Donald Trump, members of Congress, and other politicians often talk of wanting to revitalize American industry on the one hand, and to modernize the corporate tax code on the other hand. Why, then, is the most obviously appealing tax reform option of all from a competitiveness point of view not being discussed? I refer to a sales-based, formulary apportionment – i.e., "SFA" – tax system.
[Robert Hockett | October 12, 2017 | Forbes]
Yes, I know. You’re probably already saying, "Huh?" So let me explain.
An SFA regime taxes firms on what matters most: the privilege of accessing what is by far the most coveted consumer goods and services market in the world – ours. In so doing, it levels the playing field between domestic American firms that access our market on the one hand, and foreign and multinational firms that seek to access our market on the other hand.
Our current corporate tax regime, by contrast, by taxing what we might euphemistically call "creatively accountable" income, systematically advantages … wait for it … foreign and multinational firms over domesticfirms.
You read that right. Our current method of corporate taxation, perversely, gives a leg up to firms that incorporate, produce, or employ outside of the U.S., enabling them to out-compete firms that incorporate, produce, and employ inside the U.S. That’s obviously inimical to the cause of industrial revitalization here at home. It also, it turns out, is steadily eviscerating the US tax base, thereby depriving the government of something that politicians say that they care about - revenue.
Here’s what I mean. Our present system allows for separate corporate accounting of profits on a location-by-location basis, while at the same time allowing multinationals to engage in inter-jurisdictional profit-shifting when doing that accounting. This enables multinationals to evade much of their US taxation by electing to be taxed where their net income artificially "lands" – as determined at their own option by their own accounting practices – rather than where their grossincome actually originates. They are not taxed, in other words, on the basis of where they actually sell, but on the basis of where they claim to be ultimately "receiving"their profits.
This system, needless to say, generates tremendous incentives to "receive" – i.e., to declare – income in low-tax jurisdictions, irrespective of where firms actually produce, employ, or sell. In so doing it foments a classic "race to the bottom" among nations, rewarding those that tax least. It also, at least as importantly, systematically disadvantages U.S.-based domestically operating firms, which don’t have the luxury of declaring their incomes and costs in foreign jurisdictions. The upshot is that both domestic U.S. industry, and the U.S. corporate tax base, have been shrinking at alarming rates.
A few telling numbers tell the tale. While the effective U.S. corporate income tax rate is about 27%, this is mostly avoided by foreign firms and MNCs accessing our market. Tax haven jurisdictions, where a large proportion of foreign and MNC earnings are reported, levy very low effective rates. Those countries include Switzerland (4.4%), Singapore (4.2%), Ireland (2.4%), the Netherlands (2.3%), Luxembourg (1.1%), and Bermuda, with an astonishing 0.0% rate. Even were the US able to lower its rate to half of what it is currently, then – e.g., to 13 or 14% - that rate would still be much higher than those of the ‘Cayman style’ jurisdictions, hence would continue to encourage profit-shifting by MNCs.
Unsurprisingly, against this backdrop, profit-shifting on the part of MNCs selling to Americans has risen dramatically since 2000. In 2001, estimated profit-shifting to tax haven jurisdictions reduced corporate tax revenue by less than $15 billion. By 2012, that number had risen to nearly $120 billion. And now in October of 2017, the number is already substantially larger. This of course means that a larger and larger share of corporate tax revenues is paid by domestically operating and employing firms, while foreign firms and MNCs that outsource production and employment abroad get off closer and closer to Scot free. The same set of incentives of course drives those US corporate "inversions" - i.e., reincorporations abroad - of which you hear much nowadays.
Why do we allow this? Why do we shoot ourselves in the feet like this, and what should we do instead?
I’ll leave the why question to your imaginations. The what-to-do question, for its part, is easy.
Redefining the source of taxable corporate income is the key to ending both the race to the bottom and the outsourcing bonanza that prevents more and more American consumers from being producers. MNC income should not be allocated on the basis of the artificial "locations" of subsidiaries that allegedly earn it. Instead it should be allocated on the basis of the destinations of MNCs' sales, which are, after all, the true source of corporate income. The U.S. corporate tax base, in other words, should be calculated on the basis of that fraction of a company’s worldwide income which is traceable to sales in the highly coveted US market. It should be the share of each company’s worldwide sales that are destined for customers in the United States.
As it happens, we already have experience with an SFA-like system here in the U.S. All U.S. states used to face a dilemma in relation to one another quite reminiscent of that which we as a nation now faces in relation to other nations. Interstate firms were able to "divide and conquer" the states where the declaration of taxable income was concerned. That encouraged a domestic race to the bottom that deprived states of revenues, even as their consumer goods and services markets were exploited by firms able to "relocate" artificially through the simple expedient of changing their places of operation or incorporation. In response to that problem, some U.S. states have been moving to sales-based tax codes. Under those codes, states that account for greater market share receive greater tax revenue from the firms that access their markets, while those that account for lesser market shares receive correspondingly lesser shares of the tax take.
This is as it should be for the U.S. as a whole, not just for the states. What we need is a redefinition of the U.S. corporate tax base, in relation to the globe, that replicates the redefining that U.S. states have been doing to their tax bases in relation to the nation. In effect, firms should be taxed on their access to specific consumer markets rather than on their cleverness at finding new tax havens in which they or their subsidiaries can artificially operate or incorporate. This, after all, is what ultimately matterswhere taxation is concerned. Whether a parent company is 'incorporated' in the US or elsewhere makes no practical difference to sales and distribution. It should therefore make no difference to taxation. Market-access should make all the difference.
Unfortunately, neither Republicans nor Democrats are devoting much attention to SFA as a corporate tax reform option right now. And whether or not Congress ends up lowering current rates, domestic firms will continue to pay too much tax in comparison to MNC’s and foreign firms - all as the federal tax base continues to shrink while politicians decry "deficits." SFA can bridge partisan divides in Congress while bringing meaningful, salutary tax reform. It can achieve Democrats' and Republicans' professed goal of raising revenue while at the same time achieving both parties' professed goal of lowering the corporate tax rate overall. An SFA system will eliminate inter-jurisdictional tax competition – the race to the bottom – even as it ends the systematic favoring of firms that do not employ American labor and inputs to production. That fact should also facilitate international agreement among major trading nations to adopt SFA systems of taxation, which we will ultimately wish to secure both on the merits and in keeping with our treaty obligations.
The tax base is ultimately far more significant than the tax rate, and an SFA tax code is grounded in that all-important and inescapable fact. It is high time for White House and Congress alike to go SFA.
Robert Hockett writes on legal, financial and economic subjects and serves as a regular advisor to regulators and legislators. His book, A Republic of Owners, will be published later this year.