U.S. tax expert recommends worldwide tax system

Update: this has now been updated, with better links and, in particular, the addition of the crucial words in bold here: "Kleinbard's use of the term 'consolidation' does not necessarily suggest that he favours formula allocation approaches."

Professor Ed Kleinbard of the University of Southern California, a high-profile tax commentator, has looked at the issue of territorial versus worldwide taxation - an issue we blogged recently after a top U.S. Republican called for the U.S. to become more like a tax haven and adopt a "territorial" tax system (see our pocket explanation of the two different systems at the bottom of this blog).

To cut to the chase, Kleinbard in two papers (part 1 here and Part 2 here) looks at the huge volumes of "stateless income" (which is, by and large, offshore income subject to zero or very low tax rates - and there is about US$1 trillion of it out there for U.S. firms alone) and considers what the implications are for the U.S. tax system. He notes that "the pervasive presence of stateless income tax planning changes everything" and concludes a couple of things. First, that:

"any suggestion that current law disadvantages U.S. multinational firms in respect of the effective foreign tax rates they suffer, when compared with their territorial-based competitors," is "inconsistent with the data."

In other words, all those claims that the U.S' current corporate income tax rates are somehow 'uncompetitive' are, at least if you look at the data, bunk. Second, he concludes that

"Stateless income privileges multinational firms over domestic ones by offering the former the prospect of capturing “tax rents” – low-risk inframarginal returns derived by moving income from high-tax foreign countries to low-tax ones"

Which is as we have argued for years. And there are further conclusions:

• a systematic bias towards offshore rather than domestic investment and in favor of investment in high-tax foreign countries (TJN: because it's far easier for them to do their transfer mispricing out of other countries than out of the U.S., which for all its faults has a sophisticated revenue service.)
• the erosion of the U.S. domestic tax base through debt-financed tax arbitrage (TJN: which we've blogged often before)
  
• Many instances of deadweight loss ( TJN: as a result of all the distortions and expensive tax gymnastics required for "manning the various dials and gauges of the tax planning mechanisms" - so much for the so-called 'efficiency' of offshore that their defenders keep banging on about),
• the lock-out phenomenon, where U.S. firms accumulate vast earnings outside the U.S. - more than they profitably can redeploy, to the great frustration of their shareholders, who would prefer that the cash be distributed to them ("shareholders are tantalized by glimpses of enormous cash hoards just out of their reach.")
  

It also looks at the failure of critical assumptions that the defenders of territorial tax systems make, and finally:

"the paper ultimately concludes by recommending a worldwide tax consolidation solution."

This is similar to recommendations recently put forward by Citizens for Tax Justice in the U.S. Kleinbard's use of the term 'consolidation' does not necessarily suggest that he favours formula allocation approaches (something that the OECD opposes, and which TJN generally favours. See more on this here.) However, he does argue that

"a powerful case can be made that a well-ordered territorial tax system necessarily implies the systematic application of formulary apportionment rules for at least some activities of a multinational group."

Pocket Explanation: territorial vs. worldwide Under a 'territorial' system, countries don't tax income earned outside their borders; with a 'worldwide' system, companies are taxed on all income regardless of where in the world it is earned. (In practice, most countries have a mix of the two. The United States has a nominally worldwide system, but the fact that it often lets companies 'defer' tax by keeping it offshore makes it what Kleinbard calls a "quasi-territorial" tax system, or "an ersatz variant on territorial systems".) Tax havens generally have highly 'territorial' systems, though many supposedly 'onshore' economies do too - and territorial systems generally make it easier for companies to cut their tax bills by shifting profits offshore under these systems.