Mirrlees Review: Corporate Taxation

1. The Mirrlees ReviewReforming the Tax System for the 21st Centuryhttp://www.ifs.org.uk/mirrleesreview Corporate Taxation RES Special Session Warwick, 17 March 2008 Steve Bond Oxford University Centre for Business Taxation and Institute for Fiscal Studies

2. Mirrlees Review: Corporate Taxation • Drawing on the two commissioned chapters that focus on taxation of large corporations • Auerbach, Devereux and Simpson (ADS) • Taxing Corporate Income • Griffith, Hines and Sørensen (GHS) • International Capital Taxation • And the special study on small business taxation • Crawford and Freedman • Outline the tentative conclusions that I draw from these • not necessarily the views of the Mirrlees Review team

3. Meade proposals on corporate taxation • ‘Flow of funds’ or ‘cash flow’ tax bases for corporate taxation • Aim to tax economic rents, i.e. returns on investments over and above the minimum required return • Achieve this by allowing investment outlays to be expensed, with no subsequent deductions for depreciation or cost of finance; no attempt to match accounting treatment • Leave cost of capital unchanged for all types of investment and all sources of finance; uniform, zero EMTRs • Neutral between debt and equity finance

4. Meade proposals on corporate taxation • Choice between R-base or R+F-base (or equivalent S-base) • R-base requires distinction between real and financial flows, but not between debt and equity • R+F-base requires distinction between debt and equity, but not between real and financial flows; new borrowing taxed; repayments of interest and principal deductible • Equivalent in present value terms for borrowers • Only R+F-base taxes rents earned by banks from interest rate spreads on borrowing and lending

5. Analysis of Flow of Funds Real inflows – Real outflows = R base + Financial inflows – Financial outflows = R+F base = Share outflows – Share inflows = S base

6. Cash flow corporate taxes • In a closed economy, no distortion to investment decisions, if all investments with positive NPVs are undertaken • Taxing economic rents is efficient, and cash flow corporate taxes are natural complement to personal expenditure tax advocated by Meade • But in open economies, source-based cash flow taxes will distort location choices, unless all economic rents are location-specific • Also leave incentives for multinational firms to shift taxable profits into low tax rate jurisdictions • Two commissioned chapters disagree on the importance of these problems with source-based cash flow (or equivalent) corporate taxes

7. Key developments since Meade: changing world • Internationalisation of business activities • Huge increases in foreign direct investment • multinational firms now account for one quarter of UK employment • and in foreign portfolio investment • foreign owners now account for one third of share ownership in UK listed companies • Financial innovation (growth in derivatives and hybrid securities) has blurred the distinction between debt and equity • Big increase in the share of corporate tax revenues from the financial services sector • up from 5%-10% in early 1980s to around 25% now, in both UK and USA

9. Key developments since Meade: changing taxes • Much lower statutory corporate tax rates • particularly in smaller countries

11. Key developments since Meade: changing taxes • Much lower statutory corporate tax rates • particularly in smaller countries • Broadly stable corporate tax revenues • relatively strong revenue growth in smaller countries

12. Corporation Tax Revenues 1965-2004 (% of GDP) 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% GDP weighted average median unweighted average 1.0% 0.5% 0.0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 1995 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

13. Key developments since Meade: changing taxes • Much lower statutory corporate tax rates • particularly in smaller countries • Broadly stable corporate tax revenues • relatively strong revenue growth in smaller countries • Reflects proliferation of rate-cutting, base-broadening reforms, following UK (1984) and USA (1986) • Movement away from relatively narrow base (economic rents) advocated by Meade • Plausibly reflects increased importance of tax competition between governments • particularly for location of firms (EATRs) • and location of taxable profits (statutory tax rates)

14. Key developments since Meade: changing taxes • Revenue buoyancy also reflects increase in corporate profits relative to GDP • partly due to higher profitability, and more business activity taking corporate form • Revenue shift from (high tax) larger countries to (low tax) smaller countries suggests increased importance of profit shifting by multinational companies • Retreat of imputation systems that integrated corporate and personal income taxes • partly in response to ECJ rulings within the EU

15. Key developments since Meade: economics • Recognition that source-based taxation of capital income is likely to be inefficient in small open economies with a high degree of capital mobility • increase in required pre-tax rate of return • outflow of capital • incidence shifted onto relatively immobile domestic factors, notably labour • less capital per worker, less output per worker, lower wages • more efficient to tax domestic factors directly, avoiding this distortion to capital-labour ratio (production inefficiency) • But source-based corporate income taxes are alive and kicking

16. Key developments since Meade: economics • Models have incorporated multinational firms, taking decisions on where to invest, and where to report profits, not just on how much to invest in a fixed location • more emphasis on effective average tax rates (location decisions) and on statutory tax rates (profit shifting) • less emphasis on cost of capital and effective marginal tax rates (scale decisions, conditional on location) • Models of non-cooperative tax setting and strategic tax competition between governments • individual governments are now more constrained by the tax rates and/or rules adopted by other governments

17. Key developments since Meade: economics • Less emphasis on the importance of personal taxation of dividend income for corporate investment decisions • ‘New View’ suggests dividend taxes may only be important for investment financed by new equity; not for investment financed by retained earnings • Small open economy models suggest dividend taxation of domestic shareholders may be completely irrelevant for decisions of large corporations whose shares are owned and traded in the global capital market

18. Key developments since Meade: economics • Generalisation of cash flow tax principles • Boadway-Bruce (1984): generalised R-base • immediate expensing of investment outlays can be replaced by a flow of deductions, reflecting the costs of finance and depreciation, with the same present value • perpetual flow of r per period has same present value as immediate deduction of 1, if r is also the relevant discount rate • can further allow for arbitrary depreciation schedules without compromising zero EMTR property • IFS Capital Taxes Group (1991): generalised R+F-base • Allowance for Corporate Equity (ACE) applies this idea to opportunity cost of equity finance only; preserving interest deductibility (and taxation of interest receipts)

19. Key developments since Meade: economics • Bond-Devereux (1995, 2003) analyse these generalised cash flow taxes under uncertainty • taxes can be designed so that the appropriate rate of return for the ACE allowance is the risk-free interest rate; not appropriate to add the (project-specific) risk premium • with certainty, the risk-free rate is both the appropriate rate to discount deferred receipt of investment allowances, and the required rate of return on equity-financed investments • with uncertainty, the risk-free rate remains the appropriate rate to discount deferred receipt of investment allowances, provided these are sure to be received at some point; while the required rate of return on risky equity-financed investments is likely to be higher • appropriate bankruptcy rules allow this to be combined with deductibility of actual interest payments on (risky) debt

20. Where the two chapters agree • Both ADS and GHS emphasise globalisation as the main change since Meade with important implications for corporate tax design • Both also consider financial innovation and the growth of the financial sector to be important • Both emphasise the inefficiency of source-based taxation of capital income in small open economies, and consider this relevant for tax design in the UK • Neither proposes outright abolition of corporate taxes • Both propose radical reform of the existing corporate income tax base

21. Where the two chapters disagree • GHS emphasise the benefits from eliminating source-based corporate taxation of the normal return on capital • They propose to achieve this with a source-based ACE • which exempts the normal return on both equity-financed and debt-financed investments • at an unchanged statutory tax rate • This would make the UK a more attractive location for mobile capital investments that just earn a normal rate of return; and (though to a lesser extent) for those that earn economic rents • EMTRs fall to zero; EATRs are reduced • Capital per worker should rise, and domestic workers should benefit from higher real wages

22. Griffith, Hines and Sørensen • GHS acknowledge that this proposal may not be revenue-neutral • unless firm behaviour changes, introducing a more generous allowance for financing costs at an unchanged tax rate would imply that less revenue is collected • this may be offset by increased corporate investment in the UK, but no strong evidence that this would be sufficient • If necessary, they propose that lower corporate tax revenues should be recouped from higher taxes on relatively immobile domestic factors (labour and land); and to some extent from higher residence-based taxation of dividend income at the personal level

23. Griffith, Hines and Sørensen • GHS also propose a switch from the UK credit system to exemption of foreign-source corporate income; broadly in line with current UK government proposals • GHS acknowledge that the source-based ACE may still distort location choices, where rents are earned that are not location-specific; but no more so than under the current UK corporation tax • They also emphasise neutrality with respect to ownership of assets by multinational firms based in different countries; combining the source-based ACE with the exemption method reduces a competitive disadvantage for UK-based multinationals wanting to expand by acquiring firms in other jurisdictions

24. Auerbach, Devereux and Simpson • ADS give more weight to eliminating location distortions • They also emphasise both practical and conceptual problems in implementing source-based corporate taxes • allocating global profits of multinational firms to individual source countries using arm’s length prices is at best immensely complex; and is necessarily arbitrary in cases where comparable transactions between unrelated parties do not exist • They reject source-based taxation of either corporate income or economic rents as inappropriate in the integrated world business environment we now have • While taxing corporate-source income of individuals on a residence-basis is theoretically more appealing, they also reject this as simply infeasible

25. Auerbach, Devereux and Simpson • ADS propose a destination-based cash flow tax • The R-based version would work very like existing destination-based VATs, but with an additional deduction for wage costs • this exploits the equivalence between the VAT base and the sum of wage costs plus economic rents • In an open economy setting, the destination-based cash flow tax would only tax economic rents - as advocated by Meade and GHS - but in the location where goods and services are consumed, rather than in the location where they are produced • Since the tax liability does not depend on the location of production, the destination-based cash flow tax is neutral also with respect to location decisions

26. Verdict? • Some potentially important problems with the destination-based cash flow tax proposal are not fully resolved • The R-based version could be implemented simply by increasing (uniform) VAT rates, with offsetting reductions to payroll tax rates • But scope for increasing VAT rates is constrained in EU • Higher VAT rates would increase strains on the VAT base (missing trader/carousel frauds) • Financial services are currently exempt from VAT

27. Verdict? • A R+F-based version of the destination-based cash flow tax exists in principle, but would face similar problems to those of applying VAT to financial services • to date, these have proved to be insurmountable in practice • The destination-based cash flow tax would also be a much more radical departure from existing international tax practice than the source-based ACE • implications for bilateral tax treaties, creditability against other corporate taxes, compatibility with EU law, ...

28. Conclusion • My forecast is that the Mirrlees Review team is more likely to favour a source-based ACE as our main recommendation for corporate tax reform in the near term • While noting the remaining problems inherent in source-based corporate taxation, and recognising that taxing corporate rents on a destination-basis may be more attractive in the longer term, particularly if significant revenues from source-based corporate taxes eventually prove to be unsustainable • I am less convinced than GHS about the positive case for switching from credit to exemption, essentially because in practice the UK credit system is so close to exemption already • but this decision may have been taken before we publish, if current UK government proposals are implemented

29. Relation to personal taxation of shareholder income • ACE corporation tax fits well with the kind of shareholder income tax with a rate of return allowance proposed by GHS • This extends the ACE approach to personal taxation as well, taxing dividends and capital gains with an allowance for the normal return on capital invested • Equivalent in present value terms to the personal expenditure tax treatment proposed by Meade • Suitable rate alignment between tax rates on corporate income, shareholder income and labour income can deal with most of the problems highlighted in the Crawford-Freedman special study on small business taxation

30. Relation to personal taxation of shareholder income • I suspect we may differ from the GHS proposal in preferring a progressive rate structure for the shareholder income tax, rather than the flat rate proposed by GHS (a variant on the Scandinavian dual income tax approach) • with progressive tax rates on labour income, progressive rates are also required on shareholder income to avoid differential tax treatments of incorporated and unincorporated firms for some taxpayers • a lower progressive rate structure on shareholder income than on labour income reflects the corporate tax already paid, so that overall tax charges are equalised

31. Relation to personal taxation of shareholder income • Part of a pragmatic approach to taxing personal savings in ways that share the main benefits of the personal expenditure tax, while emphasising administrative feasibility, and retaining existing tax treatments where these are appropriate • for example, exempting interest income from taxation where economic rents are unlikely to be significant; retaining existing expenditure tax treatment of pension savings; ... • The spirit of Meade lives on, perhaps tempered by greater pragmatism after thirty years of experience

32. The Mirrlees ReviewReforming the Tax System for the 21st Century see http://www.ifs.org.uk/mirrleesreview/ Institute for Fiscal Studies