There aren’t many things that Republican and Democratic politicians concur on nowadays. But most would agree that our corporate income tax system is a mess. Barack Obama tried several times to address it without success, and Donald Trump made tax reform a rallying cry of his campaign.
The common complaint is that U.S. companies face one of the highest tax rates in the world at 35%. In reality, few pay that much, because the tax code is also full of loopholes — the worst of both worlds. While corporate giants tie themselves in knots trying to shield income, the share of federal revenue from profits has declined from around 30% in the 1950s to about 10% today.
The question is what to do about it, and that’s where consensus usually ends. But with a single party now running the government, the prospects for a tax overhaul are better than they’ve been in years. Both the president and House speaker Paul Ryan have outlined plans that aim to slash the statutory tax rate — Ryan’s to 20%, Trump’s to 15%.
These two leading Republican proposals could affect businesses in very different ways. To learn more, we sat down with Stanford Graduate School of Business professor Lisa De Simone, a former tax strategy advisor herself, whose research studies the effects of tax rules on corporate behavior.
What’s wrong with our corporate tax system?
The worst thing is it distorts business decisions. It causes firms to make choices they wouldn’t otherwise make — and that often aren’t great for the country. If you’re a CEO and you see that you can save hundreds of millions of dollars in taxes by moving your operations offshore, other things being equal, that’s what you’re going to do. Companies respond to the incentives in front of them.
Now, in principle that shouldn’t happen, because we tax U.S.-based firms on all of their global income, regardless of where it’s generated. Offshoring doesn’t reduce a company’s tax liability. But the rules say they don’t have to pay the IRS on foreign earnings till they bring the money back home. So guess what? They don’t. U.S. multinationals now have around $2.6 trillion in unremitted income parked overseas, a lot of it as idle cash.
Nobody likes this. Companies could use that money more productively at home to invest in facilities and hire people; even just distributing it to shareholders would probably be better. The government could use its portion to build infrastructure. Instead we have the sight of Apple sitting on huge cash reserves and borrowing money to fund its domestic activities.
Does the high tax rate also cause companies to game the system?
Oh, sure. For instance, companies exaggerate the significance of their foreign operations. You see these elaborate, murky corporate structures with subsidiaries that might be just a mailbox in Bermuda. If a firm transfers intellectual property rights to one of these units, it can say much of the profit on its overseas business was earned there. It’s a way of shifting income to tax havens.
Do multinational firms end up paying less tax?
Well, some of the U.S. tech giants have achieved very low effective tax rates in this way. There’s been a lot of negative press about that, and so I think your assumption is pretty common. But no, on average, the data suggest that multinationals pay slightly more than domestic-only firms.
Why is that?
In the 30 years since the last big tax reform under Reagan, a lot of exemptions and credits have found their way into the tax code, and in my opinion many of them were meant to try to keep businesses in the U.S. There’s even an explicit “domestic production activities deduction.” The upshot is that most firms don’t pay anything like 35% of their income in federal taxes; the average for profitable domestic companies is closer to 25% or less. That’s roughly on par with other developed nations.
President Trump says his tax plan will bring the factories home. But if we already have tax breaks for domestic production, can tax reform make much of a difference?
I think it’ll help. But if that’s the main reason you’re doing it, you might be disappointed. Has our high tax rate contributed to job losses? Sure, but it’s only part of the picture. You can further reduce the tax burden on U.S. factories, but it may still be cheaper to manufacture overseas.
What about the $2 trillion in foreign earnings — what would it take to bring that home?
One way is a repatriation tax holiday. That’s an amnesty that lets companies bring the money back tax-free or at a low rate. We had one in 2004, and that seems to have created expectations that another one is inevitable. So it’s become a game of chicken: Who’s going to blink, the firms or the feds? Companies have been lobbying hard for a tax holiday, and Trump endorsed the idea during the campaign. But if that’s all you do, then the cycle just starts over again.
Will Trump address the root of the problem?
I think he really wants to end the lock-out of foreign profits once and for all, but it’s hard to tell if he’s settled on an approach. During the campaign Trump seemed to favor an end to deferral on foreign earnings. In other words, going forward, corporations would have to pay tax immediately on all their income worldwide, so there’d be no reason to hold cash overseas. And then you make that palatable by lowering the tax rate.
By the way, that’s what Obama tried to do, and it’s still the approach favored by Democrats. But Obama would only have lowered the rate to 28%. Trump wants to cut the tax rate to 15%, which is pretty low by world standards.
In his latest proposal — which is still just a page of bullet points — the president seems to have adopted an idea from Paul Ryan’s House plan: He now says he wants to move away from our system of global taxation to what’s called territorial taxation, where firms are taxed only on U.S. income. So instead of taxing offshore profits at once, he’d stop taxing them altogether.
Which is how most countries do it.
Right. And of course U.S. multinationals have been clamoring for this for years. They talk about “abolishing the repatriation tax,” which makes it sound like there’s a separate, unfair tax on foreign income. It’s just the ordinary income tax that companies have deferred for so long that they sort of stop thinking of it as a liability they already owe.
Why hasn’t the U.S. adopted a territorial tax system?
There are real risks. If you say foreign earnings aren’t taxable, you’re incentivizing companies to shift more of their operations offshore. And if you try to counteract that with a low tax rate like 15% — and at the same time, you’re shrinking the tax base by excluding foreign profits — you could be looking at significant revenue losses. It might really increase the federal deficit.
Now, in transitioning to this new system, you’d probably have a one-time tax on all those past profits that are parked offshore. I suspect the administration would use that revenue bump to make the deficit effect appear smaller, but that won’t help in the future.
How does the House proposal differ?
Both plans, as they stand now, would tax only U.S. income. The big difference is in how they define what U.S. income is. Ryan’s plan proposes something really new: that tax liability be based not on where companies generate income but on where they realize it — basically, where the customer is. So if a factory in Detroit sells to a customer in the U.S., the profit on that sale would be taxable; if it sells to someone in France, it wouldn’t be. It’s described as a “destination-based cash-flow tax” — DBCF.
As a political slogan, that’s not very catchy.
It’s also referred to as a “border adjustment” tax. Not a whole lot better.
What’s the reason for defining income this way?
It’s much simpler; it’s all based on observable transactions. On the revenue side, you stop trying to determine where firms are creating value, so they can’t play this game of masking where their significant operations are. And firms would expense the full cash price of all their purchases, even for capital goods like machinery — no more complex depreciation schedules.
So it doesn’t matter how they finance those purchases?
Right. That would no longer matter. Today, firms can deduct interest payments in computing their tax, and that distorts the choice between debt and equity financing — U.S. companies are more highly leveraged as a result. It’s essentially a subsidy on borrowing. Ryan’s plan would do away with that.
Republicans like to say, “Broaden the base and lower the rate.” The idea is, you cut back on special tax breaks — in popular terms, you “close the loopholes” — and that increases the base of income that actually gets taxed. Then you offset the added revenue by lowering the rate for everyone. In broad strokes, both Trump and Ryan are following this agenda. You see it also in their proposals to eliminate a lot of the deductions in the individual income tax.
Is Ryan’s plan a bigger departure from our current system?
It is, and that probably makes it a long shot. I think it’s quite intriguing, but there are a lot of unknowns. For one thing, it could have repercussions for international trade, and that in turn would benefit some companies at the expense of others.
How would it affect trade?
It’s not a tariff, but it is effectively a tax on imports and a tax break for exports, and the World Trade Organization might well declare that it violates trade rules. Economic theory says the dollar would appreciate to exactly offset the tax so that there’d be no net effect on the trade balance. But we don’t really know. Things don’t always work out so neatly in the real world.
So it could create winners and losers?
Right. Retailers like Walmart that import goods to sell in the U.S. would no longer be able to deduct the cost of those purchases, so they’d get hit on the import side without benefiting from the tax break on exports. Same with automakers that import parts and assemble cars for the U.S. market. I think domestic-only businesses will be pretty skeptical about the House plan.
Tax reform is so hard in our political system. What are the odds of a law actually passing this time?
The fiasco over health care last month, when Republicans couldn’t agree among themselves, has probably dimmed people’s optimism. But if the White House is now endorsing territorial taxation, it means the Trump and Ryan plans have moved closer together. Let me put it this way: With an undivided government, we finally have the stars aligned to make tax reform possible. Not just tax cuts, but real reform. If they don’t get it done, it would be a badly missed opportunity.