Legislative Impact Accounting: Incorporating Prospective and Retrospective Review into a Regulatory Budget

December, 2017

Congressional decision‐making suffers from scarce information about the scope and economic consequences of legislative actions. This paper proposes a better method to overcome congressional information scarcity. Our proposal relies on the premise that regulations have similar economic effects as taxes and spending, and therefore should be scored and tracked as part of the budget process. Our proposed system of legislative impact accounting (LIA) builds on the concept of a regulatory budget by developing a system for both prospective and retrospective review to create an effective feedback loop to better communicate information about economic effects of regulations to Congress.

Getting to True Tax Reform in 2017

April 18, 2017

The United States has an infamously dense and complicated tax code that is in dire need of simplification. The tax system severely distorts individual and business decisions and the allocation of their respective resources; it hampers job creation and impedes both economic growth and tax revenue.

As policymakers further develop their tax reform agenda, a new Mercatus Center policy brief outlines the key goals for successful tax reform (below). It applies these goals to specific policy proposals, including several components of the House Republican Tax Reform Task Force Blueprint.

Academic research suggests that a successful revenue system should be:

Simple. The complexity of the tax system makes compliance difficult and costly. Complexity also encourages tax avoidance. A simpler and more transparent tax code promotes compliance and increased revenues.

Efficient. The current tax code impedes economic growth by distorting market decisions in areas such as work, saving, investment, and job creation. An efficient tax system provides sufficient revenue to fund the government’s essential services with minimal distortion of market behavior.

Equitable. Americans of all income levels believe the tax code is unfair. This perception is largely fueled by the code’s “loopholes”—provisions intended to benefit or penalize select individuals and groups. “Tax fairness” should reduce or eliminate provisions that favor one group or economic activity over another, especially among equal-income earners.

Predictable. Tax certainty is a necessary condition for robust economic growth and investment, and it enhances competitiveness. An environment conducive to growth requires a tax code that provides both short- and long-term predictability.

The House Republican Blueprint provides an overall good plan to reform the tax code. However, the novel proposal of a border adjustment tax presents an unnecessary risk to the US economy and should be avoided. The proposed border adjustment should be recognized as little more than a new source of revenue because it is not a pro-growth reform. Policymakers should focus on more conventional and pro-growth reforms going forward.

Border Adjustment Tax

February 23, 2017

The US system for corporate taxation is likely to see major reform in the coming years. Perhaps the most dramatic departure from the current income-based system is a proposal in the House Republican Tax Reform Task Force Blueprint. The Blueprint proposes a type of border-adjusted tax called a destination-based cash flow tax (DBCFT) as a full replacement to the current corporate income tax. The economics of this new tax proposal are poorly understood, and it presents unnecessary risks to the US economy.

The proposed cash flow tax allows businesses to immediately deduct all expenses from revenue, including capital investments and labor. To keep the US tax from being levied on consumption in other countries, the tax is “border adjusted,” or removed from exports and added to imports. In effect, this means imports are taxed and exports receive a form of tax subsidy. Many proponents believe that this system is more efficient than an income tax as it is a less economically distortionary form of consumption tax, similar to a European-style value-added tax. However, the deduction of labor costs significantly narrows the tax base and may change the incidence of the tax, with the result that the tax actually does not fall completely on consumption.

The efficiency claims of proponents rely on several key assumptions that are required for the tax to be non-distortionary. Mainly, the border adjustment must be implemented completely, and international currency markets must fully adjust. For example, the US dollar would need to appreciate by 25 percent to offset a proposed 20 percent import tax and export subsidy. 

The academic and policy debate on DBCFTs is generally fragmented, overly confident, and lacking in evidence, as there are no real-world examples of a destination-based cash flow tax. In this paper, we explore just a few of the most pressing questions that threaten to undermine the theoretical benefits of such a reform. Given the uncertainty and large downside risk to a DBCFT, we conclude that the proposal is not yet ready to be implemented and policymakers should focus on more traditional and straightforward reforms. 

There is additional concern that the proposed reforms, as currently understood, would not meet the trade neutrality standards of the WTO. This brief will not review these issues of international law, but if the WTO determines that a DBCFT is not allowed, sanctions could cause the United States to turn the destination tax into a European-style value-added tax (VAT), which could be achieved by simply denying the business deduction for labor. Denying the deduction for labor would create untold complications and harm workers, since labor income already pays individual income and payroll taxes.

Tax Competition and the Growth of Government

By taxing business activity based on destination, the DBCFT undermines domestic pressure from traditional international tax competition, which aims to attract economic activity by reducing the rate at which profits are taxed. The DBCFT threatens to undermine the tax competition that has contributed to the precipitous decline in global corporate tax rates over the past three decades. 

Standard principles of sound tax policy can inform policymakers on “what” to tax, but they shed little light on the question of “who” should do the taxing. The standard tax policy principles of simplicity, equity, efficiency, permanency, and predictability, carried to their theoretical ideal, result in uniform international taxation. However, to the extent that small, local political units are more responsive and efficient, tax rules should be set at the national or subnational level and should strive to maintain competitive pressures between jurisdictions.

If the system of border adjustment and currency revaluation works as proponents suggest—by removing the incentive to relocate business activity elsewhere—the DBCFT would be an irresistible source of additional tax revenue for future policymakers. The DBCFT increases the corporate tax base, and thus revenue, by more comprehensively taxing domestic business activity. To the extent that the US tax base is perfectly protected from competing jurisdictions’ lower tax rates, policymakers would be tempted to raise rates as an easy source of additional revenue.

Proponents say a DBCFT would simplify the tax code, expand the economy, create jobs, and increase revenue to pay for lower tax rates. As we discuss below, many of these benefits would likely not be realized. One of the most appealing features of the proposed border adjustment is its likeness to a territorial tax system. Thus, it is important to note that DBCFTs are certainly not the only way to eliminate our current worldwide tax regime.

The United States is one of just six OECD countries that attempt to tax the worldwide income of domestic corporations. Moving to a territorial system where foreign-sourced income is exempt from US taxation would increase economic growth and improve tax simplicity and efficiency. Much like the border adjustment, taxing income where it is earned levels the playing field, so that operations in one jurisdiction are taxed at the same rate, regardless of parent ownership. A territorial tax system is a much-needed reform, but the traditional form is highly preferable to the DBCFT’s quasi-territoriality. Tax regimes with border adjustments that eliminate competitive pressures should be approached with an abundance of caution.

Currency Revaluation and Efficiency

The understanding of the proposed DBCFT’s impact on global economies, exchange rates, and trade balances is purely theoretical. The policy and academic debates generally draw on case studies of VAT implementation or academic models. There is compelling evidence that in some circumstances, exchange rates would fully adjust, while other equally convincing research casts doubt on some of the more optimistic claims of a full exchange rate offset.

Simple models of a DBCFT or VAT assume the tax does not change the domestic savings-to-investment balance, which in turn means the trade balance cannot change. Using this assumption, the US dollar must, as a matter of simple math, appreciate to maintain the necessary trade balance. The dollar appreciation would offset the potential distortion of levying a tax on imports and subsidizing exports.

There is some limited evidence from changes in export incentives and VAT taxes to support the view that exchange rates fully—and in some cases instantaneously—adjust. There is credible evidence that anticipated changes in the likelihood of the repeal of a US tax incentive for exports were associated with depreciation of the dollar, as standard theory would predict. There is also evidence that implementing a VAT in Eurozone countries did improve trade balances in the short run. However, as theory predicts, the effects disappear in the long run as currencies adjust to the change.

However, the preponderance of evidence seems to show that currencies don’t adjust as theory would predict. Two academic analyses show that VATs do alter international trade by reducing trade volumes, contrary to standard economic models that predict no effect on trade flows. Real-world imperfections in the design and implementation of VATs, such as imperfect border adjustments, are likely to fall more directly on traded goods over others. In a higher-level analysis, Rogoff explains “the extent to which monetary models (or indeed, any existing structural models of exchange rates) fail to explain even medium-term volatility is difficult to overstate.” The economics profession’s understanding of exchange rates is so “mediocre” that our models fail to outperform random walk models—a model that assumes we can’t predict the future.

Since the DBCFT was proposed, many private-sector analyses have supported the academic literature that finds currencies do not always fully adjust. Morgan Stanley research expects that a DBCFT would have a significant impact on foreign exchange markets. It concludes that the dollar could appreciate by 10 to 15 percent, but that real-world frictions and uncertainty around WTO eligibility would keep exchange rates from fully adjusting. Citigroup research projects a 14.6 percent rise in the real effective exchange rate three years after DBCFT implementation, finding that “slow real exchange rate adjustments are the historical norm.”

Proponents who claim that DBCFTs do not effect domestic savings-to-investment decisions are at odds with others who describe the proposal as a consumption tax. To the extent that a cash flow tax falls on final consumption, it will increase saving (by making current consumption more expensive), which will change the savings-to-investment balance. This changes the trade balance and consequently keeps the exchange rate from fully adjusting.

Depending on the assumptions and historical examples, reasonable people can disagree about the question: Would exchange rates fully adjust to offset border adjustments? However, it seems clear that this type of border adjustable tax plan is an economic gamble. We cannot know in practice if any resulting exchange rate revaluation would uniformly adjust across the world or how more closely managed currencies would react. If exchange rates don’t immediately fully adjust, then at a 20 percent corporate tax rate, the United States could be creating a 25 percent tax wedge between domestic and foreign prices—dramatically increasing the prices of US consumer goods. If the resulting distortions are passed on as price increases on imported consumer goods, this tax change could be very regressive, with the increased tax burden falling more heavily on lower-income Americans. Even under a full currency adjustment, with no effect on trade flows, the adjustment itself could be a great source of wealth loss for some and windfall gains for others. This policy-caused disruption would ultimately have unknowable distributional effects on individuals and businesses through revaluation of global investments.

Negative Tax Liability and Incentives to Merge

Assuming the exchange rate fully adjusts, avoiding distortionary trade effects also depends on completely removing the tax on exports at the border. If exports included the cost of the domestic tax, domestic producers selling abroad would face a significant tax disadvantage, especially if their supply chain included imports.

Most models of border adjustments assume that a net exporter receives an actual check from the Treasury Department to compensate for domestic taxes paid on net exported goods. However, a direct cash rebate is likely politically untenable. The Blueprint’s DBCFT instead allows inflation-adjusted carryforward of net operating losses (NOLs). In theory, this acts as a direct subsidy. But in reality, a subset of businesses that predominately produce domestically and sell in foreign markets would never have a positive tax liability that their NOLs could apply to. Two Treasury Department economists estimated that 10 percent of firms with $1 billion or more in total income would have a persistent negative tax liability over a 10-year period. Another mechanism to more fully implement the refundability of losses is to allow refunds against payroll tax liability. This could reduce the 10 percent of firms with unused losses, but it would not eliminate them.

However tax losses are refunded, if refundability is not perfect, then firms with a consistent negative tax liability resulting in unusable credits will have an incentive to merge with those that have a positive tax liability and can apply the NOLs. By one estimate, about $260 billion worth of credits would be unusable over a 10-year period—this is a large economic incentive for business restructuring. Some of this problem could be mitigated through a system that allowed the sale NOLs, but the design and implementation would need to carefully consider the administrative burden and additional newly created incentives. Business organization, production chains, and location are best determined by market price signals, not changes in tax policy. Tax-motivated business decisions create economic inefficiencies and force firms to allocate resources away from productive activities and toward tax planning and compliance.

Profit Shifting: Financial Transactions and Intangibles

Proponents claim that a DBCFT will almost completely stop traditional profit shifting by eliminating the incentive to move real or fictitious activity to lower-tax jurisdictions. This is a significant benefit of the proposal, as the current US system of worldwide taxation, paired with complicated transfer pricing rules, is easily gamed and inefficient. However, the proposed replacement has two features that could provide new mechanisms for profit shifting and new types of complexity that should be considered.

Academic DBCFTs follow the “real-plus-financial” approach, include all cash inflows in the tax base, and deduct all cash outflows. Real-world border adjustments, including most VATs, exclude financial flows (the “real” approach). The real-plus-financial approach has the academic advantage of not needing to distinguish financial from other business cash flows. Designing the actual rules to operationalize the treatment of financial flows is complicated and requires significant additional research and analysis.

David Hariton discusses the various design features a DBCFT could implement by asking: “What happens when Corporation A invests $100x in a financial asset, such as a bond?” The first option is that nothing happens. In a true consumption tax base, financial transactions should be excluded. A second option is to treat these assets like any others, deduct the cost at purchase, and include the sale price in revenue. Hariton concludes that both of these options are unlikely because of significant tax planning flaws when embedded in the rest of the US tax code. The third option would require two separate sets of rules for financial and business transactions, necessitating the difficult task of drawing a “detailed and coherent line” between the two.

The development of rules to distinguish financial and business cash flows will be complicated, dense, and likely no more effective than our current system of global transfer pricing rules. The rules would likely be easily gamed, add additional administrative complexity, increase firm incentives to invest in tax planning over value creation, and provide opportunities for inefficient tax planning.

A recent analysis argues that tax proposals in the Blueprint would not completely stop the incentive for US corporations to shift income overseas. The intangible assets of any business are difficult to appropriately capture under any tax system. A destination tax would not make it any easier to determine the final location of sale of a cloud-based digital service, for example.

Designing appropriate rules around financial transactions, however imperfect, and sourcing intangibles to their appropriate destination may be an improvement over the current system of the corporate income tax. The discussion above should serve just to remind reformers that there is no silver bullet to do away with all tax-planning-motivated profit shifting.

Opacity and Cronyism

The DBCFT, specifically the border tax adjustment and currency revaluation, is difficult for experts to explain and analyze, and the general public’s understanding is even lower. This complexity allows lobbyists and special interests to exploit the system by adding loopholes, exemptions, and special rates to their favor. This is particularly worrying in the context of the uncertain effects on exchange rates, price levels, profit margins, and trade flow. Any perceived “loser” under the new system could easily make the case for selectively higher import taxes on international competitors or for selectively manipulating the border adjustment in some other way.

There are still other unanswered questions after our review of the literature. For example, if the US moves to a DBCFT, how would the individual states respond? States could continue with their current structure for taxing corporate income, they could lower rates, or they could move to a different system altogether. A worst-case scenario would be that some states keep a parallel corporate income tax system while others do something different, adding further complexity to the tax system.

Further, how would businesses react to this entirely new form of taxation? Pass-through entities would still be subject to the individual income tax, which would create new incentives for corporate reorganization. To what extent would there be major restructuring of business operations? Would existing supply chains be disrupted? Would firms be put out of business because of the potential DBCFT tax wedge between domestic and exported sales? How would state-level variation in the DBCFT rate effect currency markets and trade flow? All of these questions are left unanswered but have major implications for the US economy.

Conclusion

A DBCFT would be a new and novel way to tax corporate income. Proponents are overstating the positive effects of a DBCFT based on ambiguous results in the research literature while understating some likely negative distortions caused by the changes. In addition, there are many unanswered questions about the effects of a DBCFT that must be better understood before this reform is enacted.

In the context of the current political environment and the debate over reform of the US corporate income tax system, this type of border-adjusted tax plan is an unnecessary gamble. It is unclear whether any resulting exchange rate adjustment would uniformly adjust across the world and how currencies would adjust for those that are more closely managed by particular governments. If exchange rates don’t fully adjust immediately, then, at a 20 percent US corporate tax rate, a 25 percent tax wedge would be created between domestic and foreign prices. US consumers will likely not be pleased if prices dramatically increase. Further, for many major US corporations that heavily import products, a border-adjustment tax as described in the Blueprint would massively expand their tax base and possibly drown out any benefit from a lower corporate tax rate.

Academic research has consistently shown major benefits to economic growth and efficiency from lowering the corporate income tax rate and moving toward full expensing. That should be the focus of any corporate tax reform proposal.

A Review of Selected Corporate Tax Privileges

October 5, 2016

The US government uses the term tax expenditure to describe both privileges granted to politically favored special interests and patches to the tax system that address economic inefficiencies created by the income tax code. This use of the term confuses two very different phenomena and muddies policy discussions about tax reform.

A new study from the Mercatus Center at George Mason University examines the current accounting of tax expenditures, presents case studies of some corporate tax expenditures, and proposes reforms to reduce favoritism in the tax code. The study investigates the difference between tax expenditures that privilege a particular group at the expense of others and tax provisions that, if properly accounted for, would not be counted as tax expenditures at all.

BACKGROUND

A corporate tax expenditure is defined as a provision in the tax code that allows a firm or group of firms to not pay a tax which would otherwise be collected.

  • The modern US tax system is built on the income tax. This system double-taxes investment and savings, distorting market decisions and slowing economic growth.
  • To correct these distortions in the income tax, some special tax provisions were created to mitigate biases against savings and investment and offset other distortions.
  • Current methods employed by Congress’s Joint Committee on Taxation (JCT) and the administration’s Office of Management and Budget (OMB) for assessing the fiscal impact of tax expenditures use the income tax as the “baseline” from which to make their count.
  • Under the current accounting methods, broadly available tax expenditures that correct for economic bias are economically indistinguishable from government-provided tax subsidies that benefit some businesses and industries at the expense of others.
  • A superior tax expenditure baseline would rely on consumption, which would provide a more equal treatment of economic activity and focus attention on tax provisions that truly provide unfair advantages.

However, even by the standards of a consumption baseline, most corporate tax expenditures are unnecessary privileges that provide unfair advantages to certain industries and firms.

  • Sixty-five percent of corporate tax expenditures privilege certain activities or industries while excluding others.
  • The proliferation of corporate tax expenditures results in disparate effective tax rates that distort consumption and investment and motivate wasteful rent-seeking.
  • The growth of tax expenditures also increases compliance costs by contributing to the lengthening of the tax code, which in the past 30 years has nearly tripled in length, from 26,300 pages in 1984 to the almost 75,000-page behemoth it is today.

This general analysis applies to individual tax expenditures as well. However, the benefits that accrue under certain corporate tax expenditures are often more concentrated, and the politics of privilege shows up in starker contrast.

  • Tax credit for orphan drug research. This corporate tax expenditure targets the cost of researching certain favored drugs for which only a small market is initially thought to exist. This privilege redirects resources away from drugs that could benefit a broader range of people.
  • Special deduction for Blue Cross and Blue Shield. The tax code contains special deductions for many Blue Cross and Blue Shield companies while failing to extend those privileges to their competitors.
  • Tax credit for certain railroad track maintenance. This expenditure offsets capital maintenance costs for a limited number of qualifying railroads, driving capital investment away from its highest-value use and unfairly forcing nonqualifying railroad operators to finance their own capital maintenance.

POLICY RECOMMENDATIONS

The conversation on corporate tax expenditures is complicated by an official tax baseline that relies on a misleading definition of spending through the tax code. The following steps will help curb this problem:

  • Redefine the baseline. The current baseline for measuring tax expenditures rests on an inconsistent definition of income, rendering tax expenditure analysis subjective and unreliable. To remedy this problem, Congress should amend the Congressional Budget and Impoundment Control Act of 1974 to redefine a common baseline around a consistent, broad-based consumption tax baseline.
  • Improve reporting. Even without legislative action, JCT and OMB could begin reporting a second list of tax expenditures using a consumption baseline—a strategy for sounder analysis that has historical precedent in past presidential budgets.
  • Remove special provisions. Congress should expand narrowly applied expenditures that aim to move the tax code toward a neutral base and eliminate expenditures that fail to perform this function. Until a more robust, broad-based consumption-tax system replaces the US income tax, policymakers must also resist adding additional privileges.

Curbing the Surge in Year-End Federal Government Spending

September 22, 2016

At the end of every fiscal year, US government agencies spend large sums of their budgets in a potentially wasteful manner. These year-end spending surges are described by the “use it or lose it” phenomenon, which is driven by a fear that leftover resources will prompt future budget cuts. Every year the media documents examples of wasteful year-end spending, but there has been little empirical research on the phenomenon. 

An updated study published by the Mercatus Center at George Mason University examines existing literature on the prevalence, consequences, wastefulness, and causes of year-end spending surges. The study provides comprehensive reports of executive department year-end contract expenditure patterns, and it concludes with policy recommendations for curbing year-end spending surges. 

KEY POINTS 

  • Data from the past 13 years (FY 2003–2015) show that a remarkably large percentage of executive branch contract spending occurred in the last month of the fiscal year. Over this time period, 16.3 percent of expenditures occurred during September, the last month of the fiscal year—close to twice what would be expected if spending were split evenly over the year’s 12 months.
  • Existing literature on year-end spending suggests that federal contract expenditures in the last week of the fiscal year tend to be wasteful, funding projects that are of substantially lower quality, as well as more risky non-competitive and one-bid contracts. 
  • A potential remedy for wasteful year-end spending is to allow agencies limited rollover (also known as carry-over) authority for funds not spent by the end of the fiscal year. To maximize success in reducing waste, rollover accounts should be segregated by agency subcomponent. Separate accounts increase the incentive to save because only the agency subcomponents that achieve cost savings will be able to deploy those savings in subsequent fiscal years. 

POLICY RECOMMENDATION 

To test the merits of rollover authority, the federal government should begin with a pilot exercise. Departments or agencies that wish to participate should be given the authority to roll over up to 5 percent of their contract budget authority into the next fiscal year. Congress should direct the Government Accountability Office to oversee, audit, and evaluate the program. 

 

Comment on the Implementation of Country-by-Country Reporting by the Internal Revenue Service

March 22, 2016

Introduction 

The Spending and Budget Initiative of the Mercatus Center at George Mason University strives to provide an accurate understanding of budgets, spending, deficits, and debt and how these issues relate to economic growth and progress. As part of its mission, the program conducts careful and independent analyses of federal policy that employs contemporary economic scholarship to assess proposals and their effects on the economic opportunities and the social well-being available to all members of American society. 

This comment addresses the efficiency and efficacy of this rule from an economic point of view. Specifically, it examines how the rule may be improved by more closely examining the societal goals the rule intends to achieve and whether this proposed regulation will successfully achieve those goals. In many instances, regulations can be substantially improved by choosing more effective regulatory options or more carefully assessing the actual societal problem.

Background

The IRS has proposed regulations to implement the Organisation for Economic Co-operation and Development’s (OECD) guidelines to increase automatic exchanges of taxpayer information through a new country-by-country (CbC) reporting requirement. The proposed country-by-country report centralizes and automatically shares with all signatory countries the jurisdictional breakdown of a multinational corporation’s revenue, profit before income tax, income tax paid and accrued, employment, capital, retained earnings, tangible assets, and the business activities in which each entity engages.

The OECD hopes that the new reporting standards will provide tax administrators with useful information to more effectively direct auditors while making it easier to identify artificial profit shifting to tax-advantaged environments. This public comment will argue that the accounting costs of country-by-country reporting will be larger than the Department of the Treasury’s revenue gains and that there will be even higher unanticipated costs from inadvertent disclosures of sensitive information. Because the costs of information centralization will be greater than the benefits, we recommend that the IRS should not implement the proposed regulation on country-by-country reporting. This recommendation is informed by a recent paper from the Mercatus Center at George Mason University that explains key features of the international corporate tax system, the changes the OECD wants to make, and the potentially far-reaching consequences of those changes. The study also provides recommendations to improve corporate taxation without compromising state sovereignty or taxpayer rights.

Analysis

The Direct Costs of Country-by-Country Reporting Will Be Larger than the Treasury’s Revenue Gains

Country-by-country reporting will impose unnecessary costs on US businesses, adding to the already monumental costs of corporate tax compliance. Similar tax reporting requirements have increased tax revenue by less than the private cost of compliance and have been shown to be ineffective at decreasing total tax avoidance.

Country-by-country reporting is a substantial change from how businesses currently report tax information. It will necessitate a significant evolution in the way multinationals set, implement, monitor, and document internal transfer pricing procedures. The cost of collecting the requested information will necessitate new technology solutions for many firms since the report items are not centrally collected in a compatible format by many businesses. The cost will be high for US businesses to implement new integrated reporting systems across all subsidiaries, often in multiple countries.

Under a similar, but more limited, now defunct requirement for information exchange under the Dodd-Frank Act, the Securities and Exchange Commission (SEC) estimated, “the total initial cost of compliance for all issuers is approximately $1 billion and the ongoing cost of compliance is between $200 million and $400 million.” In addition to direct compliance costs, a challenge to the SEC rule noted that there could be billions of dollars in additional unanticipated costs from inadvertent disclosure of sensitive commercial information. 

The recently enacted Foreign Account Tax Compliance Act (FATCA), is intended to increase information reporting and exchange mechanisms for individual taxpayers. The OECD’s country-by-country reporting guidance draws heavily from FATCA, applying the rules to business income. The implementation of FATCA has shown that the private expenditures necessary to comply with the law will be equal to or exceed the estimated revenue gains from increased information exchange. The Joint Committee on Taxation estimates that FATCA will generate $8.7 billion in additional tax revenues over 10 years. A legal challenge to the law estimates that over $8 billion has been spent complying with FATCA reporting requirements, and firms are still working to make their internal computer systems FATCA-compliant. The OECD efforts will likely have similar costs, outweighing any benefits of increased compliance.

Past information exchange initiatives have not decreased tax evasion or increased revenue collection. The most recent evidence on international information exchange initiatives shows that OECD efforts that have succeeded in dramatically increasing information exchange through bilateral treaties have thus far not resulted in reduced tax evasion. Economics professors Niels Johannesen and Gabriel Zucman conclude that “treaties have led to a relocation of bank deposits between tax havens but have not triggered significant repatriations of funds. . . . Leaving roughly unchanged the total amount of wealth managed offshore.” While not accomplishing their stated goals, the costs of large-scale international information exchange provisions are high.  

There Will Be High Unanticipated Costs from Inadvertent Disclosure of Sensitive Information

The proposed regulation goes to great lengths when describing safeguards to protect confidentiality and improper use of information. Acknowledging the importance of security and confidentiality is not sufficient to prove that the IRS is ready to implement regular global transfers of confidential information. 

Assembling a new, centralized database of highly sensitive corporate financial information increases the vulnerability of proprietary business data. It would take just one breach of the system, in any one of the party jurisdictions, for all the information to be exposed. Despite promises of heightened security, independent government audits of the IRS have repeatedly found a “significant deficiency” in the IRS’s controls over financial and taxpayer data. In 2015 the Government Accountability Office found that “weaknesses in [information security] controls limited [the IRS’s] effectiveness in protecting the confidentiality, integrity, and availability of financial and sensitive taxpayer data.” Even well-developed countries with the most robust institutions struggle to uphold the rights of taxpayers. 

The often unanticipated costs of information exchange recently received empirical support. A 2015 World Bank working paper finds that financial information disclosure is a “double-edged sword.” The authors explain that disclosure “leads to a significantly higher level of corruption” that firms must face. The majority of countries in the world do not have the same robust institutions that firms in the United States can rely on. In many countries “once firm information is disclosed, the threat of government expropriation is widespread.” The authors continue: “Information disclosure thus allows rent-seeking bureaucrats to gain access to the disclosed information and use it to extract bribes. . . . With more information about firms available, government expropriations . . . become more severe, especially in countries with poor property rights protection.” 

In the proposed rule the IRS describes how automatic exchanges of country-by-country reports will be paused if a tax jurisdiction is found to be not in compliance with US standards. This ex post response will do little to stem any data breaches that have already occurred. A challenge to information exchanges by the SEC under the Dodd-Frank Act explains the high costs associated with disclosing trade secrets. In addition to the initial and ongoing direct compliance costs, reporting “‘could add billions of dollars of [additional] costs’ through the loss of trade secrets and business opportunities” as foreign competitors can access sensitive information. The IRS should focus its efforts on strengthening domestic information protections, rather than introducing additional vulnerabilities into the systems. 

It is also difficult for individual countries to remove themselves from the growing treaty system and harder still to tailor treaty language to protect their citizens. In 2010, the OECD updated a multilateral treaty on disclosure and transparency, requiring jurisdictions to sign 12 bilateral tax information exchange agreements in order to be considered in good standing and not a “tax haven.” In tandem with several other initiatives, over 100 countries met the new standards in less than two years, including Switzerland, a usual holdout in information exchange campaigns. The multilateral treaty is particularly powerful because signatories cannot negotiate individual provisions and signing onto the treaty enters the country into an agreement with all prior signatories. Although difficult to organize, when multilateral treaties obtain majority adoption, there is little room for national governments to set independent policies.

Tax practitioners also worry that the new country-by-country reports will be used to justify frivolous audits which will increase real profit shifting of jobs and physical assets. There is a widely held fear that tax administrators in other countries—in attempts to expand their tax bases—will use the new information to pressure multinationals to align taxes paid with sales, employment, or asset locations. The availability of country-by-country tax information may pressure some countries to use a formulary apportionment standard as a mechanism to artificially expand their tax bases. The OECD final reports leave the door open to future use of “profit splitting,” a formula-based method of transfer pricing, in the Actions 8-10 report—the guidance for which will not be finalized until 2017.

A country such as China could benefit by unilaterally moving to apportionment because firms in that country generally have a large employment footprint but little measurable “value creation” under the arm’s length standard. In a February statement, the Chinese tax agency made it an official policy to step up oversight of Western multinationals, scrutinizing how they move money and allocate costs. According to the New York Times, “officials in China, the world’s largest manufacturer, have long contended that much of the value of a good lies in its physical production, and not in the intellectual property that went into the item, which is often created elsewhere.” 

Country-by-country reporting will give tax administrators around the world access to information that could be used to disproportionately extract tax revenue from US companies, complicating international taxation rather than simplifying it. A Deloitte survey of tax and finance managers and executives from multinational companies in 2015 found that nearly 60 percent of multinational firms think the base erosion and profit shifting project will have a bigger impact than they originally anticipated. The survey also found that 75 percent of managers and executives expect some form of double taxation as countries respond to the recommendations in diverse ways. Country-by-country automatic information exchanges pose considerable risks to US multinational businesses’ ability to maintain a competitive edge and create value in a global economy. Further, if countries such as China force US companies with intensive foreign manufacturing operations to use formulary apportionment, the United States could lose tax revenue as a result of country-by-country automatic reporting.

Conclusion 

We have shown that the direct costs of country-by-country reporting will be larger than the Treasury’s revenue gains and that there will be high unanticipated costs from inadvertent disclosure of sensitive information. Because the total costs of information centralization will be greater than the total benefits, we recommend that the IRS should not implement the proposed regulation on country-by-country reporting. 

The OECD’s Conquest of the United States: Understanding the Costs and Consequences of the BEPS Project and Tax Harmonization

March 17, 2016

The system for international corporate income taxation is at risk of losing its most valuable feature—diversity and competition. The Base Erosion and Profit Shifting (BEPS) Project of the Organisation for Economic Co-operation and Development (OECD) attempts to change the international tax system by transferring control of corporate taxation from individual nations to an international body. This shift favors consolidated and uniform tax rules but sacrifices compliance efficiency, taxpayer rights, and nations’ ability to set the tax policies best suited to their populations.

A new study from the Mercatus Center at George Mason University explains key features of the international corporate tax system, the changes the OECD wants to make, and the potentially far-reaching consequences of those changes. The study then provides recommendations to improve corporate taxation without compromising state sovereignty or taxpayer rights.

KEY POINTS

  • The BEPS Project is intended to simplify and coordinate tax reporting, increase tax transparency, and increase corporate tax revenue by closing loopholes.
  • However, the BEPS Project’s proposal to further centralize the control of taxation would infringe on national sovereignty and taxpayer rights and impose onerous and costly compliance requirements—and would likely fail to meaningfully increase corporate tax revenues.
  • Ideally, the United States should abandon corporate taxation altogether because it is inefficient and discourages the corporate investment that produces economic growth.
  • Such a shift is probably not politically viable in the short term. However, second-best reforms to the US corporate tax system include ending worldwide taxation and moving toward a territorial tax system, allowing full and immediate expensing of business investments, and lowering the corporate tax rate, which is currently the highest in the OECD.

BACKGROUND

Corporate tax codes are highly complex and are designed to accomplish a herculean task—fairly and efficiently collecting taxes from business networks across hundreds of countries. To the extent that an international tax system exists, each individual country’s tax code is linked to others through hundreds of bilateral tax treaties. These complex treaties facilitate communication between international tax codes, which is increasingly necessary as businesses expand beyond the borders of their home countries.

International tax competition aims to attract economic activity by reducing the rate at which profits are taxed. If a firm moves from a high-tax country to a low-tax country, the high-tax country’s corporate tax base will shrink—it will face “base erosion.” In other circumstances, a business might shift profits rather than physical property to lower its tax burden, a process known as “profit shifting.”

THE OECD TAKES ON BASE EROSION AND PROFIT SHIFTING

In 2012 the OECD released a series of reports on the BEPS Project. The reports fail to show any precipitous drop in corporate tax collection as a share of either GDP or total revenue. Despite the lack of evidence that there is a significant problem, the OECD concludes that base erosion and profit shifting are real but that “it is difficult to reach solid conclusions about how much base erosion and profit shifting actually occurs,” given the available data.

The OECD outlined 15 action items and set an expedited two-year timeline for the project’s completion. This study analyzes two of these action items—pertaining to the valuation of intangibles and tax transparency—to consider their impact on multinational firms.

Action 8: Globalization and Intangible Property

The OECD has identified intangible assets such as patents, trademarks, and other intellectual property as key components in international base erosion and profit shifting. Action 8 aims to align value creation with the accounting protocols that govern the valuation of intangible assets moving across national borders. The OECD report covers the minutia necessary for tax administrators to comply with the goal of sourcing income to measurable economic activity.

However, the OECD’s project continually bumps up against the fundamental issues intrinsic to the task of taxing global firms. Intangibles are by their very nature fungible, transcending the artificial boundaries of the nation-state. These knowledge-based assets can be difficult to price because there are no comparable products and they are often developed through a diffuse global production chain. The OECD cannot remove the incredible complexities of tracing expenses to income-generating intangible assets.

Action 13: Costly Transparency and the Dark Side of Disclosure

Action 13 requires large multinational enterprises to provide detailed annual reports of their activities in each jurisdiction where they do business, known as “country-by-country reporting.” The goal of this new regime is to make multinational firms more honest in their reporting and to help tax administrators root out profit shifting from high- to low-tax jurisdictions. However, collecting and reporting this information would likely be incredibly costly for companies as it represents a substantial change in how businesses currently report tax information.

There is also concern that the new country-by-country reports will be used to justify frivolous audits and thus will increase real profit shifting. There is a widely held fear that tax administrators, in attempts to expand their tax base, will use this information to pressure companies to align taxes with sales, employment, or asset locations. A World Bank working paper finds that this type of reporting transparency exposes firms to “a significantly higher level of corruption.”

Data security is also an issue. Assembling a new, centralized database of highly sensitive corporate financial information increases the vulnerability of proprietary business data. It would take just one breach of the system in any one of the party jurisdictions for all the information to be exposed. Furthermore, governments are likely to share data which may compromise trade secrets. While the proposed multilateral treaty under the BEPS Project includes a confidentiality clause, this protection would be functionally meaningless because most countries do not consult taxpayers when an information request is made. Without consultation, it is impossible for tax officials to know what information is or is not a trade secret.

THE HARMFUL COSTS OF GLOBAL TAX CONSOLIDATION

The type of tax competition the OECD is attempting to stop is a fundamental characteristic of jurisdictional diversity. Countries compete on innumerable margins for capital investments. The United States offers a highly educated workforce and modern infrastructure. Developing countries compete by having less expensive labor and less intrusive regulations. Countries compete for foreign investments on any number of margins and it seems peculiar that governments would not be allowed to compete through their tax codes.

Any tax system can work to fully tax all corporate profits if tax rules are centralized at an international level. However, it is evident that global jurisdictional diversity has benefits that accrue outside the tax code, resulting in better governance. No matter what method is proposed for global centralization, it should be resisted because the costs of centralization are often unseen and greater than the benefits.

CONCLUSION AND POLICY PROPOSALS

There is near-universal agreement that the corporate income tax is severely flawed, and the BEPS Project highlights the need for a new approach. Instead of trying to eliminate tax competition, the United States should reform its own tax code by considering alternatives to the corporate income tax. The corporate tax is inefficient because it double-taxes income, penalizes business activity, and requires onerous and costly regulations.

While corporate income taxes are fundamentally flawed, political constraints will make repealing the tax an infeasible policy option in the short term. There are, however, several reforms Congress could enact to make the US corporate tax system more competitive.

  • End worldwide taxation. The United States is currently one of just six OECD countries that still tax worldwide income. Worldwide taxation penalizes companies for bringing foreign profits home and puts US firms at a competitive disadvantage.
  • Allow full expensing. Allowing corporations to fully expense all purchases at the time they are made would stimulate investment, create jobs, and expand the economy.
  • Lower the corporate tax rate. The United States must lower its national corporate tax rate to 20 percent or below. The United States has the single highest combined corporate tax rate in the OECD, a situation that drives companies offshore and hinders growth.

Don’t Put American Innovation in a Patent Box: Tax Policy, Intellectual Property, and the Future of R&D

December 7, 2015

Key Findings 

  • A patent box is not a solution to the many problems facing the US corporate income tax system.
  • The United States has a 39.1 percent combined state and federal corporate tax rate—the highest rate in the developed world and well above the Organisation for Economic Co-operation and Development (OECD) average of 25.2 percent.  
  • A patent box increases tax code complexity, but will not increase innovation, job creation, or tax revenue.
  • The proper policy to retain and attract business investment and encourage innovation, research, and development is to lower the corporate tax rate for all US businesses. 

In an increasingly global economy, national governments are searching for ways to keep corporations from moving highly valuable intellectual property and associated economic activity to lower tax jurisdictions. In particular, governments are concerned with losing jobs, investment that fosters innovation, and the tax base attributable to income arising from intellectual property. One proposed solution is a patent box, also called an innovation box. A patent box lowers the rate of corporate income taxes paid on income originating from targeted intellectual property.  

Congress is considering adding a patent box to the US corporate tax code to keep mobile intellectual property from leaving the United States and to further support domestic innovation. Rather than a solution to the problem, the patent box is a poor substitute for much needed holistic corporate income tax reform. International experiences with patent boxes have not demonstrated they are able to remedy any of the problems they aim to fix. The academic literature suggests that a patent box will not improve measures of job creation, innovation, or tax revenue. A better approach to encourage innovation, research, and development would be to lower the corporate tax rate for all businesses.

Profit Shifting: the Result of Systemic Problems

The United States has the single highest combined corporate tax rate in the Organisation for Economic Co-operation and Development (OECD) and the third-highest rate in the world (behind the United Arab Emirates and the Republic of Chad). As shown in figure 1, the average top combined US corporate tax rate is 39.1 percent, higher than the worldwide and OECD averages. The United States is one of just three OECD countries that have not lowered their corporate tax rates in the past 15 years. Furthermore, the United States is one of only six OECD countries that still attempts to tax the global income of multinationals headquartered domestically (offering a credit for foreign taxes paid when profits are brought back into the United States). Worldwide taxation at high rates has led to over $2 trillion in US corporate profits being kept out of the US economy.

Because of high corporate tax rates, US corporations face some of the world’s strongest financial incentives to move overseas. Rather than physically relocate as a way to lower tax burdens, it is often easier for corporations to move intellectual property or just the profits associated with the intellectual property. Pejoratively described as “profit shifting,” firms design elaborate tax strategies to lower US tax bills in order to compete in global markets where competitors are taxed at lower rates.

Profit shifting is a central issue in the taxation of multinational corporations. Leveraging the differences between tax systems will always result in corporate tax planning. Global fears of tax-base erosion caused by profit shifting have increased the perceived need for a patent box to incentivize domestic intellectual property ownership. The OECD’s base erosion and profit shifting project has popularized the idea that high-tax welfare states are losing their tax base to low-tax counties. 

Patent Box Design and Complexity 

Patent boxes have been described as a “Pandora's box of complexity.” Increased tax code complexity has been shown to slow economic growth. The United States has the eighth most complex tax code of 34 OECD peer countries. According to PricewaterhouseCoopers it takes 40 percent more time to comply with the corporate tax code in the United States (a total of 87 hours each year) than the 52-hour OECD average. 

A patent box requires certain income to fit a specified definition of income eligible for the lower tax rate. Two members of the House Ways and Means Committee, Charles W. Boustany Jr. (R-LA) and Richard E. Neal (D-MA), have introduced patent box legislation that allows corporations to deduct 71 percent of qualified profits. Qualified profits are “tentative innovation profits” multiplied by the corporation’s research and development (R&D) intensity (the past five years of R&D expenditures divided by past operating expenses). The legislation defines innovation profits as profits from “patents, inventions, formulas, processes, knowhow, computer software, and other similar intellectual property, as well as property produced using such IP.” The 71 percent deduction results in a 10.15 percent tax rate on patent box profits. 

A 10.15 percent tax rate on certain profits—a reduction of 24.85 percentage points for US firms—will place strong incentives on firms to manipulate the definitions of qualified profits to maximize tax savings by taking advantage of the lower rate. Similar definitions used by current US R&D incentives have been manipulated to increase tax savings. For example, the amount of claimed R&D spending significantly increased after the favored tax status was introduced in 1981. In a process known as relabeling, firms hire armies of lawyers to relabel profits on their income statement and tax returns, without changing any real investments.  

The proposed Boustany–Neal definition of qualified profits is not fully fleshed out, as the Ways and Means Committee itself recognizes in its request for feedback. Even with fully developed definitions, the Internal Revenue Service (IRS), which will ultimately be tasked with writing legal definitions, has struggled in the past to define qualified research. When the IRS issued its first regulatory interpretation of qualified R&D in 1998, it had to withdraw multiple consecutive versions of its definition following harsh criticism from both taxpayers and Congress. The research credit’s definition of qualified research continuously evolves through legal challenges, with significant reinterpretation of the law happening as recently as January 2015. 

The world of intellectual property has no bright lines. Similar to IRS definitions of qualified research, following implementation, each minutia of the qualified profits definition will need to be litigated, reinterpreted, and litigated again. Under the US proposal it is hard to conceive of a service or good that does not use a “design” or “knowhow" in its production. Tax expert Martin Sullivan notes that it is “likely that nearly all profits from manufacturing would qualify” for the lower tax rate. Policymakers should be concerned that resources spent interpreting, litigating, and following the law will divert resources away from real economic innovation.  

Patent boxes introduce arbitrary distortions into the tax code. The tax benefits to the Boustany–Neal plan vary widely based on a corporation’s R&D intensity and profitability. The disparate incentive will drive many firms to reorganize to maximize the tax benefits available. Tax distortions of this type inefficiently change the allocation of real resources, often causing unintended consequences. The asymmetric subsidy from a patent box will inadvertently distort investments further. Anytime distortions are introduced into the tax system policymakers must weigh the benefits against the  often high and uncertain costs. 

Common Justifications for Patent Boxes 

The patent box is a powerful tax incentive that will undoubtedly change corporate behavior. But policymakers’ statements are unclear as to what exactly they hope the patent box will encourage. Some common justifications include intervening in the market to subsidize a positive externality, protecting US jobs from overseas competition, and increasing tax revenue.   

Subsidizing Positive Externalities 

There are few economic justifications for subsidizing profits from intellectual property. Economic intervention is usually justified when there is a market failure—or, in this case, when the returns to new ideas (R&D) cannot be fully captured in private profits. For example, inventors are granted exclusive rights to new ideas through patents so they can make profits on their investments. Economic theory suggests that an inventor would be reluctant to spend 10 years developing a new vaccine if a competitor could use the inventor’s idea without spending the same 10 years of research, time, and money. 

Contrary to sound economic policy, a patent box explicitly subsidizes corporate profits that are captured by the private firm. Rather than incentivizing private investment in technologies that are under-explored (those with large and hard-to-capture benefits), a patent box incentivizes firms to invest in new technologies that return the largest private profits with the fewest externalities. Subsidizing profits also precludes start-ups from gaining any benefit. Patent boxes are poorly targeted to incentivize innovative research. 

Patent boxes could also subsidize the positive externalities some economists predict from complimentary and geographically proximate manufacturing. Still, policymakers need to show that a patent box is the best way to target manufacturing. The United States federal government currently offers eight separate tax subsidies to manufacturing and at least six other direct subsidy programs administered through various agencies. The patent box might not even subsidize manufacturing at all if its design follows that of the United Kingdom and does not tie physical activity to income.

Keeping Jobs in the United States 

Patent boxes have not been shown to increase employment or manufacturing. A 10 percent tax rate on intellectual property profits is a strong incentive for multinationals to relocate patents and other knowhow to the United States. However, more American-owned intellectual property does not mean more jobs, innovation, or economic growth. 

Whether a patent box succeeds in increasing employment depends wholly on the extent to which firms locate real activity alongside the income stream. A 2015 European Commission working paper on patent boxes corroborated an emerging body of research, finding that patent boxes decrease measures of innovation and real activity (the probability of companies’ research activities and inventors moving to a patent box country). This finding is less robust when patent boxes have strong rules that tie real activity to intellectual property. Forcing multinationals to bind income and real activity has proven to be a difficult task, as evidenced by the OECD base erosion and profit shifting project, which has spent the past two years studying the issue. Global tax incentives to shift intellectual property independent of real activity are strong and ever present. 

Increasing Taxable Income and Tax Revenue  

Patent boxes decrease tax revenue unequally and distort the tax base. Estimates suggest that the lower tax rate results in “substantial falls in tax revenue,” despite a modest increase in taxable income. The loss of tax revenue increases as more counties introduce similar tax privileges, diminishing the incentive to remain in the United States for tax reasons. Additionally, larger countries like the United States are even less likely to benefit from a patent box because of size and geographic isolation (compared to EU counterparts). 

Carving out special tax privileges for certain types of income places undue burden on the rest of the tax system. As more of the tax burden falls on a smaller portion of income, the tax system is made less efficient and less equitable. If policymakers are able to lower corporate tax rates (which is a necessary reform), they should do so for all businesses equally. 

Policy Recommendations for Reform

The system for US corporate income taxation is broken and should be repealed or replaced. If they are unable to fundamentally overhaul the corporate tax system, policymakers should follow two simple guidelines for reform: lower the statutory rate to reduce inefficient incentives, and work to remove additional complexity. 

The corporate income tax should be lowered for all profits, not just those attributable to qualified intellectual property. Lower rates reduce a variety of incentives that cause businesses to shift assets overseas. Lower corporate tax rates have been shown to significantly grow the economy, increasing investment, output and real wages. Lowering tax rates is the most direct way policymakers can encourage innovation and growth. Economists consistently find that lower tax rates increase measures of innovation and R&D spending.  

Modest simplifications of the tax code include implementing territorial taxation, allowing full expensing, and rejecting the OECD’s plan to further impose global tax rules on sovereign countries. Territorial taxation is an alternative to the worldwide system described above. A territorial system only taxes income earned in the United States and would allow the return of the $2 trillion of US profits parked overseas to be reinvested domestically. Full expensing simply lets firms deduct all expenses when they are incurred, shifting taxes into the future to simplify accounting procedures and lower the after-tax cost of capital. The OECD base erosion and profit shifting project is an attempt by high-tax OECD countries to impose more burdensome taxes on global business by harmonizing diverse international tax rules. The United States should resist the OECD’s proposal. 

A patent box is not a desirable remedy to the perceived problem of profit shifting, it is merely a Band-Aid for the broken US tax code. The proper policy to retain and attract business investment in the United States is to lower the corporate tax rate and move toward a territorial tax system. The economic literature shows that a patent box will not increase innovation, job creation, or tax revenue. If anything, the patent box proposal will make it harder to reform the tax code in the future. The introduction of any new tax privilege creates a constituency that becomes invested in the status quo and reliant on the new tax subsidy. Rather than make reform harder in the future, Congress should start by reducing the corporate tax rate. 

Closing America’s Enormous Fiscal Gap: Who Will Pay?

June 3, 2015

The true US debt is 16 times larger than what the government reports. Closing this fiscal gap with taxes alone would require a massive, immediate, and permanent tax increase on every American family. The burden grows with each year of congressional and presidential inaction, threatening future standards of living.

How would such a tax hike affect individual American households? A new study published by the Mercatus Center at George Mason University details how much Americans would have to pay to actually close the true fiscal gap with tax increases. 

UNCLE SAM’S ZERO-SUM GAME

  • The US government has a long-standing habit of understating the severity of its fiscal condition, because estimators weigh fiscal sustainability over limited time periods. When measured properly—over an infinite time horizon—the difference between all projected future government spending and all projected future government revenue and resources over time is $210 trillion, far greater than the $13 trillion usually cited.
  • The true fiscal gap is 12 times the size of the US economy, and about 10.5 percent of the present value of all future US GDP. To eliminate the shortfall solely through tax increases, the government would have to immediately and permanently raise all federal taxes—personal and corporate income taxes, excise taxes, and Social Security taxes—by 58 percent.
  • The required tax increase is 1 percentage point more than it was in 2013, because the fiscal gap has widened by $5 trillion since then. The increase is mainly because tens of millions of baby boomers are drawing closer to retirement, when they will be eligible for Social Security, Medicare, and (in some cases) Medicaid benefits.
  • As shown in table 1, the tax burden grows each year policymakers delay taking action. Just 10 years after 2013, the necessary increase will have swollen to more than 63 percent, and in 20 years to nearly 70 percent. Table 1 also shows that closing the gap through spending cuts would entail a less severe, but still substantial, change in fiscal policy.

 

THE IMPACT ON FIVE STYLIZED HOUSEHOLDS

  • Evaluating the household impact of these tax changes is done by modeling married couples in three different age groups—30, 45, and 60 years old—at five different income levels (four levels of inflation-adjusted annual household labor income—$12,500, $50,000, $250,000, and $1 million—and one non-working couple with $25 million in assets).
  • Under the two tax increases studied, all five households in each of the three age groups face an increase in lifetime tax rates—the share of lifetime taxes paid as a percentage of the couples’ total lifetime resources.
  • A 57 percent tax hike would raise lifetime taxes by 7 percentage points for 30-year-olds making $12,500 per year (see table 2). Couples of the same age making $50,000 a year would face a 15 percentage point lifetime tax increase.
  • Although delaying the tax increase would increase the percentage by which the tax must increase (as shown in table 1), it would reduce the lifetime ratio of taxes to income or assets (see table 2) because the households would be paying the higher taxes for fewer years. But the remaining burden would then fall more heavily on the children of these taxpayers.
  • Tax hikes lower household standards of living by reducing potential lifetime spending. A 30-year-old working couple making $250,000 a year will have almost $700,000 less to spend, in today’s dollars, over its lifetime—nearly three times the workers’ annual income. Even a family making $50,000 will have its lifetime spending reduced by more than a full year’s salary.

 
CONCLUSION

  • No adjustment that sufficiently addresses the US government’s enormous fiscal gap will be small.
  • Different households will be affected differently by the adjustment, but all will see an increase in their lifetime tax burdens if the gap is closed solely through tax increases—and even a 6 percentage point tax hike would materially reduce a household’s welfare.
  • Delaying the adjustment only increases the magnitude of the burden and shifts more of it onto future generations.

Options for Corporate Capital Cost Recovery: Tax Rates and Depreciation

January 29, 2015

The US tax code is excessively complex and riddled with special-interest loopholes. Tax rates that treat similar activities unequally can distort consumer and investor decisions, which damages the economy. The current tax system’s treatment of corporate capital investments is emblematic of these problems.

A new study for the Mercatus Center at George Mason University reviews the tax code’s requirement that businesses use “depreciation”—the process of writing off a capital purchase over time—and explains how this treatment leads to unequal tax rates across industries.

Shifting to “full expensing”—allowing business to write off all expenditures in the year they are purchased—would offer an even ground for capital investments. It would also simplify the tax code, increase investment, and reduce the ability of politically favored industries to gain targeted tax benefits. While expensing would likely reduce related government revenue in the short run, over the longer run it would likely be revenue-neutral or even growth- and revenue-enhancing.

Using IRS Statistics of Income data for active corporations from 1998 to 2010, the study estimates which industries would be most sensitive to changes in depreciation and how the removal of existing depreciation policies would affect the tax rates of 11 industries. Industries more sensitive to changes in capital cost recovery would likely benefit the most from full expensing, but all industries would receive some benefit.

To read the study in its entirety and learn more about its authors, Mercatus senior research fellow Jason J. Fichtner and MA fellow Adam N. Michel, please see “Options for Corporate Capital Cost Recovery: Tax Rates and Depreciation.”

SUMMARY

The US tax code requires most new purchases of capital, such as machines and buildings, to be deducted from total revenue over the course of many years. This is called “depreciation” or “capital cost recovery.”

The Advent of Depreciation
Depreciation was first instituted as an accounting practice when businesses reported earnings to shareholders. Without depreciation, years with large investment purchases could show negative profits while years with no investments showed high profits, all else being equal. To reduce these swings in reported earnings and convey a company’s true position, accountants now distribute the cost of each investment over the number of years it will be in service.

Problems with Depreciation
While depreciation helps communicate profitability to shareholders, it distorts the profitability of capital investments when applied to the tax code. This is because businesses make investment decisions based on after-tax profitability, which is directly impacted by how an asset is depreciated.

Determining how a capital asset is to be depreciated depends on its estimated “useful life.” Estimating useful lives for all possible assets is nearly impossible, which allows current depreciation rules to be arbitrarily set and manipulated.

Accelerated Depreciation
One way depreciation rules can be manipulated is through “accelerated depreciation.” Accelerated depreciation allows more of the cost of the asset to be deducted closer to the time of purchase.

  • One specific type of accelerated depreciation is “bonus depreciation,” which allows a one-time deduction of 30–100 percent of the initial cost in the year of purchase. This has become a favored policy tool in recent years to stimulate investment and the economy.
  • Accelerated depreciation, including bonus depreciation, has also received attention because it is the largest corporate tax expenditure. As a result, depreciation is a much-discussed candidate for tax reform, with various advocates arguing for manipulating the timeline in order to lower the statutory corporate tax rate, increase federal revenue, or further stimulate investment.

KEY FINDINGS

Expensing is a better alternative than depreciation for the following reasons:

  • Zero effective tax rate. Expensing lowers the effective corporate tax rate on new equity financed capital assets to zero, while leaving the statutory rate unchanged. A zero effective rate on capital increases the after-tax rate of return on new investments, making new investments more attractive under expensing.
  • Greater asset profitability. Tax depreciation decreases asset profitability by diminishing the value of the tax write-off. The decrease in value is felt disproportionately on investments that have long useful lives, such as buildings and other infrastructure. This problem is compounded by uncertainty stemming from unknown long-run expectations about inflation.
  • Less bias against equity-financed capital. The current tax code is biased in favor of debt-financed investment. Although expensing will not fix this disparity, it will move the effective tax rate on equity-financed capital to zero.
  • Equal treatment of all investments. Expensing treats all investments similarly. Depreciation will always favor certain investments over others. Even within the same industry, tangible investments can be treated differently from intangible investments and investments in equipment from investments in structures. Expensing removes these inequities. The ability to manipulate depreciation for special tax breaks also opens the door to corporate lobbying and special treatment.
  • Long-term economic growth. If an expensing policy were enacted today, there would likely be small revenue losses in the short run and modest revenue increases in the long run. Moreover, because expensing makes investment relatively more attractive, it can be reasonably assumed that there would be some economic growth effects from the tax change.

CONCLUSION

Expensing would be a more efficient tax rule than depreciation. Switching from depreciation to expensing could lower public and private administrative costs by simplifying the tax code. Because expensing makes investment relatively more attractive, switching to expensing would promote positive economic growth.

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