A Simple Solution to Corporate Tax Inversions
You have to hand it to the U.S. government: It has managed, with a web of new rules and regulations, to increase the cost to corporations of moving their headquarters overseas without doing anything to stem the actual migration.
The announced merger last month between U.S. pharmaceutical giant Pfizer Inc. and smaller Ireland-based Allergan PLC - Allergan is buying Pfizer - put corporate inversions back in the headlines.
U.S. companies have been merging with smaller, overseas partners with increasing frequency to avoid the 35 percent corporate tax rate (39 percent with state tax included), the highest of the 34 nations in the Organization for Cooperation and Development.
In addition to its high tax rate, the U.S. is one of only six OECD countries that taxes domestic corporations' foreign profits, which are already taxed by the country in which they are earned. Such a system puts U.S. companies at a competitive disadvantage at a time when most countries have adopted a territorial tax system, which taxes domestic profits only. And it explains why companies are holding more than $2 trillion of profits overseas indefinitely instead of repatriating them.
The U.S. government has several options for fixing the problem. It can a) try to embarrass companies that invert by calling them "unpatriotic" or greedy; b) write complex new rules to discourage inversions; c) threaten to enact legislation making inversions illegal; or d) reduce the incentive to invert by lowering the corporate tax rate.
A 15-year-old of above-average intelligence would not hesitate before selecting d, which is the correct answer. But not the finance wizards at the U.S. Treasury, who prefer options a, b and c. In their infinite wisdom, these folks have managed to attack the symptoms without addressing the cause.
More than a dozen U.S.-based firms have announced tax-motivated inversion plans since the Treasury issued new rules in September 2014 to increase the cost, according to a forthcoming study by Jason Fichtner, senior research fellow at George Mason University's Mercatus Center. "Plus a lot of companies are choosing to incorporate outside the U.S.," he says.
Yet the rules keep coming. Just last month, Treasury Secretary Jacob Lew issued additional requirements making it more difficult for companies to invert and to take advantage of the tax benefit.
"It's like doubling down on a bad hand," Fichtner says. "You don't want to keep your money here? Fine, we'll make it worse."
Pfizer and Allergan are proceeding with their announced merger, which at $160 billion would be the largest inversion deal ever.
While it's true that few corporations pay the 35 percent statutory tax rate, the time and money they expend on tax avoidance could be spent in more productive endeavors.
What about the lost revenue if the U.S. were to reduce its corporate tax rate to the OECD average of 25 percent? The Tax Foundation ran estimates, using 10-year budget projections from the Congressional Budget Office as a baseline.
A reduction in the corporate tax rate to 25 percent would pare corporate tax revenue by $1.26 trillion over 10 years, based on static analysis. Using dynamic scoring, which takes into account macroeconomic effects, the revenue loss is cut in half, a result of faster growth and increased tax revenue from individual taxpayers. It turns out workers - yes, workers! - would be the biggest beneficiary of a reduction in the corporate tax rate. Without the incentive to move offshore, corporations would invest more in the U.S., which would boost growth, increase the capital stock, raise productivity, create jobs and produce higher wages.
Treasury is already losing revenue because of profits being parked abroad. Without profit-shifting, the U.S. would have a broader tax base - a bigger pie - that might produce more revenue for the Treasury even with a lower rate, according to some studies. (The Tax Foundation estimates cited above did not account for reduced profit-shifting.) A smaller slice of a bigger pie may turn out to be bigger than the old slice in dollar terms.
It boggles the mind to watch the government create loopholes and then try to close loopholes of its own making. Write a new rule, businesses will find a way around it. Impose a new tax, they will find ways to avoid it. Restrictions are never as successful as incentives when it comes to motivation.
Instead of creating inefficiencies through the tax code, the U.S. government could use it to benefit everyone. Lowering the corporate tax rate and moving to a territorial system would align the interests of corporate America, individual workers and the federal government in one fell swoop. It's a no brainer, which may explain why the government is having such a hard time figuring it out.
Caroline Baum is a contributor to e21. You can follow her on Twitter here.
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