Another Job Killer: Section 385
Yet another regulation is being proposed, to treat effects rather than cure the cause of capital flight.
September 4, 2016
Fred Foldvary, Ph.D.

The transfer of corporate governance to foreign countries is called “corporate inversion” or “tax inversion”.  The American company buys a smaller firm in a foreign country, and then relocates the home base of the combined company to the other country where taxes are lower.

Businesses have been leaving the USA to move their headquarters and enterprise to other countries. Some do so because of the tax cost of labor, but many are quitting the USA to escape the higher taxes and excessive regulations on enterprise that are imposed by the federal and state governments. It is widely known and discussed that marginal corporate income tax rates are higher in the USA than in other countries, but somehow the politics has prevented a remedy.

The superficial remedy when people do things you don’t like is to physically stop them. That avoids having to deal with the incentive for the action. Thus on 4 April 2016, the US Treasury Department and the Internal Revenue Service proposed new regulations, Section 385, to stop the inversions. Typically treating effects rather than causes, the rule would re-classify some debt as equity in financial transactions.

As stated by the EY Global Tax Alert, the regulation would “establish extensive documentation requirements in order for certain related party interests in a corporation to be treated as indebtedness for federal tax purposes.... The proposed regulations reach well beyond the inversion transactions that may have been their primary impetus; they extend to routine financing transactions for both non-US-based and US-based multinational corporations...”

“Section 385" is intended to limit “cash pooling,” putting a firm’s funds in a central location to then efficiently allocate the money. The US Treasury’s regulation would impose heavy compliance costs by reclassifying some debt as equity. This regulation would impose costs also on companies that do not seek or do any tax-inverting. As PWC Tax Insights reports, “Section 385 proposed regulations would vitiate internal cash management operations”.

As reported by Politico, “A PwC study commissioned by the Business Roundtable and the Organization for International Investment concluded the regs would ‘have the potential to cause a large reduction in (1) the amount of US investment by foreign-based multinational companies, and (2) the ability of US-based multinationals to compete for investment opportunities abroad.’”

The federal government has already imposed large regulatory costs with Dodd-Frank, the Sarbanes-Oxley Act, and the accumulated regulations of the past two centuries. The regulatory compliance costs of federal regulations cost the US economy $1.9 trillion annually, 11 percent of GDP. The regulations cost U.S. households about $15,000 per year.

Now the new regulations 385 would impose an even greater burden on US industry and employment. The regulatory tax in addition to the income tax explain why the economic recovery since the Great Recession of 2008 has been so sluggish.

It is widely advocated that the US government reduce marginal income tax rates, but the revenue is not going to be replaced by closing “loopholes”. These loopholes are not easy to fix, and they don’t affect revenue by much.

If the marginal-tax-rate reduction is to be revenue neutral, it would be efficient and equitable for the US government to levy a tax on the economic land rent of commercial and rented-out real estate, and phase out the legal fiction of repeated building depreciations. The land tax would be a fixed annual cost, in contrast to the marginal cost imposed by taxes on profits. For owner-occupied housing, the tax reform should also, as a first step, phase out deductions for mortgage interest.

The only way to make the US tax code less burdensome for employment and investment is to reduce taxes on additional income and consumption, and replace them with fixed-cost taxes on the implicit rent of land. The idea is to reduce marginal costs without changing average costs. After the transition, a tax on rent, by reducing the purchase price of land, replaces what would otherwise be paid for mortgage interest, so that there is no burden even on future landowners.


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Fred Foldvary, Ph.D.

FRED E. FOLDVARY, Ph.D., (May 11, 1946 — June 5, 2021) was an economist who wrote weekly editorials for since 1997. Foldvary’s commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary’s areas of research included public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.