Since passage by the House in mid-November and the Senate on December 2, the Tax Cuts and Jobs Act (H.R. 1) has received a barrage of criticism. Critics have called the process too rushed, nontransparent, and partisan. They have said the bills are a giveaway to the rich and big corporations and create gaming opportunities for small businesses. The bills have also been criticized for unanticipated harm to different taxpayer groups, and for greatly increasing the deficit, with skepticism about administration projections that the tax cuts will “pay for themselves” through increased economic growth.
Much of the criticism is valid. Nevertheless, I view the bills favorably because they largely accomplish the widely held primary goal of tax reform: making the U.S. tax system more competitive for the 21st-century global economy. For years there has been a bipartisan consensus that corporate and international tax reform was needed to reduce U.S. multinationals’ incentives to shift profits, assets, and operations overseas, and to remove barriers imposed by the tax system to foreign investment in the country. But Congress has been unable to enact reform for the simple reason that tax reform is hard. All the criticism of the current tax bills can generally be viewed as collateral damage in the goal of comprehensive tax reform. Fortunately, collateral damage in tax reform is not irreversible.
The large cut in the U.S. corporate tax rate along with major international reforms in the bills make the U.S. corporate tax regime more competitive. To recognize the importance of the tax reform goals, it’s helpful to step outside partisan politics. Other countries’ attempts to tax U.S. multinationals’ profits are continuing, as are efforts to attract U.S. multinational profits and activities through tax and other incentives. The United States’ failure to reform its tax rules in the face of those pressures would pose a greater risk to its tax base than any of the tax bills’ loopholes. These risks are also not modeled into the projected costs of the reforms.
Criticism that Congress should have taken more time to fix technically flawed provisions largely ignores the risks that come with more delay, risks to the corporate tax base that the country can no longer afford.
Objectives
Reduce the Corporate Tax Rate
U.S. corporate tax rate reduction has been a bipartisan goal of policymakers and legislators for some time. While the U.S. corporate rate has remained at 35 percent for most of the past 30 years, rates around the world have been steadily dropping. (See Kari Jahnsen and Karl Pomerleau, “Corporate Income Tax Rates Around the World, 2017,” Tax Foundation (Sept. 7, 2017).) Policy analysts generally praise this trend because the corporate tax is considered inefficient. The OECD has noted that “corporate income taxes are the most harmful for growth as they discourage the activities of firms that are most important for growth” (OECD, “Growth-Oriented Tax Policy Reform Recommendations” (2010)).
Regardless of one’s position on whether the corporate tax is more heavily borne by labor or capital, the relatively high U.S. corporate rate is problematic simply because corporate rates of other countries have been reduced. (Prior analysis: Tax Notes, Oct. 23, 2017, p. 454.) This has led to all kinds of distortive activity by multinationals, including the buildup of foreign earnings, U.S. companies’ transfer of domestically developed intellectual property overseas, and perhaps most problematic, the loss of new investment to jurisdictions with more attractive tax regimes. The most extreme result has been the inversion trend.
The Obama administration proposed business tax reform that would have cut the rate to 28 percent. (See “The President’s Framework for Business Tax Reform: An Update” (Apr. 2016).) However, the 20 percent corporate rate included in the House and Senate bills is much lower, and is also lower than former House Ways and Means Committee Chair Dave Camp’s proposal of 25 percent. While the 20 percent rate may not be as good from a policy perspective, its political appeal is already evident in the bills’ progress to date. It also reflects the ongoing global downward trend in rates, even since Camp’s 2014 proposal.
A group of tax law professors recently released a paper arguing that without effective antiabuse provisions, the 20 percent rate will encourage taxpayers to migrate business activities into corporate form as a tax-sheltered savings vehicle (“The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the New Legislation” (Dec. 2017). But tax arbitrage exists in the current system, encouraging businesses to migrate into passthrough form for the past 30 years. Rate arbitrage is nothing new to policymakers, and they have many tools to address it. The enactment of legislation today doesn’t preclude the adoption of antiabuse rules in the future, either through statutory or regulatory means.
Reduce Buildup of Offshore Earnings
Both the House and Senate bills include a 100 percent dividends received deduction for corporate shareholders upon receipt of a dividend from 10-percent-owned foreign corporations.
The $250 billion annual increase in U.S. companies’ offshore earnings is a widely acknowledged problem. It’s also widely acknowledged that a move to a territorial system — following the approach adopted by most of our trading partners — is an effective fix. The Senate Finance Committee bipartisan working group’s 2015 report on international tax reform concluded that “it is imperative to adopt a dividend exemption regime in conjunction with robust and appropriate base erosion rules.” The Obama administration budget proposed adopting a form of territorial taxation by imposing a minimum tax on foreign earnings at a lower rate than the general corporate rate. Camp’s 2014 proposal also included a shift to a territorial system.
Two of the United States’ largest trading partners, the U.K. and Japan, adopted territorial systems within the past decade — both because of concerns like those now facing the United States. The U.K. changed its system because its headquartered companies were domiciling elsewhere. Japan adopted a participation exemption primarily out of concerns that its headquartered companies were leaving large amounts of earnings offshore. Both have managed to make the transition without eviscerating their corporate tax bases — a fear raised by opponents of a U.S. territorial system.
A participation exemption system has been criticized for increasing incentives for U.S. firms to move assets and operations overseas. The bills address that through a combination of more incentives for keeping assets in the United States and penalties for holding high-value intangibles offshore.
Tax Accumulated Offshore Earnings
The House and Senate bills each provide for a one-time deemed repatriation tax on the foreign earnings of U.S. shareholders of foreign companies held offshore.
Some writers recently have stressed the degree to which some U.S. companies will profit from the tax reform bills. (See Richard Waters and Tom Braithwaite, “Apple Will See Up to $47bn Potential Benefit From Tax Reform,” Financial Times (Dec. 6, 2017), describing how Apple “will see as much as $47 billion slashed from its expected tax liability if Republicans push through their current tax plan, making it the biggest beneficiary of the legislation now working its way through Congress.”) But that reasoning holds true only if one assumes that Apple and other U.S. companies with earnings stashed offshore will eventually bring back their earnings at the current 35 percent tax rate. Few government officials or policymakers think this is a reasonable possibility. More likely would be a continued search for overseas investment opportunities that would provide greater rates of return.
A helpful point of comparison to the Senate bill’s proposed 14.49 percent repatriation tax on earnings held in cash is Japan’s transition to a territorial system. Japan imposed no repatriation tax at all, providing a complete windfall to those Japanese companies that had been accumulating profits overseas.
Keep Intangibles in the United States
The House and Senate bills both include a variation on a foreign minimum tax, an idea that appeared in the Camp bill and Obama budget proposals. The foreign minimum tax is no giveaway to U.S. multinationals. It is the single most effective anti-base-erosion and profit-shifting proposal introduced by any country that has participated in the OECD’s BEPS project. More than any measure proposed by the BEPS action plans, it holds the potential to reduce the incentives for U.S. multinationals to transfer intangibles overseas or undertake aggressive foreign tax planning.
Some have criticized the foreign minimum tax as encouraging U.S. companies to invert. (See Reuven S. Avi-Yonah and Nir Fishbein, “Once More, With Feeling: TRA 17 and Original Intent of Subpart F,” Tax Notes, Nov. 13, 2017, p. 959.) But you can’t simultaneously argue that the corporate tax rate is too low, that the participation exemption is too generous, and that the foreign minimum tax gives U.S. companies incentives to go offshore. The bills attempt to strike a balance between carrots (incentives for U.S. companies to remain in the country and keep their earnings and assets there) and sticks (penalties for moving them offshore).
The Senate’s bill also encourages keeping intangibles in the United States through a lower rate on foreign-source intangible income, calculated in part as a share of income from export sales. The global intangible low-taxed income (GILTI) tax is a clumsy mechanism for encouraging companies to keep their intellectual property in the United States, and criticism that it violates WTO rules may be well deserved.
But the GILTI tax still contrasts favorably with other proposals that have tried to accomplish the same goals. The destination-based cash flow tax would almost certainly have given rise to WTO litigation while also causing manifold other harms to the U.S. and global economies. If the GILTI tax fails to encourage U.S. companies to bring IP onshore because of future status uncertainty, or if it violates U.S. trade agreements, little harm will have been done relative to the current situation.
Level the Playing Field
In addition to offering carrots to U.S. companies to repatriate earnings and intangibles and to keep operations in the country, the bills adopt a series of anti-base-erosion measures. Chief among them is the base erosion minimum tax proposed by the Senate. While there’s little doubt that it’s too broad, with unintended consequences that hurt various industries, it also sends a strong statement to other countries about the U.S. commitment toward protecting its corporate tax base.
Other countries are taking note. On December 11 European finance ministers sent a letter to the administration warning against U.S. tax reform undertaken under the pretext of trade protectionism. Their arguments might be considered more objective if not for the aggressive push to get U.S. multinationals to pay more taxes in their jurisdictions under the guise of EU state aid rules.
Paying All the Tax Owed
Mostly unremarked upon in criticism from the left is the extent to which the bills adopt — and in many cases exceed — antiabuse rules proposed by the Obama administration. These include an interest expense limitation provision that is tighter than the one under the OECD’s BEPS action 4; Senate bill anti-hybrid rules in line with BEPS action 2; and Senate bill anti-inversion rules that would penalize inverted companies.
The bills go further in closing loopholes than simply adopting the OECD’s proposed anti-BEPS measures. They tighten rules for transferring intangibles out of the United States tax free; limit planning opportunities now available under subpart F; change the sourcing rules applicable to the sale of inventory property; and significantly limit planning opportunities available to U.S. and foreign multinationals by eliminating the indirect tax credit.
As much of the criticism points out, the bills may open new opportunities for taxpayers and their advisors to undertake self-help and lower their tax bills because of differences in the treatment of various types of income and taxpayers, phase-outs, and the timing of rate changes. But such planning opportunities are inherent in any kind of income tax system, including the current one.
Criticism
The Middle Class Will Suffer
One serious criticism of the bills is that contrary to promises made by Republican leadership, they will hurt middle-income taxpayers. (See Institute on Taxation and Economic Policy, “National and 50-State Impacts of House and Senate Tax Bills in 2019 and 2027” (Dec. 6, 2017).)
The reality of the U.S. federal tax system is that unlike most other developed countries, it raises the bulk of its revenue from the income tax, and none from a consumption tax. For commentators who view the consumption tax as regressive, this should characterize the United States as progressive. The corporate income tax makes up less than 10 percent of total government revenue, while the individual income tax raises almost half. Among individual income tax brackets, those earning over $500,000 file less than 1 percent of total returns, but pay more than 50 percent of total individual income tax revenue. (See Drew DeSilver, “A Closer Look at Who Does (and Doesn’t) Pay U.S. Income Tax,” Pew Research Center (Oct. 6, 2017).) If you want to cut rates on the corporate tax and on passthrough business income to help increase economic growth, you must accept some possibly negative effect on some of the 99 percent of income tax returns filed.
The other unfortunate reality is that even a tax cut for lower-income taxpayers does little to address the needs of those suffering the most in the United States today. Most are not paying income taxes, because their education and experience has failed to provide them the tools to find employment in the 21st-century economy. Neither the proposed tax reform, nor those who criticize it, suggest meaningful solutions to this problem.
Increasing the Deficit
The reform has been scored as a $1.5 trillion increase to the deficit, although the administration has tried to downplay these numbers by pointing to its increased economic growth projections. (Prior analysis: Tax Notes Int’l, Dec. 11, 2017, p. 1007.) Even if the administration’s projections are taken with a grain of salt, there’s reason for optimism about the deficit. A higher deficit may force lawmakers to examine other long-term revenue sources. Decreased reliance on individual and corporate income taxes in favor of a VAT or a carbon tax — neither of which are possible in today’s political environment — would be good in the long run.
Disproportionate Impact on Particular Taxpayers
Various provisions of the bills have been condemned for disproportionately affecting certain industries or groups of taxpayers. These range from criticisms that the bill adversely affects blue states by eliminating the state and local individual income tax deduction, to others detailing the adverse impact of the Senate’s Base Erosion Anti-Abuse Tax (BEAT) proposal on the solar and wind energy companies. (See Dino Grandoni, “The Energy 202: Why the Wind and Solar Lobby Is Terrified of the Senate Tax Plan,” The Washington Post, Nov. 30, 2017.)
The endowment effect is a well-studied phenomenon from the disciplines of psychology and economics that posits that people value something which they already own more than something that they do not yet own. In tax reform terms, this would suggest that taxpayers place a higher value on deductions currently available, than on potential beneficial reforms. It should therefore come as no surprise that the press focuses on tax benefits that will be lost in the reform process, along with the adverse impacts on particular industries.
Conclusion
Criticism of the proposed tax reform implies that the inherently flawed legislative process could produce an optimal bill. A better bill might be more carefully drafted. It wouldn’t include an easily gamed separate lower rate on passthroughs. It might factor in a higher corporate rate. It might also include added revenue sources, such as a consumption tax. But that bill hasn’t passed, and probably can’t today. What has passed the House and Senate largely achieves the most crucial objectives of the mandatory 21st-century tax reform: reduction of the corporate tax rate, and revision of the international tax rules to remove incentives for U.S. companies to move, and keep their earnings, offshore.