Ending Corporate Tax Loopholes

March 31st, 2014

Tax expenditures—government spending through the tax code, also called loopholes—have increased dramatically in the last twenty years. In some ways tax expenditures are good; for example, they can be used as incentives to encourage corporate and private behavior that provides a social benefit. On the other hand, these expenditures both lower government revenue and can skew the horizontal and vertical equity of our tax system. For example, corporate loopholes can result in dramatically different effective corporate rates for nearly identical companies.

These loopholes have dramatic effects on effective tax rates. While the United States has a statutory tax rate of 35% (the second highest among developed nations) corporations in this country pay an effective tax rate of just 12.6%. Senator Tom Coburn, a Republican from Oklahoma, has responded to these statistics with this: “An individual’s or corporation’s tax rate shouldn’t be dependent on their ability to hire a tax lobbyist. It’s especially wrong to ask families who are struggling to make ends meet to subsidize special breaks for corporations.”

One particularly egregious example of these loopholes is the corporate tax deferral on foreign earnings. Though the United States technically taxes all of its corporations’ earnings, the tax code allows corporations to defer tax payments on foreign earnings until they repatriate them to America. In practice, this means corporations can reduce their net tax burden by masquerading domestic income as foreign income. They accomplish this by engaging in abusive transfer pricing to shift profits overseas. As a result, companies like Microsoft and Apple hold $50 and $100 billion, respectively, in foreign cash and investments.

The significance of these expenditures is not only how much money they raise, but also the kind of behavior they incentivize. Deferral allows U.S. corporations to indefinitely defer payment of overseas earnings. This loophole creates two incentives: (1) for corporations to shift profits overseas to tax havens using transfer pricing, and (2) for those corporations to hold large deposits of untaxed cash sitting in bank accounts overseas.

Let’s start with incentives and behavior. As I noted previously, the deferral loophole has one major incentive: for U.S. multinationals to transfer and hold their revenues overseas. From an economic and policy perspective in the United States, this is a bad incentive. Even if these corporations were just holding the cash in the bank (which they’re not), we’d rather multinationals held their money at home than abroad.

Shifting profits abroad is an economic drag. Now, to be clear, ending corporate deferral is not going to encourage multinationals to suddenly bring home the billions in cash they hold overseas. But it does remove the incentive for them to engage in abusive transfer pricing. The other economic effect will result from raising corporate taxes, which may negatively affect corporate and shareholder profits. Some of these effects may trickle down to employees, which would have a negative effect on aggregate demand (that is, economic growth).

To fix this problem, the United States could end the credit that allows corporations to defer taxes on foreign earnings. The FACT Coalition has supported this proposal—in a memo on tax reform the Coalition asked Congress to end corporate tax deferral on foreign earnings and enact a tax system for U.S. corporations that is truly worldwide. This solution is also embodied in the Corporate Tax Fairness Act, which also includes a proposal to end deferral. According to the Congressional Budget Office (CBO),closing this loophole would generate an additional $114 billion in revenue for the U.S. government over the next ten years. The CBO also noted that this change would “boost efficiency.”

Ending this deferral would shape incentives in an important, and positive, way. It’s a goal on which we should remained focused.

Written by Ann Hollingshead

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