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Is Bernie Sanders right that the Business Model of Wall Street is Fraud?

Reversing the Trend of Corporate Inversion and Noncompetitive Tax Policies

We’ve all heard presidential candidate Bernie Sanders arguing that “the business model of Wall Street is fraud”. Claiming our capitalistic system creates “corporate welfare”. Critics claim this is nonsense. The truth lies somewhere in between.

Frauds did occur that directly contributed to the financial recession. Greed was largely responsible for the financial meltdown in 2007-2008. But to prove fraud, intent must be shown. Is greed an indicator of intent, or a manifestation of ethical blindness?

Sanders likes to claim no Wall Street executives were sent to jail for their role in ushering in the financial recession, although investment banking firms paid billions in fines and penalties for their actions including Bank of America ($16.65 billion), JP Morgan Chase ($13 billion), Credit Suisse ($10 billion), Goldman Sachs ($5.1 billion), and Morgan Stanley ($3.2 billion). Sanders is almost 100% correct. The exception is Kareem Serageldin who approved the concealment of hundreds of millions in losses in Credit Suisse’s mortgage-backed securities portfolio. Fraud exists here because evidence indicated he not only approved it but knowingly participated in the concealment.

What about corporate inversions? Is it fraudulent to merge with a foreign entity and relocate headquarters to a low tax or tax-free country? One would have to demonstrate that the intent of such activity is to evade taxes rather than avoid them for fraud to exist. Inversions are a self-serving practice and gaining in popularity as U.S. corporations look for ways to hold on to as much of their cash as possible. Donald Trump talks about inversions all the time. He claims that he will stop such practices but doesn’t really give any details how it will be accomplished.

The inversion deals are driven by a desire to avoid paying U.S. corporate income taxes that are the highest in the world (35%) by relocating to a tax-friendly country. The UK tax rate is 21%, Switzerland is 18% and Ireland, with the lowest corporate income rate, at 12.5%. U.S. companies avoid paying any corporate income taxes in the U.S. (but not in the foreign country) by shifting profits overseas so that taxes are avoided until and unless those profits are repatriated from their low-taxed foreign earnings to the U.S. By simply keeping the profits overseas a U.S. company avoids paying U.S. corporate income taxes.

Many people do not understand how global taxes are collected on U.S. multinationals. There are two models: territorial and worldwide taxation. A pure version of territorial taxation imposes tax on active business income earned by corporations outside their countries of residence only in the source (“host”) country, incurring neither contemporaneous tax liability in the home country, nor taxation on dividend repatriation from foreign subsidiaries. Worldwide taxation is a system under which corporations deemed “resident” in a country are taxable by that country on their income from all over the world, normally with offset either by deduction or credit for taxes paid to source countries on the same income, and sometimes, as in the U.S. case, with deferral of tax until repatriation of the income in the form of dividends from foreign subsidiaries to the home country resident parent.

Both the UK and Japan have moved to territorial systems, with modifications, within the past few years. Several recent proposals for US corporate tax reform propose or consider this option as well—the Simpson-Bowles Commission recommended it; the Volker Report (by the President’s Economic Recovery Advisory Board) considered it favorably; House Ways and Means Committee Chairman Camp’s proposed legislation would adopt a territorial system together with a minimum tax on foreign earnings. It is argued, as it was in the cases of the UK and Japan, that the U.S. system of worldwide taxation with foreign tax credit and deferral is unduly complex and burdensome, deters repatriation of income, and encourages foreign incorporation.

Chile, Greece, Ireland, Israel, Korea, Mexico, Poland, and the U.S. follow the worldwide system while most others use a territorial tax approach. Worldwide taxation is deemed to be double taxation by U.S. multinationals. They believe taxes should be paid wherever they are headquartered (e.g. Ireland) and not taxed again (i.e. U.S.). Would a territorial system lead to fewer inversions? No one knows.

My suggestion is to keep the territorial system in the short run but take action to reverse the trend of inversion by instituting a lower rate of 15% corporate taxes paid in the U.S. to be competitive with other industrialized countries, and keep it in place for two years. Similarly, a 15% rate hopefully would lead to repatriated profits, higher taxes paid to the U.S. government, and the in-sourcing of jobs. If so, then the 15% rate should be made permanent. If, however, U.S. businesses continue to shift their profits overseas and continue to outsource jobs, it means one or more of three things: (1) they are motivated by lower wage rates outside the U.S.; (2) they may feel stifled by the excessive regulatory system in the U.S.; and (3) they may truly want to be closer to their expanding overseas markets. Of course the over-arching motivation is still to avoid taxes.

Let’s not throw out the baby with the bath water. Our capitalistic economic system has generally served us well for many years. However, it is time to significantly restructure the corporate income tax system to be competitive with other countries and incentivize corporations to stay in the U.S.; use their money to expand jobs here and create economic growth; and start to play a more active role in developing policies that conform to their corporate social responsibilities in the U.S.

Blog posted by Dr. Steven Mintz, aka Ethics Sage, on February 16, 2016. Professor Mintz is on the faculty of the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at: www.workplaceethicsadvice.com.

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