By Michael Faulkender
2:05 PM EDT, May 23, 2013
The report of Apple avoiding corporate income taxes the past four years signals it's time to overhaul the U.S. corporate tax code.
Like many multinationals with strong intellectual property, Apple legally earns nearly all of its income offshore. The U.S. tax code requires payment of corporate income taxes on domestic operations, but foreign earnings are not taxed until they are returned to the U.S. parent company, an act called repatriation. According to Senate investigators, Apple has structured its foreign operations to avoid a foreign income tax liability as well. As a result, its foreign earnings would incur a significant repatriation tax, leading those earnings to essentially be "trapped" overseas.
Attempting to nevertheless return some of those earnings to investors without incurring the repatriation tax, Apple recently announced the largest corporate debt issuance in U.S. corporate history — an anticipated $100 billion over the next six years. Apple's domestic headquarters will use the bond proceeds to return money to shareholders while its foreign operations continue generating earnings that are reinvested into cash and marketable securities. These activities could continue indefinitely.
This latest transaction demonstrates the broken nature of the U.S. corporate tax code. The earnings are generated and the shareholders are compensated while the federal government earns zero tax revenue — all completely legal. Rather than attempting to publicly shame Apple via a Senate committee hearing, Congress should get to work reforming and simplifying the tax code to encourage multinationals to locate more of their operations in the United States.
The U.S. does not have a closed economy. Business and capital increasingly cross borders, demonstrating why recent reform ideas from both sides of the aisle fall short. The Republican-proposed territorial tax, for example — in which overseas profits of U.S. corporations would be lightly taxed or not taxed at all in the U.S. — would provide little incentive for incremental investment domestically. While capital could more easily flow from foreign operations back to the domestic parent, evidence from the 2004 repatriation holiday indicates that most firms with stockpiles of foreign cash already fully fund their domestic investment opportunities.
Alternatively, the Obama administration-endorsed "global minimum tax" is based on immediately taxing income in the foreign subsidiary on top of the host government tax at the time the foreign earnings are generated, rather than waiting for repatriation. This proposal significantly risks encouraging large firms to move their headquarters out of the United States. To remain globally competitive, firms might alter where they are incorporated, not just where they place some of their operations. This would reduce tax revenues, not raise them, and would drive up unemployment.
An effective approach must make our corporate tax rate more globally competitive rather than stand at the highest rate among nations in the Organization for Economic Cooperation and Development. At the same time, our current budget deficits require any changes in the income tax code be at least revenue neutral. My solution would involve roughly reversing the corporate income tax and personal income tax ratios, while at the same time treating dividends and capital gains the same as other personal income for taxing purposes.
Because individuals are relatively less likely to move abroad than corporate subsidiaries, this rate structure would create fewer distortions. By taxing corporations at 20 percent, the U.S. would have a rate below the 23.75 percent median rate among OECD nations. Likewise, taxing dividend and capital gain income for individuals at the same rates as normal income would eliminate some of the issues created by differential tax rates for the same taxpayer. It would become significantly more difficult to reduce the tax rate on other forms of income (such as carried interest), and would thus allow President Barack Obama to claim that Warren Buffett no longer pays a lower tax rate than his secretary. Since all equity investment income eventually is taxed at the corporate rate and again at the individual rate, this proposal is revenue neutral in a static sense. Longer term, it would raise revenue by creating incentives for incremental long-term domestic investment.
Why does such a common-sense proposal face such difficulty being enacted? Put aside the entrenched special interest scapegoat and instead direct blame at Congress. It is significantly more palatable for politicians to target and demonize a large corporation than its individual shareholders. It's easier to claim that Exxon Mobil or Altria is evil and deserving of higher tax rates than to raise taxes on the investors in those companies. Yet again, political leadership (or the lack thereof) on this issue gets in the way of sound economic policy.
My idea is not the only possible reform. It's time to forge a compromise that will lead to growth and investment, reverse the sluggishness of the current economy, and overcome the failure of the existing tax code to generate income tax revenue from companies like Apple.
Michael Faulkender is an associate professor and director of the master's program in finance in the University of Maryland's Robert H. Smith School of Business. His email is firstname.lastname@example.org.
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