Whether we like it or not, we are all affected by the tax system, and corporate taxes, in particular, have been a frequent topic in the popular press and policy circles as of late.
As I’m sure you’ve noticed, there have been many articles in major newspapers and other publications over the past several years that have argued the corporate tax system is broken.
Most of these articles use one or two high profile firms as anecdotes to illustrate variations on the common theme of a broken, non-competitive corporate tax system.
Exactly why the tax system is broken, however, is sometimes less clear, and often the articles have directly opposing views about what makes the system flawed and how to correct it.
I find these articles scary, quite frankly, and I’m concerned that our policymakers could make long-lasting, growth damaging changes to our tax system unless great care is taken to first understand what is broken with our system and what we want to fix about it.
Prescribing tax policies based on extreme anecdotes that sell newspapers might be like setting construction requirements for door frames based on the height of NBA players, the danger being that the cost of implementing those policies might outweigh the benefits if the policies are based on unusual or extreme examples.
So, what are some commonly held beliefs about corporate taxes and what does the data actually tell us about those conceptions?
I’ll spend the next few minutes discussing three beliefs that I often hear recited.
The first commonly held belief is that large
U.S. multinational companies pay very low or even no corporate income tax.
This idea comes from a number of articles that have appeared over the past several years in the popular press.
Some of the most widely circulated articles publicized Google’s 2.4 percent tax rate, or GE’s 1.8 percent tax rate, or even Caterpillar’s 2.4 billion in tax savings.
These articles were adorned with the names of common tax haven countries, like Bermuda, Cayman Islands, Switzerland, and Ireland.
And they described tax saving strategies with fascinating code names, like the Double Irish or the Dutch Sandwich.
So, just how common is it for a company to pay a tax rate below five percent?
Well, it turns out that the average publicly traded U.S. company pays about 28 cents of every pretax dollar it earns in income taxes to governments around the world.
Of course, there are some firms that pay very low tax rates, like those highlighted in the articles that you’ve probably seen, but there are also companies that pay very high tax rates.
In fact, about a fourth of publicly traded U.S. companies pays more than 35 cents of every pretax dollar in taxes to governments around the world.
So, how do Google, GE, and other companies manage to pay such low tax rates?
It turns out there are volumes of research, some of which I have worked on, that examine this question.
And the major take away is that we don’t have a very good understanding of the causes of variation incorporate effective tax rates.
But we do know that many of these firms have substantial earnings in foreign countries, and have lots of intangible property like patents and trademarks.
They also take advantage of tax credits for research and development, manufacturing and energy, and they have sophisticated, sometimes very creative tax departments.
Why do we have a tax system that gives tax credits and is fraught with so many loopholes?
While your gut reaction might be to exclaim that the tax system is broken, a more complete answer is definitely more complex.
The objectives of the tax system are multifold.
It is true that one objective is to raise revenue.
But it is also the case that the government uses the tax system to encourage investment in certain types of assets or in specific industries.
The government also uses the tax system as a tool to stimulate economic growth and to achieve social goals, like wealth redistribution.
So, observing that some firms pay low tax rates, while other firms pay high tax rates, is not a smoking gun suggesting the tax system is broken, as some commentators suggest, but instead could simply be the result of 30 years of legislation designed to achieve objectives other than collecting revenue and filling government coffers.
The second commonly held belief is that the U.S. has the highest corporate tax rate in the world.
It turns out that this is mostly accurate.
It is true that the statutory U.S. corporate tax rate, at 35 percent, plus around five percent state corporate tax rate, is higher than most other developed countries in the world, including most European countries.
We have arrived at this position not because the U.S. has raised corporate tax rates, but because the rest of the world has steadily reduced corporate tax rates over the last 30 years.
But even though our statutory rates have remained essentially constant for almost 30 years, the effective corporate tax rates, or the fraction of income tax paid on each pretax dollar of earnings has steadily declined over time.
In fact, between 1988 and 2012, effective tax rates, or the rates that companies actually pay, dropped about a half a percentage point each year.
Some point to this as evidence that our tax system is not really broken, but is indeed competitive with tax systems around the world.
Others argue that making firms jump through loopholes to achieve a competitive tax rate is inefficient.
Whichever opinion you hold, the fact remains that the average U.S. corporation has a lower effective tax rate today than 25 or 30 years ago when the tax system was last reformed.
The third commonly held belief is that the U.S. tax system encourages U.S. companies to invest overseas, instead of here in the U.S.
In theory, the U.S. tax system is designed to achieve capital export neutrality, meaning that U.S. firms should be indifferent, in terms of taxation, between investing a dollar in the U.S. and investing a dollar abroad.
Thus, in theory, firms should invest their marginal dollar in the country where it can most efficiently provide a return on capital, with taxes playing a minimal role.
But, in practice, U.S. companies can defer paying U.S. taxes on foreign earnings until they need the cash in the U.S.
If the U.S. tax rate is expected to drop in the future because of tax reform or a tax holiday, then U.S. companies will face lower taxes on foreign earnings than domestic earnings.
Moreover, there is an accounting benefit to foreign earnings.
As long as those earnings are determined to be indefinitely reinvested, then there is no requirement to record a tax liability for those earnings, even though the firm may, in fact, owe tax to the U.S. in the future.
This quirk in U.S. accounting rules can provide a boost to bottom line earnings for multinational U.S. firms.
So, while there is no explicit tax provision written to encourage offshore investment, once all the nuances of our current system are understood there is some incentive to recognize earnings in relatively low taxed foreign countries, especially if those earnings can be classified as indefinitely reinvested and the cash left abroad.
What then can tax reform accomplish?
Will tax reform raise more revenue?
While this might be possible, most proposals are revenue neutral and won’t fill government coffers any more than the current system.
Will tax reform tighten the distribution of effective tax rates, so that there are fewer companies paying very low rates and fewer companies paying very high rates?
This could be achieved, but even in 1986, the last time the tax system was reformed, there was still significant variation in the rates companies paid.
It seems that politicians don’t have a strong appetite for making the system fair.
Instead, they each want something that benefits their respective constituents, which tends to lead to a tax system riddled with idiosyncratic provisions that benefit a few firms here and a few firms there, creating winners and losers.
Will tax reform encourage investment in the U.S. instead of abroad?
Maybe the system can be refined to help, but the fact of the matter is that most of the world’s untapped markets are outside of the U.S., and there is nothing in the tax system that can change the fact that the fundamental driver of foreign investment is growing in foreign countries.
So, could tax reform encourage repatriation of foreign earnings?
Yeah, if tax reform were properly executed it could mitigate, or even remove the incentive firms currently have to leave their foreign earnings abroad.
But, recent research suggests that even if those earnings were repatriated to the United States, we might not see massive new investments in domestic projects.
Instead, it is more likely that we would see dividend payouts or share repurchases.
And if earnings are ultimately returned to shareholders, then shareholders can make decisions about the most efficient redeployment of their capital.
In sum, many believe our corporate tax system is broken and have issued calls to fix it.
But very few seem to understand what it means to have a broken system, or what a repaired system might accomplish.
The research we are undertaking here at Duke and at other institutions around the country, is helping to shape this debate in a way that we hope will result in meaningful, effective tax reform.