In debates regarding higher versus lower corporate income taxes, an important issue is the impact that changes in either direction would have on the level of domestic investment, and consequently on economic growth, the strength of the labor market, and government revenues.
Proponents of the 2017 Tax Cut and JOBS Act (TCJA) argued at the time of its enactment that cutting the United States corporate tax rate from 35% to 21% would spur investment in the United States, particularly by multinational corporations. Some further claimed that, by reason of these investment responses, the TCJA would only minimally, if at all, reduce federal income tax revenues.
More recently, there have been warnings that the proposed partial reversal of the TCJA’s corporate tax rate cut would slow investment and hamper economic growth. What do economic reasoning and recent experience teach us about the effects of corporate tax rates on investment and economic growth in a global environment?
The argument that lowering the corporate tax rate increases domestic investment, economic growth, and jobs focuses on the after-tax return on investment. A multinational corporation will have investment opportunities across the countries in which it operates. Its return on an investment in a particular country may partially depend upon the statutory tax rate in that country—a higher tax rate, all else equal, reduces the after-tax profit. Lower expected after-tax profits will reduce investment.
Conversely, if a country cuts its statutory tax rate it should expect to see more domestic investment (by both solely domestic companies and multinational corporations), all else equal. This, in turn, would be expected to raise this country’s stock of capital, and, with more equipment, machines, and factories, national income should rise. Workers’ incomes could also increase, since the greater stock of capital would make them more productive, potentially raising their wages. The increase in economic activity would mute the shortfall in government revenues due to the tax cut. Note that these outcomes assume companies respond to lower tax rates by investing more, that this leads to higher national income, and that worker pay responds to changes in productivity.
The TCJA offers an example to test whether a tax cut spurs investment. There is an emerging consensus that the reduction of the corporate tax rate from 35% to 21% in the 2017 Tax Cut and JOBS Act fell well short of raising investment to an extent consistent with the argument outlined in the previous bullet point.
For example, a study conducted by the International Monetary Fund (IMF) concluded that the growth in business investment over the 2017 to 2019 period fell short of what would be expected, either under the above argument outlined or based on the historical relationship between tax cuts and investment.
In addition, the TCJA appears to have resulted in a substantial reduction in government revenue—an estimated $275 billion, or 7.6% of government revenues that were expected before the tax cuts took place. A respected independent analyst, the Tax Policy Center, recently estimated that—even before the pandemic’s onset—the TCJA was on a path to lose $1.6 trillion of government revenues over 10 years. This exceeds the initial estimate of a $1 trillion shortfall, reflecting the tepid response of investment to the lower tax rate, as well as other features of the Act.
The disappointing investment and revenue response to the TCJA reflects some important features of the current tax and economic environment; among these is companies’ ability to earn high profits in a country through valuable intellectual property (IP) that need not be generated in that country.
To illustrate how valuable IP may reduce MNCs’ responsiveness to tax-rate changes when they are earning high profits in particular countries, consider Facebook
when it is deciding whether to use its platform to generate advertising revenues from the users in a given country. It can be active in that country at a relatively low added cost, allowing it to earn high profits there (taking as given the IP it has), without reducing its presence in other countries. In addition, unlike a firm that is deciding where to place a new factory, with only one such factory being needed to support expected global production levels, Facebook’s profits from engagement in each country may be largely independent from profits it would earn in any other country.
Under these circumstances, it may neither be tax-deterred by local corporate taxes that merely reduce the after-tax level of such high profits, nor encouraged to do more by lower tax rates. Moreover, insofar as valuable IP allows MNCs to earn high profits in those countries that do not affect their profitability in other countries, the same analysis can apply to bricks-and-mortar companies that operate through conventional retail establishments, such as McDonald’s
(whose IP is their brand).
Such companies likewise can decide separately on their activity levels in each country, rather than choosing between countries, and will not be deterred by an increased tax rate insofar as the IP’s value still permits them to earn high profits.
A second key feature of the current tax and economic environment that helps to explain the disappointing investment, growth, and revenue response to the TCJA is that the statutory tax rate differs from the effective tax rate facing corporations.
The actual tax rates paid by U.S. corporations are far below the statutory rate (e.g. 35% before the TCJA, 21% after) because of a range of available deductions and other tax benefits. For example, many large U.S. companies pay no current-year income taxes at all in years when they report high profits to shareholders, due to legal deductions and exemptions in the tax code. At least 55 of the largest corporations in the United States paid zero dollars in federal corporate income taxes in 2020.
This may cause the actual effect of a tax cut to be much smaller than what would be expected based on a consideration of the change in the statutory rate alone.
The effect of a statutory tax cut is even more muted for multinational corporations because of a pervasive accounting practice known as “profit shifting.” Profit shifting occurs when multinational corporations book profits and deductions in such a way as to minimize their global tax liabilities.
For example, a multinational corporation could disproportionately report its gross income as arising in tax haven such as Bermuda with low rates, and its deductions as arising in high-tax-rate countries like the United States. Profit shifting reflects a separation between actual economic activity and where those activities are recorded for tax purposes.
Profit shifting is especially feasible for highly profitable “New Economy” companies, such as Apple
Facebook, or Alphabet
(along with many of their less famous peers). The returns to investments for these “new economy” corporations reflect the value of IP—a key input to corporate profitability today. But profit shifting is also available to a significant degree for traditional companies with retail outlets, such as Starbucks and McDonald’s, if they likewise rely on valuable IP (such as brand names, trademarks, and know-how) to generate large profits.
The ability of a multinational corporation to change its official corporate residence also affects its tax liability. U.S. international tax rules that have been around since 1962 (and that were retained in the TCJA), along with analogous provisions in numerous other countries’ international tax systems, tax U.S. companies’ foreign source income that can easily be reported in tax havens (e.g., because it is “passive,” like bank interest and dividends on portfolio stock).
However, these taxes can be avoided by a nonresident multinational corporations, giving rise to an incentive for “inversion”—U.S. companies effectively reclassifying themselves as foreign companies. The feasibility of preventing this depends on issues such as how multinational corporations’ place of legal residence is determined, the ease of changing residence, and how responsive new corporate equity and investments are to residence status.
The experience under the TCJA demonstrates the difficulty of addressing profit-shifting. The TJCA added two main provisions that were meant to address profit-shifting. The first, known as GILTI (for “global intangible low-taxed income”), imposed a10.5% tax on the amount of a U.S.-based multinational corporation’s income from foreign sources that exceeded a 10% return on all of its tangible property used in business abroad. The second, known as the BEAT (for “base erosion anti-abuse tax”), addressed the use of deductible payments to shift reported profits outside the United States by both U.S.-based and foreign-based multinational.
However, both provisions were seriously flawed. For example, GILTI’s impact can be reduced by pairing high-tax with low-tax foreign source income to derive maximum benefit from the use of tax havens. The BEAT is rife with avoidance opportunities that reflect its hasty and sloppy design. A recent study, using data predating the COVID pandemic, found that the TCJA failed to make a significant dent in corporate profit-shifting. While the TCJA’s failure significantly to reduce profit shifting reflected its rushed and secretive enactment process, it also testified to the inherent difficulty of the task.
The Biden administration’s 2021 tax proposals offer two main responses to the concern that increasing taxation of the foreign source income of multinational corporations based in the United States will lead to a reduction their investments.
First, the Biden administration plan aims to strengthen the existing anti-inversion rules, to prevent existing U.S. companies from effectively reclassifying themselves as foreign companies. Second, it aims, by multiple means, including proposed U.S. tax-rule changes, to reduce tax competition between countries and increase the extent to which they instead cooperate toward ensuring that highly profitable multinational companies will pay significant taxes somewhere.
In particular, the U.S. is seeking to reach widespread agreement that such companies should face a 15% global minimum tax, requiring them to pay at least that global rate, whether to source or residence jurisdictions. These efforts have met with some initial diplomatic success, in the form of a recent agreement between the G-7 nations to coordinate the design and imposition of a global minimum tax. However, it remains too early to tell how these efforts will turn out in the end and challenges remain, including the refusal by a set of countries to sign onto the deal.
What this Means:
The premise behind the 2017 tax act’s substantial corporate tax-rate cut, which was that it would attract a flood of inbound investment by reason of global tax competition, rested on a dated understanding of the corporate sector that has far less validity today than in the past. An analysis that takes into account the more contemporary corporate landscape, backed up by empirical studies of the investment response to the 2017 Act, suggests that somewhat increasing the U.S. corporate rate, as in the Biden administration’s 2021 tax proposals, would not lead to significant shifting of investment to other countries.
However, the extent to which increasing residence-based taxation of U.S. companies’ foreign source income would succeed in raising revenue and protecting the U.S. tax base, rather than leading to the greater use of non-U.S. companies in investing abroad, remains less certain.
Daniel N. Shaviro is the Wayne Perry Professor of Taxation at the New York University School of Law. His scholarly work examines tax policy, budget policy, and entitlements issues.