COLUMN-Stateless income: David Cay Johnston

Tue Oct 4, 2011 8:18am EDT

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The author is a Reuters columnist. The opinions expressed are his own.

By David Cay Johnston

LOS ANGELES Oct 4 (Reuters) - From the way Washington politicians in both parties tell it, you may well think that multinational companies favor low-tax jurisdictions when investing overseas. They don't.

The multinationals prefer investing in high-tax jurisdictions because it so happens that is where they can earn the highest returns.

Multinational companies then reduce or eliminate those seemingly high taxes by using simple, widely used devices to take profits in low-tax and no-tax jurisdictions.

Such practices create "stateless income," in the words of Edward Kleinbard, whose new scholarship on corporate taxation deserves our attention.

As defined by Kleinbard, stateless income means profits earned in a country other than where the firm is headquartered and subject to tax only in a third country which imposes little or no tax.

Kleinbard shows why stateless income is the most serious threat to the corporate tax base even as Washington politicians blather on about less important corporate tax issues that their remarks show they do not understand.

Kleinbard is a master designer of tax avoidance devices for multinational corporations. During three decades as a Cleary Gottlieb Steen & Hamilton tax partner, Kleinbard also wrote scholarly critiques of tax policy, simultaneously exploiting and exposing flaws in tax regimes.

In 2007 Kleinbard became chief of staff for the Congressional Joint Committee on Taxation. Since 2009 he has been a professor at the University of Southern California's Gould School of Law.

HARD FACTS

In three lengthy new essays Kleinbard tries to open minds to hard facts and logic to steer the corporate tax debate back to policies based on reality -- economic, accounting and legal.

To see the essays, click r.reuters.com/rer24s, r.reuters.com/dyr24s and r.reuters.com/hyr24s.

In a global economy in which capital markets are efficient and capital flows across borders at the push of a button, after-tax returns on investment will gravitate toward a mean. Kleinbard uses a global 5 percent after-tax return to model the issues.

Because different countries impose different tax rates this means that pre-tax returns must vary, with companies having to find ways to earn more in high-tax jurisdictions than in low-tax jurisdictions.

Kleinbard cites a hypothetical example with three countries, two of them make-believe, to show the tax algebra.

The United States imposes a 35 percent corporate income tax, Sylvania a 25 percent tax and Freedonia 10 percent. The algebra says pre-tax returns should be 7.7 percent in the U.S., 6.67 percent in Sylvania and 5.56 percent in Freedonia.

A U.S. firm will invest in high-tax Sylvania rather than low-tax Freedonia, Kleinbard wrote in a lengthy essay for Tax Notes. Then the company will game the rules of the three countries to easily report its profits for tax purposes in low-tax Freedonia.

The result is the Sylvania investment earns 6 percent after tax. That is a fifth more than the 5 percent worldwide after-tax return in Kleinbard's model.

Juicing after-tax profits using the simple, widely used devices to take profits in real places like the fictional Freedonia distorts investment decisions and erodes the U.S. corporate tax base. Kleinbard suggests it also inflates U.S. stock prices.

"TAX RENTS"

That multinationals can earn a fifth higher profit this way exemplifies what Kleinbard calls "tax rents," meaning benefits derived not from value-adding economic activity, but from exploiting the rules of different national tax systems.

Corporations that operate only in the U.S. should worry about rules that encourage multinational corporations to create stateless income because the result tilts the playing field against purely domestic companies, many of which are family-owned.

"Stateless income tax planning offers multinational firms, but not wholly domestic ones, the opportunity" to earn higher after-tax profits not because they are more efficient, but because of "their unique ability to move pre-tax income across national borders."

If tax rules let a competitor game the tax system to earn $1.20 of after-tax profit for every $1 a purely domestic company can earn, then it is just a matter of time before the disfavored business deteriorates while the competition flourishes. Thus does government policy, not market competition, subtly determine winners and losers.

Ignoring the reality of tax erodes the tax base, distorts economic decisions and through shortsighted policy enriches the few at the expense of the many.

That corporations prefer investing overseas in high tax countries may seem to defy common sense. But much of tax is counterintuitive and requires careful study of a kind that was once much more common on Capitol Hill. Sadly, as partisanship has grown along with reliance on campaign donors, serious thinking about taxes has been supplanted by ideological marketing that has more in common with advertising than serious policy debates.

Since tax is the largest economic activity in the world, it is crucial that we base our policies on facts, not fantasies, if civilization is to endure. Get tax wrong and the damage diminishes markets, distorts investments, destroys private wealth and endangers social stability.

This column will explain more of Kleinbard's insights in the weeks ahead, along with those of others whose rigorous thinking and research reveal that much of the Capitol Hill tax debate displays magical thinking. (Editing by Howard Goller)

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