Playing the role of Lewis Carroll’s Red Queen, the federal government advises U.S. companies that “…here we must run as fast as we can, just to stay in place. And if you wish to go anywhere you must run twice as fast as that.” While such advice may have helped Alice navigate her way through Wonderland, in the global economy it is a recipe for failure.
The combined federal and state corporate income tax in the U.S. is nearly 40 percent. And, the U.S. imposes this nearly 40 percent tax levy on the global earnings of U.S. based companies. Most Organization for Economic Co-operation and Development (OECD) countries only tax the profits earned in the home country – a Canadian based company only pays taxes on income earned in Canada, the Canadian government does not tax income earned elsewhere in the world.
The exceptionally high tax rate on global profits creates a burdensome competitive disadvantage for U.S. companies. Instead of facing a tax burden that can be three times as high as some of their competitors (companies located in Ireland), some companies are restructuring their operations via a corporate inversion.
A corporate inversion is a type of acquisition. Recent examples include the Burger King and Tim Horton’s deal, or the Pfizer and Allergan deal that is pending.
In the Burger King-Tim Horton deal, Burger King purchased Tim Horton’s and located the combined company in Canada where the corporate tax rate is 26.5 percent.
Burger King used to pay U.S. corporate income taxes on profits earned in Canada, Ireland, Japan, or anywhere else in the world. Now, post-merger, Burger King still pays a marginal tax rate of nearly 40 percent on its profits earned in the U.S. However, profits that are earned outside of the U.S. are not subject to U.S. taxes – a much more equitable and sensible tax basis.
Focusing solely on a company’s tax savings obscures the important economic issues at stake, however.
High and burdensome corporate income taxes diminish economic growth leading to less job creation, slower income growth, and less capital investment. Imposing a higher tax burden on U.S. companies compared to foreign owned companies compounds the damage by also putting U.S companies at a competitive disadvantage.
Corporate after-tax profits, adjusted for risk, will be similar across the major industrialized economies. Currently, U.S. companies face the highest marginal income tax rate on global profits and, without adjustments, will have lower after-tax profits than their competitors.
Unless U.S. companies are able to “run twice as fast” – an unlikely outcome – their ability to keep up with foreign competitors is being compromised. Therefore, not only is U.S. economic growth weaker, but the landscape is skewed to help non-U.S. companies grow at the expense of U.S. based companies.
Without help from Washington D.C. there are several ways U.S. companies can minimize this economic damage – however none are as beneficial as effective corporate tax reform.
For instance, many multi-national companies do not repatriate the income earned overseas. Currently it is estimated that $2.1 trillion of U.S. multi-national profits are held overseas. If not for the punitive U.S. tax code, much of this income would be reinvested in the domestic economy. However, based on the average OECD corporate income tax rate of 24.1%, any U.S. company that reinvested this income in the U.S. economy loses an additional 15-cents on the dollar. Penalizing companies for investing in the U.S. does not lead to greater domestic investment.
Corporate inversions represent another method for minimizing the economic damage caused by the punitive and uncompetitive U.S. tax code. A corporate inversion allows a company to remove the economic penalties that the U.S. government only levies on U.S.-based companies. Ironically, following the inversion the new company is now better positioned to invest in the U.S. economy than before the inversion.
Schemes, such as Hillary Clinton’s plans to impose an unprecedented exit tax on companies that are restructuring their operations through a corporate inversion, compound the harm. Companies engage in a corporate inversion as a best-response to the anti-growth U.S. corporate tax code. Imposing additional burdens on these companies raises the economic damage and forces them to compete in the global marketplace with additional competitive disadvantages.
Puzzlingly, some states are also wading into the issue. New Jersey’s Assembly, for instance, recently passed legislation to discourage inversions. The unintended consequence of such a measure would be to reduce state revenues as companies will be encouraged to seek out more friendly states in which to operate. California, which has seen a decade’s long flight of businesses, offers a prime example of the impact of such punitive policies.
Instead of further penalizing companies, the right way to reduce the number of corporate inversions is to eliminate the incentives driving companies to restructure in the first place. As an example, Rep. Devin Nunes’ American Business Competitiveness (ABC) Act, if enacted, would lower the top tax rate and transform the U.S. into a territorial based tax system (only taxes U.S. companies on income earned in the U.S.).
Effective corporate income tax reform, such as the ABC Act, eliminates the incentives for corporate inversions and the disincentives to economic growth created by the uncompetitive U.S. tax system. The result would be enhanced economic growth and opportunity. On the other hand, attempts to punish corporate inversions will not solve the competitiveness disadvantages facing U.S. companies and ultimately imposes greater economic harm.
Wayne Winegarden, Ph.D. is a Sr. Fellow with the Pacific Research Institute, a Contributing Editor to EconoSTATS, and a Partner in the consulting firm Capitol Economic Advisors.