Ongoing discussions of corporate tax reform in Washington continue to focus on shaving a few points off the income tax rate. Would that be enough to restore the nation’s global tax competitiveness? Peter Merrill doesn’t think so. Merrill, principal and director of national economics and statistics with PwC’s Washington National Tax Services practice, believes that any rate cut should go much deeper, and has also argued in favor of increased reliance on consumption taxes (such as a value-added tax, or VAT – an option that, to say the least, hasn’t had an enthusiastic reception from corporate leaders). I asked Merrill for his take on the current state of play.

BizTaxBuzz: What global trends are having the biggest impact on U.S. tax policy?

Peter Merrill: There are several important trends. First, you’ve got the growing importance of foreign operations to U.S. companies. Around three-quarters of global purchasing power is now outside of the U.S., and global economic growth – notably in Brazil, India, and China – is much faster than it is in this country. Many U.S. multinationals now derive over half of their revenues from foreign markets, and that’s been increasing over time.

Other OECD countries have reduced their rates. After the Tax Reform Act of 1986, the U.S. corporate tax rate (federal and state combined) was about 6 percentage points less than the average of other OECD countries; today, it’s 14 points higher. As a result, U.S. companies have rapidly accumulated earnings in foreign subsidiaries that are effectively trapped due to the U.S. tax on repatriated earnings.

At the same time, countries have moved away from taxing a company’s worldwide income to territorial tax systems, where there’s little or no tax on repatriated income. The United States is now the only G-7 country that hasn’t adopted a territorial tax system.

Individual and institutional investors in the U.S. are increasingly willing to invest in foreign equities; they can participate in global markets and in companies that aren’t subject to the U.S. worldwide tax. If the U.S. corporate tax regime is not competitive with that of other countries, then U.S. companies will have lower market values and will find it more expensive to attract equity capital.

BizTaxBuzz: Would a cut in the statutory corporate income rate be enough to re-establish U.S. competitiveness?

Merrill: Well, here’s a benchmark: The average combined (federal and state) statutory corporate tax rate among the other OECD countries is now about 25 percent. To match that, the federal tax rate would need to drop by 15 percentage points, to 20 percent. That would make the U.S. a far more attractive location for investment, for both U.S.- and foreign-based companies; some studies show that the international location of foreign direct investment is highly sensitive to the statutory tax rate. And it would also greatly reduce the tax on repatriated income, making it much less costly for U.S. multinationals to invest foreign earnings in the United States.

BizTaxBuzz: You’ve called for for a consumption tax, but a recent PwC study [the Paying Taxes research; see my post] says that VAT-type taxes impose a very high compliance burden on companies. Could the benefits for corporates outweigh this drawback?

Merrill: Certainly if you add a VAT on top of the existing income tax system, there’ll be additional compliance and administration costs. But there are several points to keep in mind.

First of all, the cost to the economy — in terms of reduced economic growth — of raising revenue through a broad-based consumption tax versus increasing income taxes is much lower. OECD research involving 21 countries over two decades found that the corporate income tax was most harmful to economic growth, and consumption taxes and real property taxes were the most growth-friendly. So you need to look at the total economic effect, not just compliance costs.

A number of studies have found that the cost of compliance per dollar of revenue raised is less for VAT than for the corporate income tax. And many proposals to increase revenues from the income tax system would substantially increase compliance costs – for example, legislation adopted last year to restrict the use of foreign tax credits.

Many studies have found that compliance costs per dollar of sales and per dollar of tax revenue fall sharply as the size of the taxpayer’s business increases. A PwC study of the retail sales tax found that compliance costs were six times higher per dollar of sales and tax revenue for the smallest versus the largest size category of retailers. This means that compliance costs can be sharply reduced by adopting a VAT with a high registration threshold, such as in Singapore where the registration threshold is about $775,000 at current exchange rates. This would eliminate more than 90 percent of potential taxpayers from the VAT system at a cost of less than 10 percent of total revenues.

Plus, as in Canada, the federal government could encourage states to eliminate their retail sales taxes and piggyback on the federal VAT. This would mitigate the compliance burden of VAT for retailers.

BizTaxBuzz: How much reform do you expect to see in this session of Congress?

Merrill: Revenue-neutral tax reform is exceedingly difficult. By definition, there are winners and losers, and the loser will be energized to block action. In Washington, it’s easier to block than to enact legislation. Past experience suggests that tax reform will only happen if the President makes it a top priority. If President Obama makes tax reform his top domestic priority and works across the aisle — as President Reagan did in 1985 and 1986 — then it’s possible to accomplish.

Ultimately, we know that U.S. fiscal policy is not sustainable. On the current path, we’ll have $20 trillion of federal debt outstanding by 2020 — about 90 percent of projected GDP. The unusually low interest rates at which the federal government currently is able to borrow won’t last forever. At some point, rather dramatic fiscal changes will be needed and a major restructuring the federal tax system likely will be required. ###