The left needs better tax policy (p.2)

Those evil corporations

Following from my previous article on the expenditure tax, today we tackle corporations. On the left, we tend to demonize corporations, and I’m sympathetic. Corporations do a lot of bad things like polluting the environment, crushing unions, lobbying politicians, etc., and one of the responses the left has to abuses of corporate power is raising the corporate income tax.

It’s simple enough—corporations make a lot of profit on the backs of workers and market concentration, often through morally gray or morally wrong activity. This, coupled with corporations taking advantage of subsidies and public infrastructure, makes a compelling case for high taxes on corporations, but the corporate income tax has a lot of problems. Luckily, there’s a better way to tax corporations that’s more progressive and raises more revenue.

On Corporations

To begin, it helps to take a step back. Often, the left speaks about corporations as if they are distinct, living, breathing entities. Thinking about corporations like this causes leftists to focus on the tax liability of corporations themselves. While corporations are legally distinct entities, a couple of interest groups, labor and capital, comprise them.

The owners (equity) and lenders (debt) provide capital (money) to the business so the business can get off the ground and invest in profit-maximizing things like machinery, real estate, information technology, employees, etc. The other side of the coin, labor, provides the actual work required to produce things from the company’s available capital. In exchange for their investment and risk, capital expects a return. Lenders expect interest payments, equity expects dividends and/or capital gains, and labor, in exchange for their work, expects wages and benefits.

By focusing on corporations themselves and not the shareholders of corporations, the left misses the forest for the trees. The shareholders dictate the policies of corporations within legal constraints. If the left wants to empower workers, unions and worker board membership are the answers. If the left wants to tax the wealthy, there are great ways to do that (follow this series for more great ways), and if the left wants to prevent corporations from doing immoral things like buying elections, lobbying politicians, polluting the environment, or engaging in anti-competitive practices, the corporate tax isn’t the best way to limit or stop any of those things, and for reasons we’re about to discuss, the corporate tax actually hurts workers relative to its alternatives.

The Corporate Tax Problem

This brings us to the current way of doing things—the corporate income tax. The corporate income tax is a tax on corporate profits. Profits, in this case, are revenues minus expenses and any qualified deductions, like depreciation and interest.

One issue with the corporate tax is that ‘qualified deductions’ cause a lot of trouble. Take depreciation as a big offender. ‘Depreciation’ is the loss of value on investments over time. Let’s say a corporation purchases a car for $30,000 to use for a delivery service. By the following year, the car is only worth $15,000 because its value depreciated. Even though the company spent $30,000, because of tax rules, it is only allowed to claim $15,000 in costs, which causes corporations to pay taxes as if they made higher profits than they received.

The government attempts to standardize the loss of value of investments over time (‘depreciation schedules’), but this is a very difficult thing to do in practice because all assets depreciate based on their individual asset class and context within a corporation, creating significant inefficiency and over-taxation (more on 'over-taxation' later).

The corporate tax also allows corporations to deduct interest expenses from their taxes. This biases corporations into using debt financing rather than equity. Debt financing increases returns to equity, which incentivizes corporations to debt finance with or without a tax incentive. Let’s say a corporation requires $100 million to invest in a project it expects to make $20 million in profit per year. It could raise $100 million in new equity to finance the project, but that would either risk its own capital or invite new owners to take a large chunk of its $20 million in profit. Rather, the company could take out an $80 million loan at 5% interest. Sure, the company now has interest payments, but now the shareholders only need to risk or raise $20 million in capital, splitting remaining profits between a much smaller group of owners and/or risking much less of their own money.

Despite this already huge incentive to raise capital using debt, the government takes the additional step of subsidizing corporations' interest expenses. Let’s say the $80 million loan at 5% annual interest costs the company $4 million a year for 10 years. Let’s say the corporation makes $100 million in revenue and has $80 million in costs for the year. The tax rate is 21%, but they can also count this $4 million per year as an expense, so instead of paying taxes on a $20 million profit ($100 - $80), the corporation pays taxes on a $16 million profit ($100 - $80 - $4). The amount they save on taxes is equal to the interest expense times the tax rate, meaning over the next ten years, the corporation saves $8.4 million ($40 * 21%) in taxes. This bias causes economic distortion by pushing businesses towards debt, not through debt’s actual utility, but through tax relief.

The corporate tax also taxes profits based on the company’s location rather than the location of its product’s consumption. This is part of the reason why companies move overseas and into tax havens. They want to avoid the corporate tax, and the easiest way to do that is to move your company’s headquarter or intellectual property to a country with a lower or more favorable tax code. All of the company’s actual operations and sales don’t need to change, so many companies make the choice to relocate at the detriment of the domestic government’s tax base and social investment.

The final issue, especially relevant to the concerns of the left, with the corporate tax is that it taxes normal returns. When corporations tally all investments, costs, and revenues at the end of the year, they see the size of their profit. In a competitive market, a well-run corporation expects a ‘normal return.' This return is often very low, as competitive markets compress profit margins. However, corporations often have market power from things like patents, land rent, brand equity, etc. These returns are ‘super-normal returns.’ The return is ‘super-normal’ because it implies a return from market power and/or unproductive activity alone and not a return from a productive, competitive process.

Since investment is not immediately deductible (through depreciation schedules), causing corporations to pay higher taxes and taxing ‘normal returns’, workers and consumers end up paying a large portion of the corporate tax. Taxing normal returns reduces the pool of investment dollars, so corporations don’t invest as much into innovative, productivity-enhancing things like factories and labs, so employment and wages fall, while consumer prices rise. Whether on the left or right, corporations using money for productive investments is positive. It’s the super-normal returns the tax code should target since this return isn't from competitive/productive activity. This is return from market power alone.

The left shouldn’t be in favor of a tax policy that reduces workers’ wages or raises consumers’ prices, and for what? After these accumulated distortions, the corporate income tax only raises a few hundred billion dollars per year. There’s a more efficient and progressive way to do things.

Destination-Based Cash Flow Tax

Replaces: The Corporate Income Tax

The destination-based cash flow tax (DBCFT) is a favorite of the most tax wonky people I know, and for good reason. It addresses many of the problems with the corporate tax, while having unique upsides.

The DBCFT has a few key components:

1. Corporations deduct the full value of investments immediately when incurred.

2. Corporations pay taxes on imports and no taxes on exports.

3. Corporations can’t deduct interest from debt on their taxes.

Allowing the full deductibility of investment ensures the great portion of remaining profit is a supernormal return, enabling optimal invest levels. This might look like a company buying extra equipment that increases worker productivity, wages, and employment while lowering prices for consumers.

Another structure of the DBCFT is its ‘trade neutrality.’ Not only are investments fully deductible, but the value of exports is deductible as well. Any revenue earned from selling to international buyers is not taxed. The rationale for this is twofold: (1) American-made products often already face taxation from other countries, and (2) taxing only domestic sales means a corporation’s headquarters’ location is irrelevant to the taxes it owes.

The DBCFT also taxes all imports. As in, when a company imports something from abroad, this is not an ‘expense’ for tax purposes, so the company pays whatever the DBCFT rate is. The export exemption and the import taxation are what make the DBCFT ‘destination-based.’ Companies pay tax based on where items are actually consumed and not where profits are headquartered. The anti-protectionists of the world might shout, “But that’s no different than a tariff! Why in tarnation would we support such a thing?!”

The DBCFT is industry and product-neutral since the tax rate applies to all imports. The DBCFT is also trade-neutral (i.e., it subsidizes exports and taxes imports at the same rate), so it doesn’t change trade decisions. When imports are taxed, domestically there is less demand for foreign products, which lowers the demand for foreign currency (since U.S. dollars are now exchanged less for foreign currency). This, in turn, strengthens the dollar. The strengthened dollar helps buyers import foreign products, offsetting some of the depressed demand from the import tax.

There are similar effects with the export exemption. U.S. exports become more competitive, causing demand for U.S. dollars to increase as foreign buyers want more U.S. products, but the stronger dollar makes it more expensive for foreign buyers to purchase U.S. products. Together, these effects offset much of the allocative inefficiencies with tariffs.

The DBCFT's structure also disincentivizes profit shifting and punishes tax havens. Corporations go through great lengths to shift their corporate and reporting structures to avoid corporate taxes. This is bad for domestic citizens losing out on socially valuable tax revenue, and it creates toxic international dynamics. For instance, a country like Ireland prefers the clunky, suboptimal status quo because corporations flock to its country to avoid international taxation.

Ireland helps companies shield super-normal returns to the detriment of citizens in every other country. Under a DBCFT, if a company shifts profits or production to a foreign country, but sells its products in the U.S., it still pays tax on most of its revenue. By taxing products based on where they’re consumed, the headquarter location or exact corporate structure of a business becomes irrelevant to the tax code, resulting in better outcomes for society and the economy.

The DBCFT also ends the deduction of interest from taxes. This eliminates a subsidy on debt, reducing corporations’ debt bias. As discussed above, this bias will remain as equity owners don’t like inviting outside investors if they can avoid splitting profits. However, eliminating the tax code bias on top of this results in more optimal capital structuring and allocation.

So what?

Alright, we understand the problems with the corporate tax and how a DBCFT solves them. Does this result in more revenue raised? Do rich corporations pay their fair share under a DBCFT? Does this tax really belong on a leftist policy platform?

The DBCFT has several positive distributional outcomes. (1) Full expensing causes corporations to invest more in productivity, innovation, and employment-enhancing ventures. (2) Taxing the corporate interest payments strips money away from wealthy lenders, and (3) the destination basis raises much more revenue by taxing a larger base of consumption (imports). All three of these things make the DBCFT more progressive than the current corporate income tax.

The DBCFT represents a smart and progressive tax policy for the future, and its placement on a leftist platform makes sense. A leftist can still talk about ‘raising taxes on corporations’, which the DBCFT does, and the same leftist can talk about the efficiency gains of the DBCFT relative to current policy, and I hope the DBCFT makes it into more leftist policy spaces in the future.