CFO: Direct vs Indirect Taxes

Interesting story from CFO.com, reporting on findings from a KPMG survey of multinational corporations. Apparently indirect taxes (e.g., VAT or value added taxes) are becoming more important as the burden of direct taxation (e.g., corporate income taxes) falls globally. The report raises two important points.

 
First, it reveals the inescapable reality of economic tradeoffs. While taxes on corporate investment and output are falling globally, corporations are having to wrestle with new and complex kinds of tax administration. Under VAT and similar systems (think state and local sales taxes in the U.S. for example), they are essentially tax collecting agents of the government. As Milton Friedman was fond of saying, there’s no such thing as a free lunch. Apparently the axiom holds true in corporate taxation.

Second, it confirms that the global trend towards lower direct tax burdens on productive activity is still intact. We continue to believe that this fact is the single most important aspect of the global political economy for U.S. policymakers to grasp. It means that on a relative basis, the U.S. is becoming a less competitive destination for capital investment, simply by standing still on tax policy. And given the current political winds here, there’s a possibility that this divergence will be exacerbated by heavier regulatory, tax, and trade burdens in coming years. Should that happen, we would look for some political upheaval in 2012, either in Congressional control or the Presidency; it will depend upon where the most compelling challengers show up.

On a related note, Rep. Paul Ryan of Wisconsin recently penned an encouraging op-ed in the Wall Street Journal on his recent entitlement reform proposals. Ryan is one of the boldest members of Congress regarding tax reform, though he’s clearly swimming against the tide at the moment. Perhaps he’ll gains some momentum once our current policy directions are found wanting by the U.S. electorate:

…The current federal tax code is complex, burdensome and discourages economic growth. It cannot be fixed with incremental changes; it needs a complete overhaul.

…The rates in the simplified code are 10% on income up to $100,000 for joint filers ($50,000 for single filers); and 25% on taxable income above these amounts. There is also a generous standard deduction and personal exemption totaling $39,000 for a family of four. The alternative minimum tax is eliminated. And to promote long-term investment in economic growth, taxes on capital gains, dividends and estates are also eliminated.

On the business side, the bill gets rid of our uncompetitive corporate tax – currently the second highest in the industrialized world – and replaces it with a business consumption tax of 8.5%, which is half the average industrialized world rate.

The roadmap I’m offering is a real plan, with real proposals, real numbers to back them, and real legislation to implement it. Based on the analysis of government actuaries, it is projected to make Social Security and Medicare permanently solvent, lift the growing debt burden on future generations, and hold Federal taxes to 18.5% of GDP…

We have some concerns about the plan. For example, while it might be true at times, it’s far from proven that elimination of the estate tax would lead to a higher rate of economic growth. More important, his plan continues much of the disparity that exist between tax rates on different types and levels of income. For example, it would incentivize many who are subject to the 25% marginal income tax rate to incorporate, if possible (and clever tax professionals will find a way), in order to take advantage of an 8.5% corporate tax rate. And everyone subject to income taxes would be incentivized to earn as much income as possible in the form of dividends and capital gains. Employer benefits would also remain a more attractive form of compensation at the margin.

Still, as tax and entitlement reforms go, we agree with the underlying philosophy and direction. His proposal to target a federal tax burden of 18.5% of GDP is especially interesting. Assuming that our political system is reasonably efficient (as political systems go), why not target a long term historic tax burden? Better yet, and even more efficient, why not let the electorate set the appropriate percentage every year, and require Congress to budget accordingly? Then seek to make the collection as efficient as possible in order to consume fewer resources than the current tax system’s administration,  compliance, and enforcement currently do. Taxpayers as a whole would be slightly richer in terms of time and money.