A centerpiece of President Joe Biden's address to Congress on Wednesday night is his roughly $1.8 billion American Families Plan. To fund the policies it promotes for families and poorer Americans, the president wants to increase capital gains taxes and the top marginal income tax rate. And they're only the latest in a line of proposed Biden tax hikes, which garnered attention early this month with an attempt to raise corporate tax rates.
The laws of economics are more rigid than the laws of the federal government, and these tax hikes are unlikely to yield the windfall Biden expects.
Raising taxes on companies and rich people might seem like an easy economic solution to fund spending — even if it would be politically difficult to achieve, given Republican opposition. But the laws of economics are more rigid than the laws of the federal government, and these tax hikes are unlikely to yield the windfall Biden expects.
It is unrealistic, some would say delusional, to think that the U.S. can increase taxes so significantly without costing the country in competitiveness and growth. Big businesses would still have access to global tax havens that charge little or no corporate tax (applied to company profits) and capital gains tax (applied to the growth in the value of investments when they are sold).
That means these taxes would be likely to hurt only small and medium-size businesses, as their larger competitors have the means to employ expensive tax lawyers and other techniques that secure their access to offshore loopholes — those jurisdictions that allow corporations to channel profits through them and avoid taxes. Biden needs to avoid the vicious cycle in which more tax means more tax avoidance, which in turn means lower tax revenues, which forces policymakers to raise taxes.
The effects of this pernicious tax avoidance dynamic, ironically, can best be illustrated by Biden's home state, Delaware, which is akin to an American onshore tax haven that the president seems unwilling to challenge as part of his tax increases. Unlike elsewhere in the U.S., a company incorporated in Delaware can pay a corporate tax rate of 0 percent, while company reports aren't required to be publicly available, creating a high level of privacy. Essentially, Delaware's rules make it very easy for companies to benefit from tax havens abroad.
As a consequence, two-thirds of the Fortune 500 are legally headquartered in Delaware. There are more businesses registered in Delaware than there are people by a ratio of 3 to 2. Major companies, like Google and Amazon, are incorporated there despite generally having no real connection to or operations in the state. Biden has specifically called out Amazon for not paying taxes, but while his plan would close some loopholes, it wouldn't touch the massive one in Delaware that the internet behemoth can take advantage of — even though he could include federal restrictions on Delaware's behavior in it.
This behavior is replicated around the world as businesses try to find the jurisdictions with the most tax loopholes. Keen to protect U.S. competitiveness, the White House tried to persuade the world to follow suit in raising corporate taxes, with Treasury Secretary Janet Yellen leading efforts for what has been dubbed "a global minimum corporate tax rate."
Yellen's outreach has focused on the G-20, the logic being that if she can get agreement from the world's 20 key economies, the U.S. won't lose competitiveness. But the G-20 isn't the world. There will still be many zero-tax jurisdictions for companies to choose from. Getting U.S. allies to match our tax hikes might make us feel less alone, but it wouldn't stop the damage.
Still, the need for more tax receipts isn't going anywhere. A source of funds must be found for Biden's flagship policies, such as his $2 trillion infrastructure and jobs plan and the American Families Plan.
There's a solution that's counterintuitive, but I believe it will work: The U.S. can take the tax havens head-on by lowering American taxes. This could still lead to increased tax revenues, because the biggest tax avoiders in the world — large corporations — would then be enticed back into the taxable economy.
Why would they be? Because of the lower tax rate, combined with the benefits to their reputations and legal bills. Their legal bills would be lower because they wouldn't need an army of offshore attorneys anymore, and their reputations would be better because they could announce that they were proudly paying their U.S. taxes. These latter incentives haven't changed behavior in the past, but combined with much lower tax rates, they would become more compelling.
To work, however, it's not enough to make incremental tax cuts, such as those implemented under President Donald Trump. Trump's dropping the corporate tax rate from 35 percent to 21 percent was a significant help to regular onshore businesses, but it wasn't enough to entice most major companies back into the U.S. tax system. As long as there is a huge gap between onshore and offshore rates, the biggest potential taxpayers will be the biggest tax avoiders.
The tax rate needs to be low enough that there's no incentive to use havens while being high enough to generate significant government revenue: something like 5 percent. Even at that modest rate, the U.S. tax take would go up, not down. Low tax isn't the same as no tax.
There will always be ways for big businesses and high-net-worth people to legally avoid tax. For example, "transfer pricing" lets a company channel profits into different jurisdictions, and trusts allow legal ownership to be transferred offshore. There is no meaningful way to stop these things from happening, as evidenced by decades of effort.
The only solution is for taxation by consent: to set corporate taxes at a level that businesses are willing to pay. This isn't guesswork: In 2018, the United Arab Emirates (a zero-tax jurisdiction for most corporations and individuals) introduced a 5 percent VAT. Yet there wasn't a mass stampede to move accounts elsewhere. People and businesses have been happy to pay a low tax rate for a safe, modern place to do business.
There is potentially $36 trillion in offshore jurisdictions — much of it coming from companies and residents of the U.S. The IRS knows this, which is why it is trying to clamp down on institutions in those countries dealing with U.S. residents. However, though the White House is looking to give the IRS $80 billion to increase its enforcement efforts, that wouldn't make a significant difference as long as the incentives favored offshore arrangements.
Politically, getting corporate and capital gains taxes this low would be difficult; progressives prefer headlines about taxes' going up. But having the rich pay some tax is better than the status quo, in which the poor pay high taxes and the rich pay no taxes — often helped along by our own tax havens in places like Delaware.
It's the middle class, not the truly rich, who are hit by tax rises like Biden's. But it's the rich with whom we need to work to create a functional tax system.