On Tuesday, Apple CEO Tim Cook testified in front of the Congressional Permanent Subcommittee on Investigations as a part of their look into the company's corporate tax practices — according to Sen. Carl Levin, the chairman of the committee, "Apple successfully sought the holy grail of tax avoidance. It has created offshore entities holding tens of billions of dollars while claiming to be tax resident nowhere." I asked Mihir A. Desai, a professor and dean at Harvard Business School, a professor at Harvard Law School, and the author of a 2012 HBR article on taxing businesses, a few questions about how this investigation fits into a larger debate about the corporate tax code. Our edited conversation is below.
How big of a deal is the investigation into Apple's tax practices?
These days, anything involving Apple is a big deal. But this particular investigation also touches upon a number of current issues. With a backdrop of economic anxiety and fiscal strain, claims that corporations are not paying their fair share can appeal to a wide audience. When those claims are made against what is likely the most admired corporation in the world, that makes for a powerful cocktail. And when the CEO of that company actually steps up to address those claims and offers a powerful defense, this really is a trifecta for a media sensation.
What is of more lasting significance is the possibility that this spectacle of the CEO of the world's most admired corporation being hauled up to Capital Hill will lead to a) significant reform of the tax system and b) corporate leaders becoming more vocal about policies and not remaining in the shadows at these junctures.
Cook testified that the company paid "all the taxes we owe — every single dollar." And yet legal scholar J. Richard Harvey, in earlier testimony, said that the company managed to avoid about $7.7 billion in taxes. Who is right?
My sense is that a consensus emerged from the hearings that Apple was not doing anything illegal. Claims of avoidance are tricky. When someone takes their mortgage interest deduction, they have avoided paying taxes. We don't quarrel with that and legitimate means of reducing taxes are quite acceptable.
Claims of tax evasion are much more significant as they cross the line, and it appears that a consensus emerged that this was not the case with Apple. From what I can surmise, the vast majority of the taxes paid by Apple are to the U.S. government on the income earned in the U.S. and those payments approximate a significant tax rate. At the same time, they are earning more and more profits overseas and they have ensured that they pay a very low rate, and possibly a zero rate, on that foreign income.
So the critical question is what is the appropriate policy stance to Apple paying a very low rate on foreign profits? That question hinges on three separable issues: a) should the U.S. tax the worldwide income of its corporations wherever that income is earned (a worldwide system) or should they restrict their taxing authority to income earned within their borders (a territorial system)? b) are the profits that are being reported as being foreign truly foreign or do they actually represent profits that should have been reported as U.S. profits? and c) If the mechanisms by which the foreign tax rate has been lowered involved depriving foreign governments of their tax revenues, should the U.S. care?
The first question is a design issue — the U.S. is now nearly alone in having a worldwide system and we do it in a particularly poor way as we only ask corporations to pay that tax when they repatriate those profits. Unsurprisingly, American corporations have kept more than a trillion dollars overseas in cash in order to avoid paying that repatriation tax. This is the worst of all worlds as we have a burdensome system on American corporations that distorts their allocation of capital and it raises very little revenue because of the way it is designed. For several reasons, it makes sense to switch to a territorial system, which most comparable countries have figured out. Most importantly, territorial systems ensure that corporations from around the world are competing on the basis of their underlying performance attributes rather than their tax attributes.
In addition, there is significant scope today for corporations to change their national identity via expatriations and corporate mergers, so if the U.S. is alone in using a worldwide system, our corporations have an incentive to leave. Finally, the typical logic for why taxing foreign income through a worldwide system is appropriate — that investment abroad represents lost investment at home — doesn't appear to have much empirical traction. So my sense is that if we understand the virtues of a territorial system, we don't necessarily really care what tax rate they face in foreign jurisdictions. And given that we permit deferral of tax until repatriation in the current worldwide system, we similarly don't necessarily care about that low rate paid by them on foreign profits.
The second and third questions raise enforcement and compliance issues — for the second question, things are clear. If corporations are stripping profits out of the U.S. in order to attribute them to low-tax jurisdictions, we should stop that and ensure that profits are not being reallocated away for the U.S. in inappropriate ways. Such activity undercuts the credibility of the tax system and violates many of our norms.
The third question is tricky. If firms are avoiding paying taxes to foreign jurisdictions by stripping profits from, for example, Germany to Ireland, should we care? I'm not sure why we would. I think those governments can watch out for themselves.
While the focus has been on Apple, how common is the type of overseas tax maneuvering? And how big of a problem is it, both for U.S. business and the lives of ordinary Americans?
I think the perverse incentives of the current system, and the behaviors they give rise to, are a significant problem for Americans. These incentives reflect two features.
First, the worldwide system with a repatriation tax alters the capital allocation process for our firms and locks capital out of the U.S. which hurts all of us. Second, the fact that the U.S. rate is now the highest rate amongst OECD countries means that investment in the U.S. is less attractive and that the incentives to engage in aggressive tax planning are high. Indeed, those tax planning incentives can then make it more attractive real activity abroad.
So, yes, it is a significant problem — not so much because some tax revenue may be lost because of what looks like maneuvering but because the entire system is enormously complex and gives rise to significant distortions to investment (away from the U.S.) and the allocation of corporate talent and efforts (away from productive uses and toward rent-seeking). And, nothing could be more important to our economy than the efficient allocation of financial, real and human capital.
Cook squarely placed the blame on a U.S. corporate tax code that "has not kept up with the digital age." What does he mean when he says "digital," and what would a digitally-appropriate tax code look like?
I think he likely meant three things. First, today's economy is characterized by incredible mobility. In an age of digitization, transport costs are trivial and activity can be relocated anywhere quickly. Consider the ratio of transport costs to product value for a steel bar, an automobile, a semiconductor chip and a piece of software. As digital goods become dominant, that ratio approaches zero and locational decisions are highly sensitive to various costs. In particular, tax rates and systems that are out of step with the rest of the world become increasingly problematic.
Second, the rise of intangible assets, like patents and widgets, means that transfer pricing issues become central, and so high tax rates become more untenable as they increase the incentives to be aggressive.
And finally, the importance of intangible assets means that we should be particularly focused on the incentives to undertake R&D in the U.S. Our regime of temporary and uncertain R&D tax benefits has been very disappointing and R&D incentives in a global world are more likely governed by the treatment of cost sharing arrangements than a temporary, expiring R&D tax credit. Countries have become very aggressive in trying to attract R&D activity through the use of patent boxes and otherwise and we are not in the same ballpark on these issues.
In general, what would an ideal corporate tax code look like that would make the U.S. more competitive and capture more revenue?
For starters, let me say that it's hard to be a fan of a corporate tax. It's a popular tax because of the misconception of who pays it. The usual political rhetoric of corporations paying their fair share is powerful but vacuous. The corporate tax is paid by either shareholders, workers, or consumers as all taxes are borne by people, not legal entities. And, in a world of highly mobile capital and products, the least mobile factor — labor — is the factor that will bear the corporate tax.
And it is hard to rationalize a tax borne by labor implemented through corporations for either distributional or efficiency reasons. So the irony is that people using the corporate tax to beat up on corporations and extract something from them are likely hurting the people who they think they're helping. Ultimately, we need to be thinking about consumption taxes much more seriously.
Given the nature of Washington today, though, we should probably be more modest and consider how to modify the corporate tax rather than abandon it. In my piece in the HBR last year, I argued that a meaningful reform would need to be revenue neutral and could be if a) we cut the rate substantially down to below 20%, b) we moved to a territorial system that exempted foreign income, c) we strengthened enforcement of transfer pricing, d) we raised revenue by placing a small tax on the exploding set of pass-through entities that business income is increasingly organized into, and e) ensured that taxes were levied on the profits that were reported to capital markets according to GAAP, rather than the distinctive reported profits to tax authorities.
I think I've explained a, b and c above, but d and e are really important as well.
A majority of business income is now organized through pass-through entities which means that capital is being diverted from our public corporations organized as C-Corps and toward business that shoehorn their way into pass-through entities. See, for example, the ongoing REIT-ization and MLP-ization of firms and parts of our economy. A small tax on passthrough entities would level the playing field and smaller tax rates on a broader base of business income are always a good thing.
FInally, the latitude afforded corporations in reporting profits distinctively to capital markets and tax authorities undercuts the credibility of the tax system and sows confusion and scope for opportunism for our managers. Both tax authorities and shareholders are interested in pretax profits and we should use our most advanced understanding of profitability for taxes and reporting to shareholders. This can raise revenue and, as I've argued with co-authors here, here, and here, be good for shareholders too.
Is this news about Apple a turning point, or are we likely to continue doing business with a corporate tax code that hasn't been updated since 1986?
Fortunately, I'm not a political prognosticator. But there are many positive signs. Legislators on both sides of the aisle have advanced meaningful reform ideas. Both Rep. Charlie Rangel and Rep. Dave Camp have floated interesting ideas as there is agreement that the current system is broken. And there is interest worldwide on these issues given the power of sensational show trials such as Apple's yesterday or Google and Starbucks in the UK.
I just hope we don't react to the sensationalism of these issues in an immoderate and wrong-headed way but rather in a way that addresses root causes. Then, again, one can never underestimate inertial tendencies in Washington today (see Columbia Law School fellow Andrew Stern's comments at a panel beginning at 40:30).