It would probably be premature at this point to discuss the study’s particular findings, but the administrative intervention that Manoli et al are studying involves “correspondence audits” in which the IRS sends a letter requiring documentation – say, of claimed earnings or dependents – and failure to respond with the requested items results in the EITC’s being denied.
EITC denial by reason of the correspondence audits appears to have decreased Type II errors (giving the EITC to those who didn’t legally qualify). But it also appears to have increased, perhaps quite significantly as a percentage matter, Type I errors (denying the EITC to those who did legally qualify but couldn’t handle the extra hurdles – in some cases because the IRS letter wasn’t successfully delivered to them).
Some general observations that I would offer here include the following:
1) By Congressional diktat, audit rates are generally higher for EITC claimants than for any other individual taxpayers other than the very rich. This cannot be justified as a matter of generating the maximum bang for the buck from the allocation of IRS audit resources. I don’t think there is good justification for it otherwise either. Among its possible motivations are classism, racism, and fiscal language illusion or bias (viewing over-payment of “transfers” as worse than under-payment of “taxes” even though (a) a dollar is a dollar, and (b) we are all net taxpayers on a lifetime basis, hence it’s absurd to code some of the sub-transfers differently than others).
2) Relatedly, the relative priority that public debate gives to focusing on Type II errors in EITC provision, relative to Type 1 errors, appears to me to lack adequate justification.
3) Lots of EITC non-compliance is not deliberate. This reflects the EITC rules’ excessive complexity. A prominent NYC tax lawyer of my acquaintance once wrote an article urging his colleagues to offer tax advice pro bono to needy clients, rather than working for more billable hours and giving the extra $$ to charity. One can agree or disagree with his view, given billing rates vs. the value of one’s services to someone who can’t pay for them, but one of the arguments he made was that in fact the EITC can be daunting enough in practice that skilled tax lawyers actually CAN offer their pro bono clients something that is scarce and of value. The EITC oughtn’t to have been designed in such a way that high-end legal skills might come in handy towards claiming it properly.
4) Papers on Food Stamps or SNAP, such as that by Tatiana Homonoff which we discussed several week ago at the colloquium, often discuss “targeting efficiency” – e.g., the relative social welfare costs of SNAP benefit loss to worse-off versus better-off individuals among those whose incomes are low enough to qualify for it. The welfare costs under the EITC not only of Type I errors but even of correcting at least innocent Type II errors (which often reflect the rules’ needless complexity) likewise ought to be treated as relevant to the analysis. These are generally people in the lower income ranges, often with dependent children, who may have significant unmet material needs but who are punished for lacking political clout.
I happened to go first. Keeping in mind the nature of the assignment, I started by mentioning the wonderful scene in Alice Through the Looking Glass when Alice (unwillingly) hears “The Walrus and the Carpenter,” whose two protagonists cruelly trick a group of oysters into being eaten by them (under the false pretense of taking a walk to discuss “why the sea is boiling hot, and whether pigs have wings”), and then the following ensues:
‘I like the Walrus best,’ said Alice: ‘because you see he was a little sorry for the poor oysters.’
‘He ate more than the Carpenter, though,’ said Tweedledee. ‘You see he held his handkerchief in front, so that the Carpenter couldn’t count how many he took: contrariwise.’
‘That was mean!’ Alice said indignantly. ‘Then I like the Carpenter best—if he didn’t eat so many as the Walrus.’
‘But he ate as many as he could get,’ said Tweedledum.
This was a puzzler. After a pause, Alice began, ‘Well! They were both very unpleasant characters.”
I have always admired Alice’s solution here – practical and clear-headed, as she so often is. Rather than deciding whether one’s judgment should reflect actions taken or state of mind, or whether moral judgments should be harsher or milder when one knows that what one is doing is wrong, she crisply dismisses the entire question that she has raised.
But the four of us were evidently less wise than Alice, since we took on the assignment of debating whether or not the 2017 act improved the U.S. international regime. We didn’t just leave it at agreeing that they are both very unpleasant
The case Kim and I made for “yes, it made things better” had the following main points:
1) No more deferral! – This particular way of lowering the effective tax rate on foreign source income (FSI) never made any sense (as compared to, say, contemporaneously applying intermediate rates), and led U.S. multinationals to jump through hoops to avoid taxable repatriations, while they lobbied for tax holidays, trapped themselves by accepting the accounting benefits of claiming that profits were permanently reinvested abroad, and based decisions on current versus expected future repatriation tax rates.
Our debating opponents not unreasonably pointed out in response that it’s not clear how huge the inefficiencies resulting from this admittedly quite poorly conceived regime actually were.
2) Enactment of GILTI – For all its flaws, GILTI makes it harder for highly profitable U.S. multinationals to pay a global 0% rate on large swathes of their income. And as minimum tax proposals go, it has the virtue of preserving some incentive for U.S. companies to minimize foreign taxes, rather than just pay them in lieu of higher U.S. taxes, because GILTI makes foreign taxes only 80% creditable.
3) Enactment of the BEAT – This provision, for all its perhaps even greater flaws, at least responds to the ineluctable problems with transfer pricing. In effect, it imposes an excise tax on “base erosion tax benefits” (deductible payments to foreign affiliates) that has a 0% rate until one is on the BEAT, then effectively a 21% rate. Admittedly, the rationale for this rate structure is not overwhelmingly obvious. But could one argue that it results in a kind of rough justice that might improve things overall?
4) Changes to business interest disallowance – Code section 163(j) now applies to inbound as well as outbound interest expense. Not all of its ramifications lie in the international realm, but it might be significant in relation to inbound earnings-stripping, which might (depending on the effective tax rates one favors for inbound) be a good thing.
5) Room for improvement? – We pointed out that many of the most egregious flaws in GILTI and the BEAT rules could in principle be addressed legislatively. Plus, FDII might not last long and who really cares about it anyway.
Here we were trying a rotten debating trick: Rather than debate the rules as they are, which the proposition to be debated arguably placed on the table, we tried to shift our defense to the rules as they might hypothetically become.
But then again our opponents had their own rotten debating trick, which we tried to call them on, while hoping they wouldn’t call us on ours. (Needless to say, this was all done on both sides entirely in good humor, and I am using the word “rotten” with tongue firmly in cheek.) They spent part of their time comparing the actual effects of the 2017 tax act’s international provisions to the proponents’ stated intent, which made their case (even) stronger than if they had been comparing present law to prior law, with all of its defects.
But perhaps it was more rotten still that they also powerfully addressed the comparison that the debate proposition actually called for! I have to say, listening to them I was glad I didn’t have a vote, as they might conceivably have gotten it.
1) How high should the overall effective corporate tax rate be? – Adopting the proposal, against the steady state background of current US. corporate income tax law, would affect the overall effective U.S. tax rate faced by companies subject to the tax. Included in this are the effective tax rate on U.S. companies’ foreign source income (outbound), and on foreign corporations investing in the U.S. (inbound, insofar as the provision applies to them). These aspects are of course distinguishable from each other, at least in principle.
Broadly speaking, any overall effective tax rate on any of these aspects could be accomplished with or without the RCPT. (Of course, exactly who and what will pay how much inevitably depends on the mix that is employed between the existing corporate tax and the new proposed instrument.) But while the pure structural question is simply what use to make of each instrument, given one’s overall target effective rates, in practice, and at least in the short run, adopting the RCPT would result in particular levels for everything given the background set of institutions.
2) Big companies versus small companies – With its zero bracket up to a given amount ($100 million of profits in the current proposal), this introduces a kind of rate graduation to the corporate tax. It’s often agreed that the corporate tax rate ought to have a flat rate, since marginal utility isn’t really an issue at the entity level (it pertains to individuals, who can own stock in either large or small companies). But there are a couple of rationales for having a higher tax rate for very large companies. One is that they are likely to be better at tax avoidance than small companies, so this might tend to level the playing field, albeit via the imposition of a somewhat arbitrary line. A second is that these companies might tend to have more rents and monopoly power than the smaller companies, justifying a higher tax rate (although, again, the sieve being used is imperfect) on efficiency grounds.
3) Public companies versus private companies – The RCPT’s application to non-publicly traded companies is limited by the zero bracket. But for private companies that are big enough to be subject to it – and might one need consolidation rules to ensure that commonly controlled siblings are treated as the same company? – reported profits can still be given a coherent meaning, but may be significantly less of a constraint than it is for public companies with managerial agency costs.
4) Managerial incentives issue – Clearly one of the proposal’s main virtues is what I called its metaphorically “Madisonian” character in my Georgetown Law Review piece on taxable income and financial accounting income. Madison wanted to set one distortionary interest against another in order to prevent the polity’s being captured by any of them. Here, it’s different incentives of the same people: the corporate managers who want to lower taxable income while raising financial accounting income. They face an internal contradiction in accomplishing all their aims, rather than being set against someone else, but in an optimistic view the benignity of the result might be the same.
But it’s certainly not the ideal to have financial accounting decisions affect tax liability. It’s a second-best kind of argument that one is making here, and there are certainly settings in which managerial incentives might be worse given the proposal than without it.
5) Political incentives issue – One of the RCPT’s virtues is its taking part of the effective corporate tax base out of Congress’s direct control – if Congress is willing to let things stay like that! But obviously the concern is that it will either start monkeying with financial accounting itself, or that it will start enacting RCPT exceptions from treating financial accounting income as taxable. The former risks harm to the information that public capital markets use, and the latter risks unwinding the RCPT, much as the corporate alternative minimum tax enacted in 1986 (partly based on the hope that it would lack the tax preferences in the regular corporate tax base) unwound as exceptions to it were enacted. It’s fundamentally hard to overcome our having a flawed political system in which public understanding and accountability are so low, and in which interest group politics frequently drives the bus.
6) Integration between the systems – I’m glad that the RCPT is simply an add-on tax rather than a minimum tax (like the corporate AMT, or the BEAT in international tax). Minimum taxes tend to create unneeded complications that aren’t worth the candle. But one could argue against my view that a minimum tax structure would tend to level the playing field so far as big companies paying different regular tax effective rates was concerned.
7) Other structural issues within the RCPT – As I noted in my prior post on the topic, there is the question of how to treat companies with fluctuating reported profits. Even apart from the issue of reported losses in one year and profits in another, what about “wasting” space in the zero bracket because one falls short of it some years while going above in others? There are doubtless more structural issues lurking here as well.
To repeat where I stand, I consider the RCPT a very interesting proposal that is potentially worth adopting, except we don’t really know for sure just yet (and of course we’ll never know with high confidence, other than perhaps if it is adopted and we get to observe its trajectory). Hopefully it will be debated by thoughtful people over the next year-plus, with the effect of improving our understanding of whether to do it, and if so how.
It’s true that the IRS is still, to say the least, not very computer-savvy. (But this is largely Congress’s fault for underfunding it, whatever internal institutional issues may have contributed negatively as well.) But it’s not true that a well-designed program would, e.g., undermine taxpayer confidentiality. The idea would be to create pre-populated tax returns based on information that the IRS already has, and that taxpayers could modify as needed.
And if the companies believe that taxpayers have good reason to pay for an independent service, rather than using a free pre-populated return from the IRS, let them do what businesses that have a worthwhile product usually do: that is, offer to sell it. Suppressing a free alternative that the nation’s taxpayers have already effectively paid for amounts to making them pay for the same thing twice: first as taxpayers, and then again as Intuit customers.
As Senator Warren notes, recently “Amazon reported more than $10 billion in profits and paid zero federal corporate income taxes. Occidental Petroleum reported $4.1 billion in profits and paid zero federal corporate income taxes.” Under her plan, “Amazon would pay $698 million in taxes instead of paying zero. And Occidental Petroleum would pay $280 million in taxes instead of paying zero.”
Such disparities between the income and accounting measures are multicausal. Sometimes there are just timing swings between years. Also, the income tax allows net operating losses (whereby loss years can offset the tax due in gain years), as in the case where a company loses $10 billion in Year 1 and makes $10 billion in Year 2. The financial accounting measure is for worldwide income, including that earned abroad through foreign subsidiaries. But also, the managers of publicly traded companies notoriously, at least in some cases, engage in complicated maneuvers to raise financial accounting income while lowering taxable income. The latter is likely to be in the shareholders’ interest but not necessarily the country’s. The former serves managerial goals but is potentially harmful to the aims of financial accounting, which is supposed to provide the capital markets with reliable information.
I gather that the proposal may also attempt to discern and tax inbound, U.S. source profits by foreign corporations, as measured for financial accounting purposes, and subject them to the tax as well.
I have long thought that the interplay between corporate managers’ sub-optimal incentives – i.e., to inflate financial accounting income and unduly reduce taxable income (such as through aggressive tax avoidance transactions) – creates a potentially fruitful opportunity for the U.S. federal income tax system to graze two birds with one stone. If managers have difficulty doing both at the same time – e.g., if raising financial accounting income has adverse tax consequences for them – it’s possible that the overall incentives that they face will be improved. It’s true that this creates pressures on financial accounting choices that, all else equal, would be undesirable. But financial accounting experts who make this point – and they tend, in my experience, to hate proposals of this kind! – need to consider as well the fact that this bias may potentially offset an opposite bias that they know quite well is there.
In sum, while financial accounting is not inherently well-designed as an income tax base, its use in a very secondary fashion, a la the Warren proposal with its 7% rate (I might prefer 5%) and its $100 million exemption amount (which I’d consider increasing), has the virtue of offsetting existing imperfections in both systems. One danger, however, is that having tax consequences depend on financial accounting would cause interest groups, through Congress, to bring their dark arts more to bear than they have already on distorting how financial accounting income is measured.
I discuss these sorts of issues in this article, the final version of which appeared (here, but possibly behind a paywall for some readers?) in the Georgetown Law Journal.
One issue to think about in relation to the Real Corporate Profits Tax is the equivalent of income averaging. E.g., what should be the result if a company has, say, $80 million of reported profits in Year 1, $200 million in Year 2, and $80 million in Year 3. Should the company just pay $7 million (i.e., 7% of the excess over $100 million) in Year 2? Should there be an adjustment in Year 2 for Year 1? In Year 3 for Year 2?
People in the Warren campaign asked me what I thought about the proposal, and I replied as follows:
“This is a serious proposal that has a lot of merit, and that deserves further debate. It addresses several problems at once – in particular: (1) the excessive size of the unfunded corporate tax cut that Congress enacted in 2017, (2) possible under-taxation of both outbound investment by U.S. firms and inbound investment by foreign firms, and (3) the socially undesirable incentive that public companies’ managers have to overstate their companies’ book earnings.
“It also has the potential to raise revenue from the upper tier of the corporate sector without putting Congress even further into the business of picking winners and losers as between industries, and without magnifying the importance of existing distortions in the corporate tax base.”
Yesterday at the colloquium, Steve Bank of UCLA Law School (a former Chicago student of mine, way back in the day) presented a tax history paper concerning an interesting episode in modern U.S. tax law: the failed effort by the Kennedy Administration, as part of what became the 1962 tax act, to enact withholding for people’s dividend and interest income, in response to substantial under-reporting. The effort failed due to unexpectedly intense opposition from members of the general public whom the banks successfully riled up and organized into what was apparently a genuine, not merely Astroturf, grass roots opposition movement. Faced with this level of unusual public upset, Congress settled for expanding information reporting, although it would be some time before the IRS would have the ability to make much use of this resource (which nonetheless over time led to increased compliance).
This is not an issue on which there is any possibility of reasonable disagreement. Any well-informed person who disagrees either that the Ways and Means Committee has an obligation to demand Trump’s tax returns as part of fulfilling its oversight duties, or that he is legally obliged to turn them over, is self-exposed as a partisan hack who has contempt for the rule of law.
Trump has credibly been accused of engaging in criminal activity for decades. It’s undisputed that he is still profiting from his businesses. There is substantial information in the public record suggesting that he is for sale (or subject to blackmail) and that many of his public policy decisions have been made for corrupt reasons. The tax returns may help to provide information that sheds light on his motives and incentives. It’s an indispensable part of Congressional oversight, and Republicans as well as Democrats in the Congress ought to recognize this (and in private probably do, whether or not they care).
All this is even leaving aside the law that would be quite clear in favor of the request even if all of the above evidence of criminality, corruption, and improper motives were not so powerful.
It’s perfectly obvious that business tax returns as well as individual ones are a necessary part of the oversight here. I don’t know why the particular ones were selected, and I would think that casting the net far more broadly (e.g., all Trump businesses, and all tax returns for the last 20 years) would have been well within reasonable oversight.
Any judge who votes or rules against this request does not belong on the federal courts. Such a judge would conclusively show that he or she cares more about partisan advantage than about transparency, honest government, and the rule of law.
The cast of authors for the chapter includes Devereux, Alan Auerbach, Michael Keen, Paul Oosterhuis, Wolfgang Schoen, and John Vella. (Michael Graetz is also credited with having contributed to the group’s deliberations about the chapter’s proposal.) Happily, the committee here appears to have indeed designed a horse as intended, not a camel.
The basic idea is to replace current transfer pricing practice in international taxation with something that looks a bit like it but is actually (and by design) quite different. They propose to split a multinational’s profits into the “routine” and “residual” components, allocate the former based on arm’s length comparables, and assign the latter to market countries where sales occurred, proportionally to sales.
As the paper notes, routine versus residual may tend to overlap considerably with normal returns vs. rents, but they’re not identical. “‘Routine’ profit is the profit a third party would expect to earn for performing a particular set of functions and activities on an outsourcing basis.”
The approach resembles sales-based formulary apportionment, except that it only applies that approach to the residual element. The routine piece ends up being allocated to the countries where the underlying activities take place.
It even more closely resembles this proposal by Reuven Avi-Yonah, Kimberly Clausing, and Michael Durst. The big difference is that Devereux et al look to standard transfer pricing comparables for the routine piece, rather than assigning a fixed rate of return. They argue that this makes their proposal less distortive albeit more complex to apply.
While I obviously follow international tax policy stuff pretty closely, you can only get your hands fully immersed (so to speak) in so much of it. I’ve regarded the transfer pricing / formulary apportionment et al debate as an area in which I have leanings but don’t regard myself as having invested fully enough to have the same degree of confidence about my views, as in areas that I have focused on more directly. Also there are empirical tradeoffs to worry about here that I don’t believe the literature has as yet fully resolved.
That said, my inclination has been to strongly favor an approach like that in Avi-Yonah, Clausing, and Durst, even if a given country such as the U.S. at first adopts it unilaterally. But I understand that there are serious people who have looked at this issue and NOT liked it so much (e.g., Altshuler and Grubert). Clearly such a proposal leaves in place enough distortions and tax planning opportunities that it is at best a third-best; the case for it is that transfer pricing is at best a fourth-best. (Which is not to say that I have a particular candidate in mind for second-best.)
I’m also initially inclined to view Devereux et al as an improvement on Avi-Yonah et al. The transfer pricing comparables at issue here are for routine stuff, like say for advertising and manufacture. There will be no pretense or possibility of their applying to, say, Amazon’s mega-profits from succeeding with the iPhone. They could well end up, much of the time, being about as formulary (e.g., using a fixed percentage markup) as Avi-Yonah et al, only this would be particularized to market conditions. Its retaining conventional, recognizable transfer pricing more as a matter of form than of substance (i.e., insofar as the big money is concerned) is arguably a further practical point in its favor.