorous accounting and financial reporting requirements. They are simply capitalizing on a structural advantage permitted by the existing tax system. The bottom line result, however, is perverse. Capital will flow away from domestic businesses (where after-tax returns are lower) towards multinational businesses (where after-tax returns are higher).
As noted, Bill Parks's recent article offers a set of principles to guide corporate tax reform. I've been noodling on Big Reform ideas lately, and Bill nails one of them on the head:
I propose that we assess corporate taxes on the same percentage of worldwide profits as domestic sales contribute to worldwide sales... Any anomalies will be a small price to pay for fairness and consistency. It eliminates the tendency to manipulate many factors to show most or all profits outside the United States. Calculating this percentage would require firms to report revenues and expenses to the IRS using [International Financial Reporting Standards or "IFRS"].In other words, scrap existing book-tax differences and key taxable income off book income (in Bill's article, book income reported under IFRS principles). Then, allocate book income between the U.S. and foreign jurisdictions based on a percentage of sales in the respective jurisdictions (again, as reported under IFRS principles). Bill's theory is that the allocation proposal would generate more tax revenue than the existing international tax rules. He would use the additional revenue to lower corporate income tax rates.
The proposal has an intuitive appeal based on its simplicity. It would eliminate our reliance on transfer pricing rules to define and protect the U.S. tax base. Less is more when it comes to transfer pricing: the existing rules are porous, ineffective and impose daunting costs on taxpayers and the IRS.
Let's revisit my example in light of Bill's proposal. ToolCo (the mid-size, purely U.S. business) would be a winner. By broadening the base and lowering rates, domestic manufacturers and service providers (like ToolCo) will have increasingly competitive cost structures. BigTool (the large, multinational business) could be a winner or a loser, depending on its mix of U.S. and foreign sales. If, say, 80% of its sales were made in the United States, it would pay more U.S. tax. On balance, it seems likely that Bill's idea would result in a fairer tax distribution between domestic and foreign businesses. In other words, multinationals would pay more tax under Bill's proposal, because income would no longer flush down the cracks of a leaky transfer pricing system.
Bill's article provides a reminder about tax reform. Reform should be guided by fairness and simplicity. Policymakers should weigh both virtues when designing an improved tax system. Incremental reforms that add complexity are probably worse than no reform at all.
