EDWARD D. KLEINBARD, professor of law, USC Gould School of Law.
This op-ed originally appeared in the Los Angeles Times.
For citizens hoping for serious tax policy and budget debates, this has been a dispiriting election cycle. One party urges tax rates too low to support any plausible platform from which government can deliver the services we all expect.
Those are the Democrats.
The other party inhabits a realm of fantasy akin to Erewhon, the fictional land created by the 19th century satirist Samuel Butler. In Erewhon, Butler wrote, “If a man has made a fortune … they exempt him from all taxation, considering him as a work of art, and too precious to be meddled with; they say, ‘How very much he must have done for society before society could have been prevailed upon to give him so much money.'”
It is a pity that Republicans do not appreciate that Butler was writing ironically.
And now, compounding the race to the bottom, Mitt Romney has stepped forward to congratulate corporate tax cheats. Romney recently announced at a fundraising event that big businesses “know how to find ways to get through the tax code, save money by putting various things in the places where there are low-tax havens around the world for their businesses.”
But this is not how the tax law is meant to operate. By presenting it as a sign of business savvy, Romney is further egging on U.S.-based multinationals that already are world leaders in tax avoidance strategies.
The U.S. tax principle, and the principle at work in every other major economy, is that corporate income should be taxed in the country where it is earned. If that principle were scrupulously followed, very little income would be reported in tax havens, which generally have relatively small populations and in most cases modest manufacturing bases. But instead we find that U.S.-based multinationals claim that an extraordinary percentage of their income is “earned” in tax havens.
The evidence is abundant. Firms such as Microsoft and Google regularly enjoy effective tax rates on their foreign income well below 10% — levels far below the nominal tax rates of the countries in which their customers or research activities are located.
IRS data show that the profitable foreign subsidiaries of all U.S. firms taken together pay tax at an effective rate of about 16% — less than half the U.S. statutory rate, and again far below the rates of other major economies around the world, where these subsidiaries actually do business. Reed College economics professor Kimberly Clausing in a 2011 paper found that six of the seven top profit centers for the international income, claimed by U.S.-based firms, impose tax at effective rates of 4% or lower.
A large portion of what really is going on is “profit shifting” — simply claiming that profits are earned by subsidiaries in low-tax countries rather than the parent company or other affiliates. This is simply tax avoidance by another name.
As my own research has demonstrated, there is another strand of tax planning at work, which I call “stateless income.” The idea is that income initially is recorded where it is actually earned, say, in Germany, but then is shifted to a low-tax country such as Ireland through intragroup loans, software licenses and similar financial strategies, all of which are largely invisible to the outside world.
Stateless income planning simply rewards internal tax engineering of the sort at which American firms excel.
One reaction to the stateless income phenomenon might be that if American firms systematically move taxable income (but not real economic activity) from Germany to Ireland, well then, good for them. They’ve saved on their tax bills, and why should we care?
The answer is that when we countenance a tax system that rewards such a tax strategy, we implicitly encourage U.S. firms to invest overseas — not necessarily in tax havens but in other major economies. Once a U.S.-based multinational’s income is treated as earned outside the United States, the firm then can easily migrate its income from the high-tax foreign countries in which the income is earned to tax havens.
U.S. corporate tax revenues are eroded as American firms report a disproportionate share of their worldwide income in offshore tax havens, and foreign multinationals employ similar strategies to reduce U.S. tax on their investments in the United States.
When Romney endorses the idea that U.S. firms are doing right by reporting their profits overwhelmingly in tax havens, he shows contempt for a basic principle of tax law. This encourages still more aggressive profit shifting and stateless income tax planning. The missing tax revenue must be made up by domestic firms and individual Americans.
That may be the right thing to do in Erewhon, but in the real world, corporate tax cheating hurts us all.