World needs to change the way it taxes companies

How should we tax companies in a world of mobile capital and global corporations? How should we encourage corporate investment and discourage financial engineering? How should we reduce the taxation of labour? How should we tax rent, rather than productive activity? How should we discourage complex tax avoidance? How, not least, should we reduce incentives for a global race to the bottom on taxation of companies?

These are immensely important policy questions. They matter not only for the ability of governments to raise revenue, but also for the political legitimacy of capitalism. Sadly, some good answers to these questions were under discussion in the recent US debate on reform of corporate taxation, but were buried in the end. The reform had two principles: tax would fall on cash flows and it would apply to the destination of corporate transactions, not to their origin. Some experts have proposed a system known as a “destination-based cash flow tax”. It has much in its favour.

The tax base for such a system would be non-financial inflows, less non-financial outflows. (A base that includes financial inflows and outflows is also feasible. But I will ignore that here.) The costs of investment and labour would be deducted as made, but no deduction would be allowed for financial costs. The full expensing of spending on investment would make the government a partner in investment projects, contributing to them and gaining returns from them in equal proportion. The tax would ultimately bear on corporate rent — returns above the costs of the factors of production (including capital) needed to create them. Rent is also what we should tax.

A significant benefit of this system is that there would no longer be today’s bias in favour of debt finance, which creates significant risks to economic stability, as the financial crisis demonstrated. More broadly, much of the financial engineering we witness must be driven by little more than the desire to avoid tax. This provides no social benefit whatsoever.

The other big change would be towards taxing consumption (destination) rather than production (origin). One way of thinking about this is that we would be replacing the current effort to tax profits where they are created with a value added tax that exempts labour costs. Exempting labour costs is evidently attractive.

Furthermore, under taxation by origin, companies have an incentive to move their production to low-tax jurisdictions, away from the jurisdictions that made them successful. In today’s circumstances, what with the internet and the role of intellectual property, much of this relocation of productive assets is just a (highly profitable) figment of the imagination. But destination is not a figment, since it is far harder to obscure where something is sold than where it is made. The shift to destination taxation would force companies to pay taxes in the markets that matter.

One of the big attractions of this reform is that it would benefit a country, even if it made the shift on its own. The incentive to invest in the country making the change would increase, because of the full deductibility of investment. The new tax would be relatively simple to impose, since it would be levied on the sales of a company in its own markets. More attractive still, if a country introduced this form of taxation it would cease to impose corporate taxes on domestic production aimed at foreign markets. This would create a sizeable incentive to shift production into the country introducing the reforms. That incentive might persuade other countries to follow suit.

That is why the failure of the US to implement the envisaged reform was such a pity. But the post-Brexit UK should urgently consider the proposed reform for itself. It would improve the incentive to invest; it would make the UK a more attractive base for production for world markets; and it would largely eliminate the unfairness of lightly taxed companies, based abroad, undercutting domestic competitors.

The reform would create challenges. One is that exports from resource-based companies would not bear the tax. A specific tax on resource rents would be needed, therefore. Problems, albeit soluble ones, also arise in the treatment of financial companies.

Yet the big point is clear. The present origin-based corporate tax system, especially with deductibility of interest and insufficient deduction for spending on investment, is creating huge problems. Instead of tinkering endlessly with it, we need a more radical reform. Destination-based cash flow taxation is that reform. Somebody needs to try it.


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