Zucman // The Triumph of Injustice
The Triumph of Injustice, Saez and Zucman. I spent a lot of time last year thinking and writing about the urgent need for tax reform to curb increasing economic inequality that is accelerating in the information economy and created an interactive model to simulate different tax regimes in Principles for Radical Tax Reform and a Universal Dividend.
A few week’s ago I came across some related work from Emmanuel Saez and Gabriel Zucman which could be summarized as “same income, same rate.” In The Triumph of Injustice they call for a similar simplification of tax rates to eliminate loopholes. They even have a tax simulator at taxjusticenow.org.
One of the key insights I took away was the need to fix the corporate income tax rate to the individual income tax rate to close a loophole where individuals can get preferential tax treatment by forming a shell corporation.
Saez and Zucman also explain in detail other tax dodging schemes used by corporations, where they basically ‘offshore’ profits to tax havens to avoid paying taxes. They propose a mechanism for remedial taxes (a tax collector of last resort) to close this loophole (although putting his scheme into effect would require some international coordination — and I wonder how enforceable some of this would be in the scenario where US economic dominance wanes and sanctions lose their bite). It’s an excellent idea and I think probably one of the more important policy reforms we could make.
While the taxes Saez and Zucman propose would still be progressive, they would not be continuously progressive or employ a ‘radical’ (inverse power) function, as I proposed.
The other element of my proposal that his excludes is directly redistributing proceeds of radically higher taxes, which I think would make it far easier to garner support from wealthy elites who distrust the state’s efficacy in deployment of tax proceeds.
Here are some of my favorite bits…
Social Security taxes are deeply regressive (this had never occurred to me before):
The second largest source of tax revenue is Social Security payroll taxes (8% of national income). These taxes are levied on labor earnings and come out of wage earners’ paychecks — from the very first dollar earned — at a rate of 12.4%. They are capped at $132,900 a year in 2019, a figure that roughly corresponds to the threshold for being among the top 5% highest wage earners. Any earnings above that cap are exempt from taxation, making Social Security taxes deeply regressive. A separate tax is collected to fund Medicare — the government health insurance program for the elderly — at a rate of 2.9% on all earnings. Altogether these payroll taxes, which were small fifty years ago, have grown to become almost as large as the federal income tax itself. As we will see, this development has significantly contributed to eroding the progressivity of the American tax system.
I didn’t have much of a formal econ education, so learning some of the basics of tax incidence was new to me:
Incidence is a key part of any tax policy analysis, so let’s pause on this concept to understand the merit of the arguments wielded by the opponents of capital taxation. What would happen if the corporate tax were slashed? Dividends and share buybacks might soar, boosting the income of shareholders. But firms could also increase their purchases of machines and equipment, making workers more productive and thus leading to higher wages. Or they could cut the price of the products they sell, in effect benefitting both labor and capital (to the extent that both forms of income are ultimately consumed). Tracing the myriad ways in which changes in taxation affect economic behavior, the level of economic output, and the distribution of income across the population is what tax incidence is all about.
The main result from economic research in this area is intuitive: the most inelastic factor of production bears the burden of taxes, while the most elastic factor dodges them. Concretely, if capital is very elastic — saving and investment collapse whenever capital is taxed — then labor bears the burden of capital taxation. But just as capital taxes can be shifted to labor, so too can labor taxes be shifted to capital. This happens if labor is very elastic — that is, if people work substantially less when the taxation of their earnings rises. In one of the oldest and most famous analyses of tax incidence, Adam Smith in The Wealth of Nations explained how taxes on wages could be shifted to capital. If farmers are at the subsistence level (they earn no more than what they need to barely survive), taxing their wage would make them starve. In that event a wage tax would be shifted away from poor peasants toward wealthier landowners, as those owners would be forced to increase pay to keep their workforce alive.
Tax incidence boils down to simple empirical questions: How elastic are capital and labor? Does the capital stock, in particular, vanish when capital taxes rise? If it does, then taxing capital is indeed harmful and slashing corporate taxation can be in the long-run interest of workers.
Corporate tax is a safeguard:
The threat of wealthy individuals incorporating is why all countries that have a progressive income tax also have a corporate tax. The corporate tax is a safeguard: it prevents wealthy individuals from shielding their income from the taxman by pretending it’s been earned by a firm. This is not its only role; the corporate tax also ensures that companies contribute to funding the infrastructure from which they benefit, for example. But preventing tax dodging has always been its prime justification — and the reason why, historically, corporate income taxes were created at the same time as individual income taxes. Like the O-rings of the space shuttle Challenger, if the corporate tax malfunctions, the whole system of progressive income taxation collapses.
How remedial taxes by collectors of last resort prevent corporations from using tax havens:
Exemplarity, first, means that each country should police its own multinationals. The United States should make sure that US companies, if they don’t pay enough abroad, at least pay their dime in America. Italy should do the same with Italian firms, and France with its own national champions.
To understand how this could work, let’s consider a concrete example. Imagine that, by shifting intangibles and manipulating intragroup transactions, the Italian automaker Fiat had managed to make $1 billion in profits in Ireland — taxed at 5% — and $1 billion in Jersey, one of the Channel Islands — taxed at 0%. There’s a problem here: Fiat pays much less tax than it should; much less, in particular, than domestic Italian businesses. We call this a tax deficit. The good news is that nothing prevents Italy from curbing this deficit itself, by collecting the taxes that tax havens choose not to levy. Concretely, Rome could tax Fiat’s Irish income at 20%. It could tax its Jersey bounty at 25%. More generally, it could easily impose remedial taxes such that Fiat’s effective tax rate, in each of the countries where it operates, equals 25%.
Such a reduction of Fiat’s tax deficit would not violate any international treaty. It does not require the cooperation of tax havens. And what’s perhaps more surprising, it doesn’t even require new data: the necessary information exists. Under the pressure of civil society organizations, the veil of secrecy surrounding the activities of multinational companies has started to lift. As part of the OECD’s base erosion and profit-shifting initiative, big companies are now required to report their profits and taxes on a country-by-country basis. Oh, we’re still far from total financial transparency: these country-by-country reports are not public; they’re only available to tax authorities. But they exist: Apple must now report to the IRS how much income it earns in each of the world’s countries; L’Oréal must report similar information to France, and Fiat to Italy. About seventy-five countries have started collecting that information or promised to do so in the immediate future, including all large economies.6
This seems like a mundane tax administration issue until you realize that, thanks to this rich new information source, it has never been easier for big countries to police their own multinationals. The United States, France, Italy: any country could ensure its corporate champions pay a minimum tax rate of say 25% wherever they operate. Any country can in effect serve as the tax collector of last resort for its own multinationals. Apple pays 2% in Jersey? The United States could collect the missing 23%. The Paris-based luxury group Kering books profits in Switzerland, taxed at 5%? Paris could levy the missing 20%. Such a policy would immediately remove any incentive for multinationals to book profits in tax havens. They would still pay zero taxes on the profits booked in Bermuda, but it would be pointless since any tax saving would be fully offset by higher taxes at home.
My next question was wouldn’t companies just move their HQs to tax havens? This is where the international coordination comes in, which is a big IF.
At this point you probably want to know what would happen if big countries really did police their multinationals and started acting as tax collectors of last resort. Wouldn’t Fiat, Apple, and L’Oréal move their headquarters to tax havens? Fortunately, there is more than one way to address this threat — most importantly through international cooperation.
As we have seen, most countries have already agreed to harmonize their laws to limit the most blatant forms of profit shifting. The obvious next step is for big countries to agree on a common minimum tax: G20 countries (which include all the world’s largest economies) could all agree that they will apply a 25% minimum tax rate to their multinationals, wherever they operate. These countries already have the information necessary to apply this minimum tax. And it’s in their interest to take up the job of tax collector of last resort. Strange as it may seem, and although tax competition has intensified in recent years, a solution appears within reach.
A mutually agreed minimum tax among G20 countries would not solve all the problems. Companies could still dodge taxes by moving their headquarters to tax havens. This issue looms in the public debate. In the United States, the specter of “tax inversions” — US firms merging with foreign companies in Ireland or other low-tax places, and in doing so adopting the nationality of their partner — haunts policymakers.
But the danger is exaggerated. For all the talk about tax inversions, very few firms have moved their headquarters to tropical islands. There have admittedly been some high-profile cases: the consulting company Accenture inverted from Chicago to Bermuda in 2001 (before moving to Ireland in 2009); the financial advisory firm Lazard moved its New York headquarters to Bermuda in 2005; and the dietary supplement company Herbalife has been a proud resident of the Cayman Islands since 2002. According to a tracker of tax runaways maintained by Bloomberg, in total, eighty-five US companies have expatriated between 1982 and 2017 (many of them in the pharmaceutical sector, and most of whom you have never heard of).10 To that total we can add the handful of firms that have been headquartered in offshore financial centers from the start (or that moved long ago), the most notable of which is probably the oilfield service giant Schlumberger, headquartered in the southern Caribbean island of Curaçao.
All of this sounds pretty concerning, until you realize that it adds up to a drop in the ocean. Among the world’s two thousand largest companies, only eighteen are headquartered in Ireland, thirteen in Singapore, seven in Luxembourg, and four in Bermuda today.11 Close to a thousand are headquartered in the United States and the European Union, while most of the others are to be found in China, Japan, South Korea, and other G20 countries.
The reason few companies invert, despite the incentives to do so, is probably because a business’s nationality is not easy to manipulate. The definition of a company’s nationality is constrained by strict rules. For instance, once it has been incorporated in the United States, a company cannot simply move its headquarters abroad: any firm that does so continues to be treated as a US company for tax purposes. American firms can only change their nationality in the context of foreign acquisition; that is, by merging with a foreign company. And for these mergers to result in a legally valid inversion, certain conditions must be met — conditions that have been strengthened over time, in particular by President Barack Obama in 2016. Most importantly, there must be a meaningful change in ownership: a US firm cannot become Bermudian by merging with a shell company in the middle of the Atlantic. In practice, it has thus become impossible for American giants to relocate to unpopulated Caribbean Islands. Ever since the Obama regulations (so far preserved by Trump) inversions have come to a complete halt.
A second key lesson: Even with only a handful of big countries on board, international coordination can curb tax dodging. Should G20 countries tomorrow impose a 25% minimum tax to their multinationals, more than 90% of the world’s profits would immediately become effectively taxed at 25% or more.
Why to use sales apportioned tax measures to calculate tax obligation:
In a nutshell, high-tax countries should collect the taxes that Switzerland refuses to collect. The simplest mechanism involves apportioning Nestlé’s global profits to where the Swiss giant makes its sales. If Nestlé makes 20% of its global sales in the United States, then — whatever the countries where Nestlé employs its workers or has its factories, wherever its headquarters are located, wherever it holds its patents — the United States can assert that 20% of the company’s global profits have been made in America and are taxable there. If 10% of Nestlé’s global sales are made in France, then Paris can similarly consider that 10% of Nestlé’s global profits are taxable in France.
Is this idle fantasy? Not at all, for this is already how most US states collect their own corporate tax revenues. Forty-four states have their own state corporate tax (at a rate of up to 12%, in Iowa) which adds to the federal corporate tax. To determine how much of Coca-Cola’s profits are taxable in California, the Golden State’s tax authority apportions Coca-Cola’s US-wide profits to where the company makes its sales. A few states, such as Kansas, Alaska, and Maryland, use more complicated apportionment formulas that take into account not only the geography of sales, but also the location of firms’ properties and employees. But over time the majority of US states have converged on a formula based only on the location of sales. The apportionment of profits is a time-tested mechanism, which is also used by Canadian provinces and German municipalities.12 Nothing prevents countries (and not only local governments) from applying this system.
In practice, an even more robust mechanism can be used to fight tax dodgers. Instead of apportioning Nestlé’s global profits, high-tax countries could apportion Nestlé’s tax deficit. Concretely, the United States (and any other nation that wished to do so) would compute Nestlé’s global tax deficit — that is, the extra tax that Nestlé would pay if it were subject to an effective tax rate of 25% in each of the countries in which it operates. Then if the Swiss giant made 20% of its global sales in the United States, Uncle Sam would collect 20% of Nestlé’s global tax deficit. In effect, the United States and the other countries where Nestlé sells its products would take up the role that Switzerland refuses to play — tax collector of last resort.
This solution, which to our knowledge has never been proposed before, has many advantages.
First, it’s immediately doable. As we’ve seen, information about the country-by-country profits, taxes, and sales of multinational companies already exists. In the case of Nestlé, it’s gathered by the Swiss tax authority, but since 2018 it has been automatically exchanged with foreign countries. As of February 2019, according to the OECD, there were over 2,000 pairs of countries exchanging country-by-country reports automatically.13 France, the United States, and most other countries where Nestlé sells its products already have the information in hand to compute Nestlé’s global tax deficit and collect their share of these unpaid taxes. Even if they didn’t have the information, they could easily request it. In granting firms access to domestic markets, countries already set all sorts of conditions, such as safety regulations. Nothing prevents adding a bare minimum of accounting transparency to the list.
The second advantage of our solution is that it doesn’t violate an existing international treaty. Over the years countries have signed myriad conventions to prevent the risk that firms would be taxed twice. In practice these treaties — and the inconsistencies therein — have opened the floodgates to all sorts of tax dodging. Despite that, many governments and the OECD are still attached to them, and other attempts at reforming corporate taxation have been blocked on the grounds that they would infringe these sacrosanct conventions. But since the defensive tax we propose is collected only to the extent that a firm pays less than the minimum standard of 25%, our solution by construction does not introduce any form of double taxation. As a result, it does not violate double-taxation treaties.
All countries would have an incentive to apply the defensive tax we describe, for the simple reason that each has an interest in being among the tax collectors of last resort. Not doing so would mean leaving money on the table for others to grab! If the countries where multinationals make the bulk of their sales all applied this defensive tax, the tax deficit of each company would be fully apportioned. Even firms headquartered in Bermuda would face a minimum effective tax rate of 25%. There would be no place to hide.
The “same income, same rate” section is very aligned with my proposals:
Another key step to curbing tax avoidance is a simple application of common sense: people with the same amount of income should pay the same amount of tax. This seems obvious, until you realize that most of the reforms of the first two decades of the twenty-first century have done the opposite. From a preferential rate for dividends in 2003 to a lower business income tax in 2018, the main preoccupation of American lawmakers has been to tax capital less than labor. The same trend can be observed in France, where the government of Emmanuel Macron adopted a flat tax for interest and dividends in 2018, and indeed in the rest of Europe.
Taxing people with the same income at the same rate is the concrete application of calls to “plug loopholes.” It has several implications.
First, it means that every income source should be subject to the progressive individual income tax: not only wages, dividends, interest, rents, and business profits, but also capital gains, which in many countries (including France and the United States) are currently taxed at lower, flat rates. There is no compelling reason to tax capital gains less than other income sources. The practice merely encourages the wealthy to reclassify their labor income and business profits into capital gains. The reason why many countries have historically resorted to this second-best policy is because tax authorities did not track the purchase price of assets (stocks, bonds, houses, etc.), making it hard to enforce a tax on capital gains. In the United States, the IRS only started to collect this information systematically in 2012. But with today’s ample and inexpensive computing capacities, progressive capital gains taxes can be enforced, including when assets have appreciated over more than a generation.13 The frequent objection that capital gains taxes impose unfairly hefty tax bills when businesses are sold (because capital gains are a one-time windfall) can be addressed by spreading payments out, as is routinely done in the context of estate taxation.
Further still, given that today’s governments now know the purchase date of assets, they could improve the tax code by removing from capital gains the mechanical effect of price inflation. In our current tax system, an asset bought for $100 in 2012 and sold for $150 in 2020 generates a taxable capital gain of $50. This makes little sense: out of the $50 increase in value, $20 corresponds to general price inflation, which is not income; only $30 corresponds to a true capital gain. The tax imposed on the $20 is equivalent to a wealth tax — an opaque and random type of wealth tax, since it’s determined by the inflation rate. This hidden wealth tax should be ditched, and only the $30 in pure capital gains should be subject to progressive income taxation. Here’s a tax cut we can all agree on!
In Chapter 8, “Beyond Laffer,” they make an argument for choose tax rates above the revenue-maximizing rate for the rich. Their argument boils down to a similar wealth=power argument that motivated my proposals:
On both sides of the Atlantic during these eras, tax policy reflected the view that extreme inequality hurts the community; that the economy works better when rent extraction is discouraged; and that unfettered markets lead to a concentration of wealth that threatens our democratic and meritocratic ideals.
Wealth is power. An extreme concentration of wealth means an extreme concentration of power. The power to influence government policy. The power to stifle competition. The power to shape ideology. Together, they are the power to tilt the distribution of income to one’s advantage — in the marketplace, in governments, in the media. This is, and has always been, the core reason why extreme wealth owned by some can reduce what remains for the rest of us. Why the income of today’s super-rich can be gained at the expense of the rest of society. That’s what earned John Astor, Andrew Carnegie, John Rockefeller, and other Gilded Age industrialists their epithet of “robber barons.”
If you liked this, you may also enjoy:
- Principles for Radical Tax Reform and a Universal Dividend
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- Napkin Modeling the US Govt “P&L” // Income Tax and Redistribution Scenarios
- Kinky Labor Supply and the Attention Tax