The Taxation of Business Income in the Global Economy.

• Author: Auerbach, Alan J.
• Position: The 2021 Martin S. Feldstein Lecture

It is a great pleasure to give the Martin Feldstein Lecture at the NBER Summer Institute. Marty was my dissertation adviser and a coauthor, and I learned a lot from him over the years. Indeed, I want to begin with a couple of Marty's contributions to the topic of my lecture, not simply to remind us how versatile Marty was in his research, but also because the points he made in these papers inform my discussion.

The first of these contributions is a paper that Marty wrote with David Hartman in the late 1970s that derived optimal tax rates for the domestic and foreign source income of multinational companies. (1) Key implicit assumptions in the paper were that companies' residence, and where they earn their income, are well determined. Both assumptions were perhaps quite sensible in the 1970s, but they clearly are not today.

Let me also call to your attention Marty's paper with Paul Krugman in an NBER conference volume. (2) The paper has the following quotation, expressing its aim: "The point of this analysis is more modest; we want to show that the common belief that a VAT [value-added tax] is a kind of disguised protectionist policy is based on a misunderstanding." This was an important clarification to make then, given the extent of misunderstanding. Unfortunately, it still is needed today, when policymakers debate the merits not only of value-added taxes, but of other consumption-based or destination-based taxes. This was evident during the US tax reform debate a few years ago.

To continue, let me start with a figure common to discussions of international taxation today, the G7 corporate tax rates going back a few decades. One would get a similar picture looking at other groups of developed countries.

It is evident that corporate tax rates have been declining throughout this period, starting from a much higher range in the early to mid-1990s than now. It's also worth pointing out that although the United States' tax rate reduction in 2017 occurred during a Republican administration, in other countries where tax rates have come down, they've done so under left-leaning governments. This is a phenomenon relating to something more fundamental than the politics of the day: the change in the world economy over this period.

A Changing Economic Setting

A good way to illustrate what's happened in the world economy, in particular in the US economy, is to compare the list of the largest US companies 50 years ago and today. Fifty years ago, the top five companies by market capitalization were IBM, General Motors, AT&T, Standard Oil of New Jersey (Esso, the predecessor of today's ExxonMobil), and Eastman Kodak. (Although these names are mostly still familiar, one should remember that AT&T wasn't the AT&T of today, but rather the enormous regulated monopoly, "Ma Bell," which provided local and long-distance telephone services and also manufactured and provided telephones.) These were companies that "made things" in identifiable locations, to a large extent in the United States. If we shift to today, we see another five familiar names, all giant companies: Apple, Microsoft, Amazon, Alphabet (Google's parent), and Facebook. These companies are worldwide multinationals, relying very heavily on the use of intellectual property in the goods and services they provide.

To highlight how things have changed, some statistics are also helpful. In the last half century, the share of intellectual property measured in US nonfinancial corporate assets more than doubled, according to the Fed's Financial Accounts of the United States. (3) That's probably a conservative estimate, because the measurement of intellectual property is a fairly narrow one here. The share of before-tax US corporate profits coming from overseas operations nearly quintupled, according to data from the Bureau of Economic Analysis. (4) US companies have become much more multinational in character, not just selling things abroad, but making them abroad as well. And the share of cross-border equity ownership has steadily increased, to the point that foreign individuals and companies account for a significant fraction of US companies' share ownership. (5)

What do these changes imply for tax policy? First, there is increased pressure on tax systems that are based on corporate residence. It's natural to think of individuals as residents of particular countries, but our income tax system also identifies corporations by where they reside. In 1971, it may have been pretty obvious what a US company was, in terms of who owned the company and where it produced. That's much less true now. There is much greater multinational activity of companies that legally reside in the United States, and they have many more shareholders abroad as well. These two factors make it easier to engage in so-called corporate "inversion"--that is, to change the corporate residence through corporate reorganization--which a company might want to do if being a resident of a particular country, such as the United States, is disadvantageous from a tax perspective.

The second implication for tax policy is increased pressure on tax systems based on where companies produce. The location of production is easier to change now because companies have internal supply chains; they're producing around the world already. So if they want to shift production from one location to another, they have existing operations to make that easier. Moreover, because they're producing things like microchips and pharmaceuticals and, indeed, services, rather than heavy things like autos and steel, they don't have to worry about location as much in terms of transportation costs.

Finally, there is increased pressure on tax systems based on where companies report their profits, as distinct from where they produce. We normally think of companies as earning profits where they produce, but one of the problems governments face today is that companies may produce in one location and report the profits deriving from that production in another. It's easier now for companies to shift profits in this manner because they have operations in so many countries, and it's...