The United States utilizes a “Worldwide” tax code – and that’s a problem.
Most other nations use a “Territorial” tax system – companies are taxed by the country where the economic activity takes place. This territorial system is better suited to the multi-national landscape companies operate in today – which is why all other G-7 nations use the “territorial” approach. Under a territorial system, a multi-national company pays taxes to each of the nations it does business in according to the amount of economic activity done in each nation’s borders and according to the particular nation’s tax rate. This has the obvious advantage of placing all companies operating within a given nation on the same economic footing from a tax burden perspective. Under our current Worldwide system, U.S. corporations are taxed at the same 35% federal tax rate – less taxes paid to foreign governments and allowed deductibles – no matter where their profits are made.
A further twist exists as part of our worldwide tax code. Corporate profits are not actually taxed until they are repatriated to the U.S. This incentivizes U.S. companies to keep cash from offshore operations in the place it was generated – offshore. This is known as Lock-Out – because our unfavorable tax system “locks out” repatriation of foreign earnings. Estimates vary but there appears to be at least $2.5 Trillion in cash profits residing overseas. This is a staggering level of capital that could be going toward economic investment, production and growth domestically instead of boosting the capital availability and growth of other nations.
There are problems with both Worldwide and Territorial systems.
The Worldwide system has the inherent problem of placing U.S. companies at a competitive disadvantage when operating in foreign nations where tax rates are lower than in the United States. American companies must pay both the foreign taxes plus the incremental U.S. taxes up to a total of 39% – 35% federal and 4% state and local – under our current corporate tax system. This unfair tax situation sometimes causes companies to engage in a process known as Inversion. Inversion is a strategy where a U.S. corporation merges with a foreign company and then reincorporates, as part of that merger, in the foreign company’s nation. If the tax rate is lower in the foreign country, the newly formed corporation pays less in taxes than it would have if the company had stayed domiciled in America. And the taxes on income from the company’s foreign operations are no longer being paid to the United States. It is a legal way for corporations to minimize or lower their tax burden in order to regain competitive standing. There are other methods of tax avoidance as well – such as earnings-stripping and income-shifting. Lastly, there is the issue of Lock-Out – when companies do not repatriate foreign earnings as a means to avoid paying taxes. This is a significant issue for the United States. As I noted above, it is estimated that over $2.5 trillion in cash profits is currently residing overseas due to our flawed tax system. U.S. companies have a negative incentive to repatriate this money.
The Territorial system is significantly better than our Worldwide tax system but it too has some flaws. The greatest problem with a Territorial system is that it incentivizes companies to shift production to those countries that have the lowest tax rate. Companies will effectively attempt to shift as much income as possible into low-tax countries and shift costs and deductions into countries with high tax rates. Companies will be incentivized to engage in profit-shifting. Despite these flaws, there is a reason why 27 of the 34 OECD countries have territorial systems. A Territorial system places companies on an equal competitive footing, reduces compliance costs, removes the incentive to re-incorporate overseas, allows for capital repatriation and allows capital to flow to where it can achieve the best after-tax return on investment.
In reality there should be no corporate tax. Corporations are actually just tax collectors – legal entities that serve to collect taxes on behalf of the corporation’s owners. Corporations do not really “pay” taxes. Shareholder dividends and capital gains (taxable items to the shareholder) are reduced by taxes collected by the corporation. If the corporation did not collect this tax on “behalf” of the shareholder, these extra dollars would flow through to shareholders in the form of increased profits and dividends, reinvestment in the business (which generates additional profits) and share repurchases. And these increased cash flows to shareholders would then be taxed at the shareholder level. A tax rate adjustment for capital gains might be required, but this process would provide a far better mechanism for tax collection. I explain this in more detail in an earlier post – Abolish the Corporate Tax. Unfortunately, the political reality is that this would be extremely difficult to achieve.
There is a third option – or fourth if you include a repeal of the corporate tax. The GOP’s A Better Way tax plan would change our corporate income tax into a “destination-based cash-flow” tax – a territorial tax with several twists. The proposed plan calls for four primary changes to the corporate tax base:
- Companies would fully expense capital investments in the year they are made – rather than depreciate them over a number of years
- Companies would no longer be able to deduct net interest expense against taxable income
- Foreign profits would no longer be subject to taxation
- The new corporate income tax would be destination-based – or “border-adjustable”
An important distinction of a destination-based tax system must be made. Unlike either a worldwide or territorial tax system, under a destination-based tax system, taxes on goods and services are based on where they are consumed regardless of where they are produced.
Worldwide Tax Code = An American company would owe U.S. tax on domestic profits and overseas profits (less foreign taxes paid).
Territorial Tax Code = An American company would owe U.S. tax on domestic profits only. Tax liability depends on where the goods and services are produced.
Destination-Based Tax Code = An American company would owe U.S. tax on domestic profits only. Tax liability depends on where goods and services are consumed.
Under a destination-based plan, corporate taxes would apply to all domestically consumed goods and services and would include all imported goods and services. The tax would not apply to exported goods or services. The tax would apply based on where a product is consumed – not on where a company is headquartered or where the goods are produced.
Companies currently are able to deduct the cost of imports from revenue. This would stop under the proposed plan. Exports and foreign sales would be made tax-free – they would be taxed by the nation in which the transactions occur. We would now be taxing the consumption of goods and services in the United States as opposed to the current system of taxing the production of goods and services in the United States. Instead of taxing exports but not imports we would now be taxing imports and not exports.
Any products consumed domestically – no matter where they were made – would be taxed. This is why imports would be taxed. Any products consumed in foreign countries – no matter where they were made – would not be taxed. This is why exports would not be taxed. Note that all domestic consumption – both goods domestically produced & consumed and goods imported & consumed – are taxed equally. A destination-based tax is not a tariff – a tariff applies only to imported goods.
At first glance, it might seem that imports are being punished or discouraged and exports are being subsidized or promoted under a destination-based system. After all, imports are taxed and exports are not. But in reality, this is not the case. Exports and imports are inextricably linked. And over the long-term, exports and imports must be equal. Exports are needed to pay for imports and imports are the returns from exports. Exports are the “price” a country pays to purchase foreign goods or invest in foreign assets. Imports are the “returns” from investing in foreign goods or assets. Taxing either correspondingly reduces the other. This means that even with the apparent “subsidy” on exports, the trade balance should actually stay the same. This happens due to the import/export linkage. If foreign companies cannot export as many goods and services to the U.S. they also cannot purchase as many of our exports.
Take a quick look at a basic economic formula:
Savings – Investment = Exports – Imports
A border adjustment (a tax on imports but none on exports) under a destination-based system alters neither savings nor investment – which implies the trade deficit (Exports minus Imports) must stay static despite the apparent subsidy being applied to exports. How does this work? The answer is exchange rates – and supply & demand. Currencies are needed to purchase goods and services. A switch to a destination-based tax system would alter the demand & supply for exports and imports – at first. The implementation of the border adjustment would cause demand for imports to fall (they are being taxed) and demand for exports to rise (they are not being taxed). As demand for U.S. exports goes up, demand for dollars to purchase U.S. exports goes up as well – and the supply of dollars falls. This leads the dollar to appreciate, theoretically moving us back into balance. At the end of the day, the dollar should appreciate by an amount to equalize everything – to create parity. Exchange rates are the stabilizing mechanism that should bring everything back into balance and allow a destination-based system to work effectively. And it is here that I remain somewhat uncertain and not entirely convinced. More on this later.
Another characteristic of a destination-based system is that unlike a value-added tax (VAT), the destination-based tax system allows for deduction of wages and other compensation paid to workers. A destination-based system is designed to tax business profits – not labor. The distinction between a VAT and a destination-based system is crucial. Here’s why. VAT systems do not allow for deductibility of wages and/or other compensation. Worker compensation becomes part of a VAT tax base. This means that wages are actually taxed twice. They are taxed at the the worker level as personal income. And they are taxed again at VAT level – the point of consumption. You might be tempted to argue that corporations bear this burden but it isn’t so. There would be no discernible difference between this tax and FICA taxes paid by employees under the current system. Ultimately, these would be taxes that are borne by the worker – and they would be paid twice – a regressive tax. The destination-based system by contrast, explicitly allows for deduction of employee compensation so there is no double taxation.
The end result of the destination-based system is that you have a tax on consumption from sources other than wages and salaries. This removes the regressive element that is present in a standard VAT or consumption tax. The tax avoidance strategies employed by corporations are also rendered useless. Earnings-stripping, income-shifting, profit-shifting, inversion – even lock-out – are effectively removed under this system. By taxing based on where a company’s products are actually consumed, the control over shifting of cost and profit factors is removed – it simply doesn’t matter.
Lastly, the destination-based tax is effectively a cash flow tax.
Depreciation – an outmoded and poorly matched method of expensing capital investment – would be replaced with immediate expensing of capital expenditures – investment in the business. Companies would no longer capitalize expenditures nor would they need to track their asset bases. A $100 million investment in a new plant would be a deduction in the same tax year. The investment would be expensed immediately as a cost – when it was made. Not over a period of years. Investment back into the business would no longer be discouraged.
Net interest expense would no longer be deductible. This means that companies would no longer be financially incentivized to take on debt. They would be neutral to financing their business by debt or equity – whichever appears cheaper at the time. If this one sounds a bit strange – think of owning a house. Under U.S. tax code, homeowners can deduct interest expense from their taxes – they are incentivized to borrow more – take on a larger mortgage – than they otherwise would.
If the above two issues sound a bit esoteric try this example. Company A borrows to finance its business and made large capital investments two years ago. Company B uses equity from a stock sale to finance its business and held off on capital investment. Both companies sales and costs are identical. Company A can deduct its interest expense and depreciation from its capital investment. Company B has nothing to deduct – no interest – no depreciation. Company A’s tax bill will be lower than Company B even though their underlying profits are identical – same sales and costs. This is why many investors choose to focus on EBITDA – earnings before interest, taxes, depreciation and amortization. This measure looks at the underlying cash flow and profitability of a company – a measure that ignores the manner in which a company chooses to finance or invest in its business. A secondary measure looks at EBITDA after CAPEX (capital expenditures – or investment back into the business). The destination-based tax system looks at companies in exactly the same manner.
The new corporate tax rate would be set at 20% placing us more in line with the rest of the industrialized world. The United States’ current 39% marginal corporate tax rate (35% federal and 4% average state and local) is the third highest in the world. It is the highest of the 34 industrialized nation members of the OECD – and it compares poorly with Europe’s average tax rate of 19% – 26% when weighted by GDP. A corporate tax cut has been a long time in coming and is a key component contained in both President Trump’s and the GOP’s proposals. And it would immediately place American companies on a more equal playing field versus their foreign competitors.
Time for a quick question. How much revenue is generated from corporate taxes?
The answer to this question may surprise some – in 2015 the federal government collected about $340 billion in corporate taxes. This compares to the approximately $1.5 trillion in individual taxes and $1.1 trillion in payroll taxes. The amount paid in corporate taxes is not as large as many intuitively expect. And it has been declining on a percentage basis for decades.
The reasons for this have everything to do with incentives and competition – incentives for businesses to invest, locate and produce in the United States and competitiveness of American companies in a global environment. And it’s all intrinsically tied into economic activity, productivity, wages and employment. We as a nation have stymied business activity through a combination of high taxes and excessive regulations. This is why corporate tax revenues have declined steadily as both a percent of GDP and a percent of federal revenue since the 1960s – per the Congressional Budget Office. Reducing the corporate tax rate will go a long way towards drawing businesses and business activity back to the United States.
Now, time for one last item. Imports currently amount to roughly 15% of the U.S. Gross Domestic Product (GDP). Exports make up about 12%. When you apply the 20% tax to our trade deficit, economists calculate an extra $120 billion per year in income or more than $1 trillion over 10 years. Martin Feldstein – an economist I admire – made exactly this case in a Wall Street Journal editorial two days ago. The idea is that this increase – which is eerily similar to a free lunch – would be used to offset any loss from the corporate tax cut. I’m not so sure.
On balance I am in favor of most of the components of the GOP’s tax proposal. Our corporate tax system is antiquated and in dire need of overhaul. I am drawn to the idea of a destination-based system and find great appeal in the theoretical approach of taxing at the point of consumption. A destination-based tax system brings parity back for our companies. It helps make the United States an attractive place to do business and to domicile companies. It immediately removes all types of negative incentives that lead companies to engage in accounting gimmickry and income & balance sheet gymnastics as a means to avoid unfair taxation under our current tax code. It removes the issue of Lock-Out – allowing for the repatriation of truly huge amounts of cash currently held overseas. It also removes any incentive for companies to shift their domiciled status to another country through inversion. It accomplishes many positive things.
It is also complicated – and uncertain – in regards to the border-adjustment – which I don’t like.
I have some very real hesitancy over the border-adjustment component. Which is unfortunate – because in reality you cannot have a destination-based system without having a border-adjustment. It’s ultimately intrinsically tied to the whole concept of taxing at the point of consumption – where the goods are actually consumed. I fully believe that exchange rates will adjust to help bring parity to the whole system – but I am not sure how quickly or completely this would actually happen. In my opinion, there would likely be lag effects – perhaps from long-term contracts already in place. I am more concerned over unforeseen impacts – the ever-present Law of Unintended Consequences. I can’t quite bring myself to believe that it will be as simple as having an automatic exchange rate adjustment – one that would lead to an unprecedented strengthening of the U.S. dollar – without some unforeseen impacts. I believe that there is the real issue of trade strife – at least initially. I also worry that input costs for companies using foreign goods may not be fully offset by exchange-rate adjustments. Finally, there is the issue of the World Trade Organization – of which the U.S. is a member. WTO rules allow for border adjustment of VAT taxes but might challenge or reject this particular proposal which – although similar to a VAT in many respects – is ultimately a corporate tax.
I was really hoping to find myself fully on board with this proposal. Instead, I find myself truly hesitant over what would be a full and complete commitment to a proposal that could have far-reaching impacts as a result of the border-adjustment. This is the type of tax proposal that either gets accepted – or it doesn’t. You can’t horse-trade on the border-adjustment portion – the entire proposal won’t work without it. Which is a shame because I think it will work. But I’m not sure it will work.
And that’s a big gamble for our nation to take.
Anyone up for pushing a repeal of our corporate tax instead?
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