Thursday, July 26, 2007

A formula for development?

An excellent story in the New York Times about the U.S. drugs industry has exposed one of the great canards of international tax theory: that tax breaks (we should call them tax subsidies) are a good way of creating jobs. The newspaper cites a big tax amnesty two years ago.

Drug makers were the biggest beneficiaries of the amnesty program, repatriating about $100 billion in foreign profits and paying only minimal taxes. But the companies did not create many jobs in return. Instead, since 2005 the American drug industry has laid off tens of thousands of workers in this country. And now drug companies are once again using complex strategies, many of them demonstrably legal, to shelter billions of dollars in profits in international tax havens, according to their financial statements and independent tax experts.

U.S. drug companies should pay up to 35 percent of their worldwide profits in U.S. federal taxes. Last year, according to the New York Times, Eli Lilly paid less than 6 percent, and since early 2005 the company has cut its U.S. workforce by over 8 percent. The American biotechnology giant Amgen cut its tax bill by claiming a profit margin of almost 100 percent on its foreign sales, but only 15 percent on its American sales. And so on.

Here’s the problem, as Michael J. McIntyre at Wayne State University in Detroit explains. When companies transfer products between divisions in different countries, they account for the sales internally through “transfer pricing.” But they have significant discretion in how they set prices for these transactions.

In one popular accounting move, companies declare their foreign markets as far more profitable than their American businesses — even though drug prices are typically higher in the United States than anywhere else in the world.

Under the rules of transfer pricing, if a company moves patents or other so-called intangibles from its United States division to a foreign subsidiary, the foreign unit is supposed to pay the American division a fair-market price. But outsiders have a difficult time determining if companies have properly assessed the value of patents, trademarks and other intangible properties. If they bring the money back to the United States to distribute to their shareholders, they still have to pay American taxes on it. But President Bush signed legislation in 2004 to let companies return overseas profits at a rate of 5.25 percent, far below the official tax rate of 35 percent, if they moved the money back by 2006.

This tax amnesty, which Democrats and Republicans supported, has expired, but it has emboldened companies to be even more aggressive about sheltering their money, expecting another holiday in the future. “Congress can swear on two stacks of Bibles that it’ll never do it again,” said H. David Rosenbloom, director of the international tax program at New York University “but they’ve lost their virginity.”

The United States is a grown-up country, and it can look after itself, one might argue. If a country as powerful as that struggles to tax its companies, imagine how hard it is for an African country to tax investors. Read this BBC story to find out how the Kenyan taxpayer is being diddled, using the same transfer pricing tricks. Charles Abugre, head of policy and advocacy at Christian aid, has pointed out just how important this issue is. It is, he says, “the missing link in the whole of international development campaigning." He is dead right.

More generally, in rich and poor countries alike, pernicious tax competition between jurisdictions has made this kind of tax-dodging easier, creating a trend to reduce taxes on business profits and generally on income from capital means that the tax burden increasingly falls on individuals (especially employees), as well as on indirect taxation, whose burden falls most heavily on the poor.

What is the simple answer to all this? Offshore tax havens are clearly central to the problem, and must be confronted. The New York Times offers another approach: a system of accounting rules in which companies would assign a portion of profit to each country where they made a sale, relative to the size of the sale. This would, among other things, tame the dangers of tax competition. Read more about this idea, which is known by the rather unwieldy phrase of “formulary apportionment” in this in-depth report from the Brookings Institution. As it says:

This system is similar to the current method that U.S. states use to allocate national income. The state system arose due to the widespread belief that it was impractical to account separately for what income is earned in each state when states are highly integrated economically. Similarly, in an increasingly global world economy, it is difficult to assign profits to individual countries, and attempts to do so are fraught with opportunities for tax avoidance.

TJN wants to bring these seemingly arcane matters to wider attention. Before too long we will be bringing out research on this subject which is aimed more at the UK, with the aim of linking up with the U.S. debate and on the European Commission’s work on a Common Corporate Consolidated Tax base. What is now needed is for journalists, academics, pro-democracy (and anti-poverty campaigners) and others to start grappling seriously with these issues, which have tax havens at their heart. These matters may seem arcane, they must be tackled urgently. As Raymond Baker rightly points out, the offshore world is “the biggest loophole in the free-market system.”

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