B School for Public Policy

Professor Michael Knoll

Taxation, Competitiveness, and Corporate Inversions - An interview with tax experts

A wave of corporate inversions over the past several years has generated substantial debate in academic, business, and policy circles. The core of the debate hinges on a couple of key economic questions: Do US tax laws disadvantage US-domiciled companies relative to their foreign competitors? And, if so, does inversion reduce or eliminate that tax disadvantage, and increase the competitiveness of US multinational firms for making investments both abroad and at home? In a B-School for Public Policy seminar, Professor Michael Knoll addressed these questions and their implications for tax reform discussions, drawing insight from newly published research. He joined Lori McMillan, law professor at Washburn University in Kansas, and Daniel Hemel, assistant professor of law at the University of Chicago, in the Knowledge@Wharton Business Radio studio for an interview with host Dan Loney.

An edited transcript of the conversation follows.

Knowledge@Wharton:  The GOP tax bill is in its final hours right now. The bill passed in the Senate late last night, 51 to 48, and they voted a bond in the House of Representatives for a second time today, due to a procedural glitch. A 1.5 trillion-dollar package of tax cuts and tax code revisions should go to President Trump’s desk by the end of the week. There are many benefits for businesses in this bill, but there are also some for the consumer, as well. Also those benefits seem to peter out by the end of the ten-year window of this bill. To discuss the final version, we welcome into the studio Michael Knoll, who is a professor of law and a professor of real estate here at the University of Pennsylvania. He is also co-director of the Center for Tax Law and Policy. And joining us on the phone is Lori McMillan, who is a law professor at Washburn University in Kansas. And also joining us is Daniel Hemel, assistant professor of law at the University of Chicago. Michael, great seeing you again. Thanks for coming in. I appreciate it.

Michael Knoll:  My pleasure.

Knowledge@Wharton:  Lori, Daniel, as always, great to have you joining us on the show.

Lori McMillan:  Thank you for having me.

Daniel Hemel: Thank you.

Knowledge@Wharton:  Thank you both. Michael, I’ll start with you. You have talked a lot about tax reform in general. You did so at a seminar recently. So when you look at this bill, and you look at it from the business perspective, what’s your reaction in general?

Knoll:  Well, from the business perspective, there’s certainly a number of things here to make businesses quite happy. There is the reduced tax rate for corporations and the improved and more competitive international treatment moving towards a territorial system, and for smaller businesses, there is a reduced rate on pass-through. So there’s much to make business here quite pleased with the results.

Knowledge@Wharton:  Is the U.S. going to a “territorial system” the right move in your mind?

Knoll:  A move in that direction, in my opinion, yes – that is the right direction to be moving because it’s very tough for U.S. companies to compete with foreign companies because of the tax disadvantage. It has made trouble competing in the United States. It’s one reason companies strip out a lot of money and move. It has made it harder to compete abroad. What we do need, though, is we do need strong anti-abuse measures because a territorial system encourages people to strip money out and to avoid tax entirely.

The bill certainly takes steps in those directions. Some of them are reasonably strong. Some provisions may violate international agreements, specifically the WTO, which I know you had a speaker on just before. So there are challenges there, but there are definitely steps in that direction.

Knowledge@Wharton:  Lori?

McMillan:  I pretty much agree with that. I like the fact that we’re going to a territorial system, but you have to be really careful when doing that. I see commentators all over the place mentioning that there are a lot of technical issues with this bill and what’s going on. And there are a lot of little fixes that need to be made. And I think we do need stronger provisions in there dealing with anti-abuse.

Knowledge@Wharton:  Dan?

Hemel:  I think that the shift to a territorial system is a good thing if you have all the money in the world, but it costs money. We would raise more revenue if we had a worldwide system than a territorial system. And I think that in the long run, we would make the United States more competitive if we invested in schools and in our health care sector, and we’ll see as a result of this tax plan quite likely cuts to those areas. So I’m not sure in the long run whether this is good for business because business relies upon American infrastructure, American human capital, and American consumers.

Knowledge@Wharton:  Well, the pass-through is one, Daniel, that seemingly is getting a lot of attention. I’ll let you speak on that specifically because there is a concern of whoever the person may be – whether it be a lawyer, a doctor, an athlete, whatever it might be – there’s a concern that, as a lot of people have said, that the potential for gaming is there with the pass-through, the way it’s set up.

Hemel:  So lawyers, doctors, and athletes are all specifically targeted in an anti-abuse provision that prevents them from gaming this. I think it’s going to be investors in pass-through entities who aren’t lawyers, doctors, athletes – there are a few more occupations that are specifically targeted: performing artists, accountants, consultants – who will see dramatic reductions in their marginal tax rate as a result of this.

Knowledge@Wharton:  Michael?

Knoll:  I would agree. I think there certainly is going to be gamesmanship here. On the international front, though, a lot of Daniel’s arguments really have to go to what’s really our level of taxes in total, and how is that tax revenue going to be spent? And clearly this bill is blowing a hole in an already bad fiscal situation. But I don’t think the answer is to move towards a worldwide tax system for the relatively small amount of money compared to our entire budget that that would raise, but rather through consumption and other taxes, and more taxes on individuals – perhaps not going in the direction that the bill does with individuals – and getting the money there, and then spending it on infrastructure, education, et cetera.

Knowledge@Wharton:  Dan, do you want to respond to that? 

Hemel:  I’ll agree with that. Certainly if the Republicans were willing to combine corporate tax cuts and a shift to a territorial system with higher taxes on individuals or some way to fill the deficit hole, then that could be a positive reform. But this isn’t that. This adds 1.5 trillion dollars to the deficit, and ultimately in the long run raises taxes on lower and middle income families.

Knowledge@Wharton:  Lori, going back to the international side of this for a second, we’re at a time right now where we see places like Ireland really lowering their tax rate. And it feels like the challenge for businesses here in the U.S. or ones that are outside the U.S. is seemingly growing because of how some countries really view the tax system around the world right now.

McMillan:  We do see races to the bottom when it comes to different countries trying to lower their taxes. I don’t think that has been adequately addressed in this bill because even though we’re dropping the corporate rate a great deal, and we’re going to a territorial system, you will see other countries that are most likely going to respond to this. So you won’t see the U.S. attracting a huge amount of business over it because, for example, these other countries are free to lower their rates, as well, to do lockstep and react to what the U.S. is doing.

Ireland has been in trouble a few times over the years with the E.U. for doing that, and they’ve been warned a few times that they had to increase their corporate tax rate. So you will see other countries reacting to this, but that’s just the game that we play in international tax.

Knowledge@Wharton:  Michael?

Knoll:  That’s true. Other countries, since we are such a big player, will certainly react. They will likely reduce their tax rates – their corporate tax rates – but also countries will also be thinking in terms of how they’re going to protect domestic markets, and we’ve seen that in the BEPS, the base erosion and profit shifting talks. And I think the United States is to some degree finally getting on board with what the rest of the world is doing, which is moving towards a more territorial system and trying to think about how we are in such a system going to define what is domestic income and subject to tax.

See, we were holding onto an old view of the world, which is that countries should tax corporations based on where they reside. And everyone has moved off that. And that has been detrimental to the United States. That’s why there are 3 trillion dollars of U.S. companies’ money sitting offshore and invested sometimes in lower-performing assets, because it would cost them 35% to bring it back. So I think it’s important that we’re getting on board.

Knowledge@Wharton:  So are we then, with that 3 trillion dollars – are we potentially going to see a majority of that money come back into the country? And if it does, will it be used to build up the companies and build up their infrastructure and investment in operations? Obviously I think that’s the goal, but it’s whether or not we actually see it or not. 

Knoll:  Well, the consensus seems to be yes and no. Yes, the money will, in a sense 

Knowledge@Wharton:  That’s quite a consensus.

Knoll:  Right. Yes. It will come home, in the sense that the companies will repatriate it, because they’re going to be taxed on it right away at reduced rates. But most of that money likely will go for dividends, share repurchases, for acquisitions of other companies. It’s not so likely to go into new investment by virtue of their cash being there because these were not constrained companies. These were companies who had access to borrowing and other ways to raise money to engage in investments in the U.S. The question is, will the reduced rate cause more investment? Separately in that, we have to wait to see.

Knowledge@Wharton:  Dan?

Hemel:  I think it’s important to remember that these 3 trillion dollars in cash aren’t just sitting in a pile in Bermuda or Ireland. About half of this money is already re-invested in U.S. assets. So I think we’ll still see companies holding stock in other companies, companies having a lot of cash in bank accounts and in bonds. I’m not sure whether we’ll see more dividends and more buy-backs for the reason that right now, a C corporation – so that’s virtually all publicly-traded corporations – that’s a pretty good place to have your money. You’re taxed at the top rate 23.8% on dividends and capital gains in your own individual account.

The company is taxed at a 10% rate on dividends and a 20% rate on capital gains. So if you’re just going to have your assets in stock, I would rather have my assets in Apple holding the stock rather than in me holding the stock because Apple now faces a lower tax rate than I do.

Knowledge@Wharton:  Dan, you briefly mentioned the individual tax side of this, and I’ll let you jump in on this to start. What’s your reaction to what we’re going to see potentially on the individual tax side?

Hemel:  Well, we are seeing a reduction in the top rate of about 3.8 percentage points. It’s a statutory rate reduction of 2.6 percentage points, from 39.6% to 37%. But everyone in the top bracket right now pays an extra 1.2 percentage points because of something called the Pease provision. And this gets rid of that.

So we’re seeing a big cut in the top rate. We’re seeing an even bigger cut in the top rate for folks who invest in real estate, in other pass-through business. For them, their rate is going from about 40.8% today to about 29.6% under the new plan. And we’re seeing a small reduction in the rate on capital gains and dividends. The bill itself doesn’t talk about capital gains and dividends with respect to individuals, but individuals are right now paying an extra approximately 1.2 percentage points on capital gain and dividend income. These are high-income individuals, and this bill is getting rid of that.

Knowledge@Wharton:  Lori, what’s your reaction to the personal side?

McMillan:  To the personal side I have mixed reactions, especially because the flow-through thing I look at as both business and personal. When we’re looking at what we’re doing, when we’re looking at what we’re trying to reform our tax system to be, we have two main concerns. One, are we raising enough revenue? And the other concern is are we raising it in a manner that is fair, that distributes the burden of society in a manner that’s appropriate?

When we look at the individual rates, yes there are some cuts. There’s a little bit of a reduction. And in some ways, they’re touting the fact that most people are going to have some sort of tax break as a result of this, which is great, especially for the lower and middle classes because if the lower income earners get a tax break – if they have more money in their pocket – they tend to spend it, which actually helps the economy.

But when we look at the other things that are going to be coupled with this, because of the fact that we’re looking at a 1.5 trillion-dollar addition to our deficit over the next ten years, we’re also going to be looking at other cuts that have to come into play. I live in Kansas. We’ve been through this. We’ve been through, “Hey, let’s lower the tax rate on individuals. Wouldn’t this be grand? We are going to have a “shot of adrenaline” into our economy. It’s going to be wonderful.” But it wasn’t. It absolutely wasn’t wonderful. What happened was that our economy tanked, and there were massive cuts that affected these individuals far more than the ostensible break that they got.

Knowledge@Wharton:  And what’s the change that has been necessary since all of those issues there in Kansas?

McMillan:  Oh, we have slashed funding on infrastructure. We are so far in the hole when it comes to pension obligations – public pensions. And education has been cut to the bone. We had schools last year that had to close early because they ran out of money. And when you look at what people want from their government, people want their children to actually be educated – and I’m not talking college and universities. I’m talking about K through 12 education, with middle school children that had to go home a few days early because the school ran out of money, and they just didn’t have enough for the lights or for the teachers or the janitors.

So when I look at what’s happening on the personal side, again, this is not my first rodeo, seeing something like this. This is only a few years ago that we did this in Kansas, so for the extra $60 or $80 or $100 that a low-income person might get out of this, I am seriously worried about the cuts that are going to have to come down the pipeline to pay for this. We’ve already seen rumblings that, “Hey, we’re going to have to tackle Medicare and Medicaid and other sorts of ‘entitlement spending’ as a result of this.” 

Knowledge@Wharton:  Right.

McMillan:  So that is my major concern.

Knowledge@Wharton:  I guess that is the concern of a lot of people, is the issue surrounding the entitlement programs, Michael. And you don’t want to lose a lot of the support for a lot of people around the country in those specific areas because that’s not just five dollars coming out of your pocket. That ends up being a potential life-changing issue here.

Knoll:  And very much targeted, obviously, towards the less-wealthy members of society. A lot of these issues really go to the question of what are the dynamic effects of this bill? So to some extent the argument made by some supporters is that growth will pay for it, in effect. And so it’s not really going to be a cut in revenue. That view is something of an outlier, to say the least.

There is really a range of estimates, but my guess is they’ll probably come to about a third, that is the suggestion being that there will be enough growth to increase tax revenue by about a third of what was lost. That tends to be sort of towards the high end of where most economists come out – which plays exactly into the concerns Lori is raising. The government is not going to have enough money, unless they go out and tax and make up for it – or cut spending further, which is likely to be even more harmful.

Knowledge@Wharton:  I think, though, there are some situations where – and I think a lot of people discuss this – that there are elements of government spending that probably could be trimmed and probably wouldn’t have that significant of an impact. I’m not saying that across the board, but you have to really investigate where those areas are.

Hemel:  Sure, though Social Security and health care are already half the federal budget. So if we don’t want to trim those, and if we don’t want to touch national defense – and it doesn’t seem like the Trump administration does – then there aren’t that many more federal programs where there’s a lot of money lying around. Moreover, passage of this bill is going to trigger the sequester, which we remember back from the Obama presidency. Immediate cuts across the board to a variety of federal programs, including Medicare. And Republicans could pass this tax legislation with 50 votes in the Senate. They’ll need 60 votes in order to turn off these cuts. And they don’t have those 60 votes right now. So we’re going to see immediate impacts on people who are reliant upon Medicare and other social services.

Knowledge@Wharton:  Lori?

McMillan:  I completely agree with that. We’re looking at how is this burden going to affect people? And that’s something that isn’t being talked about in this rush to get this legislation passed. It has passed so quickly, and there are so many technical issues with this bill. I mean, we don’t have enough time to go into all the problems with the ways that it’s drafted and a lot of the unintended consequences. But there are intended consequences, which is we are going to rack up a 1.5 trillion-dollar deficit as a result of this when we are not needing to. The fact that we are adding so much to our deficit at this time – it makes no sense. And there is no coherent underlying tax policy or any policy why we are doing so.

Knoll:  I would largely agree with that. A small point to make is that’s my understanding why the bill may not actually get signed this year. It may get pushed off until –

Knowledge@Wharton:  Like January 3rd.

Knoll:  Or something. So at least we’ll give a year to work on that. But part of the problem which I think Lori was alluding to is by having this be a one-party bill entirely – no Democratic buy-in. And any bill is going to need technical corrections to begin with. And then there also are the budget concerns, too. It just makes it harder to do, and it makes all of these bills or any such bill quite uncertain for its future because as the way the Republicans have been running against Obamacare for years, the Democrats will be in a position, if things change, to reverse it. And that takes away a lot of the incentives to invest and do other things based on any sort of permanence. So it makes for a very messy situation, by virtue of all of this rushing.

Knowledge@Wharton:  Daniel, in your opinion, how do we move towards at least the idea that is being brought forth by this administration of trying to build growth again here in the U.S., bringing jobs back into the U.S., and not put ourselves in a severe economic hole?

Hemel:  Ultimately, I think, the engine of American growth is going to be human capital, so investing in our people is the way to make our country the premiere economy in the world. That also includes loosening our border restrictions so that we can bring in the best engineers from other countries to start the next Google and the next Intel. But so far I’ve seen little evidence from the Trump administration that they’re interested in that. And instead, they’re dramatically cutting tax rates on income from physical capital but doing relatively little to grow the knowledge economy. 

Knowledge@Wharton:  Lori?

McMillan:  I agree with that. Part of the problem with the way that these cuts are structured, especially for business, is that it’s not tied to an outcome. We ostensibly want jobs and growth, which is exactly the mantra that was said in Kansas. “Jobs, jobs, jobs. Growth. This will be wonderful. It’s all connected” – basically trickle-down economics. But it didn’t happen. When you want an outcome, you tie it to any perks or rewards that you are getting. At least that’s best practices. What I tell my students is, “If you have children, and you want them to do their homework, and you’re going to give them a cookie as a reward – do you give them the cookie first and trust that they’re going to do their homework? Or do you have them do the homework that they’re supposed to do, and then you give them the cookie as the reward?”

And most people sensibly say, “Well, you wait for them to do the homework, then you give them the cookie,” because human nature would otherwise say that they’re going to get the cookie, and they’re going to try to get out of it.

So if we want people to create jobs, it would be a far better thing to target job creation and reward the job creation with a tax break, with a targeted benefit. And that’s not what’s happening. There is an attempt for the passed-through benefits to try to tie it to the amount of W-2 income that gets paid, except at the last minute, this massive benefit was put in for capital-intensive businesses such as real estate businesses, where it has nothing to do with job creation. So that’s a little bit of a head-scratcher when it comes to why is it structured this way? It’s absolutely just a benefit that is being given to high-income real estate developers.

Knoll:  Well, right – and in many cases to existing investment. But ultimately growth depends on improving human capital and on having physical capital available. And the tax bill does some things in terms of improving opportunities for having physical capital in the United States. It does nothing in terms of human capital. And the large budget deficit or holes being blown in the budget are going to make it much harder to improve human capital.

Knowledge@Wharton:  We’re talking with Michael Knoll here at the University of Pennsylvania, Lori McMillan of Washburn University in Kansas, and also Daniel Hemel of the University of Chicago. He’s an assistant professor of law there.

What’s your expectation, though, Michael, as to how this bill is going to play out? And what are we going to be talking about a year from now, two years from now, as really the role of this tax plan on the United States?

Knoll:  Wow. Well, there are certainly various camps there in terms of what is going to happen. I think part of the problem is that you don’t see the effect of the deficits for some time. So in many ways, some of the most damaging aspects of the bill is borrowing against the future. And one doesn’t see that right away.

I think some big questions are really going to be what’s going to happen with U.S. companies, especially on-shore versus off-shore. And I’m not entirely sure how that will cut, but I think that will be a big part of the conversation. Do we see the problems continue, or do we see some movement in the other direction in terms of even IP and other kinds of things which are kind of nominal when they get brought back? But I think that will be a big part of the conversation.

Knowledge@Wharton:  Daniel? 

Hemel:  I think there will be huge political ramifications of this. It’s really hard to cut taxes and not win votes for that, but it seems like Republicans in Congress and the Trump administration have found a way to make cutting taxes politically unpopular. The fact of the matter is that most Americans will see a tax cut in tax year 2018. They won’t actually know that for sure until they do their taxes in April, 2019, after the midterm elections. It seems like about 40% of the population perceives that their taxes are going to go up, even though the real number is much smaller than that.

So I think this increases the possibility that 2018 will be a wave election for the Democrats, and the political ramifications of this bill might be among the most significant.

Knowledge@Wharton:  Lori?

McMillan:  I think the politics is where it’s at when it comes to the impacts from this because they have to do some adjustments. They’re going to have to do some cuts. That’s what we did in Kansas – cut, cut, cut. And the fact that we are such an incredibly red state, we made tax cuts unpopular here, and I see that happening on the federal level.

Knowledge@Wharton:  Great having you all with us. Thank you Lori, thank you Daniel for joining us on the phone today.

McMillan:  Thank you for having us.

Hemel:  Thank you.

Knowledge@Wharton:  Thank you both. Michael, great seeing you. Thank you for coming in.

Knoll:  Thank you.

Knowledge@Wharton:  I greatly appreciate it.