One of the loudest critics of the recent wave of corporate inversions is University of Southern California law professor Ed Kleinbard, who warns that these transactions will erode the U.S. corporate tax base because these newly relocated firms will use “intragroup interest payments” to “strip” income out of their U.S. subsidiary. While this is thought to be a common practice with multinational corporations, IRS data actually shows that the U.S. subsidiaries of foreign-based companies have smaller interest deductions relative to their total receipts than do American-headquartered firms and, interestingly, they have higher effective tax rates than their domestic counterparts. Thus, Kleinbard’s warnings would seem to be much ado about nothing. Earnings Stripping The “earnings stripping” transaction that Kleinbard and others worry about works like a normal bank loan except that the lender is the parent company headquartered in another country. However, since interest payments are a deductible business expense, the interest payments to the parent company (like any bank loan) act to lower the taxable income of the American subsidiary. And, depending on where the parent is located, the interest income from the subsidiary may be taxed at a low rate or not be subject to tax at all by the home country. Thus, the deductible interest payments are said to “strip” income out of the U.S. tax base and transfer it into the lower-taxed coffers of the foreign parent. If foreign parent companies are indeed stripping income out of their U.S. subsidiaries we would expect to see a relatively large share of their income dedicated to deductible interest payments, and that these interest payments would be greater than those claimed by domestic corporations. To see if this is true, we used IRS data to compared the deductible interest expenses of foreign-owned companies operating in the U.S. to the interest expenses of U.S. domestic firms. Chart 1 below shows the interest deducted by foreign-owned and domestic corporations relative to their total receipts between 1994 and 2011. What is immediately noticeable is that the ratio of interest payments to receipts for both firm types seems to track the ups and downs of the business cycle very closely. Indeed, the debt load of all corporations peaked during the boom years of 2000 and 2007 and collapsed during the recessionary periods of 2001 to 2003 and 2008 to 2009. What is also noticeable is that the interest burdens of both foreign-owned and domestic companies were almost identical during the 1990s, then began to diverge after 2000 when the interest burden of domestic companies began to rise above that for foreign-owned companies. Indeed, since 2000, the interest burden of domestic companies has averaged 6.5 percent of total receipts compared to a burden of 5.5 percent of total receipts for foreign-owned firms. In 2011, domestic firms had an interest burden of 4.1 percent of receipts, compared to foreign-owned firms which had an interest burden of 2.9 percent of receipts. Why Do Foreign Firms have Higher Interest Burdens? It is difficult to know exactly what explains why foreign-owned firms have had a lower interest burden than their domestic counterparts over the past decade or so. Perhaps the U.S. “thin capitalization rules” (also known as 163(j) rules after the tax code section) actually work to prevent foreign parent companies from loading up their subsidiaries with too much debt. Or, perhaps foreign parent companies prefer to fund the expansion of their U.S. subsidiaries with equity financing or with domestically-generated profits. Either way, it would take far more granular data than the IRS makes available to understand what is driving these results. The Effective Tax Rates of Foreign-Owned and Domestic Companies Another way in which we should see the results of excessive tax planning techniques by foreign parent companies is in the effective tax rates paid by their U.S. subsidiaries. Here again, when we compare the effective tax rates paid by foreign-owned companies to the effective tax rates of domestic companies we don’t see the results of excessive tax planning. On the contrary, as Chart 2 indicates, IRS data shows that between 1994 and 2011, foreign-owned companies consistently paid a higher effective income tax rate than did domestic companies. Between 1994 and 2011, the effective income tax rate of foreign-owned companies averaged 28.6 percent while the effective income tax rate of domestic companies averaged 24.9 percent. Here, the differences can be partially explained by the foreign tax credit that domestic companies can claim for the income taxes they paid to other governments on any offshore earnings they bring home. In 2011, for example, U.S. companies claimed $105 billion in foreign tax credits on their repatriated earnings from abroad. Along with the general business credit, the foreign tax credit helped reduce the income tax liability of U.S. companies from $323.7 billion to $200.8 billion. It is likely that it in the absence of the foreign tax credit, the effective tax rate of domestic companies would tend to look very similar to the effective tax rates paid by foreign-owned firms. The Number of Inversions is Small Compared to Inbound M&A Activity It is also interesting to put inversions within the context of the normal amount of inbound M&A activity in the U.S. each year because it illustrates how over-the-top are the dire warnings by inversion critics such as Kleinbard, as well as lawmakers such as Senator Carl Levin and Rep. Sander Levin. According to Congressional Research Service data posted on Rep. Levin’s website , just five U.S. companies completed inversion transaction in 2013 and 55 have completed inversions since 2000. By contrast, in 2013 alone there were 1,354 transactions —worth roughly $60 billion —involving U.S. assets purchased by foreign companies. It is worth noting that both of these figures were at a ten-year low. Since 2004, however, the number of transactions involving the purchase of U.S. assets by foreign buyers has averaged about 1,500 annually, while the value of these transactions has averaged $105 billion each year. If these critics were consistent in their logic, they should oppose all foreign acquisitions of U.S. companies. Because, in their view, if inversions are a major threat to the U.S. tax base, then these M&A figures would suggest that the foreign purchases of American firms also ought to be a bigger threat to the corporate tax base. But as the IRS data indicates, the fears may be greater than the actual threat. Moreover, history has shown that foreign direct investment is very beneficial to the U.S. economy and should be encouraged, not chased away. The Solution Of course, the real threat to the U.S. corporate tax base is our corporate tax code itself, with the third-highest overall rate in the world and a worldwide system that requires American companies to pay a toll charge to bring their profits back home. Thus, the solution to the inversion “problem” is to dramatically cut the corporate rate and to move to a territorial tax system, not add even more unnecessary rules to an already complicated tax code. ****** Data sources: The corporate tax and interest data for foreign and domestic companies is derived from the IRS Corporation Complete Report, Tables 16 and 24, for years 1994 through 2011. Since Table 16 (Returns of All Active Corporations, Form 1120) includes the returns of foreign-owned companies, it was necessary to subtract the data for receipts, interest, and taxes found on Table 24 from the aggregate data in Table 16 for each year. The residual data is considered from “domestic” corporations. http://www.irs.gov/uac/SOI-Tax-Stats-Table-16-Returns-of-Active-Corporations,-Form-1120 http://www.irs.gov/uac/SOI-Tax-Stats-Returns-of-Active-Corporations-with-50-Percent-or-More-Foreign-Ownership-Table-24 The Mergers and Acquisition data is found at the UNCTAD website: http://unctad.org/en/Pages/DIAE/World%20Investment%20Report/Annex-Tables.aspx
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Inversions have been in the news consistently this summer as multiple companies have looked for legal paths away from the U.S. corporate tax system. Burger King became the latest corporation to add to the list after they announced their planned moved to Canada. The reason: Our corporate tax system is out of date. The average corporate tax rate across the 34 member Organization for Economic Cooperation and Development has dropped from 47.5 percent in 1981 to 25.3 percent in 2014. Since the late 1980s the U.S. rate has remained stagnant at around 40 percent . Additionally, the U.S. is one of only six OECD countries that still tax income on a worldwide basis (the lack of a territorial system is likely the main driver of inversions). So what’s the solution? Greg Mankiw has an idea. From the New York Times : “Perhaps the boldest and best response to corporate inversions is to completely rethink the basis of corporate taxation. The first step is to acknowledge that corporations are more like tax collectors than taxpayers. The burden of the corporate tax is ultimately borne by people — some combination of the companies’ employees, customers and shareholders. After recognizing that corporations are mere conduits, we can focus more directly on the people. … “So here’s a proposal: Let’s repeal the corporate income tax entirely, and scale back the personal income tax as well. We can replace them with a broad-based tax on consumption. The consumption tax could take the form of a value-added tax , which in other countries has proved to be a remarkably efficient way to raise government revenue.” Many OECD countries have been going this way as they have moved to replace taxes on corporations with taxes on consumption. This method isn’t without its critics though: “Some may worry that a flat consumption tax is too easy on the rich or too hard on the poor. But there are ways to address these concerns. One possibility is to maintain a personal income tax for those with especially high incomes. Another is to use some revenue from the consumption tax to fund universal fixed rebates — sometimes called demogrants. Of course, the larger the rebate, the higher the tax rate would need to be.” The point is: we need to reform the U.S. tax code (both corporate and individual). Not just to stop inversions, but to improve U.S. competitiveness and grow the U.S. economy (and I’m not talking about -2.1 percent growth followed by 4.2 percent, but real, long-term growth). If all sides are willing to come to the table with those goals in mind, then, as Mankiw suggests, there are solutions to be found. Trading the corporate tax for a VAT with a rebate might be one option.
New CBO report finds that debt will keep piling up unless serious reforms are enacted.
Matt Yglesias at Vox today argues that migration out of “blue states” is caused by high housing prices, not taxes, and high housing prices are essentially a function of bad zoning laws in “blue” cities. Yglesias literally wrote the book on this topic, and his argument is backed up in some ways up by some compelling academic research , so it’s well worth taking seriously. And, as far as it goes, there’s an element of truth: virtually every academic studying migration would agree that cost of living factors, especially housing costs, have an important role in determining migration patterns. But Yglesias’ “explainer” doesn’t offer a real explanation of what this means, and how housing prices relate to the broader migration debate. He suggests that the price map we created is merely a reflection of housing prices, yet doesn’t even offer a comparison to other price categories. The BEA makes available four different sets of price parities: all consumption, rents, goods, and other services. Our state and metro area maps presented just the parities for all consumption, but it’s easy enough to compare to other categories. Yglesias, and others he cites , suggests that, because the amount of variation in rent price parities is very large (larger than other categories), it is therefore the only really important component. The problem, of course, is that this argument is wrong. While rent does vary more widely than prices for goods or other services, it varies in a systematically similar way. Even when no controls for housing policies are included, variation in service prices can explain 65 percent of the variation in housing prices, and while variation in goods can explain 58 percent. These are very high numbers for a single-variable explanation. This suggests that we can’t just draw a line from housing policy to migration, because we can’t even draw a direct line from housing policy to price levels: areas with restrictive zoning policies are closely correlated with areas that also have restrictive geographies and other significant price effects. Migration and regional economics are too complicated to just blame housing policy. Zoning definitely drives up prices: but apparently a large part of high housing prices is explained by generally higher price levels for all kinds of goods. The argument that housing prices are simply driven by high demand for high wages in areas of restrictive zoning is likewise complicated by the actual data on the subject. It may be that people move to New York City for high wages, and so demand for housing rises, thus prices rise. But it also may be that firms in DC have to offer high wages in order to persuade people to tolerate high rents, bad traffic, and crowded urban living. In fact, if we look at price changes instead of price levels from 2008 to 2012, there is very little correlation between changes in nominal wages (a reasonably proxy for changes in labor demand, used in the academic research Yglesias cites) and changes in price levels, except in the most extreme cases. This suggests that, whatever the connection between local labor demand and housing prices, it isn’t as simple as Yglesias explains. It’s true that housing prices matter. Local job creation likewise obviously impacts migration and prices. But, as we’ve pointed out, local fiscal policy can also impact housing prices. Furthermore, housing prices aren’t all that matter , especially for migration. People migrate for weather, for family, for jobs, for a better quality of life , and, yes, for a lower cost of living: including both lower housing costs and lower tax burdens . The trite suggestion that everybody wants to move into “blue state” cities, but is simply priced out by zoning laws, simply isn’t true. As surprising as it may be to Yglesias, not everyone wants to live in mid-rise apartment buildings surrounded like light rail and dog parks: people have widely varying preferences, and many people (this author included) enjoy rolling hills, open land, and cheap backyard barbecue. Read our responses to Paul Krugman , CBPP , and the Upshot blog on migration issues. Read more on migration here . Follow Lyman on Twitter .
Canada is apparently becoming an attractive place to do business. This week Burger King announced plans to move its headquarters to Canada, via a merger with Tim Hortons. Other U.S. companies that have recently moved or announced plans to move to Canada include Bausch and Lomb , Allergan , and Auxilium . This Bloomberg compilation indicates Tim Hortons was once a U.S. company, until it inverted to Canada in 2009. Part of the attraction is the substantial tax reforms that occurred over the last 15 years in Canada. First among these is the dramatic reduction in the corporate tax rate, from 43 percent in 2000 to 26 percent today. The U.S. currently has a corporate tax rate of 39 percent, but lawmakers are reluctant to do what Canada did, i.e. lower the tax rate, for fear of losing tax revenue. The natural question is: how much tax revenue did Canada lose? Answer: None. According to OECD data, corporate tax revenue increased following Canada’s corporate tax rate cuts that began in 2000. The first chart below shows the data. Corporate tax revenue as a share of GDP in Canada has averaged 3.3 percent since 2000, while it averaged 2.9 percent over the years 1988 to 2000, when Canada’s corporate tax rate was 43 percent. The second chart shows the same data for the U.S. The U.S. corporate tax rate has remained at about 39 percent since 1988, but this has not translated into higher corporate tax revenue. For 15 years straight, Canada has raised more corporate tax revenue than the U.S., as a share of GDP. Since 2000, U.S. corporate tax revenue as a share of GDP has averaged 2.3 percent, compared to 3.3. percent in Canada. Follow William McBride on Twitter
Burger King’s announcement that it will move its headquarters to Canada has put the spotlight on Canada’s tax system. Just what are the tax benefits of doing business in Canada versus the U.S.? First, Canada has a much lower corporate tax rate: 15 percent at the federal level plus another 11 percent on average from provincial corporate taxes. Compare that to the U.S. federal corporate tax rate of 35 percent plus an average state corporate tax rate of about 4 percent. Second, Canada has a territorial tax system , meaning there is no additional repatriation tax on foreign profits. The U.S. has a worldwide tax system, which applies a repatriation tax to foreign profits when those profits are brought back to the U.S. The repatriation tax is basically the difference between the foreign corporate tax rate and the U.S. corporate tax rate, which is typically more than 10 percent. The average foreign corporate tax rate in the developed world is 25 percent. Third, the U.S. is not particularly competitive in terms of taxing shareholders. Canada intergrates its corporate tax with shareholder taxes to avoid double-taxation. In the U.S. it just piles up, so the integrated corporate tax rate on equity financed investment is over 50 percent. Perhaps less important to Burger King are sales taxes and property taxes, but they still matter to some extent. Canada has a superior sales tax system that largely exempts business inputs . Most U.S. states apply their sales taxes to capital goods. Canada has a superior property tax system that largely exempts business inputs. In contrast, state and local U.S. property taxes often apply to machinery and equipment and in some states to inventory. Some states also have capital taxes. Putting the domestic tax factors together, Jack Mintz and Duanjie Chen of the University of Calgary found that the U.S. Marginal Effective Tax Rate (METR) on Capital Investment is the highest in the developed world, at 35.3 percent. In contrast, Canada’s METR is about half that, at 18.6 percent. By this measure, Canada has the lowest business tax burden in the G7. In short, in terms of doing business, the U.S. has the least attractive tax regime of any developed country. That is what is causing the corporate inversions. The solution is tax reform, particularly corporate tax reform. Follow William McBride on Twitter