Tax bills speed up global tax race to the bottom

A New York Times op-ed on Nov. 2 by Danielle Wenner and Kevin Zollman brought a refreshing game-theory perspective to the arcane discussion of international corporate income taxation.

They pointed out that without international harmonization of rates, each country will try to attract investment by lowering its rate — a “race to the bottom” that erodes its tax base. Their solution is international cooperation, but such cooperation has proven elusive. 

{mosads}There is another alternative, one that does not require international cooperation and yet will also end the destructive race to the bottom. The states of the U.S. faced the same problem as countries in international commerce.

At first, most states taxed corporations by averaging the percentage of a company’s property, payroll and sales that took place in the state. Then, in 1960, Iowa started taxing only on the percentage of a company’s sales in the state.

This was a powerful change because no longer was Iowa in competition with other states. Now, almost all states that tax corporate profits either tax solely on sales or heavily weight sales in the equation. A state can lower its corporate income tax rate to attract investment from states with higher rates, and yet they do not.

That change, called sales factor apportionment (SFA) has ended the race to the bottom for many states. For example, if a Georgia corporation sells 30 percent of its widgets in New York and 10 percent of its widgets in Georgia, then New York is entitled to tax 30 percent of the corporation’s pretax profits at its rate of 6.5 percent.

Georgia is entitled to tax 10 percent of the company’s profits at .06 percent. Each state decides its own apportionment formula, and sets its own corporate income tax rate. This system has worked well for over 50 years and has avoided the destructive race to the bottom. 

Can such a system be applied internationally? Many economists believe it can. The beauty of this system is that it does not require international agreement or cooperation. Just as New York does not require approval or cooperation from other states to determine its apportionment formula or to decide whether it will use apportionment or some other system of taxation, the U.S. can act alone; and it should.

The House has now passed its version of a tax bill that would raise our already too-large deficit by an additional $1.5 trillion dollars over 10 years.

That bill would do little to end the unfairness faced by our domestic corporations that compete against multinationals, many of which offshore their profits and employ loopholes that are unavailable to domestic corporations. The House bill also leaves pass-through businesses disadvantaged, which has led Sen. Ron Johnson (R-Wis.) to oppose it. 

In contrast, SFA would raise over $1 trillion in new federal revenue. This would reduce the tax-bill related deficit increase to around $500 million. It could also help to avoid draconian cuts to social programs that are now being proposed to pay for the cut in corporate tax rates.

Sen. Johnson has a point in that small businesses, which are typically taxed as pass-throughs, cannot afford to pay the full 35-percent statutory federal corporate rate in addition to state income taxes. Thus, they become partnerships or other pass-throughs, and business income is taxed directly to the owners as personal income.

This does allow these small businesses to compete, but makes it relatively difficult for them to retain earnings in the business that would enable it to grow.

If we want to incentivize small business to grow, we can encourage them to retain earnings by becoming C-corporations, but with a progressive rate structure, for example a rate of 10 percent for the first $500,000 of income and 15 percent for the next $500,000 of income. 

Such a tax plan would solve the problem of egregious tax avoidance by multinationals, it would give our domestic corporations an even playing field to compete with the multinationals, and it would incentivize small businesses to grow. It would be a win-win-win reform. 

Bill Parks is the founder and chairman emeritus of Northwest River Supplies (NRS), a manufacturer and distributor of kayaks and other water sports equipment. He serves on the board of Coalition for a Prosperous America, a group that advocates on behalf of U.S. manufacturing.