Michael C. Durst is a columnist for Tax Notes.
This article is based on a luncheon talk he gave on October 17, 2011, to a conference of the American Tax Policy Institute in Washington. The author is grateful to the institute for the opportunity to take part in the conference.
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This article originated as a talk at a gathering of experts on international taxation sponsored by the American Tax Policy Institute (ATPI). The attendees represented different political viewpoints and diverse economic interests. Some were academics or commentators who had already articulated quite definite points of view on matters of tax policy. Others were corporate tax executives or practitioners with professional loyalties to multinational companies. Nevertheless, in its discussions the group appeared committed to objectivity in talking about tax policy, and seemed ready to devote energy to synthesizing conflicting ideas into a reform package that would benefit the public as a whole.
That characterization of the ATPI conference attendees also probably applies to many readers of Tax Notes International who could not be there. Accordingly, it may be useful to share a summary of the remarks I offered at the conference, as well as additional thoughts prompted by the suggestions of others who were present.
The discussion below addresses four topics. First, it offers thoughts concerning the role that nongovernmental tax experts can play at a time like the present when the legislative process is stalled. Second, the discussion offers -- admittedly from my own point of view -- some observations on the history of the U.S. international rules, which I hope will be useful in considering the shape that the international component of tax reform might take. Third, I briefly outline one form -- again reflecting my personal views -- that a comprehensive reform package might take. This article concludes with observations about some of the specific challenges faced by nongovernmental experts in engaging with one another, and it suggests ways we might avoid some of the pitfalls that could limit our effectiveness in facilitating compromise pending Congress's return from its current hibernation.
The Role of Experts in Exile
Today, the political prospects for serious consideration of tax reform don't seem bright. Our national politics are deadlocked over the fundamental question of how prominent a role government should play in addressing the country's social and economic problems. Differences over that issue raise obvious subsidiary questions about the optimal configuration of our tax system, and so the broad political differences in this country contribute to deadlock over tax reform.
Also, the tax system itself creates a kind of stasis -- a political bias in favor of the status quo -- that poses an obstacle to tax reform. I will discuss this factor below. The combination of broad political disagreement and the resistance to change that some features of our current tax system themselves raise make the road to comprehensive tax reform a difficult one at best.
But the obstacles that are now blocking progress toward tax reform may not be insurmountable. First, the societal divisions that now stall the legislative process presumably will not last forever. Second, a growing sense of urgency about the need to foster economic growth and employment in this country may lead to agreement that, despite the many temptations to do nothing, we need to take a serious and systemic look at our tax rules. If those two things happen, comprehensive tax reform can become a realistic goal.
And when the current logjam does break, if we have done our homework, nongovernmental experts on taxation will be in a position to suggest solutions to the many political and technical problems that a serious push for tax reform will raise. Ideally, we can operate as a kind of "government in exile," working toward shaping potential solutions to tax issues among ourselves until such time as the real government is in a position to once again become engaged. We should take part in vigorous but constructive debate with one another, in print and in conferences, and most importantly, we should try to identify and memorialize areas in which our views overlap in ways that might translate into compromise legislation.
Organizations like ATPI, the tax departments of law schools and business schools, and trade and industry associations might consider providing forums in which competing economic interests and political orientations can be articulated clearly and even self-critically, and in which compromises can be identified and fleshed out. The most important requirement for those forums is that they include participants of divergent views. Groups sponsoring the forums and inviting participants will need to refrain from stacking the deck in any particular direction.
Also, because resolution of the more difficult issues will require extended exchanges of view -- and ideally, exchanges of drafts as compromise positions are hammered out -- the forums will need to involve multiple opportunities for discussion and drafting. Thus, for example, a series of debates published in a journal over the course of a year, with an expectation that the parties will attempt to synthesize compromise positions, will be more useful than a single colloquium issue. Similarly, a series of conferences held quarterly over a year or even 18 months, with the expectation of continuing discussions in the form of simulated negotiation and, ultimately, the drafting of joint positions will be more useful than a single conference. In either case, the key ingredients will be (i) participants with adverse viewpoints and a willingness to seek compromise and (ii) institutions willing to sponsor the discussions.
Some Comments on Current Rules
And now, let me move from the topic of how to facilitate constructive debate to some thoughts concerning the possible content of a successful comprehensive reform plan. Because the conference for which these thoughts originally were prepared focused mainly on international corporate taxation, and international taxation has been my main area of professional involvement, I'll start with a brief (and admittedly somewhat argumentative) diagnostic review of the history of the rules that govern the international taxation of U.S.-based companies. Following the discussion of international rules, I'll expand the focus to a brief consideration of how the different components of a reform -- domestic as well as international -- might fit together in a comprehensive and coherent package.
I believe our current international tax rules are largely the result of historical accident. Soon after World War II, with the development of the new generation of wonder drugs by U.S. companies, pharmaceutical companies began to transfer patent licenses to what came to be known as "base companies" in low-tax countries where income could be accumulated and deferred from U.S. taxation. By the early 1960s, the Kennedy administration thought that the revenue leakages from the use of base companies were excessive, and it sought to eliminate the ability to shift income to low-tax jurisdictions. Many saw this as a move toward an economically unwise de facto tax increase on key U.S. businesses, and the attempt to eliminate deferral proved politically infeasible in any event. Accordingly, starting with the Revenue Act of 1962 and continuing over the course of the 1960s, Congress and Treasury developed a system of rules that still allowed deferral through income shifting but sought to limit income shifting to some extent.
Then, as new intangibles-intensive industries such as the electronics, and, later, software industries developed alongside the pharmaceutical industry, and as tax practitioners developed greater expertise in working with the applicable rules -- the controlled foreign corporation rules of subpart F and the transfer pricing rules -- the practice of income shifting to low- and zero-tax countries grew. The introduction in the 1990s of the check-the-box rules, and of today's cost-sharing rules, accelerated the expansion of income shifting. I think it's fair to say that the extent of income shifting by U.S.-based companies to low- and zero-tax countries today extends far beyond what Congress and Treasury could have envisioned during the 1960s.
I also believe -- and I know some may in all sincerity disagree -- that the expansion of income shifting reflects failure of policymakers in the 1960s to foresee some of the substantive implications of the system they were creating. First, the policymakers of the 1960s probably didn't foresee that the courts would hold that Treasury does not have the power to tax the transfer by a U.S. company of the right to reproduce a profitable business model outside the United States. That is, I don't think it was foreseen in the 1960s that the transfer of a so-called business opportunity would be outside the reach of the transfer pricing rules.
When a U.S. company gives a subsidiary the right to try to replicate a proven business model overseas, the parent company has an expectation that the subsidiary probably will succeed in its efforts -- that is, the expected return at the time of the transfer is positive. Yes, there is a chance that the subsidiary's efforts will fail, but the overall statistical expectation is that the subsidiary's efforts will succeed and that the subsidiary will end up generating profits. If that expectation were not present, the parent company would not make the transfer.
Because of the statistical expectation of success, companies would not transfer business opportunities to unrelated companies without requiring substantial compensation. Our transfer pricing laws, however, do not require U.S. companies to receive arm's-length compensation when they transfer business opportunities to related companies. The result is that our transfer pricing laws permit the tax-free transfer of huge amounts of income-generating potential overseas, without a requirement that arm's-length consideration be paid.
I also think the architects of our international corporate tax system failed to appreciate the consequences of permitting the sourcing of business income to be determined by the terms of contracts that are made between members of commonly controlled groups, including contracts for the license of intangibles and other contracts that allocate risks and rights to income. The related companies that are party to those contracts all have precisely the same owners -- the same ultimate shareholders. Those contracts therefore involve no genuine adverse bargaining and do not apportion risks and rewards in any real economic sense. Market forces impose no discipline on the terms of those contracts; instead, the parties are free to draft those contracts with the sole objective of moving anticipated income to the lowest-tax jurisdiction. Not surprisingly, permitting taxpayers to rely on intragroup contracts for tax purposes has amounted to an open-ended invitation to shift income to low- and zero-tax countries.
I've listed only two central errors that I think policymakers made in the 1960s and that have been perpetuated until the present time. More could be said along those lines, but I'm not sure that offering a more detailed bill of particulars right now would be useful.
So I will move on to the question whether the income shifting that currently occurs inflicts damage that should be redressed as part of tax reform. Again, opinions may differ, but I am personally convinced that the shifting of income under our current tax rules has serious adverse consequences for the United States.
First, it seems apparent to me that the current rules -- particularly by allowing the tax-free transfer of business opportunity from the United States -- have drained off a large chunk of our corporate tax base. That erosion of the tax base has, I believe, led to chronic shortfalls in revenue collections from the corporate income tax. Those shortfalls have in turn contributed to the maintenance of a statutory corporate rate that is higher than is consistent with adequate levels of corporate investment and employment in the United States. Every tenth of a percentage point in the corporate tax rate directly reduces the expected after-tax rate of return from business investment. No other component of the tax system so directly and predictably diminishes incentives for business investment. By tending to push corporate tax rates higher, income shifting discourages investment and employment in this country.
A second economic problem raised by income shifting doesn't directly involve transfers of property out of the United States, but nevertheless inflicts economic harm on this country. Our current international rules, particularly the subpart F rules, make it easier for U.S. multinationals to shift to low- and zero-income countries income that is earned from manufacturing outside the United States than it is to shift income earned from manufacturing within the United States. Edward Kleinbard explains this problem well in a recent Tax Notes article.1 The relative ease of shifting foreign-earned, but not U.S.-earned, manufacturing income to low- and zero-tax countries creates an incentive for U.S.-based companies to shift their mix of investment and employment away from the United States.
I am not in a position to know the quantitative significance of this apparent bias toward non-U.S. investment. Nor am I sure that economic science is capable of measuring the effects of that bias with any degree of confidence. I will say, however, that in practice I have seen U.S. businesses choose to locate substantial operations overseas rather than here predominantly for tax reasons. I think that is unfortunate and, indeed, unacceptable.
But the most serious harm from our current international tax rules is not a tendency to erode the tax base or to skew investment and employment away from the United States. The most serious harm is not economic at all. The income shifting I have described is "perfectly legal," as the phrase goes, but the image that it presents to the public -- an image made available by leading journalists -- is deeply harmful. The public sees our most important business corporations and policymakers in Congress and elsewhere in Washington acting together, albeit legally, to shift hundreds of billions of dollars of income to mailbox companies in countries where the companies perform little, if any, business activity. Institutions that should be among the most worthy of respect in our society appear to be engaged in a kind of behavior that typically would be associated with society's less savory actors. This spectacle cannot possibly be failing to contribute to what is already an unhealthy erosion of public respect for governmental and business institutions.
The Shape of Comprehensive Reform?
I'd now like to sketch out my own very incomplete thoughts about where reform might be headed. These thoughts are intended to reflect two important principles:
- that reform, if it is to be effective, should involve many different parts of the tax system, not just the corporate income tax; and
- that especially given our stressed economy, we must be mindful of the need to minimize disincentives for investment and employment by U.S. businesses.
In particular, while I believe the income shifting now rampant among U.S. companies damages this country, I also believe income-shifting opportunities should not be ended without a significant reduction of the statutory corporate tax rate. To eliminate income shifting without substantially lowering the statutory rate would impose a large additional tax burden on many major U.S.-based corporations, including companies involved in valuable technological innovation. I think that would be inadvisable.
The combination of international tax reform with a substantial corporate rate reduction, however, will plainly be a net revenue loser. Responsible fiscal policy will require us to make up that revenue, and indeed to generate additional revenues, from other components of the tax system. This is why we can't reform our international tax system without a comprehensive reform that extends beyond the corporate tax.
In broad outline, what might a reformed system look like? Well, that's a big question, and I can't pretend to offer anything even close to a comprehensive answer. In various installments of this column, I've tried to offer a broad list of features that a reformed system might include2 -- although I recognize that there are counterarguments to each of my suggestions.
Key components of my admittedly incomplete picture of reform include:
- eliminating income-shifting opportunities through a revitalized subpart F and also probably eliminating other provisions that narrow the corporate tax base;
- dramatically reducing the corporate tax rate -- I have suggested a rate as low as 15 percent;
- the recovery of revenue, and the generation of additional revenue for deficit reduction, through increased rates and some curtailment of deductions for the highest-bracket individual taxpayers;
- technical measures to prevent the reduction of the corporate rate from inviting high-bracket individual taxpayers to use corporations as vehicles for tax deferral; and
- a "superdeduction" for employee compensation paid by businesses that are operated as sole proprietorships or in passthrough form, because those businesses will not benefit from a reduction in corporate rates but should receive incentives for the creation of jobs.
I am aware that raising additional revenue through rate increases on high-bracket individual taxpayers poses particular political problems in the current environment. It may well be preferable on both political and economic grounds to raise that revenue through a VAT or another new consumption tax rather than from the individual income tax. I believe, however, that attempts to institute a new consumption tax are likely to be more problematic politically than increased rates on high-income individuals. Further, a new consumption tax might be difficult to implement without adversely affecting the progressivity of the tax system.
My own approximate computations suggest that high-bracket rate increases under the individual income tax can raise the additional revenues that are needed while still keeping maximum rates very low by historical standards -- that is, less than 50 percent. These expectations of the revenue potential of even moderate individual rate increases may be optimistic. Also, I may be unduly pessimistic about the prospects for a VAT or other consumption tax. The main point, however, is that effective corporate and international tax reform will cost revenue and that unavoidably, the lost revenue and more will need to be recovered from other components of the tax system.
Comparison With 1986 Act
During discussion at the ATPI conference, a participant noted that 25 years ago, the Tax Reform Act of 1986 shifted a portion of the tax burden from individuals to corporations. My proposals for tax reform today, however, would have the opposite effect.
I believe that the 1986 experience reflects the longstanding uncertainty concerning who ultimately bears the burden of the corporate income tax. That uncertainty always has contributed to its political appeal. Accordingly, in 1986 the shift of part of the burden from individual to corporate taxation may well have contributed to the political viability of the 1986 act as a whole. The incidence of the corporate tax remains empirically uncertain today, and as in 1986, that uncertainty may pose political barriers to reduction of the corporate tax burden today.
Nevertheless, much has changed since 1986. Although the incidence of the corporate tax remains unclear, fewer people today accept the assumption that the corporate tax is progressive; instead, many accept the view that some part of the burden falls on labor. Hence, some who would not have accepted a shift from corporate to individual taxation in 1986 might today view that shift as progressive, provided the increases to individual tax rates are applied in a progressive manner. Also, apparent increases in the international mobility of capital since 1986 have made clearer the economic damage -- particularly the damage to domestic investment and employment -- caused by relatively high corporate tax rates. Hence, today more political actors may be open to the idea of lesser reliance on corporate, as opposed to individual, taxation as conducive to the well-being of everyone in the country, regardless of the extent to which they derive their income from labor or from capital.3
Seeking Political Balance
By coupling the elimination of international income-shifting opportunities with a dramatic reduction in the corporate rate, my proposals combine elements that respond to traditional Republican Party concerns and others that respond to traditional Democratic Party concerns. That mix is important, because I don't think there is any route to comprehensive tax reform that doesn't involve political trade-off and compromise of the traditional kind.4
Of course, the short list I have offered provides at best only a preliminary framework for comprehensive reform. Every item on the list poses significant problems of feasibility and implementation, and every item is likely to be highly problematic to one or more political constituencies. Building an effective reform package will require challenging technical work, as well as political creativity in crafting trade-offs and compromises.
So we come back to the problem with which this article started -- namely, that right now the formal legislative process is unable to make much progress toward solving the many problems that comprehensive tax reform presents. Therefore, it's necessary for nongovernmental experts, the "government in exile," to move the processes of technical refinement and political compromise forward until the legislative environment opens up again.
Given the complexity of the task ahead, are there any nuggets of advice I might offer as finishing touches to this article? Any such nuggets will, of course, reflect my own preconceptions, but with that caution in mind, let me offer two suggestions.
First, because I believe that effective tax reform will require a political willingness to reduce the corporate rate, I think that successful reform will require willingness among some constituencies that historically have supported relatively high levels of corporate taxation to reconsider that position. High corporate tax rates are at least as inimical to the interests of American labor as they are to the interests of corporate shareholders and management. A vigorous but self-disciplined public debate showing the effects of high corporate tax rates on all sectors of our population could, perhaps more than any other single factor, help make comprehensive tax reform feasible.
A second prerequisite to an effective tax policy debate is that those who hold leadership roles within, and who advocate on behalf of, companies that today benefit from international income-shifting opportunities and from other means of obtaining greatly reduced effective corporate tax rates refrain from the posture that the status quo is the only acceptable outcome of debate over comprehensive tax reform. Yes, there are many reasons why maintaining the status quo might appear to be in the interests of the corporation's shareholders from a short-term perspective. Tax reform is a risky business, and some companies that now enjoy low effective rates will risk seeing those rates increased. Therefore, there may well be an incentive to try to forestall the entire process of tax reform. That incentive imparts to the tax system its own internally generated tendency toward stasis, in addition to the stasis produced by the broad political logjam that we face today.
In the long and even intermediate terms, however, retention of our tax regime without fundamental reform is a recipe for growing economic and even social harm to everyone. I am not suggesting that those who represent corporate interests refrain from advocating the perceived financial interests of shareholders. But the advocacy of shareholder interests needs to be leavened by a recognition that the well-being of those shareholders depends on the country's overall economic and political well-being.
There may be substantive arguments that our current international tax system, with all its ramifications for the rest of the tax system, is an optimal system, so that tax reform would be counterproductive per se. In my own judgment, however, the defects in our current tax rules are glaring, and the harm that those rules cause is serious. I will even go as far as to say -- and I know some will disagree -- that some attempts to defend the status quo have become so intellectually strained as to have lost credibility. I think it's important that instead of falling into the trap of arguing for stasis, corporate leadership instead devote its considerable energy and skill toward promoting a redesigned tax system that will promote the country's economic and social well-being far better than the current system.
To sum up, the task of tax reform is stalled for the moment, and once the reform process is restarted it will face substantial political and technical obstacles. I am confident, however, that those with expertise in tax policy in this country have the intellectual and technical skills, the commitment to the country's overall well-being, and the impulse toward moderation and constructive interchange that will be needed to devise viable reform plans.
ATPI, which provided the original forum for these remarks, has always promoted precisely the kind of interchange that will be needed if reform efforts are to succeed. Other organizations also have excellent resources and can sponsor the kind of discussions, including debate among experts with competing viewpoints, that will be needed if ideas for viable reform packages are to be available when the country's current political deadlock moderates. I'm confident that policy experts in this country are equal to the challenges of overcoming temptations toward stasis, as well as organizing and accomplishing the kinds of difficult but essential conversations that will be needed if useful reform is to occur.
1 See Edward D. Kleinbard, "Stateless Income's Challenge to Tax Policy," Tax Notes, Sept. 5, 2011, p. 1021, Doc 2011-14206, or 2011 TNT 172-5. See also Martin A. Sullivan, "'Stateless Income' Is Key to International Reform," Tax Notes, June 27, 2011, p. 1315, Doc 2011-13744, or 2011 TNT 123-1.
2 See Michael C. Durst, "Radical Centrism and the Corporate Income Tax," Tax Notes, Sept. 5, 2011, p. 1059, Doc 2011-16938, or 2011 TNT 172-6; "An Employment, Equity, and Competitiveness Tax Act," Tax Notes, Sept. 26, 2011, p. 1435, Doc 2011-18976, or 2011 TNT 186-13; and "Small Business, Passthroughs, and Centrist Tax Reform," Tax Notes, Oct. 10, 2011, p. 247, Doc 2011-19849, or 2011 TNT 196-10 .
3 My personal skepticism toward corporate income taxation as an institution reflects 30 years of work within the corporate tax system during which the defects of the tax have become continually more evident. For a comprehensive criticism of the corporate income tax on economic as well as political grounds, see Yariv Brauner, "The Nonsense Tax: A Reply to New Corporate Income Tax Advocacy," 2008 Mich. St. L. Rev. 591. Although I don't, alas, consider it desirable on fiscal and other grounds to eliminate the corporate tax entirely, I believe the economic case for minimizing it is overwhelming.
4 In October 2011, the House Ways and Means Committee released a discussion draft containing tax reform proposals. The draft focuses primarily on the issues of international taxation that are discussed in this article. (For the discussion draft, see Doc 2011-22576 or 2011 WTD 209-33.) The Ways and Means draft invites discussion of opposing points of view and employs an analytical rather than confrontational tone. It is particularly promising in pointing out that in taking steps to ensure the international competitiveness of U.S. multinationals, Congress also needs to consider means to limit income shifting to low-tax jurisdictions. The discussion draft cannot, of course, in itself resolve the broad political impasse which has stalled serious consideration of tax reform. However, it represents a welcome step toward the kind of serious dialogue that might lead to effective reform.
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