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USA: The Destination-Based Cash Flow Tax Is A Fitting Response To The OECD's BEPS Project


Added on 13/03/2017

Even before the election and the Trump presidency, the need for corporate tax reform was well understood by policymakers across the aisle. In April 2016, a joint report issued by the White House and the Treasury underscored the need for significant business tax reform given the “combination of the relatively high U.S. corporate tax rate and the complicated system for taxing multinational businesses” that have made “America a less attractive place to start and grow an international business.” Challenges posed by this system include billions of dollars lost in “artificial” profit-shifting, corporate tax inversions and a general erosion of the tax base, as I have written earlier, reports Forbes.

As the U.S. debates its move towards tax reform through a destination-based cash flow tax (DBCFT), it is important to remember the international context for tax policy. To address tax avoidance issues globally, the OECD’s Base Erosion and Profit Shifting Project (BEPS) recommends tying profits more closely to the actual source of economic activity through an increase in economic substance requirements (such as the location of employees and other people functions). The proposed destination-based tax may be the best response by the U.S. to the OECD’s Base Erosion Profit Shifting Project because it may stem the outflow of U.S. economic activity to other countries likely to happen under BEPS.

In a recent paper, Kartikeya Singh and I discuss the likely impacts of the OECD’s BEPS project on the location of tangible economic activity. In the absence of significant corporate tax reform in the United States, the BEPS economic substance requirements impose a serious risk that both profits and real activity, such as jobs, will move out of a high tax country like the U.S. to low tax jurisdictions.

The House tax reform blueprint fixes many of these problems. First, by cutting headline rates to 20%, the U.S. corporate tax rate becomes much more competitive relative to others in the OECD. Second, by taxing firms on the location of sales rather than the location of profits, it removes the incentives for profit-shifting to low-tax jurisdictions. Third, by cutting rates, providing immediate expensing and imposing border adjustment, it increases incentives for firms to locate investment (specifically, above-normal-return investments, such as in information technology) within the U.S. As Alan Auerbach and Doug Holtz-Eakin illustrate in a new report, even if the tax rate in the foreign country is very low, the destination-based cash flow tax would encourage more real economic activity to happen in the United States. This is likely to help the economy through higher rates of economic growth and higher wages for workers. While the current system of corporate taxation places a significant incidence of the tax on workers by reducing investments and wages in the U.S., the DBCFT’s investment expensing eliminates this concern. Finally, the removal of interest deductibility also minimizes the ability of firms to reduce their tax liability through debt-shifting and eliminates the tax incentive for debt-funded investment.

In addition, it is estimated that the border-adjustability would by itself be a revenue-raiser over the next decade. Since the U.S. currently has a higher level of imports than exports, the expansion of the tax base could potentially result in a $1 trillion increase in revenues over the next ten years. This additional revenue from the border adjustment could help offset the revenue reduction from some of the other reform provisions in the medium-term, although in the long run the border adjustment is revenue neutral.

While these are good reasons for adopting the DBCFT, it is not a panacea for solving the trade deficit as is sometimes claimed. Many economists, such as Alan Auerbach and Alan Viard, have shown that the currency adjustment that comes with the import tax and export subsidy will leave the trade deficit unchanged and will impose no additional burdens on importers, nor provide any additional relief to exporters. The currency appreciation will, however, lead to a large wealth transfer to foreign holders of dollar denominated assets, which should be addressed through transition policy.

Aside from the wealth transfer to foreigners and the reciprocal burden on U.S. owners of foreign investments, the panic among retailers who believe that they will be hurt by the proposed changes and the potential WTO challenge to the border adjustment may slow the adoption of the House plan. However, in my opinion, the House plan offers a smart solution to the problem of artificial profit-shifting and base erosion, and it is a serious and effective response to the OECD’s BEPS project and our current highly distortionary corporate tax system.

The larger lesson is that the U.S. corporate tax system as it currently exists is serving no one well. Cutting rates while broadening the base in other ways could retain incentives for companies to locate in the U.S. This would help American workers, their families and the larger economy by reducing the U.S. corporate tax code’s damage to the tax base, economic dynamism and business competitiveness.