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.