“Equitable Growth in Conversation” is a recurring series where we talk with economists and other social scientists to help us better understand whether and how economic inequality affects economic growth and stability.
In this installment, Equitable Growth’s Executive Director and Chief Economist Heather Boushey talks with Kimberly A. Clausing, the Thormund A. Miller and Walter Mintz Professor of Economics at Reed College. They discuss tax reform, changes to the corporate income tax, and who gains when taxes on capital are cut.
[Editor’s note: This conversation took place on Monday, September 25, 2017.]
Heather Boushey: Hi, Kim. Welcome! This is so great to have you here today.
Kimberly Clausing: I’m happy to be here.
Boushey: I’m going to get right into it. The White House recently released some more guidance [previews of the Administration’s Unified Framework] on its tax plans but not really anything specific. The ball is now with Congress, so I’m going to try and keep this conversation at a high level.
Often here in Washington, D.C., when the economic policymaking community talks about taxes, it’ll say that the federal government needs to change the tax rate and broaden the base, increasing the amount of income that is taxed. So, when it comes to the corporate tax, what in your view actually needs to be fixed? Is it the tax rate or is it the base?
Clausing: I think the tax rate is important for some companies, but companies in the United States pay a lot of different tax rates, and for some of them, effective tax rates are very low. For the big multinational companies, the federal statutory rate [of 35 percent] bears little resemblance to what they’re actually paying. And many of those big companies have even gone on the record in saying that they don’t care primarily about the statutory tax rate; they care more about other things. But many smaller companies that pay closer to the statutory rate do care a lot about the rate.
One of the really interesting features of our business landscape today is that there’s a lot of concentration of activity and profit at the very top of business ladder, just like there’s a concentration of income at the very top of our income distribution. If you look at the top 1 percent of corporate returns, big corporations account for the vast majority of all the profit, more than 90 percent. And those firms are disproportionally multinational, and they’re disproportionately likely to have profits derived from intangibles assets. And these companies are able to reduce their tax burdens in part by shifting income out of the United States toward other countries. And my work suggests such profit shifting is presently costing the U.S. government more than $100 billion each year in lost tax revenue.
So, I think good corporate-tax reform could both lower the tax rate and increase the tax base, and that would please economists and policy wonks. But it’s not clear that the corporate community is driven by both of those objectives.
Boushey: Tell me a little bit more of why so many of those firms at the top of distribution do not pay the statutory rate.
Clausing: Some of the base narrowing comes from simple things such as the research and experimentation tax credit, the production activities deduction, and other various provisions that lower the tax rate. But the biggest driver is international profit shifting.
Companies such as General Electric Co., for instance, have used the rules of our tax system to move income that really should be in the U.S. tax base to other jurisdictions—often in tax-havens. As a consequence, their effective tax rates are often in the single-digits. In General Electric’s case, its effective rate is nearly zero over the past decade or so here in the United States. Yet the company is still earning billions of dollars over that period throughout the world. It’s just that most of the income is being artificially moved offshore. And so, when you look at its taxes paid on U.S. income, it’s quite low.
Boushey: As we broaden the base, are there ways to do this so that we get around that problem?
Clausing: Yes. There are a couple of things that policymakers could do. For instance, one of the largest tax expenditures in the business area is deferral, which is this idea that you don’t have to pay U.S. tax on your foreign income until it’s repatriated. The companies that benefit from this want to remove that repatriation tax entirely and create a super-highway of tax avoidance where there’s no speed limit and you can simply shift profits to the islands [tax havens such as the Cayman Islands or Bermuda] and never worry about the U.S. government taxing it.
But a more effective way to proceed would be to still tax that income. We can combine taxation of foreign income with a lower rate (and a tax credit for foreign taxes paid), but we’ll actually collect the tax due at that lower rate. On a revenue-neutral basis, policymakers could probably lower the corporate tax rate to about 25 or 26 percent, get rid of deferral, and end up with the same amount of revenue. Basically, what would happen is that tax revenue would go up for the multinational firms that are shifting their income out of the U.S. tax base, and tax revenue would fall for domestic companies that aren’t using these techniques, and those two effects would cancel out.
Now, that approach is extremely unpopular with the multinational business community. One option short of that idea, but still moving in that direction, would be a per-country minimum tax, where you basically limit U.S. taxation of foreign income to countries with very low tax rates. So, if a multinational firm earns income in a tax-haven jurisdiction such as Switzerland or Luxembourg, then the United States applies a minimum tax as the income is earned. If these big firms’ profits haven’t been taxed substantially abroad, then the U.S. federal government reserves the right to tax it at some other rate.
The Obama administration championed this sort of per-country minimum tax regime, suggesting a minimum tax rate of 19 percent, but it wasn’t very popular with the business community. From its perspective, whatever tax rate is chosen for the minimum tax, it will still be a lot higher than zero. So, there are going to be political problems getting that idea through Congress. Still, it is a promising approach.
Boushey: Walk us through this kind of international profit shifting. What’s the scale? Is this the biggest problem we need to solve? Are there other problems that are just as big or is this one above and beyond any other?
Clausing: I think that this is the biggest tax base problem on the corporate side. My estimates suggest this costs the U.S. government about $100 billion a year, which is pretty big.
Boushey: You could invest in a lot of infrastructure with that.
Clausing: Yes, and there are other ways that our corporate tax base has eroded. Look at the interest deductibility provisions, for instance. Those imply that many companies actually face a negative corporate tax rate on debt financed investments, which also lowers tax revenues in the business sector. Also, there is the lost tax revenue from pass-through income, which also is calculated to cost about $100 billion from the domestic side of business income. There’s a nice study by eight economists, five from the U.S. Treasury Department, that shows that the average tax rate paid by pass-throughs is 19 percent, which is far lower than the statutory corporate rate.
Boushey: One of the arguments that you hear time and time again for why Congress needs to reduce the corporate tax rate is that doing so will boost investment in overall economic growth. Tell us a little bit about how strongly investment would react to a reduction in the tax rate at the corporate side?
Clausing: On the corporate side, there are a couple of considerations to keep in mind. One is that the distribution of corporate income within the tax base is highly skewed, with about three-quarters of it due to excess profits or rents. What are excess profits or rents? Well, there’s a normal return of capital, which enables a company to pay the interest costs or the equity costs of raising capital, but any income earned above that normal return is an excess profit.
For those firms that have a lot of excess profits—the Googles and Apples and General Electrics of the world—they are earning more than we normally expect for business activity. It’s not clear that giving them a windfall is going to lead to new investments. They already have more than enough after-tax profits from which to make investments.
If policymakers believe more after-tax profits are the way to suddenly spur investment, we might ask why it hasn’t already happened, since these kinds of firms are sitting on piles of cash. It’s unclear that giving them a bigger pile of cash is going to spur investment. We need companies to have desirable investments. And often what’s stopping them is not the absence of funds, but the absence of viable investments they want to make. If policymakers really think after-tax profits are what’s needed to drive investment, then we should already be in an investment nirvana, since lately we’ve had much higher profits than we’ve ever had in the past 50 years of our history.
Boushey: And yet our investment rate is quite low right now.
Clausing: Right. That’s why I don’t think after-tax profits are the answer.
Boushey: When talking to business owners, there is a wide range of things that drive their investment decisions—everything from consumer demand or where they sit in the supply chain or the quality of infrastructure around them that makes it possible to leverage their investment. Is there anything that you want to add to that list?
Clausing: When you get into tax reform debates, the business community acts as if tax is the only thing that drives its competitiveness, whereas investment decisions and competitiveness are really driven by a lot of other factors. Infrastructure, the education of the workforce, the health of the middle class—these are all crucial things for business success and competitive businesses. And, from a policy perspective, it is likely more important to focus on these factors than on making after-tax profits that are already historically high even higher. And funding education and infrastructure requires government revenue.
So, at a minimum, policymakers should pursue revenue-neutral reform, but there’s actually a case for revenue-gaining reform right now. If you look in the next decade, we are going to have 2 percentage points of GDP in additional deficits because of our commitments to the baby boomer generation’s Medicare and Social Security benefits. Also, to expand business investment opportunities, the federal government needs to make investments in infrastructure and education and in a healthy middle class.
Also, right now the U.S. economy is amid a historically long expansion, which means we’re due for a recession before long. That in itself will drive up deficits, so this seems like a particularly poor time to reduce the revenue stream for all those reasons.
Boushey: If a tax reduction in the statutory rate isn’t going to do much to boost investment, explain to us how it will actually boost the wage of the workers. President Trump and the Republican leaders in Congress claim that tax reform will boost the middle class.
Clausing: They are relying on this idea that corporate tax cuts raise investments, which raise worker productivity, and then higher worker productivity translates into higher wages. You’ll notice several things have to happen for corporate tax cuts to cause a wage increase, and each step entails some faith and some luck.
Start with the fact that the corporate tax base is mostly excess profits, so we’re not sure that extra profits are going to stir extra investment. But even if it did serve to boost investment, that would still have to translate into a wage increase for workers. The evidence on this point is pretty thin on the ground. There is some evidence from Europe that if companies with excess profits receive tax cuts, they’ll share those with their workers, but that’s not the same as causing a wage increase for workers as a whole. If policymakers give Google a big tax cut and Google employees get paid more, that’s nice for the Google employees but it’s not necessarily helping the workers in the economy as a whole.
And we have so many easier ways to help workers directly that it seems odd to rely on such an indirect mechanism. Extending the earned income tax credit is a great way to target the employment and wages at the bottom of the income distribution. Or how about giving the middle class a tax cut by lopping a couple of percentage points off the payroll tax? All of those would go straight to the workers. We have mechanisms in place already that target workers directly, so it seems odd to rely on this very indirect mechanism.
Boushey: So, it doesn’t seem like lowering the statutory tax rate is actually going to spur the kinds of investments that are going to get us to that point where productivity gains translate into higher wages for workers.
Clausing: There are better ways to target worker productivity structured around R&D investments, infrastructure investments, and education investments.
Boushey: My last questions. What’s a piece of research on this topic that doesn’t exist today that you would like to see, and what’s the question on business taxation you really wish we had more evidence on?
Clausing: I’d like to see a lot more research on the excess profits question. How important are excess profits in the modern picture of business activity? A lot of anecodotal data suggests this is a very important issue in today’s global economy, but I don’t think we have a clear picture of just how important.
I also think that there’s some promise in getting a better picture of profit-shifting behavior if we get access to better data on these questions. One of the things that the OECD [Organisation for Economic Co-operation and Development] and the G-20 [Group of Twenty] has worked on is a “Base Erosion and Profit Shfiting” initiative. And one of their items for action is to improve the public access to data on profit shifting. For example, if there were more researcher access to tax data of multinational company earnings, we could get closer to figuring out what’s happening inside the multinational firms.
Also, another one of the recommendations of that OECD group is for country by country reporting, where firms would have to tell each country government where they are earning off their profits. And just by shedding light on what’s going on, this helps curtail some of the profit-shifting activities. And if we made that reporting public as well, it shines a light on the activities of the company. The companies themselves don’t want it—they make the argument that this will basically give away some of their business secrets. But you have to ask, why is how much income you’re booking in the Caymans a business secret? Isn’t that itself a problem?
And if you are really too embarrassed to admit to the public that 90 percent of the company’s income is being booked on an island, then don’t do that in the first place. So, I think there are ways to use corporate social responsibility motives and transparency. More information will help harness the power of consumers and workers and shareholders so that we can better allocate our purchasing and investment and employment decisions. So, I think that would be a minor step forward.
Boushey: To clarify something: So, all that money that’s sitting on those islands—is it literally just sitting there? Or is it being loaned out and invested in boosting economic capacity somewhere?
Clausing: It is being invested—in fact if you look at the data, about 50 percent of it is back in U.S. financial markets—so, you’re certainly allowed to make types of investments with this money. You’re not allowed to return it to your shareholders as dividends or share repurchases, but you can invest it in a financial institution, and that often makes the funds available to U.S. capital markets.
This repatriation issue is an important one because we are distorting repatriation decisions by having this repatriation tax. But I don’t think we’re dramatically changing the investments found in the United States. The companies that have profits abroad can borrow against them to finance any desired investment. And some of the money isn’t really truly abroad—it’s invested in U.S. assets. To the extent that U.S. investment opportunities are high, we will draw more of the capital into the United States regardless.
Clausing: But there are still good reasons to get rid of that distortion—I think either ending deferral or the per-country minimum tax would be an important move in that direction. Of course, the territorial system gets rid of this distortion too, but then you run the risk of exacerbating our large profit-shifting problem unless you’re serious about base protection.
Boushey: I think we’re probably out of time. Thank you so much, Kim.
Clausing: You’re welcome. It was a pleasure talking with you.