Auerbach’s Admission on the Transfer Pricing Aspects of His Tax Idea

Brad Setser is doing serious thinking about the transfer pricing aspects of the Destination Based Cash Flow Tax (DBCFT). I will read it but first he has distracted me with a link to an interesting paper by Auerbach et al. which includes this important admission:

Taxing business income in the place of destination also has the considerable advantage that the DBCFT is also robust against avoidance through inter-company transactions. Common means of tax avoidance – including the use of intercompany debt, locating intangible property in low-tax jurisdictions and mispricing inter-company transactions - would not be successful in reducing tax liabilities under a DBCFT. Here however the distinction between universal and unilateral adoption is important. With adoption by only a subset of countries, those not adopting are likely to find their profit shifting problems to be intensified: companies operating in high tax countries, for instance, which may seek to artificially over-price their imports, will face no countervailing tax when sourcing them by exporting from related companies in DBCFT countries.

This is the point of my Trump Toaster Oven tale and what Lawrence Summers said:

Fourth, the combination of a sharply lower rate, new opportunities for tax arbitrage and the fact that any revenue gains from bringing overseas cash home are one-shot means the Federal revenue base would erode. The result would be cuts in entitlement payments to consumers who spend heavily, tax hikes on individuals and reductions in government spending. Over time, this will slow growth and burden the middle class.

A lot of folks thought DBCFT would end tax arbitrage but not if the U.S. adopts it alone. It just seems all the work for clever accountants and lawyers will be occurring offshore. Auerbach et al. do make a point that if all nations abandon the taxation of profits and raise retail sales taxes to offset the revenue loss, then transfer pricing becomes irrelevant. But let’s be a bit careful as some sales taxes such as the Medical Device Excise Tax is not retail based but set at the manufacturer’s price – an issue we dealt with here. The Auerbach et al. claim is actually well known. But will all nations choose to shift the tax burden from profits to consumption? I’m not sure but maybe the proponents of a worldwide abandonment of profits taxes replaced by higher sales taxes need a slogan:

Corporations of the World Unite!