The NYT reports that the admonistration is manipulating the IRS for political gain: I.R.S. Going Slow Before Election,
The commissioner of internal revenue has ordered his agency to delay collecting back taxes from Hurricane Katrina victims until after the Nov. 7 elections and the holiday season, saying he did so in part to avoid negative publicity.Except that it isn't routine at all: "four former I.R.S. commissioners, who served under presidents of both parties, said that doing so because of an election was improper and indefensible."
The commissioner, Mark W. Everson, who has close ties to the White House, said in an interview that postponing collections until after the midterm elections, along with postponing notices to people who failed to file tax returns, was a routine effort to avoid casting the Internal Revenue Service in a bad light.
Kudos to David Cay Johnston for doing a little fact checking.
Nixon politicized the IRS. Are there any bad habits of Nixon's left that we haven't seen in this lot? (Not to mention all their newly-minted bad habits.)
There is a cancer on the Presidency. And this is one of its many symptoms.
My colleague Fran Hill has an op-ed in today’s New York Times, Congress’s Charity Cases - New York Times.
Here’s a taste:Why were charities Mr. Abramoff’s go-to vehicles as he sought to transfer funds covertly through Washington’s corridors of power? The primary attraction was their opacity: their ability to raise money in any amount, without limit, from any individual or entity anywhere in the world without disclosing the contributors to anyone.
This makes good sense for honest charities helping people in need. But Mr. Abramoff took advantage of this situation to circumvent campaign finance laws and Congressional ethics rules and provide illicit benefits to powerful politicians.
Gee. Think there just might be a connection between this story in today's paper,
Tax Cheats Called Out of Control: So many superrich Americans evade taxes using offshore accounts that law enforcement cannot control the growing misconduct, according to a Senate report that provides the most detailed look ever at high-level tax schemes.and last week's story,
I.R.S. to Cut Tax AuditorsThe federal government is moving to eliminate the jobs of nearly half of the lawyers at the Internal Revenue Service who audit tax returns of some of the wealthiest Americans, specifically those who are subject to gift and estate taxes when they transfer parts of their fortunes to their children and others.
Both stories are by David Cay Johnston, but he's too coy to remind us of the first when writing the second...
There are still several hours in the tax year. It may be too late to emulate my brother and acquire that extra two-legged tax deduction, but it's not too late to make charitable donations online via Network for Good.
We particular favor Ashoka, Daily Bread Food Bank of Miami, EPIC, Human Rights First (formerly the Lawyers' Committee for Human Rights), and the University of Miami H.O.P.E. program (student public interest programs), but there are so many good causes to choose from.
Paul Caron has an interesting post up about a lawsuit by an orthodox Jew seeking the same tax exemption the IRS has given the Scientologists:
A lawyer for an Orthodox Jewish couple claimed Monday that the Internal Revenue Service has violated the First Amendment by refusing to allow tax deductions for their children’s religious schooling. The IRS should allow the deductions because it permits members of the Church of Scientology to write off the cost of spiritual counseling sessions, attorney Jeffrey Zuckerman said during the first day of a non-jury trial in U.S. Tax Court before Judge John O. Colvin. The First Amendment prohibits the IRS from discriminating on the basis of religion, Zuckerman said.
Coincidentally, we were talking about this case at lunch before the faculty seminar yesterday. It has all sorts of implications….
From TaxProf™ Blog
Today’s New York Times, Wall Street Journal, and Washington Post report on an October 8 letter from the IRS threatening to revoke the NAACP’s tax-exempt status in light of NAACP Chairman, Julian Bond’s speech this summer condemning the policies of President Bush. Tax Prof Frances Hill (Miami) is critical of the IRS’s action in a Newsday article on the subject:Frances Hill, a University of Miami law professor and an expert on the political rights of tax-exempt organizations, read Bond’s speech and said it was indeed critical of President George W. Bush. But she added that Bond was probably on safe legal ground because his speech was broadly conceived, didn’t focus solely on Bush and touched on a range of issues that have long been trademarks of the NAACP, such as equality and justice. “You can be passionate and still have a tax-exempt status,” Hill said. “If the IRS thinks that this speech is sufficient to trigger an audit, then I think we have quite a new standard and they must be planning to audit hundreds of other groups.”
Michael Froomkin will be back full-time tomorrow, so this is my last post. I still have a lot of stuff to say on the threads to my posts, however, which I will do over the weekend, so you are not rid of me quite yet.
Thank you all! I learned a lot about stuff and the blogosphere. Thank you Michael! It has been as much work as I expected. I cannot imagine how Michael finds time to blog, maintain this remarkable site (which I had no responsibility for, and which must take up as much time as blogging), and have a life. Amazing….. And Michael just emailed that I should have my own blog….
Well, I have been stalling for weeks on the fundamental issue of international tax policy: As a practical matter, in an open worldwide economy, can one country impose an income tax? There are two sub-issues: First, can a country tax residents (or citizens) on their worldwide income. Here, can the US tax Sue on her foreign surgeries, given that she can move? Second, can one country tax income related to mobile local factors of production? For example, can the US tax the capital of Ford Motor invested in a US factory if Ford can close the factory and move production to low-tax Mexico?
I have no special insights into these issues. The conventional wisdom, which I agree with, is that no country acting by itself can deal with enforcing an income tax on mobile capital and individuals. International cooperation is required.
Tangent: This is where I got the idea for a multinational treaty discussed yesterday. The idea of negotiated sharing (sourcing) of the revenue base is not part of the conventional wisdom, however. Somebody suggested base sharing to me in passing about 20 years ago (as part of Treasury’s discussions surrounding California’s unitary tax). Back then, I rejected base sharing so quickly, that I even forgot who mentioned it to me. Don’t want to risk slandering somebody by guessing. But, as the problems of an income tax in an integrated world have become more clear, the power of negotiated base sharing stuck, if not the identity of who mentioned it to me.
The hard part is that the multinational treaty required to deal with mobile factors must address tax rates, not just sourcing and enforcement. Only by having one world-wide rate of tax (on the same basic base), after adjusting for differences in local services (which adjustment is impossible, of course), can one assure that taxes not affect location decisions. Boy, a tough nut to crack. The US certainly doesn’t want as big a government as in Europe. But, VATs, which are less sensitive to location problems (but do have problems with e-commerce), can be used to fine-tune the size of a given country’s government.
There are some halfway measures. For example, today, the US has rules that reduce the tax benefits to an individual from expatriating artfully. International cooperation helps in enforcing such rules. But, going beyond policing citizenship and residency to place restrictions on international flows of capital or services just to solve tax problems seems like the tail wagging the dog.
Well, nobody said it was going to be easy. Like a true academic, as Johnny Rotten sang, I just see Problems, Problems….
I am sitting here reading the fine print in a contract to buy a house for a price that is three times what I sold my house in Minnesota for. I am not UMC in Miami, I guess. Forgive me if I am even less coherent than normal — and that I haven’t had a chance to do more commenting.
Oh, well, back to taxing the nowhere and everywhere profits of multinationals. The world-wide network of tax treaties rests on the arm’s-length notion, which, I have argued (and the comments seem to be moving somewhat — somewhat — toward accepting), misses nowhere and everywhere profit. This is real important, as failure to tax nowhere and everywhere profit guts business income taxes as a source of revenue for countries. (Yes, tax jocks, the current US regs, whiile pretending to be arm’s-length regs, do capture some nowhere and everywhere income.)
Quick Meta Tangent: In an open, world-wide economy, it is not clear who bears the burden of one country’s income tax. Thus, it is not clear why we want to keep income taxes. (But, I do, as a matter of faith.) Even if one is uncertain about income taxes in general, however, one should be bothered by multinationals getting a special break on one type of profit.
I have a very academic, not very novel, big government, law and economics inspired, fix: Rather than the current network of hundreds of bilateral tax treaties, we need a huge multinational tax treaty. The participant countries would work together to carve up business profits consistently in a fashion that seems reasonable to them. In other words, I would substitute governmental negotiation for policy makers trying to figure out where income is earned.
There is some reason to believe that negotiated tax bases might work: Negotiated carve-ups happen today. Under bilateral tax treaties, a multinational can request the two countiries involved to work together to avoid double taxation. A few really big multinationals have been the subject of such negotiations. These negotiations ultimately result in the countries involved carving up the income of the multinational in a fashion that is acceptable to all parties.
Obviously, a huge multinational tax treaty is so large and difficult an undertaking that only a 20-year academic would waste time thinking about it. (And don’t even think about what America’s right wing thinks about multinationalism.)
Also, under my proposal, as in every bargaining, there are problems from unequal negotiating positions. In particular, the US would be tempted to overreach. (In an earlier post, I mentioned how the Kennedy and Johnson administrations used bilateral tax treaties to protect developing countries. Those days are gone, sniff…) The multinational nature of the negotiation process that I propose is intended, among other things, to reduce the impact of uneven negotiating positions by enabling countries with similar interests to act in concert. More naive academic theory (from someone who knows little bargaining theory), perhaps. I submit, however, that multinational cooperation is the only workable long-term solution.
Tomorrow: Finale: Keeping Sue home
Well, it is time to talk about multinationals again. I am somewhat over my head here, as this is a developing area, and I am not current in the literature. That said, here goes.
The classic analysis of the “extra” profitability of multinationals looks to market barriers. If there weren’t barriers to forming a multinational, there would be new ones created seeking that extra profit. As more multinationals are formed, the extra profit goes away. After all, it must be costly to set up a business that can function legally and practically as one enterprise in many countries, or everybody would do it. Back when there were few multinationals, the market barrier analysis seemed to tell the whole story. Today?
The most common analysis of the “extra” profitability in multinationals looks to the intangible value, particularly non-asset intangible value, in multinational enterprise. This approach can include the market barrier analysis. After all, there is no international law blocking the formation and operation of multinational businesses. Thus, the market barrier must be the cost of learning and understanding multinational law and business and of developing multinational relationships. This cost can be viewed as an investment in an intangible.
Other kinds of intangibles can give a multinational extra oof. Coca Cola is the classic example. Its profitability is attributable in considerable measure to a name and a formula. Consider the tax issue: Where does Coca Cola earn money? (Note the analogy to my Sue example.) The formula sticks world-wide. Advertising, promotion, and marketing in one country can help sales in another. There is no arm’s-length price for the name or the formula to help figure out what Coca Cola US earns.
But, it appears that there is something in multinationals in addition to expertise, know-how, goodwill, going concern value, trademarks, service marks, and so on. It seems that multinationals have “extra extra” value. Multinationals can access world capital markets in ways that single-country corporations cannot. Because of thinness in the worldwide derivatives markets, a multinational can diversify risks in ways not otherwise available. Worldwide development and marketing coordination is easier in a multinational. And so on.
With a little shoving, one can push the extra extra value analysis into the other approaches. The sheer size required to be a multinational can be viewed as a barrier to entry. Knowing how to play, and playing, the world can be viewed as an intangible. But, to me, it seems helpful to analyze extra extra value separately from extra value, so long as the developing empirical research bears out that there really is extra value in multinationals that is not attributable to assets or traditional non-asset value like goodwill, know how, and going concern value.
If there really is extra extra value in a multinational, the question arises as to where that profit is situated so that countries can tax it. In fact, it is nowhere and everywhere.
Tomorrow: Taxing nowhere and everywhere…….
There have been a lot of insightful comments on my posts. sorry that I haven’t had time to comment back. Been dealing with horrendous computer problems. Comments on comments soon.
Yesterday, I noted, and one great comment (by the ominously named Consultant) telegraphed, that stripping is the ball game when it comes to protecting the US business income tax base. What is going on? One can get a feel for the hidden concerns here by reading between the lines of the Treasury report that I gave a link to yesterday.
Policy makers want to attract foreign capital and business to the US. The Reagan Administration gave us a shameless example. Most countries impose tax on interest earned within their borders (unless mutually relaxed by a bilateral income tax treaty). The US rate is 30%. In 1984, to help US corporations burdened with higher borrowing costs as a consequence of having to compete against the voracious borrowing of the Reagan Administration, the US repealed the US tax on interest earned in the US by foreign investors. (At the same time, Reagan cut back your interest deduction.) Instantaneously, Manhattan was turned into the largest tax haven in the world. The enforceable tax bases of every country in Latin America disappeared overnight. But US companies got — and continue to get — cheaper borrowing!
Which gets us back to stripping. There is an unspoken assumption among many policy makers that we have to allow Honda and Toyota to reduce their US taxes by stripping in order to get them to open plants in the US. Apparently, the US otherwise is a bum deal. But, we can take US companies for granted. Under this analysis, inversions just involve turning US multinationals into foreign multinationals, which is OK, as it just eliminates the unfair US discrimination against its own companies.
Give ‘em an inch…..
In a few days, I will write more about the “extra” value in a multinational. Today, as promised, I want to talk about expatriot corporations.
A bunch of US corporations moved to Bermuda on paper to reduce US taxes. In such a transaction, technically, the old shareholders of the US operating corporation become shareholders of a new Bermuda holding company, which ends up owning the old US operating corporation. Because the old US corporation becomes a subsidiary of the new public Bermuda company, expatriation transactions are referred to as “inversions.” The tax benefits of inversions have been there for some time. But, inversions became popular only recently as corporate managers and the stock markets began accepting Bermuda corporations more.
The inversion alone saves no taxes, as the old US company continues to be taxed as before. (A good Treasury report is here: Treasury Inversion Report.) But, the inversion sets the stage for parking money offshore with US tax advantages. Most obviously, the new Bermuda parent and its foreign subsidiaries (not owned through the old US company) can earn foreign income free of US tax (until paid to US public shareholders as dividends). This benefit from inversions really is not that important, however, since real foreign income pays little US tax today (being parked in low-tax foreign corporations).
What is important is that foreign subsidiaries of the group now can get some US income — that’s US income — at a reduced or zero US tax. As noted in an earlier post, to prevent artificially parking movable income, like interest and royalties, in tax havens, current US anti-abuse rules tax this movable income of foreign subsidiaries of US corporations as earned by the foreign subsidiaries. After an inversion, the group can have foreign corporations that are not owned by a US company. So, after an inversion, the US operating corporation can pay interest or royalties to a foreign member of the group and get a deduction that reduces the US corporation’s (and, thus, the group’s) US tax, while the payee corporation is subject to low or no US tax. (One popular technigue for securing a low US tax on the payee uses our income tax treaty with Barbados, as discussed in an earlier post.) Moving US income offshore in a deductible fashion is referred to as “stripping” US income.
Patriotic, huh? Note that business defends inversions by saying that inversions are a reasonable response to the US taxing foreign income of US persons. In fact, as just noted, the real juice in inversions is from stripping US income.The really interesting (pun?) issue here is why the US hasn’t attacked stripping more forcefully. Tomorrow.
I feel like taking a little break — two or three days —from international taxation.
Fortunately, there are even more important — at least in the medium term — tax topics. The most pressing tax issues today are presented by two time bombs in current law: (i) the sunset of the Bush tax cuts and (ii) the metastasis of the alternative minimum tax.
A few of President Bush’s tax cuts for the middle class phase down starting at the end of this year. (Yes, there is an over $11 billion a year tax increase, born mostly by the middle class, that takes effect in January. The politics leading to this are discussed in Michael Froomkin’s post, It’s Cynicism All the Way Down, on July 22, below.) All of Bush’s cuts in regular taxes expire at the end of 2010. The capital gains tax cuts expire at the end of 2008. (Dishonest budgeting is a topic for another day.) To extend all of these cuts from when they expire through the end of 2014 would cost at least $1.2 trillion. REALLY! $1.2 TRILLION! And breathtaking deficits are projected without an extension. This speaks for itself. (Or at least the silent political campaigns must so think.)
The second time bomb is the individual alternative minimum tax. This tax (in its current form) was enacted in 1986 to limit tax sheltering by the rich, but now is a misguided tax on the upper middle class, particularly those who live in states with high state and local taxes. For a good recent CBO report on this, go to CBO AMT Report . Bush’s tax cuts (although not the revenue numbers noted above) contained some minimum tax relief, but it sunsets at the end of this year. Historically, less than 1% of all individual taxpayers paid minimum tax. Next year, 11.6 million individual taxpayers (about 13% of all such taxpayers) will pay over $35 billion in minimum tax. These numbers will almost double in the following decade. Something must be done, but there is no money…
My numbers come from the CBO, the Joint Tax Committee Staff, and the Tax Policy Center.
John Kerry’s acceptance speech last night made reference to the US rules for taxing multinationals. I thought that his comment presents a nice opportunity to pull together some of the prior analysis and extend it to outsourcing.
Kerry promised to:
close the tax loopholes that reward companies for shipping jobs overseas. Instead, we will reward companies that create and keep good paying jobs where they belong, in the good old U.S.A. We value an America that exports products, not jobs. And we believe American workers should never have to subsidize the loss of their own job.
His web site says a bit more:
Close Loopholes In International Tax Law That Encourage Outsourcing. Today’s tax law provides big breaks for companies that send American jobs overseas. Current “deferral” policies allow American companies to avoid paying American taxes on the income earned by their foreign subsidiaries and encourage them to keep their profits parked overseas, not reinvested in America. As president, John Kerry will end deferral that encourages outsourcing and will shut down other loopholes to make the tax code work for the American worker, not provide tax breaks for companies that ship jobs overseas.
Kerry is troubled by the ability of US corporations to defer a full US tax indefinitely by using foreign subsidiaries to do business in low-tax jurisdictions. Accordingly, he would look through these corporations and impose a current US tax as the subsidiaries earn money (reduced, of course, by a credit for any foreign taxes on those earnings). This is consistent with current financial accounting rules, as earnings of foreign subsidiaries are included immediately in the parent’s (consolidated) financial statements. (Although, as noted in a prior post, the US taxes on those earnings are not booked until the earnings are paid to the US parent as dividends.)
There is an important point in the Kerry website note: The US respecting foreign subsidiaries rewards outsourcing. By “outsourcing,” I mean a US business having an independent foreign business provide goods or services for the US business that, historically, the US business provided for itself. To the extent that (i) the independent foreign business is in a low-tax country and, this may be unlikely, (ii) those low taxes are reflected in lower prices from the foreign business, little can be done to reduce the US tax incentive to export. But, under current law, outsourcing makes it easier to move the extra profit in a multinational — which, in this context, most would view as profit attributable to non-asset intangible value, like know-how and non-patented technology — outside the reach of an immediate, full US tax. Kerry’s proposal to look through foreign subsidiaries would get at this incentive to outsource.
It is important to note that full look-through does not eliminate all incentives to move offshore. Most obviously, there still are problems from the averaging of foreign tax rates for purposes of the limit on the foreign tax credit. (This was discussed in an earlier post.) For example, a US business with operations primarily in high-tax countries still will be able to avoid all tax on some item of US income by moving the US income to a law-tax jurisdiction. Similarly, a US business with operations primarily in low-tax jurisdictions can move US income to a high-tax jurisdiction at no extra tax cost. These problems will be worse once the ETI bills become law, as they cut back on the 1986 restrictions on averaging.
Your posts make it clear that I should say more about how a multinational can have “extra” value. But, tomorrow. Today, as promised, formulary apportionment.
“Formulary apportionment” is the most talked about alternative to the arm’s-length method discussed yesterday. Most US states use formulary apportionment to attribute a multistate business’ income to the taxing state. As the name suggests, a formula is used to figure out how much income a business earns in a taxing jurisdiction. The classic formula allocates on the basis of three factors: the business’ property, payroll, and sales. Each year, the business figures out what percentage of its property, payroll, and sales are located in the taxing state. These percentages are averaged. This average percentage is applied to the business’ income to figure out the portion of the income to be taxed.
Many US states apply formulary apportionment on a “unitary” basis: Corporate shells — including foreign corporate shells — of a group of companies under common control are ignored. When one corporation in the group does business in a state, the income of the entire group of corporations is allocated to the state based on the worldwide factors of the group.
There are substantial problems with formulary apportionment: It can be as difficult to situate the factors as to situate income. Where are intangibles located? How does one value property? Where is the payroll of employees that work in various jurisdictions? Where are sales? Where delivered? Where title passed? And so on.
There is nothing magic about the three factors. To get revenues, some US states use inconsistent formulas. In particular, some non-manufacturing states give extra or complete weight to the sales factor. This demonstrates a broader concern: formulary apportionment turns an income tax into as much a tax on the factors as on income. This is not a particularly good thing.
In the international context, there is another problem with formulary apportionment (noted in some prior comments on posts in this series): To work, apportionment must be applied on a unitary basis. Otherwise, prices could be rigged to hide income in corporations not subject to apportionment. The piercing of corporate veils under the unitary method would violate international custom and all bilateral tax treaties. Consequently, it would be extremely difficult to move away from an international regime rooted in the arm’s-length method.
Tomorrow: This and that
As noted yesterday, the US does not tax foreign income of foreign corporations, even when the foreign corporation is a wholly-owned subsidiary of a US corporation. Under this regime, a US parent corporation with a subsidiary in a low-tax (tax haven) jurisdiction has an incentive to park income in the tax haven by (i) paying the subsidiary too much for goods and services and (ii) charging the subsidiary too little for goods and services. The US polices this with two mechanisms: First, some very mobile income, like royalties, of a controlled foreign corporation is taxed to US shareholders as earned by the foreign corporation. Second, there are rules that attempt to insure that parent/subsidiary transactions are priced at “arm’s length.” The arm’s-length rules don’t work, which calls the entire regime into question.
The arm’s-length standard fails both in theory and in practice. The theoretical problem probably doesn’t seem all that compelling (except to a hand full of theorists), but it helps understand the practical problems. Here is the idea: Income is a measure of individual wellbeing. It is not earned in any place or by a legal entity. This was illustrated in the Sue hypothetical. She performed her surgeries offshore. But, in the abstract, the earning process began the day that she was born. To try to figure out what she earned offshore –- to try to break a seamless earning process into artificial pieces –- seems doomed to failure.
And fail it does. To figure out an arm’s-length price, one needs a comparable transaction between unrelated parties. In every interesting case, there is no useful comparable. Economists are beginning to figure out why. Multinational corporations are more complicated than initially thought. They are more than the sum of their parts. (Like The Beatles, I like to say.) This violates traditional economic theory, but the empirical work bears out that there is extra value in multinationals. Thus, comparables may not exist, as multinational groups can do things that a collection of independent local companies cannot. Also, a multinational has extra profit from being a multinational, which is not attributable to any local piece, and which is missed in traditional arm’s-length pricing. (But yes, tax jocks, is dealt with toward the end of the 1994 regs somewhat.)
Tomorrow: Formulary apportionment
The multinationals discussion thus far has felt a bit like a trip down memory lane. Today, however, we have a topic, foreign subsidiaries, that is so topical that there is news today! (My source is today’s The Wall Street Journal Online.)
Part IV noted that the US’ foreign tax credit regime represented altruism in the interests of encouraging trade and helping developing countries. Well, once one takes foreign subsidiaries into account, one realizes that we have done less.
The US does not tax foreign corporations, per se. (As to be discussed in a couple of days, we do tax US income of foreign corporations.) Thus, a US multinational can park foreign income in a low-tax foreign subsidiary with no current US tax. Also, as a number of posts have noted, the US multinational can manipulate the prices charged and paid to the low-tax subsidiary so as to park even more profits in low-tax countries. The US has some rules that limit such price manipulation, but they are fatally flawed, as to be discussed tomorrow. Also, the US has rules that impose an immediate US tax on certain passive and other easily movable income “earned” in tax havens. Of course, the pending ETI bills cut this current-law immediate tax back.
Dividends from foreign subsidiaries are subject to a full US tax (with a credit for any foreign corporate taxes on the earnings underlying the dividends). Thus, a full US tax is preserved, sort of. Deferring the US tax, so that the offshore money can grow subject only to a low foreign tax, is a real benefit.
Deferring the US tax on foreign earnings until the earnings are repatriated as dividends poses a problem, however: It discourages US multinationals from bringing their low-tax profits home to use in the US. (There are easy ways to get the money out of the tax haven and use it someplace else offshore.) Thus, in the questionable spirit of tax amnesties, the pending ETI bills provide for a temporary reduced tax on such dividends.
Which gets us to today’s news. The staff of the Financial Accounting Standards Board (the trade association that the SEC lets set accounting rules) recommended that multinationals be required, as foreign income is earned, to show a current expense for the ultimate US tax when the foreign earnings are repatriated. No additional expense would be recorded when dividends are paid, which is the current rule. Thus, repatriation would be encouraged, as there is no associated tax hit to reported financial statement earnings. Don’t hold your breath for this staff recommendation to be adopted any time soon.
Tomorrow: A source is a source, of course, of course? NOT!
Thank you all for the posts. Compare Jim’s comments on Part III to Paul’s on Part IV and you get the contours of the contemporary debate. Dan’s, PGL’s, and Jim’s posts flesh out how complicated these issues are in the real world. (Jim, I really hope that Michael takes the blog back over before I have to talk about consumption taxes.) In the end, I do not have a view on the deduct vs. credit issue with regard to foreign taxes, because I do not understand the welfare effects of international trade adequately at this time. But, I can focus the analysis so that others can apply their views of trade.
Which gets us back to the foreign tax credit.
The discussion thus far has dealt with foreign taxes at a rate below the US rate. Sue’s European taxes, however, are at 50%, which is above the US rate. For simplicity, assume that the US rate is 35%. Even if one accepts a credit for foreign taxes, giving a full credit when the foreign rate exceeds the US rate can be troubling. The US not only would be forbearing from taxing the foreign income but would be paying Sue’s extra 15% foreign tax. This seems wrong, even if in the best interests of trade. Also, the extra 15% may pay for extra benefits in the foreign country, so that a deduction, not a credit, is appropriate.
The US has dealt with high foreign rates with a limit on the amount of the total credit for foreign taxes equal to total foreign income multiplied by the US tax rate.
Unfortunately, this creates a new set of problems: Sue’s foreign taxes are $1 million. Her US tax credit limit is 35% (the US rate) of the $3 million of foreign income, $1,050,000. Since this exceeds her $1 million of foreign tax, so all of Sue’s foreign taxes are creditable. Thus, while her foreign income generates $1,050,000 of pre-credit US tax (35% of $3 million), she is allowed a $1 million credit, and her foreign income bears only $50,000 of net US tax. In other words, her $1 million of low-tax foreign income bears only $50,000 of net US tax because of the way that the current US foreign tax credit works.
The phenomenon discussed in the preceding paragraph is referred to as the “averaging” effect. Creditable foreign taxes are limited so that the average creditable foreign rate (not any actual foreign rate) does not exceed the US rate. Consequently, the high-tax European income shelters the low-tax other foreign income. In fact, Sue may have done some surgeries in low-tax countries in order to exploit averaging.
Why is the US so dumb? One argument is simplicity: Separate limits on each item of foreign income (or even on income from each country) are unworkable, say the lobbyists. Also, business argues that averaging encourages trade. The 1986 tax act put some limits on averaging, but the pending ETI bills would soften them. Oh, well.
Tomorrow: foreign subsidiaries.
So far, the discussion has ignored any foreign income taxes on Sue’s surgeries. It now is time to look at this double taxation –- US income taxes plus foreign income taxes.
An obvious preliminary question is why do foreign income taxes, as compared to other costs of doing business overseas (like other foreign taxes), present a special case? The idea is that most costs are reflected in the prices at which goods and services are sold. Federal-level income taxes, however, are bone by the owners of the business. Thus, being required to pay US and foreign income taxes is double taxation. (The born-by-owners assumption is shaky, but further analysis is beyond this little post.)
So, there is double taxation, so what? The analysis here involves trade concerns more than tax policy analysis. A business’ taxes should not depend upon where it does business (after adjusting for other local factors, such as malpractice liability in Sue’s case), goes the analysis. This will interfere with free trade, so as to reduce world-wide well-being.
Which presents the question of which tax is the “extra” tax, the US tax or the foreign tax? The assumption underlying current international practice is that the source country (where Sue does her surgeries) gets first shot. Income is viewed as a thing that is more connected with the source than where it ends up. (As I mentioned in an earlier post, I do not view income as a thing, but what this means to this analysis I will not get to until later posts.)
Assuming that the US is to blink first, it needs a mechanism to do so. The US could just not tax foreign income that bears a foreign tax. This would unduly reward foreign income that bore only a low foreign tax. however. So, the US’ mechanism is a dollar-for-dollar credit against US taxes for foreign taxes (subject to limits, which are the topic of tomorrow’s post). If the foreign rate is the same as the US rate, the US gets no net tax. But, if the foreign tax is at a low rate, the US pockets the difference.
Note the US’ altruism here: Historically, most multinational enterprises resided in the US. The US forbore collecting some taxes on these enterprises in the name of trade. Also, the Kennedy and Johnson Administrations embraced this regime because it discouraged tax competition between developing countries. (If the source developing country didn’t impose a tax, the US would.) It was hoped that this would help such countries build needed infrastructure and institutions.
Tomorrow: more on the foreign tax credit.
I have argued thus far that (ignoring foreign taxes and the possibility that a US tax would drive Sue out of the US) the US should tax Sue on her foreign surgeries. Even under the assumptions thus far, however, the analysis is incomplete. I must address the argument that we should not tax Sue as that would undermine her competitiveness.
The competitiveness argument is that, if Sue is taxed, she is handicapped in competing with foreign doctors who would not have to pay income tax on the same surgeries. It is not clear that Sue’s competitiveness, in this sense, is in the best interests of the US. This would be true only if total US welfare is higher if the US does not tax Sue than if she is taxed. This could be the case, say, if the taxes would drive Sue out of business altogether, which does not seem likely. More likely, the benefits to America of Sue paying her fair share of taxes outweigh any marginal burden on her. But, this is a very difficult question which I cannot answer with any authority.
While it is hard to decide if we want to make Sue competitive, it is important to note a more straightforward defect in the competitiveness argument: Taxing Sue probably does not make her less competitive. If Sue is paid the same amount for foreign surgeries as she would in the US, not taxing the foreign surgeries just would encourage her to ply her trade offshore. She is less competitive only if the foreign surgeries pay proportionately less due to the lack of foreign income taxes on other doctors who would perform the surgeries. (The foreign surgeries may pay less, for example, because of more limited malpractice liability, but that is not a tax concern.) While possible, this seems sufficiently unlikely that the entire competitiveness argument seems questionable.
Tomorrow: Those pesky European taxes.
I was catching up on my reading and stumbled upon something: Last week, the US and Barbados agreed to fix the treaty-shopping article of their income tax treaty. This treaty was the heart of a structure used by some of those great American corporations that reincorporated in Bermuda to avoid US tax. If I understand the significance of the amendment correctly — these deals are real complicated — the Bermuda/Barbados structure will trigger a lot more tax as soon as the amendment is ratified by the Senate. Also, new expatriations will be discouraged as planners see new taxes on the horizon. May talk about this more next week.
PS PART III of US Taxation of Multinationals will be delayed a day.
Back to my Sue hypothetical from yesterday. The right would say that we can’t tax her, so we shouldn’t. I prefer a more optimistic, can-do, American approach: See if we want to tax her and how, and then figure out a way to do it. (In other words, I’m putting off discussing the hard practical problems.) Also, let’s ignore the European taxes for now.
So, should the US tax Sue on the income received as a consequence of her offshore surgeries? Well, she is a US citizen. The historic US view has been that US citizenship alone justifies taxation on world-wide income. After all, Teddy Roosevelt would send gunboats to protect a US citizen. This argument just seems out or date to me, however.
Sue also is a US resident. One can argue that she gets all of the benefits of living in the US and should pay her fair share of the cost of our country. This argument, while having some force, does not seem powerful enough to justify full progressive taxation.
But, there are more reasons for the US to tax Sue. In the abstract, much of the money generated by the foreign surgeries was earned while she was in the US. Performing surgeries just finished a long process. She learned her art and honed her skills in the US. Without her US life, she could not have demanded megabucks offshore. The US supported her earning process by supporting her education and the schools and hospitals where she trained. Less importantly, she arranged and prepared for the offshore surgeries in the US. All of this convinces me that the US should tax her offshore surgeries. (Remember, I assumed away a bunch of hard issues above, for now.)
I suspect that unspoken analyses like that in the preceding paragraph is why most tax types accept residency as a basis for taxation. Current residency alone may not show large current governmental benefits, but may be a good proxy for lifetime benefits that provide a sound basis for taxation.
Law types, note that this analysis is somewhat inconsistent with legal (power) notions of jurisdiction. These notions would suggest that some of the foreign surgery earnings (some amount viewed as really earned offshore) are beyond US taxing jurisdiction. Ignoring physical notions of jurisdiction is acceptable here, however, because, as it turns out, income is a concept, not a thing, and doesn’t really have a geographic source!
Have I convinced you? More tomorrow.
Everybody seems most interested in talking about US taxation of multinational enterprise, so, bring it on!
As a law professor, I must start with a hypothetical: Sue is a leading heart surgeon. She went to college and med school on federally-guaranteed loans at schools that received considerable state and federal support. Her clinical work, internship, and residencies were at hospitals that received much government aid. After establishing herself at THE private clinic in New York, she decided to operate only in countries with “reasonable” malpractice laws.
In 2004, Sue received $1 million for surgeries performed in countries with no income tax. $2 million was earned for surgeries in Europe, which was taxed by the countries where the surgeries were performed at 50%. Her only other income was on investments held in an account in London. She is a US citizen and resides in Manhattan. If the US were to tax her, she would happily move to Geneva (where she has numerous personal and professional connections) permanently and renounce her US citizenship. (Remember, this is a hypothetical. Currently, the US would tax her, but little tax would be owed, because of the way that the US foreign tax credit works, which will be discussed in later posts)
How should the US tax her on her $3 million of 2004 surgery income? The pro-business, anti-tax right would say not at all, as taxation would drive her to Europe. More tomorrow.
Hi, I’m George Mundstock. Michael was kind enough to let me guest blog while he travels. Always wanted to try running a blog, but was afraid of the start-up and commitment (and, OK, that I would throw a blog and nobody would come). This is a great opportunity for me. Thanks Michael! Hope that you all find my stuff at least somewhat interesting.
As a tax type, it seems mandatory that my first entry be on taxes. Unfortunately for America, there is a huge corporate tax bill working its way through Congress, which is likely to pass after the elections and, therefore, makes a perfect first topic. The House passed the American Jobs Creation Act with $130 billion (over 10 years) in new corporate tax breaks (and some offsetting corporate tax increases, but only one big one, which will be discussed in a minute). The Senate has its Jumpstart our Business Strength (JOBS) Act with about the same total new benefits (although it, unlike the House bill, also includes the energy stuff that will be discussed tomorrow), but a few more revenue offsets, so as to have a lower net cost.
Quo Vadis? Well, its a long story: Since the 1960s, the US has had a tax incentive for exports, first called DISC (Domestic International Sales Corporations), then FISC (Foreign International Sales Corporations), and now ETI (Exempt Territorial Income). Most of the current tax benefits go to few companies (Boeing, GE, Intel, Microsoft, Honeywell, Caterpillar, Motorola, and Cisco). Surprise, all 3 versions of the incentive have been ruled to violate GATT by interfering with free trade, most recently in January of 2002. Since then, Europe has waited patiently for Congress to repeal ETI. (The Bush Administration did not push very hard for a fix.) Finally, in January, various European countries began imposing WTO-approved sanctions: tariffs on various imported US goods, which tariffs increase the longer that the US is in non-compliance, until the tariffs reach a total of $4 billion a year. So, now, Congress must Act. But, there is a problem: Chair Thomas of the House Ways & Means Committee views this as a “competitiveness” issue: US corporations must pay as little tax on foreign operations as some hypothetical tax outlaw foreign corporation (that doesn’t really exist). In other words, GE needs new breaks for its foreign operations to replace its lost export incentive — that this makes it more desirable for US businesses to export jobs be damned. But, wait, says the Senate, what about Boeing and Caterpillar? We also need tax breaks for US manufacturing to replace the lost break for US manufacturers who export. And the House, which never met a tax cut that it didn’t like, agrees. So, now, we have 2 bills that, rather than pick up $50 billion in much needed federal revenues by repealing an illegal subsidy, instead provide expensive new rules that benefit companies’ offshore operations, while also rewarding anything that some accountant thinks is US manufacturing. Aarrgh! Why isn’t your business as valuable to America as manufacturing?