The Panama Papers has suddenly made taxes a very sexy issue.
The massive leak of documents tied to the Panama law firm of Mossack Fonseca revealed that Chinese and Russian heads-of-state as well as other government leaders have been stashing millions of dollars in shell companies incorporated in the so-called tax haven.
U.S. companies don’t use shell companies to hide their cash from authorities though they do use tax havens such as Panama and the Cayman Islands to shield profits generated abroad from U.S. tax collectors.
At present, U.S. companies hold somewhere between $2 trillion and $3 trillion in cash outside this country. They choose not to repatriate that money because to do so would expose them to a 35% marginal corporate tax rate that applies to revenue generated both within the U.S. and abroad.
Unlike most developed countries, the U.S. tax code, which hasn’t gone through a meaningful overhaul since 1986, taxes foreign revenue at the same rate as domestic sales.
Texas Senator Ted Cruz has called for reducing the effective corporate tax rate to 16% while the New York businessman Donald Trump does him one better, proposing to cut it to 15%. Neither Hillary Clinton nor Bernie Sanders have said they’re willing to lower the 35% corporate tax rate, insisting that whatever changes are made to the U.S. tax regimen generate more revenue for the government, not less.
“The debate on this issue, like the debate on many issues, is very exaggerated,”Robert C. Pozen, a senior fellow at the Brookings Institution, said in a phone interview in New York. “But if you continue to allow people to defer and shovel money into tax havens, they’ll do. You’ve got to deal with the tax haven problem.”
While the parties are far apart on the corporate tax level, they agree something needs to be done to encourage U.S. companies to invest their foreign profits in the U.S.
Sanders argues that U.S. companies should no longer be allowed to defer taxes on foreign profits. The right of deferral is an integral part of current law, allowing multinational corporations to sit on that money indefinitely, susceptible only to local taxes. Sanders says that by ending deferral, U.S. multinationals would have to pay the government around $620 billion.
Of course, ending deferral without setting a lower tax rate for previously generated profits would likely prompt dozens of U.S. corporations to execute “corporate inversions” as Pfizer (PFE – Get Report) did last year when it merged in 2015 with the Irish drug company Allergan Inc. in a $160 billion transaction.
So, how does the U.S. government devise a tax code that encourages repatriation?
The Cruz plan, like those favored by Pozen, would apply a 10% tax on previously generated foreign profits. Going forward, though, Cruz’s 16% tax would cause a revenue shortfall for the government of $8.6 trillion over 10 years, according to the non-partisan Tax Policy Center. Trump’s plan would create a gap of $9.5 trillion, increasing the national debt by 80%, the center estimates.
Neither Trump not Cruz lay out how they’d bridge that gap, and it’s unclear whether they’d even seek to do so. Cruz, for one, has called for eliminating the IRS as well as the departments of education, commerce and energy as well as that of housing and urban development.
“I don’t get the impression that they’re thinking about any offsets for their trillions in tax cuts,” Hunter Blair, budget analyst at the liberal Economic Policy Institute, said in a phone interview from Washington. “It’s mostly that they plan to make it up with enormous spending cuts.”
Clinton argues that U.S. corporations use a variety of lenient deductions to pay less taxes their counterparts in Europe and Asia. In recent weeks, her focus has been on preventing companies from using “tax inversion” mergers to relocate outside the U.S.
The former New York senator’s favors an “exit tax” to prevent companies from leaving the U.S. tax system through corporate inversions as Medtronic (MDT – Get Report) did earlier this year when it completed its acquisition of Dublin-based Covidien. Like Clinton, the Economic Policy Institute says that any reform of corporate tax rates should result in a system that is “revenue positive. In other words, generating money that either pays down the deficit or funds programs approved by Congress.
Apple stock is a holding in Jim Cramer’s Action Alerts PLUS Charitable Trust Portfolio. See how Cramer rates the stock here. Want to be alerted before Cramer buys or sells AAPL? Learn more now.
The argument in favor of cutting the corporate tax rate is that companies would bring money currently stashed in lower-tax countries or tax havens such as Panama or the Cayman Islands back to the United States to invest in factories and new jobs. The conservative Tax Foundation estimates that 425,000 to 613,000 new jobs would be created depending on whether the rate was lowered to 25% or 20%. Wages, the Foundation says, would increase by 1.9% and 3.6%, over the long-term.
Cruz and Trump are equally adamant that cutting the corporate tax rate would unleash a surge of investment by U.S. corporations, building factories and expanding their workforces within the U.S.
Others are less sanguine, arguing that lower taxes aren’t the main reason a company chooses to invest or not, and companies are just as apt to invest in hard assets as they are to use the cash to buy back their own shares. But that hasn’t kept proponents of a rate cut, such as CNBC’s Larry Kudlow from endorsing Trump’s plan while claiming it would “grow the economy…easily pay for itself.”
If the corporate tax rate is cut to 25%, Brookings Institution’s Pozen says, the government would have a shortfall of between $1.2 trillion and $1 trillion over 10 years. Bridging that shortfall will require closing a number of loopholes such as limiting the interest companies can deduct on their debt. Such a reduction could generate around $400 billion over 10 years.
Other loopholes worth closing would probably include those on hedge funds and corporate jets, but Pozen says that would only generate around $100 billion over 10 years.
To further close the shortfall, Republicans and Democrats will likely to establish a compromise rate on the $3 trillion that U.S. companies hold outside the country. Trump has proposed a rate of 10%, which Pozen says would likely be low enough to actually convince companies to move much of that money back to the U.S.
“Now 10% of $3 trillion is real money, it’s $300 billion,” said Pozen, who also serves on Medtronic’s board of directors.
Democrats, meanwhile, want to eliminate the right of corporations to defer paying tax on income generated outside the country. To do that, Republicans will want to establish a new rate on future income generated outside the U.S. That’s important given that U.S. companies currently only pay about 13% of their worldwide income in taxes, according to the U.S. Government Accountability Office.
So, what’s a reasonable corporate rate, and how can that shortfall be bridged?
Pozen proposes a rate of 25% for domestic income, and 17% for foreign income while eliminating the deferral.
However, each company would pay a foreign tax rate depending on where they were located. If the company is based in Ireland, where the rate is 12%, they’d pay just 5% to the U.S. If they’re in the Cayman Islands, which has a zero rate, they’d be required to pay the full 17%.
“With a 17% global rate, we’d start to see a lot of companies and people would be bringing back profits to the U.S.,” Pozen said. “The question is whether you could do it politically, whether people can get serious about this. And right now, who knows?”