Tim Cook Congressional Hearing: Exploiting Tax Laws Is a Fact of Life Unless We Change the System

Apple became successful not just by making good products, but by making cool products. It isn’t so easy, however, to be cool while trying to explain to a Senate committee why you have been running a scheme allowing subsidiary companies to pay a 0.05% tax on billions of dollars of revenue. So the Apple PR guys were probably not so happy about CEO Timothy Cook’s day out at Capitol Hill Tuesday, following an investigation that branded Apple’s tax minimization strategy “highly questionable.”

The investigation revealed that Apple had created subsidiaries incorporated in the Republic of Ireland but managed and controlled in the United States. Since Irish law defines tax residency according to where a company is managed, while the U.S. defines it according to where it is incorporated, they fell between the stools of the international tax system. The results are staggering: One subsidiary, Apple Sales International, had an income of $22 billion in 2011 from Apple’s international sales, but paid just $10 million in tax.

Now this is an emotive issue. Senator John McCain’s constituents are apparently “mad as hell” about it. Senator John McCain (R-Ariz.) is — perhaps not coincidentally — also mad as hell about it. However, before we all start drowning our MacBooks and dropping our iPhones from a height of six inches in protest, I want to say one thing. If you pull an egg out of the fridge and find it’s a rotten egg, curse the egg. But if you’re always pulling them out rotten, check your fridge is actually working.

The last month few months have seen a string of revelations on both sides of the Atlantic about tax avoidance schemes. In the UK people have been “mad as McCain” at Starbucks devising schemes to ensure that the money it makes selling mocha frappuccinos on the mean streets of Chelsea have barely contributed to the British exchequer.

In the UK we’ve learned that neither Amazon, nor Facebook, nor Google are paying the tax we think they should. The list goes on, and so will the story. Why? Because any company faced with the tax systems that currently exist would be simply idiotic to behave in the way that populist legislators would like them to (“Thirty-five percent tax, you say? Don’t mind if I do!”)

Part of the solution is, of course, to tighten loopholes in the tax code. However, with each loophole closed, there are likely to be others that will be found and exploited, so long as the system gives companies such strong incentives to do so. As Timothy Cook told the committee, at least part of the problem is a “corporate tax system, which has not kept pace with the advent of the digital age and the rapidly changing global economy.”

If states are to retain any control over multinational companies, multilateral agreements will be required, to ensure that these companies are not able to play the tax codes of different countries off against each other. There must also be realism about the fact that as the increasingly internationalized world breaks down the ties between companies and states, the maximum rate of tax that can be efficiently levied on the revenues of international companies is declining.

Rather than ranting against this development, we need to look at how our tax systems will have to adapt. The obvious implication is to lower corporate taxes and simplify the tax code to prevent the inefficiencies of complex tax avoidance schemes, and accept that governments will have to raise an increasing share of their revenue by taxing individuals rather than corporations. This is already happening: In 2011 individual income taxes raised $1.1 trillion from the U.S. government, while corporate taxes raised just $181 billion. This won’t please many people, but it’s worth remembering that companies are not a closed loop. Sooner or later individuals extract wealth from them in salaries or dividends, and then the taxmen will get their chance to claim their pound of flesh.