Billions of dollars in tax revenue per year that could be going to fund government programs and projects such as improving American infrastructure are instead going overseas.
And that's why Rep. Carlos Curbelo (R-Fla.) told Independent Journal Review in an interview last week: “The most important thing for us to do is address corporate base erosion.”
U.S. multinational businesses obviously do what they can to avoid paying taxes — and the GOP-led Congress is still haggling over how to solve that in their quest to reform the tax code. Now that the border adjustment tax, one of boldest (and most reviled) aspects of the Republican tax reform plan has been ruled out, lawmakers are working through possible replacements to deal with the growing problem.
“If all we do is reduce rates, we’re still going to see corporations transferring intellectual property overseas, jobs, operations, and loading up their American companies with debt to benefit from our current tax code with interest deductibility,” Curbelo said.
Reducing rates, simplifying the tax code, and moving to a territorial system to encourage economic growth are all important goals, Curbelo said. “But if we don’t address base erosion, we’re still going to see a lot of frustration in the American economy,” he said.
What Is Corporate Base Erosion?
Corporate base erosion is what happens when U.S. multinational businesses take steps to avoid paying America's steep corporate tax rate on their income. The top U.S. corporate tax rate is 35 percent. Elsewhere, such as in Ireland, companies pay rates in the low teens. So multinationals move some of their business and earnings abroad, which leads to a smaller pool of taxable income from which Uncle Sam can collect his 35 percent.
Lawmakers on both sides of the aisle agree they need to address corporate base erosion, but they disagree on the ways to do so.
For a clearer explanation, Independent Journal Review caught up with Alan Cole, who was an economist with the Center for Federal Tax Policy at the Tax Foundation from 2013 until this summer, when he left to pursue a Master of Business Administration at Wharton. Here's his three-pronged definition:
- “Corporations are multinational. Multinational means there's more than one tax system. So a company will pay taxes in many different jurisdictions, each of which has their own tax system.”
- “When we talk about 'base' in taxes, it means the thing you're taxing.” (So corporate base erosion equals dwindling of the amount of taxable corporate income.)
- In the same way bodies of water find leaks to flow through, corporations will always find ways to avoid corporate taxes — which should be noted isn't necessarily illegal.
It's all about moving income from high-tax jurisdictions to low-tax jurisdictions — also known as profit shifting.
How Do Corporations Avoid Corporate Income Taxes?
One of the many ways multinational corporations shift income from jurisdictions with high tax rates to jurisdictions with the lowest rates is by manipulating transfer pricing. In summary, according to Cole:
- Imagine you have a U.S. corporation. You also have a subsidiary of the corporation based in Ireland, which has a much lower corporate income tax than the U.S.
- When you do business with your Irish subsidiary, they charge you exaggerated prices for products, intellectual property rights, or services, and you're OK with that. You don't try to negotiate lower prices, because you're on both ends of the transaction (and you want your money to go to Ireland, where it will be taxed at a lower rate.)
- Your U.S. corporation deducts the income you gave to the Irish subsidiary against the 35 percent rate in the U.S. Meanwhile, the Irish subsidiary's income (which is also your income) is taxed in the low teens across the pond.
- If the IRS takes notice of your soft negotiating, they’ll accuse you of not doing transfer pricing at arm's length. That means your transactions are too cozy with the subsidiary, rather than acting like it's a deal with a separate entity in the open market.
“[The IRS] will say, ‘No, you can’t pay the Irish subsidiary that much.’ And that’s a whole field of law,” Cole said. “If the company can justify it, and if they can do just enough that the IRS doesn’t come after them, they’ll do it.”
How Big of a Problem Is Profit Shifting?
As markets have become increasingly globalized over the past half-century, profit shifting and base erosion have plagued every country that levies a corporate income tax.
A research paper published in the National Tax Journal last December titled “The Effect of Profit Shifting on the Corporate Tax Base in the United States and Beyond” by Kimberly A. Clausing, an economics professor at Reed College in Oregon, argued that “base erosion and profit shifting is a larger problem today than ever before.”
Clausing put the issue into context using Bureau of Economic Analysis data from the years 1983-2012:
- She estimated profit-shifting behavior by U.S. multinational corporations cost the U.S. government anywhere from $77 billion to $111 billion in corporate tax revenues in 2012. Those costs amounted to about 30 percent of U.S. corporate income tax revenues that year.
- “These revenue losses have increased substantially in recent years; in dollar terms, revenue losses have increased by about 250 percent since 2004,” Clausing wrote. “For the world as a whole, including the United States, revenue losses may be in excess of $280 billion in 2012.”
Clausing also found that in 2012, half of all foreign income earned by U.S. businesses was reportedly earned in seven of the top nine low-tax locations — the Netherlands, Ireland, Luxembourg, Bermuda, Switzerland, Singapore, and the U.K.'s Caribbean islands — none of which have effective tax rates above 5 percent. At the same time, those countries accounted for only 5 percent of the foreign employment of said U.S. firms.
Clausing testified in May before the House Ways and Means Committee, where she emphasized the magnitude of the profit shifting problem.
While it's clear to members of both parties that profit shifting and base erosion are problematic, it's not exactly clear how best to deal with it, considering its global scope.
“There have been efforts to save the corporate income tax, but as of right now, the pressures to lower your corporate rate are just very, very strong, especially in Europe,” Cole told IJR.
“As a result, corporate rates around the world keep declining,” he said. “Some people call that a 'race to the bottom.'”
The BAT: Elegant, Loathed ... And Now Dead
House Speaker Paul Ryan (R-Wis.) thought he had a way to solve the issue of base erosion in the U.S.: the border adjustment tax (BAT).
The BAT would have made income from U.S. exports tax-exempt while imposing a 20 percent tax on imports. The Tax Policy Center calculated the BAT would raise just over one trillion dollars in a decade, partially financing the dramatic individual and corporate tax cuts Republicans want to pass.
Such a system would have disincentivized many American businesses from moving operations and profits abroad, as the costs of selling goods with the BAT likely would outweigh the tax breaks associated with profit shifting.
“That was bold and radical and of course, that was why it failed,” Cole told IJR. Opposition among retailers and other businesses who rely on legitimate cross-border transactions was fierce, and there was little support for the policy within the Republican Party.
In July, after a drawn-out battle, the Big Six — a group of administration officials and Republican lawmakers shaping the tax plan including Ryan, Treasury Secretary Steven Mnuchin, National Economic Council Director Gary Cohn, Senate Majority Leader Mitch McConnell (R-Ky.), Senate Finance Chairman Orrin Hatch (R-Utah), and Ways and Means Chairman Kevin Brady (R-Texas) — declared the BAT officially dead.
Now, Cole said, Republicans don't have a plan to address base erosion. They may consider previous strategies to close loopholes, which were more industry-specific.
Finding the Republican Tax Plan
Republicans instead have been toying with a few ideas over the August recess, but no decisions have been made public. With border adjustment off the table, companies are more optimistic about the impending tax plan.
One reason for private-sector optimism: Many Republicans support the idea of switching to a territorial system. Under such a system, U.S. corporations wouldn't be taxed on their foreign income, eliminating the so-called lockout effect that happens when companies don't bring their foreign earnings back to the U.S. to avoid taxes.
Income earned in Ireland would be taxed at the Irish rate, and the profits would be free to flow into the U.S. (for investments, shareholder payments, and more) without another layer of taxes, which is currently determined by the difference between the foreign rate and the U.S. corporate rate.
But a territorial system without a border adjustment tax would encourage foreign investments, rather than the other way around, potentially exacerbating the problem of corporate base erosion instead of solving it.
Grover Norquist, a high-profile Republican activist and the founder of Americans for Tax Reform, told IJR in an interview Wednesday that the best way to end corporate base erosion would be to simply cut the corporate tax rate, making America more competitive globally.
“Rates down solves most of your problems, and that's the best way to avoid base erosion,” Norquist said. He argued that complaining about American companies leaving the U.S. is “like the East Germans whining about people going over the wall.”
“If you didn't have such an ugly structure in East Germany, people wouldn't go over the wall. If you didn't have such an ugly tax policy, people wouldn't move out of the States,” Norquist told IJR. “So we need to focus on the part that the government can do to fix this problem by reducing government abuse, not by adding to it.”
Like President Donald Trump, Norquist wants Republicans to slash the corporate tax rate to 15 percent, but congressional Republicans doubt such a drastic cut would be feasible under plans for the bill to be revenue-neutral.
House Republicans are instead shooting for a 20 percent corporate rate. And hurdles remain for the tax effort — Republicans will have to pass a budget resolution when they return in September, which currently lacks support to pass on account of conservative lawmakers who want to see more drastic cuts to federal spending.
In the meantime, policy writers are attempting to find some kind of elusive fix for base erosion.
“It's a really important part of our system: getting to the right balance on our international tax priorities," a House GOP aide told IJR.