reforming ct in a global economy

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HAMILTONTHE

PROJECT

Advancing Opportunity,

Prosperity and Growth

The Brookings Institution

Reforming Corporate Taxationin a Global Economy:A Proposal to Adopt Formulary Apportionment

D I S C U S S I O N P A P E R 2 0 0 7 - 0 8 J U N E 2 0 0 7

Kibery A. Causing

Reuven S. Avi-Yonah



The Haiton Project seeks to advance Aerica’s proise o

opportunity, prosperity, and groth. The Project’s econoic

strategy reects a judgent that ong-ter prosperity is best

achieved by aking econoic groth broad-based, by

enhancing individua econoic security, and by ebracing a

roe or eective governent in aking needed pubic

investents. Our strategy—strikingy dierent ro the

theories driving econoic poicy in recent years—cas or fsca

discipine and or increased pubic investent in key groth-

enhancing areas. The Project i put orard innovative

poicy ideas ro eading econoic thinkers throughout the

United States—ideas based on experience and evidence, not

ideoogy and doctrine—to introduce ne, soeties

controversia, poicy options into the nationa debate ith

the goa o iproving our country’s econoic poicy.

The Project is naed ater Aexander Haiton, the

nation’s frst treasury secretary, ho aid the oundation

or the odern Aerican econoy. Consistent ith the

guiding principes o the Project, Haiton stood or sound

fsca poicy, beieved that broad-based opportunity or

advanceent oud drive Aerican econoic groth, and

recognied that “prudent aids and encourageents on the

part o governent” are necessary to enhance and guide

arket orces.

HAMILTONTH E

PROJECT

Printed on recyced paper.




JUNE 2007

HAMILTONTHE

PROJECT

This discussion paper is a proposal rom the authors. As emphasized in The Hamilton Project’s

oriinal stratey paper, the Project is desined in part to provide a orum or leadin thinkers

rom across the nation to put orard innovative and potentially important economic policy ideas

that share the Project’s road oals o promotin economic roth, road-ased participation in

roth, and economic security. The authors are invited to express their on ideas in discussion

papers, hether or not the Project’s sta or advisory council aree ith the specifc proposals.

This discussion paper is oered in that spirit.

Reforming Corporate Taxationin a Global Economy:

A Proposal to Adopt Formulary Apportionment

Reuven S. Avi-YonahUniversity o Michian La School

Kimerly A. ClausinReed Collee



ReoRming CoRpoRate taxation in a global eConomy: a pRoposal to adopt oRmulaRy appoRtionment

www.HAMILTONPROJECT.ORg |

JUNE 2007

C

1. Introduction 5

2. The U.S. System o Corporate Taxation 6

2.1. Description o Current System

2.2. Prolems ith Current System 82.2.1. Current System Is Not Suited to a gloal Economy 8

2.2.2. Current System Creates Artifcial Tax Incentives 9

2.2.. Current System Is Too Complex 10

2.2.4. Current System Raises Little Revenue 10

. A Proposal to Adopt Formulary Apportionment 12

.1. Ho would Formulary Apportionment work? 12

.2. Four Key Advantaes o Formulary Apportionment 1

.2.1. FA would Alin the U.S. Tax System ith a gloal Economy 1

.2.2. FA Eliminates the Tax Incentive to Shit Income

to Lo-Tax Countries 14

.2.. FA Increases Simplicity 14.2.4. FA would Raise Revenue or Enale a Rate Reduction 16

4. Donsides o FA 19

4.1. Is FA Aritrary? 19

4.2. Implementation Issues 20

4.2.1. Defnin a Unitary business and the Destination o Sales 20

4.2.2. Interactions eteen Countries ith Dierent Tax Systems 21

4.2.. Defnin the Tax base 22

4.2.4. Interaction ith Tax Treaties 2

4.2.5. Distriutional Issues 25

4.2.6. Interaction ith wTO Rules 25

4.. Neative Eects on Some Corporate Stakeholders 265. Conclusion 27

Appendix A: Estimates o Revenue gain Due to FA 29

Appendix b: Alternative Formulas 2

Reerences

Other Suested Readin 4

http://www.hamiltonproject.org/






JUNE 2007 5

The current system o taxing the income o

multinational enterprises (MNEs) in theUnited States is fawed across multiple di-

mensions. The system provides an articial tax

incentive to earn income in low-tax countries, re-

wards aggressive tax planning, and is not compat-

ible with any common metrics o eciency. The

U.S. system is also notoriously complex: observers

are nearly unanimous in lamenting the heavy com-

pliance burdens and the impracticality o coherent

enorcement. Furthermore, despite a corporate

tax rate one standard deviation above that o other

OECD countries, the U.S. corporate tax systemraises relatively little revenue, due in part to the

shiting o income outside the U.S. tax base.

In this proposal, we advocate moving to a system o

ormulary apportionment (FA) or taxing the cor-

porate income o MNEs. Under our proposal, the

U.S. tax base or MNEs would be calculated based

on a raction o their worldwide income. This rac-

tion would simply be the share o their worldwide

sales that occur in the United States. This system

is similar to the current method that U.S. states useto allocate national income across states.1 The state

system arose due to the widespread belie that it

was impractical to account separately or what in-

come is earned in each state when states are highly

integrated economically. Similarly, in an increas-ingly global world economy, it is dicult to assign

prots to individual countries; attempts to do so are

raught with opportunities or tax avoidance.

Under our proposed FA system, rms would no

longer have an articial tax incentive to shit in-

come to low-tax locations. This would help protect

the U.S. tax base while reducing the distortionary

eatures o the current tax system. In addition, the

complexity and administrative burden o the system

would be reduced. The proposed system would beboth better suited to an integrated world economy

and more compatible with the tax policy goals o

eciency, equity, and simplicity.

Section 2 will discuss the current U.S. system o

corporate taxation and its faws. Section 3 will

propose an FA system, discuss its advantages, and

clariy how the proposal addresses the faws o the

current system. Section 4 will address potential

hurdles and problems associated with FA, includ-

ing implementation issues. Section 5 will conclude,briefy contrasting this proposal with other reorm

suggestions.

1. We should note, however, that our proposal is signicantly dierent rom current state tax law, in ways discussed in §3.1.

1. irc






6 THE HAMILTON PROJECT|

THE bROOKINgS INSTITUTION

2.1. dcr Crr s

Under the current tax system, MNEs (both resi-

dent and nonresident) pay tax to the U.S. govern-

ment based on the income that they report earning

in the United States. As is typical, the United States

uses a separate accounting (SA) system, where rms

account or income and expenses in each country

separately. The current U.S. tax rate is 35 percent.

Figure 1 shows the evolution o corporate tax rates

or OECD countries over the past quarter century.

As is clear rom this diagram, the U.S. statutory cor-

porate tax rate has been increasing relative to otherOECD countries over the previous teen years,

and is now one standard deviation higher than the

average OECD tax rate.2

The U.S. government taxes U.S. MNEs on a resi-

dence basis, thus U.S. resident rms incur taxation

on income earned abroad as well as income earned

in the United States. This system is sometimes re-

erred to as a credit system: U.S. rms receive a tax

credit or taxes paid to oreign governments. The

tax credit is limited to the U.S. tax liability, althoughrms may generally use excess credits rom income

earned in high-tax countries to oset U.S. tax due

on income earned in low-tax countries, a process

known as cross-crediting . Taxation occurs only when

income is repatriated. Thus, income can grow ree

o U.S. tax prior to repatriation, a process known

as deferral .3 Deerral and cross-crediting provide

strong incentives to earn income in low-tax coun-

tries. There is also typically an incentive to avoid

income in high-tax countries due to the limited tax

credit.

As an example, consider a U.S.-based MNE that op-

erates a subsidiary in Ireland. Assume that the U.S.

corporate income tax rate is 35 percent, while the

Irish corporate income tax rate is 12.5 percent. TheIrish subsidiary earns €800 and decides to repatriate

€70 o the prots to the United States. Assume, or

ease o computation only, a one-to-one exchange

rate. First, the Irish aliate pays €100 to the Irish

government on prots o €800. It then repatriates

$70 to the United States, investing the remaining

prot (€630) in its Irish operations. The rm must

pay U.S. tax on the repatriated income, but it is eli-

gible or a tax credit o $100 (the taxes paid) times

70/700 (the ratio o dividends to ater-tax prots),

or $10. This assumes that the U.S. MNE does nothave excess oreign tax credits rom its operations in

high-tax countries; i it does, it can use these credits

to oset taxes due on the repatriated Irish prots.

Due to deerral, the remaining prots (€630) can

grow abroad tax-ree prior to repatriation.

This system creates a clear incentive to earn pro-

its in low-tax countries. Firms may respond by lo-

cating real activities (jobs, assets, production) in

low-tax countries. In addition, rms may respond

by shiting prots to low-tax locations, dispropor-tionate to the scale o business activities in such lo-

cations. There are multiple ways to shit income

among countries. For example, it may be advanta-

geous or MNEs to alter the debt-to-equity ratios

o aliated rms in high- and low-tax countries in

order to maximize interest deductions in high-tax

countries and taxable prots in low-tax countries.

Furthermore, MNEs have an incentive to distort

the prices on intrarm transactions in order to shit

income to low-tax locations. For example, rms can

ollow a strategy o under- (over-) pricing intrarmexports (imports) to (rom) low-tax countries, ol-

lowing the opposite strategy with respect to high-

tax countries.4

2. The trends or average eective tax rates are similar. Data are available rom the authors upon request.3. The Subpart F provisions o U.S. tax law prevent some rms rom taking ull advantage o deerral. Under Subpart F, certain oreign

income o controlled oreign corporations, including income rom passive investments, is subject to immediate taxation.4. There are numerous other margins along which income-shiting incentives infuence MNE behavior, including the location o intangible

2. th u.s. s Crr t





JUNE 2007 7

In theory, rms should be limited in their abil-

ity to engage in tax-motivated transer pricing by

ear o detection. Governments generally use an

arm’s length standard, requiring MNEs to price

intrarm transactions as i they were occurring at

arm’s length. Nonetheless, there is universal agree-

ment that this standard leaves substantial room or

tax incentives to aect pricing: arm’s length prices

are oten dicult to establish or many interme-

diate goods and services. Furthermore, as arguedin §3.2.3, the arm’s length standard has become

administratively unworkable in its complexity. As

a result, the arm’s length standard rarely provides

useul guidance regarding economic value.

Some countries (such as Japan and the United King-

dom) use a tax-credit system similar to that used by

the United States. Others (such as France and the

Netherlands) exempt most oreign income rom

taxation, which is reerred to as a territorial system

o international taxation. In theory, MNEs basedin these countries have an even greater incentive

to incur income in low-tax countries because such

income will not typically be taxed on repatriation.

Some authors argue that excess oreign tax credits

and deerral blur the distinction between these two

systems (e.g., Altshuler 2000).5

Shortly beore the 2004 election, the U.S. Congress

passed the American Jobs Creation Act (2004). The

international tax provisions o this law represent a

subtle shit toward a territorial system o taxing in-

ternational income in the United States. For exam-

ple, the legislation contained a provision to allowa temporary tax holiday or dividend repatriations

o 5.25 percent. This provided a substantial tax ad-

vantage to repatriate unds rom low-tax countries

in the year o the tax break.

On net, this holiday made investments in low-

tax countries more attractive relative to the prior

status quo, because there is now the promise o

methods or repatriating prots without incurring

large tax costs. In addition, other measures o the

legislation permanently lighten the taxation onoreign income, including provisions that acilitate

cross-crediting as well as changes in the interest

allocation rules. Recently, George Yin, the ormer

property, the payment o royalties, and the timing and planning o repatriation decisions.5. de Mooij and Ederveen (2003) nd evidence in support o this view. In addition, several countries have hybrid systems that lie somewhere

in between these two systems. For instance, oreign income may be exempt rom taxation in the home country provided that the oreigncountry’s tax system is suciently similar to that o the home country.

iguRe 1

sr Crr t R, oeCd Cr, 1979–2004

Source: PriceaterhouseCoopers (various years)

Notes: Statutory tax rate data are rom Priceaterhouse Coopers. Eective tax rate data are calculated as orein income taxes paid relative to net (pre-tax) income or

U.S. afliates operatin in a particular country. These data are rom bEA. They are discussed urther in Appendix A.

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

0%

10%

20%

30%

40%

50%

60%

Average Plus One St. Dev. Minus One St. Dev. United States








chie o sta o the Joint Committee on Taxa-

tion, concluded that the American Jobs Creation

Act (2004) takes the U.S. system o taxation closer

to a territorial system, and speculated that uture

tax policy could move arther in that direction

(Glenn 2004).

2.2. pr wh Crr s

The current system o corporate taxation has both

conceptual and practical weaknesses.

2.2.1. Crr s i n s

g ec

First, the system is not suited to the global nature o

international business. In particular, international

production processes make the SA system o as-signing prot to specic geographic destinations

inherently arbitrary. Furthermore, the very nature

o MNE operations generates additional prot

over what would occur with strictly arm’s length

transactions between unaliated entities. Theories

o MNEs emphasize that they arise in part due to

organizational and internalization advantages rela-

tive to purely domestic rms. Such advantages im-

ply that prot is generated in part by internalizing

transactions within the rm. Thus, with rms that

are truly integrated across borders, holding related

entities to an arm’s length standard or the pricing

o intracompany transactions does not make sense,nor does allocating income and expenses on a

country-by-country basis. In act, similar logic was

behind the use o FA or U.S. state governments.

With an integrated U.S. economy, it does not make

sense to attribute prots and expenses to individual

states, nor to regulate transer prices between enti-

ties o dierent states.

In addition, the current system is based on an arti-

cial distinction among legal entities. For instance,

companies are taxed dierently based on whetherthey use subsidiaries or branches. As one example,

deerral o taxation on unrepatriated prots is al-

lowed or the ormer but not or the latter. Recently,

there has been an increasingly common use o hy-

brid entities (treated as subsidiaries by one country

and branches by another) to achieve double non-

taxation.

iguRe 2

Whr Wr h prf 2003?

Source: .bEA.ov/international/di1usdop.htm

Notes: In 200, majority-oned afliates o U.S. MNEs earned $26 illion o net income. This fure shos percentaes o the orldide (non-U.S.) total net income

occurrin in each o the top-ten income countries. Thus, each percentae point translates into approximately $. illion o net income. Eective tax rates are calculated

as orein income taxes paid relative to net (pre-tax) income. The year 200 is the most recent year ith revised data availale. The bEA conducts annual surveys o

operations o U.S. parent companies and their orein afliates. These data are discussed in more detail in Appendix A.

Cr

ecv t

R (rc)

Netherlands 5.Ireland 6.1

bermuda 1.7

United Kindom 20.1

Luxemour –1.8

Canada 2.5

Sitzerland 4.5

germany 8.2

U.K. Islands 1.

Japan 6.9

0%

2%

4%

6%

8%

10%

12%

14%

N e t h e r l a

n d s

I r e l a

n d

B e r m

u d a

U n i t e

d

K i n g

d o m

L u x e

m b o

u r g

C a n a

d a

S w i t z

e r l a

n d

G e r m

a n y

U . K .

I s l a

n d s

J a p a

n

Profits as a percentage of the worldwide total





JUNE 2007 9

Another related problem is that the current sys-

tem is based on an increasingly articial distinc-

tion between MNEs whose parent is incorporated

in the United States and MNEs whose parent is

incorporated elsewhere. The ormer, but not the

latter, are subject to worldwide taxation with itsattendant complexities (which are primarily the

oreign tax credit and Subpart F). But in today’s

world, this distinction is less and less meaning-

ul or MNEs as the sources o capital, location

o R&D, location o production, and location o

distribution become increasingly globalized. The

current distinction has led to a spate o inversion

transactions, in which U.S.-based MNEs ormally

shit the location o incorporation o their parent

oshore without changing the location o any o

their business activities. Arguably, it has also en-couraged takeovers o U.S.-based MNEs by larger

oreign-based MNEs who can benet rom ter-

ritorial systems o taxation.

2.2.2. Crr s Cr arfc t

icv

Second, as explained in §2.1, the current U.S. sys-

tem o international taxation creates an articial tax

incentive to locate prots in low-tax countries, both

by locating real economic activities in such coun-tries and by shiting prots toward locations that are

taxed more lightly. It is apparent that U.S. MNEs

book disproportionate amounts o prot in low-tax

locations. For example, Figure 2 shows the top-ten

prot locations or U.S. MNEs in 2003, based on

the share o worldwide (non-U.S.) prots earned

in each location. While some o the countries have

a large U.S. presence in terms o economic activity

(Canada, Germany, Japan, and the United King-

dom), seven o the top-ten prot countries are loca-

tions with very low eective tax rates.

The literature has consistently ound that MNEs

are sensitive to corporate tax rate dierences across

countries in their nancial decisions.6 One recent

6. See de Mooij 2005 or an overview o this work.

iguRe 3

Whr Wr h J 2003?

Source: .bEA.ov/international/di1usdop.htm.

Notes: In 200, majority-oned afliates o U.S. MNEs employed 8.2 million employees. This fure shos percentaes o the orldide (non-U.S.) total employment

occurrin in each o the top-ten countries. Thus, each percentae point translates into approximately eihty-to thousand jos. Eective tax rates are calculated

as orein income taxes paid relative to net (pre-tax) income. The year 200 is the most recent year ith revised data availale. The bEA conducts annual surveys o

operations o U.S. parent companies and their orein afliates. These data are discussed in more detail in Appendix A.

Cr

ecv t

R (rc)

United Kindom 20.1Canada 2.5

Mexico 4.8

germany 8.2

France 25.1

brazil 65.4

China 1.0

Australia 28.0

Japan 6.9

Italy 5.1 C a n a d a

M e x i c o

G e r m a n y

F r a n c e B r a z i l

C h i n a

A u s t r a l i a J a p a n I t a l y

0%

2%

4%

6%

8%

10%

12%

14%

16%

Employment as a percentage of the worldwide total

U n i t e d

K i n g d o m








study suggests that corporate income tax revenues

in the United States in 2002 were approximately 35

percent lower due to income shiting.7

This problem has worsened because U.S. corpo-

rate tax rates have become increasingly out o line

with other countries. In the past twenty years, most

OECD countries have lowered their corporate in-

come tax rates, whereas U.S. rates have remainedrelatively constant. This increasing discrepancy

between U.S. and oreign rates likely results in in-

creasing amounts o lost revenue or the U.S. gov-

ernment due to the strengthening o income-shit-

ing incentives.

Also, the literature suggests a substantial real re-

sponsiveness to tax rate dierences among coun-

tries.8 These ndings imply less activity in the

United States and less tax revenue or the U.S.

government. However, the tax responsiveness o real activity is less immediately apparent in the data.

For example, Figure 3 shows the top-ten employ-

ment locations or U.S. MNEs in 2003, based on

the share o worldwide (non-U.S.) employment in

each location. The high employment countries are

the usual suspects—large economies with close eco-

nomic ties to the United States. As the accompany-

ing table indicates, tax rates are not particularly low

or these countries.

2.2.3. Crr s i t C

Third, the current system is absurdly complex. As Taylor (2005, slide 9) notes, observers have de-

scribed the system as “a cumbersome creation o

stupeying complexity” with “rules that lack coher-

ence and oten work at cross purposes.” Altshuler

(2005) noted that observers testiying beore the

President’s Advisory Panel on Federal Tax Reorm

(White House 2005) ound the system “deeply,

deeply fawed,” noting that “it is dicult to over-

state the crisis in the administration o the interna-

tional tax system o the United States” (p. 12).

2.2.4. Crr s R l Rv

Fourth, particularly given the high U.S. corporate

statutory tax rates, the U.S. corporate tax system

7. This estimate is rom Clausing (2007b). The calculation is based on a regression o U.S. MNE aliate prot rates on tax rate dierencesacross countries. See Appendix A or more details.

8. See de Mooij 2005 or a review.

iguRe 4

Cr gvr Crr t Rv Rv gdp, oeCd Cr

Source: gDP data rom world bank (various years); corporate tax revenue data rom OECD (various years).

C o r p o r a t e R e v e n u e s / G D P

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0% Average Plus One St. Dev. Minus One St. Dev. United States





JUNE 2007 11

raises relatively little revenue. Figure 4 shows the

evolution o government corporate tax revenues

relative to GDP or OECD countries. For most

OECD countries, revenues have increased as a

share o GDP even as corporate tax rates have de-

clined. The average OECD country receives 3 per-cent o GDP rom corporate tax revenue by the end

o the sample. Most observers attribute this trend

to a broadening o the tax base or many OECD

countries during this period. For the United States,

revenues are lower. Although they fuctuate with

the cyclical position o the economy, they tend to be

closer to 2 percent o GDP. There are several plau-

sible reasons or the lower amount o U.S. revenue,

including the increasingly aggressive use o corpo-

rate tax shelters, a narrower corporate tax base, andstronger incentives or tax avoidance, which tend to

increase because the U.S. tax rate is high relative to

other countries.9

9. Auerbach (2006) also notes that there is a declining ratio o nonnancial C corporation prots, although he notes that this is oset by anincreasing average tax rate due to the increasing importance o tax losses.








Our proposal would address most o the

aorementioned faws with the currentsystem o corporate taxation. Under FA,

tax liabilities would refect truly globally-integrated

business, and they would not be dependent on ar-

ticial distinctions among legal entities. Under FA,

unlike SA, rms would have no incentive to shit in-

come across countries because tax liabilities would

be based on total world income as well as on the

share o a rm’s sales that occur in each destina-

tion. Since there would be no tax savings associated

with shiting income across countries, the overall

incentive to locate real activities in low-tax coun-tries would also be reduced.

Furthermore, absent income shiting, U.S. gov-

ernment revenues would be higher. I the proposal

oered here were implemented in a revenue-neu-

tral ashion, it would enable a substantial cut in the

corporate income tax rate. Since the proposed sys-

tem could entail dramatic simplication and help

nance a corporate tax-rate reduction, there is jus-

tication or corporate support.

3.1. Hw W rrar Wrk?

Under FA, a unitary business is dened based on

whether the parent corporation exercises legal and

economic control over its subsidiaries. That uni-

tary business is treated as a single taxpayer and its

income is calculated by subtracting worldwide ex-

penses rom worldwide income, based on a global

accounting system, without regard to legal distinc-

tions among units. The resulting net income isapportioned among taxing jurisdictions based on

a ormula that takes into account various actors.

Each jurisdiction then applies its tax rate to the in-

come apportioned to it by the ormula and collects

the amount o tax resulting rom this calculation.

Our proposed system would use a sales-based or-

mula.10 In the experience o U.S. states, income has

been allocated to state jurisdictions using a variety

o ormulas. Historically, many U.S. states have

used the so-called Massachusetts ormula, which

uses equal weights on property, payroll, and sales.

For example, under an equal-weighted FA system,

tax liability to the U.S. government would be based

on the U.S. tax rate times the raction o worldwide

prots that are attributed to the United States. Thisraction would be based on how much o worldwide

economic activity (an average o sales, assets, and

payroll shares) occurs in the United States.

Observers have noted that an FA system creates an

implicit tax on the actors used in the ormula, thus

discouraging assets and employment in high-tax lo-

cations. This ormula also leaves unresolved issues

concerning the treatment o intangible property,

how to value property, and so on. In part due to

these concerns, we propose a ar simpler ormula, which would consider only the raction o sales in

each location. Sales would be determined on a des-

tination basis: that is, they would be based on the

location o the customer rather than the location o

production. We propose this destination-basis sales

ormula or several reasons. Alternative ormulas

are discussed in Appendix B.

The key advantage o a sales-based ormula is that

sales are ar less responsive to tax dierences across

markets, because the customers themselves are arless mobile than are rm assets or employment.

Even in a high-tax country, rms still have an in-

centive to sell as much as possible. In addition, i

10. A similar proposal has been advocated by Durst (2007), who oers legislative language or implementing a ormulary approach to corpo-rate taxation. He notes that technical barriers to adopting FA have been overstated; dening a unitary group and establishing the destina-tion o sales are both attainable objectives.

3. a pr a rr ar





JUNE 2007 1

some countries adopt sales-based ormulas, other

countries will have an incentive to adopt sales-based

ormulas as well, in order to avoid losing payroll or

assets to countries in which these actors are not

part o the ormula.

The U.S. state experience reinorces the merits o

this proposal. In recent years, many U.S. states have

shited to a ormula that double-weights the sales

actor, oten based on a desire to encourage exports

out o state and to discourage imports into the state.

State incentives to move toward a sales-based or-

mula are well documented. For example, Edmiston

(2002) generates a model with this prediction, and

Omer and Shelley (2004) empirically document this

trend. Goolsbee and Maydew (2000) demonstrate

that U.S. states that lower the weight on the pay-roll actor experience increases in manuacturing

employment. According to Weiner (2005), twenty-

three states double-weight sales as o 2004, and eight

others have an even larger weight on sales. Some

states even use a sales-only ormula (which was ap-

proved or Iowa by the U.S. Supreme Court).

In addition, international experience suggests that

movement toward a sales-based ormula is likely.

Because o the widespread belie that imposing taxes

on imports and exempting exports boosts nationalcompetitiveness and reduces trade decits, it is pos-

sible that i some countries were to adopt a sales-

based ormula or apportioning corporate income,

other countries would ollow suit. It would also be

in these countries’ economic interest to avoid the

implicit tax on assets and payroll that is embedded

in a three-actor ormula.11 This built-in incentive

or sales-based ormulas would minimize the like-

lihood o over- or undertaxation due to disparate

ormulas, which is an obstacle to adopting FA. Still,

it would be ideal to have international cooperationand consensus regarding both the adoption o FA

and the choice o ormula. We will discuss in §4.2.2

the problems that would arise i only the United

States were to adopt FA, or i dierent countries

were to use dierent ormulas.

3.2. r K av rrar

3.2.1. a W a h u.s. t s

wh g ec

The rst advantage associated with this proposal

is that it would align the U.S. corporate tax system

with the reality o a truly global world economy. In

a world where most major corporations are MNEs,

where 70 percent o U.S. international trade is done

by MNEs, and where many opportunities or tax

avoidance have an international dimension, the

current U.S. system o corporate taxation is obso-

lete. In particular, SA systems treat each aliate o an MNE as a distinct entity with its own costs and

incomes. Allocating income and expenses across

countries is both complex (an issue discussed in

§3.2.3) and conceptually unsatisactory, given that

worldwide income is generated by interactions

between aliates across countries. MNEs exist in

large part because these interactions generate more

income than would separate domestic rms inter-

acting at arm’s length. Requiring rms to allocate

this additional income among domestic tax bases

is necessarily articial and arbitrary, thereore, be-cause it would by denition disappear i the related

entities operated at arm’s length. Furthermore, such

allocation generates ample opportunity or MNEs

to reduce worldwide tax burdens by shiting income

to more lightly taxed jurisdictions, an issue to which

we will return in §3.2.2.

Under an FA system, tax liabilities are instead based

on an MNE’s global income, and the share that is

taxed by the national jurisdiction depends on the

raction o a rm’s economic activity that occursin a particular country. In the case o a sales-based

denition, the measure o economic activity is sales,

which ocuses on the demand side o market value.

11. In the past ty years, more than one hundred countries have adopted the value-added tax (VAT); each o these countries (including allother members o the OECD) has adopted the destination principle (i.e., imposing VAT on imports and rebating it on exports). Thespread o destination-based VATs around the world provides a good example o how tax innovations can spread without a coordinatingsupranational agency or world tax organization, simply on the basis o countries’ perception o their sel-interest.








One could argue that a three-actor ormula would

also take into account the supply side o economic

activity (with payroll and assets representing the

capital and labor inputs into the production pro-

cess), but we eel that the disadvantages o adopting

a three-actor ormula outweigh this conceptual advantage. Alternative ormulas are discussed in Ap-

pendix B.

Thus, while a truly precise denition and measure-

ment o economic value is probably unattainable,

FA provides a reasonable, administrable, and con-

ceptually satisying compromise that suits the na-

ture o the global economy. Furthermore, an FA

system does not create an articial legal distinction

among types o rms, whether the MNEs are or-

ganized as subsidiaries, branches, or hybrid entities,nor does an FA system rely on an articial distinc-

tion between MNEs whose parent is incorporated

in the United States and MNEs whose parent is

incorporated elsewhere.12

3.2.2. a e h t icv sh

ic lw-t Cr

The second advantage associated with the proposal

is that it eliminates the tax incentive to shit income

to low-tax countries. Because income-shiting in-

centives are an important part o the overall tax in-centive or locating operations in low-tax countries,

removing this incentive would result in ewer tax-

distorted decisions regarding the location o eco-

nomic activity. Under FA, rms are taxed based on

their global income. Thus, accounting or the in-

come earned in each country is no longer necessary,

and there is no way to lighten global tax burdens

by manipulating this accounting or tax purposes.

Since the share o global income that is allocated to

each country under FA depends on the share o an

MNE’s sales that are in each country, there wouldbe some tax incentive to distort the location o sales

among markets. However, this could be combated

by basing the sales denition on a destination prin-

ciple. In general, rms have an incentive to encour-

age sales in each market in order to serve the cus-

tomers there.

Under FA, there is no reason or the sort o prot

distortions that are so clearly visible in Figure 2, which shows prots in 2003.13 In addition, when

rms consider the tax advantages associated with

operating in low-tax countries, these advantages

would be based simply on the lower tax associated

with their sales in such countries, rather than any

additional advantages conerred because real opera-

tions in low-tax countries acilitate tax avoidance.

Thus, the adoption o FA should vastly reduce tax

distortions to MNE decisionmaking. Also, it is im-

portant to note that, despite the emphasis on the

sales o MNEs in dierent countries, this remainsa corporate income tax, not a consumption tax. For

example, tax liabilities do not arise unless an MNE

is earning prots worldwide, irrespective o their

sales.

Even though a unilateral move toward FA creates

large incentives or other countries to adopt FA, and

in particular sales-based ormulas, such changes in

the taxation o international income ultimately help

governments set their tax policies more indepen-

dently. The wishes o voters in each governmentinfuence the ideal size o government, required

revenue needs, and the allocation o the tax burden

among subgroups within society. Under FA, gov-

ernments would be able to choose their own cor-

porate tax rate based on their assessment o these

sorts o policy goals, rather than the pressures o

tax competition or an increasingly mobile capital

income tax base.

3.2.3. a icr sc

The third advantage associated with the proposal isthe massive increase in simplicity that it would en-

able or the international tax system. I FA were ad-

opted by our major trading partners, simplication

12. I a sales-based ormula is adopted, both U.S.- and oreign-based MNEs would be able to locate their headquarters (which requently produce positive externalities, such as those that fow rom R&D) in the United States without increasing the MNEs’ tax burden.

13. A very similar pattern is apparent in other years. The Bureau o Economic Analysis (BEA) data are discussed urther in Appendix A.





JUNE 2007 15

gains would be particularly large, but simplica-

tion would still exist even i FA were to be adopted

unilaterally. To determine U.S. tax liability, there

would be no need to allocate income or expenses

among countries, resulting in ar lighter compli-

ance burdens or rms. Subpart F and the oreigntax credit, which are both hugely complicated and

a major source o transaction costs or U.S.-based

MNEs, are no longer necessary, since there is no

deerral under this system (which is essentially ter-

ritorial and which treats U.S.- and oreign-based

MNEs alike).

Furthermore, the likely administrative savings rom

abandoning the current cumbersome transer-pric-

ing regime are huge. The current regime consumes

a disproportionate share o both public (i.e., IRS)and private sector resources. For example, several

recent Ernst and Young surveys o MNEs have con-

cluded that “transer pricing continues to be, and

will remain, the most important international tax is-

sue acing MNEs” (Ernst and Young 2005/2006, p.

5). Seventy percent o the surveys’ respondents eel

that transer-pricing documentation has become

more important in recent years, and 63 percent re-

port transer-pricing audit activity in the previous

three years (Ernst and Young). For the government,

audit costs are three to seven times higher or ed-eral transer-pricing cases than or state FA audits,

even in cases where the most ecient ederal cases

are compared to the least ecient state cases (Bucks

and Mazerov 1993).

Opinions in transer-pricing cases run to hundreds

o pages each, and litigation involves billions o dol-

lars in proposed deciencies, such as the recently

settled Glaxo case ($9 billion in proposed decien-

cy, settled or $3.4 billion) or the Aramco advantage

case (litigated and lost by the IRS, which asserteddeciencies o more than $9 billion). There is no

indication that the 1994 regulations under Internal

Revenue Code (IRC) §482 (implementing SA) have

abated this trend (Avi-Yonah 2006). There have

been ewer decided cases than under the pre-1994

regulations because both taxpayers and the IRS

have been devoting enormous resources to settling

these controversies in the appeals process, in litiga-

tion, or through advance pricing agreements, since

both sides have been wary o losing a major court

case.

The contemporaneous documentation rule ad-opted by Congress requires taxpayers to develop

documentation o their transer-pricing methods

at the time the transactions are undertaken rather

than when they are challenged on audit. This re-

quirement, as well as the complexity o the new SA

methods (such as the comparable prots method,

or CPM), have led the major accounting rms to

develop huge databases and expertise in preparing

transer-pricing documentation or clients. This

imposes large costs on major U.S. MNEs (Durst

and Culbertson 2003). Meanwhile, small and me-dium-sized enterprises, which cannot aord the

major accounting rms, are let to end or them-

selves and are requently targeted or audits in

which the IRS can use more sophisticated meth-

ods than the taxpayer’s methods: only the IRS and

the large accounting rms have the necessary data

to apply CPM. Thus, while the IRS continues to

lose transer-price cases against major MNEs (e.g.,

Xilinx) under the 1994 regulations or has to settle

or less than hal the proposed deciency in Glaxo,

it is able to win cases against small and mediumrms on the basis o superior resources, rather than

on the basis o a greater substantive justication o

its position.

By contrast, FA is relatively simple since all that it

requires is determining which businesses are uni-

tary (discussed in §4.2.1), and establishing the des-

tination o arm’s length sales o goods or services.

Once these two elements are established, the re-

sulting ormula permits both the taxpayers and the

IRS to determine the correct tax liability or each jurisdiction that uses FA. This means that there is

no longer a need to allocate or apportion expenses

(a source o major complexity in the current rules,

as the 861 regulations indicate), because all a busi-

ness needs is to calculate its worldwide net income

(worldwide gross income minus worldwide expens-

es). This net income is then allocated to various ju-








risdictions based on a single ormula, the tax rate o

each jurisdiction is applied to the allocated income,

and the tax is paid.

For small and medium-sized enterprises in par-

ticular, FA results in major cost savings as well asthe likelihood o paying less tax (since such busi-

nesses are rarely in a position to take on the IRS

under SA). For major MNEs, FA also oers the

prospect o avoiding the costs o contemporaneous

documentation. While some rms may pay more

tax than under SA, many would welcome the op-

portunity o paying a single, low rate to each juris-

diction in which they do business (especially i the

adoption o FA is coupled with a reduction in the

corporate rate), instead o having to cope with the

complexities and costs o SA. O course, some rms would also be hurt by the change in tax environ-

ment. These issues are discussed in §4.3.

3.2.4. a W R Rv r e

R Rc

The ourth advantage associated with the adoption

o FA or the United States is that the new sys-

tem would either raise more revenue or enable a

substantial rate reduction. Estimating exactly how

much revenue such a change would raise is a di-

cult and imprecise task, and the details o the imple-menting legislation and regulations would likely be

infuential in determining the ultimate eects o the

proposed change. Still, previous studies and back-

o-the-envelope calculations suggest that such a

change is likely to generate substantial additional

U.S. government revenue.

Appendix A reviews several such calculations in

more detail. For example, one recent study nds

that tax avoidance activities reduced income earned

in the United States by U.S. MNEs by more than$150 billion in 2002, lowering corporate tax rev-

enues by about 35 percent. Since FA would elimi-

nate tax avoidance incentives, one would expect it

to raise revenues by a similar margin. I corporate

tax revenues were to increase by 35 percent, that

would correspond to an increase o approximately

$50 billion (annually) over the period 2001–04.

The most thorough estimate o the revenue eects

o FA to date is Shackleord and Slemrod (1998):

they use accounting data in nancial reports or or-

ty-six U.S.-based MNEs over the period 1989–93

to estimate changes in revenue under a three-ac-

tor FA system. They estimate that U.S. govern-ment revenues would increase by 38 percent. This

increase is not dependent on any particular actor,

and they calculate that a single-actor sales ormula

would increase revenues by 26 percent. Given the

changes in the international tax environment since

the time period o their data, and in particular the

increasing discrepancy between the U.S. corporate

tax rate and those o other major countries, these

estimates likely understate the current U.S. revenue

gain with FA adoption.

Table 1 shows illustrative statistics on the opera-

tions o U.S. multinational aliates in 2003 or all

countries where the Bureau o Economic Analysis

(BEA) reports data and where aliate operations

are at least 0.5 percent o worldwide totals in ei-

ther sales or income. Column (1) shows the share o

worldwide oreign aliate sales that occur in each

country, Column (2) shows the share o worldwide

aliate net income earned in each country, Col-

umn (3) shows the eective tax rate, and Column

(4) shows the percentage by which the income shareexceeds or alls short o the sales share. Countries

are shown in descending order o values or Column

(4). It is immediately apparent that those countries

with income shares that vastly exceed their sales

shares tend to be very low-tax countries, and those

with sales shares that exceed their income shares are

typically high-tax countries. Thus, it appears quite

likely that a sales-based FA system would increase

revenues in comparatively high-tax countries, de-

creasing them in low-tax countries.

As one plausible conjecture, i revenues increase by

35 percent with FA, one can also calculate the tax-

rate reduction that would be possible with a reve-

nue-neutral implementation o FA. In that case, the

implied new corporate tax rate would be 26 percent,

nine percentage points lower than the current cor-

porate tax rate o 35 percent. O course, one could






also pursue an intermediate policy that allowed a

smaller rate reduction and also increased revenues

more modestly. Appendix A provides more back-

ground on these calculations.

Thereore, adoption o FA can help address theour faws in the current system o U.S. taxation

that were discussed in §2 o the paper. There are

also potential gains due to coordination with other

taxes and among other countries. Consider rst co-

ordination with value-added taxes (VATs). Existing

VATs around the world depend on dening the des-

tination o sales o goods and services. Determining

destination or goods is relatively easy because o

customs enorcement. In act, many jurisdictions use

harmonized rules or customs, VAT, and income tax

collection. Determining destination or services isharder, but countries have developed signicant ex-

pertise in it under VAT. I the United States adopts

sales-based FA, it can learn rom this experience

even without adopting its own VAT. I the United

States subsequently adopts a VAT, the existing rules

or determining sales destination under FA can be

coordinated with the VAT rules. In addition, exist-

ing U.S. regulations already dene destination and

origin o goods or purposes o trade regimes and

tax-based export subsidies; the regulations also de-

ne destination and origin under the base company

rules o Subpart F. Any FA regime can build on this

expertise as well.

This proposal also introduces the possibility o gains

rom coordination with other countries. The Euro-

pean Union (EU) Commission is actively workingon dening a common tax base and apportioning it

among member states by ormula.14 We can learn

rom this eort (which itsel learned rom the U.S.

state and Canadian province experiences) (Weiner

2005). Also, i the United States and the EU both

adopt FA, there is obvious potential or coordinat-

ing their eorts through the OECD. It may be

possible, given current discussions o FA within the

EU, to reach agreement with the EU (and possibly

with other OECD members) on the adoption o FA

beore it is actually implemented.

Still, while an international agreement would

be ideal, we do not believe that reaching such an

agreement should be a necessary prerequisite to the

United States adopting FA unilaterally. Many sig-

nicant advances in international taxation—such as

the oreign tax credit and CFC regimes, as well as

more problematic developments such as the current

transer-pricing methods—resulted rom unilateral

action by the United States, which was ollowed by

most other jurisdictions and by the OECD.

14. Gnaedinger and Nadal (2007) report that EU Tax Commissioner Kovacs is optimistic that the common consolidated corporate tax base would move orward, despite the opposition o a minority o EU member governments. I a member country vetoes the drat legislation,the EU may turn to the enhanced cooperation procedure through which action can still proceed. According to these authors, Kovacsdescribed a timeline through which the common tax base could be in place as soon as 2010.





JUNE 2007 19

This section o the paper will consider poten-

tial drawbacks associated with this proposal. The concerns t into three broad catego-

ries. First, some critics argue that FA is inher-

ently arbitrary. Second, there are implementation

issues associated with the denition o a unitary

business and the determination o the location

o sales. There are also problems associated with

interactions between countries with incongruent

corporate tax systems. There is a potential or

non-taxation or double taxation, accounting stan-

dards across countries are not uniorm, tax treaties

may need modication, revenues may systemati-cally shit away rom some countries, and there

may be issues o compatibility with WTO obliga-

tions. Third and nally, the proposed FA system

is likely to negatively aect some stakeholders,

because some domestic industries and rms would

nd that their tax obligations increase under the

new system.

4.1. i a arrr?

Some would consider basing the corporate incometax liability solely on the extent o sales in a particu-

lar country to be arbitrary. Indeed, this approach

ocuses on the demand side o the value created by

the corporation. For example, the market jurisdic-

tion would levy the entire corporate income tax in

the case o an MNE that produces in one country

and sells in another. Still, it is not clear that the cur-

rent SA regime is less arbitrary, given the incentive

to shit prots to low-tax jurisdictions.

Under the current regime, it is quite possible that

an MNE will not pay taxes either in the loca-tion o production (because o tax competition and

production tax havens) or in the location o distri-

bution (because it can avoid having a permanent

establishment or minimize the prots attributable

to the distribution unction), while any taxes due

to its residence jurisdiction are subject to deer-

ral or exemption. Such a result is more arbitrary

than consistently assigning prots to the market

jurisdiction, especially i most countries adopt the

same ormula.15

It is true that any ormula can produce arbitrary

results in a given industry. For example, the oil

industry has long argued that it is unair or it to

be taxed based on payroll, assets, or sales because

most o its prots result rom the oil reserves

themselves, which are not refected in the ormula

(since they are typically not assets o the company

or any length o time). However, while some in-

dustries would lose under the proposed ormula,

others (such as major U.S. exporters) would win,

and most taxpayers would gain rom the increasedsimplicity and transparency o the FA regime. I

companies are willing to pay one level o tax and

are concerned only about double taxation, they

should be willing to accept the FA option, which

prevents double taxation but also prevents double

non-taxation.16

4. dw a

15. In act, it is likely that a high proportion o current corporate tax collections come rom taxing distribution activities that rise over thepermanent establishment threshold (or are conducted in a separate subsidiary), given the ubiquity o targeted tax incentives or productionactivities. This explains why there is so much current pressure on the denition o permanent establishment (Le Gall 2006). Thus, otherthan reducing distortions, our proposal is a less radical shit rom current reality than it appears to be rom a theoretical perspective.

16. It can also be argued that ignoring intangible property, which is the source o most o the value added by MNEs, is arbitrary under bothour ormula and the state ormulas (i.e., those state ormulas that do not include intangibles in the property actor). But intangibles do nothave a real location, and their value inheres in the whole MNE, which is why they cannot be adequately addressed under SA. Any ormulathat ignores intangibles assigns their value to the entire MNE (divided based on the other actors used in the ormula), and we believe thisresult more accurately refects the nature o intangibles.








4.2. i i

4.2.1. df ur b h

d s

First, a dicult implementation issue in adopt-

ing FA is how to dene a unitary business. Cur-rent IRC §482 (implementing SA) merely requires

direct or indirect control among related parties,

without even a precise denition o what control

requires such as is ound in other IRC provisions.

However, or purposes o FA, mere control is not

enough: in the absence o unitary business activities

(i.e., an integrated MNE), FA can lead to signicant

distortions in the way a business operates (lumping

together disparate sales rom dierent businesses).

In addition, relying solely on control would violate

tax treaties that require something more or a sub-sidiary to be an agent o the parent.

We would suggest a test o unitary business that

depends on whether the subsidiary operates under

the legal and economic control o the parent.17

Such a test would look at actors such as where

overall business strategy is set, the extent to which

risk o loss is shared, and the extent to which there

are transers o goods and services among the con-

stituent units o an MNE. In most modern MNEs,

the level o integration is sucient to nd a unitary business, as the experience o the states in admin-

istering this test has shown. About 40 percent o

all U.S. international trade takes place between a-

liates o MNEs, suggesting the extent to which

they are integrated. Moreover, the underlying

transer-pricing problem depends on transactions

among constituent parts o an MNE, so relying

on such transactions as the basis or nding that a

unitary business exists is appropriate to address the

problem.18 Imposing a rebuttable presumption o

control whenever there is a combination o legal

control (i.e., ownership o more than 50 percent

o the stock by vote or value, with the usual attri-

bution rules) plus some de minimis level o inter- MNE transactions should go a long way to prevent

tax-motivated attempts to break control.

While it is possible that taxpayers may try to avoid

taxation by using independent distributing agents

or their sales, it is unlikely that they would be will-

ing to relinquish real control over their marketing

and distribution activities, since that is why they are

organized in MNE orm in the rst place.19 In addi-

tion, we would adopt a look-through rule that would

regard any sales made by an MNE to an unrelateddistributor as sales made into the United States

i the distributor sells the goods into the United

States and does not substantially transorm them

beore they are resold.20 This would prevent MNEs

rom avoiding tax by selling their goods into the

United States via unrelated strawmen who would

themselves have minimal prots.21

Second, implementing a sales-based ormula de-

pends on the ability o tax administration to deter-

mine the destination o sales o goods and services. This issue also arises under VATs and state income

and sales taxes. In general, or a country such as

the United States that maintains customs controls,

establishing the destination o goods is not a signi-

cant problem and is already the basis o several IRC

provisions.22 The destination o services poses more

dicult issues, but these problems also arise under

a VAT and have, in general, been treated success-

17. This denition tracks the requirement or nding that a subsidiary is a dependent agent o the parent under tax treaties, discussed in

§4.2.4.18. I an MNE has several lines o business that are truly not related to each other (e.g., GE’s nancial and nonnancial businesses), FA should

be implemented or each line o business separately. While this raises some denitional issues as well as the possibility o having to apply SA-based transer pricing to any transactions between such lines o business, these problems should be ar narrower in scope than thoseraised by the current system.

19. Otherwise, they could begin operations in a oreign country by selling through independent distributors, which is usually less costly.20. The substantial transormation test can be based on current Treasury Regulation §1.954-3(a)(4).21. Since we ignore intra-MNE sales, the MNE cannot engage in round-tripping transactions in which it exports goods and then reimports

them into the United States.22. See, e.g., Treasury Regulation 1.954-3(a)(3) (the base company sales rule), as well as the various export-related rules (IRC §§941-943, 970-

971, 991-994), all o which rely on establishing the destination o goods sold.





JUNE 2007 21

ully. For business-to-business provision o services

(which covers the majority o services to unrelated

parties), a rule that the destination o services is the

jurisdiction in which the receiving business takes

a deduction or payment to the service provider

should establish the destination o the service.

4.2.2. irc w Cr wh

dr t s

It would be ideal or most major countries to co-

ordinate implementation o FA and to come to a

joint agreement on the denition o the ormula

or apportioning global income. Given that the

EU is already pursuing the possibility o FA within

Europe, a natural orum or reaching international

consensus on these issues would be the OECD.

With international cooperation, the possibility o double or non-taxation would be reduced and there

would be less room or MNEs to respond strategi-

cally to variations in country ormulas.

Moreover, one should note that unilateral adop-

tion by the United States o an FA system or tax-

ing international income would create a powerul

incentive or other countries that use SA to also

adopt FA. In a world with both FA countries and SA

countries, FA countries would immediately appear

as tax havens rom an SA country perspective. Forexample, an MNE operating in SA and FA coun-

tries would have an incentive to book all its income

in FA countries: the tax liability in such countries

does not depend on the income booked there, but

rather on the raction o a rm’s activities in that lo-

cation. Such responses would likely greatly reduce

the tax revenues o remaining SA countries. Thus,

SA countries would have a strong incentive to adopt

FA, particularly i large economies adopt FA.

Moreover, the experience o the U.S. states amend-ing their ormulas to emphasize the sales actor and

the experience o more than one hundred countries

adopting the destination-based VAT suggest that

there is a signicant likelihood that i the United

States were to adopt a sales-based ormula, other

countries would be inclined to ollow suit. The

United States led the way in adopting the oreign

tax credit (1918), Subpart F (1962), and the current

transer-pricing regulations (1968 and 1994), all o

which were ollowed by most o our major trading

partners and recognized by the OECD. It is quite

possible that i the United States were to adopt

sales-based FA, this, too, would be a widely copiedinnovation, with or without explicit coordination.

Still, i the United States adopts FA unilaterally and

other countries do not ollow suit (or i they ol-

low suit much later), or i countries adopt dierent

ormulas, there is the potential or double or non-

taxation. This is the largest obstacle to adoption o

FA. As argued above, there are built-in incentives

or countries to respond to other countries’ adop-

tion o FA by themselves adopting FA, and there are

also built-in incentives to move toward sales-basedormulas. These incentives might help promote in-

ternational cooperation in the initial negotiations

regarding adoption and ormula determination.

Still, absent oreign adoption, problems o double

or non-taxation may be particularly worrisome.

Furthermore, even i other countries eventually

adopt FA, there would likely be a transition period

while governments and MNEs adapt to the new tax

environment. During this transition period, there

may be problematic instances o double taxation,and the rms that experience increased tax liabili-

ties under FA may prove to be vocal critics o FA.

While situations o double taxation could arise, it is

not clear that FA would produce more double taxa-

tion or double non-taxation than the current SA re-

gime. As noted in §2.1, there is signicant evidence

that the SA regime results in undertaxation because

MNEs succeed in shiting prots rom high-tax to

low-tax jurisdictions. However, SA can also result

in double taxation to the extent that a high-tax ju-risdiction successully asserts that prots belong to

it and not to another high-tax jurisdiction.

For example, the IRS recently settled a major trans-

er-pricing case with the British rm Glaxo or $3.4

billion. This additional revenue resulted rom shit-

ing to the United States prots that Glaxo claimed








belonged in the United Kingdom. It is ar rom clear

that the U.K. tax authorities would accept the result

o this settlement: under the U.S.-U.K. tax treaty,

they are not required to do so.23 The dispute resolu-

tion mechanism in most o our tax treaties does not

provide or binding arbitration and thereore doesnot necessarily lead to a resolution. As Justice Bren-

nan observed in Container Corp. v. Franchise Tax

Board (1983) (approving Caliornia’s application o

worldwide FA to U.S.-based MNEs), it is not clear

which method (FA or SA) produces more over- or

undertaxation, even when some countries use FA

and some use SA, or when dierent countries use

dierent ormulas.

Fundamentally, the issue o double or undertaxa-

tion under SA and FA resolves to the incentivesacing taxpayers and governments, and whether

taxpayers or governments are better positioned to

respond to such incentives. Under SA, taxpayers

are able to achieve undertaxation by shiting pro-

its to low-tax locations, and governments have an

incentive to prevent that. Nevertheless, orty years

o experience have shown that governments are

slow to act, and that the SA rules are insucient

to deter taxpayers or to enable governments to

collect the corporate tax due. Under a combina-

tion o FA and SA, double taxation can result, butthere is an incentive or the taxpayers to prevent

that by shiting prots out o SA countries into FA

countries, which would in turn incentivize gov-

ernments to adopt FA. Finally, under FA, double

taxation can result i dierent countries have di-

erent ormulas, but taxpayers can prevent it by

shiting production actors out o countries that

have production actor–based ormulas. Since tax-

payers are more nimble than governments, i the

goal is to prevent over- or undertaxation it would

seem preerable to err on the side o temporary double taxation, which can be remedied by tax-

payer action, rather than to rely on governments

to prevent undertaxation.

4.2.3. df h t b

There are issues associated with the need or com-

mon accounting standards. Still, the unilateral

adoption o FA by the United States need not re-

quire the United States and other countries to have

a common tax base. However, as noted in §4.2.2,the ideal situation would be or most countries to

adopt FA using the same (sales-based) ormula. For

this purpose, a common denition o the tax base

is needed, as currently advocated by the EU Com-

mission.

Such a common denition o the tax base (as op-

posed to harmonized tax rates, which are unlikely as

well as undesirable) could be achieved: MNEs al-

ready use uniorm accounting or worldwide nan-

cial reporting purposes. Thus, it is possible to usenancial reporting as the starting point or calculat-

ing the global prot o the MNE, to be allocated to

jurisdictions based on the FA ormula. While there

are still dierences in accounting among countries,

those dierences are diminishing due to the spread

o international accounting standards, which have

been adopted in the EU and Japan. Alternatively, it

may be possible to let each MNE use its home coun-

try accounting methods or calculating the global

tax base (as suggested by the EU Commission or

inter-EU purposes). In that case, U.S. MNEs wouldbe able to use U.S. generally accepted accounting

principles or tax reporting in the EU and Japan,

rather than incurring the cost o producing two sets

o nancial reports under generally accepted ac-

counting principles and international accounting

standards. Many European MNEs support FA in the

EU precisely because o the cost savings involved.

Such changes would also have the advantage o more

closely aligning book income and tax income. This

could act as a damper on both the underreportingo income or tax purposes and the overstatement

o income or the purpose o signaling protability

to nancial markets.24

23. Article 9 o the treaty only states that a country must make a “correlative adjustment” when prots are shited by the other treaty partneri it agrees that the prot shit was justied, which the United Kingdom seems unlikely to accept.

24. This is discussed in Desai (2005), where he recommends reconsideration o the dual-reporting system. Desai (2003) reports an increasing





JUNE 2007 2

However, i coordination o the tax base with ac-

counting-based measures were unachievable or

undesirable, FA could also be implemented uni-

laterally by the U.S. government using its deni-

tion o taxable income and applying it to the entire

MNE. U.S.-based MNEs already have to calculatethe earnings and prots o CFCs or purposes o

Subpart F and the oreign tax credit, so the addi-

tional inormation required or unilateral adoption

would not be overly burdensome. For non-U.S.-

based MNEs, we could use nancial reporting to

shareholders (already required by the SEC or by

home country regulators) as the base or calculat-

ing worldwide income. While this would create a

disparity between U.S.-based and non-U.S.-based

MNEs, the result is similar to allowing MNEs to

use their home state base or tax purposes, as rec-ommended by the EU.

4.2.4. irc wh t tr

Some have argued that tax treaties will need modi-

cation with adoption o FA, but it is not clear that

existing U.S. tax treaties would have to be renegoti-

ated. Transer pricing is currently governed by Ar-

ticle 9 o the treaties (U.S. Treasury 2006), which

assumes the SA method because it addresses the

commercial or nancial relations between associat-

ed enterprises. I FA were adopted, Article 9 wouldbecome irrelevant in those situations to which FA

applies (i.e., where a unitary business is ound to

exist) because FA ignores the transactions between

related parties and treats them instead as part o a

single enterprise.

Instead, FA would be governed by Article 7 (U.S.

Treasury 2006), which governs the relationship be-

tween a parent company and a branch (permanent

establishment) or an agent. Under Article 5(7), “the

act that a company that is a resident o a Contract-ing State controls or is controlled by a company

that is a resident o the other Contracting State …

shall not constitute either company a permanent es-

tablishment o the other.” However, it is well estab-

lished that a dependent agent can be a permanent

establishment (Article 5(5)), and whether an agent

is dependent is based on whether the principal ex-

ercises legal and economic control over the agent.“An agent that is subject to detailed instructions

regarding the conduct o its operations or compre-

hensive control by the enterprise is not legally in-

dependent” (U.S. Treasury, Article 5(6)).

In the case o a modern, integrated MNE that oper-

ates as a unitary business, a strong argument can be

made that the parent o the MNE exercises both le-

gal and economic control over the operations o the

subsidiaries, especially where the subsidiaries bear

no real risk o loss and acquire goods and servicesexclusively or almost exclusively rom the parent or

other related corporations. In that case, the subsid-

iaries should be regarded as dependent agents o

the parent. Such a nding is made with increasing

requency.25

I the subsidiary is an agent o the parent, Article

7(2) (U.S. Treasury 2006) o the treaties requires

the attribution o the same prots to the subsid-

iary “that it might be expected to make i it were a

distinct and independent enterprise engaged in thesame or similar activities under the same or similar

conditions.” Arguably, the application o FA, even

when based on a sales-only ormula, satises this

arm’s length condition because, in the absence o

precise comparables (which almost never exist), it

is not possible to determine exactly what prots

would have been attributable to the subsidiary un-

der SA.

When the United States adopted CPM and prot

split in the 1994 transer-pricing regulations, somecountries objected that it was violating the treaties

because these methods did not rely on exact compa-

divergence between book income and tax income, with more than hal o the divergence not explained by conventional dierences be-tween the measures. For the United States in 1998, he estimates that this discrepancy amounts to about 34 percent o tax income (a bitmore than $150 billion). He attributes these trends to increased tax-sheltering activities.

25. See Le Gall’s (2006) discussion o recent cases rom Canada, Germany, and Italy, as well as rom developing countries, and o the Inver- world case in the United States.








rables to nd the arm’s length price. However, these

objections soon subsided, and even the OECD en-

dorsed similar methods in its transer-pricing guide-

lines. The United States always maintained that

both CPM and prot split satisy the arm’s length

standard despite the lack o precise comparables(and, in the case o prot split, using no comparables

at all to allocate any residual prots). Similarly, the

United States has maintained that the superroyalty

rule o IRC §482 (which requires royalties to be

commensurate with the income rom an intangible,

and thereore subject to periodic adjustment) is con-

sistent with the arm’s length standard, even though

no comparables can be ound to show that such ad-

justments are ever made by unrelated parties.

Thus, were the United States to adopt FA, it couldsimilarly argue that the resulting allocation o prots

to the subsidiary is consistent with the arm’s length

standard embodied in Articles 7 and 9 (U.S. Trea-

sury 2006). Despite the OECD’s traditional hostil-

ity to FA, there is no way to prove—in the absence

o comparables—that any prot allocation deviates

rom an arm’s length result. As articulated in 1993 by

senior ocials o the U.S. Treasury, the U.K. Inland

Revenue, the Fiscal Aairs Division o the OECD,

and the Japanese National Tax Administration,

the arm’s length principle and ormulary ap-

portionment should not be seen as polar ex-

tremes; rather, they should be viewed as part

o a continuum o methods ranging rom

CUP to predetermined ormulas. It is not

clear where the arm’s length principle ceases

and ormulary apportionment begins, and it

is counterproductive and unimportant to at-

tempt to apply labels to the methods (Arnold

and McDonnell 1993 (p. 1381).

Nevertheless, although the adoption o FA would

not require renegotiating any U.S. treaties, it would

be a good idea or the United States to explicitly

sanction the use o FA in uture treaty negotiations.

This can be done by inserting in uture U.S. treaties

the language o the OECD Model (OECD 2005

Article 7(4)):

Insoar as it has been customary in a Con-tracting State to determine the prots to be

attributed to a permanent establishment on

the basis o an apportionment o the total

prots o the enterprise to its various parts,

nothing in paragraph 2 shall preclude that

Contracting State rom determining the

prots to be taxed by such an apportionment

as may be customary; the method o appor-

tionment adopted shall, however, be such

that the result shall be in accordance with

the principles contained in this Article.

This language is ound in many existing tax treaties

based on the OECD and UN models, and it can be

used by the United States as a basis or applying FA

without resorting to a treaty override.

There is one situation where existing treaties would

prohibit application o FA based on sales: when a

corporation is able directly or indirectly (through

an agent) to sell goods or provide services to a mar-

ket without any kind o permanent establishment. This situation can arise in some cases o electronic

commerce.26 However, the same problem arises

also under SA, and countries in general have been

able to avoid signicant revenue losses by aggres-

sive interpretation o the permanent establishment

threshold, and because it is dicult as a business

matter in most situations to avoid having a perma-

nent establishment in the market jurisdiction. In

the long run, we would support renegotiating the

treaties to incorporate a modernized version o per-

manent establishment that depends not on physicalpresence, but rather on the volume o sales into a

market jurisdiction, as is commonly done or VAT

purposes.27

26. See, e.g., the recent state case involving MBNA, which applied an economic nexus theory in the absence o any physical nexus ( Tax Com-missioner of West Virginia v. MBNA America Bank, 2006).

27. Most VAT jurisdictions have de minimis rules or volume o sales.





JUNE 2007 25

4.2.5. dr i

Revenues may systematically shit away rom some

countries under FA. The current tax-haven coun-

tries would likely experience large reductions in

revenues. For example, Ireland and Luxembourg

are both low-tax countries where disproportion-ate amounts o corporate income are earned, and,

in 2002, Ireland received 3.8 percent o GDP

and Luxembourg received 6.2 percent o GDP in

corporate tax revenues; both are well above the

OECD average revenue share o 2.9 percent.

Also, some have argued that a sales-based ormula

would benet countries such as the United States,

which runs a large trade decit, at the expense o

countries with large trade surpluses. However, the

key determinant o which countries would gain orlose revenue is whether countries have dispropor-

tionately large or small amounts o local corporate

sales relative to corporate income. There is no

evidence in the data that this actor is related to

countries’ trade positions.

I one considers the operations o U.S. MNEs

and their oreign aliates as a guide, it is quickly

apparent that it is dicult to make regional gen-

eralizations about which countries would gain and

which would lose. For example, developing coun-tries do not have systematically lower (or higher)

levels o local aliate sales relative to aliate

income in comparison with richer countries. It

appears, or example, that the ratio o local sales

to corporate income or U.S. aliates in Arican

countries is similar to the world average. Asian and

Latin American countries actually have a higher

ratio o local sales to corporate income than the

world average, whereas European countries have

a slightly lower ratio o local sales to corporate

income. In all cases, however, regional averagesmask signicant dierences across countries. In

general, with the adoption o FA, high-tax coun-

tries would likely gain revenue at the expense o

low-tax countries because high-tax countries tend

to have higher shares o local corporate sales rela-

tive to corporate income.

This conclusion assumes widespread adoption o

FA. Absent that, the remaining SA countries would

also lose revenue: MNEs would have a strong in-

centive to book income in FA countries because

their tax liabilities in such countries would not be

aected by this accounting. Still, despite concernsabout systematic revenue losses in some countries,

we believe that our proposal would eventually help

many governments by eliminating incentives or

tax competition.

4.2.6. irc wh Wto R

Finally, some scholars have argued that the use o

a sales-only ormula by U.S. states violates WTO

rules against export subsidies because they consti-

tute an illegal border adjustment or direct taxes. In

general, the WTO rules permit border adjustability or indirect taxes, but not or direct taxes. Although

this line has been widely criticized as incoherent, it

is embedded in the current WTO agreements.

It is not clear that the adoption o a ederal sales-

only ormula or income taxes would be a WTO

violation. It can be argued that the ormula is not

explicitly contingent on export perormance, and

that it serves only as a means or allocating the in-

come tax base among jurisdictions, as opposed to

exempting transactions that would otherwise betaxable (as in a VAT). No WTO complaint has been

led against the United States on the state ormu-

las, even though state taxes are subject to WTO

constraints.

Also, i the adoption o FA by the United States oc-

curs alongside widespread adoptions at least among

OECD member countries, it would seem plausible

that the WTO rules (which are widely regarded as

obsolete) can be renegotiated. In general, progress

in the WTO is usually impeded i the United Statesand other OECD members disagree (e.g., on agri-

cultural subsidies), but not i they agree. As noted in

§3.2.4, the EU Commission has already endorsed

FA, and thus is unlikely to challenge it.

I a country does successully challenge the United

States over the adoption o sales-based FA and the








rules cannot be renegotiated, the ormula might

need to be changed to one based equally on assets

and sales, which is not open to WTO challenges.

However, this would come at a price o encouraging

more articial shiting o assets to low-tax jurisdic-

tions, so we do not advocate it at present.

4.3. nv ec sCrr skhr

Analysts have noted that adoption o FA would dis-

proportionately aect some industries and rms

negatively. For example, Shackelord and Slemrod

(1998) nd that FA raises tax liabilities or some in-

dustries and rms, lowering liabilities or others.

They estimate that the oil and gas industry would

see an increase in tax liabilities o 81 percent underFA, compared with 29 percent or all other rms in

their study.28 The authors also estimate that some

rms—including Boeing, Procter & Gamble, and

Dow Chemical—would experience a tax decrease.

Under our proposal, rms with a disproportion-

ate amount o U.S. sales relative to U.S. income

would see tax increases under FA, while those with

relatively low U.S. sales compared to U.S. income

(e.g., large exporters) would see tax decreases. In

addition, observers such as Durst (2007) note that

intangible-intensive rms would likely be adverse-

ly aected by adoption o FA, because these rmshave been particularly adept at lowering their tax

burdens through careul tax planning under the

current system.

Still, negative impacts could be muted by several

considerations. First, rms would benet rom re-

ductions in complexity and compliance burdens.

Small and medium-size businesses should be par-

ticularly appreciative o such benets. Second, i

FA is accompanied by a reduction in the corporate

income tax rate, which could prove quite substantiali FA is implemented in a revenue-neutral ashion,

the number o rms beneting rom the adoption

o FA would increase. A rate reduction would also

appeal to those concerned that the United States is

losing competitiveness because o the current rate

disparity.

28. In their study, the mean oil and gas company reports 68 percent o assets in the United States, 70 percent o sales in the United States, and78 percent o total compensation paid to U.S. employees, but such companies book 42 percent o pre-tax earnings in the United States.





JUNE 2007 27

Our proposal or the adoption o ormulary

apportionment (FA) or the U.S. taxationo corporate income responds to the real-

ity o an increasingly global world. MNEs have in-

ternationally integrated operations, and they are re-

sponsive to the incentives created by discrepancies

among national tax policies. A separate accounting

system generates an articial need to assign income

and expenses by location, and this creates ample op-

portunities or tax avoidance.

An FA system would remove the complexities as-

sociated with sourcing income and expenses acrosslocations, and it would eliminate the tax incentive

to shit income to more lightly taxed locations. Ab-

sent tax incentives to shit income away rom the

United States, U.S. corporate tax revenues would

likely increase signicantly. I this proposal were

implemented in a revenue-neutral ashion, on the

other hand, the corporate tax rate could be cut sub-

stantially. Even a revenue-neutral implementation

o FA would retain the simplicity and eciency

gains associated with the proposal.

The common objections to FA appear surmount-

able. We have argued that the FA system is less

arbitrary than the current system and that imple-

mentation issues can be overcome. While it would

be ideal to implement FA with international coop-

eration, there are also natural incentives within an

FA system that encourage international adoption

and ormula harmonization. Even absent interna-

tional cooperation, problems o double taxation

or double non-taxation need not be any larger

than under the current separate accounting (SA)system. Furthermore, it is likely that FA would be

compatible with current treaty and WTO obliga-

tions.

We also maintain that U.S. adoption o FA would

be preerable to the other suggested reorms. First,consider a simple base-broadening, rate-lowering

reorm. This would no doubt be an improvement

relative to the status quo because a lower rate would

reduce the tax incentive to earn income in oreign

countries and other distortionary eects o the cur-

rent tax system. In addition, base broadening would

level the playing eld among dierent corporate

activities, reducing the deadweight loss associated

with tax-induced modications in nancial or real

behavior.29 Yet, while such a reorm would be desir-

able relative to the status quo, it would all short o the gains rom FA in terms o compatibility with

the global economy, administrative simplicity, and

the eciency gains associated with eliminating in-

come-shiting incentives.

Second, consider the Simplied Income Tax Plan

suggested by the President’s Advisory Panel on

Federal Tax Reorm (White House 2005, Chapter

6). This plan would adopt a territorial system or

U.S. MNEs, exempting oreign income o U.S.

rms rom taxation. The report notes that this plan would create

more even treatment o cross-border in-

vestment by U.S. multinational corpora-

tions. Under the new system, territorial

taxation o active oreign business income

would be available to all U.S. multinational

corporations, not just those that are able

to “sel-help” themselves to this result or

its unctional equivalent. The new sys-

tem is designed to make U.S. businessesmore competitive in their oreign opera-

tions, while reducing the extent to which

tax planning allows some multinationals to

29. As just one example, the production income deduction in the recent American Jobs Creation Act (2004) creates an articial incentive toengage in production activity or to re-label income as production income. Eliminating such provisions would be benecial to the broaderintegrity o the tax system.

5. Cc








achieve more avorable results than others

(White House 2005, p. 105).

Unortunately, this proposal has a negative impact

on many o the problems discussed in §2.2. In par-

ticular, rms would have an even larger incentiveto shit income to low-tax locations. Furthermore,

while a territorial system could be designed to be

revenue neutral, the past experience o OECD

countries suggests that territorial systems raise less

corporate revenue (Clausing 2007a). In addition,

there would be limited simplication gains in com-

parison with FA, because MNEs would still be re-

sponsible or sourcing income and expenses across

locations, and the territorial nature o the tax system

would put even greater pressure on the transer-

pricing rules, as the report itsel notes.30 We wouldargue that adopting FA is the only way to achieve

territoriality or U.S.-based MNEs without risking

signicant revenue losses, worsening income-shit-

ing incentives, and increasing the complexity o the

U.S. international tax regime.

Third, compare adoption o FA to a proposal that

would simply end deerral o taxation on oreign

income or U.S. MNEs. One such proposal is dis-

cussed in Altshuler and Grubert (2006), as a bur-

den-neutral worldwide taxation plan. Under thisplan, all oreign income would continue to be

taxed as it is currently, there would be no required

allocation o expenses to oreign income, and the

U.S. corporate tax rate would be lowered to keep

the overall U.S. tax burden on oreign income the

same. This system would eectively end deerral

or U.S. resident corporations, and thus dramatical-

ly reduce income-shiting incentives. The authorsestimate that a burden-neutral implementation o

the proposal would entail a corporate tax-rate re-

duction on oreign income to 28 percent.31

Still, under their plan, income-shiting incentives

would not be completely eliminated: oreign-based

MNEs would be largely unaected. This consid-

eration could create a stronger tax incentive or

changing ownership patterns. For example, rms

could undertake inversions, basing their parent

company in a tax haven. In addition, income-shit-ing incentives still exist or U.S. MNEs that have

excess credits.32

While all o these proposals have merits, they also

illustrate the diculties associated with the taxa-

tion o MNEs in a globally integrated economy. It

is nearly impossible to eliminate the tax distortions

associated with the location o economic activity

and prots across national boundaries without a

dramatic rethinking o the nature o corporate in-

come taxation in the world economy. We hope thatthis proposal contributes to that deliberation.

30. The Advisory Panel on Federal Tax Reorm also suggested a growth and investment tax plan that would use domestic consumption as a taxbase. While this plan has intriguing elements, it also raises broader issues that cannot adequately be addressed in the scope o this paper.

31. Their estimates are based on tax return data rom the Treasury Department or U.S. MNEs. The estimates are static estimates that do notaccount or behavioral responses such as changes in income-shiting behavior or reduced incentives to lower oreign taxes.

32. The authors estimate that about 30 percent o oreign income would be earned by U.S. rms with excess credits under their plan. For rms with excess credits, there would still be tax planning opportunities associated with moving income rom high-tax to low-tax countries, and with shiting income out o the United States.





JUNE 2007 29

This appendix considers methods o estimat-

ing the revenue gain to the U.S. governmentdue to FA. All o these methods rely on mul-

tiple assumptions and simplications. The data are

imperect and incomplete. Furthermore, there are

multiple margins under which this change would

aect MNE behavior both in the United States and

abroad, and there is substantial uncertainty regard-

ing the net infuence o these responses on govern-

ment revenues. Finally, the actual legislation and

accompanying regulations implementing FA would

matter a great deal in terms o ultimate eects on

revenue.

Thereore, all o these estimates should be treated

with a great deal o caution, as a mere starting point

or thinking about this question. That said, all three

methods below paint a broadly consistent picture

o large U.S. government revenue gains with the

adoption o FA.

1. The simplest estimate o the revenue gain relies

on inerences rom the BEA data regarding the

operations o U.S. MNEs. According to 2003data rom the BEA, U.S. MNEs earn 56.7 per-

cent o their worldwide net income in the United

States. However, 69.6 percent o worldwide sales

or these rms occurs in the United States. I

the U.S. tax base were 69.6 percent o worldwide

income, it would increase by $149 billion. With

the increment taxed at the marginal tax rate o 35

percent, that would generate $52 billion in ad-

ditional revenue. Since revenues rom the corpo-rate income tax in 2003 were $131.8 billion, that

represents an increase o 40 percent. Table A1

shows the results o the same calculations with

available data or the three most recent years.

The year 2002, however, was likely an usual year,

because net income in the United States was ab-

normally low in comparison with other years.

I one assumes instead that the increments were

taxed at the average tax rate paid on corporate

prots, then this increase would be smaller. Yet, in other ways, this estimate represents an

underestimate o the revenue gain, since it in-

cludes only U.S. MNEs. Foreign-based MNEs

with aliates in the United States would also

ace changes in their tax treatment that would

increase revenues as long as the raction o their

worldwide sales in the United States exceeds

the raction o their worldwide income booked

in the United States. While this is not possible

to ascertain given the absence o BEA data on

oreign parent rms, prots do appear to bedisproportionately low or these rms relative

to their sales in the United States. For example,

in 2003, net income o U.S. parent MNEs was

6.5 percent o their U.S. sales, while net income

or U.S. aliates o oreign parent rms was 1.4

percent o their U.S. sales.

a a: e Rv g d a

table a1

e Rv g d a, 2002–04

2002 2003 2004

Fraction o orld sales in United States 71.6% 69.6% 68.2%

Fraction o orld income in United States 8.2% 56.7% 56.0%

Implied ne tax revenue $79 illion $52 illion $5 illion

Implied ne tax revenue as share o same year’s

ederal corporate tax receipts 54% 40% 28%

Source: bEA (various years)








A nal issue concerning these calculations is the

possibility o double counting in the BEA net

income gures. These gures include income

rom equity investments, some o which may be

counted more than once i there are tiers o hold-

ings within the same country. Unortunately, itis impossible to tell rom existing BEA data ex-

actly how large this problem is, or how much

this problem is correlated with the tax rate o

the country in question.a Using an alternative

data series rom the BEA on direct investment

earnings, one can exclude all income rom eq-

uity investments. Although this too is concep-

tually inappropriate, we nonetheless perormed

calculations that used this series. To make the

data comparable to net income, we adjusted or

the act that direct investment earnings were prorated to refect the ownership stake o the U.S.

parent, assuming an average ownership stake o

68.6 percent or all rms, which was the aver-

age ownership stake in 2003. One nds a similar

raction o worldwide income abroad—roughly

57 percent in both 2003 and 2004. Estimates

o revenue gain rom FA are about 35 percent

smaller, due to some combination o a narrower

denition o income as well as the elimination o

any double counting.

2. Clausing (2007b) estimates revenue lost to the

United States due to income shiting by U.S.

MNEs. These are based on regressions that

consider how prot rates (prot-to-sales ratios)

depend on aliate country tax rates. For the de-

cade 1995 to 2004, the regression results indicate

that a tax rate 1 percentage point higher (relative

to the United States) is associated with an ali-

ate prot rate 0.5 to 0.8 percentage points lower.

Together with inormation regarding prots and

sales or each country and year, this result is usedto calculate how prots would be dierent ab-

sent tax infuences, and thus how revenue would

be dierent in the United States absent income

shiting.

Results vary by year, by whether one uses a stat-

utory or an eective tax rate in the regression

analysis, and by the assumption regarding the

U.S. tax rate that would apply to higher levels

o income in the United States. One representa-

tive calculation nds that in 2002 U.S. corporateprots would be $170 billion higher absent in-

come shiting. This additional prot generates

$54 billion in tax revenue, assuming additional

prots are taxed at an eective tax rate o 32

percent. Since corporate tax revenues in 2002

were $148 billion, this represents a 37 percent

increase in tax revenue.

Some estimates are lower or higher than this

number. For the years 2001 to 2004, the aver-

age estimate indicates an increase in revenue o 38 percent, assuming new U.S. prots are taxed

at an eective rate o 32 percent. Estimates are

lower using a statutory tax rate in the regressions

(compared to an eective tax rate), and estimates

are lower in 2001 or 2002 (compared to 2003 or

2004).

While these calculations are intuitively plau-

sible, several assumptions are embedded that

could cause the results to be underestimates or

overestimates. For example, it is assumed thatall prot shiting occurs between the United

States and aliate countries, rather than among

aliate countries. This consideration would

make this estimate o revenue gain too high.

Still, estimates consider the activities o only

U.S. MNEs. This consideration would make

this estimate too low because oreign-based

MNEs likely engage in income shiting away

rom their U.S. aliates.

3. Other studies have generated estimates o a simi-lar magnitude. The most thorough estimate is

Shackleord and Slemrod (1998): they use ac-

counting data in nancial reports or orty-six

large U.S.-based MNEs over the period 1989 to

a. Using German data, Weichenrieder (2006) nds no relationship between the tax rates o host countries and more complicated ownershipchains. However, other tax actors are important, including whether the investing country has a credit or exemption tax system.





JUNE 2007 1

1993 to estimate changes in revenue under an FA

system. Their estimates are based on rm nan-

cial statements and the related income tax oot-

notes. Three certied public accountants inter-

preted each detailed disclosure. Both domestic

and oreign taxable income were estimated as thesum o the current relevant tax provisions and

credits divided by the relevant statutory tax rate.

Worldwide income is then the sum o domestic

and oreign income. The U.S. tax liability under

FA is then calculated as the product o worldwide

taxable income, the ormula or the raction o

income allocated to the United States, and the

U.S. tax rate.

O verall, Shackleord and Slemrod (1998) esti-

mate that revenues would increase by 38 percentunder a three-actor FA system. This increase

is not dependent on any particular actor, and

they calculate that a single-actor sales ormula

would increase revenues by 26 percent. Given

the changes in the international tax environment

since the time period o their data, and in par-

ticular the increasing discrepancy between U.S.

corporate tax rates and those o other major

countries, these estimates likely understate the

current U.S. revenue gain with FA adoption.

Any o the rst three estimates can also be used

to generate an estimate o what corporate tax rate

would be associated with a revenue-neutral imple-mentation o FA. Taking as one baseline that tax

revenues would increase by 35 percent with FA, this

implies that the corporate tax rate could be lowered

by 9 percentage points, to 26 percent. O course,

one could also pursue an intermediate policy that

lowered the corporate tax rate less but that also

modestly increased tax revenue.

Note that the estimates discussed above are based

on book income gures, not tax income gures.

Numbers (1) and (2) use data rom the BEA surveys on MNEs. Number (3) uses data rom rm

nancial statements. It would be preerable to use

data on tax income, which is also presumably more

responsive to tax incentives. However, this is not

possible absent access to Treasury data. Also note

that these methods do not address methods that

rms use to lower their taxable income overall. In-

stead, the ocus is on the sourcing o income.








Section 3 o the paper explains the merits o

using a sales-based ormula rather than thetraditional Massachusetts ormula, which is

an equal-weighted average o sales, payroll, and as-

set shares. A sales-based ormula has several advan-

tages. First, rms have little ability to undertake tax

avoidance strategies with a destination-based sales

ormula, since rms have no control over where cus-

tomers are located.b Second, this avoids an implicit

tax on payroll and assets, which can distort MNEs’

investment and employment decisions. Third, U.S.

states have demonstrated a tendency to increase the

sales weight over time, so adopting a sales-basedormula at the outset may encourage countries to

adopt ormulas that are more uniorm.

Still, multiple actor ormulas have some advan-

tages. First, while the incidence o the corporate

tax is a complex matter beyond the scope o this

paper, one advantage o the equal-weighted or-

mula is that the incidence o the tax may be more

ideal. For example, some argue that the asset por-

tion o the ormula is particularly compatible with

the desire to have the corporate tax be borne by capital. Second, some argue that a three-actor

ormula more adequately captures the supply side

o the process that generates prot. Still, as was

recognized as ar back as Marshall (1890/1997),

value has its roots in both supply and demand

actors, and trying to separate them is as utile as

trying to determine which blade o scissors does

the cutting. Third, to the extent that rms are able

to manipulate the destination o their sales (which

we deem unlikely; see §4.2.1), a multiple-actor

ormula would make that type o avoidance more

dicult. Finally, to the extent that some countries

view a sales-based ormula as not suited to theirinterests, a ormula with several actors could be

viewed as a useul compromise.

In addition to a sales-based ormula and an equal-

weighted ormula, some have suggested a ormula

with a double weight on sales. For example, Eich-

ner and Runkel (2006) argue that such a ormula

would reduce the harmul eects o tax competition

because the scal externalities o corporate income

taxation would be minimized.

Sorensen (2004) and Agundez-Garcia (2006) have

discussed the possibility o using industry or macro-

based weights in these ormulas. Thus, a rm’s tax

liability in a particular country would not depend

on its own share o worldwide activity in the coun-

try, but rather on the industry-wide average o these

shares. I a rm is small relative to the industry, then

its own decisions have little eect on where its tax

liability is assigned, and rms have no incentive to

distort their behavior. However, this method has

the downside o separating a rm’s activities romthe jurisdictions in which it incurs taxation, which

would likely prove too arbitrary. In the extreme, i

macroweights were used, a rm’s tax liability in a

given country would depend on, e.g., the size o

that country in the world economy. So i the United

States were 25 percent o the world economy, any

rm with nexus in the United States would have a

U.S. tax base equal to 25 percent o its worldwide

prots, even i the particular rm did 1% (or 99%)

o its activity in the United States. This would strike

many as unduly arbitrary.

a b: arv r

b. O course, this assumes that the denition o a unitary business is sucient to prevent manipulation o the destination o sales. This issueis discussed in §4.2.1.





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JUNE 2007 5

ahr

REUVEN S. AVI-YONAH

Irwin I. Cohn Professor of Law, University of Michigan Law School Reuven S. Avi-Yonah, the Irwin I. Cohn Proessor o Law and director o the International Tax LL.M.

Program, specializes in international taxation and international law, and is widely published in these

subject areas. He also served as consultant to the U.S. Treasury on tax competition and OECD on tax

competition, and is a member o the Steering Group o the OECD’s International Network or Tax

Research and chair o the American Bar Association’s Tax Section Committee on Consumption Taxes.

Proessor Avi-Yonah earned his B.A., summa cum laude, rom Hebrew University and then earned three

degrees rom Harvard: an A.M. in history, a Ph.D. in history, and a J.D., magna cum laude, rom Har-

vard Law School. Avi-Yonah has been a visiting proessor o law at the University o Michigan, New

York University, and the University o Pennsylvania. He has also served as an assistant proessor o law

at Harvard and as an assistant proessor o history at Boston College. In addition, he has practiced law

with Milbank, Tweed, Hadley & McCloy, New York; Wachtell, Lipton, Rosen & Katz, New York; andRopes & Gray, Boston. His teaching interests ocus on various aspects o taxation and international law.

KI MBERLY A. CLAUSING

Professor of Economics, Reed College

Kimberly Clausing is a Proessor o Economics at Reed College. Her current research studies the taxa-

tion o multinational rms, exploring how international tax incentives aect international trade, govern-

ment revenues, and the location o economic activity. This research has been supported by a National

Science Foundation grant. Recently, she has worked on related policy research with the Brookings

Institution and the Tax Policy Center. During 2006-7, she was an Associate Proessor o Economics at

Wellesley College. During 1999-2000, Pro. Clausing was a Fulbright Research Scholar in Brussels,

Belgium. During 1994-5, she worked at the Council o Economic Advisers as a sta economist special-izing in international economic policy. She received her B.A. rom Carleton College in 1991 and her

Ph.D. rom Harvard University in1996.

ackw

The authors acknowledge valuable eedback rom Rosanne Altshuler, Mihir Desai, Jon Talisman, Michael

Durst, Michael Knoll, Reed Shuldiner, Chris Sanchirico, Joann Weiner, Diane Ring, Yariv Brauner,

Joseph Guttentag, Philip West, and The Hamilton Project sta, especially Peter Orszag, Jason Bordo,

and Michael Deich.






1775 Massachusetts Ave., NW, Washington, DC 20036

(202) 797-6279 n www.hamiltonproject.orgHAMILTONTHE

PROJECT

reforming ct in a global economy

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