Published in Pacific Standard
Over the last several weeks, Republicans in the House and Senate have released their proposed tax reform legislation. Much of the media coverage of the corporate measures in the tax reform legislation to date has focused on both plans’ proposed dramatic cuts to the corporate tax rate.
Both the House and Senate versions, however, also make a number of significant changes to the business tax code beyond just lowering the corporate rate. To find out more about the nuances of the GOP’s proposed changes to business taxes, Pacific Standard spoke to Gary Hufbauer, the Reginald Jones Senior Fellow at the Peterson Institute for International Economics, who’s in favor of many of the GOP’s proposed changes.
You believe that there’s a pretty strong case to be made for the need to pass corporate tax reform?
Yes, absolutely. The U.S., I feel, is way out of line with other countries, and that’s damaging in many different ways. This [legislation] is a much-needed and long-awaited change on the corporate side.
Obviously, the big headline change in both the Senate and House bills is the reduction in the corporate tax rate to 20 percent. But I actually want to talk about some of the more complicated changes. First, can you tell me how the bills deal with the repatriation of past corporate earnings being held offshore?
Both bills want to extract some tax revenue from past earnings of U.S. companies which were never repatriated to the United States. The latest version of the House bill, which includes the chairman’s amendment added last week, puts a 14 percent rate on any of these past earnings in cash or the equivalent, and a 7 percent on anything that was reinvested. And the Senate bill is somewhat similar, but with slightly different rates. It’s a big piece of cash, payable over eight years—so over eight years, it’s going to generate like $350 billion, a big amount of money.
Both the House and Senate bills transition the country to a territorial tax system for international income, although they do it a bit differently. Can you explain to me, in laymen’s terms, what this means?
Let me back up a little bit from your question because they also both try to get at what you could call mobile intellectual property income—income derived from trademarks, patents or copyrights that are used abroad, or where the actual intellectual property right is transferred to a foreign subsidiary.
Here, there are differences. The House bill has this concept of “high return”—defined as anything in excess of 7 percent plus the federal funds rate. And half of that will be included in the parent firm’s domestic income, so that means an effective rate of 10 percent on the high return income. That’s the House version. The Senate version targets intellectual property income: whether the property is owned in the U.S. or owned by a foreign subsidiary, any income generated is taxed by the U.S., whether it’s generated abroad or generated at home.
Then, on the territorial side of thing, apart from these high returns or intellectual property income, for future earnings which are paid back to the corporation by way of a dividend from the foreign subsidiary, that dividend is not subject to U.S. tax. It’s exempted from U.S. tax. That’s the core of the territorial system going forward in time. And that’s mostly the same in both bills.
Why do you (and others) think a territorial tax system is a good idea?
There are three big things we’re doing with this. The first thing is that it’s basically what all other countries do. There are some countries that, like the U.S., practice a worldwide system, but those countries tend to have much lower tax rates than our current 35 percent tax rate. If this change were enacted, U.S. firms which have subsidiaries abroad—those subsidiaries would be taxed just like the foreign subsidiaries of French multinationals or British multinationals or Dutch multinationals or Japanese multinationals. That’s the classic level playing field that seems desirable so that U.S. firms aren’t more heavily burdened by the tax system, which they are now, than French or British subsidiary firms.
The second big plus is that, with this system, when foreign subsidiary firms remit funds to the U.S., they are not hit with an extra tax burden of any size. They pay dividends, and there it is … no tax on that. What that would mean is that if it’s more attractive to put money down the line in some U.S. venture—whether it be buying a U.S. company, or building a U.S. plant, or buying back shares or whatever—they won’t be deterred by the U.S. tax burden, which is exactly the same as what happens for a British company or a Dutch company. You’re not deterred by paying home country taxes from bringing money back. As it stands now, that home country tax is a pretty big deterrence, and that’s why there’s currently $2.6 trillion of estimated unrepatriated foreign earnings of U.S. multinationals.
The third big thing is that this will take away nearly all of the incentive for any U.S. firm to invert. The big payoff from inversion was that if you put your headquarters in the U.K. instead of the U.S., then the subsidiary firms of that headquarters firm are no longer taxed by the U.K. That’s why a lot of firms have inverted … this removes the incentive for that because if you have a multinational parent based in the U.S., you are not more heavily taxed than if the parent were based in the U.K. or France.
Both the House and Senate versions also propose some changes to how companies are permitted to expense capital investments and allows companies to immediately expensing of capital investments, for the next five years.
Those of U.S. in the tax weeds have been writing about this for decades. Expensing makes a lot of sense because it takes the tax burden away from doing new capital investment. And we all tend to believe that capital investment, particularly in new equipment, the econometrics are quite strong that new equipment does boost labor productivity. And that’s what we want. And the firm which puts in the equipment, it gets a payoff obviously, but a good part of the payoff cascades to the workers, and they’re more productive. You get increases in wages, the firms are less resistant to raising their wages, whatever.
So yes, I’m very much enamored of this part and I’m just as happy they’re not extending it to structures, because there the argument is econometrically much weaker that investing in structures raising productivity.
The other big change on the business side concerns how pass-through income is taxed, but here the House and Senate bills look different. Can you explain to me the difference in how the House and Senate bills are looking at this?
As I understand it, the House bill has a 25 percent rate on pass-through income. But they’re trying to ring-fence it so that doctors, lawyers, and accountants don’t create any pass-through firms just to have that income be taxed at the 25 percent, whereas their personal rate under the new legislation might be 35 percent, or whatever. This ring fencing is very complicated. How do you distinguish/where do you draw the line?
The Senate version, instead of putting a limitation on what kinds of businesses can get the break, reduces the rate that the pass-through beneficiary pays on his or her personal tax return. Instead of having a 25 percent flat rate and then have ring fence around it, they take some points off the normal rate that pass-through beneficiaries pay.
This is a pretty big part of the legislation. It’s a huge thing politically, because these pass-throughs have a lot of people who are engaged in these. And, in terms of economic activity, a rough calculation is about half of U.S. economic activity in the private sector is conducted by pass-through firms. It’s big both politically and economically.
Do you have any opinions on whether the House or Senate approach is better in terms of reducing the possibility of abuse?
I understand the political draw of this change: You’re probably not going to get the bill through unless you have it [because of the power of the small business lobby]. But my view is that there’s no real reason to prefer these pass-throughs as opposed to businesses doing business in corporate form. I mean, the reason we created all these pass-throughs was because the corporate rate was so high. Instead of actually reducing the corporate rate, which would have made a lot of sense, over the years, what Congress did was waive the small business flag and create a green field for all these pass-throughs.
Back in 1980, they were about a quarter or 30 percent of business activity. Now they’re 50 percent of business activity. Based on this reasoning that we got into this business because of the high corporate rate to begin with, for my taste it’s better to have the slightly higher rate on pass-throughs in the Senate bill than the House bill, because it’s closer to what the corporates pay. I’m not favorably inclined to have one business form get lower taxes than the other business.
This interview has been edited for length and clarity.