Five Reasons Why You Should Worry About Tax Havens

I have a funny feeling that when someone like Michelle Malkin spends a couple of sentences mocking the administration's plan to change the rules for by which international business income is taxed (it is both a "knee-slapper" and a "snort-inducer"), it's because she doesn't understand it. Corporate tax havens are complicated. Really complicated!

But whatever you think of the corporate tax in general -- and in a tax fantasy world, we might want to scrap it in exchange for other things -- it's clear that the current system for taxing international business income is screwy and needs changing. Whether or not the president's plan is the right solution is something I will try to take up in a later post. But for now, here are five problems with the current system for taxing international corporate income:



1. The United States has a high statutory corporate tax rate, but a relatively low effective rate. This suggests that the corporate tax base is quite narrow, and the government is raising less revenue than it could be.

And, in large part, that's because of the ease with which American companies can protect income through the magic of tax alchemy. Here's a comparison of corporate rates across OECD countries (the graphs are from a good paper from Brookings):
But as a percentage of GDP, the US raises relatively little revenue:
2. The current system wasn't intended for a global economy, and it isn't very responsive to the realities of a global economy. Under current law, US firms must account for income and expenses separately for each country in which they operate. But this is largely arbitrary: international companies have production processes that span several continents and dozens of countries.

3. The current system create really does create artificial incentives for American companies to invest abroad. There is, of course, absolutely no reason why American companies shouldn't invest abroad. And it is perfectly rational for companies to pursue the lower rates that they can get abroad. But no one makes a robust philosophical argument for why the government should be engaging in industrial policy -- and all the attendant inefficiencies of industrial policy -- such that American companies send more money abroad than they otherwise would. If you are a fan of the free market, you shouldn't want to encourage or discourage it. The current system encourages it.

How? Two big ways, known as the "deferral rule" and the "check-the-box rule."

The deferral rule let's US companies avoid US corporate taxes by not repatriating profits earned abroad. If an American company builds a plant in Ireland, it will only pay US taxes on the profits from that plant if the profits are returned to the US. That's sounds fair, except that the American company can still deduct the cost of building the plant from the taxes it already pays. This means the government is subsidizing investments abroad.

The check-the-box rule is much more direct: It let's US companies shift income between a parent company and a subsidiary in another country, and avoid paying taxes on that income.

4. The current system hinges on artificial distinctions between legal entities of little or no practical difference. International subsidiaries are taxed differently from international branches, which in turn are taxed differently from hybrid entities -- branches in one country and subsidiaries in another -- that get the best of both worlds. Um, what?

5. As #3 suggests, the current system is hideously complex. More than 800 rules govern how companies must account for international income and expenses. Compliance is costly, and complexity breeds unfairness. Large companies have an easier time paying compliance costs than smaller ones. But everyone whines, and rightfully so.