Are Corporate Taxes Headed the Way of Prohibition?

Argument 1: Corporations that shift their legal residence overseas to avoid U.S. corporate taxes are flouting the spirit of the law. “I don’t care if it’s legal — it’s wrong,” President Obama said last week in Los Angeles. “We need to stop companies from renouncing their citizenship just to get out of paying their fair share of taxes.”

Argument 2: The U.S. corporate tax code is an ill-begotten mess that is driving companies into all sorts of weird behavior. “Moving legal headquarters abroad through cross-border mergers is a logical way for a growing number of U.S. companies to counter the competitive disadvantages imposed on them by the current U.S. tax system,” the bipartisan economic duo of Douglas Holtz-Eakin and Laura D’Andrea Tyson wrote in The Hill last week.

There’s something to both of these arguments, right?

It would be a disaster if the current trickle of corporate “inversions” turns into a flood, something Allan Sloan warned may be imminent in his wonderfully ill-tempered Fortune cover story about the phenomenon a few weeks ago. It’s not just the loss of tax revenue — in fact, as you can see in the chart below, corporate tax revenue has been shrinking as a percentage of economic activity for decades. What seems most hazardous is that if inversions become commonplace, this country’s corporate leaders will have effectively absolved their organizations of the responsibilities of citizenship, which could eventually have all sorts of ramifications beyond how much money they hand over to the IRS.

At the same time, U.S. corporate tax laws have become unique globally in both their ambition and ineffectuality. The U.S. has the highest statutory corporate tax among the world’s developed countries, at 39.1% (that’s a 35% federal rate plus the average of state rates), and is also one of the few countries that requires its corporations (and its citizens) to pay tax on their overseas earnings. Yet the GAO found last year that profitable U.S. corporations face an effective tax rate of only about 17%. As for those overseas earnings, multinational companies where intellectual property plays a big role (most notably Google and Apple) are increasingly able to distill much of their profit into what legal scholar Ed Kleinbard calls “stateless income” that will never be taxed unless they try to bring it back into the U.S. And again, as you can see in the chart below, corporate tax revenue has been shrinking as a percentage of economic activity for decades even while rates have remained high.

The Profit/Tax Gap Chart

Going back to Argument 1 and Argument 2, you could portray this ineffectuality of the tax code as evidence of nothing other than corporate dastardliness. Or you could conclude that corporate taxes resemble Prohibition in the late 1920s: a set of laws that have lost their legitimacy, and can be flouted with little or no loss of social status.

Some economists have long questioned the legitimacy of corporate income taxes, because when corporate income is paid out as dividends or realized as capital gains, corporations and shareholders end up paying tax twice on the same income. Others argue that the burden of corporate income taxes ends up falling mostly on workers. In his classic early-1960s tract Capitalism and Freedom, Milton Friedman somewhat mischievously proposed that the corporate income tax be abolished and shareholders instead pay tax on all corporate income, whether it is paid out to them as dividends or not.

Also, much the rest of the world has for the past four decades been reducing corporate income tax rates and generally trying to design corporate tax systems that attract companies rather than drive them away. This includes lots of the high-tax, high-spending Western European countries that many proponents of Argument 1 tend to otherwise cite as examples of how to do economic policy right. For the U.S., the corporate tax code has almost certainly become a source of competitive disadvantage, and its outlier status makes it ever easier for corporate executives here to dismiss it as illegitimate.

Prohibition eventually lost so much legitimacy that it was repealed outright, although states continued to restrict alcohol sales to minors and more recently began to harshly punish drunk driving. A better fate for corporate taxes would be a more rational, internationally competitive U.S. tax code (HBS professor Mihir Desai described one reasonable approach in a 2012 HBR article), coupled with a more sensible rule on inversions.

Right now a U.S. corporation can shift its tax domicile overseas after a merger with a foreign company as long as its shareholders own less than 80% of the combined entity — or more than 25% of combined company’s employees, sales, and assets are in the foreign company’s country. The President’s FY 2015 budget and the “Stop Corporate Inversions Act of 2014” introduced earlier this year by Michigan’s bicameral Levin brothers would drop the shares percentage to 50%, which seems reasonable. The Levins’ bill would also ban inversions for any company that keeps its headquarters or more than 25% of its employees in the U.S. — which seems like it would perversely up the incentive for companies to move operations out of the country.

I’m willing to buy the argument, made recently by Sloan, that stopping the inversion wave is more pressing than reforming corporate taxes. But I don’t get the sense that passage of such legislation is imminent, and broader corporate tax reform certainly doesn’t seem to be on the way. Washington has so far remained as gridlocked on corporate taxes as ever. The issue isn’t (just) the usual partisan divide; there are substantial elements in both the Republican and Democratic parties in Washington that favor cutting corporate tax rates and rationalizing the corporate tax system — and the inversion debate crosses party lines as well. The biggest stumbling block is that, while corporate taxes may have lost legitimacy with CEOs and economics professors, they remain extremely popular with the electorate. Years of polling have shown that, if there’s one thing that Americans can agree on, it’s that corporations should pay more taxes. While there might be a way to sell voters on a corporate tax rate cut that’s accompanied by the elimination of lots of deductions and loopholes, any attempt to do the latter will be met with feverish lobbying by the affected corporations. And on inversions, which are kind of hard to understand, fear of lobbyists may outweigh fear of voters.

So this is an issue that, understandably, hardly anybody in elected office really wants to deal with. Yet it’s also an issue where continuing official inaction is likely to lead to a flood of corporate action that we’re all going to regret.

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