You've been hearing a lot about corporations "renouncing their U.S. citizenship" through "tax inversions." This is when a company buys or merges with a non-U.S. company and claims to no longer be based in the U.S. to get out of paying certain taxes. The company does, however, keep the same employees, executives, buildings, sales channels and customers it had inside the U.S. before the switch.
The epidemic of tax inversions represents just one of many ways corporations are dodging their taxes by taking advantage of our outdated and rigged corporate tax system. It is time for a serious debate about corporate taxes, and on Monday a new report by District Economics Group economist Michael Udell offered a bold new alternative that is so radically simple that even the most clever corporate tax accountant would have a hard time finding a way around its fair and universal proposition: If a company sells products or services in the U.S., it must pay taxes on the U.S. proportion of its worldwide sales.
But first, let’s explore how today’s complexity enables corporate tax avoidance.
Are We "Broke" Or Just Not Collecting The Taxes We Are Owed?
"America is broke," declared House Speaker John Boehner a few years ago. But clearly the country is not broke; we are just being robbed, as many corporations create ways of avoiding, dodging, shirking and generally not paying their taxes. The share of federal revenue coming from corporate taxes has dropped from around 32 percent in 1952 to around 8.9 percent now. As a share of gross domestic product it has fallen from about 6 percent of GDP then to less than 2 percent now. Meanwhile the rest of us – including small domestic companies that don’t have armies of tax consultants – have to make up that shortfall, either through increases in things like payroll taxes, or through cuts in the things government does to make our lives better.
Our big problem is that the big, multinational corporations use so many tax avoidance techniques that it is difficult to keep up. One of the larger dodges is that we allow corporations to “defer” (i.e. never pay) taxes on profits made outside the U.S.. So they engage in all kinds of schemes to make it look like their profits are not made here. As a result many companies owe very little tax on the proceeds from their U.S. operations, and then defer their non-U.S. profits from being “brought home” to avoid paying the taxes on non-U.S. sales.
It is estimated that as much as or even more than $2 trillion of taxable profits are being hoarded outside of the U.S. because of deferral. Meanwhile, the corporations lobby for a "repatriation tax holiday" to let them bring these profits back with little or even no tax.
For example, currently Pfizer sells a whole lot of its medicines inside the U.S., but claims to lose money here, resulting in little-or-no inside-U.S. tax to pay. A Bloomberg story on Pfizer’s tax schemes reports, "earnings before taxes outside the U.S. were $15 billion in 2011 while losses within the country were $2.2 billion. … These operating results appear to be inconsistent with your domestic and international revenues, which in 2011 were $26.9 billion and $40.5 billion, respectively."
So Pfizer piles up cash – as much as $73 billion of taxable profits were held outside the U.S. in 2012.
Even if these corporations do bring the money back, it is very difficult to pin down which countries may have already taxed them and by how much, so it is very difficult to compute their U.S. tax liability. If it very difficult to sort through the complex maze of corporate ownership and the use of schemes like “transfer pricing, advance pricing agreements, cost sharing agreements, interest allocation arrangements, and check-the-box regulations,” along with the rest of the ways corporations game the tax system.
So along with this maze of complexity in figuring out how much corporations owe, in most cases the tax system depends on the corporations themselves to accurately report and pay the correct amounts. Needless to say, the incentives can end up working against the revenue needs of the government. The end result is that, one way or another, the multinational corporations get away with paying a lower effective tax rate than they should.
Current System Hurts Purely Domestic Companies And Jobs
Another result of the confusing state of loopholism is that corporations that use offshore breaks and subsidiaries gain a big advantage over purely-U.S. companies. The worst consequence of this is that the current tax system encourages these corporations to locate jobs, manufacturing operations and profit centers in lower tax countries instead of here so they can take advantage of the same loopholes.
More and more companies are moving more and more of their jobs, production, profit centers and profits out of the country. That is our future if we continue to accept the current system and the endless job of trying to make it more fair and consistent.
A New Study Shows A Solution
Udell's report, "Single Sales Factor Apportionment of Global Profits to Broaden the Tax Base" shows that as an alternative to the U.S. corporate tax system – called a single sales factor apportioned corporate tax – would not only simplify the tax code and reduce the burden of corporate tax compliance, but also promote the principle that all businesses pay their fair share.
The idea of “single sales factor apportionment” is to tax corporations based on where sales are made, not where profits are reported. So the share of a corporation’s total profit that the U.S. would tax would be based solely on the share of the corporation’s worldwide sales that occur in the U.S. If a company shows 10 percent of its sales occur in the U.S., then the U.S. taxes the company on 10 percent of its worldwide profits.
This new system treats foreign multinationals just the same way it treats American multinational corporations – and the same way it treats smaller U.S. domestic companies.
As this new study calculates, “using 2010 data, that an alternative definition of a corporate tax base using a sales factor apportionment of global profits could be as much as 159 percent larger than the current tax base. This tax base can be more transparent by design and less costly to comply with, both for taxpayers and the tax authority.”
Once again, the country could collect as much as 159 percent more corporate taxes using this method. This is as much as $200 billion more in corporate income taxes these companies should be paying now but have found various ways to dodge. This could be additional revenue for the government to pay for the courts, roads, schools, military and the rest that these corporations benefit from, or could be used to reduce corporate taxes to a rate of 29 percent, rather than the current 35 percent.
Simple and Enforceable
Corporate profits and the resulting tax liability are very hard to verify and enforce. The study looks at current tax laws and the ways corporations currently are able to make it look as if profits are made in various countries, or just underreport their profits. It addresses “asymmetric information” – meaning they can report one thing in one place and something different in another.
One example the study looks at is the different between “two-party” and “three-party” reporting. Currently corporate taxes are “two-party” while individual taxes are “three-party.” The two parties for corporate taxes are the corporation and the government. The government has to rely on the corporation accurately reporting its tax liability and/or use audits to verify its reporting. With individual taxes, a third party – employers – reports the wages to the Internal Revenue Service, and the employee also does. This works because the employer wants to report paying the highest income because they get a deduction, while the employee wants to report low income. This conflicting interest helps guarantee there is honest reporting. Without this third party the only way to verify is an audit.
The study explains that using “single sales factor apportionment” introduces a third party into the calculation of multinational corporate profits. Corporations want to report high worldwide sales and profits to shareholders because that boosts stock price and increases executive bonuses. This adds to the simplicity of taxing these corporations based on the share of sales that occur in a given country.
Companies "Leaving" The U.S. Still Would Pay The Same Taxes
Implementing the single-sales factor tax system would mean that companies gain no advantage from renouncing their U.S. corporate citizenship through an inversion, as described above. They would still pay taxes to the U.S. government based on the percentage of sales they make inside of the U.S.. If half the company's (and subsidiaries') sales are inside the U.S. then the company is taxed on half of their total worldwide profits, including subsidiaries.
The details of the study are laid out with discussions of various “in the weeds” points that the tax policy geek community understands.
… economic activity is captured and because cross-border income stripping is netted out. Global profits are defined as revenues less the sum of cost of goods sold, selling, general, and administrative expenses, and depreciation and amortization. (Research and development costs are included in administrative expense). This pre-tax, pre-interest expense, pre-other income definition of a tax base is shown in table 3 below. …
[. . .] estimated amounts of apportioned global profits are shown in the second row of table 5, and increase the financial statement sample’s U.S. apportioned global profits from $643 billion (table 3 above) to $1,196. Finally, these 14 industries accounted for 58 percent of business receipts for all corporate income tax returns (excluding financial services). Grossing up the U.S. apportioned global profits for the 14 industries to all corporations by (1/0.58) yields an estimate of apportioned global profits as $1,196 billion X (1/0.58) = $2,074 billion. This sales factor apportioned global profits tax base is 159 percent larger than the $801 billion of net income subject to tax reported for all corporations on 2010 returns.
You get the picture. Yikes! But it’s all there. Especially that last sentence, by the way: "This sales factor apportioned global profits tax base is 159 percent larger than the $801 billion of net income subject to tax reported for all corporations on 2010 returns (other than financial services)." That is a lot of opportunity to get the needed revenue to fund our roads, bridges, courts, schools and the rest of the things government does to make our lives – and the lives of our corporations – better.
The study shows that adopting sales factor apportionment could:
- Redefine the corporate tax base, permitting lower rates, increased revenue or some combination of both.
- Remove the incentives for U.S. multinational corporations to leave the U.S. through corporate inversions, and to leave their profits in offshore tax havens.
- Level the playing field between purely domestic businesses and multinational corporations.
- Reduce tax incentives to locate jobs and manufacturing operations in lower tax foreign nations, bringing opportunities for economic activity to the United States.
- Maintain Congress’ ability to lower rates or increase revenue to execute policy.
- Simplify accounting and reduce the burden of compliance on corporate taxpayers as well as administrators.