The argument over taxing corporate profits may sound familiar, because claims that corporations aren’t paying their fair share of taxes have been going on for decades. But the circumstances of large corporations have changed considerably in at least two ways: 1) they have become much more likely to cross national boundaries in their inputs, production, customers, and owners; and 2) they depend more on intellectual property, which means that profits are coming from something that isn’t physical in nature.
Alan Auerbach lays out the issues that arise, and runs through the solutions that have been tried, in “The Taxation of Business Income in the Global Economy,” delivered as the 2021 Martin S. Feldstein lecture at the National Bureau of Economic Research (NBER Reporter, September 2021). Here’s Auerbach on how the nature of the largest US corporations has changed (footnotes omitted):
Fifty years ago, the top five companies by market capitalization were IBM, General Motors, AT&T, Standard Oil of New Jersey (Esso, the predecessor of today’s ExxonMobil), and Eastman Kodak. … These were companies that “made things” in identifiable locations, to a large extent in the United States. If we shift to today, we see another five familiar names, all giant companies: Apple, Microsoft, Amazon, Alphabet (Google’s parent), and Facebook. These companies are worldwide multinationals, relying very heavily on the use of intellectual property in the goods and services they provide …
In the last half century, the share of intellectual property measured in US nonfinancial corporate assets more than doubled, according to the Fed’s Financial Accounts of the United States. That’s probably a conservative estimate, because the measurement of intellectual property is a fairly narrow one here. The share of before-tax US corporate profits coming from overseas operations nearly quintupled, according to data from the Bureau of Economic Analysis. US companies have become much more multinational in character, not just selling things abroad, but making them abroad as well. And the share of cross-border equity ownership has steadily increased, to the point that foreign individuals and companies account for a significant fraction of US companies’ share ownership.
When production, customers, and owners are distributed around the world, when the “product” can be a service supplied digitally, and when the ultimate source of profit is closely tied to intellectual property, taxing big global firms becomes complex. The idea of corporate profits itself is far from a crystal-clear idea in a world of high-powered accountants and finance, operating against a backdrop of differing national tax codes. Every country would prefer to draw up the rules so that it attracts companies that it can tax. Companies that are operating across national borders in multiple ways have the ability to shift between countries, and to claim that profits are actually being earned in one place rather than another. What might be done. Auerbach discussed the possibilities, which I summarize here.
- Make corporate taxation rules that seek to block firms from avoiding taxes. This has been the main strategy for some years, and the whole point of the earlier discussion about the changing nature of large firms is that it can be hard to make this work in the modern economy.
- “Patent boxes” are a way of encouraging firms with intellectual property to claim residence in your country, so that your country can tax the company. But to attract the company, the “patent box” approach often promises lower corporate taxes. As Auerbach writes: “One problem with patent boxes is that, in a sense, they deal with tax competition by simply giving up.”
- Tax global companies based on their users, not their profits. For example, European countries where a company like Google or Facebook has essentially zero employees might seek to tax these companies because people in the country use services from these firms. The idea is that some of the profits of the company trace back to users from a certain country, so the country should be able to tax the firm’s profits. But of course, drawing a straight line from users to profits for these companies is an enormous oversimplification. Their profits are based on many factors, including advertising revenues, operating costs, intellectual property, and other factors. The US is typically not pleased if foreign countries try to tax US-based firms.
- Use a “destination-based tax,” which means taxing firms in proportion to where their sales are. This approach requires some detailed analysis, and Auerbach runs through variations of a destination-based tax like the Residual Profit Allocation by Income (RPAI) and a Destination-Based Cash Flow Tax (DBCFT). Given international cooperation, this approach seems broadly workable. But notice that it is a fundamental shift from the idea of taxing corporate profits to an idea of taxing corporate sales: that is, two firms with equal sales would pay equal taxes, even if one earned positive profits and one lost money. When people argue over whether corporations pay their fair share, I’m not sure if this approach accords with their intuition.
- Scramble all of these approaches together, don’t worry too much about the contradictions, and do a bit of each. As Auerbach points out, this was essentially the approach of the 2017 Tax Cuts and Jobs Act.
The current international negotiations over global corporate taxation basically have two “pillars,” as they are often called. One “pillar” would take a certain share of the profits of big digital services companies and let other countries split up that tax revenue. Given that these big companies are mostly American firms, the rest of the world likes this idea, but it’s not clear that the US Senate will approve. The other “pillar” would be a minimum 15% tax rate on profits of large companies. The problem with this approach is that it essentially ignores the underlying issues. As Auerbach writes:
But beyond the immediate hurdles facing adoption, there is also a more fundamental, longer-term challenge arising from the attempt to preserve a tax system based on concepts that don’t really work anymore, that are ill-defined and endogenous: corporate residence and the location of production and profits (something that tax authorities have taken to referring to as the location of value creation). Because it relies on these ill-defined concepts, the two-pillar system is not going to be sustainable unless countries adopt and adhere to similar rules that lessen incentives for companies to shift production, profits, and residence.
Auerbach is a supporter of a destination-based tax approach, and thinks that economic and political forces will tend to push in that direction over time. Maybe he’s right. But an alternative possibility is that the nature of corporations keeps evolving, the importance of intangibles like intellectual property keeps growing, and the long-term argument over what it means for corporations to pay their fair share keeps sounding much the same, even though the underlying conditions keep changing.