Invert the Tax Code

It's time to turn the tax code on its head. There are lots of reasons to push for tax reform, but the most proximate demand is the need to end so-called "tax inversions." These started out as situations in which a U.S. company would literally swap the roles of the U.S. headquarters and the foreign subsidiary. By "inverting" the company would attempt to be subject to the tax rules of the country in which the new headquarters was located. Tax changes in the early 2000s put an end to the plain vanilla tax inversion.

More recently, a second phenomenon developed. As U.S. firms purchased or merged with foreign corporations it quickly became obvious that it would be advantageous for the headquarters to be located abroad. Why? To begin, the U.S. corporation tax rate is 35 percent - well above the 15 to 20 percent range that is competitive with other developed countries. Worse, that rate applies to income earned anywhere in the world, whereas competitors headquartered elsewhere would be liable for tax only on what was earned in each country. A second wave of inversions ensued as ordinary business deals ran into the unavoidable tax facts: the U.S. is an uncompetitive place to be headquartered.

Ultimately, it became recognized that it did not matter who started the transaction; it could just as well be a foreign firm purchasing or merging with a U.S. firm. In either event, it made sense for the headquarters to be abroad. Whether as predator or as prey, U.S. companies have no choice but to locate headquarters abroad in the midst of these transactions.

The right response is tax reform - move the rate from being too high to competitive and move away from worldwide taxation of income toward territorial taxation. Unfortunately, the left's response has been to blame the companies and the administration's response has been executive actions that worsen incentives.

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Now the administration has turned to so-called "section 385" rulemaking. This rule would reclassify some debt as equity in related-party financing transactions in an effort to curb earnings stripping, and according to the administration, curb corporate inversions. Unfortunately, this has nothing to do with inversions. Instead, it threatens the corporate financial structures of even purely domestic companies without solving the real problem.

The second recent indicator of the need for tax reform is the ballyhooed release of a snippet of Donald Trump's 1995 tax information. That release indicated that Trump lost nearly $1 billion in 1995, and seemingly raised the specter of him using those losses to legally avoid taxes for years to come. Ignore for the moment the fact that there is exactly zero information about his actual tax payments. Instead, recognize that what got everyone's attention was the possibility that a person living in luxury, traveling on a private plane, and flaunting his affluence was paying no taxes.

Legally paying no taxes, that is. And that is what reveals the real problem: the tax code. Suppose that instead of the U.S. tax system, taxes were levied on "consumed income." Given his extravagant lifestyle, it is clear that Mr. Trump was consuming a lot of income, most likely some of it saved up in the past and used to offset the current business losses. Under a consumed income tax, those dollars would have been fair game and Mr. Trump's tax bill would match his lifestyle.

The good news is that there is a tax proposal that lowers the corporate rate, moves toward territorial taxation and shifts the focus to taxation on the basis of consumed income. That is precisely the kind of bold reform that the U.S. needs. It may not be a perfect way to proceed, but as the authors argue, it is a better way.