This week’s uproar over Apple’s tax strategies merely highlighted something that everyone in the tax world already knows. The U.S. corporate tax system is needlessly complex, dysfunctional and needs to be fixed. Could there be an elegant solution right under our noses?
Apple’s Tim Cook and many others have proposed lowering the top U.S. corporate rate, which currently stands at 35 percent. Doing that alone, though, misses a root problem in the current system: the incentive for companies to shift profits toward low-tax countries.
Apple’s adventures in Ireland are just a hint of how much big firms have flocked to countries with low tax rates. A Congressional Research report found that in 2008 U.S. multinationals reported 43 percent of their overseas profits in Bermuda, Ireland, Luxembourg, the Netherlands and Switzerland — places known more for having low tax rates than being the world’s biggest hubs of commercial activity. As a result, countries like the United States are seeing a fraction of the money they’re owed based on the 35 percent rate.
Multinationals, meanwhile, are encouraging governments around the world to lower their tax rates even more, with little or no ways to stop firms from continuing to shift income to tax havens. The risk, tax experts warn, is a global “race to the bottom” with countries increasingly undercutting each other on rates. British Prime Minister David Cameron has recently called for a global standard.
“It’s exactly like a trade war,” said Edward Kleinbard, a professor at the University of Southern California’s Gould School of Law. “We’ve never had any progress in multilateral tax agreements. But that’s really what we need right now. ... We need a cease-fire.”
Could the solution be found in a strategy adopted by California and a handful of other U.S. states? Some tax experts think so.
U.S. states, if you think about it, face a very similar situation as countries around the world. Domestic companies sell across state borders, have employees scattered around the country and do business in different states, each with their own unique tax laws.
So a number of states have come up with a simple way to calculate what firms owe them in taxes: If a company sells its product or services in a given state, it pays a tax proportionate to the sales in that state.
Here’s how it would work. Let’s say a company earns 20 percent of its sales in California. The company would pay 20 percent of its worldwide sales to California at the state’s corporate tax rate. No need to worry about where the firm has offices or where its employees work — and no chance of the firms shifting their income to other states using elaborate, hard-to-trace methods.
Just last year, the state of California passed just such a law moving to a sales-based corporate tax system. Bill Parks, a retired finance professor, recently wrote an op-ed in USA Today proposing that the entire country move to a similar approach.
“Adopting California’s sales-based corporate tax system would simplify the tax code and level the playing field,” he wrote. “Under sales-based apportionment, it is conceivable that a medium-size corporation could file its report on a single sheet of paper attached to its annual Form 10-K filed with the SEC without needing the help of a tax attorney.”
In 2007, Kim Clausing, a professor of economics at Reed College, and Reuven Avi-Yonah, a professor at the University of Michigan Law School, produced a paper proposing the U.S. corporate tax system adopt the states’ model.
Such a solution, they wrote, would reflect the globalized way that companies actually do business now. Rather than figure out the location of a company’s production — which can get complicated when an iPhone is designed in Cupertino and manufactured in China — the taxes would be based on where customers are located.
“Absent tax incentives to shift income away from the United States, U.S. corporate tax revenues would likely increase significantly,” they wrote. And, Clausing and Avi-Yonah wrote, the tax rate could be cut “substantially.”
The United States, with its army of consumers, would certainly stand to gain.
Clausing and Avi-Yonah estimated that in 2004, the fraction of worldwide sales in this country was 68.2 percent. By comparison, the fraction of worldwide income, as it’s calculated now, was just 56 percent. With a sales-based tax system, they calculated that new tax revenues for that year would have been as high as $53 billion.
The United States could move to this system unilaterally, though if the U.S. did and no one followed, there’s a risk that companies would be taxed twice. More ideally, they wrote, countries would adopt it together.
A worldwide sales-based system is one way to potentially end the escalating tax trade war. Of course, companies like Apple would face much higher tax bills in the United States and other places where they appeal to consumers. But then they would also save money on their accountants.