March 13, 2017

Mindy Herzfeld

   

 

The border adjustment tax under consideration by Congress was conceived by some of the most creative and original academic economists working in public finance. But it is innovative precisely because it recognizes the limitations of economics in applying the current international tax rules in a coherent fashion. With a theory firmly grounded in economics, it allows the international tax system to move beyond the distortions that result from trying to apply the arm's-length standard in today's global markets.

Politicians who promote the border adjustment tax argue that taxing imports and exempting exports from taxation will create American jobs and spur economic growth. But that rationale is unfounded. If, as economists predict, the value of the dollar rises enough to fully offset the impact of the tax (and eliminate any economic distortions), a properly functioning border adjustment tax should have no net effect on the U.S. trade balance. It is impossible to reconcile the competing notions about the border adjustment tax -- that one, currency exchange rates will adjust to accommodate any trade distortions created by the tax, and two, the tax will cause a rebalancing of the country's trade deficit.

No -- the appeal of the border adjustment tax is that it forces a fundamental rethinking of the arm's length standard -- a standard that is under attack around the world. The tax is attractive because it removes from economists (who struggle to develop and justify coherent methods for applying an arm's-length standard in the wake of the OECD's base erosion and profit-shifting project) decisions about how to allocate companies' global profits. Instead, consideration of the proposal forces policymakers to decide where, as a normative proposition, global profits should be taxed. Adopting a tax based on those principles could then allow companies to decide where to locate operations and property on the basis of business efficiency, rather than forcing them to expend energy trying to justify why they choose to locate profits in low-taxed jurisdictions.

Ultimately, the border adjustment tax can strengthen American business because it may prompt multinationals to move their operations and assets back to the U.S. But that impetus will come from substituting sound economic principles for a broken transfer pricing system, not from taxing imports and exempting exports.


Questioning Economics

While the basic principles of modern economics are almost universally accepted, questions are increasingly being raised about how well they address real-world problems. In 2012 students at Manchester University formed the Post-Crash Economics Society, with a goal to reform the economics curriculum in response to the perceived failures of the discipline to address the root causes and consequences of the Great Recession. (David Pilling, "Crash and Learn: Should We Change the Way We Teach Economics?" Financial Times, Sept. 30, 2016.) Also in the United Kingdom, a group with similar goals has formed the Cambridge Society for Economic Pluralism. And the Rethinking Economics Network is a global network of local organizations that aims to democratize economics, make it more accessible to the public, and reform university economics curricula.

Joe Earle, a founder of the Post-Crash Economics Society and coauthor of The Econocracy: The Perils of Leaving Economics to the Experts, describes mainstream economists as:


    true believers in a largely discredited set of assumptions, who have invented a parallel universe with "well-defined mechanical relationships between different moving parts, connected by metaphorical pipes, cogs and levers."

A book by James Kwak of the University of Connecticut law school, Economism: Bad Economics and the Rise of Inequality, takes mainstream economics to task for refusing to take into account assumptions about the real world in creating economic models. Kwak coined the term "economism" to refer to a belief in a discipline based on the assumption that simple economic models accurately describe the world.

Economic Failures in Transfer Pricing

The failure of economic theories to address issues of distributional equality and inequality parallels many shortcomings of the international tax system. That system relies on transfer pricing rules -- with an arm's-length standard as their practical embodiment -- to allocate multinationals' profits among jurisdictions. The standard requires economic modeling to determine whether the prices charged by one entity to a related entity for goods, services, or the use of intangibles are at arm's length.

Applying the standard requires examination of comparables supposedly based on how unrelated third parties would price a given transaction. But here the notion of comparables is problematic because third parties cannot have contractual terms similar to those of related parties, and global groups allow for synergies that generate greater profits than unrelated parties could possibly achieve.

Reliance on a method supposedly grounded in sound economic theories has allowed tax policymakers to avoid responsibility for the results of the rules they've put in place. It has permitted them to skirt the hard questions that should be answered in trying to design an international tax policy grounded on principle.

It's not just the arm's-length standard that is increasingly divorced from economic reality, but, more fundamentally, the basic building blocks of the U.S. international tax rules as well. In a 2013 article that predicted many of the challenges the OECD would face during BEPS, Hugh Ault of Boston College Law School explained that the failures of the international tax system stem from an essential disconnect between the rules and basic economic principles, specifically as they relate to defining the source of income 2013 WTD 116-17: Viewpoint.

Allocating income among jurisdictions according to U.S. tax rules requires identifying the source of an item of income. But as Ault observed decades ago, "the source of income is not a well-defined economic idea." ("Taxing International Income: An Analysis of the U.S. System and its Economic Premises," National Bureau of Economic Research Working Paper 3056 (Aug. 1989).)

Ault is not alone in pointing out that the notion of source is not based on well-defined economic concepts. More recently, Wei Cui of the University of British Columbia has written about the arbitrariness of the concepts of source and residence. ("Minimalism About Source and Residence," 38 Michigan Journal of International Law (2016). See also Allison Christians, "Human Rights at the Borders of Tax Sovereignty" (Feb. 2017).) If the source rules are essentially arbitrary, Ault notes, "decisions about the assignment of taxing jurisdiction in terms of source rules and the corresponding obligation to give double tax relief are essentially political." But, historically, policymakers may have tried to obscure the political nature of their decisions by coating them in the veneer of economics.


Economics and BEPS

The BEPS project highlighted the disconnect between attempts to paint the system of allocating profits among countries as rooted in economics and the sound application of economic principles. According to the BEPS action plan 2013 WTD 140-17: Other Administrative Documents, the updated transfer pricing rules developed in the project will ensure that profits are taxed where value is created. The OECD has emphasized that the overall goal of the BEPS measures "is to realign taxation with economic substance and value creation" (http://www.oecd.org/ctp/beps-frequentlyaskedquestions.htm).

But as economists Michael Devereux and John Vella (who have worked to develop a destination-based cash flow tax proposal) noted in 2014, looking to value creation as a rationale for determining the allocation of global profits was invented during the BEPS project. ("Are We Heading Towards a Corporate Tax System Fit for the 21st Century?" Oxford University Working Paper Series WP 14/25 (Oct. 2014).) They argue that "the use of a new notion of economic activity, substantial activity, or value creation raises a number of problems," and explain why focusing on value creation and economic activity as a basis for allocating global profits is so problematic.

Devereux and Vella point out that because multinationals have shareholders, affiliates, and consumers located in different countries, "there is no clear conceptual basis for identifying where profit is earned; all those locations may be considered to have some claim to tax part of the company's profit." They argue that rules developed under transfer pricing guidelines -- such as cost contribution agreements and the treatment of risk -- demonstrate that "blindly following an apparent principle" such as the arm's-length standard "can lead to outcomes that make little or no sense from an economic perspective." They conclude that, while ostensibly grounded in sound economic principles, the arm's-length standard as applied today reflects results that arise when the rules are divorced "from any economic reality."


BEPS Arm's-Length Standard

To tax profits where value is created, the new BEPS transfer pricing guidelines supposedly rely on the arm's-length standard. To determine where the profits derived from intangibles should be allocated, transfer pricing guidelines require analysis of the development, enhancement, maintenance, protection, and exploitation functions to determine where value has been created. But the new guidelines simply make the incoherent pre-BEPS standards even more so. (Prior analysis: Tax Notes Int'l, Aug. 1, 2016, p. 360 2016 WTD 147-1: News Stories.)

Companies trying to meet the poorly defined new transfer pricing guidelines and ensure they have met the requirements for supporting a claim that value creation has taken place in a specific jurisdiction can do little more than play a guessing game. That game will likely lead to further distortions of business models in order to minimize tax risks in the most aggressive jurisdictions, as companies shuffle people around to ensure that their country-by-country reports reflect enough high-level personnel within a jurisdiction to justify the profits allocated there.

CbC reporting will likely force companies to better align the number of workers in a jurisdiction with the profits allocated there. But the number of workers in a country may relate only tangentially -- if at all -- to the profits earned there. High-tech firms can produce huge profits with just a few employees, while companies in industries like agriculture and retail generate low profits with small numbers of people.

There is little economic rationale for this whole exercise. As Devereux and Vella note, "from a conceptual perspective, a system that seeks to align taxing rights over income with the 'economic activity' which created it is questionable because it is not at all clear where such economic activity actually takes place."

The BEPS transfer pricing guidelines disadvantage companies and tax administrations alike as they seek to identify reliable standards to determine the acceptability of competing methods for allocating value among different jurisdictions. Poorly articulated rules open the door for aggressive planning. But they also permit aggressive tax administrations to claim that the standards haven't been met, regardless of the facts and a company's profit model. When that happens, auditors can go fishing for profits, and taxpayers have little ground to stand on.


The Promise of a Border Adjustment Tax

The failure of our system purportedly based on economics to address broader distributional questions -- and to develop meaningful principles to allocate profits among jurisdictions -- heightens the appeal of a border adjustment tax. At the same time, it's important to recognize that the tax proposed in the House Ways and Means blueprint is no magic bullet. The concerns of its many detractors -- such as the potential for serious repercussions to the global financial system if widely adopted by others, and likely retaliation from trading partners -- are valid. And as some have noted, the border adjustment tax will likely still employ transfer pricing principles, along with all their attendant tax planning opportunities . (David Hariton, "Planning for Border Adjustments: A Practical Analysis," Tax Notes, Feb. 20, 2017, p. 965 .)

But the proposal for a destination-based cash flow tax also takes the first real steps away from the current system based on economic principles that have failed in the real world. In a recent paper, Devereux and his colleagues argue that taxing business income in a relatively immobile location -- where goods are sold -- "should not distort either the scale or the location of business investment and eliminates the tax bias towards debt finance by assuring neutral treatment of debt and equity as sources of finance." ("Destination-Based Cash Flow Taxation," Oxford University Centre for Business Taxation Working Paper Series WP 17/01 (Feb. 2017).)

If a system based on economic principles that cannot be implemented in the real world has led to inefficient structures, it's time to try one that could eliminate those inefficiencies. If the role of tax rates is minimized in business decision making, operations and high-value assets could very well move back to the U.S.

The authors make other arguments for the destination-based cash flow tax as well. They argue that it would be more progressive than a single rate VAT and more progressive than current corporate taxes. They say it should make it "considerably harder" to shift profits to low-tax jurisdictions and will minimize the pressure for countries to set a low corporate tax rate to compete with neighbors.

One of the biggest objections to the destination-based cash flow tax is that it would violate U.S. trade obligations under WTO agreements. It's easy to dismiss comments made by the Trump administration questioning whether the United States should continue adhering to those agreements, as indicative of a general antipathy to multilateral agreements. But in acknowledging that the international tax system is based on economic principles that have failed, part of that reexamination may require a review of the trade agreements that articulate distinctions between different types of taxation that may also lack a solid economic rationale.

Despite the challenges of its adoption, the serious consideration of a border tax adjustment as proposed by the House Republican blueprint allows policymakers to begin a thoughtful conversation about how to allocate taxing rights in the modern economy, better grounded in principles of sound economics and distributive justice. It's a conversation that is needed so that the tax world can stop pretending that an allocation based on a flawed application of the arm's-length pricing has any real economic meaning and can be justified on grounds of international equity.