Monthly Archives: June 2010

Slicing the Global Tax Pie

Jun 28, 2010 Craig M. Boise

Tax scholarship produced abroad frequently offers a unique perspective on the same knotty domestic and foreign tax issues with which we wrestle here in the United States.  A case in point is the recent article from Maarten de Wilde of Utrecht University, the Netherlands, which combines original thinking with elements of Dutch tax law in proposing a solution to perhaps the most perplexing problem in taxation today; namely, how to allocate the right to tax income between and among competing, sovereign jurisdictions, each of which asserts legitimate residence–or source–based claims to tax the global income of multinational enterprises (MNEs).

The current formula for global tax allocation attempts to assign a source to business income that reflects the physical location in which the income was produced. As de Wilde observes, however, the formula was developed in the 1920s, when there were far fewer MNEs, Europe was decades away from being economically integrated, and technological advances had not produced “e-commerce” and the bewildering array of intangible assets and financial products that are an integral part of the global economy and that have become increasingly difficult to source.  Complicating the essential sourcing problem are state tax systems that are not only internally inconsistent in their treatment of income from domestic and foreign transactions, but also differ among one another in their choice of rates, taxable units, tax bases, treatment of deductions, definitions of particular entities, and a host of other matters.  As a result, much business income is either subjected to double taxation, or to the extent MNEs are able to successfully arbitrage the differences among tax systems, no income taxation at all.

De Wilde argues that fixing this broken international tax system requires adherence to both “internal equity” and “internal neutrality.”  The first is satisfied when no more than one tax is imposed on income by a single state (the single tax principle) in exchange for that state’s provision of public goods.  The tax burden imposed by a state should attach at the point that the corporate taxpayer’s economic presence in the state exceeds a specified minimum threshold.

Internal neutrality requires that the tax burden that a state imposes on business income not vary based on whether the corporate taxpayer earns all of its income within the source country or not.  De Wilde argues that neither of the two most familiar concepts of economic neutrality, capital export neutrality (CEN) and capital import neutrality (CIN), achieves this result.  On the one hand, CEN, which is generally associated with worldwide taxation and a residence-state credit for source-country taxes paid, discriminates against MNEs (as opposed to domestic corporations) to the extent that the resident country does not fully credit source-country taxes (this violates the “benefit principle” of international tax law, which links tax liability with public goods received).  On the other hand, CIN, which is usually associated with territorial tax systems, discriminates by taxing source-country income without reference to losses incurred in non-source country jurisdictions (this violates the “ability to pay” principle, which links tax liability to actual overall income).

De Wilde proposes to combine the irreconcilable and unsatisfactory neutrality concepts of CEN and CIN into something he calls “capital neutrality.”  Capital neutrality requires a jurisdiction to impose worldwide taxation on the income of its residents (CEN).  But, in order to avoid discrimination, it also requires worldwide taxation of non-residents that meet a minimum threshold of economic presence such as having a permanent establishment (or, in the case of the U.S. where no tax treaty applies, a U.S. trade or business).  To satisfy the single tax principle de Wilde’s capital neutrality must be coupled with some form of double tax relief.  Again, however, he finds the methods associated with CEN (the foreign tax credit) and CIN (exemption of foreign income) unsatisfactory.  Here, de Wilde draws upon Dutch tax law for a solution—specifically, the form of double tax relief known as the “tax exemption method,” which he sees as a combination of the CEN and CIN concepts, and which he describes in some detail in the paper.  The paper contains a number of examples that illustrate the application of de Wilde’s proposal, but rather than give away the entire article here, I’ll let readers evaluate the rest of de Wilde’s thoughts on this issue for themselves.

To the extent that it relies on elements of the current global tax allocation formula, de Wilde’s proposal will be saddled with familiar difficulties. For example, states would still have to grapple with source issues, and those issues likely will become thornier as technology continues to affect the global business structures and transactions of MNEs.  Nonetheless, de Wilde has produced a very well written paper that presents fresh, provocative thinking about a problem to which few workable solutions have so far been proposed.

Health Care Costs and Fiscal Infirmity

Jun 2, 2010 Neil H. Buchanan1 comment

Anyone who wants to understand fiscal policy in the United States for the next fifty years will need to understand health care costs.  There are many important issues in tax policy – the income/consumption debate, whether and how to tax wealth (especially at death), how to deal with transfer-pricing problems, when to tax capital gains, how to handle tax protesters, and so on – but the single issue that is going to drive tax policy is health care inflation.

Scary proclamations that the U.S. faces a “long-term fiscal crisis” are actually statements that health care costs could ruin the economy.  If health care costs stop increasing – either by government action or because of some “natural” maturation process in the medical-industrial complex – then there is no long-term fiscal crisis.  The so-called Social Security crisis is an over-hyped non-event, as I have argued elsewhere, and as even the most serious budget hawks will admit.  Nothing else in the budget (certainly not “waste, fraud, and abuse”) even comes close to justifying alarm about the long-term need to raise taxes.  It is all about health care.

Of course, the health care cost crisis is really a crisis for the whole economy, not just the federal and state governments.  Even if we were to raise taxes to cover all government health care expenditures, the scariest predictions about health care costs indicate that half of the economy’s resources will be dedicated to health care long before the end of this century.  Of course, there are good reasons to be skeptical about any long-run forecast, especially one that predicts such an extreme result.  If there is going to be a long-term fiscal crisis in the United States, however, it will be because health care costs have continued to spin out of control.

This basic fact – that the politics of tax policy will be driven largely by health care costs – suggests that tax policy scholars in the United States (and possibly elsewhere) need to expand their knowledge base to include some fundamentals about how health care works (and fails to work) in this country.  An extremely good place to start is with Atul Gawande’s article from The New Yorker, “The Cost Conundrum.”  Gawande is a Harvard Medical School professor who has written on health care issues for, among others, The New York Times op-ed page.  His analysis of the challenges facing health care provides a bracing insight into the ways that bad policy choices interact with self-interest to produce a terrible combination of high costs and bad health outcomes.

Although written for a non-academic audience, and although written by a medical doctor, Gawande’s article is in some ways among the best empirical social-science writing available.  As has become the trend in many economics departments, he exploits a “natural experiment,” that is, a situation where two outcomes can be compared meaningfully because the underlying facts of the two situations are otherwise so similar.  (A natural experiment, therefore, mimics a controlled laboratory experiment by “holding constant” other possible explanations for an observed outcome.)

The natural experiment in question is the difference in health care costs between two cities in Texas: McAllen and El Paso.  McAllen is the second-most expensive city in the country for per-person health care costs, behind only Miami, which has much higher labor and living costs.  By contrast, El Paso’s health care costs are only one half of McAllen’s.  Gawande spends much of the article exploring the various reasons that might explain the difference between the two cities’ health care costs.  It turns out that both cities have similar poverty rates, racial and ethnic profiles, high-fat diets, and nearly every other possible factor that could explain a difference in health care costs.

Notably, because both of these cities are in the same state, the doctors and hospitals in each city are operating under the same medical malpractice laws.  When I gave a talk on this subject at a conference in Jackson, Mississippi, earlier this year, an otherwise extremely receptive audience turned a bit icy when I denied that malpractice is a meaningful explanation for rising American health care costs.  No matter how one reads the national evidence, however – and for what it is worth, credible evidence suggests that perhaps 1% of the growth in health care costs is explained by malpractice costs – this explanation cannot possibly explain the difference in costs between two cities in the same state – a state, by the way, that has already adopted aggressive “tort reforms” in response to assertions that malpractice costs are driving up health care costs.

Gawande narrows down the list of possible explanations to one: the fee-for-service model in U.S. health care reimbursements.  If you are a doctor and you want to earn money with a Medicare patient, the rules set up a very simple incentive structure: the more you do to the patient, the more you will be paid.  If you do unhelpful and even dangerous things, such as surgeries that have a low chance of fixing the problem, you will be paid.  If you need to go back and fix something that would not have needed fixing but for your first medical intervention, you will be paid again.  Your income has nothing to do with your patients’ health.

There are, of course, professional ethics to consider, as well as anti-fraud provisions in the reimbursement rules.  What Gawande shows, however, is that an entire city can work within the rules and run up its costs to twice the level of another (extremely similar) city’s costs, because the latter city’s doctors and hospitals have simply not yet responded as strongly to the income-producing incentives inherent in the fee-for-service system.  Worse, he shows that El Paso (the low-cost city) is moving in the direction of McAllen, with medical professionals in El Paso finding it nearly impossible to continue to resist the financial incentives in the system.

No single article, and no pair of cities, can explain health care inflation.  If you are looking for a place to start to understand the myriad of issues underlying America’s biggest fiscal time bomb, however, you could do much worse than starting with this extremely engaging article.