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Eric Toder



Who Should Get the Tax Revenue from Apple’s Intellectual Property?

March 17th, 2014

U.S. lawmakers are not alone in their frustration over Apple’s success at avoiding corporate income taxes by shifting reported profits to other countries. News organizations in Australia report that since 2002 Apple has paid only $193 million of Australia corporate income tax on domestic revenues of $27 billion – an income tax equal to just 0.7 percent of gross receipts.
If the analysis is correct, does Australia have a legitimate beef? Should Apple be paying Australia more? And, if not, where should Apple report its income?

The simple story is as follows: Apple licenses its technology to a contract manufacturer in China that produces iPads sold in Australia. Apple engages in marketing activities in Australia but its patents and other intellectual property (IP) are owned by an Apple subsidiary in Ireland, which receives a significant share of Apple’s worldwide profits. Apple pays only a 12.5 percent corporate tax rate in Ireland and avoids even some of this tax by shifting its reported profits to Bermuda, which has no income tax. This is perfectly legal.

Under current rules for taxing multinational companies, the country where the income is generated (the source country) gets the first bite. The United States (along with a few other countries) taxes the worldwide income of resident corporations, but allows firms to both take a credit for foreign income taxes they pay and defer tax on the active profits of their controlled foreign subsidiaries until the profits are repatriated back to the U.S. parent. Thus, Apple pays no U.S. corporate income tax on its active foreign-source profits as long as these profits remain overseas.

The value of iPads sold in Australia is generated from three sources: 1) Apple’s IP, 2) manufacturing of the tablets, and 3) marketing activities. The source of the income from manufacturing and local marketing is clearly China and Australia. Australia’s income tax collections reflect the return from local marketing activities, which are a very small share of the total value of Apple sales. But who should get the IP profits?

Is it Ireland, home of an Apple subsidiary that is treated as an independent firm even though it is owned by the U.S. parent? Or perhaps it is Bermuda, if Apple can shift the income there? The current rules allow this, but the idea that an Irish or Bermuda company, with little more than an office and a handful of employees, is generating a large share of Apple’s profits doesn’t meet a smell test, even if it is legal.

It is just this type of arrangement, combined with competitive and political pressures for countries to protect their home-based multinationals, that has led the OECD, at the request of the G20, to establish its Base Erosion and Profit Sharing (BEPS) process aimed at preventing profit shifting to low-tax countries.

If Apple is barred from reporting IP profits in Ireland, where should it report them? The income could be allocated to the United States, where most of the IP assets were originally developed. The Camp tax reform plan moves in that direction by requiring U.S.-based multinationals to report more of their low-taxed IP profits as current U.S. taxable income, albeit at a reduced rate for non-U.S. sales. This solution makes sense for profits from the iPad, which was developed in California.

But this answer is not always so clear-cut. An increasing number of companies are decentralizing their R&D operations. And because IP assets support production wherever it occurs, they don’t really have a single home.

Another solution would copy a model used by U.S. states: allocate worldwide profits based on some combination of tangible assets, employment, and sales. But with Apple using an independent contract manufacturer in China, its employees and factories would escape this allocation method. The Chinese company is taxable in China on its manufacturing profits, but these profits do not reflect the value of Apple’s IP.

That takes us back to Australia. No current theory of international corporate taxation – whether based on the source of profits or the residence of the corporation – supports the Aussies claim that they should tax a bigger share of Apple’s profits based on sales of iPads there. The Apple corporate group is not resident in Australia and very little of the value from Australian sales is generated there. However, some tax experts would allocate IP profits by sales of the multinational group, on the theory that firms would not forgo sales in a country to lower the tax rate on their worldwide profits. Under this type of destination-based tax, Australia might have a larger claim to the revenue after all.

There is no obvious answer to this conundrum. Those profits should be reported somewhere. The $64 billion question is: Where? A lot of countries would like a chunk of all that potential tax revenue.

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Tax Reform’s Quiet Protectionism

March 10th, 2014

House Ways and Means Chairman Dave Camp has offered a detailed and thoughtful set of proposals on international tax reform, as did former Senate Finance Chairman Max Baucus in November, 2013. The proposals, however, contain a new form of subtle protectionism. They quietly aim to discourage U.S.-based multinationals from making products overseas and selling them back to the U.S.

In effect, income from the sale in the United States of goods manufactured overseas by controlled foreign subsidiaries (CFCs) of U.S.-resident multinational companies would be taxed at a higher U.S. rate than other income from the same factory.

Here’s how it would work: Camp—like Baucus– would mostly or fully eliminate the taxation of dividends that these foreign subs pay to their parent company (Baucus would remove the dividend tax entirely on these repatriated earnings, while Camp would allow firms to deduct 95 percent of dividends.)

To limit firms’ incentive to shift reported profits to low-tax countries, both would impose minimum taxes on new forms of income accrued within foreign subs. Camp would exempt most active profits of foreign subs, but would apply a minimum tax of 15 percent (10 percentage points below his proposed corporate rate of 25 percent), to profits attributable to their intangible assets. These are the profits that are easiest to shift to tax havens because it is so hard to establish their correct value. Baucus would have gone even further by including either 80 percent of active income in low-tax countries or 60 percent of all active income of a foreign subsidiary (Baucus proposed two different options for corporate reform, dubbed Y and Z).

Camp would create a simple formula to compute intangible profits. He would assume firms earn a 10 percent rate of return on physical investments such as plant and equipment and attribute any excess returns to intangible assets such as patents or brand name reputation.

The net result is that the United States, like our major trading partners, would continue to tax most foreign-source income of U.S. firms at a lower effective rate than their domestic income. We’d also follow most of our major trading partners by mostly or fully eliminating the tax on overseas income that is returned to the United States while increasing taxation of accrued foreign-source income.

But here is the kicker: Camp would deny preferential U.S. tax rates for intangible profits of foreign subs for goods imported into the United States. Instead, they’d be taxed at the full domestic rate of 25 percent. Baucus would similarly deny the preferential treatment he provides to active income of foreign subs from sales to the United States by including all of these profits in current income.

The following table compares the U.S. tax rates on foreign subsidiary income under current law,Baucus’s option Z assuming a 30 percent corporate rate, and Camp’s plan with its 25 percent rate.

U.S. corporate   income tax rate Current Law Baucus Option Z Camp
Income of U.S.   domestic corporations 35%, 31.9% with   domestic production deduction 30%, 27.1% with   domestic production deduction 25%
Active income of foreign   subsidiaries of U.S. corporations from foreign sales 0% as accrued; 35%   when repatriated 18% as accrued 15% as accrued for   intangible income from low-tax countries; 0 for other active income with   1.25% repatriation tax
Active income of foreign   subsidiaries of U.S. corporations from U.S. sales 0% as accrued; 35%   when repatriated 30% as accrued 25% as accrued for   intangible income from low-tax countries; 0 for other active income with a   1.25% repatriation tax

 

Under current law, most income accrued within foreign subs is tax-free until it is returned to the U.S. and firms escape most of this tax by retaining and reinvesting these profits over seas. The lock-in of funds overseas does impose some costs on firms, estimated at slightly over 5 percent of foreign profits by economists Harry Grubert and Rosanne Altshuler. Still, this is much lower than the net tax they would pay by repatriating the profits.

Camp and Baucus remove most of this repatriation tax, thus eliminating a firm’s incentive to retain profits overseas. They’d tax foreign subsidiary income when it is earned to help prevent base erosion and income shifting. And they’d apply a higher tax rate to income of foreign subs from sales to the United States than to income of foreign subs from sales overseas.

What does a discriminatory tax imposed on income from imports from U.S. firms look like in the real world? Suppose Ford and Volkswagen produce automobiles in both the United States and Germany for sale to the United States and Europe. The U.S. would impose the same corporate tax rate on income earned from either firm’s U.S. plants no matter where the cars are sold. VW would pay no U.S. tax on income from its German plant, no matter where those cars are sold. But the story would be different for cars Ford produced in its German factory. Ford would pay a higher U.S. rate on income from the cars it sold into the U.S. than on sales anywhere else in the world.

This is what would happen under the Baucus plan because its tax is aimed at active income. Camp’s effective tariff would be more limited because it would apply only to intangible profits in low-tax countries. But U.S. firms that shift their profits from the use of intangibles to low-tax countries would still face a higher tax on sales to the United States than on sales overseas.

Since the end of World War II, the U.S. has gradually reduced its trade barriers, lowering tariffs that impose discriminatory taxes on goods produced overseas and sold here. But Camp (and Baucus before him) includes provisions that move in the opposite direction for goods and services produced overseas by U.S.-resident multinational corporations. The proposals discourage U.S. corporations from producing overseas for the U.S. market, but apply no similar tax penalty to imports from foreign-owned corporations.

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How to Improve the Tax Subsidy for Home Ownership

April 30th, 2013

Last week, at the request of the House Ways and Means Committee, I testified on how Congress could reform the mortgage interest deduction, a popular tax expenditure provision with a big sticker price.

The congressional Joint Committee on Taxation estimates the mortgage interest deduction will cost $380 billion over the next five years, making it one of the largest individual tax preferences in the Internal Revenue Code. The Urban-Brookings Tax Policy Center estimates that 40 million taxpayers will benefit from the deduction in 2015.

In spite of its widespread use and large fiscal cost, the deduction does little to promote home ownership. It provides no subsidy to the nearly two-thirds of taxpayers who do not itemize and only a modest subsidy to those in the 15 percent bracket.

The subsidy’s value is largest for families in high tax brackets who are most likely to own a home even without preferential tax treatment. Instead of promoting more home ownership, the deduction mostly encourages those who already own homes to buy larger and more expensive houses with borrowed money.

If Congress wants to encourage homeownership, it could direct more of the tax subsidy to prospective homebuyers who straddle the line between renting and buying. Two ways to better target the subsidy: Replace the deduction with a uniform percentage tax credit for mortgage interest, or provide an investment credit for first-time home purchases.

Replacing the deduction with an interest credit has enjoyed bi-partisan support. It’s been endorsed by the federal tax reform panel appointed in 2005 by President George W. Bush, the National Commission on Fiscal Responsibility and Reform appointed by President Obama, and the Debt Reduction Task Force of the Bipartisan Policy Center.

In my written testimony, I provided estimates for the effects of four potential reforms:

• Eliminating the deduction.
• Limiting it to interest on the first $500,000 of home acquisition debt.
• Replacing it with a 15 percent refundable credit on the first $25,000 of eligible interest.
• Switching to a 20 percent non-refundable credit for interest on the first $500,000 of home acquisition debt.

All these options would raise taxes and reduce the subsidy– mostly for upper-middle income taxpayers. Replacing the deduction with a credit would reduce tax burdens on average and increase the housing subsidy for those in the bottom 80 percent of the income distribution.

The revenue gains from all these options would be smaller if they are part of a broader tax reform that lowers marginal individual income tax rates. In that case, some options would even lose money. With lower rates, eliminating deductions raises less money, but new credits would cost just as much.

It is important to recognize that proposals to pare back the mortgage interest deduction could adversely affect housing prices, though how much of a hit they’d take is uncertain at best. Introducing reforms gradually would reduce risks to the housing market, though such transition rules would delay both the revenue gains and the improved incentives from the reforms.

The current mortgage interest deduction is hard to justify on policy grounds. Implementing policy reforms such as those I presented to the committee would encourage more homeownership at a lower fiscal cost. But designing appropriate transition rules that reduce market disruptions while simultaneously retaining the benefits of reforming the mortgage interest deduction will be challenging.

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Moving to a Territorial Tax May Not Be the Windfall Multinationals Expect

April 4th, 2013

House Republicans, former GOP presidential hopeful Mitt Romney, and the chairs of President Obama’s 2010 fiscal commission, Erskine Bowles and Alan Simpson, have all called for changing the way the U.S. taxes multinational corporations. The concept: Shift from a system where U.S. firms pay U.S. tax on their worldwide income to one where they’d pay U.S. tax only on what they earn at home—a structure known as a territorial system. A territorial system would accomplish this by removing the current tax that U.S. multinationals pay, net of foreign income tax credits, on dividends that their foreign affiliates repatriate to the U.S. parent company.

Backers of a territorial tax, including CEOs of many multinationals themselves, argue that the current worldwide system puts U.S. firms at a competitive disadvantage since they must pay the high U.S. tax rate on repatriated profits earned by their affiliates in low-tax countries, while multinationals based in territorial countries pay only the local tax rate on these profits. They also argue that since nearly all of the rest of the world uses a territorial system, it only makes sense for the U.S. to follow suit. The United Kingdom and Japan are the latest nations to eliminate their taxes on repatriated dividends.

These are compelling claims but for one problem: Existing territorial systems are in fact hybrids that include elements of a worldwide tax. And the current U.S. system is itself a mix of worldwide and territorial systems, in large part because it allows U.S. companies to defer tax on foreign income until they repatriate those earnings back to the U.S.

Any new system in the U.S. would almost certainly be a hybrid as well. As a result, the benefits to U.S.-based multinationals would vary widely. Some firms would come out ahead, but others would not.

While some worry about relatively high U.S. taxes on foreign source income, others worry that some U.S multinationals pay little tax on their domestic income. Multinational companies can shift their reported income from the U.S. to low-tax jurisdictions by allocating interest expenses and other fixed costs to domestic operations and manipulating the prices they report on intercompany transactions (transfer prices). This erodes the domestic tax base, especially for companies with large amounts of intangible assets such as patents, technical know-how, and brand identification. There is no easy way for tax authorities to determine what price companies should charge their affiliates for the use of these assets.

All countries have rules to protect their domestic corporate tax base. Transfer pricing rules and limits on interest deductibility (“thin capitalization” rules) curb income shifting. Other rules depart from a pure territorial system by requiring companies to pay an immediate tax on passive income accrued in foreign jurisdictions or by imposing a minimum tax on income from tax havens. For instance, the U.S. “subpart F” rules apply accrual taxation to portfolio investments and certain other foreign-source income.

While the United Kingdom and Japan have eliminated their taxes on repatriated income, they are also re-assessing their taxes on foreign accrued income. Japan taxes on a current basis foreign income that is subject to local tax rates of less than 20 percent. The U.K. limits the deductibility of interest expense against U.K income and is considering reforming rules for taxing accrued foreign profits.

U.S. lawmakers are trying to find the same balance. House Ways & Means Committee Chairman Dave Camp (R-MI) has proposed a territorial tax that would exempt 95 percent of foreign dividends received. But he’d also tighten subpart F and enact new thin capitalization rules. In addition, he’s considering three options to prevent base erosion –a tax on excess returns (similar to a proposal by President Obama), a version of the low effective tax rate test used by Japan, and inclusion in subpart F of intangible income from low-tax countries.

In practice, going territorial would eliminate all or most of the tax on repatriated dividends from foreign affiliates. But to counter increased incentives to shift reported profits overseas, the move to territorial could also include new rules to prevent income shifting and increased accrual taxation of some foreign source income.

These changes would eliminate the lock-in for repatriated profits, but could raise the tax burden on profits left overseas. Such a switch could increase economic efficiency because the lock-in of funds overseas imposes costs on multinationals, while producing no revenue for the U.S. Treasury. But would this benefit U.S. multinationals? Some corporations will indeed benefit from the chance to bring back their overseas profits without paying today’s repatriation tax. But others, who have learned how to avoid tax on their intangible profits under the current rules, may find themselves paying more. As with much else, the devil is in the details. Some corporations may regret getting what they wished for.

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Not Yet Time to Break Out the Champagne

March 18th, 2013

Those of us who have spent much of our careers in Federal tax policy offices have reason this week to feel vindicated. While the two political parties could not be further apart in their ideologies and their views about the proper role of government, the budget resolutions in both the Republican House and the Democratic Senate have taken a firm stand in favor of reducing special tax breaks.

The House Ways and Means Committee, in a letter signed by all its Republican members to Budget Committee Chairman Paul Ryan, states its intention to “make the tax code fairer by scaling back preferences that distort economic behavior and often benefit only a narrow group of individuals and businesses.” These cuts in preferences will be needed to meet Chairman Ryan’s goal of a tax code that raise the same revenue as current law with sharply lower individual and corporate rates.

The Democrats’ Senate Budget Resolution calls for “deficit reduction of $975 billion to be achieved by eliminating loopholes and cutting unfair and inefficient spending in the tax code for the wealthiest Americans and biggest corporations.” This consensus on the need to reduce tax breaks is truly extraordinary.

Tax wonks should celebrate this new development. For years, we have fought against proposals by politicians of both parties to lard the tax code with more special credits, deductions, and exemptions for supposedly worthy purposes. We have argued that these preferences make the tax law more complicated, distort economic choices, create unfairness in the treatment of taxpayers with equal ability to pay, and produce a general public cynicism with the income tax system. We have called the preferences “backdoor spending” or “tax expenditures” and argued that many of them would not stand up to scrutiny if introduced as direct spending programs.

With the notable exception of the Tax Reform Act of 1986, we have become accustomed to losing one battle after another.  And we have become resigned to defeat, explaining why politicians prefer tax breaks over direct spending and why that’s not always such a bad thing

Now both parties appear to be coming around to our long-held point of view. But there’s still a big problem: With the exception of a reference to benefits for corporate jets in the Senate’s resolution, there is no mention of a single tax benefit that the Committees would eliminate. And most of the money from tax expenditures comes from popular and widely used provisions, such as the exemption of employer benefits for health care and the home mortgage interest deduction.

The Senate Democrats do suggest some type of across the board limit on tax expenditures claimed by high-income taxpayers, an approach Governor Romney also discussed in the presidential campaign and Republican economic advisor Martin Feldstein promotes. But both sides have yet to identify the specific preferences they would remove to reach their revenue targets.

So I’ll keep the champagne bottle corked. Until the tax-writing committees offer specific proposals, we may only be seeing the tax side equivalent of familiar promises to control spending by eliminating “waste, fraud and abuse.” And, of course, Congress will have a hard time judging as wasteful any tax break that benefits a mobilized constituency. But we can still hope.

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The Coming AMT Debacle

December 10th, 2012

The Tax Policy Center (TPC) has estimated that going over the fiscal cliff will raise taxes on average by about $3,500 per household in tax year 2013, compared with extension of 2011 tax law. But tens of millions of Americans have a much more immediate problem. They’ll face a huge tax increase when they file their 2012 tax returns early next year. And many of them don’t even know it.

The trouble: A number of major tax benefits expired earlier this year, including the deductibility of state and local sales taxes as well as many business incentives. But by far the biggest problem comes from the expiration of the temporary increase in exemption levels under the alternative minimum tax (the “AMT patch”).

In 2011, the exempt income levels under the AMT were $48,450 for single taxpayers and $74,450 for married taxpayers. If Congress fails to act, these exemptions will decline to $33,750 for singles and $45,000 for couples. As a result, 28 million more taxpayers will be hit by the AMT, and many of the 4 million who would owe AMT even with a patch will owe even more.  

Overall, AMT liability will rise from $34 billion to $120 billion. Of that $86 billion increase, new AMT taxpayers will owe $64 billion—an average of about $2,250–while those currently on the tax will pay another $22 billion—an increase of about $5,500 each over the nearly $8,500 average they would pay with a patch.

If you suspect that a tax that affects 32 million households is not limited to the rich, you are right. It is true the enhanced AMT will hit upper middle-income taxpayers the hardest – 98 percent of those with adjusted gross income between $200,000 and $500,000 will pay an average of almost $11,000 in AMT on top of their regular tax liability.

But taxpayers with more modest incomes won’t be spared. About 88 percent of taxpayers with incomes between $100,000 and $200,000 will pay an average AMT of over $3,100, while 61 percent with incomes between $75,000 and $100,000 will be hit with AMT liabilities averaging nearly $1,500. Even many making between $50,000 and $75,000 will get hit: About 22 percent will have to cough up an average additional tax of more than $1,100.

To make matters worse, many of these taxpayers have no idea they will owe this extra tax when they file their 2012 returns.  Withholding schedules for 2012 did not reflect the expiration of the patch and it is a safe bet that few taxpayers factored it into their estimated payments for tax year 2012. One can hope that underpayment penalties will not be assessed on AMT taxpayers who paid too little withholding and estimated tax this year.  But even without penalties, an extra $1,000 or more in unanticipated liability in April will be a cruel hit on many middle-income families.

I wish I could end this post here. But the damage goes beyond those who will pay more taxes. The unpatched AMT includes complex rules for reducing certain tax credits and deductions under the regular tax if these benefits would otherwise make a taxpayer subject to AMT. IRS has designed its systems under the assumption that Congress would patch the AMT for tax year 2012 and will need to make extensive changes absent a patch. As a result, IRS estimates that over 60 million taxpayers, nearly half of all individual tax filers, may not be able to file their 2012 returns until March or later. So even if you won’t owe more tax this spring, your refund may be delayed for months.

Those lawmakers who seem willing to drive us over the cliff should consider how their failure to fix the AMT would affect millions of Americans. They are going to need a good story to tell taxpayers whose refunds will be delayed and a better one to tell those who will owe thousands of dollars more in taxes come April.

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Obama and Romney Display Their New Clothes

February 23rd, 2012

After a frantic day of listening to rival briefings and addressing reporters’ questions on the new tax reform plans unveiled by President Obama and Governor Romney, an old tale stuck in my mind. It was the famous Hans Christian Anderson fable of the emperor and his new clothes. You know the story: A powerful emperor hires two men representing themselves as expert weavers to make him a new and beautiful suit. He then goes to display his new clothing in public. The story concludes:

The emperor marched in the procession under the beautiful canopy, and all who saw him… exclaimed: “Indeed, the emperor’s new suit is incomparable! What a long train he has! How well it fits him!” Nobody wished to let others know he saw nothing, for then he would have been unfit for his office or too stupid. Never emperor’s clothes were more admired.

“But he has nothing on at all,” said a little child at last. “Good heavens! listen to the voice of an innocent child,” said the father, and one whispered to the other what the child had said. “But he has nothing on at all,” cried at last the whole people. That made a deep impression upon the emperor, for it seemed to him that they were right; but he thought to himself, “Now I must bear up to the end.” And the chamberlains walked with still greater dignity, as if they carried the train which did not exist.

That brings us to the new tax plans of Romney and Obama. In one sense, they were very different, as one would expect from two candidates with diverse philosophies and constituencies. Obama addressed corporate tax reform. Romney, who had already proposed to reduce the corporate rate, focused on individual taxes. Obama’s plan was complex and detailed; Romney’s simplistic.

But beneath the deep differences, there were striking similarities. Both men promised a 20 percent marginal tax rate cut – Obama in the corporate income tax rate, Romney in individual income tax rates. Both promised to pay for the rate cuts by closing loopholes. And, although Obama has advanced some proposals to end corporate preferences, both refused to identify fully (or, in Romney’s case at all) the specific measures needed to pay for the rate cuts.

All that is missing is a little child who will point out the obvious.

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Another Great Morning in the Nation’s Capital

June 24th, 2011

I woke up to the headlines in today’s Washington Post – House Majority Leader Eric Cantor and Senate Minority Whip Jon Kyl were walking out of the budget negotiations. The Democrats, they said, were insisting that revenue increases be part of any agreement. No revenue increases were acceptable – period. Not even the closing of loopholes that few could defend with a straight face would pass muster. As the Post editorial writers noted this morning, Tom Coburn and other Senate Republicans may think it is OK to cut ethanol subsidies, but because that is scored as a revenue increase, it will never be acceptable to the House majority.

I ate a healthy breakfast in my comfortable air-conditioned house and stepped into the air-conditioned car in my garage to head for the DC Metro. As I drove into a nearby suburb to catch the subway, I noticed all the traffic lights were out. Today we have another power failure, affecting who knows how many homes and businesses. It will just be a blip on the evening news. The drivers adjusted, treating the nonfunctioning traffic signals as four way stop signs, and I soon arrived at the Metro. Today, the trains on the line I take were running on schedule. But at my downtown station, one of the deepest in the system, none of the escalators were working. We trudged quietly and uncomplainingly up the steps in the heat and humidity. And metro escalator failures are such a common event, I doubt it will get any news coverage.

But we are told we don’t need to spend more on these or other public services or public and private infrastructure. In fact, if they are in the public sector, we should cut them. And no one should have to pay higher taxes – especially those with the highest incomes who may rely less on public services or the social safety net. The worst thing we can do is to enact “job-killing” tax increases. If we have 9 percent unemployment following a decade of tax cutting, imagine how bad it would be if we reversed course. Instead, we are told, we need deep and immediate spending cuts, although advocates of these cuts sometimes forget that people who work on publicly funded projects also have jobs.

You may think I just woke up in a bad mood today. But that would be wrong. I woke up in a good mood. After all, it’s Friday. It was the series of breakdowns – none an extraordinary event – in the first hour of the day that soured my outlook.

We do face a serious long-term budget problem going forward. And both spending cuts and revenue increases will need to be part of the solution. I hope our leaders can find sensible ways to pare spending that maintain key infrastructure and protect our most vulnerable citizens. And I hope they find ways to raise revenue that eliminate outmoded preferences, spread the burden fairly among those with different incomes, and minimize economic harm. But sometimes, I confess, I am not very optimistic that any of this is about to happen and today is one of those days.

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Is the Corporate Tax Going Away?

April 25th, 2011

Individuals who just filed their taxes this year might be wondering why they face high tax rates when big corporations apparently manage to escape the tax net. In the March 25, 2011 New York Times, David Kocieniewski reported that the nation’s largest corporation, General Electric, earned a profit of $14.2 billion in 2010, while claiming a tax benefit of $3.2 billion. He went on to note that the strategies GE and other corporations have followed to reduce their taxes, combined with tax law changes that have encouraged more businesses to file as individual taxpayers, have pushed down the corporate share of the nation’s tax receipts from 30 percent of all federal revenue in the mid-1950s to 6.6 percent in 2009.

GE of course has its own defense of its tax position and Mr. Kocieniewksi was careful to attribute GE’s low reported taxes to aggressive tax minimization strategies and successful lobbying, not to any illegal tax evasion. And there are many reasons that taxes reported on financial statements may not provide a very accurate picture of a company’s effective tax burdens.

But what struck me more in the article was the apparent sharp decline in corporate receipts. Is the corporate tax really going away or was this just a cleverly constructed example?

Let’s start with the two time periods cited in the article, the 1950s and 2009. Corporate taxes were much higher in the 1950s than they are now, measured either as a share of all federal receipts or as a share of gross domestic product (GDP). High rates enacted during World War II were still in effect (from 1952 to 1963, the top corporate rate was 52 percent, compared with 35 percent today), globalization of corporate activity had barely begun, and U.S. corporations faced little competition from foreign-based multinationals. In contrast, in 2009, we were in the deepest economic slump since the Great Depression and corporate profits dropped sharply. Revenues from corporate taxes plummeted from 2.7 percent of GDP in 2007 to just 1 percent in 2009 (see TPC graph).

So, what has been the long-term trend in corporate revenues? Corporate receipts as a percentage of GDP were indeed much higher in the 1950s than today and were still higher than today in the 1970s. But in recent decades, including CBO’s projections for 2010-2019, corporate receipts have been remarkably stable as a share of GDP. Here are the figures:

Following a sharp dip after Congress enacted massive corporate tax breaks in 1981 (mostly reversed in the Tax Reform Act of 1986), corporate tax collections have stayed fairly constant at slightly under 2 percent of GDP and between 10 and 11 percent of federal receipts for most of the past thirty years. If the CBO projections are correct and Congress does not enact additional corporate tax cuts, they will remain in the same range in the next decade as well.

Within these broader trends, there have been some sharp annual ups and downs resulting from the economic cycle and enactment of temporary tax incentives. And we know there are ways that some large corporations can and do legally reduce their tax liability. Corporate tax receipts are a less important source of federal revenue than they were in the early post-war period. But the data simply don’t support a conclusion that the corporate tax is going away.

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Tax Expenditures are not Loopholes

April 22nd, 2011

George Orwell once wrote: “If thought corrupts language, language can also corrupt thought.” I am reminded of Orwell and his deep concern with the misuse of language for political ends when I see pols of both parties label tax expenditures as “loopholes” or “earmarks.”

The House Budget resolution promises an individual tax reform that “simplifies the broken tax code, lowering rates and clearing out the burdensome tangle of loopholes that distort economic activity.” The Fact sheet describing President Obama’s new budget framework calls for “individual tax reform that closes loopholes and produces a system which is simpler, fairer, and not rigged in favor of those who can afford lawyers and accountants to game it.” The bipartisan National Commission on Fiscal Responsibility and Reform notes that the tax system is riddled with tax expenditures and adds, “These earmarks not only increase the deficit, but cause tax rates to be too high.”

The Congressional Budget Act of 1974 defines “tax expenditures” as “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of liability.” The late Stanley Surrey, a Harvard law school professor turned top Treasury tax official, promoted the use of the term “tax expenditures” to highlight the increased use of the federal income tax as a vehicle for Congress to enact backdoor spending. And they are very big: the annual revenue loss from these provisions now totals more than $1 trillion.

But the largest tax expenditures are not loopholes or earmarks snuck into the law in the dead of night to benefit a shadowy handful of super-wealthy individuals or well-connected corporations. Rather, they benefit tens of millions of taxpayers. Among the biggest: itemized deductions for home mortgage interest, charitable contributions, and state and local taxes, exemption of income accrued within tax-preferred retirement saving accounts, and the exemption from tax of employer contributions to health insurance plans. IRS data show that 39 million taxpayers claimed deductions for home mortgage interest and charitable contributions in 2008, and 35 million deducted state and local income taxes.

Loopholes and earmarks are something entirely different. That great source of all knowledge, Wikipedia, defines a loophole as “a weakness or exception that allows a system, such as a law or security, to be circumvented or otherwise avoided.” From the same source, an earmark is “a legislative provision that directs approved funds to be spent on specific projects, or that directs specific exemptions from taxes or mandated fees.” When people think of “tax loopholes”, they rightly think of sophisticated transactions that enable the well-advised to avoid taxes that Congress wanted them to pay. When they think of “tax earmarks”, they rightly think of narrow and highly technical provisions slipped into legislation at the behest of a compliant Member of Congress. These provisions—once dubbed “rifle shots” — benefit only a few very specific taxpayers (sometimes only one), and are the tax equivalent of appropriated funds given to a single project or congressional district.

Labeling broad provisions that are easy to use and benefit millions of taxpayers as “loopholes” or “earmarks” exaggerates the benefits of tax reform. But worse than deceiving others is the self-deception this misuse of language produces. There are strong arguments for paring back or eliminating some of the large and popular tax expenditures and tax expenditures should certainly not get a free pass when Congress is cutting direct spending. And I agree that restructuring and cutting tax expenditures should be a big part of any effort to bring the deficit under control. But let’s not kid ourselves that these cuts will be easy or that cutting back on provisions like the mortgage interest deduction, exemption of employer-provided health insurance, or retirement saving incentives will affect only a few well-advised taxpayers. And let’s also not kid ourselves that we can raise any significant money from tax expenditures without touching these and other large and popular provisions.

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