The US and other countries have proposed a global 15% minimum corporate tax. However, it’s not a change in tax rates that our corporate tax system needs, it’s a change in structure. We need to move from taxing profit to taxing revenue. Doing so would be a far more effective way to end the tax avoidance strategies of multi-national corporations and would reduce bureaucratic costs for all businesses. If the transition was revenue neutral, it would result in a tax cut for many small and medium sized US businesses, and a significant tax increase in companies that use accounting to move their profit offshore to avoid paying US taxes.
When the corporate income tax was established in the early 20th century, it better fit the stage of development of our economy. Industrialism was new and the United States was a land of virtually untouched natural resources. Giant oil fields were being discovered in Texas and other states, creating immense wealth almost overnight. Cheap energy was transforming our economy, allowing new industries to be established and capitalists to quickly accumulate fortunes. We had a young, immature, rapidly growing economy that allowed many companies to generate significant profits.
A tax on profits also captured the spirit of the times. A leading economic philosopher, Henry George, noted that it wasn’t just the ingenuity or luck of the capitalist that allowed them to create their vast fortunes. The progress of our civil society created the infrastructure that allowed capitalists to derive that wealth and markets in which to sell their products. In George’s view, society was a critical partner with the capitalists, a primary reason they were able to succeed. And as a partner, society deserved a share of the profits as compensation for the value it brought.
However a profit-based tax also introduces an inherently complicated question: what constitutes profit? Profit is what is left over when expenses are subtracted from revenue. In a simple world, this is a simple question. A blacksmith could easily track their cost of the iron and coal, the rent on their shop and the handful of other supplies they purchased for their business. However as our economy became more complex, calculating profit also became more complex. A simple blacksmith’s hammer was replaced by expensive machines to shape steel. How much of the cost of a machine should be written off as an expense each year? Is the value of the machine in its parts and components, or the idea of the machine? Manufacturers ship raw materials and parts from one subsidiary to another – where does the cost of that material get booked as an expense?
Because the government was setting its taxes based on profit, the government then also had to define what was an allowable expense, and even when money coming in should be counted as revenue. And because the government was setting the definition of profit, businesses had a strong incentive lobby government to manipulate the definitions in their favor. Businesses could increase the amount of money they made for their shareholders, their real profit, by taking advantage of rules that allowed them to report less profit to the government and so pay less in taxes. A profit-based tax created a lucrative new category of economic activity: tax avoidance.
Taxing profit is even more complicated with international trade. Different nations tax corporations differently. Where is the profit generated? Is it in the nation where the product was actually sold? Where components were produced? Or at the corporate headquarters, where ownership of the ideas was based? Our profit based tax system allows multi-national corporations to shape their financial statements so that the profit of their international operations is realized in the jurisdiction with the most favorable tax treatment. It allows companies such as Apple, with US sales of over a hundred billion dollars, to book most of its profits at its Irish headquarters and so greatly reduce its US tax burden. And on the other side, it also causes US corporations that have generated profits oversees to leave these profits in overseas subsidiaries, to avoid paying US taxes on money earned in other jurisdictions.
The US and other countries have proposed that every country should set a minimum 15% tax on corporate profit. But the answer isn’t to get international buy in to our dated, flawed current approach. Instead we need to change our approach to corporate taxation to match the realities of our complex, globally competitive economy. With capital and production flowing back and forth around the globe, we need to quit trying to figure out where the gain is booked, and instead shift the corporate tax to revenue, based on where the product or service sold.
The math is fairly straight forward. Gross Domestic Product (GDP) is the value of all goods and services purchased in the US, about $21 trillion per year. Our annual corporate tax receipts are about $212 billion, or about 1.01% of our GDP. A revenue tax of about 1.01% of revenue would generate that same $212 billion in tax receipts.
Our current federal tax rate is 21% of profit. If a restaurant does $900,000 in revenue with an 8% profit, it’s profit is $72,000 and it pays $15,120 in federal taxes. Under a 1.01% revenue tax, the restaurant would have paid $9,090 in taxes. Any tax change creates winners and losers and moving to a revenue based tax would do the same. If a company’s annual profit is over 4.81%, it will save on its taxes. If it’s under, it will pay more in taxes.
Industries with low profit margins, for instance grocery stores, will see a slight increase in their tax burden. However in theory many of their suppliers will see a slight drop in their tax burden, which will eventually flow through to lower prices to the grocery store. Changing to a revenue-based tax will shift around which companies pay the $212 billion in federal taxes, but it will not increase the overall taxation cost to our economy. Yes, taxing profit instead of revenue will make it a little harder to start a new business and will make it a little harder for a marginally profitable business to stay in business. Taxing revenue will add an additional cost to these businesses, and for some that will be enough to cause them to shut their doors. It will expose failing businesses to the pressures of the free market.
Arguably, a revenue-based tax is far more appropriate to the state of development of our economy. While there are occasionally companies with outsized profits, virtually every sector is much more mature and much more competitive, which has brought down the profit margin. Our free market tends to respond very quickly to bring new participants into any lucrative market activity.
Civil society is still the context in which all companies operate. However government isn’t a partner in a company’s economic efforts, it is a service provider like a trucking company or janitorial service. Government provides the infrastructure and financial systems necessary to allow a business to do its business. And it should be paid this way. Businesses don’t get free janitorial service if they are having a hard time making a profit. Why should the services of government be treated any differently? The amount of government a business uses is based on its revenue, not how profitable that revenue is. Businesses shouldn’t get free government if they do a bad job making money, and they shouldn’t pay more for the same government service if the company does better.
Our current tax law also has its own winners and losers. The winners are the companies that manage to hide their profit through accounting measures. The losers are the companies that don’t pay enough attention to tax avoidance. We aren’t rewarding the companies that create the most value – we reward the companies that use bureaucracy to hide the most value. It’s a wasted effort for our society.
Our country has an ongoing conversation about the fairness of our tax system, and regular explosions of frustration at how the system has been gamed. We periodically talk about reimaging our tax code. We need to do so – we need an approach that matches the realities of our global economy. We need to move from taxing corporate profit to taxing corporate revenue. Doing so would end the tax avoidance strategies of multi-national corporations and reduce bureaucratic costs for all businesses. It will be good for our economy and good for our country.