Corporate Tax Avoidance: Could Reform Make a Difference?

November 16, 2015


Calls for corporate tax reform only get louder as presidential campaigns click into gear. Scott Dyreng, an associate professor of accounting at Duke University's Fuqua School of Business, studies corporate taxation. He says there are a lot of misconceptions about the system and argues that any reform effort has to identify what is wrong with the system, and how it can be fixed.

Dyreng discusses these ideas in a Fuqua Q&A.

Professor Scott Dyreng


Scott Dyreng

Q: A lot of the loudest calls for corporate tax reform stem from cases of huge firms paying taxes at low rates. What's going on there?

It's a commonly-held belief that large U.S multinationals pay low or no corporate income tax. The media has reported on Google paying 2.4 percent, or GE paying 1.8 percent. It turns out, however, that the average publicly traded U.S. corporation pays about 28 cents of every pretax dollar to governments around the world. About a quarter pay more than 35 cents. So how does Google pay so little? There's a lot of research, but we don't have a very good understanding of the causes of variation in effective corporate tax rates. We do know that many firms with substantial earnings in foreign countries also have lots of intangible property, like patents and trademarks. They also take advantage of tax credits for research and development, manufacturing and energy. And they have sophisticated and sometimes very creative tax departments. Some companies are able to navigate the complexities inherent in the U.S. tax system and other countries' tax systems to reduce their tax bills. But setting tax policy based on extreme examples of huge companies paying very little in taxes might be like setting construction requirements for door frames based on the height of NBA basketball players. The danger is that the cost of implementing those policies might outweigh the benefits, if the policies are based on unusual or extreme examples.

Q: There's also a popular argument that the corporate tax rate in the U.S. is too high. Is that fair to say?

The statutory corporate tax rate in the U.S. is higher than most developed countries. That's not because the U.S. has raised corporate tax rates, but because the rest of the world has steadily reduced them over the last 30 years. Nevertheless, although statutory rates in the U.S. have remained essentially unchanged, the effective tax rate - the fraction of tax paid on each dollar earned - has steadily declined by about half a percentage point each year. To understand why this might be the case, one must consider the fact that the objectives of the tax system are not just to raise revenue, but also to encourage investment in certain types of assets or in specific industries, to stimulate economic growth, and to achieve social goals like wealth redistribution. So observing that some firms have low tax rates while other firms have high tax rates is not a smoking gun suggesting the tax system is broken. It could simply be the result of 30 years of legislation designed to achieve objectives other than collecting revenue and filling government coffers.

Q: Does the current system encourage firms to invest overseas?

Not in theory. The U.S. is one of the few developed nations that uses a worldwide tax system, which is designed to tax a dollar invested in the U.S. at same rate as a dollar invested abroad. That should make companies indifferent between investing here or overseas. But in practice, U.S. companies can defer paying US taxes on foreign earnings until they need the cash at home. That incentivizes companies to leave cash abroad, and in turn, can lower the cost of investing overseas. There is also an accounting benefit to foreign earnings. As long as those earnings are determined to be indefinitely reinvested then there is no requirement to record a tax liability for those earnings, even though the firm in fact may owe tax to the U.S. in the future. This quirk in U.S. accounting rules can provide a boost to quarterly earnings for multinational U.S. firms. So while there is no explicit tax provision written to encourage offshore investment, once all the nuances of our current system are understood, there is some incentive to recognize earnings in relatively low-taxed foreign countries, especially if those earnings can be classified as indefinitely reinvested and the cash left abroad.

Q: What is corporate inversion and how is it driving the debate?

As originally conceived, a corporate inversion occurred when a U.S. parent company sold its shares to its own subsidiary based in a country with a lower tax rate, such as Switzerland. The subsidiary then gave its shares to the shareholder of the original parent company. Once all the dust settled, the Swiss company became the parent, taxed at a lower rate, effectively flipping the company upside down, or "inverting" it. But these inversions were not politically popular with policy makers, and so the government adopted anti-inversion rules. In today's world, an "inversion" takes place as a merger of approximate equals. This past 18 months, the inversion wave has been a series of large companies merging, and the combined firm locates their parent company in a low-tax country. But the real benefit to an inversion is not having your parent company be in a low-tax country, but in a country with a territorial system, which taxes only income earned in that country. The U.S. has talked about changing to a territorial system, and that's what these companies are really trying to achieve. It's do-it-yourself tax reform.

Q: A tax holiday has been suggested as one way to encourage U.S. multinationals to bring their cash home. How does that work and could it be effective?

A tax holiday allows multinational U.S. firms to return foreign earnings to the U.S. at a lower tax rate. A 2004 tax holiday saw firms pay 5 percent tax, instead of 35 percent, on any earnings they returned to the U.S. This was a really big incentive and firms returned about $320 billion in one year. There are many firms currently lobbying for another tax holiday, with about $2 trillion being held offshore as firms hope for one. My suspicion is the U.S. learned its lesson and realized this experiment, though successful in returning capital to the U.S., was not as successful as they thought it would be in stimulating investment. Companies were supposed to use the money to pay down debt, hire people and open factories. That happened, but shareholders also got big payouts. If tax reform were properly executed, it could mitigate or even remove the incentive firms currently have to leave their foreign earnings abroad. But recent research suggests even if those earnings were repatriated to the U.S., we might not see massive investments in domestic projects. Instead it's more likely we would see dividend payouts or share repurchases.

Q: What could tax reform realistically accomplish?

While it might raise more revenue, most proposals are revenue neutral, meaning they won't fill government coffers any more than the current system. Reform could tighten the distribution of effective tax rates, so there are fewer companies paying very high and low rates. But even in 1986, the last time the tax system was reformed, there was still significant variation in the rates companies paid. It seems like politicians don't have a strong appetite for making the system fair. Instead they each want something that benefits their respective constituents, which tends to lead to a tax system riddled with idiosyncratic provisions that benefit a few firms here and there, creating winners and losers. 
As for encouraging investment in the U.S., maybe the system can be refined to help. But nothing in the tax system can change the fact that the fundamental driver of foreign investment is growth in foreign countries, and most of the world's untapped markets are outside the U.S.
It's common to hear people say our corporate tax system is broken. Exactly why the tax system is broken, however, is less clear and people often have directly opposing views about what makes the system flawed and how to correct it. I'm concerned our policy makers could make long-lasting, growth-damaging changes to our tax system unless great care is taken to first understand what is broken with our system and what we want to fix about it.

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