What Was U.S. President Trump’s Tax Reform All About?

SATO Motohiro Faculty Fellow, RIETI

U.S. President Donald Trump's tax reform plan, which has sparked international controversy, appears to be settling on cutting the federal corporate tax rate to 15%. This alone is enough to fuel the ongoing international tax war, in which countries compete to attract businesses and investments by cutting corporate tax rates. It could also exacerbate the United States' fiscal problems. However, the corporate tax rate cut is not the only pillar of Trump's tax reform. To be precise, the corporate tax reform is based on the House Republicans' tax blueprint, rather than Trump's own making, and meant to be a shift to a destination-based cash flow tax (DBCFT). DBCFT is cynically referred to as a "border tax" because imports are taxed (i.e., not deductible as expenses) while exports are not (i.e., excluded from income). However, this structure is the same as that of consumption taxes.

Tax avoidance not induced by destination-based taxation

The conventional practice of corporate taxation is to tax either corporate income earned worldwide or only that earned domestically. Under the former system, referred to as worldwide or residence-based taxation, corporations are taxed based on the country in which their head office is located. In contrast, under the latter, called territorial or source-based taxation, each country in which corporations operate imposes taxes on the portion of income earned in the country. The United States has consistently employed the residence-based system, while the Japanese system is closer to the source-based one, allowing companies to exclude dividends received from their overseas subsidiaries from their taxable income.

However, under whichever system, multinationals have incentives to avoid taxation. As such and because of the continuing globalization of the world economy, it is becoming increasingly difficult for tax authorities to make sure that corporations pay their fair share of taxes. Even when they are subject to residence-based taxation, they can retain their overseas earnings by establishing foreign subsidiaries unless they receive such earnings as dividends. From the viewpoint of corporations, consolidated net income, which includes income earned by their foreign subsidiaries, is their profit. On the other hand, from the viewpoint of taxation, income earned by subsidiaries are taxed, not when accrued, but when realized as dividends to parent companies. Thus, a corporation can defer taxation by having its subsidiaries retain their earnings. Meanwhile, in the case of source-based taxation, corporate taxpayers are left with room to manipulate transfer prices, i.e., prices charged in transactions with their subsidiaries. For instance, a company can reduce its taxable income by paying high prices for purchases from its foreign subsidiaries and keeping revenue (e.g., royalties) from them low. In other words, corporations based in high-tax countries can shift their profits to low-tax countries overseas. Such tax avoidance practice by multinationals, referred to as base erosion and profit shifting (BEPS), has prompted calls for concerted international action. Corporate taxpayers would not be tempted to resort to such practice if made subject to destination-based taxation. Under this system, purchases from foreign subsidiaries are treated as imports, which are not deductible from taxable income. Therefore, whatever prices they pay for purchases from foreign subsidiaries would not reduce the amount of taxable income by any. Likewise, reducing the prices of goods and services sold to foreign subsidiaries has no impact because exports are not included in taxable income. Indeed, profit shifting has never been an issue when raising the rate of destination-based consumption taxes, which are levied where goods and services are consumed.

Relabeling corporate tax as consumption tax

"Cash flow" in DBCF refers to the amount of net sales less the costs of purchases—including raw materials as well as equipment and facilities—and personnel. Unlike the conventional corporate tax system, investment in equipment and facilities is immediately deductible as an expense for the current period, not expensed over time as depreciation. On the other hand, interest paid on borrowings is not deductible. In this sense, the concept of cash flow here is different from that of income. Indeed, the operation of the DBCF tax in the United States is identical to that of the consumption tax in Japan and value added taxes in Europe. To be sure, they are different institutionally, for instance, in that the Japanese consumption tax is an indirect tax whereas the DBCF tax is a direct tax. Nevertheless, they have the same economic impact, which can be observed in the equivalence of three formulas for calculating gross domestic product (GDP) (Note 1).

Consumption = Compensation of employees + (Operating surplus - Investment) - (Exports - Imports) = Compensation of employees + Sales excluding exports - Purchases excluding imports and including investment) = Compensation of employees + DBCF

While consumption tax (indirect tax) is levied on the furthest left component above, DBCF in the furthest right component is the base for border tax (direct tax). Indirect taxation on the furthest left component and direct taxation on the furthest right component have the same economic impact. This is referred to as "tax equivalence." Generally, the following formula holds:

Consumption tax = Payroll taxes including social security taxes + DBCF

What is meant by the above equation, which describes the equivalence of direct and indirect taxes, is that DBCF is equivalent to (1) raising the consumption tax rate and (2) decreasing the payroll and social security taxes, as substitute for the conventional corporate taxation because:

Change in DBCF = Change in consumption tax - Change in payroll and social security taxes

Trump's tax reform (House of Representatives' blueprint) is not just about reducing the corporate tax rate. It is tantamount to "abolishing" corporate taxation and introducing a new consumption tax instead, and reducing social security taxes at the same time. In their respective tax reform, the United Kingdom and Germany also lowered statutory corporate tax rates and held down social security taxes (employers' contribution), while value-added (consumption) tax rates rose. That is, some European countries were moving ahead of the United States in pursuing tax reform in the same direction as that of Trump's reform. Meanwhile, Japan has lowered the combined national and local corporate tax rate to below 30%, but the rate remains higher than that of many other countries. Furthermore, while social security tax rates are on an upward trend due to population aging, the government has postponed its planned consumption tax rate hike until October 2019. We are making a mistake if we feel relieved by the United States' decision not to introduce a DBCF tax. A shift in the tax mix, away from source-based corporate and social security taxes to consumption or destination-based cash flow taxes, already is a global trend. Can Japan afford to remain unchanged while the rest of the world is changing?

May 26, 2017
Footnote(s)
  1. ^ From the equivalence of the three GDP calculation formulas;
    GDP = Compensation of employees (wage) + Gross operating surplus = Consumption + Investment + Exports - Imports

June 27, 2017