Tax reform is coming

For all the partisan squabbling in this bizarre election year, a consensus has emerged in one important area: The U.S. corporate-tax system is broken.

No matter who wins on Nov. 8, there’s surprising agreement that change is coming. To get ready, think tanks are pumping out reform proposals, tax experts are updating their research and Congress is holding hearings.

Both Hillary Clinton and Donald Trump have plans. But the one most popular among politicians and scholars is by House Speaker Paul Ryan, who is offering a type of consumption tax to fix a multitude of problems with the existing code. His plan, however, could destabilize U.S. financial markets, especially the bond market. It may also violate the U.S.’s trade commitments.

The ease with which multinational corporations avoid taxes is just one of many problems with the existing tax code. The top U.S. rate of 35 percent, the highest in the industrialized world, pushes companies to game the system.

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The tax code also encourages companies to stash earnings abroad by merging with overseas firms for no better reason than to obtain an address in a low-tax country. Known as corporate inversions, those transactions have kept $2 trillion safe from U.S. taxes.

The current system also discourages investment by taxing corporate profits twice, once at the company level and again at the individual level as dividends.

That’s a lot of dysfunction, and the presidential candidates have ideas for ending it. Clinton often calls on corporations to pay their “fair share” of taxes, and has already decided where she’d spend a $275 billion windfall from corporate-tax reform (on a burst of infrastructure spending). But she hasn’t yet said where she would set the top rate or which tax breaks she would end.

Clinton has been specific only when it comes to stopping companies from inverting: She would impose a stiff exit tax – by tapping the earnings companies have stashed overseas – in hopes they’ll decide against taking a foreign address.

Trump’s most recent plan would end many deductions and slash the top corporate rate to 15 percent. He would cut corporations’ tax burden (and government revenue) by almost $2 trillion over a decade.

Ryan would lower the top rate to 20 percent and move the U.S. toward a tax on consumption with something called a destination-based cash-flow tax, developed by Alan Auerbach of the University of California at Berkeley.

Like the current system, it would tax revenue minus expenses – but would do it in a way that would give companies incentives to hire workers, invest in new equipment and keep cash at home.

The merits of Auerbach’s proposal are many. Complicated depreciation schedules would go out the window. The ticklish matter of how to treat profits earned in foreign countries, and the gaming that worldwide taxation encourages, would disappear. Inversions would come to a halt. There would be no need for special-interest lobbying to win tax breaks. Corporate taxes would be simpler.

Now for the demerits. Taxes on imports but not exports are usually called tariffs. By taxing only transactions in the U.S. (including imports), exports would be indirectly subsidized. And taxing foreign but not domestic labor could distort trade flows. In all cases, says the University of Southern California’s Edward Kleinbard, the proposal appears to violate World Trade Organization rules, though tax and trade lawyers are vigorously debating this.

Kleinbard favors more incremental reforms that would stop inversions, lower the top rate to 25 percent – the average for developed economies – and cap interest deductions.

Everyone will have an incentive to compromise, no matter who wins on Nov. 8. What better way to do this than to fix the corporate-tax mess? •

Paula Dwyer writes editorials on economics for Bloomberg View.

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