sou · H2B340 · 2014-06-12 00:00:00 — What will determine the choice between, say, ACE and CBIT? A common advantage of ACE and CBIT is their balanced treatment of debt and equity capital. De Mooij (2012) and Fatica et al. (2012) both investigate whether there is any reason for a debt bias in corporate income taxation. They conclude that there are no legal reasons for preferential treatment of debt. As to possible economic reasons, they examine arguments having to do with bankruptcy costs, agency costs (related to tensions between managers and shareholders, and between shareholders and debt holders), and signaling costs (high debt signaling confidence or lack of liquidity?). Their conclusion is that corporate finance theories do not offer clear guidance on whether debt levels chosen by non-financial firms are too high or too low. Add to this that firms are very heterogeneous, so that it would be extremely difficult to fine-tune any debt (or equity) preference. At the same time, the financial sector has produced a series of hybrid financial assets, for which it is difficult to ascertain whether they are debt or equity instruments. The borderline between debt and equity is withering, and it is time to concede a level playing field to debt and equity. ACE exempts the ordinary return to capital from tax. It can also be shown that despite possible differences between tax-related and economic depreciation, there will be no investment distortions in the ACE, as long as the base for the deduction of imputed return on equity capital is the book value of capital which is written down in line with tax-related depreciation. (Relatively fast tax depreciation which would otherwise promote investment is exactly counteracted by relatively low deduction for imputed return on equity capital later on.) The other side of no tax distortion to investment is a relatively narrow base for ACE. In comparison with the conventional CIT a loss of tax revenue must be expected, if the same tax rate is applied.19 So either the rate must be increased, or other taxes must 19 DeMooij (2012) computes the budgetary cost of introducing the ACE tax to an average of 15 percent of the revenue from the existing traditional corporate income tax. be raised in order to recoup missing revenue. Finally, like all variants of CIT, also ACE is vulnerable to international profit shifting (see below in chapters 4 and 8), and even more so, if a transition to the ACE is financed by an increased corporate income tax rate. CBIT implies taxation of the ordinary return to business capital, whether debt or equity. This creates distortions to investment. On the other hand, its base will be relatively broad, and in comparison with todays conventional CIT it will generate higher revenue. Accordingly, a lower rate will suffice to generate the same revenue as today, or the greater revenue can be used to cut other taxes and the distortions associated with those. Even with income shifting across borders, CBIT should create sizeable revenue. CBIT should make current limitations on interest deductions redundant, securing tax revenue in the face of artificially high intra- MNE loan arrangements. Further, it obviates the need to distinguish debt from equity instruments as well as scrutiny of hybrid financial assets. Contrary to CBIT, ACE will be vulnerable to distorted interest rates in intra-company debt arrangements (and thereby to some degree to thin capitalization). ACC (allowance for corporate capital) abolishes the interest deduction and replaces it by deduction for notional risk-free return on all capital, debt as well as equity. Accordingly, it will not be vulnerable to transfer pricing via interest rates and also not vulnerable to thin capitalization. (However, artificially high levels of assets are easy to create and must be counteracted by supplementary rules.) All three corporate income tax versions will a fortiori be vulnerable to international profit shifting via transfer pricing of goods and services traded internally within multinationals - just like the traditional corporate income tax. Both ACE and CBIT are sufficiently dissimilar to the traditional CIT that if they are considered serious candidates for replacing the current CIT, they merit in-depth investigation of the transition and the international ramifications. ACE faces the question as to whether the allowance for corporate equity should be conceded to old equity or exclusively new equity. CBIT faces a similar question though, that this amount underestimates the total revenue loss, as there will be a parallel drop in personal taxation of capital income from non-corporate businesses. as to whether the removal of interest deduction should hold for old debt as well as new debt. Furthermore, ACE implies that (new) foreign shareholders will not be taxed on their normal return, in effect handing over taxation powers to foreign governments. Conversely, CBIT implies introduction of a tax on the return to foreign debt holders who then risk double taxation, in case they are also taxed at home. How international markets for equity and debt will respond to these effects is worth a closer look.20 3 BALANCES IN THE TAX SYSTEM The premise for the following remarks is that unequal tax treatment -of labor effort in different contexts -of alternative placements of saving -of alternative types of investment and their financing causes behavior and choices to depend in part on taxation in lieu of more fundamental considerations, thus generating distortions to those very choices. Under special circumstances, differential tax treatment may be warranted, but as a general rule such differential tax treatment is best avoided. Savings can be placed in bank accounts, bonds, shares in different types of companies, housing stock, and pension plans (occupational or individual). To avoid distortions in the placement pattern, the effective tax on the return to all these saving instruments ought to be similar. Companies can invest in machinery, , intangibles, and financial assets. And these investments can be financed by debt, new equity issues, and retained earnings. To avoid interference in the investment and financing pattern, the effective tax on all pairs of capital investment and financing ought to be similar. Finally, labor effort can be exerted in different contexts. Individuals can be regular employees; they can work in their own 20 A complicating factor in the comparison between ACE and CBIT is the fact that at unchanged tax rate, corporate income tax revenue is bound to go down with ACE and up with CBIT. This may prompt an increase in the ACE rate and a fall in the CBIT rate, if the corporate income tax is to deliver the same revenue as the previous standard CIT. Foreign equity holders would then face a higher (lower) statutory tax rate under ACE (CBIT). Alternatively, lower revenue under ACE may be covered by, say, an increase in the VAT rate, the effect of which would then have to be included in the analysis. firm (sole proprietorship), work in a partnership or work in a closely-held corporation, where they own a substantial share. In small firms, they can basically decide the way in which income is paid out to them, i.e. in the form of wages, dividends, or, upon sale of (shares in) the firm, in the form of capital gains. To avoid distortions associated with the organization of labor effort, the various income flows resulting from labor effort ought to be taxed at similar rates. Let us consider an example. Suppose the economy has a pro- gressive labor income tax. Also suppose that corporations are taxed by means of a comprehensive business income tax, CBIT, and that the CBIT rate corresponds to the lowest rate of tax on labor income. , in corporations both the ordinary and the extraordinary return to capital, whether debt or equity, is taxed. Regular employment resulting in wage payments is simply taxed via the progressive labor tax. Widely held, public corporations are simply taxed via the CBIT, ensuring that debt holders and shareholders in those widely held corporations have their returns taxed at least once. The treatment of intermediate types of firms is more tricky. We focus on sole proprietorships (SPs) and closely held corporations (CHCs). Taking a CHC first, the value created in such a firm represents the owners capital investment, those same owners labor effort, the injected debt, as well as labor on the part of the regularly employed. The latter item is filtered out via wage payments. Moreover, return to debt is easily filtered out, using the firms interest payments. Left is income corresponding to the owners capital investment, respectively their labor effort. The owners labor effort ought to be subject to the personal labor income tax like other forms of remuneration of labor effort. Some of that labor effort may be remunerated in the form of wage payments, but maybe not all of it. With the CBIT, the remaining labor effort is taxed at a rate corresponding to the lowest marginal tax in the progressive labor income tax scheme. With sizeable labor effort, however, a need arises for taxation at higher marginal rates and thus supplementary taxation over and above the CBIT. One possibility is then to consider the dividends paid out from the CHC. Part of it can be deemed to be the ordinary return to capital invested in the firm by owners; the remaining part of dividends can be deemed to be labor income, to be added to other labor income on the part of the owner in question. But how to secure appropriate taxation of the income in the CHC, if only part of it is paid out in the form of dividends and the rest plowed back into the company? Move on to the SPs. The simplest possible system for taxing SPs is to treat the income from SPs as personal labor income. Thus all income from a SP, regardless of whether it really represents labor effort or return to capital invested in the economy, is taxed in the progressive income tax system. Some countries do, however, permit SPs to opt for alternative taxation schemes. In these, the sole proprietor is given the opportunity to impute a return to capital invested. This return is then deducted from total income, and the remainder is interpreted as return to labor effort to be taxed in the progressive income tax scheme, very much like the possible treatment of CHCs above. What if the sole proprietor prefers to pay out to herself only part of the income generated and instead retain the earnings in the personal company? How to make sure that that income, to the degree it represents returns to labor effort, is actually taxed as such? Having once stated a preference for taxing labor income and capital income differently, and having in particular opted for progressive taxation of labor income and flat-rate taxation of capital income, it clearly is a challenge to make sure that what is really the labor income part of total income in SPs and CHCs is taxed as such, while allowing what is really capital income in those companies to undergo capital income taxation. So far so good. We have considered labor income from regular employment and from effort exerted in sole proprietorships and closely held corporations, and we have also considered return to capital invested in these corporations as well as in widely held public corporations. However, individuals savings can be invested elsewhere, and it remains to secure similar treatment of returns to these alternative investments. Savings can be placed in the form of housing stock. Accordingly, taxation of imputed rent on housing belongs to the balanced tax treatment of capital income. Capital income can also result from placement abroad, in foreign bank accounts, bonds or shares. To complete the flat-rate capital income tax, also the return from these placements ought to be taxed at the going capital income tax rate. Summing up, many things have to be considered in order to ensure that -remuneration of labor effort is taxed to a similar extent in different contexts -taxation of return to savings is similar in alternative placements -taxation of investments in companies is similar across investment type and type of financing. Whenever the tax system is not balanced this way, the system opens up for all kinds of tax planning and tax arbitrage in order to mini- mize taxation. Income is shifted across income types, the organization of firms is affected, savings patterns are altered, and the same goes for the composition of firms investment and the pattern of financing. 4 THE OPEN ECONOMY Until now, we have not paid due attention to the open economy. The arguments so far have primarily turned around conditions in a closed economy, in that we have not really considered foreign owners of domestic firms and assets nor domestic ownership of foreign firms or assets. Moreover, firms have implicitly been founded and owned by domestic citizens, and assets have been issued and owned by home country individuals. Two modeling assumptions are the simplest ones. First, the closed economy as de facto described above. Second, the small, open economy with perfect capital mobility, in which the domestic (risk-free) market interest rate is completely tied to the international interest rate, and where the cost of capital requirements of firms are governed by personal tax conditions for international owners. None of these extremes describes realities of small countries like or very well, but for tax policy purposes it is nonetheless essential to think through the implications of the jurisdiction being small and open with a reasonably high degree of capital mobility. Some domestic assets may attract foreign investors, and vice versa. Some domestic firms are in part or in full owned by foreigners, and vice versa. Perhaps especially big firms have to orientate themselves to international shareholders, while small firms must finance themselves primarily from funds made available by domestic citizens.21 The theory of taxation in an open economy predicts that marginal increases in the capital stocks in firms are related to the effective marginal tax rate (EMTR); a low EMTR implies relatively high investment. Similarly, it predicts that the effective average tax rate (EATR), i.e. the tax burden on income of the entire company, will determine location of the company, in conjunction with non- tax determinants. Both effective tax rate concepts hinge on the statutory rate of corporation tax together with depreciation rules, the inflation rate, immediate expensing, etc.; in the case of EATR, also the profit rate enters. Not only capital is mobile. Importantly, company income is, too. Income generated in a domestic entity of a multinational enterprise (MNE from now on) can be so difficult to determine, due to the uniqueness of goods and service flows involving the entity, that in reality taxable income can be attuned to tax characteristics. It is the statutory CIT rate which determines where MNEs to report their income. Further, individuals; labor services; and consumer purchases are also to a smaller or greater degree mobile, a fact which will condition tax policy, albeit in other areas than capital income taxation. How mobile is capital, then? An old insight in the finance literature is that with perfect capital mobility,22 each individual in the world economy will hold domestic risk-free bonds plus a share of the world portfolio of risky assets. In other words, a small country citizen would hold only a miniscule portion of domestic shares to go with lots of shares from all other countries. This result is actually very far from reality. There is a very significant home bias. That is, individuals hold a much greater portion of domestic assets than prescribed, and correspondingly much fewer international shares. 21This is the situation investigated by Apel and (1999). They derive unexpected effects of interest and equity return taxes on the required return on shares in domestically owned firms. 22And in the absence of taxation. and (1983) and Branson and (1985) contain clear presentations of the result. Home bias is a fact for all countries,23 although the strength of the puzzle differs across countries. One way to get an impression of the extent of home bias is to look at the prevalence of foreign owners of domestic listed companies. Typically, between one third and one half of such shares are in foreign hands; in the UK, it is about a third, in the Nordic countries it is closer to one half. For tax policy purposes it is potentially important to inquire about the reasons behind the home bias. To the extent that home bias is determined by endogenous forces which may be affected by tax policy itself, this must be accounted for in gauging the effects of policy changes. So what could be the possible reasons behind home bias?24 First, one reason may be transaction costs. It is generally significantly more costly to acquire foreign assets, both because of the fees to involved financial intermediaries and because of the costs of devoting the extra attention to understand foreign country conditions and acquire relevant information on foreign asset issuers in order to select preferred assets. Second, and relatedly, there may be an asymmetric information barrier. While the domestic investor may be reasonably well informed about domestic firms and financial institutions, the extent of information on foreign firms and financial institutions may be much smaller. Once this is recognized, the investor must also acknowledge that those with better information may try to take advantage of their superior information. The lesser informed may as a result decide not to invest or at least invest less than if adequate information was at hand.25 A related argument for home bias involves corporate governance considerations. If domestic citizens are better informed about a particular company, they are in a better position to exert monitoring of management of the company. In order to motivate such monitoring, those individuals have to possess a sizeable fraction of shares in the company, in effect generating home bias.26 Third, and also relatedly, knowledge may be so imperfect about foreign firms and institutions that the consequences of the lacking 23Obstfeld (2007) notes that the home equity bias remains substantial, although it is falling over time. 24For a couple of nice overviews, see Obstfeld (2007), and and Bellalah (2010). 25For an examination of the implications of asymmetric information for tax policy formation see and Bovenberg (1996). 26See Kho et al. (2009). Their explanation may work for home bias in equity, but not for that of bonds. information cannot even be estimated. If the investor only invests in assets, about which a sufficient amount of information is available, she may simply stay away from a good deal of foreign assets. Fourth, there may be uncertainty as to political conditions, i.e. Policy in foreign countries may change in unforeseen directions, and there may even be a perceived risk of foreign governments seizing investments by outsiders. Fifth, some have argued that the asset home bias is caused by a goods home bias. That is, the established fact that trade costs lead to preference for domestic goods or goods from nearby countries may have repercussions on the asset holding pattern via fluctuations in real exchange rates. There is some disagreement about such links in the literature. 27 Sixth, home bias may itself be caused by tax policy, if domestic (foreign) holdings of domestic (foreign) assets are leniently treated relative to domestic (foreign) holdings of foreign (domestic) assets.28 Such differential treatment is only effective to the extent that assets are characterized by idiosyncratic (country-specific) risk.29 Yet further reasons for the home bias can be imagined. As stated, before tax policy is designed for cross-country holdings of assets, it would be desirable to know the cause(s) of home bias in order to estimate the effects and incidence of particular taxes. In particular, asymmetric information should be properly taken into account. and Bovenberg (1996) demonstrate, in their asymmetric information framework, how foreign investors vulnerability to being overcharged by domestic agents leads to too importing of capital in a capital-importing country. The authors demonstrate that the optimal policy response to this state of affairs is a subsidy to capital imports. In estimating their cost of capital (for equity financed invest- ments), domestic firms have to have some idea of the properties of the marginal investor. Is it a foreigner, and if so, what personal tax treatment abroad leads to what required return on the investment? And for tax policy makers, how will corporate tax and personal tax changes affect investment behavior, if the marginal investor very 27See the article by van Wincoop and Warnock (2010) and the articles cited therein. van Wincoop and Warnock themselves conclude that the portfolio home bias that results from trade costs is close to zero. 28For example, cross-country investments may be subject to withholding taxes that may not be fully offset by home country tax credits. 29Idiosyncratic risk implies that domestic assets become imperfect substitutes to foreign assets. The preferential treatment of domestic assets could constitute an optimal policy response; see, for example, (1998). well might be a foreigner? Similarly, to the extent that foreign assets are relevant to domestic savers, how will personal tax changes affect domestic portfolios? These are not unimportant questions also for the overall design of the tax system. To take an example, Sørensen (2005) shows that the Norwegian shareholder tax using RRAs will be neutral towards financing and investment decisions in firms. However, as and (2012) demonstrate, this does require full capitali- zation of the RRA; to the extent that the before-tax equilibrium rate of return is in fact determined by international investors, the neutrality result no longer holds. International tax regimes belong to the preconditions for forming tax policy in the open economy. In the corporate income tax area, the reigning regime is one of separate accounting; i.e. firms are required to compute the income they generate in the country where they are operating, so that it can be taxed there. In principle, the production and trading of goods and services in the world economy could be accomplished by purely national firms. They could be owned by domestic citizens as well as foreign citizens, but their activity would be confined by the national border. There might be complications in assessing the effects of tax policy given the doubt as to who the marginal investor in the firm would be, but computing the income of the firm would present no major difficulty. Taxing companies becomes a bigger challenge when they become multinational. The typical multinational consists of pro- duction facilities, sales facilities, financial centers and the head quarter, and all kinds of inputs and non-financial as well as financial services are traded between the entities of the multinational. That gives rise to a need to price all the internal cross-border shipments to delimit the income generated in each location, so that the entities can be subjected to national taxation. Setting appropriate transfer prices on shipments of goods and services, and setting appropriate interest rates on internal loans is no simple matter for the multinational itself, and it is even less simple for tax authorities to assess whether prices applied in computing taxable income are appropriate. In fact, under many circumstances there is no correct price, and authorities may be left with an interval in which no price can be rejected as a possible transfer price/interest rate.