- Time and Date: 12:15-14:00, Monday, August 21, 2017
This RIETI special seminar focused on the prospects for major tax reform in the United States. Professor Alan J. Auerbach, the Robert D. Burch Professor of Economics and Law at the University of California, Berkeley, made a presentation detailing the prospects of tax reform with the unexpected victory by Donald Trump and congressional Republicans. He also explained the merits of a destination-based cash-flow tax (DBCFT) system, which is similar to introduction of a value added tax (VAT), reducing employment taxes, and reducing the corporate tax. The need for these reforms was highlighted by the fact that there is tax competition happening around the world that has led to companies moving profits from the United States to tax havens. However, he explained that in the current political climate it is likely that no major tax reforms will take place before the 2018 congressional elections, especially considering the chaos in the U.S. government.
Presentation: U.S. Tax Reform: Prospects and Roadblocks
Alan J. AUERBACH (Robert D. Burch Professor of Economics and Law, University of California, Berkeley)
The problems that U.S. President Trump is encountering right now may have little to do with tax reform, but they affect the prospects for tax reform because they distract from more substantive policy issues.
State of play
Regarding the state of play, remember that the president and Congress are nearly co-equal in the development of policy in the United States. When the president does not present detailed proposals, Congress then develops its own proposals. According to the U.S. Constitution, tax legislation must originate in the House of Representatives through the Ways & Means Committee.
At the start of the Trump administration, the plan was to first deal with healthcare reform and move on to tax reform due to an arcane parliamentary issue. In the Senate, there needs to be a supermajority of 60 votes to approve legislation, and the Republicans only have 52 seats. Republicans decided to use the once-yearly budget reconciliation procedure, which requires a simple majority to pass. Therefore, Congress planned to handle healthcare through the 2017 reconciliation process and then to do tax reform through the 2018 reconciliation process.
However, healthcare reform was a disaster for the administration since Republicans could not get enough votes to pass legislation in the Senate. With the failure on healthcare, Congress and the president could move on to tax reform, but the precedent of failure means that passing a successful tax reform plan is less likely.
The original proposal for tax reform was put forward in a document released by House Republican leaders at the end of June 2016 under the leadership of Speaker Paul Ryan. It was a fairly bold plan for tax reform that was released when it was thought that Hillary Clinton would be president. Republicans were not expecting unified control of government and were expecting to have to negotiate with a president from the opposite party. Therefore, this document was more of a statement of principles and was a political document set forward as the first step in a bargaining arrangement. With the Republicans winning unified control of government, this proposal turned into an actual plan of action that received a lot more support and a lot of opposition.
DBCFT: What is it?
The plan was to cut individual tax rates to 33% and the corporate tax rate to 20% as well as to change the business tax system more fundamentally. This is to adopt a DBCFT system. In response to the House plan, the Trump administration released its own plan that lacked new ideas and details. It included individual tax cuts and even bigger business tax rate cuts, but none of the other reforms proposed by the House such as an exemption system of taxation for international taxes. The Trump plan also appeared to be very fiscally irresponsible with an estimated revenue loss over 10 years of over 2.5% of gross domestic product (GDP) each year, which represents about a 14% reduction of federal tax revenues. Inclusion of the DBCFT would raise a substantial amount of revenue to help make the tax reform more fiscally responsible.
The U.S. tax system currently works in about the same way for corporate and non-corporate businesses. The income tax system is quite standard where the United States attempts to impose a worldwide tax system where U.S. companies are also taxed on activities abroad. Income earned abroad is subject to U.S. tax when the earnings are repatriated with a credit for foreign taxes paid. DBCFT would replace scheduled depreciation allowances with immediate deductions for capital purchases, eliminate interest deductions for non-financial companies, ignore all foreign-sourced income, and adopt border adjustments. Border adjustments remove tax liability for U.S. exports and offset the deduction for imported inputs. The net effect is that U.S. taxes would ignore both export revenues and import costs.
Relation to other policies
Border adjustments are equivalent to a “subtraction-method” VAT plus a wage reduction or equal-rate payroll tax credit. Although the United States may have a VAT in the future, historical reasons prevent its adoption in the near term.
The motivation for a DBCFT is that corporate tax rates in the United States have remained unchanged since 1990 while corporate tax rates in other G7 countries have fallen. In 1966, the top five U.S. companies were AT&T Inc., IBM Corporation, General Motors Company, Exxon Mobil Corporation, and Eastman Kodak Company. AT&T was a regulated monopoly providing nearly all telecommunications in the United States, whereas Exxon Mobil was an international oil company. The other three companies were exporters that manufactured their products in the United States. In 2016, only Exxon Mobil is in the top five, and the other four (Apple Inc., Alphabet Inc., Microsoft Corporation, and Amazon.com, Inc.) are all focused on goods and services based on intellectual property.
Over 50 years, the share of intellectual property and nonresidential assets doubled, while the share of before-tax corporate profits of U.S. resident companies coming from overseas operations quadrupled. Fifty years ago, it would have been difficult for companies to invert by changing their residence since most of their operations were based in the United States. However, companies have become international and inversions picked up in the mid-1990s. Legislation made it more difficult to do so in the early 2000s, but inversions picked up again as a new form of inversion emerged where a U.S. company merges with a foreign company. The Barack Obama treasury created new regulations to reduce inversions, and in 2016, the number of inversions decreased.
The U.S. tax system incentivizes companies to keep profits offshore since they are taxed upon repatriation. U.S. companies have $2.6 trillion of already earned profits kept offshore. The dominance of international supply chains makes it hard to know where value is being added and where profits are being produced. For companies such as Google, the location of production is easy to change and is more sensitive to taxes. This puts downward pressure on tax rates. Companies also can decide where to report profits. It is hard to tell where profits are being earned, especially if intellectual property plays a big role in production where it is easy for companies to shift asset locations and hence the location of their profits. Estimates suggest that the United States should have $280 billion more in reported profits in 2012 due to profits being shifted to countries with lower tax rates.
A traditional approach to remedy this situation is to lower corporate tax rates. However, for the United States to be competitive, it would need a tax rate of around 20%, which would cause a very big revenue loss.
A second approach is to charge U.S. companies higher and more immediate taxes on profits earned offshore. This would reduce the lock-out effect since earnings could be brought back home without additional taxes. However, this would exacerbate the inversion problem since non-U.S. companies would not be subject to these rules. Therefore, this Obama administration idea did not receive much support.
Another approach is a territorial tax system where U.S. companies are taxed less on foreign-sourced income. Doing this without lowering the corporate tax rate would encourage companies to move profits and activities offshore since profits moved to a foreign country could be repatriated with no additional tax. This Republican proposal did not get much support.
The final approach is base erosion and profit shifting (BEPS) where adopting rules cooperatively would make it difficult to locate profits in low-tax countries unless you have significant economic activity there. This system would encourage companies to shift activities in order to report profits in tax havens, so companies would shift activities overseas. This is bad for the United States since investment and employment along with profits could be shifted to another country.
DBCFT as an alternative
A DBCFT system eliminates all of the above problems. It eliminates the ability to shift profits out of the United States, the incentive to shift production out of the United States, the incentive for corporate inversions, and the lock-out effect.
Potential economic effects
DBCFT appears to be roughly revenue neutral thanks to the border adjustment. This led to the criticism that countries cannot run trade deficits forever. Since deductions are denied for imports and exports are not taxed, the U.S. trade deficit of around 3% of GDP would represent large revenues. Although we may generate revenue in the short run with border adjustments, the argument is that there is no long-run benefit since bigger trade surpluses would occur to make up for past trade deficits.
However, this argument ignores the fact that much of the U.S. trade deficit comes from related party transactions. For example, if Google runs a trade deficit with its Irish subsidiary, that is not an overall liability of the United States because Google Ireland is owned by Google. We will benefit from eliminating deductions for net imports from related parties forever because we will never have to run a trade surplus with Google Ireland to offset trade deficits.
The evidence for value-added tax changes is that real exchange rate changes, through a combination of domestic prices and the nominal exchange rate, offset changes in the price of domestic versus foreign goods. However, substantial U.S. dollar appreciation expected under this system could negatively affect other countries that use the dollar as their currency or have dollar-denominated loans outstanding.
The DBCFT system would impact incentives for investment in the United States. Investment expensing would encourage investment, but removal of interest deductions would raise the cost of capital. Zero tax on overall profits based on a location in the United States would encourage investment in the United States. There is evidence that lower tax rates on production and profits lead to substantial movements of activities.
DBCFT is controversial
DBCFT is controversial because it is a big change and would affect different companies in different ways that are not well understood. Based on evidence, the real exchange rate response should not leave importers in a difficult situation, but import-intensive industries have been skeptical. Industries that rely heavily on interest deductions such as real estate could be worse off. DBCFT has also been controversial internationally. The changes would encourage companies to move borrowing and interest deductions to other countries while encouraging them to move production to the United States and to shift profits to the United States.
Three possibilities for tax reform
Following the failure of healthcare reform, a one-page joint declaration on tax reform was put together by six leading politicians (Gary Cohn, Steven Mnuchin, Paul Ryan, Mitch McConnell, Kevin Brady, and Orrin Hatch). The declaration called for lower business tax rates, keeping investment expensing, no border adjustments, and gave no indication they would eliminate interest deductions. Without border adjustments, a large corporate tax rate reduction involves a big revenue loss. Based on what is coming from the Trump administration about protecting American jobs, there is a signal that large tax cuts might be offset by more tariffs.
The first possibility is to use the Senate budget reconciliation process to pass a large tax cut. However, legislation passed in this way cannot cause effects beyond the budgeting period of 10 years. Therefore, one possible outcome is a large tax cut that can only last for 10 years combined perhaps with tariffs.
A second possibility is that business tax reform might attract bipartisan support. The problem is that features of the Republican tax plan are not favored by Democrats, so a bipartisan approach would be very different from what we have already seen.
The third possibility is that nothing will happen given the chaos in the U.S. government. 2018 is a congressional election year where the entire House of Representatives is up for reelection as well as one-third of the Senate. Republicans are looking for accomplishments that are not controversial and would not hurt reelection chances, so it is entirely possible that nothing will be done before the election on tax reform. It is possible that following the election there will be more productive tax reform discussion. I personally think that any tax measures passed before the next election will not be good policy.
Discussant and Moderator:
SATO Motohiro (Faculty Fellow, RIETI/Professor, Graduate School of Economics, School of International and Public Policy, Hitotsubashi University)
SATO: Regarding the U.S. tax reform implications for Japan, many think that corporate income tax cuts mean that the United States is engaged in international tax competition as a country. People might also think that this proposal is anti-free trade because tariffs may prevent Japanese companies from exporting to the United States. However, those views do not capture the whole vision of this proposal. The proposal aimed at fundamental reform of corporate income tax shifting its tax base from income to consumption and tax principle from residential to destination.
Probably a border adjustment will not be introduced and the United States will focus on tax cuts. This would be problematic for Japan since the United States would then have a lower tax rate. Japan's corporate income tax rate is 30% including both central and local taxes. The proposed 15% tax proposed by President Trump would make the U.S. corporate tax rates lower than the Japanese rate.
Many European countries are increasing the VAT, cutting social security contributions, and cutting corporate income taxes, which is exactly the same as expanding the DBCFT system. Japan is moving in the opposite direction from other countries with high corporate tax rates and increased social security contributions. Japan does not need a DBCFT since it already has a VAT. Japan needs to increase the VAT rate, cut social security contributions, and reduce the corporate income tax to at least to the Organisation for Economic Co-operation and Development (OECD) average, but this is not being discussed in the government.
Question 1: Are there estimates of the quantitative impact on U.S. GDP/GDP growth if the plan is implemented?
AUERBACH: Larry Kotlikoff and his co-authors have estimated U.S. growth and wages using a version of the Auerbach-Kotlikoff model and determined that adopting the House blueprint and business tax provisions could increase wages by as much as 8%, but this seems high. Implementing the proposals could increase GDP growth by 0.1% to 0.2%. Adopting this proposal on a revenue-neutral basis would contribute toward higher economic growth. It would probably increase measured GDP in the United States because it would deflate the inflated level of imports. It is possible that low current measured U.S. productivity growth could be caused by increased profit shifting and more profits showing up abroad.
Question 2: Standard economics say that the burden of the corporate income tax falls on labor. Is the DBCFT different? Will tax reform be discussed along with infrastructure?
AUERBACH: The theory states that in an open economy with mobile capital that corporate taxes would be borne by labor because of capital flight. A DBCFT system is different since there no longer would be a tax wedge on producing in the United States. Since taxes would be assessed on asset owners rather than labor, I have always thought that this system should be championed by the Democrats. However, I think there is a lack of understanding on this point and the current political environment discourages bipartisanship.
The Trump administration has talked about public-private partnerships in infrastructure, but except for toll roads, it is difficult for public companies to get revenues from infrastructure projects. We need more detail. I think that infrastructure plans will come independent of tax reform.
Question 3: Do you think lifting the debt ceiling would stand in the way of tax reform? What percentage do you expect for individual and corporate tax cuts?
AUERBACH: I do not know how the fight over the debt ceiling will progress, but I do not think the debt ceiling will become a real problem. However, with the lack of coherent White House leadership I have less confidence that debt ceiling problems will be avoided like they were during the Obama era.
About tax cuts, I do not know. Some Republicans care about the deficit and would limit the extent of tax cuts. Tax cuts could be scaled back and be only at the business level, but most voters know nothing about business taxes, so this also seems unlikely.
Question 4: Would a DBCFT system be illegal in terms of the World Trade Organization (WTO) regime?
AUERBACH: As an economist, it makes no sense that the WTO would cause problems. The DBCFT system includes a VAT, reducing employment taxes, and reducing the corporate tax. Any one of these would not violate WTO rules, so neither should a combination of them. Itai Grinberg at Georgetown Law wrote a paper indicating confidence that a DBCFT proposal could be written in accordance with WTO rules.
Question 5: If it is the case that tax reform is not progressing due to political issues, if a DBCFT is not established, then what reaction would you expect in the U.S. community? I believe that DBCFT discussion will take place, so what is your opinion?
AUERBACH: The DBCFT plan in the 2016 proposal was not expected to be part of immediate legislation, but it now is under consideration. Many groups mobilized either for or against based on incomplete information and discussion. There have been no congressional hearings about the specific proposal, so I do not expect it to be part of major tax reform this year. I hope there will be serious discussion about it in the future. Other countries are now considering a DBCFT, so I hope the plan becomes better understood.
Question 6: Which groups of politicians would be supportive of a DBCFT? I understand that businesses such as Toyota Motor Corporation are supportive of border adjustments.
AUERBACH: The biggest supporters were in export industries such as the Boeing Company. Major opponents included importers such as Walmart and Nike, Inc., but I think this was based on misinformation that border adjustments would have permanent effects, allow exporters to undersell their competition, and make importers pay higher costs. They did not think that exchange rates, wages, and prices would adjust. However, some companies will suffer such as those that heavily rely on borrowing due to eliminating the interest deduction. Companies that pay little tax, such as some of those in Silicon Valley, oppose DBCFT, but it is hard to lobby for continuing to pay nothing in taxes. As discussion continues, I believe that importers will be less upset and exporters less excited.