the border tax

too-high corporate tax rate

The rate at which the domestic earnings of US corporations are taxed by the federal government is unusually high by world standards.

Corporate response has been what one would expect:  some firms leave for lower-tax jurisdictions; others engage in elaborate tax avoidance schemes, the bare bones of which I wrote about yesterday; still others spend tons of time and money lobbying Congress for exemptions.  Not a pretty picture.

What to do?

The straightforward answer would be to lower the tax rate and eliminate the special treatment.  Of course, congressmen, lobbyists and the industries receiving tax breaks are all against the latter.

border tax

That’s one reason for the appeal of a flat tax of perhaps 20% on the value of all imports–it leaves the status quo untouched but raises tax dollars to offset those lost through reducing rates.

A border tax would have another advantage, eliminating abuses from transfer pricing.  This is a practice whereby goods imported into the US are first shunted on paper through a tax haven where their price is raised.  The effect is to redirect profits from the US to the tax shelter country.

problems

The biggest theoretical issue with a border tax is the law of comparative advantage, the idea on which most international commerce is based that countries all gain by specializing in what they do best and buying everything else from abroad.  Contrary to what one might think at first, trying to do everything in-country and taxing imports reduces national wealth.

A big practical defect of the border tax, to my mind, is that there are mammoth categories of everyday goods–food, clothing, furniture, toys–that are only available at low cost in the US because they are made abroad.  Another is the question of retaliation, as the US is now doing against Canadian efforts to favor local milk products over imports from Wisconsin.

a rising dollar?

Border taxers reply to the higher-cost-of-imports issue by claiming that implementing a border tax will cause the dollar to rise–maybe even by enough to offset the effects of the border tax in dollar terms.  How so?

The argument is that every day US parties go into the currency markets wanting to exchange dollars for foreign currency.  Similarly, foreigners come with their currency to exchange into dollars to buy US-made stuff.  The interaction of supply and demand sets the exchange rate.

Post border tax, higher prices of foreign goods means less demand in the US for them, which means fewer dollars available for exchange, which means the price of dollars goes up. Some border tax advocates claim the dollar spike could be as much as +25%-30%.

huh?

I suppose this line of reasoning could be right. But it seems to assume, among othe things, that, contrary to what we’re doing with Canada, no one retaliates; and that demand for now-higher-priced US goods remains relatively unaffected.  Good luck with that.

Ultimately, though, I think that, whatever the strength of its conceptual underpinnings, the border tax is an attempt to avoid attacking the rats nest of special interest exemptions in the tax code while still lowering the headline rate. So it’s “fixing” one tax distortion by creating another.  That’s vintage Washington.  But making taxes more complex, not less, is a recipe for trouble.

 

 

the Trump tax plan

President Trump has submitted the outline of his income tax plan, reportedly in bullet points on a single sheet of paper, to Congress.  Although some have derided the lack of detail provided, the submission at least makes it very clear what is going on–and will likely help underscore the allegiance to special interests that opponents to what I considr a no-brainer tax fix may be serving.

On the corporate side, the reduction of the top rate to 15% will address three very important tax issues, all spawned by the fact that US corporate income tax (for those unable to cut a sweetheart deal) is higher than just about any other place on earth.  The current problem areas I see them are three:

inversions, where a company paying full freight in the US reincorporates on paper, usually through a merger with a foreign firm, in a low-tax country like Ireland (where the tax rate is in the low teens).  Pharmaceutical companies, which have few ways of reducing their taxable income, have been the most prominent group doing this.  At the stroke of a pen, their after-tax income goes up by 30%.

transfer pricing, a long-time standby of multinationals.  That’s where goods made by a third party in, say, China and destined for ultimate sale in the US are bought for, say, $10 each by the on-paper subsidiary of a US firm.  The goods are marked up by Hong Kong to $20 and sold for that to the US parent.  Since foreign firms doing business in Hong Kong pay no corporate tax, that $10 markup, which probably remains in a bank in Hong Kong, allows the parent to avoid paying $3.50 or so in tax to the IRS.

intellectual property transfer, a variation on transfer pricing.  A US firm transfers its patents, ownership of its brand name… to a subsidiary in a low-tax jurisdiction.  Ireland is a favorite destination.  It pays royalties to the subsidiary for the use of the intellectual property, generating an expense that reduces US income otherwise taxed at 35%, while paying less than half that to the country where the intellectual property is now domiciled.

One major effect of these strategies is that all of the cash saved is trapped abroad.  This is because IRS regulations require corporations repatriating such foreign income to pay tax on the transfers equal to the difference between the US and foreign tax rates.  That’s the reason multinationals are constantly lobbying Congress to declare a tax holiday for repatriations like these.

It will be interesting to see what happens.

 

Note:  the one virtue of what I consider the otherwise loony border tax is that it would remove the appeal of the extensive network of transfer pricing/IP transfer schemes already in place.  More about this tomorrow.

 

transfer pricing

transfer pricing

Consider the case of a Japanese company that makes cars in Brazil, which it then sells in the US.  Its internal control books will allocate a portion of the revenues and costs of a given car to operations in Japan for use of the brand name and the firm’s intellectual property, another portion to the manufacturing operations in Brazil and a third to the sales operations in the US.

This allocation process is called transfer pricing.  This in itself is a benign process.  After all, the firm has to understand whether Brazil is a profitable place to make cars and whether the Brazilian output should be allocated to the US or to other, potentially more profitable, markets.

What makes transfer pricing controversial, however, is that the firm also has tax books.  And the logic that dictates the management control profit decisions may not be the same as the one that minimizes taxes.

An example:

When I began working as a global portfolio manager in the mid-1980s, Tokyo was a very important stock market.  Multinational brokers all had lavish offices in swanky downtown districts and very large staffs–all of which seemed to be growing by the day.  Yet, I kept reading, at my then glacial, now non-existent, kanji speed–in the Nihon Keizai Shimbun that these same brokers were losing tens of millions of dollars a year.  This state of affairs had been going on for years, with no relief in sight.

I began asking around.  What I learned , after a long time of digging, was that all of the Japanese securities trades that customers placed with these brokers were funneled through their Hong Kong offices.  In an operational sense, this was crazy.  I knew most of the Hong Kong operations of these firms.  They knew nothing about Japan, in my opinion.  And, of course, this was an extra, possible mistake-inducing, step.  Why?

The answer is simple.  Japan had, along with the US, the highest corporate tax rates in the world.  In Hong Kong, the tax on foreign corporations’ profits was zero.  So every foreigner in any line of business established a Hong Kong office and recognized on its tax books as much international profit there as it thought it could get away with.

What’s in this for Hong Kong ?  Again, simple.  The move created employment, commerce and taxable salary income that the now-SAR would not have had otherwise.  The price was only forgoing tax income it would never have had anyway.

The general transfer pricing tax strategy:  recognize as much profit as possible in low-tax jurisdictions, the minimum amount in high-tax locations.

turning to the EU today…

Margrethe Vestager, the new EU competition commissioner, is starting a crackdown on what the union considers abusive tax practices.  Her first targets are Starbucks and Fiat.

In the Starbucks case, Vestager has two gripes.  Both relate to a low-tax corporate subsidiary set up by Starbucks in the Netherlands, using an aggressive tax strategy endorsed as legal by that government thorough an informal tax letter.   (The situation is outlined best, I think, in a New York Times article).  The subsidiary allegedly:

–bought coffee beans for Starbucks worldwide from Switzerland and marked them up by 20% before selling them to other parts of the company, thus shifting profits away from higher-tax jurisdictions around the globe, and

–levied charges for the use in the EU of the Starbucks name and its secret coffee roasting recipe (which the EU competition commission claims was basically a temperature setting).  In the case of the large UK subsidiary of Starbucks these fees for intellectual property apparently amounted to most of its pre-tax income.

 

Vestager is not saying that Starbucks, Fiat and others did anything wrong.  She’s saying the Netherlands, and other countries that offered sweetheart tax deals did.  And she wants those countries to collect back taxes.

It will be interesting to see what develops, since presumably every multinational doing business in the EU is employing similar devices.