Readers of the Aug. 19 Week Observed: here’s the piece you’re looking for.
Here’s a puzzle: If 89 percent of Apple’s ideas are invented in the U.S., why is 92 percent of its profit overseas?
The link between local economies and tax bases has long been obvious and physical. Companies paid property taxes on their buildings and equipment, people and businesses paid sales taxes on their purchases, and employers and employees paid taxes on their income. But the economy is changing, and the link between economic activity and taxes has changed.
Perhaps no products are a better examples of this trend than Apple’s iPhone and MacBookAir laptop computer. If you look at the polished aluminum backside of any Air, you’ll find an emblazoned slogan: “Designed by Apple in California.” That imprint has a strong basis in fact.
The next line on the back of the MacBookAir is “Assembled in China.” Stories of the globalization of production of high-tech devices abound. Many reports have chronicled the conditions of the tens of thousands of workers employed by contractors like China’s FoxConn, which produce all manner of technological devices. But the labor and even the components in most tech devices reflect only a small portion of their value. The cost and profitability of devices stems not from their physical elements or the labor used to assemble them, but from the superior software and design features—or, the intellectual property generated by Apple.
As The Economist explains, “Apple, it’s worth pointing out, continues to capture most of the value added in its products. The most valuable aspects of an iPhone, for instance, are its initial design and engineering, which are done in America.” InformationWeek estimates, “The cost of parts and labor to assemble an iPhone 6S, for example, cost an estimated $160, compared to a selling price of $399.”
However, even though Apple does 90 percent of its creative work in the United States, it pays very little in U.S. taxes. Instead, Apple attributes a disproportionate share of its earnings to the Republic of Ireland. Nobel laureate and former World Bank economist Joseph Stiglitz has called Apple’s accounting “fraudulent,” telling Bloomberg:
“Here we have the largest corporation in capitalization not only in America, but in the world, bigger than GM was at its peak, and claiming that most of its profits originate from about a few hundred people working in Ireland—that’s a fraud.”
How does Apple do it? The exact mechanics are hidden in the company’s tax filings in the U.S. and Ireland, but the basic mechanism at work here is transfer pricing. Apple has transferred ownership of its intellectual property (its patents and software designs, and perhaps even its brand and logo) to its overseas subsidiaries. Obviously, Ireland is not a major center for Apple’s technology development. According to USPTO, between 2011 and 2015, Apple received exactly zero patents for work performed in Ireland. By contrast, at least some other U.S. technology companies, including IBM, Intel, Microsoft, and Google, all reported Irish patents.
Nonetheless, Apple’s operations in the U.S., and throughout the rest of the world, make payments (including royalties and purchases) to foreign affiliates in, say, Dublin, in to make use of the intellectual property. The foreign affiliate records its income and pays any applicable taxes in its low-tax or no-tax jurisdictions.
This strategy shifts profits from the United States, where they might be taxed at the high statutory 35 percent corporate tax rate, to places like Ireland, where taxes are much lower and can be deferred. As a result, Apple’s profits have piled up overseas. Today, $215 billion of Apple’s $232 billion cash hoard is located outside the United States.
Apple is hardly alone in pursuing such strategies to avoid U.S. taxes. Facebook is facing an IRS claim for billions in back taxes for a single year, based on its strategy of shifting its intellectual property to the Cayman Islands.
Because so many companies are doing this, the cumulative reduction in American taxes paid by American corporations is significantly reducing federal revenue. The most comprehensive analysis of tax avoidance is by University of California’s Gabriel Zucman, author of The Hidden Wealth of Nations. Zucman estimates that these tax avoidance tactics cost the U.S. Treasury $130 billion annually in lost revenue.
A bizarre side effect of these tax-avoiding machinations showed up last month in the form of a breathtaking report that in 2015, the Gross Domestic Product of Ireland had increased an astonishing 26.3 percent over the prior year. This Irish miracle, as it turns out, has almost nothing to do with local economic activity and everything to do with the nation’s tax haven status, which artificially inflates the size of Ireland’s measured GDP.
The economy is increasingly dominated by global, knowledge-based companies whose profits are largely attributable to their intellectual property. The current system of taxation rewards Apple, Google, Facebook, and others for offshoring their patents, brands, or proprietary designs.
While the primary implications are for the U.S. Treasury, it’s also likely that shifting taxable income outside of the United States shortchanges states and cities as well. Most state tax systems piggyback on important aspects of the federal system, and state revenue departments are even more hamstrung in dealing with the high-powered lawyers and accountants of global firms than is the IRS.
As more sectors of the economy are disrupted by big firms using brands and patents, it may be harder for states and cities to collect taxes. This could also put smaller local firms at a competitive disadvantage. A city or state may have the legal ability to collect taxes from a local coffee shop, a bookstore, or a taxi company, but if a Starbucks, an Amazon, or an Uber attributes its profits to foreign domiciled intellectual property, that’s likely to be beyond the understanding, much less the reach, of local tax collectors.
This is a global problems that affects local economies and local governments, but it’s almost entirely beyond their ability to influence. At some point national governments—and international cooperation—will be required to establish clear ground rules and a level playing field in a world increasingly characterized by global, knowledge-based competition.