In 2002, The Century Foundation convened the Working Group on Tax Expenditures to examine and propose reforms to the tax code. The resulting report, Bad Breaks All Around, identifies twelve tax breaks with little or no economic justification. These “dirty dozen” are no less ripe for the chopping block a decade later, as Congress finally takes up the task of simplifying the tax code. Follow along at Blog of the Century and on the “Dirty Dozen” expenditures homepage as we reintroduce each of the “dirty dozen” and explain why it's long past time to eliminate these costly tax breaks.
In 1952, the corporate income tax accounted for about one third of of all federal tax revenue. But, over the years, U.S. multinationals have devised increasingly complex tax avoidance schemes, far beyond the ability of the IRS to credibly monitor or enforce. Although the corporate tax rate was also lowered significantly in 1986, tax avoidance is one of the primary reasons why corporate taxes supply less than 9 percent of federal revenues today.
At the time Bad Breaks All Around was published, its authors identified two export tax loopholes—the indefinite “deferral” of tax on the profits of controlled foreign subsidiaries, and the “inventory property sales source rule exception”—sufficiently egregious to make their “dirty dozen” list. The first, which allows foreign earnings by U.S. corporations to go untaxed until they are repatriated to the United States, has become an ever larger and more complex problem for regulators. While the Office of Management and Budget estimates that deferred income from foreign subsidiaries costs some $35 billion annually in lost revenue, more in-depth investigations have yielded estimates in the hundred-billion-dollar range.
Although TCF's Working Group on Tax Expenditures identified export tax incentives and corporate loopholes as part of its “dirty dozen” tax breaks in 2002, little has changed in the intervening decade. If anything, multinationals have become even more adept at exploiting corporate tax arcana: the amount of deferred corporate income from controlled foreign subsidiaries has increased fivefold since 2002 and the Senate Permanent Subcommittee on Investigations now estimates that more than $1.7 trillion in U.S. foreign earnings are sheltered overseas, with more than 60 percent held in cash.
Some companies, like Microsoft, have exploited elements of this loophole that allow them to sell valuable intellectual property rights to shell corporations in low-tax territories such as Puerto Rico in exchange for licensing fees, which are taxed at a lower rate than ordinary income. The IRS has no way to determine the value of the intellectual property, essentially allowing the exporter to determine its own tax liability as it repatriates foreign profits. Other companies, like Hewlett-Packard, have devised ways of turning their foreign subsidiaries into offshore bank accounts, from which they can cyclically lend themselves billions in short-term, tax-free loans.
These sorts of loopholes are “arguably . . . an enforcement problem, not a tax expenditure issue,” according to TCF's 2002 Working Group. “But using an inherently unenforceable mechanism for calculating the taxes of multinational corporations is as effective in subsidizing their activities as would be an explicit, statutory, tax break.” So while the intent of corporate tax evaders like Microsoft and Hewlett-Packard influences our understanding of “indefinite deferral” as a loophole rather than a deduction, this is essentially a semantic difference. The “inventory property sales source rule exception,” which became a consciously provided tax benefit for exporters in 1987, operates within a similarly ambiguous legal context.
The problem with all such loopholes, as Bad Breaks All Around points out, is that U.S. multinationals “have a huge incentive to pretend that their American operations pay too much or charge too little to their foreign operations for goods and services (for tax purposes only), thereby minimizing their U.S. taxable income.” In the absence of stricter tax law or enhanced regulation and enforcement, any exporter can set their “transfer prices” to reduce their tax liability in the United States while “repatriating” deductible expenses. Until Congress eliminates these loopholes and deductions, and finds a way to disincentivize corporations' hoarding cash in offshore accounts, the Treasury will continue to lose untold billions in taxable revenue.