By Tom Pallow of Third Way Progressives
With the rising problems in the Middle East, it is now more important than ever that we begin to fix and reverse our nation’s budget and economic problems. Not doing so will only further embolden those in this world who hate the US, think we are now weak, and therefore believe that this is the best time to attack! Yes, we are now actually in a time in our nation’s history where the courage and hard work of tax and economic counsels on Capitol Hill will save American lives!
A little more of this paper will be about Employer Tax Carve Outs and how important and beneficial it would be for all Americans if Democrats help enact ETCOs, like that in Collins/McCaskill S 1960, and other tax reforms as soon as we can while beginning now to talk on the campaign trail about tax inversions, tax reform, and ETCOs. But most of this paper will be what I believe is a great outline of a very specific and very workable and bipartisan, comprehensive tax reform plan, with a very specific emphasis on issues related to forms of foreign tax evasion, like tax inversions, income stripping, transfer pricing, and intellectual property tax avoidance, and the like, also with an emphasis on how Employer Tax Carve Outs, and Employee Tax Credits which create ETCOs, can help the US and our OECD partners in these problematic areas.
With Americans being beheaded, very porous US borders, and an economic “recovery” of low paying and part-time jobs, Americans will now vote for real problem solvers of any party, I believe the below, tax reform plan would play an intricate role in helping to solve our nation’s budget and economic problems, while also being of great political benefit to agreeing politicians!
When addressing the problems of Foreign Tax Evasion, problems like Earnings Stripping, Transfer Pricing, Tax Inversions, and Intellectual Property Tax Avoidance, there are three very important realities to kept in mind. First off, for the US, all forms of foreign tax evasion only affects the area of our federal tax code that collects usually less than 10% of all federal revenues, this primarily being from the C Corporation portion of Title 26, so therefore, any minor political disagreements over how the issues of FTE are resolved in any less or more comprehensive tax reform legislation should not be used as an excuse for Congress to not move on overall business tax reforms that will, with Employer Tax Carve Outs, positively affect at least 45% of our federal revenues and as much as 60%. Secondly, there already exists much bipartisan political agreement regarding a few of the most prominent questions regarding FTE, and some newly proposed legislation regarding FTE will also improve our code. Thirdly, ETCOs, and Employee Tax Credits that help create ETCOs, can greatly improve the efficiency and fairness of our nation’s, as well as the world’s, international tax system.
Very quickly, ETCOs in their simplest form allow governments to raise revenues through the personal income tax system without raising taxes. This is possible by shifting the tax burdened off of domestic employers and onto wealthy non-employers. With such a shift America’s fastest growing domestic job creators, an area of the economy with one of the fastest rates of velocity of money, get to keep more of their capital so that they can invest more in the US and increase the demand for labor domestically. Also with ETCOs, taxes are raised on wealthy non-employers, where the lowest velocity of money exists, and with ETCOs a new tax incentive exists for the wealthy and all to find ways to become wealthy by employing domestically!
The primary keys for allowing this all to work are the fact that relatively few people employ fellow citizens and the fact that ETCOs are created by using Employee Tax Credits that are always worth less than the employer’s side of all FICA taxes paid which also must be paid in order to take advantage of ETCs. So therefore, ETCOs are not government subsidies, and they will be very easy for the IRS to police because they will be worked through our FICA tax system that, despite it’s problems, is one of the most well documented groupings of tax or economic data either with the public or private sector.
Most importantly, ETCOs simply allow governments in the world’s now hyper competitive global economy, with a 12 fold increase in economic competition for the US since 1967 alone, to raise personal income taxes on their wealthy without adversely affecting potential domestic job and income growth and domestic global business competitive advantage. With ETCOs the math of the personal economics of the wealthy always works to create a more efficient, wise, and prosperous tax policy. That is, with a peak of about 16% at about the point of the top 1% of US incomes, and dropping quickly going higher or lower, the fact is that very few personal income tax revenues are generated from the active profits of a business that is taxed as personal income that has one or more employees in the US, and these numbers have remained historically and universally very stable (1). ETCO will allow the US, the rest of the OECD, and more, to raise taxes in the area of the economy where the lowest velocity of money exists, with wealthy non-employers, while giving more capital to the economy’s most dynamic and fastest growing domestic job creators. ETCOs allow for much more sound government budgets, increases in private sector job growth, and the ability for governments to increase government investments that will have the effect of increasing the ability of the economies of the world to grow, increasing prosperity, and making the US and the world more egalitarian and safe!!!
Now on to the specifics of forms of Foreign Tax Evasion, and a plan to fix these problems while incorporating ETCOs and ETCs. But as you read them keep this in mind: One of the most prominent questions regarding FTE that is agreed upon among most on Capitol Hill regardless of party is that, regarding reducing the number and severity to federal revenues of forms of FTE that occur primarily for tax purposes, that the most efficient and effective method for accomplished the successful legal reversal of these forms of tax avoidance is by bringing the effective tax rates for business, and especially employment, done in the US to about equal to the tax rates for business and employment done with most of our foreign economic competitors.
With the above in mind, let us first look in detail at the issue of Earnings Stripping. “Earnings Stripping usually refers to the payment of excessive deductible interest by a U.S. corporation to a related person ( or entity ) when such interest is tax exempt (or partially tax exempt) in the hands of the related person” (2). In more plain English what US Corporations are doing to avoid taxes with Earnings Stripping most commonly is, through a related and foreign person or business in a low tax rate nation, on the US parent’s tax books and those of that related foreign entity, it will be posted that the US parent Corporation is “borrowing” a substantial amount of money from the related foreign entity. By doing this the US parent could then write off from their taxes as an expense the “interest” that is paid to the foreign entity for this “borrowing”. These interest payments can also be taken as profit in the foreign nation and therefore with a lower income tax rate.
Senator Schumer has proposed “taking away deductions companies can take when making loans between subsidiaries, repealing a current standard for debt that companies use for additional breaks, and allowing interest expense to make up no more than 25 percent of the subsidiary’s adjusted taxable income, down from the current 50 percent threshold. Schumer’s bill also repeals the interest expense deduction carryforward and excess limitation carryforward so that companies can’t use the deductions in future years, and mandates that U.S. subs get IRS approval for transactions from the IRS for 10 years after the inversion. Schumer had proposed reaching back to companies that have inverted since 1994, but the version introduced Wednesday doesn’t include a date”(3).
All of the above, Senator Schumer ideas, would help reduce Earnings Stripping to an extent, and they should be enacted. However, alongside these tax law changes, a much more effective and efficient policy regarding Earnings Stripping would be to also enact an ETCO and Employee Tax Credit tax system and use this system as a legal tax tool against Earnings Stripping. This can be done by only allowing such “borrowing” with foreign entities to be written off as an expense if there is a near, within 20%, relative and corresponding, to the last 5 years, increase in US Employee Tax Credits accumulated by the US Corporation, of course, for investments in the US. Also, the closer to 20%, the less the tax deduction could be written off. Such a tax policy would mean that, through the Employment Incentive and the Compensation Incentive that exist within ETC’s for C Corporations and businesses in the US with over 500 employees, new and/or higher paying jobs must be growing in the US with that US business through this borrowing in order for the borrowing from the foreign entity to be able to be written off as an expense. Such a policy will better help allow for real business investments while greatly helping to reduce Earnings Stripping. For much detail on my C Corporation and Over 500 Employee tax system read my submission paper to the Senate Committee on Finance that can be found on my website, ThirdWayProgressives.org in the Weekly Blog section.
ETCOs and ETCs can also help police and make more efficient tax laws regarding the FTE problem of Transfer Pricing. Transfer Pricing is a tax avoidance scheme wherein, generally speaking, a multi-national business will overstate their business expenses in high tax rate nations they do business in, thereby lowering their profits stated in their high tax rate nations and thereby lower their total global tax bill, while understating on their tax books their business expenses with legally related foreign entities in foreign nations with lower income tax rates, thereby further reducing their total global tax bill.
ETCOs and ETCs can help in this entire area by making it easier to coordinate and lock real business expenses to the nation where the value of the product and/or service was generated. Creating the ability for the IRS to tie the amount to which a business expense can be deducted to the level of domestic employment and the rates of domestic employee compensation will make this area of our international tax code more truthful, fairer, more egalitarian, and much less subject to fraud! Such a policy can function in the real world by simply only allowing income to be counted as foreign income if there is a corresponding increase in investments in that foreign nation with that investment having a ratio of “phantom” ETCs to all other business spending in that nation, that is at the same ratio as that firm’s like spending in the US, within 30% and less so approaching 30%. “Phantom” ETCs are the calculation of foreign labor expenses as though this foreign nation had an ETCO and ETC tax policy identical to the US’s. Such an overall policy would be fairer to all involved, and it also fits perfectly with the OECD mandate of connecting taxes and tax jurisdictions to where the value of products and/or service are generated (4).
So how can ETCOs and ETCs help to prevent Tax Inversions? Tax Inversions are generally defined as a domestic business in a high tax rate nation buying a foreign entity in a nation with a low tax rate, then moving the headquarters of that conglomerate from the high tax rate nation to the low tax rate nation for tax purposes. ETCOs and ETCs can help prevent such Tax Inversions by connecting the deductablity of this type of headquarters change to the relative amount of Employee Tax Credits that are acquired in the US versus what ETCs would be acquired in the new foreign country if their government also had an identical ETCO and ETC tax policy to the US’s. More specifically, the legality of the deductiblity of such a headquarters change could only be considered deductible if a corresponding investment were to occur in the foreign nation with “phantom” ETCs within a 30% range of what ratio is typical of US ETCs earned in the US to total business deductions in the US for the US parent. This policy could use a sliding scale wherein such a headquarter change would become considered more foreign income if a proportionate amount of “phantom” ETCs are created in the foreign nation minus as much as 30%. Such a policy would greatly reduce Tax Inversions while allowing for the true dynamism of a free market global economy to also flourish.
I will have more on why we should count ETCs versus simply only counting employee expenses, and before I discuss Intellectual Property tax evasion, or “Patent Boxes”, let me first cover the controversy of a World-Wide tax system versus a Territorial tax system.
Regarding this extremely important debate, again keep in mind that the most important aspect of successful international tax policy is to maintain an income tax on the profits generated from domestic employment that is about the same as those rates for our foreign economic competitor, and that the maintenance of these rates can best be achieved with an ETCO and ETC tax system, that can flourish in either a World-Wide or Territorial tax system.
I will argue that for now, at this point in our nation’s history, an ETCO modified World-Wide system will clearly be the best international tax system for us to reform into for now, as well as being a model that the rest of the world will want to emulate most of.
An ETCO modified World-Wide tax system could essentially have a lowest top tax rate for all US businesses with over 500 employee of 20% for income generated in the US, and then a tax on foreign income of from 1% to 5% depending upon how many US ETCs that a business is able to generate relative to that business’s total foreign labor expenses. Obviously a C Corporation, or over 500 Employee, tax rate of roughly 20% to 25% would be competitive with our major foreign economic competitors. A comprehensive tax reform plan much like this can be found in my submission paper to the Senate Committee on Finance that can be found in the blog section at ThirdWayProgressives.org.
However, why still keep the World-Wide system?
There are several reasons, but perhaps the greatest is that:
Even if every government in the world were to enact all of the specifics and that which has been outlined by the OECD regarding reversing tax base erosion, profit shifting, and FTE, and all of the good legislative ideas of all members of the US Congress regarding reversing FTE were enacted and enforced, there would still exist incentives everywhere in the world, and even in the most tax regulated and inforced OECD nations, to want to attract new business investment by competing on being the lowest tax government. This incentive will always exist for all governments, as well as of course for all private business entities. Therefore, even though the recent OECD reports on foreign tax evasion demand that all OECD nations share all business deduction with total transparency with all governments involved (4), there will always exist a financial motivation, especially for the private businesses, but as well as for all governments, to want to claim income, or have income claimed, within the jurisdiction with the lowest effective tax rate. With a constant motivation to create and accept inconsistencies in tax books in ways that lower tax revenues for governments far away, if the US were to move relatively quickly into an ETCO tax regime but with a Territorial tax system, such a move would create a risk that I believe would better be mitigated by using an ETCO modified World-Wide tax system.
The risk with a Territorial system exists for several reasons. For one, Territorial tax systems themselves are something that still, in reality, have not been proven to be sufficiently efficient given that, considering only relevant periods of analysis, they have only occurred predominantly throughout the world in our hyper competitive global economy and only over the past few decades in an era of global race to the bottom policies on tax rates, and especially for large multi-national businesses, and especially what supports this “unproven” theory is the record high level of global savings relative to the entire global economy, much of it existing due to lower effective tax rates and perhaps even likely, tax avoidance due to the prevalence of global trade and Territorial tax systems. Also, it still could be that over time the compliance costs for the IRS and for US businesses of a World-Wide tax system will be well worth those costs given that no one could seriously argue that a World-Wide tax system would not make IRS policing much easier. For one, if in a World-Wide system a business entity doing business and employing in both the US and a foreign nation has to pay some kind of US tax for income made in the foreign nation, then the ability to prosecute a person for tax evasion related to any aspect of global taxation, will be made much easier when compared to most similar situations within a Territorial tax system, and even if this amount of tax is relatively small.
Then there exists the fairness argument for a World-Wide tax system. That is, under the plan that I propose, a top income tax rate for US businesses with over 500 employees could have a top tax rate of 20% for US generated income, but then would have to begin to also pay an income tax at a rate of 1% to 5%, and likely closer to 1%, on income made in a foreign nation with sufficient investments there. This 1% to 5% tax could be considered the fair price for the US government now protecting and policing the parent firms new trade now done across US borders. This small extra income tax can help pay for policing and regulating the global economy that the US does more than any other nation. Meanwhile however, this tax rate is so small as to not hamper the dynamic growth and improvement abilities of a free-market global economy while keeping total US tax rates competitive globally.
Back to the better policing argument for an ETCO and ETC modified World-Wide tax system, ETCOs and ETCs make tax policing and accuracy much easier for the IRS as well as for all tax administrations. ETCs are calculated using, despite it’s problems, one of the most well documented forms of documentation in the world of economics and tax, that being US FICA taxes, furthermore, in order for tax payers to acquire ETCs they must fully pay their employee FICA taxes. Also, fellow OECD members will likely want to emulate our ETCO and ETC tax laws which will also make all IRS policing much easier. Lastly, the 1% to 5% tax rate that is paid by US businesses on foreign income earned works as an added tax incentive to employ more and in higher compensating ways in the US. Remember that, the more a business acquires US ETCs relative to the rest of the firm’s total foreign labor expenses world-wide, the more likely that firm will have a 1% tax rate on foreign income or closer to 1%.
Just for total clarity here: Under such a system a foreign parent doing business in the US is taxed almost identically to and mirroring US businesses. They would be taxed on their US generated income by taxing their US income using a lowest top tax rate of 21%, with exactly the same ETCOs and ETCs as US businesses with US income, with the exception that a Phantom World-Wide tax at a rate of 1% to 5% will be paid by the foreign business on their income in the US that would be closer to 1% the higher the percentage of the foreign parent’s worldwide portfolio were US ETCs.
So an ETCO and ETC Modified World-Wide tax system with lowest top rates of 20% to 25% would work ideally for the US right now! A similar comprehensive tax plan can be found a ThirdWayProgressives.org. in my “Submission to the Senate Committee on Finance” paper.
Regarding the issue of intellectual property and foreign tax avoidance, once again ETCOs and ETCs can greatly help. The primary way in which multi-nationals use intellectual property to avoid taxes is by engaging in a form of Transfer Pricing wherein typically a US parent company, connected typically to a foreign entity that is selling it’s product outside the US, then transfers the intellectual property of the US parent to the foreign subsidiary, and then uses this as a tax rule justification for moving the parent’s profits that are generated in the US under a higher income tax, to profits made through the foreign subsidiary with the lower income tax.
ETCOs and ETCs can greatly improve tax law in this problematic area by locking much more accurately and transparently law regarding the US tax liability of profits acquired through the ownership of intellectual property to the nation or state where the labor that generated that IP and profits did in fact come from, and once again the accuracy in calculating this measure of “labor” can be improved by using ETCs acquired by individual firms. This accuracy occurs because ETCs foster greater documentation regarding labor. The recent OECD reports on reversing foreign tax evasions also mandates that, regarding tax evasions involving intellectual property, as they do with virtually all areas of tax, the OECD reports mandate that profits attempt to be booked as profits in the jurisdiction where the value of production was generated (5). Locking the generation of value of products to labor expenses, and by adding as a measure of these labor expenses ETCs, and along with some IP law changes and new tax regulations, can greatly tighten the tax definition of “intellectual property labor” while greatly improving our international tax code. There are many reasons why an ETCO and ETC Modified World Wide tax system would work best for all in the area of IP. The security issues addresses above and fairness to the nation’s where the intellectual property was generated are chief among them.
There are also law changes outside of the area of tax but regarding intellectual property law that would also have the effect of better connecting profits related to intellectual property to the jurisdiction where that intellectual property was produced. These IP law changes are related to new industrial policy ideas and more open patent and IP models, some of them are much like those in President Obama’s Manufacturing Institutes, and more of these great ideas can also be found in the “Wrestling ……..” paper that can be found at my website ThirdWayProgressives.org.
Due to the new war with isis, we will need new federal revenues. Also, due to our nation’s persistent federal budget and economic problems that would be greatly reversed with an ETCO and ETC tax regime, and due to the reality that not fixing our budget and economic problems will only embolden those who wish us harm because they perceive us as weak, and because an improved economy will help with domestic moral, it is imperative that Washington begin to talk about tax reform and especially ETCO tax reform! Moreover, ETCO tax reform would be extremely politically popular for Democrats, and it might be one of the only issues for Democrats to pull out at the last hour to win this November 4th.
Right now more than anything American votes want to vote for problem solvers. ETCOs would solve a major problem by allowing governments to raise personal income tax rates on their wealthy, the place where the slowest velocity of money exists except for employers, and also the tax that raises by far the most government revenues, to much higher rates than governments otherwise would be able to raise in the hyper-competitive global economy we now live in without adversely effecting domestic job and economic growth and competitiveness. Therefore, Democrats should immediately begin to promote ETCO tax reform.
Democrats should try this fall to make Tax Inversions, tax reform, and ETCO tax reform a major campaign issue. But if Democrats fail to retain the Senate this year, then in the lamb duck session, centrist Democrats and Republicans should compromise on an ETCO tax reform plan as part of legislation for avoiding the budget ceiling that will come this December. As part of this compromise, the medical device tax should be eliminated. After all, given how much more efficient an ETCO tax regime would raise government revenues compared to our current tax system, why in the world would we continue a tax that is only going to make one of the fastest growing industries in the world, one that saves lives hourly, one that the US is still a world leader in, and one that is high employee compensating, less competitive to do business in in the US!
But American’s deserve bold work by Washington! Washington should at the very least enact an ETCO along with an end to the medical device tax, and this compromise should be part of a budget deal that raises the debt ceiling until at least October 2015 and perhaps even unlit late 2016. But as part of this, December 2014 budget deal, not only would an income tax shift occur, from domestic employers onto wealthy non-employers, thus not being a tax increase, but this tax shift in itself would raise much federal revenues, and the repeal of the harmful medical device tax would also be more than paid for, but also in this December 2014 budget compromise deal should included in writing a real commitment to engage in 2015 in further tax reforms, like those in this paper, and perhaps healthcare reforms, a highway bill, and perhaps even immigration reforms. Also, ETCO’s make easier for employers, minimum wage increases!
If these reforms were not to occur in 20015, then Democrats can run in 2016 on a personal income tax increase on the wealthy with an ETCO. Moreover, Tax Inversions and ETCOs would even be a great campaign issue for Dems in 2014, if they gave it a shot. With this political effort and the understandings that would come from it, Republicans should come to see sometime in 2015 or sooner that their best strategy for not losing big in the 2016 election would be to have extensive tax and healthcare reforms, a highway bill, and perhaps even immigration reforms, in 2015, thereby removing taxes and perhaps these other issues as winning issue from Dems in 2016. Also keep in mind that ETCO would help with immigration reforms by creating an incentive for employers to pay all FICA taxes. And again, ETCO’s make easier for employers, minimum wage increases!
Democrats could greatly help all Americans and greatly improve our nation’s government budgets and economies, and lead the world, by letting the Republicans take taxes as an issue away in the above manor. Historically, this has been the way such political situation in the US have played out. You can now do all you can to help make this happen, and this time this should help save American lives!!!
(1) Tax plan found at ThirdWayProgressives.org in the “Submission Paper to the Senate Committee on Finance.”
(2) Report to The Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties, Department of the Treasury 2007, page 33.
(3) Politico’s Morning Tax email, 9/11/14
(4) OECD Report: OECD/G20 Base Erosion and Profit Shifting Project 2013
(5) OECD Report: OECD/G20 Base Erosion and Profit Shifting Project 2014