The American Disadvantage: Corporate Tax

American corporations should be complaining about their taxes. The United States has the highest corporate tax rate in the industrialized world – a 39 percent combined state and federal rate, and the highest statutory corporate tax rate among all OECD members. This is 14 percentage points higher than the OECD average of 25 percent (see Figure 1). Even with tax deductions, the effective rate paid by U.S. corporations is still seven percentage points higher than the OECD average.

Figure 1: OECD Statutory Tax Rates, 2013
Figure 1: OECD Statutory Tax Rates, 2013

The United State’s has a worldwide system of taxation, where corporate profits earned abroad are also taxed at 39 percent. However, American corporations are not required to pay U.S. taxes on overseas income until it is repatriated, or brought back, to the United States. In order to avoid a tax on foreign profits, U.S. multinationals invest, spend, or save foreign profits abroad. Through this process, U.S. corporations can defer U.S. taxes on foreign profits indefinitely by “locking out” these earnings offshore.

U.S. multinational companies are currently holding $2.1 trillion in earnings overseas to avoid the repatriation tax. For instance, Apple has booked $111.3 billion in offshore earnings, and keeps these funds and investments within the balance sheets of foreign subsidiaries. If Apple were to repatriate these earnings, it would owe $36.4 billion in U.S. taxes. Research from Harvard Business School estimates that the median size firm facing repatriation holds 47 percent of its total cash earnings abroad. Keeping cash abroad is not only bad for U.S. tax coffers, but it also limits corporate investment in American workers, factories, and production.

If firms choose to bring profits back to America, they must pay the difference between the amount of tax paid to the foreign jurisdiction and the amount that would be owed under the U.S. rate of 35%. Therefore, as foreign profits are generally taxed at below 25%, if not 15%, firms seeking to bring profits back to America face an incredibly high opportunity cost.  This incentivizes U.S. corporations to “lock out” offshore earnings from America. Over the past few years, deferred foreign earnings from U.S. multinationals have been increasing at an annual rate of 8 percent. Regardless of how the tax is assessed, America’s high repatriation tax rate distorts the flow of capital into America and decreases the after-tax value of domestic investments.

Foreign Takeovers and Tax Inversions

Keeping earnings “locked out” of America encourages not only foreign investment, but also the foreign acquisition of American multinationals. For instance, if Company A (an American company) wants to buy Company B (a U.S. multinational with foreign profits), Company A must value the repatriation tax cost of bringing back Company B’s profits/capital to America. However, Company C (a foreign company acquiring a U.S. firm) would face no tax by acquiring Company B, and therefore could spend Company B’s foreign profits anywhere in the world, or in America, tax-free. Therefore, a dollar of pre-tax earnings is worth more to a foreign acquirer than a U.S. firm. By acquiring a U.S. company in a more favorable tax jurisdiction, foreign companies can instantaneously create billions in value. Before a foreign company acquired the American pharmaceutical company Allergen, its CEO estimated that Allergen was worth $9 billion more in value to a foreign company.

Rising dramatically over the past few years, the gross value of foreign takeovers of U.S. companies is expected to surpass $400 billion this year. Throughout this process, according to the U.S. Senate Permanent Subcommittee on Investigations, foreign acquisitions due to tax benefits lead to a loss of American domestic investment, jobs, and tax revenue.

This is especially true for more profitable firms, where a Carnegie Mellon study found evidence that the more profitable a U.S. multinational is, the more likely a foreign corporation will acquire the firm rather than a U.S. firm. As such,  American companies seeking to avoid a foreign takeover, have increasingly turned to tax inversions, whereby  U.S. corporations re-incorporate themselves overseas to reduce the tax burden on income earned abroad. In the past decade, 47 U.S. companies have announced tax inversions, with 35 of these happening over the last five years. This includes some of the largest American corporations like Medtronic, AbbVie, Pfizer, Burger King, Monsanto, and Chiquita.

Over the past three decades, other industrialized countries have continuously lowered their corporate tax rates to remain competitive (See Figure 2). In the past four years alone, 75 countries have cut their corporate tax rates; this has led to a decline in both statutory and effective rates, and it is time for America to do the same. In order to fix this problem, America needs a more competitive tax rate with a territorial tax system that ends the current policy of making repatriation of profits to America inefficient.

Figure 2: Drop in OECD Average Tax Rates (1981 – 2010)
Figure 2: Drop in OECD Average Tax Rates (1981 – 2010)

Proposal 1. Lower the Corporate Statutory Rate to 25 percent

With the highest rate in the industrialized world, American corporations are basically competing at a disadvantage no matter what jurisdiction they are operating within. Ernst & Young estimated that if the corporate tax rate were 25 percent (the OECD average) over the past decade, U.S. companies would have been a net acquirer, rather than a net target of acquisitions. Furthermore, this would have kept 1,300 companies in the U.S. and led to a net increase of $769 billion in assets from foreign countries to America. By eliminating loopholes, the Joint Committee on Taxation, the Simpson Bowles Commission, and President Obama have proposed a revenue-neutral corporate tax rate between 25 to 29 percent, which should be enacted to level the playing field for American companies.

Proposal 2. Create a Territorial Tax System

Since 1989, 18 OECD nations and all G-8 nations (besides America) have adopted a territorial tax system. Within a territorial tax system, multinational companies only pay taxes on the income they earn within the nation’s jurisdiction. By encountering the same foreign tax rate as their competitors, the Congressional Research service believes a territorial system would help domestic corporations compete internationally.  It is estimated that an American transition to a territorial system would increase the amount of U.S. acquisitions of foreign firms by over 17 percent, while promoting domestic investment.

Benefits

The benefits of this dual proposal should be measured through the social welfare of not just multinationals, but also domestic companies and American citizens. The existing system creates a tax distortion and inefficiency. Foreign companies have an incentive to buy U.S. multinationals with the goal of generating value by reducing tax liability, instead of focusing on improving U.S. factory growth and wages. Current policy creates an economic barrier for American companies operating abroad who cannot maximize the productivity of their cash assets by bringing back profits to America.

When U.S. corporations can compete on a level playing field in the global market, research demonstrates that U.S. workers are the winner. Protectionists fear that a lower tax rate and territorial system of taxation would incentivize American companies to invest abroad and lead to a displacement in American jobs. However, a Harvard study examined how by isolating multinational firms, every 100 jobs added abroad by a U.S. multinational resulted in an average increase of 124 domestic jobs. Furthermore, the CBO estimates that labor currently bears 70 percent of the corporate tax burden. Reductions in corporate taxes are considered one of the most effective ways to boost capital investment and labor productivity; on the margin, extra corporate revenue is often dedicated to capital investment. The Joint Committee on Taxation demonstrated that compared to other tax cuts, a reduction in the corporate statutory tax had the greatest long-term effect on increasing capital stock and labor productivity. A 2004 repatriation holiday brought home $360 billion, and almost 40 percent of companies spent some of this on U.S. capital investment (See Figure 3).  Following the same ratio as the 2004 repatriation holiday, Douglas Holtz-Eakin, a former director of the CBO and McCain’s 2008 chief economic adviser, estimates a repatriation holiday today would bring back $765 billion and promote investment in American factories, equipment, and labor.

Figure 3: Uses of Repatriated Cash From 2004’s Repatriation Holiday
Figure 3: Uses of Repatriated Cash From 2004’s Repatriation Holiday

Conclusion

Reducing the corporate tax rate to the OECD average and moving to a territorial tax system would erase tax distortions and inefficiencies, allowing businesses to reinvest foreign profits in America. As Rep. Paul Ryan claims, “Our tax code is costing us jobs, depressing wages and chasing companies out of the United States.” With the goal of increasing domestic investment, the proposal can also decrease the rate of hostile foreign takeovers and corporate inversions. Today, the villain does not need to be fought with guns or artillery, but through legislation to reform an ineffective tax code that handicaps U.S. businesses and negatively impacts our economy. As Senator Portman said, “If there is a villain in this story, it is the U.S. tax code.”