The costs of offshore tax avoidance, part 1

Nobody likes paying taxes. The rich, however, can reduce the burden more easily than others because capital is more mobile than labour.

A clever new paper in the Journal of Economic Perspectives by Gabriel Zucman attempts to measure how much government revenue is lost because of the careful re-routing of capital income into tax havens. He also suggests ways that governments can crack down on tax minimisation strategies, even in the absence of international coordination.

We’re going to break up our discussion into two parts. The first covers his analysis of why corporate profit tax payments have been shrinking relative to corporate profits. The second looks at the ways individuals stash money offshore and how governments might be able to get the tax they are owed.

Zucman begins by noting that none of the issues discussed today are particularly new. (See, for example, this paper from 1925 by W H Coates.) Those who say we should eliminate all taxes on businesses in exchange for higher taxes on dividends and capital gains should remember that profit taxes were originally established as a check against the possibility that people would route all their earnings through closely-held corporate structures. This is also why, since the beginning, tax rates on capital gains and dividends were set below individual income tax rates to avoid double-taxation.

(N Gregory Mankiw avoided this problem by arguing for the simultaneous elimination of corporate and individual income taxes in favor of a new tax on consumption, for what that’s worth.)

The challenges of international coordination were also recognised nearly a century ago and debated within the League of Nations. However, questions about how to identify where profits were earned — much less how different governments should tax those profits — were ignored for decades because global trade collapsed almost immediately after the issues started received attention. Even as recently as the 1980s, American companies only earned about 15 per cent of their profits from foreign operations. Nowadays, about a third of total US corporate profits come from abroad:

At the same time, the share of those foreign profits earned in countries Zucman identifies as “tax havens” — Ireland, Luxembourg, the Netherlands, Singapore, Switzerland, and a few Carribean islands — has risen from about 20 per cent in the mid-1980s to more than half:

All of this coincided with a large decline in the effective tax rate paid by US corporations to the US Treasury, from about 30 per cent as recently as 1998 to 20 per cent in 2013. At least 6 percentage points of that decline — worth at least $120 billion in 2013 — can be attributed to “increased tax avoidance in low tax countries,” according to Zucman.

We don’t want to downplay the extent to which this has been a substantial transfer from taxpayers and smaller businesses to managers at big companies and the relatively small share of the population that holds the vast majority of corporate equity, but this estimate is too high, at least if Zucman is only referring to the growing popularity of corporate tax havens.

First, it’s important to remember that the total share of US corporate profits coming from these havens only increased from about 8 per cent in 1998 to about 18 per cent in 2013:

This growth is too small to explain the broader decline in the corporate tax burden. Consider a simple example of a company that earned $100 in worldwide profits. For simplicity’s sake, we will assume that profits earned in “tax havens” are un-taxed and fully reinvested in the haven to avoid US repatriation taxes.

In 1998, our imaginary company paid about $30 in taxes to the US government on $92 of profits that didn’t stay in tax havens. The effective tax rate on that $92 was therefore about 32.6 per cent. In 2013, the same company still earned $100. This time, it moved an extra $10 into tax havens, leaving $82 in non-haven profits. But the US government only collected $20 from those $82, meaning that the average effective tax rate on non-haven income was about 24.4 per cent — 8.2 percentage points lower than in 1998!

If the effective tax rate outside the haven countries hadn’t changed, our hypothetical US corporation would have paid $26.74 in taxes, instead of just $20. Rather than explaining at least two thirds of the decline in the effective tax burden, the greater use of tax havens by themselves can barely explain one third.

A possible explanation is that basically all foreign corporate tax rates are lower than those in the US, and those rates have fallen significantly from 1998 to 2013. Zucman dismisses this by noting that “this reduction does not drive a wedge between the nominal and effective rate because lower foreign taxes are offset by lower tax credits when foreign profits are repatriated to the United States.”

However, the data show that US companies have been repatriating a smaller and smaller share of their foreign earnings abroad, even in countries that Zucman doesn’t classify as havens — exactly what you would expect managers to do in response to a widening gap in corporate tax rates. In fact, the share of profits retained abroad (outside of havens) increased from 26 per cent in 1998 to 62 per cent in 2013:

With the notable exception of 2005, when corporations were allowed to repatriate earnings without having to pay much tax to the IRS, the trend has been towards more and more reinvestment abroad and less and less repatriation.

We have evidence from other countries that differences in corporate tax regimes affect the incentives to reinvest vs repatriate profits earned abroad. In 2009, the UK effectively eliminated taxes on repatriated profits by switching from a worldwide to a territorial system. That understandably led to a sharp increase in the share of direct investment income that was repatriated, rather than retained in foreign countries:

It’s also worth noting that some tax-minimisation strategies do not seem to require any cross-border chicanery. According to data compiled by NYU Stern’s Aswath Damodaran, the sectors that pay the lowest effective tax rates in the US include broadcasters, coal companies, homebuilders, and telecoms operators — all businesses that make the bulk of their money from domestic operations.

So what is to be done? Before getting to his own ideas, Zucman discusses a few proposals that he readily admits all have serious flaws.

One popular suggestion is to stop letting multinationals shift the bulk of their taxable profits into tax havens, and instead determine where profits came from with a simple formula based on the distribution of capital and workers. That would reduce the incentive to route earnings through shell companies in the Netherlands and Ireland but it would create a significant incentive to shift production towards low-tax regimes, which would be particularly painful for a high-tax country like the United States.

Others have suggested taxing only sales. As Zucman says, “a company like Starbucks can easily shift its headquarters to Ireland, but not its customers.” While this would be a good way to capture additional revenues from the technology and pharmaceutical companies that relocate their intellectual property abroad, this policy would heavily subsidise exporters while penalising foreign importers. It’s not clear whether such a tax system would even be allowed under existing World Trade Organisation rules.

A cleverer approach comes from recalling that corporate profit taxes are meant to complement capital gains and dividend taxes as a way to go after the rich, rather than an end in themselves:

Once profits are paid out to shareholders, the government allows any corporate tax previously withheld to be credited against the amount of personal income tax owed. Imagine that Microsoft had managed to avoid taxation entirely: in an imputation system, its shareholders would get not credits and pay up to 48 per cent (the combined federal corporate tax and top dividend tax rate on $1 of corporate profit in 2013) on the dividends they receive.

Any dollar paid by Microsoft would reduce the tax bill at the shareholder level. Such an imputation system combines source- and shareholder-based taxation in the most logical way, and, most important, removes incentives for firms to relocate to Ireland or shift profits to Bermuda, since shareholders would recognise that it’s a wash.

However, countries that had this system eventually abandoned it because “govermments found it unacceptable to give credits to domestic shareholders for corporate taxes levied by foreign countries.” Moreover, it doesn’t do anything to address the ways that wealthy owners can enjoy unrealised capital gains without having to pay any taxes.

Another obstacle is that nobody knows who owns a lot of these assets, which also makes it tricky to tax the ultimate beneficiaries of corporate tax avoidance. We’ll get into these challenges and Zucman’s proposed solutions in part 2.