Brookings: Topics - Corporate Taxes

Corporate Tax Reform Without Tears

Robert C. Pozen — Sun, 31 Mar 2013 00:00:00 -0400

Economists have long recognized the damaging effects of the high U.S. corporate tax—at 35%, the rate is the highest in the industrialized world. Over the past few years, politicians in both parties have come to understand that the corporate tax system itself is dysfunctional, causing resources to be misallocated and encouraging corporations to invest overseas.

In February 2012, President Obama proposed a substantial reduction in the corporate tax rate to 28% from 35%. This year, the president has spoken positively about corporate tax reform if it is revenue-neutral, meaning the rate cut should be paid for by broadening the corporate tax base.

This is progress toward a bipartisan solution. Lowering tax rates and broadening the tax base is a central tenet of conservative economic philosophy. High tax rates distort decisions on the margin, as do many specific deductions, exclusions and deferrals. Lower tax rates and a broader base allow the market to allocate resources with less interference from the government.

But what is the best way to meaningfully broaden the corporate tax base? Eliminating tax credits to specific industries, such as green energy, is a good place to start. Unfortunately, repealing these provisions wouldn't raise enough revenue to make a significant dent in the corporate tax rate. Larger corporate tax expenditures, such as the research and development credit, have strong political support on both sides of the aisle.

Congress could also raise revenue by requiring U.S. corporations to immediately pay tax on all of their foreign profits. Currently, corporations may defer taxation on their foreign profits until they bring them back into the U.S. However, almost all Republicans would prefer for the U.S. tax system to move in the other direction: taxing only those profits earned in the U.S. (with some exceptions to prevent such abuses as shifting profits abroad to take advantage of lower rates).

Given the importance of reducing the corporate rate—and the infeasability of the other options for paying for it—Rep. Kenny Marchant (R., Texas) and Rep. Jim McDermott (D., Wash.) are floating a proposal to modestly restrict the deductibility of gross interest expense for corporations. This change would meet two crucial criteria: It would raise a significant amount of revenue and significantly reduce economic distortions caused by the tax code.

Based on Internal Revenue Service data from 2000 to 2009 (the most recent available), I estimate that disallowing roughly 30% of interest deductions (that is, allowing for a 70% deduction for gross interest expense) would have fully paid for a reduction in the corporate tax rate to 25% from 35%.

Limiting interest deductions for corporations would also correct, to a degree, a serious imbalance. When a corporation finances an investment by issuing debt, the interest payments generate a stream of tax deductions. When a corporation finances an investment by using its cash on hand or by issuing new shares of stock, there are no analogous tax deductions.

Because of this difference, many corporations choose to maintain a debt-intensive capital structure—primarily for tax reasons instead of underlying economics. As a result, the economy will tend to be overly leveraged relative to a true free market. This makes corporations overly at risk of going bankrupt, increasing the fragility of the economy.

Some corporate officials have criticized such a limit on interest deductions based on the fear that it would increase their tax burden. This is false, on average, since the proposal would be structured to be revenue neutral.

Here's a simple example. Consider a corporation with taxable income of $100 million, calculated after deducting interest expense of $90 million. Currently, it would pay $35 million in corporate tax—35% of its $100 million taxable income. If interest deductions were capped at 70%, $27 million of interest expense would become nondeductible, increasing the corporation's taxable income to $127 million from $100 million. At a 25% tax rate, it would pay $31.75 million in corporate tax—slightly lower than under current law. In other words, because the proposal would be revenue-neutral, some corporations will pay a little more and others a little less.

A more legitimate concern is how existing debt would be treated under this proposal. Corporate executives have made financing decisions based on good-faith beliefs about the tax law going forward, so it might be unfair to deny a full deduction for interest payments on existing debt. Any restrictions to interest deductions should be phased in very slowly and should not apply to debt issued before some relevant date.

Congress need not finance the entire rate reduction by restricting interest deductions. For instance, Congress could cap interest deductions at a higher level—say, 80%—and finance the rest by limiting other deductions and credits now available to corporations.

But there's a particularly strong case in favor of restricting interest deductions: It could raise significant amounts of revenue while at the same time reducing economic distortions. This proposed change should be the core of any revenue-neutral legislation to reduce the corporate tax rate to 25% from 35%.

Authors

Robert C. Pozen

Publication: Wall Street Journal

U.S. Tax Reform: Reducing the Tax Code’s Bias for Debt

Robert C. Pozen — Mon, 18 Feb 2013 00:00:00 -0500

To begin with, let me summarize the specifics of my proposal, which I detailed in Tax Notes. My proposal would reduce the U.S. corporate tax rate from 35% to 25%. I would finance such a rate reduction by limiting deductions for the gross interest expense of corporations (I call this provision the “interest cap”). Non-financial corporations would be allowed to deduct 65% of their gross interest expense, while financial corporations would be allowed to deduct 79% of their gross interest expense. There would also be special rules for corporations that would have reported a loss for tax purposes, but for these restrictions on interest deductions.

My piece in Tax Notes was not intended to set a specific proposal in stone, but rather to illustrate the general strategy: reducing the corporate tax rate while limiting interest deductions. I believe that such a combination would reduce the tax code’s bias in favor of debt, while making the U.S. a more attractive location for discrete, profitable investment projects.

With that said, let me address the main objections to my proposal.

Winners and losers

The most common objection to my proposal is that it would create winners and losers. While that objection is true, it is true because my proposal would substantially correct a significant distortion within the tax code in favor of debt finance. As a result, some corporations that are taking advantage of this bias in the tax code might see a higher tax burden under my proposal.

However, any revenue-neutral tax reform is mathematically guaranteed to create winners and losers. So, in my view, the primary criterion for evaluating a tax reform proposal should be whether it would reduce economic distortions.

I believe that my proposal would meet this criterion by moving the tax code closer to a neutral position between debt- and equity-finance. Under my proposal, corporations would no longer issue debt mainly because interest payments are deductible and returns to equity (dividends or share appreciation) are not. This means that corporations would make financing decisions for economic reasons rather than tax reasons—leading to a more efficient allocation of resources.

Transition relief

Other commentators in the International Tax Review article objected to the idea of applying the interest cap to pre-existing debt. I share this concern: corporations have made decisions about issuing debt based on good faith beliefs that the current treatment would continue.

I had been hesitant to allow for a broad grandfathering of existing debt. If the tax reform legislation allowed such grandfathering—effective on the enactment of the legislation—then corporations could rush to issue long-maturity debt shortly before the enactment of the legislation. In my piece, I proposed instead a 10-year, linear phase-in of rate reductions and restrictions to interest deductions.

However, I would accept an alternative approach: grandfathering existing debt effective as of January 1 of the year in which the legislation was first introduced (rather than at the date of enactment). That could substantially reduce any rush to issue debt shortly before the enactment of the legislation. The corporate tax rate could then be gradually reduced in a revenue-neutral manner.

Net interest versus gross interest

Observers frequently argue that my interest cap should apply solely to net interest expense, rather than gross interest expense. I disagree for two reasons.

First, applying the interest cap to net interest expense would raise only a small amount of revenue—enough to finance a reduction in the corporate tax rate by about 1.5 percentage points, based on estimates by the Congressional Research Service. As a result, the U.S. corporate tax rate could not be reduced to a level competitive with most industrialized countries.

Second, restricting net interest deductions would (by itself) increase effective marginal tax rates (EMTRs) on debt-financed investment to nearly the same extent as restricting gross interest deductions (though average tax rates on debt-financed investment would be substantially different).

Consider a hypothetical non-financial corporation that has $300 million in gross interest income and $500 million in gross interest expense. Imagine it is considering a marginal investment that would cause it to incur an additional dollar in interest expense. Under my proposal, that corporation could deduct 65 cents of that additional dollar. If I instead applied the restrictions to net interest expense, that corporation could still deduct 65 cents of that additional dollar. This corporation’s incentives—on the margin—essentially do not depend on whether the interest cap applies to net or gross interest expense.

Yet, as mentioned above, applying the interest cap to gross interest raises much more revenue, and thus can finance a much more significant reduction in the corporate tax rate. The reduced corporate tax rate mitigates the increase of EMTR on debt-financed investment and sharply reduces the EMTR on equity-financed investment. According to the model developed by the Congressional Budget Office, the average EMTR facing non-financial corporations would be roughly unchanged under my proposal.

By contrast, applying the interest cap to net interest expense could not finance a reduction in the corporate tax rate sufficient to offset the increase in EMTR associated with the interest cap. Thus, financing a corporate tax rate reduction by restricting net interest expense would cause the average EMTR facing corporate investment to increase.

Alternative approaches

Lastly, some commentators argue that we should reduce the distortions to financing decisions by cutting shareholder-level taxes on dividends and capital gains, rather than imposing an interest cap. While there are many good reasons to support lower dividend and capital gains taxes, such tax relief would in fact work against the goal of raising revenue to reduce the corporate tax rate. If corporate executives wish to reduce shareholder-level taxation, then they must put forward specific revenue or spending proposals to offset the revenue loss.

In fact, though most corporate executives want a 25% corporate tax rate, they have not been willing to eliminate or restrict the large tax preferences built into the tax code—such as the deduction for domestic production activities and the research and development credit. The items usually identified for repeal—such as accelerated depreciation for corporate jets or credits for green energy—are too small to finance any meaningful reduction of the corporate tax rate.

In these times of tight budgets, any proposal for tax reform must be at least revenue-neutral. And while I support “comprehensive” tax reform, this seems to be a long-shot.

A continuing process

I want to thank International Tax Review for giving me the opportunity to respond to the earlier article. But it is equally important to thank all those who commented on my proposal for that article. The thoughtful comments will help me refine the proposal—both to bolster the U.S.’s global competitiveness and to reduce the distortive effects of the tax code.

Authors

Robert C. Pozen

Publication: International Tax Review

Image Source: © Jessica Rinaldi / Reuters

A Win-Win: Compromise on Foreign Profits

Robert C. Pozen — Thu, 07 Feb 2013 00:00:00 -0500

In last year’s State of the Union, President Obama argued in favor of reforming how the U.S. taxes the foreign profits of U.S. corporations: “From now on, every multinational company should have to pay a basic minimum tax.” While an international minimum tax is a sound idea, it should be part of a broader effort to fix our dysfunctional system for taxing foreign profits.

Currently, foreign profits of U.S. corporations are subject to a Hobson’s choice. Such profits are subject to a 35 percent tax rate if repatriated to the U.S. parent company. But if a corporation keeps that money permanently outside of the U.S., it typically owes no U.S. tax on those profits.

This bifurcated tax treatment leads to two related economic problems. First, corporations can reduce their tax burden by artificially shifting their profits from the U.S. to a tax haven, such as Bermuda or the Cayman Islands. Because highly mobile intellectual property (such as patents, brand names, and the like) has become an increasingly important driver of corporate profits, corporations have been able to shift more and more of their profits to tax havens. In 2008, U.S. corporations reported profits in Bermuda over 1000% of that island’s GDP.

Second, U.S. corporations have a huge disincentive to bring any profits earned in a foreign country back to the U.S. If a corporation did repatriate those profits, it would owe the difference between the 35 percent U.S. corporate tax rate and the local corporate tax rate. As a result, trillions of dollars in cash is currently being held by overseas affiliates of U.S. corporations—cash that cannot be invested in the U.S. by the parent company.

An international minimum tax, as President Obama has proposed, is a smart way to reduce profit-shifting—the first problem. Such a minimum tax should allow a credit for foreign taxes paid (as allowed under the current system); if the minimum tax were 17 percent and the local tax rate were 5 percent, the U.S. would impose an immediate tax equal to the difference between the two rates (12 percent in this case).

However, the international minimum tax would not address the second problem of today’s system: the incentive for U.S. corporations to keep their cash in the hands of their foreign affiliates. The U.S. could fix this second problem if it taxed foreign profits at 35 percent regardless of whether they were repatriated. But such a “worldwide system” of taxation would put U.S. corporations at a significant disadvantage to their foreign competitors. For instance, McDonald’s would face a 35 percent tax rate on the profits they earn in their restaurants in the United Kingdom, while a U.K.-based competitor (say, Harry Ramsden’s) would pay the U.K. rate of 24 percent.

Most jurisdictions take the opposite approach, taxing only those profits earned within their borders (with limited modifications to try to prevent egregious forms of profit-shifting). This system, known as the “territorial system” of taxation, is also the proposed solution of the GOP. If Congress enacted a territorial system, it would essentially remove the tax-related barriers blocking corporations from using foreign profits to invest in the United States. However, it would also strongly encourage the transfer of corporate profits to tax havens—especially income attributable to intellectual property or mobile investments.

Fortunately, there is a sensible compromise in the offing: policymakers could combine President Obama’s proposed international minimum tax with the GOP’s proposed territorial system. Here’s how this combination could work:

First, there would be an international minimum tax rate equal to, say, 17 percent. If a corporation paid less than 17 percent to a foreign government, it would immediately owe the difference to the U.S.—reducing the incentive to artificially shift profits to tax havens.

Second, if a corporation paid more than 17 percent in taxes to a foreign country, it would be allowed to repatriate that income freely to the United States and owe no (or minimal) taxes. This would substantially reduce the incentive to keep cash in the hands of overseas affiliates.

By imposing an international minimum tax, this combination would ensure that all corporate profits were taxed at some reasonable rate by some government. And by allowing corporations to easily repatriate profits earned in most foreign countries, this combination would strengthen the competitive position of multinational corporations based in the United States. President Obama proposed the first half of this combination in last year’s State of the Union; I hope he finishes the job in this year’s speech.

Authors

Robert C. Pozen

Image Source: © Darley Shen / Reuters

35 Percent Is Way Too High For Corporate Taxes

Robert C. Pozen — Tue, 29 Jan 2013 10:53:00 -0500

If there's one policy agreement between Republicans and Democrats, it's that the 35% corporate tax rate in the United States should be reduced to 28% or 25%. The current rate, highest in the advanced industrial world, disincentivizes investment and encourages corporations to relocate overseas.

Unfortunately, the deficit is a major hurdle facing any proposal to reduce the corporate tax rate. Because of the fiscal pressures facing the government, most politicians recognize that any corporate tax rate cut must be paid for by eliminating tax preferences and "loopholes." But few politicians have identified enough revenue-raising measures to offset the cost of a significant reduction of the corporate tax rate-cutting the rate from 35% to 25% would cost roughly $1.2 trillion over ten years.

I believe that there is a sensible answer: a modest limit to the deductions that corporations claim for the interest they pay on their bonds and other debt.

Admittedly, interest deductions probably won't be the first target for politicians. Most likely, politicians will first take a close look at the myriad of provisions designed to benefit specific industries. For instance, the fiscal cliff deal extended tax benefits for car racing facilities, railroads, mining companies, and various alternative energy companies. Indeed, many of these preferences have highly suspect economic justifications; unfortunately, these special deals are too small for their repeal to raise a significant amount of revenue.

Politicians might then turn to some of the larger tax preferences that corporations enjoy, collectively known as "tax expenditures." However, they will likely find it unwise, or politically infeasible, to repeal any of these large tax expenditures, such as accelerated depreciation or the research and development credit. Most Democrats and Republicans view these policies as being essential to economic growth. In any case, the bipartisan Joint Committee on Taxation has estimated that the elimination of virtually all corporate tax expenditures would not be sufficient to reduce the corporate tax rate to 25%.

Another approach would be to change how the U.S. taxes the foreign profits of U.S. corporations. Currently, U.S. corporations can avoid paying U.S. tax on foreign profits so long as they keep those profits overseas. Congress could raise a significant amount of revenue if it required U.S. corporations to immediately pay U.S. taxes on their foreign profits-beyond the foreign taxes that they already pay. However, this change would make our corporate tax system even more out of step with the rest of the world; most foreign countries require corporations to pay tax only on profits that were earned in that country (with exceptions designed to prevent abusive tax-shifting).

Thus, if policymakers are serious about reducing the corporate tax rate, they will need to consider other revenue-raising measures. To merit serious consideration, such reforms should offer the potential for meaningful new revenue, and they should also make sense from a policy standpoint.

My proposed limits to interest deductions (which I call the "interest cap") would meet both criteria. Currently, corporations may fully deduct the interest they pay on their bonds and other forms of debt. This deduction costs the Treasury a significant amount of money, and encourages corporations to take on too much debt, increasing the fragility of the economy.

Using data from 2000 to 2009 (the most recent available), I estimate that a 65% cap on deductions for gross interest would have paid for a reduction in the corporate tax rate from 35% to 25% over those ten years. In other words, corporations would be able to deduct 65% of their gross interest expense, rather than 100%; from 2000 to 2009, this modest restriction would have been enough to finance the entire rate reduction to 25%.

My proposed "interest cap" would also reduce a significant distortion in the tax code. Currently, if a corporation finances an investment with debt, it can deduct the interest that it pays on that debt. If a corporation finances an investment by issuing new shares of stock, or by using money in the bank, there is no equivalent deduction. As a result, the tax code effectively encourages corporations to load up on debt. This makes companies more vulnerable to downturns-exposing their employees to a greater risk of layoffs and prolonging recessions in the broader economy.

I acknowledge that the treatment of financial institutions under my proposal is a tricky issue. Financial institutions typically borrow significant amounts of money in their daily operations. On the one hand, a vibrant financial sector is a critical component of a healthy, growing economy, and the "interest cap" could constrain these daily operations. On the other hand, excess debt within the financial sector can be especially damaging, as it has the potential to increase the severity of financial crises.

To balance these competing demands, my proposal would apply the interest cap to financial institutions, but at a lower rate. They would be allowed to deduct 79% of their interest expense-less than the 100% that they may deduct currently, but more than the 65% that nonfinancial corporations could deduct.

Undoubtedly, certain debt-intensive industries will lobby against my proposed cap on interest deductions. But policymakers should resist such pressure: any revenue-neutral tax reform must necessarily create winners and losers. Instead, policymakers should focus on setting the stage for broad-based economic growth by reducing the distortions in favor of debt-finance, and by bringing our corporate tax rate in line with the rest of the world.

Authors

Robert C. Pozen

Publication: Real Clear Markets

Image Source: © Robert Galbraith / Reuters

How to Slash the U.S. Corporate Tax Rate

Robert C. Pozen — Sun, 20 Jan 2013 11:47:00 -0500

Both Republicans and Democrats agree that the 35 per cent corporate tax rate in the US is too high. Yet discussions over the corporate tax fizzled out during the recent fiscal cliff negotiations, partially because of the budgetary maths. Neither party has identified enough revenue increases to offset the $1.2tn cost over 10 years of lowering the corporate tax rate to a more reasonable 25 per cent.

We would like to offer a proposal: limiting the tax deductions for the interest that corporations pay on their bonds and other debt they issue. This change alone could raise the required revenue for a 10 percentage point reduction in the corporate tax rate. And this change would also improve the allocation of capital and deter excessive leverage.

Although there are three alternative approaches to financing a corporate rate deduction, none of them are large enough or politically feasible.

Read the full op-ed at FT.com »

Authors

Robert C. Pozen

Publication: Financial Times

Image Source: © Brendan McDermid / Reuters

What’s the Answer for Corporate Taxes?

Robert C. Pozen — Tue, 23 Oct 2012 10:37:00 -0400

President Obama and Governor Romney may have their differences on tax policy, but both candidates agree that the United States needs to cut its corporate tax rate. Including federal, state, and local taxes, corporate profits are currently taxed at 39.1 percent, the highest rate in the industrial world. This high corporate tax rate distorts investment decisions and encourages corporations to relocate overseas.

However, given the federal government's large deficits, any reductions in corporate tax rates should be paid for by broadening the tax base. In February, President Obama released a corporate tax reform framework that endeavored to do just that. Although Governor Romney is less specific, he has suggested a willingness to broaden the corporate tax base to pay for rate reduction.

An Imperfect Solution

Unfortunately, revenue-neutral corporate tax reform will prove very difficult for either candidate. Oft-mentioned tax breaks, such as those favoring hedge fund managers or green energy firms, are simply too small for their repeal to have a substantial effect on tax revenues. And both President Obama and Governor Romney have called for the expansion of other, larger corporate tax breaks, such as the credit for increasing spending on research and development. Thus, if either candidate wants to reduce the corporate tax rate, he will likely have to search for other revenue-raising measures.

One particular reform should get a close look: limiting the deductibility of corporate interest expense. Such a reform could raise a large amount of revenue and would improve economic efficiency by treating different investments more equally. President Obama has suggested this approach be "considered," as has Congressman Dave Camp (R-MI), the Chairman of the House Committee on Ways & Means.

Significant New Revenue

According to the IRS, corporations with net income paid $2.1 trillion in corporate tax between 2000 and 2009 (the most recent years with available data). During this same period, these corporations claimed over $8.5 trillion in gross interest deductions—at a 35 percent tax rate, those deductions were worth almost $3 trillion.

Based on an analysis of data like these, I calculate that the corporate tax rate could have been reduced from 35 to 25 percent from 2000 to 2009, financed solely by disallowing roughly 30 percent of gross interest deductions. In other words, corporations would have been able to deduct nearly 70 percent of their gross interest expense, instead of 100 percent as under current law. The revenue raised from this limitation (at a 25 percent tax rate) would have been roughly equal to the revenue loss resulting from the rate cut.

Of course, this simple estimate misses some key factors. First, interest rates and corporate leverage will likely be lower over the next 10 years than over the past 10 years, reducing the value of interest deductions. Second, such a reform would need to give special treatment to the financial sector, which would face a large burden under this proposal. Nevertheless, this back-of-the-envelope calculation shows that limiting the deductibility of corporate interest expense could play a large role in rate-reducing corporate tax reform.

Reducing the Bias Toward Debt

Disallowing a modest portion of the interest deduction would also improve economic efficiency by reducing the tax code's large bias toward debt-financed investment. Currently, corporations can deduct the returns to a debt-financed investment (interest expense), but not the returns to an equity-financed investment (dividends or stock appreciation). This differential treatment leads some corporate managers to make financing and investment decisions for tax reasons, instead of economics.

Even worse, when a corporation takes on too much debt, it increases its risk of bankruptcy—an event which imposes significant costs on the corporation's employees, customers, and suppliers. Because these costs affect external parties, corporate managers won't be sufficiently motivated to take these costs into account when deciding how much debt to take on. Thus, these managers are likely to choose a level of debt that is too high from the standpoint of society as a whole.

Banks will argue that limits on interest deductions should not apply to them because borrowing money is the "raw material" in the lending process. However, as recent history has demonstrated, the demise of one large bank can trigger a cycle of panic, fire sales, and more bank failures. So, while the financial sector should be given special treatment under this type of reform, it should not be exempted entirely.

In short, the U.S. urgently needs a reduction in the corporate tax rate implemented on a revenue neutral basis. As part of the tax package to achieve this goal, Congress should include some limits on the deductibility of corporate interest expense. Such a limitation would raise enough revenue to allow a substantial reduction in the corporate tax rate, increasing the global competitiveness of the U.S. Such a limit would also reduce the tax bias in favor of debt by decreasing the effective tax rate on equity—without raising the average cost of capital in the U.S.

Authors

Robert C. Pozen

Publication: Yahoo! Finance

Image Source: © Jim Young / Reuters

A Recipe for Cutting Corporate Taxes

Robert C. Pozen — Thu, 04 Oct 2012 00:00:00 -0400

Amid all the division on Capitol Hill, both parties generally agree that the corporate tax rate, which at 35 percent is among the highest in the world, needs to be cut. During Wednesday’s presidential debate, both candidates advocated a significant reduction in the corporate tax rate.

Yet the federal budget’s unsustainable fiscal path should preclude a large unfunded tax cut. Given these competing demands, policymakers have been searching for revenue-neutral reforms that reduce the corporate tax rate and broaden the corporate tax base.

Few politicians have offered sufficient details about how they would pay for a reduction in the corporate tax rate. Politically vulnerable tax breaks, such as special treatment of corporate jets and “green” energy, are small relative to total corporate tax receipts. And large tax breaks, such as those for research and development, are considered essential to economic growth.

So if Congress wants to finance a meaningful reduction of the corporate tax rate, it will need to find other base-broadening measures that meet two criteria: a solid policy rationale, and the potential for significant new revenue. Fortunately, there is a base-broadening reform that fits both: limiting corporate interest deductions. Democrats, including President Obama, and Republicans, including House Ways and Means Committee Chairman Dave Camp (R-Mich.), have suggested that Congress seriously consider such an approach.

Currently, when a corporation pays interest, it may deduct that interest on its tax return. By contrast, a corporation may not deduct its dividend payments to shareholders. This bias distorts the financing decisions of corporate managers, who might choose, solely for tax reasons, to finance a certain project with debt instead of equity. This bias also distorts investment decisions in favor of easily collateralized equipment suitable for debt finance, at the expense of investments better suited for equity finance, such as capital-raising by small business.

The tax code’s bias for debt is even more worrying, because excess leverage often imposes costs on external parties other than the debt issuer. For instance, a highly indebted company is more likely to go bankrupt, which can seriously harm its employees, customers and suppliers. Companies are unlikely to fully consider those external costs when deciding how much debt to take on.

Furthermore, reforming the treatment of interest expenses can raise a large amount of revenue and thus pay for a significant reduction of the corporate tax rate. In 2007, corporations with net income paid $294 billion in corporate taxes and claimed $1.37 trillion in gross interest deductions, according to the Internal Revenue Service.

I estimate that from 2000 to 2009 — the most recent years with relevant data — a reduction of the corporate tax rate from 35 percent to 25 percent could have been financed solely by disallowing the deductibility of roughly 30 percent of corporations’ gross interest expenses — that is, by allowing corporations to deduct only 70 percent of their gross interest expenses, rather than 100 percent, as they can now. Although this would increase the effective tax rate on debt-financed investment, the overall cost of capital would remain roughly the same because equity returns would be taxed at 25 percent instead of 35 percent.

Looking forward, our revenue estimates would have to take into account the lower interest rates and lower corporate leverage expected over the next decade. Also, debt issued by the financial sector is likely to need special treatment, because the profits of a financial institution depend largely on the spread between the interest rates at which they borrow and the rates at which they lend.

That is not to say that the financial sector should be exempt from this reform. Excess leverage increases the odds that a financial institution can fail. And as the 2008 financial crisis vividly demonstrated, the failure of one financial firm can damage other firms, governmental entities and the economy as a whole. While regulators are trying to adopt measures to make the financial system more stable, tax subsidies for leverage in the financial sector have the opposite effect.

In short, modifications to the treatment of corporate interest expense should be a key component of bipartisan corporate tax reform. Such a restriction could finance a significant reduction in the corporate tax rate and greatly reduce the tax code’s implicit subsidy to debt-financed investment. This would make the United States a more competitive place to do business, reduce distortions in corporate decision-making and help foster a more stable financial system.

Authors

Robert C. Pozen

Publication: Washington Post

Image Source: © Brendan McDermid / Reuters

Pension ‘Savings’ in Transportation Bill May Be Costly

Robert C. Pozen — Thu, 02 Aug 2012 00:00:00 -0400

The transportation bill that Congress passed this summer is financed, in part, with a budget gimmick: Lawmakers changed the funding rules for corporate pension plans. These changes help the federal budget in the short term by reducing the tax deductions that corporations take for contributing to these plans — thereby reportedly increasing their taxable income.

These changes, however, encourage companies to contribute less to pensions, which raises the long-term risk that a governmental insurer will need to step in to pay benefits. Under the new funding rules, the required pension contributions for public U.S. companies could drop in one year from $58 billion to approximately $33 billion, says accounting expert Chris Senyek.

To understand these accounting changes, consider how corporate pension plans calculate their future obligations to plan beneficiaries. Actuaries begin by projecting the number of current and future employees and their life expectancy to estimate a total plan obligation. The actuaries then reduce this total by applying a “discount rate,” which should represent the risk-free return that plans could be certain of earning on their investments.

The lower the discount rate, the higher the estimated pension obligation. And if the plan has a gap between this amount and its current assets, the company must make up the difference through regular contributions.

The discount rate, then, is an important factor to businesses. Under the old funding rules, companies used a discount rate based on the interest rate for high-quality bonds, averaged over the past two years. Under the new rules, companies may use an alternative discount rate, based on the interest rate for the same bonds but averaged over the past 25 years. Because interest rates today are near historic lows, this new alternative discount rate is likely to be at least 1 percentage point higher than the prior discount rate and, therefore, to lead to much lower required contributions by companies with underfunded pension plans.

Estimates by David Zion of Credit Suisse show that a 1 percentage-point increase in the discount rate would require Lockheed Martin to contribute $1.4 billion to its pension fund in 2013, instead of $2.4 billion under the old rules. According to the same estimates, UPS’s required contributions would drop to $47 million in 2013, compared with $1.6 billion under the old rules.

Unfortunately, these substantial “savings” to companies pose a substantial risk to the Pension Benefit Guaranty Corp. (PBGC), the federal agency that guarantees up to $56,000 per year in benefits for each pension participant. The PBGC would assume the obligations of a pension plan if participating companies filed for bankruptcy or their plans otherwise became insolvent.

These companies pay annual premiums to the PBGC, but what is paid in is insufficient to finance the agency’s ongoing obligations. In 2011, it reported a deficit of $26 billion. Although the new legislation would also increase corporate premiums paid to the PBGC by $9.6 billion over the next decade, this increase would be grossly inadequate to pay for the agency’s overall exposure to risk from underfunded pension plans.

Some argue that the “artificially” low interest rates engineered by the Federal Reserve in the past two years do not accurately reflect expected risk-free returns over the long term. While there is some validity to these arguments, using the 25-year average is similarly unrealistic, since it includes the high interest rates of the early 1980s that were “artificially” engineered by then-Federal Reserve Chairman Paul Volcker.

Fortunately, this reform effectively phases out in a few years. By 2016, the alternative discount rate is scheduled to drop to 70 percent of the 25-year average rate (down from 90 percent in 2012). Moreover, the high rates of the late 1980s will fall out of the 25-year average by 2016, further reducing that alternative discount rate. Since lower discount rates result in larger calculated funding gaps, the supposed “pension relief” produced by this legislation will quickly disappear.

The transportation legislation is, in short, another example of Congress kicking the can down the road. The esoteric changes in funding rules will not actually improve the financial condition of corporate pension plans; instead, the new rules will allow companies with deeply underfunded plans to avoid the day of reckoning when they must deliver on their promises to plan beneficiaries.

Authors

Robert C. Pozen

Publication: The Washington Post

Image Source: Joshua Lott / Reuters

Whose Capital; What Gains?: Why the U.S. Economy Needs to Change Incentives

Lawrence E. Mitchell — Tue, 10 Jul 2012 00:00:00 -0400

If we fail to change the incentive structures of American management and financial markets, our nation’s long-term economic well-being and, with it, our national security, will suffer, writes Lawrence Mitchell. The crisis was decades, and perhaps more than a century, in the making, and is the result of many different factors that can be found in the historical record.

In this new paper, Mitchell argues that common stock has almost never been a source of permanent capital in American industry. And, he writes, the sources of capital gains has also dramatically shifted from the 1950s, when Merton Miller and Franco Modigliani, developed their famous dividend irrelevance theory, from corporate profits in the form of retained earnings to future profits in the form of velocity-induced trading gains. While both of these propositions may seem counterintuitive, the latter will seem plainly wrong, at least to devotees of efficient market theory. But the empirical correctness of the former proposition underlies the contemporary theoretical weakness of the latter.

The net results are that shareholders, or managers on their behalf, are gambling with debtholders’ money, and that the future profits of American industry are being spent today. Both call into question the sustainability of American industry and the future wealth of the United States.

Mitchell makes a number of recommendations in this paper, incuding:

Build long-term investing into the initial investment decision by developing a sliding scale capital gains tax, with highly punitive taxation for short-term trading, diminishing over time to tax forgiveness for long-term holding.
Include returning to largely insider boards (outside directors tend to manage by stock price) and making appropriate accounting changes to rely more heavily on cash flow than income statement accounting.

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Whose Capital; What Gains?: Why the U.S. Economy Needs to Change Incentives

Authors

Lawrence E. Mitchell

Image Source: © Chip East / Reuters

A Sensible Plan to Bring U.S. Corporate Profits Home

Robert C. Pozen — Wed, 13 Jun 2012 15:23:00 -0400

The current system for taxing the international profits of U.S. corporations is highly flawed. It raises very little revenue and encourages companies not to invest in the United States. But Democrats and Republicans disagree about how to fix the broken system.

Current tax policy penalizes corporations when they reinvest their foreign profits in the United States. Corporations currently pay the 35 percent U.S. tax rate on the profits of their foreign subsidiaries, but they can defer those taxes until they bring those profits back to the United States.

Even though a corporation is eligible for a tax credit equal to foreign taxes paid, the decision to repatriate earnings typically requires that corporation to incur a significant tax cost. As a result, corporations usually find it more attractive to defer U.S. taxation by reinvesting their foreign earnings abroad.

One proposed fix, a temporary tax holiday for repatriated profits, is a bad idea. In 2005, corporations were allowed to repatriate their foreign earnings at a tax rate of 5.25 percent. Corporations did indeed bring home over $300 billion in foreign profits that year, five times as much as normal. But very little of that income was reinvested in the United States to create jobs: a National Bureau of Economic Research study suggested that a majority of that income went to shareholders, mostly in the form of share buybacks.

Even worse, another tax holiday would cause corporations to conclude that Congress would allow further tax holidays in the future. This would likely lead corporations to hold cash abroad and wait to repatriate their income until the next tax holiday comes along.

Many Republicans have called for a more fundamental transition to what's known as a "territorial system" for international taxation. Under such a system, foreign-source income would be taxed only in the country where it was earned, and would not be taxed at all by the United States. This approach would reduce the tax burden on American corporations and eliminate the disincentive for corporations to repatriate their foreign profits.

Arguments in favor of a territorial system are based on the premise that profits should not be taxed twice. However, Democrats point out that certain profit would not be taxed at all under a territorial system.

In particular, corporations can fairly easily shift earnings attributable to intangible sources-patents, brand names, or know-how-to tax havens that collect little or no tax. Under a territorial tax system, the U.S. would never collect taxes on that income either.

Although existing tax laws try to prevent such shifting, they are imperfect at best. An IRS study found that U.S. corporations' subsidiaries in Bermuda reported income in 2004 equal to a whopping 646 percent of Bermuda's GDP. Presumably, most of that profit was actually earned in a higher-tax jurisdiction; U.S. corporate profits are roughly equal to 10 percent of U.S. GDP.

To address the income-shifting problem, President Obama has called for an "international minimum tax." Under his proposal, all income of U.S. corporations must be immediately taxed-by the U.S., or some foreign country - at a rate greater than or equal to the (as yet unspecified) international minimum tax rate. So, if a corporation reported profits in a country that collects no corporate tax, the United States would immediately tax those profits at the international minimum tax rate-greatly reducing the appeal of the tax haven.

Though the territorial tax system and Obama's proposed international minimum tax represent vastly different policy objectives, a combination of the two could result in a plausible, coherent compromise position. Here's how it should work:

First, we should adopt the GOP-favored territorial tax system for profits reported in any country that taxes corporate profits at an average effective rate above some minimum threshold, approximately 15 to 18 percent. With that threshold, U.S. corporations would no longer incur an additional tax burden when repatriating profits from most countries where they legitimately conduct business.

Second, we should adopt President Obama's proposed "international minimum tax," equal to that 15 to 18 percent threshold, to minimize profit shifting. Corporations should still be allowed to claim a credit against any actual foreign taxes paid; if a corporation paid 13 percent in taxes to, say, Switzerland, it should only owe to the U.S. the difference between 13 percent and the international minimum tax rate.

In combination, such a compromise would ensure that all foreign profits of U.S. corporations are taxed consistently at a reasonable rate. If foreign profits were reasonably taxed by a legitimate tax-collecting country, such as France, Brazil, or Japan, they would be taxed only by that country. But if other foreign profits were allocated to a tax haven, they would be taxed, at a reasonable rate, by the United States.

Such a policy would require transition rules. Specifically, we should allow corporations to repatriate any existing profits currently held overseas at a low rate, such as 10 percent-not as a one-off repatriation holiday, but rather a transition to a better, permanent approach. Such a transition is needed because it would be unfair to suddenly impose a 15 to 18 percent tax on what had previously been a perfectly legitimate strategy.

In short, no one likes our current system of taxing the foreign profits of U.S. corporations. However, there is little agreement between Republicans and Democrats on reforming this system. Fortunately, we can achieve both parties' policy priorities by combining their two best ideas: a territorial tax system for legitimate tax-collecting nations, and an international minimum tax rate for those nations which collect little corporate tax. Such a policy would be fairer, raise more revenue, and encourage corporations to invest in the United States.

Authors

Robert C. Pozen

Publication: Real Clear Markets

Image Source: © Christina Hu / Reuters

How to Tax U.S. Companies’ Foreign Profits

Robert C. Pozen — Wed, 22 Feb 2012 00:00:00 -0500

On Wednesday the Obama administration proposed a long-awaited cut in the top rate of U.S. corporate tax from 35 per cent to 28 per cent. But the White House also disclosed something more contentious. The administration is suggesting U.S. companies’ foreign earnings should be subject to a “minimum tax”.

The current system for taxing earnings of foreign subsidiaries controlled by U.S. companies is controversial and counterproductive. Such foreign earnings are theoretically taxed at a 35 per cent rate if brought back to the U.S., but not taxed at all by the U.S. as long as these earnings are kept abroad.

Faced with this choice, U.S. companies are unsurprisingly holding abroad more than $1.5tn in foreign profits. The current tax system thus discourages U.S. companies from using their foreign profits to build facilities in the U.S. or buy American companies. It also generates almost no tax revenues for the U.S. Treasury.

To replace the current system, business lobbyists have suggested the U.S. follow the lead of other industrialized countries by adopting a "territorial" system for taxing foreign profits of domestic corporations. In such a territorial system, the foreign profits of U.S. companies would be taxed only in the country where they were earned, and not by the U.S.

However, none of our major trading partners actually has a pure territorial system for taxing foreign corporate profits. Almost all countries impose domestic taxes on "mobile" corporate income such as investment interest. And many still collect taxes on corporate income earned in tax havens. These tax havens violate the fundamental premise supporting a territorial system - that foreign profits are already effectively taxed where they are earned, so should not be taxed again in the home country.

Mr. Obama's idea could fix this problem by ensuring that all foreign profits of U.S. companies are taxed once at a minimum rate - either by the U.S. or another country. To be workable, this proposal should have three main components.

First, Congress should enact a permanent tax exemption for U.S. corporate profits earned in countries with effective corporate tax rates above a specified minimum. The minimum rate should be no higher than 20 per cent because that is the effective corporate tax rate in most of our major trading partners, according to a 2011 study by the National Bureau of Economic Research.

Second, Congress should levy a minimum tax on U.S. corporate profits in any tax haven to prevent a "race to the bottom" in which countries bid for corporate facilities by offering to minimize corporate taxes. In other words, the U.S. would no longer allow its corporations to defer indefinitely U.S. taxes on any profits allocated to these tax havens.

This general rule should be subject to a major caveat for low-tax jurisdictions where corporations conduct actual operations. A U.S. company should receive a credit against the minimum tax for the taxes it actually paid in such a jurisdiction. For example, if the profits of an Irish subsidiary of a U.S. corporation were taxed at 12.5 per cent in Ireland and the U.S. minimum tax was 20 per cent, these profits would be subject to a U.S. tax of only 7.5 per cent.

Third, Congress should allow all corporate profits earned overseas before 2012 to be repatriated to the U.S. at a low rate, such as 8 per cent, for the next two or three years. This low rate would facilitate the transition to a better permanent system, and would not be part of a one-off tax holiday for repatriated corporate profits. Another tax holiday would merely reinforce the current counterproductive system for deferring U.S. taxes on foreign profits.

Such a transitional rule is needed because corporations reasonably relied on the current system in the past - which allowed U.S. corporations to defer U.S. taxes forever on all their foreign profits as long as they were kept abroad. It would be unfair to impose a minimum tax now on a corporate strategy that was perfectly legitimate for many years.

This three-part proposal would be superior to the current system, which discourages U.S. companies from deploying their foreign profits in the U.S. and raises almost no tax revenues for the U.S. This proposal would raise revenues from U.S. corporate activities in jurisdictions with no or low taxes, while encouraging U.S. corporations to use their foreign profits to build facilities and create jobs in the U.S.

The critical political question that Mr. Obama needs to answer is: what should be the minimum tax rate? Although 20 per cent is the effective corporate tax rate in our major trading partners, business lobbyists might push for a lower rate - such as a 12.5 per cent rate, like in Ireland.

Critics might say even 20 per cent is too low, relative to the newly proposed 28 per cent rate on domestic corporate profits. However, with the effective U.S. tax rate on foreign profits of U.S. corporations currently at zero, there should be clear incentives for even Congress to reach a reasonable compromise.

Authors

Robert C. Pozen

Publication: Financial Times

Image Source: © Crack Palinggi / Reuters

Obama's Proposed Minimum Tax on Foreign Earnings

Robert C. Pozen — Mon, 20 Feb 2012 00:00:00 -0500

In the State of the Union, President Obama suggested that the foreign earnings of U.S. corporations should be subject to a "minimum tax" to prevent corporations from shifting earnings to tax havens. The White House has promised to release the details about the level and operation of such a minimum tax in the next few weeks.

If properly designed, the president's minimum tax could substantially improve the current system of taxing foreign profits of U.S. multinational corporations -- by both raising revenues and encouraging domestic investments.

The current system for taxing earnings of foreign subsidiaries controlled by U.S. corporations is counterproductive. Such foreign earnings are theoretically taxed at a 35% rate if brought back to the U.S., but not taxed at all by the U.S. as long as these earnings are kept abroad.

Faced with this stark choice, U.S. corporations are holding abroad over $1.5 trillion in foreign profits, and this amount is rising rapidly. The current tax system discourages U.S. corporations from using their foreign profits to build facilities in the U.S. or buy American companies. It also generates almost no tax revenues for the U.S. Treasury.

To replace the current system, business lobbyists have suggested that the U.S. follow the lead of other industrialized countries by adopting a "territorial" system for taxing foreign profits of domestic corporations. In such a territorial system, the foreign profits of U.S. corporations would be taxed only in the foreign country where they were earned, and not by the U.S.

However, none of our major trading partners has a pure territorial system for taxing foreign corporate profits -- for two good reasons. Almost all countries impose domestic taxes on "mobile" corporate income, such as investment interest or royalties, because it can be so easily shifted from one country to another.

More importantly, many of our major trading partners collect taxes on corporate income earned in tax havens where companies effectively pay little or no tax. These tax havens violate the fundamental premise supporting a territorial system -- that foreign profits are already effectively taxed where they are earned, so they should not be taxed again in the home country.

The president's proposal would fix this inherent problem in a territorial system by ensuring that all foreign profits of U.S. multinationals are taxed once at a minimum rate -- either by the U.S. or another country. To be workable, this proposal should have three main components.

1. Congress should enact a permanent tax exemption for U.S. corporate profits earned in countries with effective corporate tax rates above a specified minimum. The minimum rate should be no higher than 20% since that is the effective corporate tax rate in most of our major trading partners, according to a 2011 study by the National Bureau of Economic Research.

This general exemption should not apply to mobile income of U.S. corporations, such as investment interest, which should continue to be subject to U.S. taxes as it is currently under the Internal Revenue Code. More broadly, U.S. taxes should be assessed on foreign profits of a U.S. corporation if these profits were artificially transferred through complex transactions to countries exempt from US tax.

2. Congress should levy a minimum tax on U.S. corporate profits in any tax haven to prevent a "race to bottom" -- in which countries bid for corporate facilities by offering to minimize corporate taxes there. In other words, the U.S. would no longer allow its corporations to defer indefinitely U.S. taxes on any profits allocated to these tax havens.

This general rule should be subject to a major caveat for low-tax jurisdictions where corporations conduct actual operations. A U.S. corporation should receive a credit against the minimum tax for the taxes it actually paid in such a jurisdiction. For example, if the profits of an Irish subsidiary of a US corporation were taxed at 12.5% in Ireland and the U.S. minimum tax were 20%, these profits would be subject to a US tax of only 7.5% ( 20% -12.5%= 7.5% ).

3. Congress should allow all corporate profits earned overseas before 2012 to be repatriated to the U.S. at a low rate, such as 8% or 9%, for the next two or three years. This low rate would facilitate the transition to a better permanent system, and would not be part of a one-off tax holiday for repatriated corporate profits. Another tax holiday would merely reinforce the current counterproductive system for deferring U.S. taxes on foreign profits.

Such a transitional rule is needed because corporations reasonably relied on the current system in the past -- which allowed US corporations to defer U.S. taxes forever on all their foreign profits as long as they were kept abroad. It would be unfair to impose a minimum tax now on a corporate strategy that was perfectly legitimate for many years.

This three-part proposal would be clearly superior to the current system, which discourages U.S. multinationals from deploying their foreign profits in the U.S. and raises almost no tax revenues for the U.S. This proposal would raise revenues from U.S. corporate activities in jurisdictions with no or low taxes, while encouraging U.S. corporations to use their foreign profits to build facilities and create jobs in the U.S.

The critical political question is: what should be the minimum tax rate on foreign earnings of US corporations? Although 20% is the effective corporate tax rate in our major trading partners, business lobbyists might push for a lower rate -- such as the 12.5% rate in Ireland.

On the other hand, liberals might object to 20% as too low, relative to the 35% tax rate on domestic corporate profits. However, the effective U.S. tax rate on foreign profits of U.S. corporations is zero, so there should be strong incentives to reach a reasonable compromise.

Authors

Robert C. Pozen

Publication: The Huffington Post

The Myth of Corporate Tax Reform

Robert C. Pozen — Tue, 27 Sep 2011 00:00:00 -0400

House Speaker John Boehner recently joined the chorus of notables calling for corporate tax reform in any deficit-reduction package. Both Democrats and Republicans want to reduce the corporate tax rate from 35 percent to 25 percent, in return for eliminating the tax credits and deductions available primarily to U.S. corporations.

The rationale behind the proposal is sound in theory — a lower tax rate would help all profitable corporations. By contrast, Congress often bestows tax benefits on industries that are perceived as potential winners or those wielding political clout.

In theory, this proposal would also be revenue-neutral. The rate reduction would decrease U.S. tax revenue by approximately $600 billion during the next five years, but this would be offset by the additional tax revenue gained with the elimination of corporate tax “loopholes.”

But the chances of this proposal passing Congress on a revenue-neutral basis are slim. Most of the corporate tax benefits that would need to be repealed have both a significant positive effect on economic growth and deep political support among powerful constituencies. Moreover, repeal would hurt many non-corporate entities, such as local governments and partnerships running operating businesses, that would gain nothing from a lower corporate tax rate.

The biggest portion of tax benefits to be eliminated, more than $200 billion over five years, encourages U.S. companies to expand their activities in the United States — just what we need in these slow economic times. Examples include:

$109 billion for accelerated depreciation that encourages U.S. corporations to buy machinery or equipment.
$62.4 billion for U.S. corporations that locate their manufacturing facilities here, rather than abroad.
$43.4 billion for U.S. corporations that increase their research activities and expense their experiments.

A second large chunk of corporate tax benefits, almost $100 billion over five years, supports the issuance of state and local bonds. Of this total, $73 billion is for the interest exemption on bonds for “public purposes” — which reduces the borrowing costs of cash-strapped states and cities. The rest is for the interest exemption on “special purpose” bonds — used to construct airports, docks and hospitals as well as water and sewage facilities. Such construction generates jobs and lays the foundation for future economic growth.

A third category, worth $54 billion over five years, provides tax benefits to specific industries. Some of these might seem vulnerable because they support industries under political attack, such as oil and gas, coal and other minerals. However, the total value of tax benefits to these industries that focus on extraction is less than $12 billion over five years — a minute portion of the $600 billion needed to finance the proposed reduction in corporate tax rates. Most industry-specific benefits go to less controversial businesses, such as $18 billion for non-taxed earnings by credit unions, mutual savings banks, nonprofit health insurers and other types of cooperatives.

A fourth category of tax benefits, worth about $50 billion over five years, promotes various social causes. The two largest in this category are tax credits for low-income housing ($34 billion) and tax deductions for corporate charitable contributions ($13.4 billion). Both of these tax benefits have a well-developed rationale and a well-organized group of political supporters.

The final category is the most complex — $213 billion for taxes deferred over the next five years on foreign profits of U.S. corporations. Although such corporate profits are officially subject to a 35 percent U.S. tax rate, this tax can be avoided as long as those profits are held by U.S. corporations in foreign bank accounts.

In other words, corporate tax reform can be achieved on a revenue-neutral basis only if Congress decides to raise $213 billion by repealing the current ability of U.S. corporations to defer indefinitely the 35 percent U.S. tax on their foreign profits. Instead, Congress is considering a proposal that would temporarily allow U.S. corporations to repatriate their foreign profits at a tax rate below 6 percent.

Of course, a compromise could be reached by lowering the corporate tax rate to 30 percent and retaining half of the current tax benefits for U.S. corporations. In a recent Grant Thornton survey, however, most corporate executives said that they would be unwilling to give up their tax credits and deductions unless Congress reduced the corporate tax rate to 25 percent or lower.

In short, corporate tax reform on a revenue-neutral basis would be politically unrealistic. Quick action to achieve this end is also likely, without careful management, to have an adverse impact on our fragile economy. Congress should focus its tax reform efforts on other dysfunctional aspects of the U.S. tax system.

Authors

Robert C. Pozen

Publication: Washington Post

Image Source: © Jessica Rinaldi / Reuters

How to Bring Our Companies’ Foreign Profits Back Home

Robert C. Pozen — Mon, 19 Sep 2011 00:00:00 -0400

As Congress starts the next round of debt ceiling negotiations, the United States Chamber of Commerce and other business groups are advocating tax relief for foreign profits of corporations based in the United States. Those profits are now subject to a 35 percent corporate tax rate, but the tax can be totally avoided as long as the United States corporations hold the profits in their accounts at foreign banks.

The current system needs reform: it generates minimal tax revenue while deterring American corporations from using their foreign profits to build facilities in the United States.

Business interests are calling for a so-called tax holiday, in which American corporations would be allowed to transfer their foreign profits to their American bank accounts at a tax rate under 6 percent for one year. Such a holiday would raise revenues and create jobs in the United States, according to the WinAmerica Campaign, a coalition of companies including Apple, Google and Pfizer.

But the last time such a holiday was tried, in 2004, it raised less than $19 billion and did not substantially increase jobs. Most of the repatriated profits went to corporate shareholders, through dividends or stock repurchases.

Instead of a one-off holiday, some corporations — Caterpillar and Kimberly Clark, for example — have called for a permanent fix: a territorial system for taxing foreign corporate profits, as most industrialized countries use. In a pure territorial system, the profits of multinational companies based in the United States would be taxed only by the country in which the profit is earned.

But none of our major trading partners takes a pure territorial approach, for two good reasons. First, almost all countries impose domestic taxes on “mobile” corporate income — for example, investment interest or royalties that can easily be shifted from one country to another. Second, many countries still collect taxes on foreign profits of domestic corporations if those profits are earned in tax havens that collect little or no taxes, like Bermuda and the Cayman Islands. These havens violate the premise of the territorial system, which is that corporate profits are taxed somewhere in the world at a reasonable rate. (The major European powers have been pressing Ireland to raise its 12.5 percent corporate tax rate to a minimum level acceptable to the European Union.)

Congress should use the budget crisis as an opportunity to permanently adopt a modified territorial system for taxing foreign corporate profits. Here is how the system would work.

First, Congress should exempt United States corporate profits earned in countries with effective corporate tax rates, on average, of 20 percent or higher. These countries include England, France and Japan. (This exemption would be subject to two exceptions: passive income like investment interest, and profits artificially transferred through complex transactions to countries exempt from United States tax.)

Second, Congress should levy a 20 percent tax on United States corporate profits in any country with an effective corporate tax rate below, on average, 20 percent. Corporations would no longer be allowed to indefinitely defer American taxes on profits in these jurisdictions.

But the 20 per cent levy should be reduced to reflect any taxes paid by United States multinationals in low-tax jurisdictions.

If a foreign subsidiary of an American corporation pays some tax in a low-tax jurisdiction, it should receive a tax credit for that amount against the 20 percent tax. For example, if corporate profits in Ireland were taxed at 12.5 percent, they would be subject to an American tax of only 7.5 percent (20 percent minus 12.5 percent).

Third, Congress should allow American corporations to transfer foreign profits earned overseas before 2012 back to the United States at a low rate — say, 10 percent — for the next two or three years. This rate would be part of a transition to a better permanent approach — not a one-off repatriation holiday.

Such a transition is needed because, in the past, corporations reasonably relied on the current system, which allowed them to defer American taxes forever on their foreign profits as long as they were kept abroad. It would be unfair to suddenly impose a 20 percent tax on a strategy that until now has been perfectly legitimate.

This three-part proposal, while not perfect, is far superior to a one-off tax holiday or indefinite deferral under the current system. This proposal would raise revenues from corporate activities in jurisdictions with no or low taxes, while encouraging American corporations to repatriate their foreign profits at reasonable rates.

The money can be used to reward shareholders, build factories or create jobs in the United States. Our economy needs all of these.

Authors

Robert C. Pozen

Publication: New York Times

A Plan to Tax the Foreign Income of U.S. Companies

Robert C. Pozen — Mon, 27 Jun 2011 11:12:00 -0400

The current system for taxing foreign source income of U.S. corporations makes no sense. In theory, income earned by controlled foreign subsidiaries of American companies is taxed at the U.S. corporate rate of 35 percent; in practice, the Treasury receives no taxes on that income as long as it is held overseas.

U.S. corporations now have overseas cash holdings of almost $2 trillion, which they are encouraged to deploy by acquiring companies and building facilities outside the U.S.

As an alternative, business lobbyists have advocated a so-called territorial system under which foreign source income would be taxed only in the country where it is earned. These lobbyists correctly argue that almost all advanced industrial countries follow this system, though many don’t allow tax havens to take advantage of it.

This alternative is based on the premise that foreign source income is being taxed once somewhere, at a reasonable rate by a credible tax enforcing government such as Germany. But this premise doesn’t apply to tax havens, like the Cayman Islands, where the tax rate is minimal, or places where a reasonable official rate isn’t enforced.

To reform the current system, Congress should exempt from U.S. taxes corporate income earned in foreign countries with an effective corporate tax rate of 20 percent or higher. Such earnings could be repatriated to the U.S., subject to payment of a 5 percent administrative charge. Such a fee, applied in France and other countries, would be a simple way to account for prior deductions from U.S. taxes by American corporations to generate foreign source income -- for example, on salaries of U.S. executives who helped start European operations.

Ending Deferral

At the same time, Congress should end the current deferral system for foreign source income earned by U.S. corporations in countries with effective tax rates under 20 percent. Instead, that income would be taxed every year in the U.S. at a rate equal to the difference between 20 percent and the actual rate paid by the corporation in the tax haven. For example, if an American company generated $100 million of income in Bermuda, which collected $2 million in taxes on that income, the corporation would pay $18 million in U.S. taxes. And if the company repatriated that income to the U.S., it would pay the 5 percent administrative charge.

Effective Corporate Rates

There are a few likely objections to this proposal. First, some might take issue with the 20 percent rate because it is much lower than the current 35 percent corporate rate. But few companies in the U.S. ever pay such a high rate. A recent academic study on effective corporate rates -- what companies paid on average in major countries -- found the average was 22.5 percent in the U.S., and 19.8 percent to 21.5 percent in large European countries. In addition, U.S. corporations are never subject to the 35 percent rate on foreign source income that is kept overseas.

Moreover, there is little merit to the argument that the difference between the 35 percent rate on domestic income and the proposed 20 percent rate on foreign income would reward U.S. companies for building facilities abroad. This incentive is much stronger under current law, which effectively subjects companies to a 0 percent tax rate on foreign source income.

Second, there is some truth to the claim that a territorial tax would encourage American companies to move income to countries such as the U.K., where they wouldn't’t be subject to U.S. corporate tax. Yet even that situation would be much better than the current system, which encourages U.S. corporations to move income to countries that collect minimal corporate taxes. A company that transfers income to the U.K. will probably be taxed there at an effective rate of 20 percent or higher.

Investment Interest

In addition, to limit the ability of U.S. multinationals to shift easily movable income from country to country, Congress should strengthen existing rules for mobile income such as investment interest or royalty fees.

Third, it would be feasible to identify countries with average effective corporate rate of 20 percent or higher -- not the rate paid by the individual company. In most cases, the conclusion will be clear. Nevertheless, there will be countries with borderline tax systems that will have to be evaluated by the Treasury, which should establish a transparent determination process for country appeals.

Fourth, a scaled approach should be applied to U.S. companies that already have substantial facilities in countries like Ireland because of their low tax rates. Under the new system, U.S. corporate income earned in Ireland would be taxed at its local 12.5 percent rate, and would be subject to U.S. taxes at a 7.5 percent rate. This proposed approach would encourage U.S. companies to choose the location of their European operations on the basis of nontax factors such as workforce productivity and transport links. This result would be strongly supported by our major trading partners in Europe, which have objected to Ireland’s low tax rate.

Transitional Regime

As the proposed approach is put in place, the U.S. would have to devise a transitional regime to minimize disruption. When American companies built facilities in Ireland and similar countries, they reasonably relied on the current system that allows indefinite deferral of taxation on foreign source income. Therefore, Congress should enact a transitional rule that would allow prior foreign profit of U.S. corporations to be repatriated for the next few years at a favorable rate such as 10 percent.

Fifth, the proposed system is a much better solution than granting another tax holiday to U.S. multinationals, which in 2005 were allowed to repatriate foreign profit at a tax rate below 6 percent. Such measures only encourage U.S. companies to keep their foreign profits abroad until the next tax holiday.

Tax-Code Overhaul

But we shouldn’t wait for a promised comprehensive reform of the corporate tax code to take action on foreign income. Both the Obama administration and the business community want to lower the corporate tax rate to about 25 percent from 35 percent on a revenue neutral basis. However, it is unclear whether a tax-neutral package can be enacted because such a measure would require several important industries to lose their special tax benefits.

The current tax system for foreign-source income is so poorly designed that reform wouldn’t be a zero-sum game. By adopting the modified territorial approach I propose, Congress could simplify the rules and give companies more flexibility on their business decisions, and still increase the total revenue collected by the U.S. government.

Authors

Robert C. Pozen

Publication: Bloomberg

Don't Fall for Corporate Repatriation

William G. Gale and Benjamin Harris — Mon, 27 Jun 2011 10:43:00 -0400

Some observers are calling for a “repatriation holiday” on profits held by foreign subsidiaries. Some members of Congress, eager to stimulate our fragile economy, are listening.

They shouldn’t. A tax holiday on repatriated funds is a proven failure — expensive in both direct and indirect ways. It was already tried in 2004 and didn’t work.

A repatriation holiday would allow corporations to transfer profits from foreign subsidiaries to the U.S. parent company at a steep tax discount. Now, corporations can defer U.S. corporate tax on overseas income until profits are transferred back to the parent company.

Repatriation could allow a large proportion of foreign profits — probably 85 percent — to be distributed tax-free to the U.S. This would essentially reduce the effective tax rate to just 5.25 percent from 35 percent.

This sounds like it should be an effective strategy for jump-starting the economy. U.S. firms have roughly $1.5 trillion sitting on foreign balance sheets. In theory, that money could be put to productive uses in the U.S. economy.

But the idea is replete with problems. In many cases, these corporations have already accrued profits tax-free using techniques that shift reported income to tax havens like Bermuda or the infamous “Dutch sandwich,” which was used by Google to avoid an enormous amount of tax. Certainly, taxes ought to be paid at some point.

In addition, firms are unlikely to invest the repatriated funds. Congress passed a similar repatriation tax holiday in 2004 and required firms to create domestic jobs or make new domestic investments to get the tax break. Nonetheless, the firms, on average, used the tax break to repurchase shares or pay dividends — not to increase investment.

The holiday, instead, turned into a massive tax break for shareholders — resulting in little or no economic gain or job market expansion. Why? Because money is fungible, to satisfy the requirements of the law, corporations reported repatriated funds as the source of money for investments or jobs they would have created anyway — and used other funds to increase shareholder wealth.

Today, domestic firms are sitting on near-record levels of liquid assets. The reason they’re not investing or creating more jobs is not a cash shortage. Allowing them to repatriate foreign profits at low tax rates would only heap more cash onto their already huge stockpile.

There are also substantial costs associated with a repatriation holiday. First, allowing repatriation today means less taxable corporate profits in the future — which would translate into less government revenue.

Second, and perhaps even more costly than the lost revenue, would be the dangerous precedent that firms would expect regular repatriation holidays. This expectation may persuade firms to hoard profits overseas and perhaps even move production abroad, betting that Congress will eventually grant another “one-time” tax break.

Indeed, the prior tax holiday was supposed to discourage firms from holding profits overseas. But instead, firms stockpiled new reserves, presumably in anticipation of another holiday. The Joint Committee on Taxation estimates that these two factors would contribute to the $79 billion 10-year price tag on a second repatriation.

For years, companies that invest overseas claimed this practice bolsters U.S. jobs. Now, they argue sending the money back to the U.S. would spur economic expansion. They should make up their minds.

Reed Hundt of the Coalition for Green Capital and Thomas Mann of the Brookings Institution recently proposed a variant of the tax holiday. Their plan would allow firms to repatriate profits tax-free — if the funds are invested in an infrastructure bank. Given the current political divide, they argue this is the only way to increase U.S. investment in infrastructure.

While we agree smart infrastructure investment can help the economy, whatever the merits of an infrastructure bank, coupling it with a corporate tax holiday on repatriated funds is not a worthwhile idea. This is just the latest effort to marry a repatriation holiday with something productive — just as Congress made the link to domestic job creation and investment in 2004.

The notion that an infrastructure bank could be funded only from corporations’ foreign stash of cash is untenable. There is plenty of money available to fund U.S. infrastructure. Multinational firms, for example, could use some of their cash to fund such a bank, if it were created. The U.S. also has access to large amounts of cheap capital from world financial markets.

The Treasury shouldn’t become the Charlie Brown of the tax world — repeatedly being tricked into trying to kick a football that isn’t there. We do need to stimulate a wavering economy and reform our tax system. But periodic tax holidays on repatriated funds are not the way to achieve either goal.

Authors

William G. Gale
Benjamin Harris

Publication: POLITICO

Rebuild American Infrastructure? Companies’ Offshore Profits Can Help

Reed Hundt and Thomas E. Mann — Thu, 16 Jun 2011 00:00:00 -0400

America needs investment in its infrastructure. We need someone to invest hundreds of billions of dollars into for-profit trains, roads, airports, clean electricity generation, high-voltage transmission lines and more. As former Treasury secretary Larry Summers has noted, the nation’s commercial and residential housing stock probably does not need to be increased, but it could be improved in quality by replacing windows, insulation and monitoring systems, which save more in energy spending over time than would be spent on the renovations. Ideally, all the infrastructure projects should generate at least a modest profit, to ensure that the investments are productive.

The total plausible investment, even if all projects are for some profit, would easily exceed $1 trillion.

Not surprisingly, neither Congress nor state governments believe they can afford to spend money on infrastructure. The parties are sharply divided on the efficacy of any new public spending, but even Democrats are wary of proposing investments in the face of the nation’s huge deficits and increasing debt. Moreover, since such infrastructure projects typically provide such small returns on capital, they are not suited to most private-sector investors.

Meanwhile, American businesses have more than a trillion dollars sitting in bank accounts in other countries. They do not want to transfer the money back to the United States because the second the cash hits our shores, the Internal Revenue Service will tax the gains — as much as 35 percent of profits.

Just to avoid the IRS, some CEOs are willing to spend their overseas profits on buying overseas companies or making overseas investments at prices that are too high.

But many in Washington remember that in 2004 the business community persuaded Congress to pass a law allowing firms to bring home profits without incurring taxation in return for the promise to invest the money. According to the Congressional Research Service, the repatriated money “did not increase domestic investment or employment,” and instead firms used “much” to buy their own stock. Democrats in particular felt hoodwinked by the exchange and now don’t want to let firms replenish their American coffers from foreign sources without paying taxes.

In other words, under these circumstances, firms are leaving the trillion overseas and Congress is letting them do so.

But putting these problems together could produce a common solution.

Why doesn’t Congress let firms bring back their overseas profits without taxation — if, and only if, they put the money into an infrastructure bank for a certain period? This bank would then issue low-interest, long-term loans for projects that in flusher times would be funded by municipalities or utilities.

In return for obtaining the cash infusion of overseas profits into the infrastructure bank, the Treasury would forgo taxation on a schedule set by auction. By a bidding mechanism, the Treasury would obtain the best deal offered for funding an amount, say $100 billion, in the infrastructure bank. We believe that firms would agree to invest in the bank for five or even 10 years in return for avoiding taxation. An infrastructure bank capitalized with a hundred billion dollars could be expected to finance projects that, combined with private capital, would exceed a trillion dollars of investment.

The bank would dedicate its capital solely to American infrastructure. That way, U.S. firms’ profits overseas would come back to rebuild America. At least one study of the effect of the 2009 American Recovery and Reinvestment Act suggests that a billion dollars of investment in construction-related activity could create about 10,000 job years. A trillion dollars of investment, then, equates to 10 million job years, created between now and 2020. McKinsey and Co. found recently that by the end of this decade the United States needs 21 million new jobs to achieve full employment. In that light, our proposed infrastructure bank is more of a must-have than a nice-to-have new institution.

Private-sector infrastructure initiatives across the range of transportation, communication and energy needs (examples include high-speed rail in the Northeast Corridor, energy-sector generation and building efficiency), some operating under public-private partnerships, could be launched expeditiously to generate jobs and investments critical to our economic recovery and long-term growth.

If we put the offshore profits and infrastructure bank problems together, we might find a solution that works for both sides of the aisle, even in these sharply polarized times.

Authors

Reed Hundt
Thomas E. Mann

Publication: The Washington Post

The Scouting Report: Tax Reform

Wed, 15 Apr 2009 12:30:00 -0400

Event Information

April 15, 2009
12:30 PM - 1:30 PM EDT

Online

1775 Massachusetts Ave., NW
Washington, DC

April 15 is tax day in the United States and some Americans are scrambling to complete their 1040s and gather their receipts.

Leonard Burman, director of the Urban-Brookings Tax Policy Center, thinks that the nation urgently needs tax reform. On tax day, he answered questions about what the Obama administration should do to create a fair and equitable tax system during an online web chat moderated by Politico Senior Editor Fred Barbash.

Transcript

Transcript (.pdf)

Event Materials

0415_tax_reform_chat

Participants

Moderator

Fred Barbash

Senior Editor
Politico

Panelists

Leonard Burman

Director, Urban-Brookings Tax Policy Center

The Concept of Neutrality in Tax Policy

Jason Furman — Tue, 15 Apr 2008 09:50:10 -0400

Chairman Baucus, Ranking Member Grassley and other members of the Committee, thank you for inviting me to testify at this hearing on tax policy. In my remarks I will focus on the concept of “tax neutrality.” The basic concept is simple: generally the tax system should strive to be neutral so that decisions are made on their economic merits and not for tax reasons. In some cases, neutrality is impossible and policymakers have to accept a certain level of distortion to behavior as inevitable. In other cases, neutrality may be undesirable if policymakers intend to promote specific goals like the provision of health insurance or contributions to charity. Examining ways that the tax system approximates or departs from neutrality can be a helpful lens for thinking about a range of tax policy and economic problems.

Tax neutrality is a widely accepted concept in principle. In practice, however, tradeoffs between different concepts of neutrality and different goals can be difficult to resolve. But in several cases this concept can provide a useful way to cut through some of the debates about tax policy and identify a more economically efficient way to organize the tax system.

In my testimony I first provide a general introduction to the concept of neutrality and then applications to five specific areas of tax policy. To preview my substantive conclusions in these areas:

1. The concept of neutrality is the underpinning of the canonical goal of tax reform: achieving a broader base with lower rates.

2. To the degree that policymakers depart from neutrality to achieve specific goals like encouraging homeownership or childcare, it is generally better to implement these measures through refundable tax credits rather than deductions.

3. The tax treatment of healthcare is the most economically important way that the tax code departs from neutrality. Reforms to this tax treatment can make it more neutral with regard to some decisions (like how much insurance to purchase) while providing more incentive to purchase basic insurance.

4. The tax code also departs from neutrality to discourage specific activities, like smoking and alcohol consumption. In these cases, the tax should be set to capture the cost of the activity that individuals do not take into account. This is also the principle underlying carbon taxes and cap-and-trade systems to address climate change.

5. Although the proper level of capital taxation is highly controversial, there is little or no justification for the widely varying rates on different forms of capital income. Establishing more uniform rates would improve the allocation of investment and finance, reduce wasteful tax avoidance expenditures, and ultimately enhance the productivity and stability of the economy.

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Authors

Jason Furman

Publication: U.S. Senate Committee on Finance