Loopholes Turn Corporate Tax into Swiss Cheese
The U.S Treasury has been causing some business investors heartburn this week by suggesting that some cherished loopholes in the tax code could be closed and the resulting revenue used to lower the corporate tax rate. The argument was made in a report published by the Treasury and then discussed at a conference yesterday. Among the tax subsidies mentioned were the research credit, which Citizens for Tax Justice has criticized in the past, as well as several others that we noted last week in our "Hidden Entitlements in the Federal Tax Code" feature. The report finds that loopholes reduce the Federal corporate tax base by around 25 percent.
It's certainly true that there are plenty of business-oriented loopholes in the tax code that need to be closed. As the report points out, many of these are quite inefficient and result in business decisions based on tax reasons rather than cost-effectiveness.
But it's not at all clear that the revenue generated by closing loopholes should be used to lower the corporate tax rate. If federal revenue is not increased at some point, Congress may have to cut public services that Americans from all walks of life depend on. Further, if the corporate rate falls far below the top personal income tax rate, this may encourage wealthy people to use corporate entities to avoid the personal income tax.
International Tax Avoidance Also a Major Issue
But the report does not address another factor that is seriously eating away at corporate tax revenue: tax avoidance associated with multinational firms involving transfer pricing. Transfer pricing is basically the accounting that must take place when divisions of a corporation that are based in different countries "sell" and "buy" products or services to and from each other. In theory, if an American division of a company buys something from its division in another country, then that purchase can be deducted for American federal tax purposes. The foreign division has revenue and may have a profit, but in theory, the foreign government will tax that profit.
The problem is that a multinational corporation can exploit this system. For example, it may transfer its patents and trademarks to a division in a low-tax foreign country with little transparency (a tax haven) and then have that division "charge" the American division for the use of these "intangibles." The accounting can be done in such a way that the American division appears to have no profits after making these payments, and all the profits appear to go to the division in the tax haven.A recent report from the Hamilton Project of the Brookings Institution explains the inefficiencies in this system and cites a study finding that a 35 percent reduction in corporate tax revenue results. The report argues that the United States and its major trading partners should switch to a system in which a company's total global expenses and profits are calculated and then tax is apportioned to the various countries where it does business based on sales in each country.
The problems with the current system are evident. The New York Times recently reported on how drug companies are particularly likely to take advantage of transfer pricing. Eli Lilly, for example, only paid about 6 percent in U.S. federal taxes on its profits of around three and a half billion dollars last year.