TaxProf Blog

Paul L. Caron
Dean





Friday, September 29, 2023

Weekly SSRN Tax Article Review And Roundup: Roberts Reviews Tax And The Boundaries Of The Firm By Barry & Fleischer

This week, Tracey Roberts (Cumberland; Google Scholar) reviews a new work by Jordan M. Barry (USC; Google Scholar) and Victor Fleischer (UC-Irvine; Google Scholar), Tax and the Boundaries of the Firm (2023).

Roberts (2020)While a significant tax scholarship examines the way that tax may distort firm capitalization, financing firm operations through debt, equity, or retained earnings, Jordan Barry and Vic Fleischer explore how the U.S. corporate income tax distorts non-financial decisions in Tax and the Boundaries of the Firm. They reflect on the way the corporate tax influences firm decisions about the location of assets and production within a firm, the existence and location of corporate subsidiaries, and the reinvestment of profits, by applying Ronald Coase’s transaction cost analysis from his seminal work, The Nature of the Firm. Coase explained that a decision by a firm about whether it should produce a good internally (“make”) or acquire those goods from other firms (“buy”) depends on the relative benefits, costs, and risks of the two choices.

Acquiring a good from a third party may increase efficiency; market transactions reveal prices and allow one to shop for the best price. On the other hand, market participants face information costs in finding suppliers, and in determining quality. They face transaction costs in processing that information, in negotiating prices and contracts, and in enforcing those contracts. Finally, a firm that buys goods from third parties exposes itself to the risks of strategic behavior. While some of these risks may be reduced or offset through investigations, insurance, hedging transactions, or other mechanisms, all of these efforts also increase transaction costs. Taken together, these costs and risks may push a firm toward manufacturing the good itself (or aquiring the manufacturer as a subsidiary). On the other hand, a firm manufacturing its own inputs also faces hazards. Employers and managers may act and interact in self-interested ways, and they may make less well-informed decisions, since information on market prices is not readily available for intra-firm, non-arms-length transactions. Coase concluded that the boundaries of the firm will be set based on which pathway bears the least transaction costs. When the costs of market transactions are higher, a firm will bring those operations inside the firm. When those transaction costs are lower, the firm will buy what it needs from the marketplace.

Applying this analysis to U.S. corporations and multinational entities, Barry and Fleischer identify three sets of tax effects that distort economic decisions with respect to the boundary of the firm. First, “intrinsic distortions” arise from imposing an income tax at all. Income is measured by reference to gains from transactions. Arms-length transactions provide a measure of the fair market value. On the other hand, with intra-firm transactions, a firm may set its own prices and thereby reduce or avoid tax. Determining an arms-length price outside of the marketplace is difficult. Consequently, IRS challenges to internal prices and the resultant tax paid are hard to prove. While they reduce the tax to be paid, distortions in the decision to make or buy goods may have more significant harmful economic effects on the firm.

Second, “doctrinal distortions” arise from design choices for the US income tax. While they may be supported by good economic reasoning, they give rise to (possibly) unanticipated behavioral effects. Some of these tax distortions build upon one another. For example, the general bar on transfer of net operating losses and tax credits combined with the consolidated return rules encourage firms to acquire other businesses so that they may use those tax losses and credits to the greatest extent. Likewise, the double tax on corporate profits and dividends to shareholders encourages firms to retain their earnings rather than distribute them to shareholders. Prior to the Tax Cuts and Jobs Act of 2017, the tax on repatriated earnings deterred multinationals from bringing cash back into the US. By acquiring other foreign subsidiaries, multinational corporations could “permanently invest” that cash abroad and avoid the U.S. corporate tax altogether. While multinationals increased the size and the scope of their foreign holdings, those investments were not always the most productive for the firm. What’s worse, those decisions did not benefit the U.S. economy, or the U.S. Treasury, or the U.S. worker. Barry and Fleischer demonstrate how these tax rules continue to drive firm decisions despite recent international tax reforms.

Third, the income tax may also encourage “regulatory arbitrage.” Tax experts may structure firms and transactions in ways that allow the firm to enjoy tax benefits while avoiding any significant change to their real economic activity. Barry and Fleischer note that while it is beneficial that firm economic choices are not affected, the money spent to procure special tax treatment is viewed as economically wasteful (since a portion of those tax savings go to tax attorneys and accountants rather than the U.S. Treasury), fundamentally unfair (since those taxes must be made-up with taxes on those who cannot afford to engage in regulatory arbitrage), and administratively expensive (since the IRS must spend significant time and money pulling out, taking apart, and scrutinizing “double Irish Dutch sandwiches” and other such unsavory mouthfuls). And I thought such unappealing tasks were reserved to parents of young children!

In view of all of these strategies and distortions, Barry and Fleischer appear to favor giving up. They applaud the reduction in the corporate tax from 35% to 21% as reducing the incentives for such distortions, despite the lack of any beneficial effect on U.S. revenues from the “trickle down” effect,  and the growing interest on the expanding federal debt, which could certainly be put to better uses. They also suggest that we might eliminate the corporate tax, which is borne, at least in part, by shareholders, and replace it with a value added tax, which is regressive, and will be born by consumers. However, before making that decision, we should surely analyze the actual costs to society of those tax distortions from corporate tax gaming. To do so, we must disaggregate tax avoidance incentives from the other significant drivers for maintaining foreign subsidiaries: externalized costs. Economists (and tax lawyers) like to quote Adam Smith to extoll the quaint notion that value is maximized through international trade in such cases as when the Scottish, instead of making their own claret at thirty times the cost, buy wine from the French, who have better terroir and skills for winemaking. Similarly, Barry and Fleischer note that, in China, manufacturing workers are plentiful, talented, and cheap. What is omitted is that in many foreign countries workers are “cheap” because they lack basic rights and protections, workers are “plentiful” because the state may use its power in ways that amount to forced labor, and as for talent, can anyone really say that these workers are more talented than those you might find in the U.S.?  Another significant driving force for shifting production abroad is the complete absence of pollution controls or regulatory enforcement in many jurisdictions. Furt Corporations are machines for externalizing costs and hoovering up benefits. It’s no surprise that corporations, while at the same time claiming all the benefits associated with U.S. sovereignty, the U.S. legal system, the U.S. capital markets, and U.S. government subsidies, would externalize the costs associated with paying for those benefits: U.S. taxes. Disentangling the benefits of externalized costs from the benefits of reduced taxes available in foreign countries will be difficult. In large part, the same forces blocking regulations to protect workers and the environment are those pushing for reduced or nominal taxes.

Barry and Fleischer are not completely committed to the diminution or elimination of the corporate tax. They note that the OECD Base Erosion and Profit Shifting project has sought to reduce the distortive effects of the corporate income tax by applying a 15% tax on financial statement income of corporations within the 142 countries that have signed on to the agreement to date.  Nevertheless, they express concern that the accounting rules, which define income more conservatively than the income tax rules, may offer additional regulatory arbitrage opportunities to lower tax burdens. Note, however, by aligning the tax rules with the financial accounting rules, the BEPS proposal achieves something different: by measuring tax against the same income investors use to measure return on investment, BEPS pits the benefits of tax avoidance (which may attract investors) against the benefits of inflating corporate income (which also attracts investors).  Consequently, the BEPS experiment may point to a better solution to counter corporate tax avoidance: the integration of tax and financial reporting systems.

In  Tax and the Boundaries of the Firm Barry and Fleischer have advanced the literature significantly in the ways taxation distorts firm behavior, size, location, and economics. We should all look forward to further empirical studies that pursue this line of thought to quantify the extent of the deadweight loss arising from these distortions.

Here’s the rest of this week’s SSRN Tax Roundup:

https://taxprof.typepad.com/taxprof_blog/2023/09/weekly-ssrn-tax-article-review-and-roundup-roberts-reviews-tax-and-the-boundaries-of-the-firm-by-bar.html

Scholarship, Tax, Tax Daily, Tax Scholarship, Tracey Roberts, Weekly SSRN Roundup, Weekly Tax Roundup | Permalink