What Did the Rising Tide Lift at the Turn of the Millennium?

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The Mirrlees ReviewReforming the Tax System for
the 21st Century http//www.ifs.org.uk/mirrleesre
view Corporate Taxation RES Special
Session Warwick, 17 March 2008 Steve Bond Oxford
University Centre for Business Taxation and
Institute for Fiscal Studies
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Mirrlees Review Corporate Taxation

• Drawing on the two commissioned chapters that
  focus on taxation of large corporations
• Auerbach, Devereux and Simpson (ADS)
• Taxing Corporate Income
• Griffith, Hines and Sørensen (GHS)
• International Capital Taxation
• And the special study on small business taxation
• Crawford and Freedman
• Outline the tentative conclusions that I draw
  from these
• not necessarily the views of the Mirrlees Review
  team

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Meade proposals on corporate taxation

• Flow of funds or cash flow tax bases for
  corporate taxation
• Aim to tax economic rents, i.e. returns on
  investments over and above the minimum required
  return
• Achieve this by allowing investment outlays to be
  expensed, with no subsequent deductions for
  depreciation or cost of finance no attempt to
  match accounting treatment
• Leave cost of capital unchanged for all types of
  investment and all sources of finance uniform,
  zero EMTRs
• Neutral between debt and equity finance

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Meade proposals on corporate taxation

• Choice between R-base or RF-base (or equivalent
  S-base)
• R-base requires distinction between real and
  financial flows, but not between debt and equity
• RF-base requires distinction between debt and
  equity, but not between real and financial flows
  new borrowing taxed repayments of interest and
  principal deductible
• Equivalent in present value terms for borrowers
• Only RF-base taxes rents earned by banks from
  interest rate spreads on borrowing and lending

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Analysis of Flow of Funds
Inflows Outflows
Real Sale of products, services, fixed assets Purchase of materials, wages, fixed assets
Financial Increase in borrowing, interest received Repayment of borrowing, interest paid
Shares Increase in own shares issued, dividends received Repurchase of shares, dividend payments
Real inflows Real outflows R base Financial
inflows Financial outflows RF base Share
outflows Share inflows S base
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Cash flow corporate taxes

• In a closed economy, no distortion to investment
  decisions, if all investments with positive NPVs
  are undertaken
• Taxing economic rents is efficient, and cash flow
  corporate taxes are natural complement to
  personal expenditure tax advocated by Meade
• But in open economies, source-based cash flow
  taxes will distort location choices, unless all
  economic rents are location-specific
• Also leave incentives for multinational firms to
  shift taxable profits into low tax rate
  jurisdictions
• Two commissioned chapters disagree on the
  importance of these problems with source-based
  cash flow (or equivalent) corporate taxes

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Key developments since Meade changing world

• Internationalisation of business activities
• Huge increases in foreign direct investment
• multinational firms now account for one quarter
  of UK employment
• and in foreign portfolio investment
• foreign owners now account for one third of share
  ownership in UK listed companies
• Financial innovation (growth in derivatives and
  hybrid securities) has blurred the distinction
  between debt and equity
• Big increase in the share of corporate tax
  revenues from the financial services sector
• up from 5-10 in early 1980s to around 25 now,
  in both UK and USA

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Key developments since Meade changing taxes

• Much lower statutory corporate tax rates
• particularly in smaller countries

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Key developments since Meade changing taxes

• Much lower statutory corporate tax rates
• particularly in smaller countries
• Broadly stable corporate tax revenues
• relatively strong revenue growth in smaller
  countries

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Key developments since Meade changing taxes

• Much lower statutory corporate tax rates
• particularly in smaller countries
• Broadly stable corporate tax revenues
• relatively strong revenue growth in smaller
  countries
• Reflects proliferation of rate-cutting,
  base-broadening reforms, following UK (1984) and
  USA (1986)
• Movement away from relatively narrow base
  (economic rents) advocated by Meade
• Plausibly reflects increased importance of tax
  competition between governments
• particularly for location of firms (EATRs)
• and location of taxable profits (statutory tax
  rates)

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Key developments since Meade changing taxes

• Revenue buoyancy also reflects increase in
  corporate profits relative to GDP
• partly due to higher profitability, and more
  business activity taking corporate form
• Revenue shift from (high tax) larger countries to
  (low tax) smaller countries suggests increased
  importance of profit shifting by multinational
  companies
• Retreat of imputation systems that integrated
  corporate and personal income taxes
• partly in response to ECJ rulings within the EU

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Key developments since Meade economics

• Recognition that source-based taxation of capital
  income is likely to be inefficient in small open
  economies with a high degree of capital mobility
• increase in required pre-tax rate of return
• outflow of capital
• incidence shifted onto relatively immobile
  domestic factors, notably labour
• less capital per worker, less output per worker,
  lower wages
• more efficient to tax domestic factors directly,
  avoiding this distortion to capital-labour ratio
  (production inefficiency)
• But source-based corporate income taxes are alive
  and kicking

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Key developments since Meade economics

• Models have incorporated multinational firms,
  taking decisions on where to invest, and where to
  report profits, not just on how much to invest in
  a fixed location
• more emphasis on effective average tax rates
  (location decisions) and on statutory tax rates
  (profit shifting)
• less emphasis on cost of capital and effective
  marginal tax rates (scale decisions, conditional
  on location)
• Models of non-cooperative tax setting and
  strategic tax competition between governments
• individual governments are now more constrained
  by the tax rates and/or rules adopted by other
  governments

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Key developments since Meade economics

• Less emphasis on the importance of personal
  taxation of dividend income for corporate
  investment decisions
• New View suggests dividend taxes may only be
  important for investment financed by new equity
  not for investment financed by retained earnings
• Small open economy models suggest dividend
  taxation of domestic shareholders may be
  completely irrelevant for decisions of large
  corporations whose shares are owned and traded in
  the global capital market

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Key developments since Meade economics

• Generalisation of cash flow tax principles
• Boadway-Bruce (1984) generalised R-base
• immediate expensing of investment outlays can be
  replaced by a flow of deductions, reflecting the
  costs of finance and depreciation, with the same
  present value
• perpetual flow of r per period has same present
  value as immediate deduction of 1, if r is also
  the relevant discount rate
• can further allow for arbitrary depreciation
  schedules without compromising zero EMTR property
• IFS Capital Taxes Group (1991) generalised
  RF-base
• Allowance for Corporate Equity (ACE) applies this
  idea to opportunity cost of equity finance only
  preserving interest deductibility (and taxation
  of interest receipts)

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Key developments since Meade economics

• Bond-Devereux (1995, 2003) analyse these
  generalised cash flow taxes under uncertainty
• taxes can be designed so that the appropriate
  rate of return for the ACE allowance is the
  risk-free interest rate not appropriate to add
  the (project-specific) risk premium
• with certainty, the risk-free rate is both the
  appropriate rate to discount deferred receipt of
  investment allowances, and the required rate of
  return on equity-financed investments
• with uncertainty, the risk-free rate remains the
  appropriate rate to discount deferred receipt of
  investment allowances, provided these are sure to
  be received at some point while the required
  rate of return on risky equity-financed
  investments is likely to be higher
• appropriate bankruptcy rules allow this to be
  combined with deductibility of actual interest
  payments on (risky) debt

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Where the two chapters agree

• Both ADS and GHS emphasise globalisation as the
  main change since Meade with important
  implications for corporate tax design
• Both also consider financial innovation and the
  growth of the financial sector to be important
• Both emphasise the inefficiency of source-based
  taxation of capital income in small open
  economies, and consider this relevant for tax
  design in the UK
• Neither proposes outright abolition of corporate
  taxes
• Both propose radical reform of the existing
  corporate income tax base

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Where the two chapters disagree

• GHS emphasise the benefits from eliminating
  source-based corporate taxation of the normal
  return on capital
• They propose to achieve this with a source-based
  ACE
• which exempts the normal return on both
  equity-financed and debt-financed investments
• at an unchanged statutory tax rate
• This would make the UK a more attractive location
  for mobile capital investments that just earn a
  normal rate of return and (though to a lesser
  extent) for those that earn economic rents
• EMTRs fall to zero EATRs are reduced
• Capital per worker should rise, and domestic
  workers should benefit from higher real wages

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Griffith, Hines and Sørensen

• GHS acknowledge that this proposal may not be
  revenue-neutral
• unless firm behaviour changes, introducing a more
  generous allowance for financing costs at an
  unchanged tax rate would imply that less revenue
  is collected
• this may be offset by increased corporate
  investment in the UK, but no strong evidence that
  this would be sufficient
• If necessary, they propose that lower corporate
  tax revenues should be recouped from higher taxes
  on relatively immobile domestic factors (labour
  and land) and to some extent from higher
  residence-based taxation of dividend income at
  the personal level

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Griffith, Hines and Sørensen

• GHS also propose a switch from the UK credit
  system to exemption of foreign-source corporate
  income broadly in line with current UK
  government proposals
• GHS acknowledge that the source-based ACE may
  still distort location choices, where rents are
  earned that are not location-specific but no
  more so than under the current UK corporation tax
• They also emphasise neutrality with respect to
  ownership of assets by multinational firms based
  in different countries combining the
  source-based ACE with the exemption method
  reduces a competitive disadvantage for UK-based
  multinationals wanting to expand by acquiring
  firms in other jurisdictions

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Auerbach, Devereux and Simpson

• ADS give more weight to eliminating location
  distortions
• They also emphasise both practical and conceptual
  problems in implementing source-based corporate
  taxes
• allocating global profits of multinational firms
  to individual source countries using arms length
  prices is at best immensely complex and is
  necessarily arbitrary in cases where comparable
  transactions between unrelated parties do not
  exist
• They reject source-based taxation of either
  corporate income or economic rents as
  inappropriate in the integrated world business
  environment we now have
• While taxing corporate-source income of
  individuals on a residence-basis is theoretically
  more appealing, they also reject this as simply
  infeasible

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Auerbach, Devereux and Simpson

• ADS propose a destination-based cash flow tax
• The R-based version would work very like existing
  destination-based VATs, but with an additional
  deduction for wage costs
• this exploits the equivalence between the VAT
  base and the sum of wage costs plus economic
  rents
• In an open economy setting, the destination-based
  cash flow tax would only tax economic rents - as
  advocated by Meade and GHS - but in the location
  where goods and services are consumed, rather
  than in the location where they are produced
• Since the tax liability does not depend on the
  location of production, the destination-based
  cash flow tax is neutral also with respect to
  location decisions

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Verdict?

• Some potentially important problems with the
  destination-based cash flow tax proposal are not
  fully resolved
• The R-based version could be implemented simply
  by increasing (uniform) VAT rates, with
  offsetting reductions to payroll tax rates
• But scope for increasing VAT rates is constrained
  in EU
• Higher VAT rates would increase strains on the
  VAT base (missing trader/carousel frauds)
• Financial services are currently exempt from VAT

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Verdict?

• A RF-based version of the destination-based cash
  flow tax exists in principle, but would face
  similar problems to those of applying VAT to
  financial services
• to date, these have proved to be insurmountable
  in practice
• The destination-based cash flow tax would also be
  a much more radical departure from existing
  international tax practice than the source-based
  ACE
• implications for bilateral tax treaties,
  creditability against other corporate taxes,
  compatibility with EU law, ...

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Conclusion

• My forecast is that the Mirrlees Review team is
  more likely to favour a source-based ACE as our
  main recommendation for corporate tax reform in
  the near term
• While noting the remaining problems inherent in
  source-based corporate taxation, and recognising
  that taxing corporate rents on a
  destination-basis may be more attractive in the
  longer term, particularly if significant revenues
  from source-based corporate taxes eventually
  prove to be unsustainable
• I am less convinced than GHS about the positive
  case for switching from credit to exemption,
  essentially because in practice the UK credit
  system is so close to exemption already
• but this decision may have been taken before we
  publish, if current UK government proposals are
  implemented

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Relation to personal taxation of shareholder
income

• ACE corporation tax fits well with the kind of
  shareholder income tax with a rate of return
  allowance proposed by GHS
• This extends the ACE approach to personal
  taxation as well, taxing dividends and capital
  gains with an allowance for the normal return on
  capital invested
• Equivalent in present value terms to the personal
  expenditure tax treatment proposed by Meade
• Suitable rate alignment between tax rates on
  corporate income, shareholder income and labour
  income can deal with most of the problems
  highlighted in the Crawford-Freedman special
  study on small business taxation

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Relation to personal taxation of shareholder
income

• I suspect we may differ from the GHS proposal in
  preferring a progressive rate structure for the
  shareholder income tax, rather than the flat rate
  proposed by GHS (a variant on the Scandinavian
  dual income tax approach)
• with progressive tax rates on labour income,
  progressive rates are also required on
  shareholder income to avoid differential tax
  treatments of incorporated and unincorporated
  firms for some taxpayers
• a lower progressive rate structure on shareholder
  income than on labour income reflects the
  corporate tax already paid, so that overall tax
  charges are equalised

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Relation to personal taxation of shareholder
income

• Part of a pragmatic approach to taxing personal
  savings in ways that share the main benefits of
  the personal expenditure tax, while emphasising
  administrative feasibility, and retaining
  existing tax treatments where these are
  appropriate
• for example, exempting interest income from
  taxation where economic rents are unlikely to be
  significant retaining existing expenditure tax
  treatment of pension savings ...
• The spirit of Meade lives on, perhaps tempered by
  greater pragmatism after thirty years of
  experience

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The Mirrlees ReviewReforming the Tax System for
the 21st Century see http//www.ifs.org.uk/mirrl
eesreview/ Institute for Fiscal Studies