Why a U.S. Tax System Overhaul Would Be ‘a Massive Undertaking’

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Wharton's Jennifer Blouin discusses the potential impacts of U.S. tax reform.

With a new administration in Washington, D.C., tax reform is a topic of conversation this year. The White House would like to get something in place for 2018. But many questions surround the complex issue, both on the personal and the corporate tax side. Wharton accounting professor Jennifer Blouin recently gave a presentation on the issue to congressional staffers as part of an effort by the Penn Wharton Public Policy Initiative. Blouin joined the Knowledge@Wharton show on SiriusXM’s channel 111 to discuss the potential impacts of changes to business and personal income taxes.

An edited transcript of the conversation follows.

Knowledge@Wharton: The tax plan proposal from President Trump would drop the number of personal income tax brackets from seven to three. What would the impacts of that be?

Jennifer Blouin: Ultimately, the issue is that the bulk of our tax revenue comes from the individual base. There are about 150 million individual returns, relative to 10 million corporate returns. The problem is we want to have some sort of sweeping reform, but how do we pay for it? Ultimately, it’s going to have to be some give and take with regard to the individual items.

The White House proposal is really more about simplification. Bringing it down from seven rates to three, saying let’s just give one big standard deduction and take away the deductibility of the state and local taxes, get rid of AMT (alternative minimum tax), and of course my personal favorite, get rid of the death tax. Wrap all those together and it sounds pretty feasible. But the big item with regard to individual taxation is this treatment of pass-through income [when the income of an entity is treated like income of its investors or owners. Trump’s tax plan proposes to cut the rate for these taxpayers to 15%, the same as his proposed maximum cut for corporations.] Does it seem equitable that we should give some sort of rate reduction to business income that is from a corporation, like a publicly traded corporation, relative to the moms and pops who are running a shop or business and have a meaningful number of employees, yet they should be subject to the high 35% tax rate, which is even a proposed reduction from 40%. I think you get an equity or fairness discussion.

The current proposal says, “No, that [pass through] income should be subject to a lower tax rate.” That’s great. But then where do you define business income versus labor income or salary income? Is it fair that because I do my teaching through a university, I will be subject to a 35% tax rate, but if I set up as my own mom-and-pop shop and contract with the university, I would get a 15% rate? It also has self-employment implications in terms of Social Security and FICA. If you’re self-employed, everybody has a responsibility to pay their appropriate payroll taxes. So can you have 15% business income without it being self-employed? There’s a lot of dynamics in play. We just have the bare bones of an outline of what might happen.

Knowledge@Wharton: How much of a structural change are we talking about with the tax system under this simplification plan?

Blouin: This would be a massive undertaking. Every time you say simplification, I think all we do is multiply the number of code and regulation pages that we’ll ultimately have to wade through. It’s easy to say we’re going to make something simple. If we just say flatly, which is what this proposal does, that it’s a 15% [rate] for everybody that has business income, then somebody has to score it and say, “Do you recognize that bringing us down to 15%, each percent costs [the federal government] an enormous sum of money? Multiply that over a number of years and you’ve got some sort of significant fiscal deficit.”

“Once we start talking about reducing the tax rate to 15% percent on all business income, then we have to start thinking about some back stops or some additional limitations that we have to have.”

Knowledge@Wharton: A lot of people don’t realize that a lot of corporations aren’t paying 35%. They’re paying lower than that number already. So, this narrative about every business paying 35%, it’s not the case.

Blouin: This is a conversation about what is your average tax rate versus your marginal tax rate. If you and I were to look at our personal returns, we might look like we’re falling into what would be a 28% statutory tax rate. But if you take our total taxes paid over all our income, including our dividends and everything else, that tax rate is going to be lower just merely because we know we have a preference for what we call investment income in the United States.

I’m going to talk now specifically about corporations relative to the mom-and-pops and the pass-through business income. Corporations get things like depreciation. Bonus depreciation is something we have right now. If you buy a $1 million machine, you get to deduct it immediately. That makes the cost of buying that machine a little bit cheaper because now you get a 35% shield on that income, and that’s good news. But what it means then is when I look at their average tax rate this year on the income, it’s something less than 35%. The argument that’s been made is the corporations really aren’t paying 35%.

So, they’ve bought their $1 million machine and they make $5 million or $10 million more. Recognize that their average tax rate is going to rise because every time they make an additional dollar, they’re not going to buy an additional dollar of machine. At the margin, I would make the argument that they are paying 35%. Ultimately, I think the decision-making comes in at the margin. Will I do this activity and how expensive it is to me? That’s the rate that I think is relevant that we don’t see in a lot of the data because it’s always looking at some aggregate burden over a notion of income.

Knowledge@Wharton: There is an element to this tax reform that plays into whatever the rates may end up being. The possible growth on the back end ends up bumping up the tax rate. That’s a discussion happening on both the personal and the corporate side. A lot of people on the personal side believe if you’re lowering the tax rate, people are going to spend more money and have the potential to get a better job and make more money, and that bumps up the tax rate. It’s the same thing for corporate.

Blouin: That’s right. Right now, if you’re collecting something less than 35% on $1 billion, but if I can grow that to $30 billion and collect 15%, I’m still better off. That’s ultimately the notion of this proposed legislation. The proposed change in the system would say growth will help us pay for it, and I think there is some evidence to that. We can look back to some of the capital gains tax rates cuts and dividend tax rates cuts that have happened over history. What you see is there’s two elements to reducing the rate, particularly on this type of income. One is, I’m more likely to report it if I feel like the tax rate is going to be acceptable to me, a lower rate. And the second is, I’ve always been reporting it but maybe I’ll trade more. Maybe I will buy more, I will do more activity because this burden seems more appropriate.

I think that’s where we’re in the discussion now, particularly with regard to corporations. We want corporations to be doing business in the United States. I think if you talk to most of our public companies, they would say, “We like being in the United States. We like the fact that we’ve got good court systems, good infrastructure, skilled labor. But can we really justify being here at 35% when I can be in the United Kingdom, which is a five-hour plane ride away and they speak English and they have a 19% tax rate, soon to be 17%?” I think this is, hopefully, the dialogue that needs to be had.

Knowledge@Wharton: Can the corporate tax rate really survive at 15%? Does it need to be 15%, 20%, somewhere in the middle?

Blouin: How are you going to pay for it? The argument is, right now if we reduce to 15%, we’ll grow enough to pay for it. I am not qualified to say, “Yeah, I think we will.” I would cross my fingers and hope that it would. But I think that’s why there are those existing, cryptic arguments about how we’ll eliminate certain tax breaks for special interests. That’s always the, “We’ll grow and we’ll close other loopholes to help us pay for that.” That said, if you’re just looking at reducing the tax rate on corporations, I think that’s viable. Once we start talking about reducing the tax rate to 15% percent on all business income, then we have to start thinking about some back stops or some additional limitations that we have to have.

Knowledge@Wharton: On the corporate side, one of the big topics is this potential repatriation of more than $3 trillion in corporate money that’s being held overseas and whether there will be a one-time 10% tax on this repatriation of funds. A lot of people believe bringing that money into the country is so important for the economy right now.

Blouin: I absolutely agree. I think it’s imperative to reduce or eliminate this fraction within a multinational corporation. I always like to point out that if you have a multinational corporation that was born here, the U.S. asserts its right to tax you in perpetuity, regardless of where you do business. So, if you have a U.S. multinational corporation that is headquartered here but has a Swiss affiliate, that Swiss affiliate can put its cash in the Bank of New York. The Bank of New York can lend out that cash. But the U.S. parent of that Swiss affiliate cannot access that cash. That in itself sounds a little distortionary. By changing our system, whether it be through some sort of one-time transition tax and then we move onto a [new] system, these U.S. companies will now have the ability to remit or repatriate this accumulation of roughly $3 trillion of earnings back into the United States.

We’ve all read what I call the corner cases — Apple, which is basically a small bank. I mean, come on. I don’t even know what their cash holdings are. They exceed the GDP of many small countries. What you have is a situation where roughly $220 billion could ultimately be [brought] back into the United States. Now they’re not going to hire that many people, but at the margin they’re going to do something. What I think they’ll do is they’ll ultimately send that cash back out to their investors, who then can redeploy and invest in entrepreneurial endeavors, buy other corporations and get that reinvestment back domestically.

“What you have is a situation where roughly $220 billion could ultimately be [brought] back into the United States.”

Knowledge@Wharton: Will most companies that are in that situation bring all of that cash in? Or will they bring a portion of it and still leave some of it offshore?

Blouin: [Firms have] got the cash, and then they have the earnings. There’s roughly $3 trillion worth of earnings. The cash number, I think, is a fraction of that. Because if you have a multinational that is overseas because that’s where its customers are, it could be profitable in selling consumer goods in France and the U.K. and Germany, then it will probably reinvest those fortune earnings into what I call brick and mortar there — new plants, new distribution, new trucks, new people. That money isn’t going to immediately come back to the United States because it’s profitable over there. But at the margin there will be that which is locked into probably cash or marketable securities, which will almost certainly be remitted back to the United States. So, it’s some fraction.

Knowledge@Wharton: But from what I was reading, the amount of permanently reinvested earnings has skyrocketed in the last decade.

Blouin: There are a couple of reasons why. One is because of the U.S. system. I think there was a little bit of unintended consequence because we had a nice, true tax holiday in 2004 where we told our multinational companies, “Oh, we recognize that this money is over there and we will give you a one-time only holiday to allow you to bring all that cash back at 5.25% versus 35%.” So what did they do? They brought back roughly $450 billion in that years’ time. That was great, but what it did is it led firms to say, “Hey, I got it once, I’ll get it again.” Makes it infinitely more probable. You’ve seen this logarithmic build up in their accumulated foreign earnings since then. The other reason is because they’ve grown a lot in the United States, but your expansion is overseas. I think that that’s also contributed to that buildup.

Knowledge@Wharton: Why is it important to build a tax structure where you don’t have to worry about this problem of earnings and cash being overseas as much as we have seen?

Blouin: What we’ve started to see is this distortionary behavior with the fact that, for example, my Swiss affiliate in the Bank of New York can lend, but the U.S. parent can’t borrow. But we’ve also started to see this big inversion discussion, and that is completely an artifact of our crazy system. A U.S. multinational essentially figures out that if they had not been born in the United States, they would pay less tax. So, there’s a lot of effort now and essentially size-matching a U.S. multinational with a multinational that’s outside of the U.S., preferably in a low tax jurisdiction. You do a business combination of some sort, which is completely valuable to shareholders, and as long as they meet a certain ownership requirement you’ve removed a lot of this potential income from U.S. taxation.

Knowledge@Wharton: You were talking about the fact that this may make it easier for foreign companies to buy U.S. multinationals because of the tax system.

“We have a system that incentivizes the flight of U.S. ownership.”

Blouin: Exactly. We have this notion of inversion. And because they are politically unappealing, unpatriotic is how they’ve been labeled, what the U.S. Congress has done over time is try to limit this behavior. There is some abuse there, don’t get me wrong. They’ve said there’s this arbitrary notion where if the U.S. shareholders own too much of the combined entity, then there will be limits placed on the ability of this organization to access its foreign earnings. However, if a large enough foreign buyer comes along, they can buy a U.S. multinational and be able to access all of its foreign permanently reinvested earnings, its accumulated cash, without triggering any punitive issues in the U.S. tax law. Now what you have is a U.S. multinational and two buyers — one domestic, one foreign. The foreign buyer is going to be able to outbid the U.S. buyer. We have a system that incentivizes the flight of U.S. ownership.

Knowledge@Wharton: Does Washington understand this problem?

Blouin: I think there’s starting to be some awareness of this issue. And I think it’s a very difficult issue to broach because it’s back to this notion of fairness. They’re in this situation and have these accumulated earnings because they should have been paying U.S. tax to begin with. That’s the way our systems work. But can we back away and say, is that appropriate that the U.S. gets the right to tax every dollar of income that’s made outside of its borders? I’m a person. I have a U.S. citizenship. I get the benefits of being here day in, day out. I should absolutely be taxed here. But if I am a multinational company and I have business in the United States and they do pay tax on the business in the United States, but I have a significant part of my business offshore and I pay tax in those jurisdictions off shore, do I really have to pay the other 35%? I think it’s hard to convince people that that’s the right way to think about this.

Knowledge@Wharton: There’s also this issue of a territorial tax system for companies that are in countries that have such a system.

Blouin: That’s pretty much what everybody else does. That’s why the United Kingdom is a nice comparison. They left their worldwide system that we have currently in the United States right now in 2009. Since then, that’s where you’ve started to see this inversion wave, as I will call it, these U.S. multinationals essentially inverting to the United Kingdom, to Ireland and those jurisdictions because they’re territorial now with a low tax rate.

Knowledge@Wharton: You’re also involved in this new series of seminars by the Penn Wharton Public Policy Initiative for policymakers in Washington to really educate them more. Tell us more about it?

Blouin: This is a fantastic program that the Public Policy Initiative has put together. They just invited me down, invited a group of both House and Senate joint committee tax staff, essentially to hear a discussion about the U.S. multinational system, how does it work, what are the distortions. You never know what you’re going to get with the crowd given what’s going on with tax reform. What I found is to be able to be down there for about 90 minutes, we were able to have [an] engaged dialogue and a very balanced perspective by everybody in the room. That gives me confidence that we’re going to progress towards some sort of bill or meaningful legislation in that there’s awareness about the distortionary effects of the U.S. system.

There’s no bright line answers, but hopefully I’ve done my bit. Other faculty are going down and speaking on a number of other policy issues without any sort of strong political bent one way or the other. We just want to lay out the issues so that we can understand the pluses and minuses, because there will be winners and losers in every change in policy.

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