Taxes

There's a Better Way to Reform the Corporate Tax

A Berkeley professor's plan could increase investment, improve efficiency, lower the trade deficit and help the poor.

Tax it where it's sold.

Photographer: Michael Short/Bloomberg

The Republican tax reform plan looks like it will contain few or none of the innovative, interesting ideas that were being thrown around a few months ago. That's too bad. But when the smoke clears from the current political battle, whichever side wins, hopefully there might be room for smart reforms to sneak in.

One of the smartest ideas comes from Alan Auerbach, an economist at the University of California, Berkeley. Auerbach's baby goes by the incredibly unwieldy, nerdy-sounding name of the Destination-Based Cash Flow Tax. It was part of the original Republican tax reform effort, but was axed fairly early on.

If the name is a mouthful, the substance is even trickier to grasp. In a new essay, Auerbach explains the essence of the policy, including its potential advantages and the difficulties with implementation.

The biggest change would be to stop taxing corporate profits -- as the U.S. and most countries now do -- and start taxing corporate cash flow instead. In the long run, these two should be roughly equal, so this wouldn't change the corporate tax base very much. But it would involve two other changes to the way companies get taxed, all of which could yield big benefits for the U.S.

First, a cash flow tax means that investments don't get expensed over time, as they depreciate, but immediately, when the investment is made. That allows companies to write off investments sooner, rather than later. Because accelerated depreciation is widely believed to give investment a boost, immediate expensing -- which is just an extreme form of accelerated depreciation -- would probably have an even bigger effect in terms of getting companies to make capital outlays. More investment means more jobs in the short run, and a higher national savings rate in the long run.

Second, Auerbach's tax would eliminate interest deductibility for most companies. Currently, tax law favors debt finance over equity finance, encouraging companies to borrow more. But leverage is inherently dangerous, so switching to a system that wouldn't encourage excessive borrowing would help make the economy more robust against future financial crashes.

The other big change involves how overseas business activity is taxed. It would be levied where sales are made, instead of where a company is officially headquartered. So if Apple, for example, decided to move its headquarters to the Virgin Islands, it would still be taxed just the same based on the iPhones and iPads it sold in the U.S.

That would, at least in theory, have a couple of beneficial effects. By itself, it probably wouldn't raise investment much -- companies would repatriate cash being held overseas, but they'd probably just return it to shareholders. However, ending the incentive for companies to shift profits overseas would result in increased collections, allowing the headline corporate tax rate to be safely reduced without affecting revenue.

Also, a substantial amount of the U.S. trade deficit probably comes from companies' efforts to shift their profits to overseas subsidiaries -- if Auerbach's plan became reality, the trade deficit would appear to shrink enormously, almost overnight. That would reduce political pressure for dangerous protectionist measures.

So Auerbach's plan is smart for a number of reasons. But there are some major issues with implementation. One big problem -- and possibly the reason that the idea was nixed earlier this year -- is that many people believe the plan violates World Trade Organization rules. The reason is that it works by taxing imports more than exports -- a feature commonly called the "border adjustment." That could be construed as an export subsidy, which the WTO forbids. Switching to a new system would not be worth the cost of withdrawing from the WTO and starting a global trade war.

But as Auerbach shows, there may be a way around the problem. His plan is really just the combination of two other policies -- a value-added tax on consumption and a wage subsidy. Neither is banned by the WTO -- most countries use VATs, in fact. So, instead of the DBCFT, the U.S. could simply replace the corporate tax with a VAT plus a wage subsidy whose rate is equal to that of the VAT. Voila!

One added benefit of this plan is that the wage subsidy could be tweaked to make it progressive -- if the subsidy is less for high-wage workers than for low-wage ones, it could be used to do some income redistribution. In fact, much of the subsidy could be accomplished simply by cutting payroll taxes. This sort of redistribution would be both easier and more efficient than most other methods currently in use.

So Auerbach's tax represents a challenging but ultimately very promising way to overhaul the creaky, outdated U.S. corporate tax system. It could offer the U.S. a chance to increase investment, improve efficiency, lower the trade deficit and redistribute some income from the rich to the poor, all at once. It's the kind of smart policy that doesn't get much attention as a political rallying cry, but that has the potential to do some real good for the economy. Hopefully, politicians will give it a second look after the current tax reform battle is over.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Noah Smith at nsmith150@bloomberg.net

    To contact the editor responsible for this story:
    Mark Whitehouse at mwhitehouse1@bloomberg.net

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