[Noah Smith| December 06, 2016 |Bloomberg]
Few are paying attention, but a proposal now working its way through Congress could change the U.S.’s whole approach to trade, industrial policy and taxation. The plan would exempt income earned on exports from corporate taxation. Today, corporations pay federal taxes on the profits they make from goods and services sold overseas; only the location of the company’s headquarters matters. Under the new proposal, taxes would be based on where the sales are made. The Republican plan also cuts the top corporate tax rate from 35 percent to 20 percent and limits the deductibility of interest expenses, among other changes.
The switch in the location of taxation is the most important change. First, it would crack down on tax havens. By moving its headquarters to a country with a low or zero corporate tax rates — Bermuda or the Cayman Islands — a company now can avoid U.S. taxes by holding cash offshore until it’s ready to repatriate it. This results in lost revenue for the federal government, and also incentivizes corporations to sit on cash instead of investing it in the United States.
Many economists, such as Thomas Piketty and Joseph Stiglitz, have called for the tax system to be changed to eliminate this practice. Although cracking down on tax havens has typically been a battle cry of the left, it’s the Republican Congress that is actually tackling the problem. This is good, because it provides scope for bipartisan consensus. (Note that this plan is about corporate taxation; it’s different from Trump’s plan for cutting personal taxes.)
The GOP plan also lowers the corporate tax rate — another good move. The U.S.’s top rate, now at 35 percent, is one of the world’s highest. But the actual tax rate paid by U.S. companies is relatively low, since they put vast amounts of money and effort into tax avoidance. Reducing the rate, while closing some of the biggest loopholes, would allow the government to keep collecting the same amount of revenue, but would make companies stop spending so much money on avoidance — money that could then be used to hire workers and expand business in the U.S., or returned to shareholders to be invested elsewhere.
Limiting of interest deductibility is yet another good idea. The current system favors debt to finance operations and expansion rather than equity. That leaves the U.S. economy more vulnerable to asset bubbles, since bubbles that involve lots of debt are more damaging than those that are concentrated in the stock market. The GOP tax plan would thus make the economy a little more robust against crises like the one in 2008.
But the most potentially far-reaching change in the GOP proposal is the export subsidy. Under the plan, U.S. exports would be charged corporate tax in whatever country they’re sold in. But products made in that other country would be charged both corporate taxes and other local taxes, like value added tax (VAT). Since the U.S. doesn’t have a VAT, the U.S. tax system would effectively be subsidizing exports by American companies.
Many economists turn up their noses at export subsidies, viewing them as similar to tariffs or other trade barriers. But there are big differences. Export subsidies can be an effective tool for increasing productivity and boosting long-term economic growth. Though the World Trade Organization prohibits members from subsidizing exports based on volume, the House GOP plan might pass muster, as it is somewhat similar to the tax systems used by most other developed countries.
Evidence shows that companies that sell goods and services overseas tend to be more productive than those that sell domestically. This is partly because more productive companies are better able to compete in global markets, and hence more likely to export. When a country allocates more resources toward exporters, overall productivity in the economy goes up, since the exporters expand more quickly than the less productive domestic-selling companies.
But there’s also some evidence that the mere act of selling into foreign markets induces companies to raise their productivity levels. Companies can learn from foreign competitors and foreign customers alike.
Harvard economist Dani Rodrik has an interesting theory about why export subsidies work. Instead of traditional industrial policy, which involves the government picking winners, export subsidies give companies an incentive to discover what they’re good at. Corporations and countries don’t automatically know what they’re doing well, and in fact, these specializations can change rapidly as technology and trade patterns shift. Since export subsidies make it easier for companies to enter the hypercompetitive, ever-shifting global marketplace, they give these companies some breathing room to discover their own comparative advantage. In the long run, that means higher productivity and more gains from trade.
So the House GOP’s tax plan represents not one, but several big important positive shifts for U.S. tax policy. It cracks down on tax havens, reduces the burden on U.S. companies, encourages investment in the U.S. and makes the economy slightly less vulnerable to bubbles. And it would give U.S. companies more of an incentive to go out into the world and discover what they’re the best at, while reallocating resources toward the most productive companies. The plan was written by Republicans, but its appeal should be obvious to those on the left of the political spectrum as well.