The author is a Reuters columnist. The opinions expressed
are his own.
By David Cay Johnston
LOS ANGELES Oct 4 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.
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
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
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
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
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.
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
"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
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
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)