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Corporate Taxation Gets Nasty

Governments have been getting tougher on the use of corporate tax havens.

Britain recently reached a $200 million deal with Alphabet Inc. (GOOGL) – better known as Google – for back taxes. French Finance Minister Michel Sapin also said Google would pay “way more” to France.

Yet when you look at U.S. figures, the share of corporate income taxes paid in the U.S. has declined steadily and is now at little more than half the level from the 1950s.

In short, all the money is disappearing down rabbit holes.

Indeed, the trend in corporate tax payments is very clear – and startling.

Corporate tax payments averaged 46% of profits in the 1950s, according to the Bureau of Economic Analysis. But in the five years from 2010-14, the same payments averaged only 22% of profits.

In terms of GDP, which is more relevant – especially when looking at corporations’ contribution to government – corporate tax payments have declined from 5.1% of GDP to 2.7% over the same period.

The Problem With Tax Havens

Many economists will tell you that corporate taxes are paid by customers and suppliers, and should therefore be eliminated altogether. Needless to say, corporations pay most of those economists’ wages, either directly or indirectly.

Even if you eliminate the corporate tax, the money would have to come from somewhere, and the rich would find other ways of dodging the burden. In the end, it would end up increasing the tax burdens on the middle class.

Conversely, increasing the corporate tax burden back towards its 1950s level would help eliminate the U.S. federal budget deficit – a huge problem at current levels – as we shall find out, once the 2016 election is over.

Other countries are worried about the same trend, which is why France and Britain are going after Alphabet.

These days, corporations have many ways of hiding income in tax havens, notably by registering their intellectual property there. (How many great new inventions actually get made in the Cayman Islands?)

Thus, more and more corporate income is being lightly taxed – or not taxed at all.

International tax is still governed by the League of Nations Model Double Tax Treaty of 1928 – which has been adopted by most countries in a laudable attempt to harmonize world taxes.

However, as you can see from the figures above, the loopholes and scams, both domestic and international, have proliferated – and now the system doesn’t work.

The most likely solution is for the major world economies – probably the G20 – to devise a system that removes the profitability of tax havens, and then impose it on the world. This is the approach taken for individual tax evasion through tax haven bank accounts.

However, legitimate activity will also be quelled along with the tax scams, and we’ll probably end up with an international tax avoidance bureaucracy that’s both expensive and destructive of civil liberties.

A Unilateral Solution

The alternative approach that the U.S. could take would be a unilateral one. It should avoid eliminating all tax on foreign income – as lobbyists are suggesting – as that would make the problem worse.

Instead, the U.S. should go in the other direction and tax worldwide income, whether or not it’s remitted to the United States, with generous allowances under double tax treaties for foreign taxes already paid.

There would then be no advantage for Alphabet and Apple to hide their intellectual property in tax havens. The intellectual property income would simply be taxed wherever it’s located.

This should be accompanied by two other changes: a massive bonfire of domestic tax loopholes and a reduction of the tax rate from the current 35% to 30%, essentially making the corporate tax a flat tax of 30% on income.

That would presumably produce about 30% of corporate income as tax revenues, raising it to the 1996 level. This would have produced an additional $108 billion of tax revenues in 2014, a useful contribution to reducing the current $500 billion federal deficit.

France, Britain, and other countries could then undertake similar reforms, eliminating or at least greatly reducing the use of tax havens by corporations.

Finally, it would also allow the repatriation of the $2 trillion currently held offshore by U.S. companies, providing a boost to the domestic economy.

At the end of the day, corporations have spent billions on lawyers, accountants, and lobbyists to create and use loopholes to reduce their tax payments far below the payments seen in the 1950s. We need to return at least half way to 1950s levels to ensure that big business, as well as small business, pays its share of the state’s costs.

Good investing,

Martin Hutchinson