My prior blogpost offered background concerning check-the-box (CTB) in the international realm. It sought to explain why the adoption of CTB amounted to a partial indirect repeal of the US subpart F rules. Partial because it only undermined the rules’ deterrence of foreign-to-foreign tax planning, as opposed to its continued application to the earning of net passive income abroad. Indirect because the rules were still on the books, but now one could easily avoid them through the properly implemented use of transparent / disregarded foreign entities.
These two aspects of CTB inspire the 2 big topics in the paper that we discussed at the colloquium yesterday. The first is how CTB affected organizational complexity (e.g., from the incentive to add transparent entities to one’s organizational schema in order to effectuate foreign-to-foreign tax planning that would escape subpart F). The second is how it affected US companies’ worldwide and US tax liabilities with respect to foreign source income (FSI), along with their US tax liability with respect t domestic source income (DSI).
The paper is based purely on data preceding the enactment of the 2017 US tax act. Given, however, that the 2017 act retained subpart F, that should not prevent it from being highly relevant to what US companies might be doing today. To be sure, the 2017 act’s tax rate change, enactment of dividend exemption, and enactment of GILTI et al might have important effects on US companies’ precise marginal incentives and choices, but the basic subpart F parameters did not themselves change.
1) CTB and Organizational Complexity
a. Empirical Evidence
One would expect CTB to have encouraged US companies to create more foreign affiliates, especially in tax haven countries. It should also have encouraged them to increase their foreign-to-foreign intra-group cash flows. One might also speculate that it would have decreased foreign-to-US parent cash flows pre-2017. There would be less previously taxed income that one might as well repatriate given that it has already been hit by subpart F. And, cross-crediting maneuvers responding to subpart F liability might not now as often be necessary.
The paper finds very strong correlations between the promulgation of CTB and multiple measures of organizational complexity. For example, post-CTB as compared to pre-CTB, US companies have far more foreign affiliates in far more countries – and especially in tax havens – along with longer corporate chains, more chains with 4+ tiers, and greater sales dispersion under the Herfindahl index.
While all this is consistent with concluding that CTB had the expected effects, the authors recognize that it does not necessarily establish causation. During the same period (i.e., pre- vs. post-CTB’s adoption at the end of 1996), a lot of other things might have pushed in the same direction. For example: ongoing globalization, falling travel and communications cost, increased global production chains for economic as well as tax reasons, the rise of e-commerce, the big accounting firms’ rising role in customized global tax planning, the rise of highly valuable IP associated with various global brands that were even friendlier to profit-shifting and the use of tax havens than “old economy” factory production, etc., etc.
In addition to its tables showing pre- vs. post-CTB aggregates, the paper contains a Figure that shows the year-by-year trend line for various parameters of organizational complexity. This one arguably doesn’t look as I might have expected insofar as CTB was driving the change. It shows a fairly steady rate of increase throughout the period, with no particular inflection point for CTB’s adoption at the end of 1996 (or for the enactment of section 954(c)(6) in 2005). I might have expected CTB to yield a sharper rate of increase right when it came into effect. In addition to having been hard to anticipate, as it arose as a byproduct of a Treasury project aimed mainly at domestic entity classification, it strikes me as not being super hard to exploit promptly. The measures it encourages (e.g., creating transparent entities that link tax haven jurisdictions and “real” source” jurisdictions) are not super hard either to figure out or to implement. Then again, maybe the knowledge did need time to disseminate past the most well-informed circles, plus there may have been concern that Treasury would take it back (as it tried to do, only to be scared off by the lobbyists and their Congressional friends). And also perhaps taking full advantage requires first converting more DSI into FSI, which might not be easy to do overnight. So perhaps there is an explanation (other than that CTB wasn’t having large standalone effects) for the relatively smooth upward drift of complexity indicators without particular inflection points.
A couple of other tables in the paper – although likewise showing just correlation, not causality – might further support the inference that here the correlation was indeed causal. Companies that did more of the sorts of things that CTB encourages had greater tax liability reductions than their peers. In terms of explaining this intuitively, it is plausible both that (i) these changes indeed drove a significant piece of the tax liability reductions, and (ii) were sufficiently well-recognized by the firms as to support the inference that they were doing it deliberately for tax reasons once the adoption of CTB had cleared the decks of certain subpart F concerns.
b. Normative Implications
All else equal, encouraging greater organizational complexity is surely a bad thing. It may increase deadweight loss (DWL) both by imposing various costs (e.g., filing fees, hiring various lawyers and accountants, arranging various in-house cash flows after determining their optimal amount, etc.) and by reducing the companies’ transparency, which might increase agency costs.
CTB increased DWL insofar as it caused these things to be done more than previously. But it is very hard to quantify, or even estimate with any confidence, how high or low the marginal DWL would have been. So how to trade this problem off against other considerations, or merely just how much to disvalue it, is far from clear.
A further normative complexity is the following. While DWL, considered in isolation, is always bad, causing undesired tax planning to require increased DWL can possibly be preferable to the alternatives This is why, for example, economic substance rules may desirably (on balance, all else equal) impede aggressive tax sheltering that one wishes one could stop directly. Thus, suppose one believes that subpart F’s discouraging effect on foreign-to-foreign tax planning was good US policy and should not have been scaled back. CTB’s doing so indirectly, rather than more directly through repeal of the undermined provisions, might limit the net harm relative to the case of outright and direct repeal.
2) CTB’s Effects on US and Foreign Tax Revenues
a. Empirical Evidence
The paper finds significant declines, post-CTB, in US multinationals’ worldwide effective tax rates. This decline is incremental to the effects of declining statutory rates abroad.
It also finds that US multinationals’ effective worldwide tax rates on their FSI declined, not just absolutely, but also relative to that on their DSI.
And it finds a more than 50% decline in US multinationals’ effective U.S. tax rates on their FSI.
Once again, the findings pertain to correlation, not causation. But here, despite similar independent contributing factors to those I noted in 1 above, it may be intuitively more plausible that CTB may have been doing a lot of the work here. At least to my mind, it simply looms larger in the universe of plausible explanations that naturally suggest themselves.
Purely as a mechanical matter, there are just 3 main ways that the US tax rate on US companies’ FSI could have declined during the period. (I leave aside such further explanations as declining FSI from US companies’ foreign branches, on the view that this seems unlikely to have been a quantitavely significant contributor.)
These three main mechanical explanations are (1) reduced subpart F income, (2) reduced taxable repatriations (since this is pre-2017 act), and (3) increased use of cross-crediting to reduce foreign tax liability.
Of these possibilities, (3) seems unlikely to have helped much. If anything, declining foreign tax rates seem likely to have increased its scope.
(2), reduced repatriations, is a plausible contributor. The rise of permanently reinvested earnings (PRE) that US companies pinky-swore they would never be repatriating would have tended to reduce (and to reflect reduced) repatriations. Plus the 2004 foreign dividend tax holiday is shown by several papers to have apparently reduced repatriations once it expired, due not only to the release of pent-up demand but also rising expectations that it would soon happen again. But, while reduced repatriations during the period surely is a plausible ground for the reduction in US tax liability on FSI, the amount involved may simply have been too small to yield reductions as great as those that the paper finds.
This leaves reduced subpart F income as a likely major culprit, and here it is highly plausible that CTB would have been playing a major role.
b. Normative Implications
It is telling, although not surprising, that the paper finds reduced US tax liability on US companies’ FSI once CTB comes into play. It would have been startling not to find this result.
Absent far more repatriation than was occurring, and thus far greater marginal importance for US foreign tax credit claims, there is perhaps only one plausible way that this could not have happened. That would be if, given investors’ ability to escape the US tax net by not using US companies (in particular, to invest abroad), the tax burdens that the US system would have been imposing if not for the indirect partial repeal of subpart F would have been above the Laffer Curve peak.
While this by itself is probably not plausible, at least in the short run and as applied to the period under study in the paper, tougher issues are raised in a very long-term projection. Also, a set of rules that raise revenue may nonetheless be bad for national welfare, if the associated deadweight loss is great enough (also taking due account of distributional effects). So the fact that CTB did what it apparently did – that is, reduce US tax revenues from US multinationals’ FSI – the broader normative debate of course continues.
There is also, however, a plausible source of revenue loss from the repeal of CTB that the paper’s methodology would not have caught. That is the revenue loss from increased conversion of DSI into FSI, now that the repeal of CTB makes it easier to on-shift the reported profits from peer countries to tax havens.
Here too, of course, there are Laffer Curve / broader desirability issues that have fueled decades of international tax policy debate. This will not change any time soon, but the Blouin-Krull paper does indeed offer suggestive evidence on some of the parameters.