A Fine Mess

by T. R. Reid

  There was considerable public consternation, in Congress and on the nation’s editorial pages, about the surge of tax-ducking inversions that began in mid-2014. While members of Congress from both parties were lamenting this trend, nobody suggested that a gridlocked Congress might actually agree to do something about it. Accordingly, the secretary of the Treasury, Jacob Lew, stepped up three times—in the fall of 2014, and again in late 2015, and yet again in 2016—with new regulations designed to make inversions more difficult to pull off. Lew himself conceded that his proposals were weak reeds at best, but he said his actions went as far as he could go without congressional action. Tax accountants generally agreed that Lew’s new rules would not stop the inversion craze among corporate treasurers. After Lew’s second round of regulating, a Wall Street Journal headline neatly captured the business view: “‘Inversion’ Rule Changes Appear Minor.” The only institution that punished U.S. companies for committing inversion was Fortune magazine, which refuses to list a company incorporated overseas in the famous Fortune 500 rankings. Fortune kicked out about ten companies, including Pfizer, which had ranked at No. 51 before it became an Irish corporation in order to cut its tax bill.

  One company that did get in trouble with the IRS, and with criminal prosecutors, over its tax-avoidance efforts was Caterpillar Inc. After Caterpillar paid PricewaterhouseCoopers for figuring out the Swiss-subsidiary profit shift, it saved some $200 million each year in U.S. taxes for more than a decade. Things were going fine until the company ran into a buzz saw by the name of Carl Levin—and that convoluted tax diversion plan began to crumble.

  Carl Levin, a Democratic U.S. senator from Michigan, served in Congress so long that he became chairman of an entity called the Permanent Subcommittee on Investigations. This is an obscure but powerful unit with a generous budget and a sizable staff that can probe, essentially, anything its chairman wants to probe. Levin chose to investigate tax avoidance by multinational U.S. corporations. This won the senator mixed reviews. The New York Times called him “a gift” to ordinary U.S. taxpayers; the Wall Street Journal called the same senator “a one-man wrecking crew of American job creation.” Regardless, Levin pursued his tax probes with a passion. Thus it was, on an April morning in 2014, that the permanent subcommittee held a cantankerous hearing on the subject of “Caterpillar’s offshore tax strategy.”

  Levin and his investigative staff laid out the history, in which some $8 billion of profits on spare-parts sales were transferred to a country that never designed, built, or warehoused a single spare part. Caterpillar executives responded, saying the profit shift to Switzerland was a “prudent, lawful business activity,” carried out strictly for business purposes without consideration of the tax benefits. “We do not invent artificial business structures,” said the company’s vice president for financial services. Unfortunately for Caterpillar, the committee staff had obtained documents from PricewaterhouseCoopers that explicitly declared that the point of the Swiss transfer was to cut taxes. The smoking gun was an e-mail from a PwC tax partner that warned Caterpillar about the risks of its plan. “We are going to have to create a story,” the tax man noted. “Get ready to do some dancing.” As if that weren’t bad enough, another PwC tax expert sent back a flip e-mail of his own: “What the heck. We’ll all be retired when this comes up on audit.”12

  At the end of the hearing, Levin called on the IRS to investigate the Caterpillar maneuvers. Roughly a year later, Caterpillar announced that the IRS had dunned it for some $1 billion in back taxes and penalties for just one three-year period, from 2007 to 2009, because of improper shifting of profits to the Swiss subsidiary. The IRS was also probing the company’s tax returns for other years. Meanwhile, federal prosecutors in Illinois subpoenaed corporate documents to determine whether the profit shifting violated federal law. And the Securities and Exchange Commission launched its own probe of Caterpillar’s tax-avoidance efforts. To add insult to all these legal injuries, the Wall Street Journal reported that this flurry of investigations “threatens to become a serious embarrassment for Caterpillar, which has long projected a squeaky-clean Midwestern image.”13

  But such federal probes of tax-dodging efforts were hardly common. Most American companies that created an intricate avoidance apparatus were basically left untouched by the underfunded IRS and other U.S. agencies. The real heat over profit shifting, earnings skimming, and sweetheart deals with national tax agencies came from two international organizations, the OECD and the European Union. After years of study, the OECD in 2015 issued an “action plan” called BEPS—the Base Erosion and Profit Shifting Project—that gives countries various tools to prevent their companies from fleeing the nest to find a lower tax rate somewhere else.

  Meanwhile, EU authorities had repeatedly expressed concern and anger about corporate tax-avoidance shenanigans, but their power to act was minimal, because it is a basic principle in Europe that the EU cannot dictate any country’s tax rules or rates. If Switzerland wanted to offer a French company a special 2% tax rate, the EU commissioners in Brussels could only look on.

  In 2014, though, the EU began pursuing tax dodgers under a new legal theory: the “state aid” rules. These regulations say that European governments cannot give their home-country companies special benefits that would give them an economic advantage over foreign competitors. For example, if France let some lumber company take timber from the national forests at no charge, that would be an unfair advantage over a German company that had to pay for its trees and would thus violate the “state aid” regulations. So the tax police in Brussels started citing certain countries—mainly Ireland, the Netherlands, Luxembourg, and Switzerland—for giving special low tax rates to certain companies; the regulators said those tax breaks amounted to “state aid” for the favored firms. And this had some impact. A few companies—Apple, Starbucks, and Fiat—were eventually required to pay back taxes to European countries that were found to have taxed them too lightly. In 2016, the EU ordered Apple to pay more than $14 billion in back taxes to Ireland—an order that was immediately challenged by Apple and the Irish government. The national tax authorities in several countries dropped some of the gimmicks they had used to lure foreign corporations; thanks to the European Union crackdown, the notorious “Double Irish” is no longer a viable path toward tax avoidance. Of course, the tax lawyers immediately started designing new ways for companies to duck taxation.

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  THE U.S. CORPORATE INCOME TAX is not working. We have a higher corporate tax rate than almost any other country, and we apply it to income earned anywhere in the world. And yet corporate income tax revenues have fallen so sharply that they now make up a fairly small share of the federal government’s annual tax revenues. In the 1960s, the corporate tax brought in about 33% of U.S. tax revenues. Today, the same tax provides less than 9% of revenues; that means individual taxpayers have to take up the slack and pay more. Which we do. In the 1960s, the individual income tax and the Social Security tax constituted about 50% of all federal tax revenues; today their share of the nation’s total tax burden is more than 80%. Corporate tax revenues are plummeting partly because Congress has larded the corporate income tax with costly preferences and giveaways for corporations, and partly because American multinationals have become so successful at shifting income overseas. Hundreds of millions of dollars—money that might have gone to raising wages, or creating new medicines, or building factories—have been paid to tax lawyers for the creation of elaborate evasion schemes. The result is a complicated, unpopular, and stiff corporate income tax that actually doesn’t do much taxing. “Both the high U.S. tax rate and the worldwide system of taxation have more bark than bite,” notes the tax scholar Kimberly Clausing of Reed College.

  What should we do? The solution proposed by politicians in both parties and by many (but not all) economists is to reduce that 35% rate. A lower rate would bring the United States more into sync with other wealthy countries. Reducing the
corporate rate has been an international trend for the past three decades. Virtually all the other rich countries have done so, which is why it seems so attractive to American corporations to move their taxable income, or even their legal existence, overseas. If we were to follow the BBLR principle, we could almost certainly lower the rate of corporate tax without a loss of revenue.

  The Government Accountability Office added up the cost of some eighty major business tax preferences and reported a tax loss for the year 2011 at $181 billion, which is not much less than the total revenue the corporate income tax brings in each year. Eliminating most of those deductions, exemptions, credits, and allowances would broaden the base significantly, so the rates could be lower. And many of these loopholes are indefensible. Why should a company be allowed to lend itself money, pay itself interest, and then take a tax deduction for the interest it paid to itself? No individual taxpayer could get away with that scam. But Congress lets corporations use that “earnings skimming” gambit every day of the year.

  The most common proposals for cutting the corporate income tax rate call for a new rate in the range of 25%. President Barack Obama suggested cutting the rate to 28%, a proposal that was pronounced dead on arrival as soon as it reached Capitol Hill. The presidential candidate Donald Trump went further, of course, proposing a 15% corporate tax rate. A study by the Tax Analysis Center concluded that if all deductions, credits, and so on for business were eliminated, the IRS could collect the same revenue with a rate of 9% that it brings in now with the 35% rate. A rate that low, most likely, would take away the incentive to hire tax consultants and shift profits overseas.

  The problem here is that if the United States cuts its rate, other countries might well respond by cutting their rates even lower. How low can you go? Congress might cut the U.S. corporate income tax rate to 12.5% to be competitive with Ireland. But then Switzerland, with its 8.5% rate, would still be a lure for chief financial officers looking to reduce the tax bill—not to mention Bermuda, New Zealand, and other countries where the corporate income tax rate is zero. And if the United States did agree to a large cut in the rate, other countries might well cut their tax rates even more sharply. This is a race to the bottom that nobody can really win.

  How low does the tax rate have to go to stop corporations from devising intricate mechanisms to avoid paying? Great Britain, which reduced its corporate tax rate half a dozen times in the twenty-first century, now taxes profits at 20%. But that didn’t stop Starbucks from creating an intricate multinational network to avoid tax in Britain. Starbucks had more than eight hundred outlets in Britain in the second decade of the twenty-first century, and the company repeatedly told financial analysts that the U.K. business was “profitable.” But when it came time to pay the U.K. “company tax” on its income in Britain, those reported profits disappeared. Starbucks told the tax authorities that it had actually lost money for fourteen of the fifteen years between 1998 and 2013 and thus paid no U.K. tax.

  Here’s how: The Starbucks stores in the U.K. had to make royalty payments to Starbucks subsidiaries in other countries. Every time Starbucks sold a cup of coffee in Britain, it paid a royalty to a Swiss company called Starbucks Trading, which owned the rights to all coffee beans the company sold in Europe. There was a second royalty payment due to a Dutch company, Starbucks Coffee EMEA BV, which held the rights to all the “intellectual property” in a cup of coffee (presumably meaning the recipe for a Frappuccino or the trademarked logo on the paper cup).14 And those royalty payments to other subsidiaries of the same company totaled more than Starbucks had earned in Britain. The upshot: no profit to report in Britain and thus no British tax. This neat arrangement caused such an uproar in the U.K. when it was reported (by Reuters, in October 2012) that Brits all over the country mounted a noisy, angry boycott of Starbucks. The protest campaign was so effective that Starbucks finally agreed to pay £20 million in U.K. tax—more than $30 million—in an effort to get its customers back.

  Another approach to corporate tax reform would be to induce companies to bring home some of the money they have stashed away overseas. The amount at stake here is staggering: an estimated $2.3 trillion “permanently invested” outside the United States. Much of this money is actually held in bank accounts or investment funds within the United States, but on paper it is officially overseas and thus not subject to U.S. corporate tax. If all these profits were repatriated, and the full 35% tax were paid, the government would take in a revenue windfall of about $700 billion; that’s enough to fund the entire defense budget, including the Middle East and Afghanistan, for a little more than a year. If all these profits were repatriated and corporations paid a tax of 15% on these earnings—roughly the effective rate they’re paying now—the tax revenue would come to $300 billion, which would totally cover the government’s combined annual spending for education, environmental protection, agriculture, housing, homeland security, national parks, and NASA.

  To induce corporations to bring some of that money home—so that the government gets some tax revenue and the companies can have cash they could use to create new jobs or build new factories—many have proposed a tax holiday, in which the funds can be repatriated with a smaller tax bite. President Obama suggested a onetime cut to 19% for taxing profits brought home from overseas.

  As a matter of fact, we tried the tax-holiday approach in 2004. After intense lobbying from American multinationals eager to bring their money back home, Congress passed a law optimistically titled the American Jobs Creation Act. One section of that law, known as the Homeland Investment Act, said that corporations could repatriate foreign-held profits and pay tax on them at a onetime rate of 5.25%—that is, about one-seventh of what they would have paid at the full corporate income tax rate. Wary of what corporate titans might do with this money, Congress specifically said that the repatriated funds could not be used to increase dividends to stockholders or to juice up executive pay. Instead, the money brought home was supposed to fund job creation, research, and capital investment here in the United States.

  The government subsequently estimated that some $300 billion came home to the United States because of this break, generating about $16 billion in tax revenues. But the money didn’t go where Congress had hoped it would.

  “Repatriations did not lead to an increase in investment, employment or R&D—even for the firms that lobbied for the tax holiday stating these intentions,” concluded a report from the National Bureau of Economic Research. “Instead, a $1 increase in repatriations was associated with an increase of approximately $1 in payouts to shareholders.”15 Beyond that, the tax holiday probably had the perverse effect of inducing corporations to keep more money overseas. “The provision also sends firms a strange message,” noted Professor Clausing of Reed College; “they have an incentive to leave income abroad in the hope of similar holidays in the future.”16 Clausing concluded that the American Jobs Creation Act lived up to its name in one respect: “creating jobs for accountants and lawyers.”

  As the mountain of corporate cash piled up overseas grows higher and higher, some experts predict that American corporations will bite the bullet and pay the full rate of tax in order to get some of their money back home. “American corporations have been so proficient at shifting their earnings overseas . . . that today they’re hoist by their own petard,” notes Martin Sullivan, the highly regarded chief economist at the Washington firm Tax Analysts. “It’s great to keep your profits out of the U.S. tax net, but as those piles of cash grow, you are missing more and more opportunities to employ that cash in the U.S. At some point, saving tax is not worth it.”

  From this point of view, Congress should hang tough—keep the corporate rate high, refuse to authorize another tax holiday—and sooner or later corporate America will bring its money home and pay the tax. Indeed, this has seemed to be the case in recent years. Economists estimate that some $300 billion was repatriated, at full tax rates, in 2015—about the same amount th
at came home following the 2004 tax holiday. When General Electric, under pressure from stockholders, decided in 2015 to repatriate $36 billion that had been held overseas for years, the Wall Street Journal reported that “GE’s decision suggests more companies may be reaching a tipping point.”17

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  LARGE QUANTITIES OF MONEY and effort—resources that might have been used for something productive—have been poured into “convoluted and pernicious strategies.” Accordingly, some tax experts recommend that we eliminate the corporate income tax completely. Professor Laurence J. Kotlikoff of Boston University makes the case as follows:

  Many economists . . . suspect that our corporate income tax is economically self-defeating—hurting workers, not capitalists, and collecting precious little revenue to boot. . . . The rich, including . . . stockholders, can take their money and run. . . . To avoid our federal corporate tax, they can, and often do, move their operations and jobs abroad. Apple . . . paid only 8.2 percent of its worldwide profits in United States corporate income taxes, thanks to piling up most of its profits and locating far too many of its operations overseas.18

  Those who agree on eliminating the corporate tax tend to disagree on what should be done to make up for the lost revenue. On the left, economists like Robert Reich of the University of California, Berkeley, say corporate profits should still be taxed but not until the corporate earnings have been distributed to stockholders. Then the government can make the stockholder pay a higher rate of tax on the dividends or on the increase in the value of the stock. The shortfall from lost corporate tax revenue would then be offset by the higher revenues from taxing the stockholders’ dividend and capital gain income. Conservative economists like N. Gregory Mankiw of Harvard argue that we should stop trying to tax corporate earnings in any form and make up the revenue through “a broad-based tax on consumption.”