USC Gould School of Law JANUARY, 2011 THREE FLAVORS OF CORPORATE TAX REFORM Edward D. Kleinbard Professor of Law ekleinbard@law.usc.edu 1
Corporate Income or Capital Income? Do we want to reform the taxation of U.S. corporations (in practice, public companies), or of capital income? Efficiency argues for a comprehensive tax scheme for all capital income Capital income : All returns to savings & investment Not just capital gains Includes interest, rents, dividends Also includes net business profits, because labor inputs are deductible. This includes the corporate income tax. Integration proposals point (often imperfectly) towards a constant burden on capital income. 2
Business Income or Corporate Income? When we say corporate income, do we mean net business income, or only the income earned by (public) corporations? One-half of net business income in the United States falls outside the corporate income tax. If we mean just income earned by corporations Are we introducing/perpetuating substantive tax differences based on formalistic distinctions? What is our goal? Revenue neutral lower rate and broader base? Or do we intend to raise tax revenues on corporations? 3
One Capital Income Rate or Many? Economic components of capital income : Normal returns (boring returns to waiting ) Risky returns Supernormal returns (economic rents) Good arguments for taxing each differently Normal returns probably should be taxed at zero, or a low rate Risky returns require symmetry in profit/loss tax treatment Supernormal returns (economic rents) can bear higher tax And no particular reason to believe that any logically should be taxed at the same rates as labor income 4
What About International Tax? Taxation of international operations is critical (and currently screwed up) Behavioral distortions Complexity Protection of domestic revenue base Only three obstacles to doing better The definition of corporate residence is impossible The identification of the source of income is even tougher Politics made still more difficult by tax mercantilism of many countries 5
Current Law Inefficiencies Current law does an acceptable job of taxing labor income, but a terrible job of taxing capital income CBO 2005 study found enormous variations in the tax burdens on returns to different investments, taking into account: Form of business organization Nature of investment asset Choice in financing the investment CBO study found that effective tax rates on corporate investments varied from +36% to -6%, a 42 percentage point swing! Consequences? Underinvestment where tax burden is high Misdirected investment, compared to a world of constant burden taxation 6
Why is capital income taxation broken? Perhaps the answer is in the premise! U.S. tax ideal has always been to tax all income from whatever source derived under one progressive tax rate schedule But lawmakers intuitively understand that there are sound reasons in many cases to tax capital income more lightly than the general rate schedule needed to generate adequate revenue Distorts current vs. future consumption Can actually be seen as a form of double taxation on labor income Taxes inflation (nominal rather than real income) So lawmakers implement a broad and uncoordinated array of exceptions, exemptions and subsidies to bring down the effective tax rate on the returns to some capital investments while retaining conformity in nominal statutory rates 7
Reform I: Dual Income Tax What happens if we abandon the premise of one tax rate for all types of income? Many economists have advocated such an approach in the form of consumption tax proposals (= zero tax on normal returns) But consumption taxes raise both revenue and transition issues as well as distributional issues Instead, tax capital income under one rate schedule and labor income under another. This is the essence of a dual income tax. Theoretically imperfect (normal returns taxed too heavily, and rents too lightly) but nonetheless attractive compared to current hodgepodge approach 8
Basic Dual Income Tax Principles Broaden business / investment / savings tax base to track economic income more closely A comprehensive base is key to economic efficiency gains and to raising adequate revenues In return, tax all capital income at one low flat rate* Corporate income Personal capital income (e.g. interest income earned by individuals) Use base broadening to pay for lower rate Retain current law treatment of labor income Variations on the theme have been adopted, but this is the essence of the idea in its original, simplest, form * The U.S. has several very low tax rate brackets; in practice, a U.S. dual income tax probably would have graduated rates up to a lower maximum rate than would apply to labor income. 9
DIT: Simple Example Current Law Dual Income Tax Base: Narrow Very Broad Corporate Income Tax: 35% 25% Unincorporated Business Income Tax: 35% 25% Dividend Tax: 15% 0% (ideal) Capital Gains Tax: 15% 0% stock (ideal) 25% other Personal Interest Income Tax: 35% 25% 10
DIT: Making a Virtue of Necessity A bifurcated tax rate schedule for capital and labor income may be inevitable in practice Corporate income tax is the most important tax on income from capital and it is a flat tax already Ditto capital gains tax Globally, corporate income tax rates appear to be trending down, while personal income tax rates appear to be heading up So, the question is not, do we want a dual income tax but rather, do we want a thoughtful one? 11
Reform II: Auerbach Proposal Step One: convert corporate income tax into a cash flow tax All purchases and loans deducted; all sales and borrowings included in income. Depreciation replaced by expensing. In econo-speak, an R+F cash flow tax at corporate level Economic effect if tax rates remain constant is exemption of normal returns (but not economic rents) from corporate tax Effect is that investment net of borrowing is deductible, disinvestment net of loan repayment is taxable Apply rule to corporations and large unincorporated businesses 12
Auerbach Proposal International Step Two: adopt a destination-based international tax system VAT-style principles extended to the corporate tax arena No deduction for cost of imported goods, no tax on exports Foreign borrowing is tax-free, no deduction for foreign loan Effect is to tax all domestic consumption, not production Value of imported goods bears U.S. corporate tax Domestic value-added consumed abroad not taxed 13
Auerbach International (Con t) Also intended to address transfer pricing shenanigans No tax advantage to runaway plants (unless sales are direct to consumer). And domestic tax rate on normal returns = 0. Not intended to give boost to exports This is the myth of border adjustments US dollar expected to adjust up in value relative to foreign currency But this in turn has important knock-on effects 14
Auerbach Proposal: General Issues Counterintuitive to many But counterintuitive aspects may not be difficult in practice, because business borrowings usually offset by investment No coordination with investor-level taxes, Presumably to follow! Without coordination, no consistent tax on capital income But still contains implicit incentive for corporate debt, because all returns on debt (not just normal returns) avoid corporate tax Extensive arbitrage opportunities if some businesses are outside the system, even if only small ones Transition and Revenue Transition has been the sticking point in previous consumption tax proposals, and consumption tax base is smaller than an 15 income tax base.
Auerbach: International Issues Financial flows part will be tough to implement Secondary market sales of debt from foreign to domestic, or vice versa: does character change for issuer?? If not, how do you preserve fungibility across a global issue? More generally, firms do not know who owns their debt! Very large cash flow issues for cross-border spread lending Anticipated currency responses have large wealth consequences Basically a large immediate wealth transfer in dollar terms to foreign investors in US assets 16
Reform III: Business Enterprise Income Tax The BEIT is a comprehensive and detailed proposal for taxing capital income Step One: Subject all businesses (except the tiniest) to new entity level-tax (the BEIT) Step Two: Replace business interest deductions with a Cost of Capital Allowance (COCA). COCA rate set each year by reference to 1-year Treasuries Rate x Adjusted basis in all assets = deduction. So effect is a deduction for both equity and debt-financed assets. COCA + depreciation = same economics as cash flow tax at entity level. Self-corrects for any depreciation schedule. 17
BEIT Overview (con t) Step Three: Investor taxation rewritten. Investors taxed only on Minimum Inclusion amount. Minimum Inclusion = same COCA rate x investor basis in financial investments in business enterprises. So price of system is current investor taxation on COCA rate returns, regardless of cash flow Basis increases for prior income inclusions, etc. Investor level the cleanest base for taxing normal returns Step Four: International system is worldwide true consolidation, with foreign tax credit. Effect is an enterprise-level apparent subsidy (FTC for foreign tax on normal returns that are exempt in the US) offset by inclusion of those normal returns at investor level. 18
BEIT economics: BEIT Results Entity consumption tax (exemption of normal returns) Plus investor tax on normal returns Equals comprehensive and consistent tax on all capital income from business complete integration I.E. Only entity taxed on risky returns + rents, only investors taxed on normal returns. Other achievements of BEIT: Completely eliminates debt/equity distinctions Optically closer to current law than a cash flow tax, but identical economics at entity level More robust than cash flow tax to changes in tax rates, and easier transition (depreciation retained, COCA for interest) 19
BEIT Results (con t) Worldwide tax consolidation may seem countercompetitive But that overlooks fact that normal returns from foreign operations are tax-free at entity level Tax on normal returns paid at investor level, where mobility issues are much less salient Entity tax rate and investor tax rate on M.I. can: Be the same (DIT) and different in turn from labor tax rates Be the same as labor rates Be different from each other (e.g., lower rates on normal returns to investors, higher on rents collected on entities) But price for all this is individuals accepting tax on phantom returns 20