If you ask the mayor of Zug, a tiny Swiss suburb, what his town’s population is, he would likely give you the official estimate of 27,000.
But a quick dive into Switzerland’s most recent census report reveals that Zug is also home to over 30,000 businesses. This means one of two things. Either each of Zug’s residents was the president of his high school DECA club or there are some businesses that just don’t belong.
As you might have guessed, the latter is a more logical explanation. In the words of 60 Minutes anchor Lesley Stahl, Zug has become “a tax haven within a tax haven.” Even when compared with Switzerland’s relatively cushy 18 percent corporate tax rate, Zug’s 15 percent rate is still a bargain. When compared to the United States’ 35 percent rate, the difference is even more pronounced.
Thanks to the U.S. tax code’s deferral system, which prevents foreign-earned income from being taxed in the current year, multinational corporations have taken full advantage of these tax differences by investing over $2.3 trillion overseas. Of that total, roughly $1.2 trillion takes the form of liquid assets, which could theoretically come back to the United States at any time.
But rather than bring these earnings back to the U.S., where they would be taxed at the full 35 percent rate, many multinationals have chosen to reinvest the funds abroad. Corporate lawyers have also wriggled their way through a series of loopholes, allowing multinationals to shift an ever-increasing proportion of their income to low-tax areas like Zug. This ultimately results in an erosion of the U.S. tax base, a dent in U.S. GDP, and a migration of investment overseas.
While some cost-cutting crusaders see this as a divine mandate to slash the corporate tax rate, their vision doesn’t tell the whole story. Any tax cut must be coupled with comprehensive tax reform that brings our medieval tax code into the 21st century.
To do this, the United States must consider the two extremes of tax reform – switching to either a residence-based or source-based taxation system – and then develop a multinational tax solution that best suits its needs.
The residence-based taxation system is sort of like a family potluck.
In a family potluck, one family from several different places exerts time and effort making food and bringing it to a central location. In a residence-based taxation system, one corporation with several different branches exerts time and effort filing taxes to a central authority.
But while potlucks have more of a widespread appeal, residence-based taxation systems only sound good if you’re the government of one of the world’s 195 sovereign nations. Under such a system, any corporation that calls the United States home would be required to pay tax on all of its worldwide income. This would prevent corporations from shifting their profits to tax havens like Zug by ending the United States’ tax deferral system and requiring firms to account for all of their profits in a given year.
Residence-based tax systems are beneficial because they theoretically lead to capital export neutrality. Capital export neutrality occurs when corporations are indifferent between investing in a high-tax country and a low-tax country. This promotes efficiency in investment, because corporations can direct their investment funds to the locations that offer the highest economic returns. Regardless of where a U.S. company invests, it will still pay the same 35 percent tax rate.
But when corporations like General Electric operate in over 170 countries worldwide, how do international governments determine who gets a cut of the GE treasure chest?
In the United States, a corporation’s residence is defined as its principal place of incorporation. In other words, the country where the firm has its business license is its country of residence. Meanwhile, in several European countries, residence is defined by the location of a company’s headquarters or executive offices.
Each of these systems has its drawbacks. Corporate inversions allow firms to switch allegiances to a foreign land. Construction allows them to build a few pretty buildings and call it a headquarters. Both of these methods can be pursued and exploited by wily corporations with shrewd tax lawyers.
A residence-based taxation system has no solution to this jiggery-pokery, leading some economists and business leaders to call for a source-based taxation system.
A source-based system would indeed eliminate jiggery-pokery by eliminating a firm’s incentive to shift their place of residence. Instead of taxing a corporation’s worldwide profits, a source-based system taxes only the profits earned within the borders of any given country.
U.S. tech giant Apple has a business presence in 16 countries worldwide. Under a source-based system, it would only be required to pay U.S. tax on sales and business activities that actually take place within the United States. Sales in Spain would be taxed at the Spanish rate, R&D in Romania would be taxed at the Romanian rate, and, looking to the future, marketing on Mars would be taxed at the Martian rate.
The best part of a source-based system is that it leads to capital ownership neutrality. Capital ownership neutrality occurs when all companies face the same relative tax treatment, regardless of their location. This system would eliminate any reason for big businesses to artificially change their place of incorporation. When taxes are based on economic activity, there is no reason for a firm to set up shop in the middle of nowhere just to receive a tax break.
Under this system, U.S. firms would no longer be at a competitive disadvantage relative to other firms. In fact, the equal treatment could actually encourage firms to incorporate in the United States. More than just a legal document, incorporation may bring other perks to the United States, such as corporate headquarters, more jobs, and additional R&D investment.
But like its residence-based counterpart, the source-based system is no panacea. Unless the U.S. cuts its feverous corporate tax rate, multinationals will have an incentive to inject future investment dollars into lower-tax countries. After all, a new factory in Vancouver is just as good as a factory in Seattle, but at three-quarters of the price.
While a residence-based system would centralize the tax authority that firms are responsible to, it would also put U.S. firms at a competitive disadvantage. Whereas a source-based system would tax income where it is earned, it would also encourage investment abroad. Neither of these options is right for the United States.
What the U.S. needs is a tax system that is both fair and efficient. It needs a tax system that eliminates both double-taxation and double non-taxation. It needs a tax system that is thoroughly integrated with the rest of the world.
The OECD’s BEPS Action Plan has the potential to achieve this ideal tax system. The Action Plan seeks to unify worldwide tax systems and eliminate loopholes that allow corporations to shift profits to Zug-like tax havens. It believes that a multinational tax effort will level the corporate playing field, eliminate tax avoidance, and help ensure that all corporations pay their fair share of taxes.
The United States government would be wise to cement its place in the BEPS negotiating process. Only then can it avoid the corporate tax zig-zag caused by the hamlet of Zug.