Political campaigns are not generally known as ideal laboratories for devising sensible, innovative policies. Yet Hillary Clinton’s proposals to combat corporate inversions — in which U.S. companies move their tax homes abroad — are just that. They would largely eliminate the tax incentives to invert.
A U.S. company currently has many such incentives. It can lower its taxes by creating a home base in a low-tax country, even if it leaves its headquarters and other operations in the U.S., and even if the U.S. operations represent as much as 79.9 percent of the new combined company (though the rules are stricter if the share is 60 percent to 80 percent). In many cases, the re-domiciled company can avoid tax on profits that it accumulated tax-free abroad while it was still a U.S. company. And it can further reduce its U.S. taxes through “earnings stripping,” in which the U.S. company loads up on debt owed to the parent; the payments on such debts are deductible in the U.S., even as the corresponding income is received in the low-tax country.
In the past two years, the Treasury Department has imposed tighter restrictions on inversions when the U.S. company represents 60 percent to 80 percent of the combined entity. It’s now harder, for example, for these companies to access foreign earnings without triggering tax in the U.S. But corporations are getting around this by devising transactions that barely avoid the 60 percent threshold. It’s clear that more has to be done, and while further administrative action is possible, the most substantial changes will require legislation.
The question is, what kind of legislation. Many people emphasize the need for comprehensive tax reform. Yes, the U.S. corporate tax code is a complex mess. Yes, it would be good to clean it up, and, yes, this might discourage inversions — though not as much as you might think, especially if the tax reform were designed to be revenue neutral. After all, the point of inverting is to reduce a company’s overall effective tax rate, regardless of whether its initial rate is high or low. A revenue-neutral change to the corporate tax system, by definition, would reduce some companies’ effective tax rates only if those of other companies went up.
Similarly, some strategies for reform would raise the tax rate on American companies’ foreign income, while others would reduce it. The net effect on the overall incentive to invert is thus not clear.
Also note that a so-called territorial tax system, in which the tax on foreign profits is eliminated, might reduce the incentive to invert, but at the same time it would increase incentives to play other games to shift foreign profits on paper. For example, it would encourage companies to abuse transfer pricing, in which profits are shifted abroad by manipulating the prices that a U.S. company pays its foreign subsidiaries.
The one strategy for comprehensive corporate tax reform that would minimize the incentives for game-playing is something called formulary apportionment, in which X percent of a company’s global profits are taxed in the U.S. if X percent of the company’s sales or employment are here, regardless of where the firm is domiciled for tax purposes.
Gabriel Zucman explains the rationale for this in his new book, “The Hidden Wealth of Nations: The Scourge of Tax Havens“: Sales and employment are the hardest things for a company to manipulate in trying to reduce its tax bill. While this may be the most effective comprehensive reform to combat inversions and other tax games, however, it’s not the one that most advocates have in mind when they argue for reform. It would also probably require re-negotiating most if not all of the tax treaties the U.S. has with other countries.
So, comprehensive reform is more complicated than it initially sounds. And, more important, in today’s stultified and polarized political world, waiting for comprehensive corporate tax reform simply guarantees that inversions continue. That brings us to Clinton’s proposals, which are more targeted.
Clinton would do three things. She would drop the 80 percent threshold to 50 percent. That means that U.S. companies wanting to invert would have to find a foreign partner that’s at least as large as the U.S. company. She would also impose an “exit tax” on profits that the U.S. company had accumulated tax-free abroad — so that it would be taxed just as money that accumulates tax-free within retirement-savings accounts is taxed upon withdrawal. And she would make it harder to strip earnings, even if that means acting without Congress via executive authority.
Taken together, those three targeted steps would effectively eliminate the tax incentives for inverting. And they could be done without major legislation. Indeed, they would combat inversions more effectively than many if not most comprehensive reforms would. So we have a choice: We could spend the next several years debating big reforms while inversions continue — or we could adopt Clinton’s proposals now.