Below is a guest post by Washington University Law Professor Adam Rosenzsweig on international tax law.

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The Problem of Intuition in International Tax Law

The news is filled with stories of abuse of the international tax system, from General Electric to Apple to Google toPfizer, typically with outrage and scorn.  There seems to be consensus that these are examples of how the system clearly is broken and in need of desperate repair.  What follows is typically calls for obvious solutions to these obvious problems, whether it be replacing transfer pricing with formulary apportionment or adopting minimum foreign tax rates or shifting to a territorial tax system.  Yet, when pushed, few can clearly articulate exactly why these examples are so troubling in the first place.

For example, if Apple pays too little US tax, it would be simple to impose a US excise or excess profits tax on Apple’s cross-border activity.  If Google uses artificial shell companies to hide income in Ireland without any real economic activity, it would be easy to disregard such sham entities.  If GE siphons all of its US profits to other countries it would be easy to impose US tax on its foreign source income.  Yet for the most part nobody has proposed these solutions, presumably because they violate some underlying deeply held norm of the international tax system.  So what are these norms, and why are they not being discussed?

This cycle is not new, however.  In the early 1960s Congress adopted the Subpart F rules as a way to shut down the scourge of tax havens by requiring current inclusion of certain highly mobile income.  This was supposed to kill the use of tax havens by US companies.  By the mid-1970s, however, the system was perceived as broken again, this time because of gaping exceptions permitting deferral for investments in “less developed” countries.  By the end of the decade the less developed country rules were repealed.  And then again a new concern arose about the abuse of the foreign tax credit by cross- crediting income from one country with tax credits from another, leading to the credit being “basketed” on a per-country basis.  And this itself was also repealed once it came to light that taxpayers could simply shift losses around countries rather than pool income and credits, leading to income-type baskets rather than per-country baskets.  Even then the problem continued, leading to calls to prevent companies from “inverting” by moving their headquarters offshore to avoid paying US tax.  This led to the enactment of the so-called anti-inversion legislation, or what could be thought of as the “once a US company, always a US company” rule, in turn leading to our current debate over “Double Irish” sandwiches and the like.

Each of these rule changes was supposed to end the apparent and outrageous abuse of the international tax regime.  Yet we find ourselves once again in the thick of this debate, with new obvious abuses and new obvious solutions.  But if none of the old obvious solutions fixed the problem, what makes us so sure the new ones will?

This is what I refer to as the problem of intuition in the international tax laws.  There is near-uniform scorn and outrage over international tax abuse but very little discussion over precisely what is so troubling about them in the first place.  Is it any surprise, then, that the obvious solutions rarely solve the problem?  How can we measure if we are any closer to an ideal system if we don’t identify the ideal in the first place?

This is not a problem of second-best, as that would require a clear first-best and some constrained variable preventing achievement of that first best.  This is recourse to deep-seated intuitions about a field that should be purely instrumental in its goals.  This, I would contend, is the real problem underlying international tax law.

Not everyone would agree on the underlying normative goals of the international tax regime, or even where to start.  But there is an obvious place to start as an initial matter, and that is where the focus traditionally has been, i.e., on the efficiency of the international tax regime.  From that perspective, the international tax laws have two consequences: (1) they raise revenue, and (2) they distort cross-border activity.  The second has received significant attention, in the form of the debate over “capital export neutrality” and “capital import neutrality” among others.  But the first has received less attention.  At first this would seem strange – isn’t the outrage over Apple and Google and GE all about revenue?  Yes and no.  Most of the outrage over these companies seems to that they are not paying the US enough revenue.  But, by definition, international tax is only relevant when more than one country is involved.  So what about the other country?  What would it do with the revenue?  Is one dollar in revenue for the United States more important than ten cents in revenue for Haiti?  Perhaps that intense need for ten cents is contributing to tax competition in the first place?

The answer, at least from an efficiency standpoint, depends on what the relative countries do with the revenue.  After all, raising tax revenue would never be worth the efficiency losses if the money was simply thrown in the ocean.  Assume the revenue is used to provide for industrial public goods, those public goods that increase returns to private capital within a jurisdiction.  Now the question is whether, at some point, the twentieth or fiftieth or one thousandth port in the United States is always more efficient than the first one in Haiti.  If returns to industrial public goods are constantly increasing in scale, then the answer is yes; if returns diminish in scale, then the answer is no.

This too is not a completely new idea.  Keen and Wildasin modeled a similar concept in 2000, among others.  But the legal literature, and the popular debate, hasn’t seemed to have caught up.  Raising US taxes on companies with activities in Haiti may be good for the US but it may be bad for Haiti.  Raising US taxes may increase distortions to cross-border activity, but it may better allocate returns to revenue.  It is this tradeoff that has been underappreciated in the current debate for the most part.

For example, if opponents of Google really wanted to raise the taxes it pays to the United States doing so would be easy: simply deny Google all of its foreign tax credits (or impose an excise tax on their use).  But nobody proposes this, presumably because it would “double tax” Google on its cross-border activity, a cure considered worse than the disease.  Rather, opponents of Google want Google to pay more tax to the United States and less to other countries.  But this then directly confronts the revenue question.  If building a port in Haiti is better for worldwide growth than paying for social security in the United States, which country should have a greater claim to the tax revenue?  Does the fact that Google is incorporated in the United States answer this question at all?  If not, then why adopt increasingly complex anti-inversion rules to prevent companies like Google from moving its place of incorporation to Haiti?

Perhaps this post raises more questions than it answers.  But at a minimum I would like to start a conversation challenging the intuitions, apparently deeply held, upon which most of the legal debate seems to rest.  Agree or disagree with this normative starting point, as I have done in prior work, but the debate should be engaged explicitly on that level rather than simply labeling some companies good and others bad, some countries cooperative and others tax havens, changing the rules to combat phantom menaces only to discover they were never there in the first place.