A Destination-Based Cash Flow Tax in a Digital Age (or, How To Game the House Republicans’ Plan)
The House Republicans’ plan for a “destination-based cash flow tax” is generating lots, lots, lots of attention. The basic premise is as follows: A 20% tax would apply to the domestic sales of U.S. corporations, with an immediate deduction for domestic expenses. There would be no tax on exports, but no deduction for imports. The intellectual architect of the plan, UC Berkeley economist Alan Auerbach, argues that there would be “no incentive for profit shifting” if such a tax were implemented. And while the proposal has been criticized on grounds that it would resemble a tariff and thereby violate World Trade Organization rules, the premise that a destination-based cash flow tax would eliminate the incentive for profit shifting seems to have gone unquestioned.
But does the premise survive scrutiny? First, imagine that Microsoft develops a new Windows operating system and sells it to a consumer in Chicago. The consumer pays $100 and downloads the software onto his laptop; Microsoft’s costs (e.g., the salaries it pays to programmers in Redmond, Wash.) are $50; and Microsoft’s tax under the House Republicans’ plan is 20% x ($100 — $50) = $10. If Microsoft sold the same software to an Irish consumer in Dublin, it would still have a deduction worth 20% x $50 = $10, but no taxable income from the overseas sale. If Microsoft developed the software in Dublin rather than in Redmond, then its $50 of costs wouldn’t be deductible and its tax would be 20% x $100 = $20.
Now, imagine that Microsoft develops the operating system in Redmond but sets up a Dublin-based subsidiary, Microsoft-Ireland. Microsoft-Washington sells the software to Microsoft-Ireland for $98, and Microsoft-Ireland then sells it to the consumer in Chicago for $100. Microsoft-Washington still gets to claim the $50 deduction, but owes no tax on the $98 it receives from an overseas purchaser (Microsoft-Ireland). Microsoft-Ireland has income of $100 — $98 = $2, which is subject to an Irish tax of 12.5% x $2 = $0.25. By routing the sale through Dublin, Microsoft lowers the tax on its software sale to the Chicago consumer from $10 to $0.25.
Maybe the House plan will be wise to this and incorporate some sort of look-through rule that treats the two-step transaction (Microsoft-Washington’s sale to Microsoft-Ireland; Microsoft-Ireland’s sale to the consumer in Chicago) as if Microsoft-Washington had sold the software directly to the consumer in Chicago. In that case, expect to see a new enterprise, ShamrockSoft, with the following business plan: ShamrockSoft, an Irish corporation, purchases Windows licenses from Microsoft-Washington for $98 each and resells to U.S. consumers for $100. Microsoft is happy with this because its tax is -$10 rather than $20, and its after-tax income is $98 — $50 + $10 = $58 rather than $100 — $50 — $10 = $40. ShamrockSoft is happy with this because it’s making a small profit off the arbitrage, and Ireland is happy with this because it’s collecting an extra $0.25 in tax. The consumer in Chicago is indifferent as to whether he downloads Windows from Microsoft.com or from ShamrockSoft.com. The only loser is the U.S. Treasury.
How can the House plan prevent this? I’m not sure. It will be hard to collect tax from ShamrockSoft, which has no physical presence in the United States. Perhaps the House plan will incorporate some sort of use tax payable by U.S. consumers on digital purchases from overseas? (And how does that sit with the WTO?) Note that this isn’t just a problem with respect to digital sales. Expect to see mail-order retailers with warehouses along the Canadian border selling goods directly to U.S. consumers. Will we impose a 20% tariff on direct-to-consumer imports from abroad? If we already thought that “House Republicans’ tax-reform plans risk a trade war,” adding an actual 20% tariff isn’t going to help.
Maybe proponents of a destination-based cash flow tax have a solution to all of this. (A recent paper by Auerbach and Douglas Holtz-Eakin walks through some implementation details but doesn’t discuss the challenge posed by foreign entities selling directly to U.S. consumers.) If the House Republicans’ plan is passed without closing this gap though, 2017 could be a very good year for Irish software resellers and Canadian direct marketers — and a very bad year for the U.S. tax base.