Jared Bernstein: The new inversion rules are a fine start, but the business tax code needs serious attention

By Jared Bernstein
September 26th, 2014

Now that the dust has settled a bit on the Treasury’s exciting announcement of their new inversions rules, let’s kick back and cogitate a bit more on a few of the many remaining issues in the US corporate code.

Inversions: The Treasury has thus far created but a speed bump on the international tax avoidance highway. As I read it, they’ve made it harder for newly merged corporations to make their deferred earnings—profits the former US parent company was holding abroad to avoid US taxation—appear to be property of the new foreign firm. (Treasury: “Today’s notice removes benefits of these “hopscotch” loans by providing that such loans are considered “U.S. property” for purposes of applying the anti-avoidance rule.”)

I suspect that changes the marginal calculus for some firms considering inversions—most analysts view this issue of distributing foreign holdings tax free as the main motivator for many an inverter—but no one who follows this sees it as a game changer. That’s not a dis of the Treasury; as I wrote the night the rules came out, this is a bold, albeit limited, move to do what they can without Congress to partially close a loophole and protect the eroding tax base. But I expect them to return to this well, both on their own (next up, I’d guess: rule changes to block “earnings stripping”) and, in the unlikely event that they can find some dance partners, with Congress.

Debt Financing: CEA chair Jason Furman just presented a paper on corporate tax reform, mostly reviving ideas that the administration put forth a few years ago—lower rate, broader base, minimum tax on deferred foreign earnings. In the process, he updated two charts of which you should be aware.

Suppose I told you a fable about a country that massively favored debt financing for business investment over equity financing, where “massive” implies almost a 100% difference. You might think: there’s a country that is asking for over-leveraging problems.

Well, according to Furman’s chart, that’s no fable. Since interest is a deductible expense, the marginal tax rate for debt financing in the corporate sector is negative 60%; for equity, it’s +37%. Jason notes that the “…United States has the lowest tax rate on debt-financed investment in the OECD and the largest debt-equity disparity in the OECD.” The solution, likely not coming anytime soon to a tax reform near you, is to reduce this huge tilt by limiting the amount of interest that can be deducted.


Source: CEA, Furman.

Monster Tax Havens on Steroids: If you pay any attention to the tax avoidance problem you know that there’s been a sharp rise in the amount of what Ed Kleinbard calls “stateless income,” basically stealth profits that are designed to fly under the radar of any country that might tax them. So this next chart won’t surprise you, but the magnitudes are still worth observing.

It shows the ratio of offshored US corporate profits relative to the GDP of the countries where these dollars reside. In Bermuda, the British Virgin Islands, and the Cayman’s, that ratio is over 1,000%. I hope you’ll allow me to speculate that such location decisions are not the result of corporations answering the question, “in terms of growth, innovation, and productivity, where’s the best place for us to invest our profits?”


Source: CEA, Furman.

These three points provide good examples of the extent of base erosion, incentives to overleverage, and the distorted behaviors generated by our benighted corporate code. They also show you why corporate tax reform is such a heavy political lift. Policy makers and wonks like me can talk all day about the economic benefits of squeezing these inefficiencies out of the system, but the vested interests have huge bucks invested in a) the status quo, and b) members of Congress who will do their bidding to keep things just the way they are.

Reprinted with permission from jaredbernsteinblog.com