Friday, August 1, 2014

The insanity of the US tax code: Bad Laws and Predictable Consequences

If taking the same action, over and over, expecting different consequences, is the definition of insanity, it aptly describes the US tax code, where legislators write tax laws designed to elicit bad behavior, moan about the consequences and then write even worse tax laws. In the last few weeks, AbbVie’s acquisition of Shire seems to have brought the complaints about perverse tax law and badly behaved corporations to a boil. In particular, the news headlines have been centered on AbbVie’s plan to move its corporate headquarters to the UK from the US after the acquisition, part of an emerging trend among US companies towards tax inversions, designed to generate tax benefits. The New York Times thinks it borders on the criminal, Paul Krugman accuses corporations of being "tax dodgers", Senator Carl Levin has written legislation to stop the practice and even Jon Stewart has joined in the fun.  

The US Tax Code = Invitation to Move

To understand the “inversion” story, you have start with the US tax code. The US requires domestic corporations, i.e., companies incorporated in the US, to pay the domestic marginal tax rate on their global income. It is one of eight OECD countries that continues to use a global tax system, while the remaining twenty six OECD countries have shifted to a territorial tax system, where corporations  pay the domestic tax rate on income that they generate domestically and the local tax rates on income generated in foreign locales. (See the list of countries using each tax system at this link).

The US tax law does allow for a timing lag, since the differential tax (between the US tax rate and the tax rate on the foreign income) does not have to be paid until that foreign income is repatriated back to the US. To illustrate, assume that you have a US company that generates $50 million of its income in the US (with a tax rate of 40%) and $50 million of its income in China (where the tax rate is 25%). The company will pay a total of $32.5 million in taxes when it generates that income, 40% of the $50 million of US income and 25% of the $50 million of Chinese income, If the company now returns the $50 million in Chinese income to its US domicile, it will have to pay the differential tax of $7.5 million, reflecting the differential tax rate of 15% (US tax rate - Chinese tax rate). What happens if the company chooses to leave the cash in its Chinese subsidiary? That cash of $50 million cannot be used for investments in the United States or to pay dividends/buybacks to stockholders. In effect, it is “trapped”, but it can be used for investments anywhere else in the world. The longer the company continues to hold back cash in foreign locales, the larger the trapped cash balance becomes and after a decade of not repatriating cash, it can amount to hundreds of millions or even billions of dollars.

Now, assume that this company relocates its headquarters to Singapore, a country with a territorial tax system. After the relocation, the taxes it pays on its US income remain unchanged at $20 million but there are two tax benefits that follow:
  1. The trapped cash that the company has is no longer trapped and the differential tax due to the US dissipates into thin air. The larger the current trapped cash balance, the greater this immediate benefit will be. 
  2. The second tax benefit is that the company’s future income in China is no longer subject to a differential tax and is thus released from that obligation. The tax benefits from relocation will therefore be greater for companies that expect their foreign operations to grow at a higher rate than their domestic (US) business.
Given how large these potential benefits can be for many US companies, relocation becomes an attractive option and inversion is one way of accomplishing this objective, though a 2004 law does put restrictions on its use. With inversion, the company will acquire a Singapore-based company of sufficient size (to meet the law's requirements) and relocate the headquarters of the combined company after the merger in Singapore. 

Changing Times. Static Code
Since the US tax code has always taxed global income, you may wonder why this trapped cash phenomenon is suddenly in the news. Is it because no one noticed the problem three decades ago or because US companies have become bigger tax avoiders? I think that the answer is that the US tax code has not changed much but the world has changed in two significant ways:
  1. US companies are more global: As the rest of the world's economies have grown, the US economy has become a smaller part of the global economic order and US companies are increasingly dependent on their foreign operations. In 2012, almost 50% of the revenues of S&P 500 companies came from foreign locales, with the number varying widely across sectors (with utilities getting almost no revenues from outside the US and technology companies getting about 58%). In fact, this document has an exhaustive breakdown of this phenomena. It is also worth noting that in 2012, the companies in the S&P 500 paid $146 billion to the US government and $139 billion to foreign governments as taxes, which should dispense with the canard that the foreign income of US companies is somehow untaxed.
  2. The US corporate tax rate has become high, relative to the rest of the world: In the early 1980s, the US corporate tax rate was 46% but that tax rate would have put the US in the middle of the global pack in that period. The US federal marginal tax rate on corporations dropped to 35% in 1993,  and has stayed at that level since. With state and local taxes added on, the marginal tax rate on US corporate income is now close to 40%. The rest of the world seems to have shifted to lower corporate tax rates, giving the US the higher marginal corporate tax rate in the world in 2014, as can be seen in the global tax map below (KPMG maintains an excellent public database of marginal tax rates, by country):

The combination of the globalization of US companies and a high US marginal tax rate has had predictable consequences. Companies that generate a big portion of their revenues from outside the United States are choosing to leave the income they generate overseas. Last year, the cumulative trapped cash at US companies was conservatively estimated at more than $1.5 trillion, and growing. Apple alone had more than $100 billion in cash in its overseas locales and a large portion of AbbVie’s current cash balance of $10 billion is probably trapped its foreign subsidiaries. AbbVie can use this trapped cash outside the US, to invest in non-US assets or but non-US companies, but the decision to move its headquarters to the UK frees it up to invest the money wherever it wants (including in the US). The UK follows a territorial-based tax system, where you pay taxes based on where you generate income and not where you are headquartered. Thus, the question again becomes not why AbbVie is buying a UK-based company and moving its headquarters to London, but why it took them so long.

Do US companies pay their fair share of taxes?
Any question about whether someone else is paying their fair share of taxes is fraught with complications, since the rule in this debate is that every tax payer (and even a few who don't pay taxes) seems to believe that he (she) pays more than his (her) fair share of taxes and that the rest of the world is shirking. We have all heard the anecdotal evidence about individual companies that don't pay their fair share of taxes and I am sure that some companies fit the billing of tax scofflaws. To answer the question of whether US companies collectively are tax avoiders, relative to corporations elsewhere in the world, I computed the effective tax rates for all publicly traded companies listed globally and estimated the average effective tax rates by sector and by region. The effective tax rate is computed by dividing the accrual taxes in the income statement by the accrual taxable income reported in that same statement. In the table below, I compare three measures of the average effective tax rate across global companies: the simple average effective tax rate across all companies (including money losers), the weighted (by taxable income) average effective tax rate across all companies that have a  positive taxable income and an aggregate tax rate (obtained by dividing the total taxes paid by the total taxable income).
Effective Tax Rate: 2013
There is something in this graph for almost every side of this debate. On all three measures of the effective tax rate, Japanese companies pay the most in taxes, even though Japan has a territorial tax system where foreign income is not taxed at the Japanese marginal tax rate (of approximately 38%), backing those who believe that the US will gain from moving to a territorial tax system. When you look at the weighted (by income) average effective tax rate across money making companies, US companies actually pay a higher percentage of their taxable income than much of the rest of the world and almost as much as European companies, bolstering those who contend that US companies pay roughly the same amount in taxes as companies in the rest of the world and are not tax shirkers. However, those who contend that US companies pay too little in taxes will undoubtedly point to aggregate effective tax rate, which is lower in the US than in the rest of the world.

My measure of how effective a tax system is the difference between marginal and effective tax rates. I computed this statistic, using the marginal tax rate at the start of 2013 and the effective tax rate for that year, for every country for which I was able to obtain both a marginal and an effective tax rate, and ranked them based upon the difference. The list below includes my ranking of the ten most ineffective tax regimes in the world, with a comparison to some developed markets and four emerging markets (Brazil, India, China and Russia).
Marginal & Effective Tax Rates: 2013
The US has the ninth most ineffective tax system in the world, collecting 13.34% less in taxes than its marginal tax rate. Lest you are comforted by the fact that there are 8 countries in the world that have even more ineffective tax systems, it should be give you pause to see Greece, Venezuela, Nigeria and Kazakhastan on that list. While I am not a fan of first-world versus third-world categorizations, I think it is fair to say that the US is a first-world economy with a third-world tax system, a point that is made starkly when you contrast it with other developed markets or the largest emerging markets. (You can get the entire list of countries by clicking here.)

I don't think that you will get any disagreement from either side (right or left, Republican or Democrat, liberal or conservative) that the US tax code today is ineffective, though the solutions they offer are starkly different. The combination of a global taxation system, high marginal tax rates and debt-friendly clauses in the US tax code create predictable and perverse consequences. With the current tax law, US companies will continue to move more of their business and earnings overseas and keep the cash there, reinvest too little in the US, borrow too much (often to pay dividends or buy back stock to US investors) and hold on to too much cash.   

The Solution
At this point, if you are a US taxpayer, you are probably boiling with rage, ready to pick up your pitchforks and to attack unpatriotic companies. Vent as much you want, if it makes you feel better, but you have to decide whether you want a tax code that makes you feel good or one that actually works. Some of the solutions suggested to the US tax problem may work well as political selling points but will only worsen the perverse effects. 

Punitive Solutions
Once you label corporations as tax dodgers, crooks or reprobates, you are signaling that you favor a punitive solution. After all, why would you try to negotiate with such entities? Before we look at some of remedies (mostly legal) that are being suggested for both trapped cash and tax inversions, it is worth retracing the three steps in the process that lead to these remedies, with the flaws in logic I see in each step.
  1. The first step is an appeal to patriotism, where corporations are asked "what they will do for their country of incorporation, rather than what that country will do for them". In fact, the taxation of global income at the US tax rate is not restricted to US corporations. It applies to all US citizens who work abroad, requiring them to pay not only the taxes due in the country in which they work in but the additional tax that they would owe the US, if that country has a lower individual income tax rate than the US does. Thus, long-term expatriates working in low-tax locales are given a choice of whether they want to continue to be US citizens (and pay the extra tax) or give up their citizenship. In effect, their patriotism is put to the test and while many people pass that test (even if it means paying extra taxes), more and more chose to give up their US citizenships each year.  There are some who think that US corporations can be put to the same patriotism test, I don't think that the argument make sense. Since a publicly traded company is owned by its stockholders, should we determine patriotic standing based upon the nationality of the stockholders who hold its stock? Thus, should a US company where Chinese own 51% of the outstanding shares try to maximize taxes paid to the Chinese government? Even if you don’t buy the “stockholders as owners” argument, what if more than 50% of your employees now work in a different country? Is it your patriotic duty to maximize taxes paid to that country?
  2. Shame corporations into paying their "fair" share of taxes: An extension of the patriotism argument is to push the theme that it is shameful for taxpayers not to maximize taxes paid to the government. You may view this as a sign of my moral decay or ethical shortcomings, but I don't believe that taxpayers (individual or business) should be required to maximize taxes paid to the government. That does not preclude individual taxpayers who want to maximize taxes from doing so, but you cannot demand that other taxpayers (individuals or corporations) do more than pay what they legally owe in taxes. 
  3. Force immediate tax payments (and ban inversions): The punitive solutions almost always revolve around legislation. You could change the US tax code to force all multinationals to pay the US marginal tax rate on their global income, when the income is earned, not when it is repatriated and the trapped cash problem will go away, we are told. Really? I will argue that  passing this law will create two consequences. The first is that if you think that US companies moving their headquarters outside the US is a problem now, it will become a deluge, if you pass this law. The second is that even those multinationals that choose to stay US-based will spin off their foreign subsidiaries as stand-alone companies. I guess you can try to pass more laws to prevent both these developments, but legislation that goes against common sense (and economic self interest) is doomed to fail.
There are two other weapons that the punitive solutions crowd plan to use to keep companies in line. The first is to bar companies that move their headquarters outside the US from ever doing business with the US government. Thus, AbbVie’s drugs can be removed from the list of Medicare/Medicaid allowed medications, which would cost the company money, but would also leave a whole group of patients in both programs without their preferred medicine. And if enough US pharmaceutical companies follow AbbVie out the US, then what company’s drugs will be left on the medication list? The second is to penalize stockholders in companies that move outside the US by charging them a higher tax rate on their dividends/capital gains. I am not even sure how this would work, but I am sure that an aide to some legislator will come up with a "can't miss' scheme.

Implicit in the punitive solutions is the belief that the benefits that companies get from being incorporated in the United States are so large that most of them will not consider moving elsewhere. But what exactly are these benefits? The first is the legal and institutional protection that operating in the United States offers companies: a well-functioning, efficient legal system that enforces laws and contracts is critical to running businesses. The second is the political climate in the US has historically been viewed as more favorable for private enterprise, in general, and corporations, in particular. Both may have been compelling considerations three decades ago, but the US advantage has shrunk on both counts. European countries, other than France, have become more receptive to businesses and Asian and Latin American countries, not counting the obvious exceptions, are fixing their worst excesses. In fact, there is reason to believe that just as the rest of the world is getting friendlier towards corporations, the US is moving in the opposite direction.

Temporary Solution
There is a temporary solution to the problem that will alleviate the immediate pressure on companies to invert and that is to offer a tax holiday, where companies will be allowed to bring their trapped cash home, without paying taxes due or only a small portion thereof. It will be marketed as a one-time deal, and will be coupled with feel-good clauses, requiring companies to use the cash to fund more investments and create more jobs in the United States. Not only will these investments and jobs never come to fruition, but the incentive to let cash build up in overseas locales will only increase after such actions. After all, one-time tax holidays that seem to happen once every decade are really not really one-time, are they?

Long term Solution
If we do not want companies trapping cash in overseas locales or trying to move from the United States, there are two solutions. One is to lower the marginal tax rate for US corporate income to a level closer to those that you observe in the rest of the world, since it reduces the cost of repatriating foreign income to the United States. On that count, the Obama administration's proposal to lower the marginal corporate tax rate to 28% is a sensible one. I believe, though, that this has to be coupled with a shift to a territorial tax system, in recognition of the reality that corporations are now multinational in every sense (investors, employees, operations) and have to be treated as such. In conjunction, I think the tax code should be stripped of most or all of the "goodies" that legislators have added to it over time.

Will these changes create costs, especially in the near-term? Of course. There will be companies that will pay more in taxes than they do right now and tax lawyers and transfer pricing specialists will have to find something else to do. Paul Krugman will probably have a conniption, Senator Carl Levin's legislative masterpiece will not see the light of day and Jon Stewart will have to find other comedic material. To be honest, I would not be unhappy with any of these developments.

A pessimistic end note
Writing bad tax law is easy, but changing it is really difficult. It is generally true that even the most sensible (and obvious) fixes to the tax law can be used against those who vote for it. Populists of all stripes (right and left) will tar you as a corporate stooge or worse, if you do vote to lower corporate tax rates or change from a global tax to a territorial tax system. Not only am I pessimistic about Congress making sensible changes to tax laws, but I fear that any changes that get made will only make the long term problems worse. That, in turn, will set off a new round of outrage and more misguided tax law changes and the cycle will continue.

Marginal tax rates, Effective tax rates and Tax Regime Efficiency: By Country


Lou said...

Is inversion unpatriotic? As you've described it here, companies are unlocking large sums of money that can potentially be reinvested right here in the US, thereby creating jobs and economic growth. All of this not because of our political "leaders" but in spite of them. The less money we ship to the IRS the better. The federal and state governments use our tax dollars so irresponsibly that it's best they get as little as possible. Our country was founded on freedom and capitalism. Our politicians are unpatriotic for getting in the way of that by bickering with one another instead of crafting real solutions. It's good to see that the system still works in spite of their bumbling.

Christian Cadeo said...

The funny thing is that it gets worse for the individual. For companies they have the option of keeping that money overseas indefinitely and not paying any tax to US till the repatriate. '

For individuals we don't have that choice and have to pay US tax irrespective if we keep our salary overseas indefinitely. It is an absolute mess the US tax system.

Anonymous said...

Totally agree on how bad the US Tax system is (especially due to its untenable complexity) but with all due respect, there's one fundamental flaw in the proposal.

Actually, The best way to repartriate overseas money, increase domestic investment and hire more workers in the US is to declare _zero_ tax on corporations.

Corporations are NOT people. They are legal entities designed by people to benefit people. They create desired services and products and improve the lives of their employees, customers and suppliers. Taxing them more only hurts the people and the communities for which they were created.

Aswath Damodaran said...

Economically, you may be right that the best way to encourage business is to have a zero tax on corporations but you would have to then tighten up how you tax income in the hands of investors. (Otherwise, every business will just restructure itself as a corporation, never pay dividends and you would lose a whole chunk of tax revenues). Politically, there is no chance that this will ever get through.

Anonymous said...

You made the common mistake of mis-characterizing the trapped cash as income earned overseas, i.e., like an iPhone sold in Germany or Japan. That is not what's driving this. Companies (often tech hardware manufacturing companies) have set up manufacturing subsidiaries in low tax countries. Then they play games with the internal transfer rate (the company has to decide how much profit goes to the US entity that sells the IP to the Irish or Singapore supply hub, etc.). These intra-company transfer rates are abused and cause quite a bit of the problems. I think lowering marginal rate combined with much stricter rules in intra-company transfer rates would go a long way to solving this issue.

Stock Future Tips said...

The temporary solution to the problem that will should be used is the immediate pressure on companies to invert and that is to offer a tax holiday, where companies will be allowed to bring their trapped cash home,

Nurul said...

The funny thing is that it gets worse for the individual. For companies they have the option of keeping that money overseas indefinitely and not paying any tax to US till the repatriate. '

For individuals we don't have that choice and have to pay US tax irrespective if we keep our salary overseas indefinitely. It is an absolute mess the US tax system.

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