Corporate tax reform may prove harder than Republicans expect
Legislating can be so much more challenging than it seems during an election campaign. That's becoming increasingly clear about Republican promises to repeal and replace Obamacare. And it's about to become clearer on corporate tax reform.
Tax reform is a relatively easy concept: Most people favor lowering the tax rate and closing loopholes. The difficulty is in the details.
Consider the proposal now before the House of Representatives. It includes a reduction in the corporate tax rate; a one-time lower tax on profits accumulated abroad; an end to the tax deductibility of interest expense, coupled with immediate expensing of investments; and a border-adjustment system that would impose the corporate tax on imports but not exports.
The plan has several potentially desirable attributes. It would, for example, effectively eliminate the incentive for companies to shift profits abroad. However, the plan as a whole also has little chance of being enacted into law. Here's why not.
The first two components of the House plan are popular and are likely to be enacted in some form: a cut in the corporate rate and a reduced one-time tax on profits accumulated abroad. The latter will likely take the form of “deemed repatriation,” in which the tax is imposed on foreign profits to date, regardless of whether they are repatriated to the U.S. Then any subsequent repatriations of those funds would be free of tax. Among the details that need to be worked out are the tax rate (probably 7-15 percent), whether the tax can be paid over time or must be paid all at once, and how to treat foreign taxes already paid. Such details are the bread and butter of legislative negotiations.
What's much harder is changing the current Tax Code with regard to interest payments and introducing a border adjustment. And as those details are examined, we are likely to see the plan shift away from broad, comprehensive tax reform to a much more targeted scheme.
Economists and tax scholars have long disparaged the tax deductibility of interest expense, because it leads companies to use debt rather than equity to finance their activities. If one were designing a new tax system from scratch, a decent argument could be made that debt and equity should be treated similarly. The problem is that lawmakers are not designing the system from scratch. The U.S. nonfinancial corporate sector has more than $8 trillion in debt outstanding, debt that was taken on under the assumption that the interest would be tax-deductible. Multiple business models are based in part on that provision. So removing the tax deductibility at this point would wreak varying degrees of havoc on indebted firms, real estate investment trusts, the private equity sector, and many other companies. Whether or not you think it worthwhile to wreak such havoc, legislation producing it would likely be challenging to enact.
The same principle applies to the border-adjustment system. Economists and tax scholars generally favor tax structures, like the border-adjustment one, that eliminate incentives for companies to use transfer pricing techniques to shift profits overseas. In the current system, for example, companies have an incentive to reduce U.S. profits by inflating the price paid to a foreign subsidiary, and this practice is very hard to police. Under the border-adjustment structure, the incentive would disappear, because the tax imposed on the import from the foreign subsidiary would offset any benefit.
Proponents of the border-adjustment system also argue that any burden the tax imposed on importers would be mostly or entirely offset by an appreciation of the exchange rate, which would reduce the pre-tax cost of the imports. But to many retailers who rely on imports, that offset seems quite theoretical, and they are already ramping up to fight the legislation. It's also unclear whether the border adjustment would comply with World Trade Organization rules. But domestic opposition is likely stop this proposal before it gets as far any international panel.
Vague predictions are of little use. So let me make a specific one: Deemed repatriation will be enacted this year, but at the end of 2017, interest on corporate debt will still be a deductible expense and the corporate income tax rate will not be imposed on imports.