A wizened soul who worked in the bowels of the United States Treasury in the Eisenhower administration once explained to me all that is wrong with the U.S. tax code.
He opined that every so often politicians perceive—rightly or wrongly—a “problem” with the tax code and resolve to fix it. The fix seems elemental taken alone: If we want more of a good thing we should tax it less, or tax it more if it is a bad thing—or disallow it all together. But do this a couple dozen times a year, and in a mere 28 years—the time that’s elapsed since passage of the 1986 Tax Reform Act—we are left with a profoundly convoluted tax code that is complicated, at odds with itself, and not at all amenable to economic growth. If we took a holistic approach to the tax code and endeavored to create one with few warts but geared towards economic growth, the retired Treasury Mandarin growled, we would have a tax code that made sense and did much less harm to the economy than the one we’re presently saddled with.
We may be about to make such a mistake once again by disallowing corporate “inversions” that result in a U.S. company—through either a merger, takeover, or some ambiguous way station between the two—effectively changes its domicile to another country. The Administration has seized upon this in a major way, with Treasury Secretary Jacob Lew—never a man prone to subtlety—accusing such corporations of not being patriotic, with a gaggle of the administration’s hallelujah chorus in the press singing the same tune. The Senate Finance Committee held a hearing week on the topic as well.
The inclination of anyone who pays attention to the goings-on of Congress is to dismiss the chance of any legislation becoming law as slim and none, given the ever-widening chasm between Harry Reid and the Democratic Senate and John Boehner and the Republican House of Representatives. But some Congress watchers suggest that a spate of inversions in the near future could put pressure on fiscal hawks facing reelection to declare their support for banning future inversions.
That would be a grievous mistake. Stopping inversions by merely outlawing it, without addressing the problems with the tax code pushing multinationals to relocate in the first place, is a short-sighted approach that would make U.S. businesses less competitive and chase commerce elsewhere.
Flaws in our Corporate Tax Code
The main reason inversions make sense is because we have sky-high corporate tax rates. The U.S. currently has the highest corporate tax rate of the 32 developed nations that belong to the Organization of Economic Cooperation and Development, with a top rate (federal plus state) averaging nearly 39 percent—twice the average corporate rate in Europe. In the last twenty years literally every single OECD country has reduced its corporate tax rate, save for the United States.
The United States is also one of the few developed countries that taxes its companies’ foreign profits as well. The ostensible purpose for doing so is to eliminate any tax incentives for companies to move operations abroad. However, reducing a complex decision such as where to locate production to a pure tax minimization strategy is facile: companies often choose to put some production in foreign countries for a host of reasons. Most often, the most important factor in moving operations abroad is to produce closer to the customers, which reduces transportation costs and can also lessen the exposure to risk from fluctuations in exchange rates.
Imposing a sharply higher tax rate on U.S. businesses operating abroad than their foreign-based competitors puts U.S. companies at a competitive disadvantage. A tax counsel for a Fortune 100 company told me he estimates that their foreign competitors pay a tax rate about five percentage points below theirs in overseas markets. Another remarked ruefully that corporate headquarters located in the United States are here solely because of an historical accident.
American companies operating abroad can just pay the foreign corporate income tax on their profits and avoid U.S. taxes as long as they don’t bring their profits back into the U.S. Many do precisely this—U.S. corporations have over $2 trillion of profits invested abroad. Sometimes companies invest this capital in bonds or other liquid assets, but many companies in this situation make more permanent investments abroad, such factories or stores or other productive assets. That money will never return to the U.S.
Other companies have attempted to reduce their tax obligations and remain competitive by merging with another company and becoming a foreign entity that is subject to the tax laws of another country. No one in the United States wants this to happen: it deprives the U.S. of revenue and it can also destroys jobs. When Budweiser and the Miller Brewing Company were both taken over by foreign concerns—transactions that made sense largely for tax reasons—the communities not only lost a wealth of well-paid white-collar jobs but also the cachet and munificence that such corporations typically provide in their hometown.
Lew’s patriotism angle is truly the last refuge of a scoundrel: if we hold corporate managers to make decisions for what’s best for their owners then they have a fiduciary obligation to pursue an inversion if it would save their company money.
And it’s not necessarily the case that Treasury loses money from all inversions. A company with a foreign domicile could bring foreign-sourced profits back to pay dividends (which are taxed) or to invest in new projects, which would generate higher future U.S. profits and more taxes as well.
Don’t Spackle a Crater
The fix is obvious: we should lower our corporate tax rate to a level that’s competitive with the rest of the world, and stop taxing profits earned by U.S. corporations operating abroad, just like most other countries. Dave Camp’s comprehensive tax reform plan would take the corporate tax rate down to 25 percent, mostly paid for by getting rid of corporate tax deductions and exclusions, while conforming to the rest of the world and ending the taxation foreign-sourced income.
Doing so would end any incentive for U.S. companies to move their headquarters abroad or keep their foreign profits out of the U.S. It would also create jobs in the U.S.: by making U.S. firms more competitive abroad, they will be more successful competing in the global marketplace.
Regardless of the tax rate, Pepsi (to cite just one company with a large overseas presence) is never going to make coke and potato chips in the U.S. and sell them abroad. However, if it faced a lower effective tax rate on foreign profits it could expand foreign operations. Doing so would create jobs in Pepsi’s headquarters for IT professionals, marketing and media professionals, logistics experts, and a host of other support staff—precisely the kind of high-paying skills that we want for our economy.
The White House could never countenance to the Camp plan, of course: for six years it has complained that U.S. corporations are exporting jobs abroad, and that companies doing business overseas should be punished for their perfidy. Their idea of corporate tax reform is to make a modest cut in tax rates and eliminate the ability for U.S. companies to defer paying taxes on foreign income until it returns to the U.S.
The Obama tax “reform” is breathtaking in its cynicism, purporting to offer something close to what most tax economists think makes sense but combined with a poison pill that would negate much of the good that would come from a lower tax rate.
To its credit (I think) the administration doesn’t pretend that their corporate tax reform would fix their perceived inversion crisis, since abolishing deferral would make the problem worse. Instead, they want a law to ban inversions from taking place. It’s a recipe for tax code disaster—yet another short-term hole plug in a tax code replete with them.
In the meantime the rest of the world continues to lower its corporate tax rate in a quest to create jobs domestically and remain competitive globally. There have been nearly 100 incidences of an OECD country reducing its corporate tax rate in the last fifteen years, the vast majority of which were not “paid for” by a commensurate tax increase elsewhere.
Congress is not in a hurry to legislate this non-solution of banning corporate inversions, and the White House knows it: It’s flogging this dead idea to generate some enthusiasm from its union base and paint a picture of Republicans as being unfriendly to the working man ahead of the November elections. That their solution would likely destroy jobs if enacted is of little import in their political calculus.
The U.S. economy would be better off if U.S. corporations did not have an incentive to relocate abroad: the way to fix that would be to simply removing the incentives to do so by lowering corporate tax rates and reforming how we tax foreign-sourced income, preferably in the context of a comprehensive tax reform.
Ike Brannon is a Senior Fellow at the George W. Bush Institute and President of Capital Policy Analytics, a consulting firm based in Washington, DC.