Taxing Corporate Income

1. Taxing Corporate Income Alan Auerbach University of California, Berkeley Michael P. Devereux Oxford University Centre for Business Taxation, and Institute for Fiscal Studies Helen Simpson Institute for Fiscal Studies

2. Tax on corporate income: outline • Brief summary of Meade’s recommendations • Developments since Meade in economies, theory and empirical evidence • Globalisation and tax competition • Relationship with personal taxes • Financial innovation • Alternative tax systems

3. 1. MEADE’S PROPOSALS:A Flow-of-Funds Tax • Aim to leave marginal investment tax-free; cost of capital and choice of finance unaffected by tax • Achieves this by allowing all expenses to be deducted from taxable profit when they are incurred; so no attempt to match accounting profit • Choice of three possible tax bases: R, R+F and S

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

5. 2. SUBSEQUENT DEVELOPMENTSA: Growth in Cross Border Flows of Capital and Profit

6. Impact of Taxes on Capital Flows • Direct flows depend on different decisions • discrete choice of where to locate • depends on effective average tax rate – not zero under a flow of funds tax • conditional on discrete choice, usual investment decision • depends on effective marginal tax rate • Considerable evidence of significant role of tax – but mainly for average rate

7. Profit Shifting • Another type of internationally-mobile flow • Conditional on the location of plants and capital, profit possibly more mobile than capital • Considerable empirical evidence • Generally depends on statutory tax rate • Also not zero under a flow of funds tax

8. Tax Competition • Between governments: • over statutory rate to attract profit • over effective average tax rate to attract firms • over effective marginal tax rate to attract capital • Empirical evidence especially for competition over statutory rates

11. Source county taxation • What is the source country? • “source” = “where profit generated”? • but where is it generated? – could be a number of necessary elements of profit generation • Provision of finance by shareholder • R&D, marketing, head office, etc, etc • Sales to final consumer • Global businesses make global profit • So where should profit be taxed?

12. Arm’s length pricing: an example Production process in country A requires use of 2 patents • Patent 1 generated by R&D lab in B • Patent 2 generated by R&D lab in C • What price should be paid for use of patents? • “arm’s length” price for each patent on its own is zero • “arm’s length” price for patent 1, conditional on having use of patent 2 = total economic rent • “arm’s length” price for patent 2, conditional on having use of patent 1 = total economic rent

13. 2. SUBSEQUENT DEVELOPMENTSB: Relationship Between Corporate and Personal Taxes Two issues: • Does a classical relationship for taxation of dividends imply lower investment? • Do differences between taxation of corporate and personal income distort choice of organisational form?

14. Why Might Effects on Investment be Small? • In a small open economy, shareholders are dispersed around the world • A higher tax on domestic investors will not affect the asset price (and hence not investment) if the wealth of domestic investors is small in world terms • “New view” • Dividend taxes are capitalised into share prices • For investment financed by retained earnings, dividend taxes are like an S-based tax, which is neutral

15. Differences in Legal Form • Choice to incorporate can depend on the relative overall tax treatment of corporate income v personal income • e.g., in US, strong growth of S-corporations, which have limited liability but are not liable to corporation tax

17. 2. SUBSEQUENT DEVELOPMENTSC: Financial Innovation • Substantial increase in the availability of new financial instruments, blurring the distinction between debt and equity • Growth in financial sector • Increasing difficulty of distinguishing real and financial flows

18. US Common Stock & Hybrid Equity Issuance, 2001 – 2005

20. 3. REFORMING THE CORPORATE TAX • 2 fundamental questions: • What to tax • Where to tax it • Consider alternative proposals in the context of these two questions

21. Alternative systems of capital income taxation

22. Source county taxation (1) • International norm • levied on return to equity in each country • Distorts: investment (location and scale), financial & incorporation decisions • Multinationals can shift profits elsewhere, using transfer prices and finance • Induces competition between countries

23. Source country alternatives (2):Consolidation and allocation CCCTB (Common Consolidated Corporate Tax Base) - proposed by European Commission • Like conventional corporation tax, but profit computed only once for whole of EU • EU profit then allocated to individual countries on the basis of a simple formula (eg. sales, labour costs in each country) • Avoids profit shifting within EU & may reduce distortions to investment location • But fundamentally, standard CT on a larger scale

24. Source country alternatives (3):tax full return to capital • Comprehensive Business Income Tax (CBIT) and Dual Income Tax; • Both equity and debt income taxed • although interest may be taxed at shareholder level (and non-residents may avoid this) • Can have low rate on capital income to keep distortions low • But creates other problems – eg. self-employed can choose form of income

25. Source country alternatives (4):tax only economic rent • Cash flow tax (as in Meade), or Allowance for Corporate Equity (ACE) • removes distortions to source of finance and scale of investment • But does not remove distortions to location of investment, nor profit shifting opportunities • in fact, may worsen them

26. Residence of Head Office Some countries (eg. UK) tax dividends received from affiliates (with credit for taxes already paid) Taxing worldwide income only at residence level would: • avoid distorting choice of location of production But • Could affect location of head office • Be very difficult to administer

27. Residence of Shareholders Individuals are less mobile – so less distortion to location But • Impossible to administer

28. Destination-based tax (1) Tax where consumers are located (relatively immobile) ? • Would avoid distortion to location of production • If based on sales to third parties, would avoid transfer pricing problems • Cash flow tax would avoid distortion to scale of investment and type of finance • But how & where would costs be allowed?

29. Destination-based tax (2) One possible route – like VAT • Value added = profit +labour income • Give full relief for all costs, including relief for labour costs (unlike VAT) • Exports tax-free, imports taxed Problems: • Rebate paid if domestic sales < costs • Financial services tax-free

30. Other issues • Small business • is corporation tax required as a backstop? • What dividing line should there be between “small” and “large” business • Financial sector • What should be taxed? • Is an R+F base a reasonable approximation

31. Conclusions Existing corporation taxes work in practice, but not in theory • Are they broken – should they be fixed? • Source-based taxation increasingly problematic • Residence-based taxation not feasible • Destination-based taxation should be seriously considered