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A revolution in US corporate tax

As reported by the media, US Republicans in the House of Representatives have launched an initiative to lower corporate tax to 20%, instead of 35% today, one step further in the tax competition between countries. The Trump administration seems to support the project. Donald Trump himself even mentioned the possibility of lowering this rate to 15%. As worrying as is seems for the United States' trading partners, this drop isn't even the most important part of the reform. In reality, the measure forms part of wider radical project that will give corporate tax the same features as a tax that doesn't exist in the United States, namely, VAT or value-added tax, probably the most innovative and popular tax (as far as governments are concerned) since the 1950s.

7
April 2017
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lire en français
Executive resume

As reported by the media, US Republicans in the House of Representatives have launched an initiative to lower corporate tax to 20%, instead of 35% today, one step further in the tax competition between countries. The Trump administration seems to support the project. Donald Trump himself even mentioned the possibility of lowering this rate to 15%. As worrying as is seems for the United States' trading partners, this drop isn't even the most important part of the reform. In reality, the measure forms part of wider radical project that will give corporate tax the same features as a tax that doesn't exist in the United States, namely, VAT or value-added tax – probably the most innovative and popular tax (as far as governments are concerned) since the 1950s.

The innovative idea of copying corporate tax on VAT has been devised by one of the best economists in tax matters, Alan Auerbach, and presented in an ambitious paper published in 2010: “A Modern Corporate Tax,” Center for American Progress, The Hamilton Project, December 2010. The Republican plan, significantly different, was designed by two economists from the Tax Foundation. Given the unusual context of the United States at the moment, many believe this project to be a mere protectionist mechanism. The European Union is worried and some members within the Commission even wish to seize the the World Trade Organization. And yet, this project is not per se protectionist. In order to respond to these original proposals and take part in the upcoming debate, it would be useful to examine the project in detail.

What is the definition of this tax?

The Destination-Based Cash-flow Tax (DBCFT) has the following features, apart from being set at 20%.

The tax does not apply to the accounting profit before taxation, as a conventional corporate tax, but, as suggested by the name, to the operating cash flow or net operating profit. This is the total operating revenue (turnover) less the operating costs (intermediate consumption and wages) and investment costs (alternatively, EBITDA less investment).

Compared to the current corporate tax, all investment is deducted from taxable profit, not only the amortization on investment. At first glance, the reform has a stimulus effect on investment: a firm always deducts investment expenditure, but it does so with a delay in time when only amortization is deductible from income. With the reform, it keeps the carried interest on tax, which represents both a cash facility and a financial cost saving, especially if the cost of capital is high.

Generally, a growing company has a negative cash flow (because it invests a lot): it will pay less tax or none at all. A business without growth or with an economic rent will pay more taxes. Since investment is erratic, the tax base can also greatly vary, which is probably one of its weaknesses.

Another change compared with the present base of corporate tax: interest on loans is no longer deducted. This deduction is increasingly challenged: why are interests on loans tax-deductible while dividends paid by equity are not? Investors who lend to businesses have an advantage over those who provide their own funds. This subsidy to debt distorts the choice of corporate financing, while increasing financial risk. It is great time to introduce such a reform in the European context.

Finally, what does “destination-based” refer to? It is the major originality of this reform and refers to the fact that economic flows between the company and abroad are not subject to any taxation. Only US transactions of goods and services are subject to taxation. In the tax jargon, the tax applies to economic transactions “at destination” i.e. where the property is purchased; and not “at source” i.e. where it is produced. This has two consequences that we will now examine.

Border adjustment and the link with VAT

Border adjustment concerns profits made by subsidiaries of the company abroad: they are no longer taxed (but remain taxed in the countries where they operate). Let us remind here the originality of corporate tax in the United States, as compared to European countries. The subsidiary of a French company that operates in Germany is subject to the German corporate tax and, under the agreement between both countries, its profits are no longer submitted to corporate tax in France and can be freely repatriated. However, in the US tax system, the same subsidiary of a US group is liable to tax in the US, at least for the balance of the US rate of 35% and the German rate of 30%.

In the case of Apple, whose European profits are now taxed around 0% (thanks to Ireland!), the company would have to pay a tax of 35% if it were to transfer its foreign-earned profits back home. Just like for many other companies, it isn’t in Apple’s best interest to do so, and the total amount of cash shown in the balance sheet of US businesses (often hidden in tax havens) now reaches a staggering $2.1 trillion, an amount almost equal to France’s GDP. This aspect of the reform brings the US rule in line with the one which prevails in most countries and will help transfer these funds back to the United States.

But repatriating these funds too quickly could also push the dollar upwards and destroy the sought competitive edge.

The second consequence deserves more attention because it has produced many confusing comments. Sales made by the company abroad (in exports) are not taxed. By contrast, intermediate consumption and investment goods purchased abroad (in imports) are no longer deductible from the tax base: in other words, they are taxed.

This reflects exactly the principle adopted by our European VAT, which is also a “destination-based” tax. The company charges 20% VAT on its domestic customers but nothing on its export customers. Similarly, it recovers the VAT, also at 20%, on all of its supplies of intermediate consumption and capital goods from the country itself. Since foreign suppliers didn’t pay any VAT, the company cannot deduct it. In short: exports are not taxed but imports are. Only the “domestic” added value (i.e. produced by resident entities) is taxed. (By “added value”, we mean the balance between revenue and intermediate consumption and investment. This can be confusing, since accountants usually use “added value” to design the balance between revenue and intermediate consumption alone.)

The DBCFT project expands this principle by adding an extra element: salary costs incurred on the production of goods for the domestic market are deductible; those applied to the production of exported goods are not. Where VAT is based on the “added value”, DBCFT is based on “added value less wages”, with the same distinction between what is “domestic” and for “export”. In short, DBCFT is the same as VAT apart from a refund of tax at the same rate on the wages allocated to domestic production.

Not taxing exports and taxing imports: isn’t this protectionism?

This argument is often raised against VAT, and now DBCFT. It is simply wrong. There is no distortion of tariff related to border adjustment. Consider a US company that buys 100 before tax from a US supplier (case 1). The latter charges the company 100 + 20, with a VAT or DBCFT at 20%. If the company imports from a Chinese supplier at the same price of 100 before tax, it cannot deduct the tax paid on the good, since it hasn’t paid it in first place. In total, the Chinese good also costs 120, i.e. a purchase price of 100 and a tax deduction of 20.

People who speak too fast about protectionism make an incomplete calculation: they say it is in a company’s interest to buy from domestic suppliers, because it can deduct these purchases from its tax base. They forget that these domestic purchases, unlike imports, cost them more because of the upstream VAT.

What is true at the company level is also true at the domestic level. Let’s compare two countries: the first raises tax in the form of VAT and the other not. The VAT of the first country applies to domestic production (GDP excluding taxes) and imports: it doesn’t distort the relative prices on its home market. As for the second country that doesn’t use VAT, the domestic production of the country isn’t taxed but imports (i.e. exports of the first country) aren’t either. Again, no distortion.

Of course, if the country imports more than it exports, which is the case of the US – and to a much lesser extent, of France – the loss of tax on exports is more than offset by the gain on imports. In the US case, border adjustment will boost tax revenues of the federal government.

And, more importantly, there remains one central question concerning transfer pricing, as we will see below.

Ultimately, VAT is a consumption tax. Can the same be said about DBCFT?

All businesses either sell on the domestic market or for export; buy on the domestic market or for import; hire their employees for domestic sales or for export. In other words, they are the fictitious sum of a “domestic” business, purchasing, selling and employing only for the domestic market, and of an “onshore” company that imports exclusively from abroad, employs locally and re-exports the products that are manufactured domestically. Now, let’s implement the DBCFT, i.e. VAT plus a return on “domestic” salary expenditures.

Now subject to DBCFT, the “domestic” company already pays the VAT fraction of its tax and passes on the charge on its selling price. And so on, until it reaches the end consumer: the only link in the chain that cannot transfer the tax to another party. That’s why VAT is only a consumption tax; and a very effective tax, for that matter, since it is largely painless for households. The company acts as a collector and tax auditor (it is in their best interest to check that the supplier has paid their VAT: otherwise, they cannot benefit from the deduction). Similarly, at every stage of the value chain, domestic firms reduce their tax by deducting salary expenses and by transferring the benefit downstream. For DBCFT, an upstream to downstream cascade impacts consumers, positively or negatively. Ultimately, DBCFT is a tax on the part of consumption that isn’t funded by wages. Only the consumption financed by non-wage income is taxed, i.e. the income from property, dividends and interest.

The “onshore” company avoids any tax or reimbursement of expenses. The property income it pays, whether in the form of dividends or interest, will be subjected to more tax. The same would apply, it should be recalled, if this “onshore” company was based abroad, i.e. if it were a real subsidiary that purchases, recruits and sells abroad: it wouldn’t pay any taxes in the United States. US companies don’t receive any extra advantage when basing their operations and/or transferring their profits abroad, via transfer pricing. Quite the contrary, as we shall see.

Why does the UE threaten to bring the case before the WTO?

First of all, let’s recall that VAT still affects competitiveness, indirectly. This happens if VAT, and therefore DBCFT tomorrow, replace income tax (corporate tax or turnover tax for businesses; income tax for employees): this would reduces the production costs of domestic producers vs foreign producers. The country that provides a greater share of VAT in its total taxes would gain in competitiveness, a kind of second-round distortion. But this isn’t what the EU is complaining about. On the contrary, as the matter currently stands, the EU can be criticized.

The complaint concerns a potential specificity, not in the concept of DBCFT as conceived by Auerbach, but in the way the Republicans in the Congress wish to implement the system. According to the current project, the total of wage costs is deducted from the tax base; but strictly speaking, it should only concern salary costs assigned to the production of domestic goods. The reason is the difficulty for companies to make a difference between employees working for export and those working for the domestic market. This could be an element of distortion of international trade, with a strong impact because the US have a considerable trade deficit. This impact is only possible because the principle of border neutrality is not respected. Economists that are familiar with the European debate should note that this “boosted” version of DBCFT reminds the so-called “social VAT” or “internal devaluation”, i.e. an increase in VAT compensated by a decrease of one of the cost elements of the company, for instance, taxes or social charges on wages. We must fight these measures, while noting that in open economies, with flexible exchange rates, any gain in competitiveness that is based only on the variation of taxes or exchange rates, rather than on a productivity edge, is gradually undermined by the variation of price indexation, of imported inflation and the new adjustment of the exchange rate.

Another issue raises with one last, and potentially significant, distortion: when DBCFT in a country coexists with a conventional corporate tax in a second country. Our so-called “onshore” company is not taxed at all in the US, as we have seen earlier. But if transferred to Mexico under the form of a subsidiary, it will be subject to the Mexican corporate tax and lose in profitability. For a multinational, the idea is therefore to reverse the current pattern involving the transfer of profits abroad. In its own interest, through variations of transfer pricing, it will do everything to reduce the profitability of its foreign subsidiary. For example, Apple will lower the price of iPhones imported from China from its Chinese subsidiary, or increase the intellectual property rights payed by the same subsidiary to its parent company: these measures will reduce the tax base of its subsidiary in China, without any impact on its tax in the United States.

Some believe this creates an enormous risk of illegal transfer of profits towards the United States. However, it should be noted that undermining the profitability of international subsidiaries by transferring profits encourages even more to relocate activity in another country: it is in Apple’s interest to continue basing their production of iPhones abroad. The opposite of what protectionist lobbies are seeking in the US.

In truth, this emerging debate around DBCFT and its effect on fair trade also forces us to focus on a tax that makes price distortion even worse, namely, corporate tax in its conventional form. Regrettably, we are witnessing a downward trend at European and even global scale.

What is the overall balance for DBCFT?

It is generally positive, which makes it an interesting measure. In a world where companies are increasingly integrated internationally, transferring profitability through intercompany billing, location of production assets, debt, intellectual property... has deleterious effects on the funding of governments and therefore, on the trading environment and international political balance. DBCFT has the advantage of reducing the incentive of tax exile, even if it raises important problems related to the coexistence of conventional corporate tax and DBCFT. Of course, just like VAT, it is not immune to tax fraud, including false billings from abroad. In contrast, its administrative cost is relatively cheap. It successfully corrects the distortion introduced in the relative cost of debt and equity and between consumption and savings.

Both the OECD and the EU are thinking about the correct localization of profits, with an approach based on withholding taxes, unlike DBCFT. These two ideas need to be further explored. Maybe Trump will take credit for the DBCFT and implement an extremely low and aggressive rate. “Sad!”, as he often tweets. Sadly enough, this would only accelerate tax competition at the international scale. But it wouldn’t question per se the choice of a DBCFT structure.

Francois Meunier
President, Alsis Conseil, Associate Professor of Finance, ENSAE ParisTech