Politics of Poverty

Dear Republican Congress: Forget border adjustments, fix the worldwide system

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Fixing the worldwide system of corporate taxation is a better way to boost America’s competitiveness than border adjustments, without the economic destruction involved in the latter.

Here is a rare bipartisan consensus in Washington: the current way Uncle Sam taxes the international income of corporations is a mess. It fosters tax dodging.

Of course the consensus ends there. Two opposite approaches compete to fix the problem. House Republicans want a small revolution involving a shift from a worldwide system (what we have now) to a territorial system together with something called “border adjustments.” Some Democrats want to fix the worldwide system by closing the mother of all loopholes: deferral. Interestingly, Trump’s initial tax reform plan also called for an end to the deferral loophole, but he later dropped the idea.

A wave of big business interest groups is rising to oppose the border adjustments idea, arguing that it will disrupt supply chains and make import-intensive industries like retail unprofitable. Moreover, border adjustments could spark a debt crisis in poor countries with dramatic consequences for the global economy and are likely to be found illegal under the rules of the World Trade Organization.

So why not ditch border adjustments and keep the rest of the House Republican plan? The thing is, without border adjustments, the plan makes tax dodging even worse.

If there is one undeniable message coming out of the Presidential election, it is that people want to drain the swamp of interest groups rigging the rules to line their pockets. Corporate tax dodging – with its armies of accountants and lawyers gaming the system to shift the tax burden from big business to small business and from the wealthy to the middle class – is at the deep end of the swamp.

It is the battleground Republicans have chosen for their first year of undivided government. And to make good on their promises to improve the economic situation of working class Americans, they must kill corporate tax dodging for good here and now.

The mess we are in

The “worldwide system” we now have means that US corporations pay federal tax on their global profit, but they get a credit for foreign taxes paid. The federal rate of corporate income tax is 35 percent. So if US Widget Company has a factory in Cambodia where the national tax rate is 20 percent, it pays 20 percent tax to the Cambodian government and 15 percent (35 percent minus 20 percent) to the US government on that factory’s profits.

In theory, this system is great to counter international tax dodging. There is no point using accounting gimmicks to move the factory’s profits to Bermuda, where the tax rate is 0 percent, because they would end up paying the full 35 percent rate anyway (0 percent to Bermuda and 35 percent to the US).

But luckily for corporations seeking to dodge taxes, our current worldwide system has a giant loophole called “deferral.” Tax on foreign profits can be deferred until the profits are repatriated to the US. The result of this, predictably, is that big corporations keep their money “permanently reinvested abroad”. Over $2.5 trillion and counting is stashed offshore out of reach of the IRS.

Deferral may also encourage the offshoring of American jobs because it allows companies to defer taxes on profits earned outside the US. In reality the whole thing is a big accounting gimmick; US corporations can easily borrow and invest in the US using their offshore treasure as collateral without ever having to pay the deferred taxes. They can even deduct the resulting interest expenses from their US taxable profit, dodging even more taxes.

A radical agenda

House Republicans want to throw out the baby (worldwide system) with the bathwater (deferral). Their solution combines a territorial system with border adjustments.

A territorial system means that US corporations would only owe tax on their profits earned in the US. So instead of closing the loophole, Republicans want to eliminate the tax on foreign profits altogether.

However, the territorial system exposes the US Treasury to even more virulent tax dodging on profits earned in the US by creating a massive incentive for US companies to park their profits in tax havens where they won’t face any taxes at all.

There are many ways to shift US profits overseas. One is to transfer intellectual property to a foreign subsidiary, and pay it royalties (i.e. why pharmaceutical and IT companies that heavily rely on intellectual property count among the biggest tax dodgers). Another is to borrow from a foreign subsidiary at very high interest rates (a practice called “earning stripping”). The most important practice is to overprice imports from foreign subsidiaries and under price exports (known as abusive transfer pricing). All these techniques and more result in deflating a company’s US profits and inflating profits of the company’s subsidiaries in tax havens. Global before-tax profits are unaffected but the tax bill decreases.

Border adjustments address these abusive transfer practices. That is why they are a critical part of the House Republican plan. Without them, tax dodging gets worse.

How do border adjustments work?

The corporate tax is a tax on a company’s profit.  Profit is the difference between a company’s revenues and expenses. With border adjustment, export sales are excluded from the company’s revenues for tax purposes, and import purchases are excluded from its expenses. So if your company exports a lot of goods you have fewer taxable revenues; if your company imports a lot of goods you have lower costs for tax purposes. Exporters will suddenly have lower taxable profits and a big tax cut. Importers will suddenly have higher taxable profits and a large tax hike.

According to economics theory, the US dollar should increase in value and cancel out the effect of the tax on both importers’ and exporters’ bottom lines. However, importers are not ready to bet their lives on that theory. Nor should they: this theory rests on the assumption that the value of the dollar is driven purely by merchandise trade. In practice the value of the dollar is set by financial markets. Border adjustments will impact the dollar’s value, but other financial forces could disrupt the economy in ways that are impossible to predict. Meanwhile, this uncertainty will upset the strategies of most businesses.

Poor people will suffer                     

The winners of border adjustments will be holders of dollar assets, and the losers the holders of dollar debt. Among the latter, governments of some developing countries could come under severe strain that could result in a debt crisis. This would have debilitating results for poor people who could face cuts to basic services like healthcare and education, or even worse political unrest and social disruption.

For House Republicans, the stated objective of border adjustments is to make America more competitive and repatriate jobs shifted overseas. That is not lost on America’s trading partners, who are likely to challenge this policy at the World Trade Organization and win. But the legal proceedings will last for years, creating uncertainty that will compound the economy’s disruption.

Stopping tax dodging is another stated objective of border adjustments. Border adjustments would indeed end the incentives multinational companies face to cheat the US Treasury. But they don’t discourage US corporate tax dodging at the expense of developing countries.

Fix the worldwide system

Fixing the worldwide system is much simpler, less disruptive, and more effective at tackling corporate tax dodging than shifting to a territorial system with border adjustments. It is also good for America’s competitiveness.

Ending deferral is a simple reform that would force US companies to pay taxes on their foreign profits immediately, which would suppress the incentive to move profits to tax havens.

Fixing the worldwide system also requires steps to prevent inversions. US companies can now escape tax on their worldwide income simply by buying a foreign company and changing their nationality in the process. Several legislative proposals to deal effectively with this problem exist.

Some business interest groups claim that the worldwide system makes America uncompetitive. But that’s a red herring. First of all, tax matters relatively little to competitiveness. What makes America competitive is the quality of its workforce, the strength of its institutions, the dynamism of its enterprises, the density of its infrastructure (although that needs fixing), and the unmatched size of its domestic market.

Without deferral, the worldwide system removes the incentive to move jobs offshore, as companies pay the same tax rate on overseas and domestic production. Moreover, compared to the territorial system, the worldwide system allows for a lower tax rate to meet a given budget deficit goal because the rate is paid on foreign as well as domestic profits.

The worldwide system does put US companies competing with foreign multinationals at a disadvantage for business in countries with low tax rates. But the same is true for border adjustments: US companies that have facilities overseas to serve foreign consumers in foreign currencies will lose out as those currencies lose value against the dollar.

Many countries have shifted to the territorial system. It is part of a race to the bottom that also involves lower statutory rates and a multiplication of tax incentives like patent boxes that cut tax on revenues from intellectual property. Yet despite all that, they still struggle to stop corporate tax dodging and job offshoring, as there is always a country with lower tax rates.

If the US government deems that US companies are paying too much tax compared to the competition (an arguable proposition at best considering record profits and current effective rates in line with competitors), the correct response is to lower the statutory rate, not to abandon the worldwide system. The welcome thrust of the House Republican plan is to simplify the tax code and cut tax rates while broadening tax bases. The shift to a territorial system with border adjustments flies in the face of these principles.

By contrast, ending deferral will free US companies from the tax dodging treadmill. They will save on accountants and lawyers, not to mention public relations consultants, and be able to refocus their strategies on fundamental economic value instead of the vagaries of tax policy.

Whatever their disagreement on the tax rate may be, both Republicans and Democrats should agree that fixing the worldwide system is simpler, less disruptive to the economy, and a better way to strengthen America’s competitiveness than shifting to a territorial system with border adjustments.

More importantly in the current political context, fixing the worldwide system is definitely more effective to drain the swamp and protect the American people from corporate tax dodging.

EDITOR’S NOTE: The original version of this blog has been corrected to reflect GOP proposals on interest deductions and intangibles.

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