Foundation

Where Have All the Corporations Gone?

by Brandon Arnold / /

Despite the repeated efforts of the U.S. Treasury Department, several corporations are taking steps to relocate their headquarters to other countries. Others are considering similar moves. Many of these moves occur in the form of an “inversion,” in which an American corporation purchases a foreign-owned business and reconstitutes itself as a new foreign company. This practice has been the source of some rare bipartisan accord, as politicians from across the ideological spectrum have heaped scorn upon these “unpatriotic” companies. However, when it comes to proposing solutions, there is considerable disagreement.

Though not a new problem, the rate of inversions has seemingly quickened and Congress can no longer afford to stand by as the corporate tax base erodes.[1] Policymakers must create a better tax climate that will help retain existing businesses and encourage the formation of new firms. This Issue Brief will provide policymakers an overview of the root cause of the problem and offer solutions to fix the Tax Code and the related, growing problem of corporate flight. 

A Broken Tax Code

From Wall Street to the White House, there is broad agreement that the current Tax Code is a major culprit behind corporate inversions. In short, the Tax Code is a disaster – the rate is too high, the targeted tax provisions are too numerous, the compliance burden is excessively onerous, and the worldwide basis has trapped revenues abroad. It has created a strong economic incentive for businesses to relocate overseas to countries with more favorable tax climates. This is an issue that policymakers must address – and must make certain to do so in a manner that alleviates, rather than exacerbates the problem. 

Step One: Lower the Rate, Broaden the Base

The United States currently has the highest statutory tax rate in the industrialized world. Our combined federal, state and local rate of approximately 39 percent is more than triple that of Ireland and nearly double the rates of the United Kingdom, Switzerland, Poland and Finland.[2]

As has been the case for several years, President Obama’s annual proposed budget calls for the current rate of 35 percent to be dropped to 28 percent.[3] This would be a step in the right direction, but with the current Organization for Economic Cooperation and Development (OECD) simple average at approximately 24.7 percent, the President’s proposal would not go far enough. To encourage greater competitiveness and economic growth, the rate should be reduced to at least 25 percent – preferably far lower.

The reason for such a step is clear – the lower the rate, the more economic growth and job creation. The Tax Foundation’s economic model estimates that adopting a rate of 25 percent would increase GDP by 2.3 percent and create 425,000 new jobs. But dropping the rate to 15 percent – thus matching Canada’s federal rate – could increase GDP by 4.3 percent and yield 786,000 new jobs.[4]

The statutory rate is only part of the problem. Many have argued that policymakers should be more attuned to the effective rate – the amount that companies actually pay as a percentage of total taxable income. They argue the average effective rate is much lower than the statutory rate due to the large number of credits and deductions that exist in the Tax Code.

The average effective tax rate is a useful indicator, but it, too, tells only part of the story. A 2013 analysis in The New York Times illustrated the wide discrepancy in effective tax rates for various companies in the S&P 500 from 2007 to 2012. It found that the average effective rate across the index was 29.1 percent. However, because the Tax Code provides economic advantages to some types of companies but not to others, the effective tax rate for individual firms varies wildly. Nine businesses paid an effective rate of zero percent while several others paid rates over 70 or even 80 percent. A comparison of industries showed that on the low end of the spectrum, utility companies paid an average effective rate of 12 percent while the energy and insurance sectors paid 37 percent and 51 percent, respectively.[5]

As noted in a 2015 Tax Foundation study by Jack Mintz and Duanjie Chen, “the wide variation in effective tax rates among different business activities in the United States undermines productivity. With a non-neutral corporate tax system, capital is allocated to tax-favored activities with other activities subject to significantly high effective tax rates.”[6] This essentially means that the Tax Code is picking winners and losers rather than allowing market forces to determine how companies should allocate their resources. 

The Mintz-Chen paper provides a detailed evaluation of another important measure of tax competitiveness – marginal effective tax rates, which are the rates that companies face as they consider making additional investments and capital purchases. This is a critical indicator of a country’s entrepreneurial climate as it can play a large role in determining if – and where – a business chooses to grow and expand. On this indicator, the U.S.’s rate of 35.3 percent is far out of line with the OECD average of 19.6.  By comparison, our Canadian neighbors have a rate of 18.6 percent – just over half of the U.S. rate. This is extremely problematic – as Mintz and Chen note, the “U.S. has been among the least tax-competitive countries for capital investment over the past nine years.”[7]

In recent years, many industrialized nations have reduced their corporate tax rates to promote economic growth, while Congress and state governments in the U.S. have done essentially nothing. According to Mintz and Chen:

“On average, the G7 countries have reduced the corporate income tax rate by 4.4 percentage points from 2005 to 2014. The emerging G20 countries have, on average, reduced corporate tax rates by 3.1 percentage points, from 29.3 percent in 2005 to 26.2 percent in 2014. Countries in the OECD have reduced corporate tax rates by 2.8 percentage points. Meanwhile, the U.S. statutory corporate tax rate has dropped by 0.2 percent, due to corporate tax changes at the state level. In some countries, part of the corporate tax relief has been offset by the removal of certain tax preferences.”[8]

Regardless of which type of tax rate calculation is used, it’s clear that the United States has a Tax Code that has hurt the competitiveness of our businesses. This problem is compounded by the hefty compliance burden that the Tax Code imposes on companies. A 2014 study by the National Association of Manufacturers showed that tax compliance costs each American business $960 per employee annually. The total cost of tax compliance to all firms is a staggering $159 billion.[9]

Congress must act to drastically simplify the Code while lowering rates if it wants to retain existing companies and encourage new ones to develop and expand.

Step Two: Implement a Territorial System

One of the biggest problems with the current Tax Code is that it applies U.S. taxes on a worldwide rather than a territorial basis. This means a company must pay U.S. taxes on overseas earnings when it repatriates these profits. The result is that many multinational corporations opt to keep foreign earnings abroad due to what is described as the “lockout effect.” The magnitude of this problem is quite large. A study by the liberal Citizens for Tax Justice estimated that U.S. companies currently hold $2.4 trillion in offshore profits.[10]

Some on Capitol Hill have proposed short-term policies that would encourage corporations to bring these earnings to the U.S. A “repatriation holiday,” for instance, would offer a limited window during which a reduced tax rate would apply to foreign earnings when they are transmitted from foreign holdings to the domestic parent company.  Such a policy would deliver additional tax revenues to the U.S. Treasury, but would fail to fix the underlying problem and provide comparatively modest economic benefits. As the Congressional Budget Office noted in a 2011 report, a similar provision was enacted as part of the American Jobs Creation Act of 2004 and generated little in the way of economic stimulus:

“While empirical evidence is clear that this provision resulted in a significant increase in repatriated earnings, empirical evidence is unable to show a corresponding increase in domestic investment or employment by firms that utilized the repatriation provisions.”[11]

A short-term fix is insufficient; especially as the U.S. stands to be an outlier should it maintain its current basis structure. As the Tax Foundation’s Kyle Pomerleau notes:

“The United States is one of only six industrialized nations (of 34 OECD members) that taxes domestic corporations on a worldwide basis. In the past fifteen years, thirteen OECD countries have moved to a territorial system that exempts all or most of active foreign earned income from domestic taxation.”[12]

Congress should follow the global trend and convert to a territorial basis.

Step Three: Don’t Make the Problem Worse with Targeted Approaches

Corporate tax reform is essential, but achieving it will continue to be a challenging, lengthy task. In the interim, some legislators and politicians have proposed more targeted approaches to curtailing corporate inversions. Unfortunately, most of these options would exacerbate the problem in the long term and should be avoided.

For instance, during her campaign for President, former Senator Hillary Clinton has proposed applying an “exit tax” to corporations that pursue an inversion. She has similarly called for a crackdown on “earnings stripping,” in which a U.S. subsidiary company borrows from its foreign parent and subsequently deducts interest payments on the loan from its overall tax base.

Others have called for statutory changes to the foreign ownership rules pertaining to inversions. Currently, at least 20 percent of a company’s stock must be held by non-Americans. Some have proposed increasing that threshold to 50 percent, which would make the inversion process more difficult and costly.

The problem with all these proposals is they double-down on the root cause: we have a punitive Tax Code. Making it more punitive might provide a short-term hiatus from inversions and relocations, but will only delay the inevitable and ultimately, worsen the situation, as recent evidence demonstrates.

In 2004, the American Jobs Creation Act included a provision to tighten foreign ownership rules. This effectively eliminated the tax benefits of certain types of inversions, but hardly solved the problem.

As noted in a recent report by the Congressional Research Service:

“The post-2004 approaches to inversions no longer involved countries such as Bermuda and the Cayman Islands, but larger countries with substantial economic activity such as the UK, Canada, and Ireland. The UK, in particular, has become a much more attractive headquarters.”[13]

When the 2004 law proved ineffective, the U.S. Treasury acted unilaterally in 2012 to scale back a statutory exemption that allowed inversions to take place if a business had substantial business activity in the country to which it relocated.

After this attempt proved inadequate, the Treasury Department responded in September 2014 and November 2015 with additional regulatory changes and promises of more to come. Indeed, in April of this year, Treasury issued new regulations that change the rules pertaining to the ownership of foreign stock and further restrict earnings stripping.[14]

Policymakers must understand that patchwork attempts to fix the inversion problem simply will not work. They may enjoy temporary success, but the trend will continue, as noted by an article last year in the Wall Street Journal:

“Their deals show that, despite Washington’s efforts [in 2014] to protect the U.S. corporate tax base, revenue keeps trickling out. Since the Treasury rules went into effect last fall, 55 U.S. companies have been sold to or targeted by foreign buyers, many of those acquirers formed by inversions themselves, according to FactSet.”

Even worse, these targeted approaches come at a cost. Forcing a few companies to remain in the U.S. might earn politician’s plaudits; but it also constrains future economic growth while sending a counterproductive message to would-be entrepreneurs. Consider that each year about 5 million new businesses are formed in the United States – a figure that has unfortunately plateaued over the past decade.[15] Fewer new businesses and start-ups will originate in the United States if we fail to offer an environment that encourages growth and expansion. No law passed by Congress or regulation issued by Treasury can prevent a new company from choosing its original country of incorporation.

Conclusion

The Tax Code desperately needs a complete overhaul. Rates must be lowered, provisions must be eliminated, and a shift to a territorial system must occur. Short-term, targeted approaches may yield the occasional “success” story, but in the long run, will only serve to worsen the business climate and deter the formation of new companies.

Corporate inversions are a clear signal to policymakers: it’s time to fix the Tax Code and restore an entrepreneurial climate that fosters growth, job creation, and prosperity.

 


a Wallace, Gregory, “More companies bail on U.S. for lower taxes,” CNN.com, July 7, 2014.

http://money.cnn.com/2014/07/07/news/economy/tax-advantage-inversion/.

b Organization for Economic Cooperation and Development, OECD.Stat, “Table II.1. Corporate tax rate,” accessed on April 8, 2016. http://stats.oecd.org//Index.aspx?QueryId=58204.

[3] Office of Management and Budget, “Budget of the U.S. Government: Fiscal Year 2017,” p. 51. https://www.whitehouse.gov/sites/default/files/omb/budget/fy2017/assets/budget.pdf.

[4] Hodge, Scott, “The Economic Effects of Adopting the Corporate Tax Rates of the OECD, the UK, and Canada,” Tax Foundation, August 20, 2015. http://taxfoundation.org/article/economic-effects-adopting-corporate-tax-rates-oecd-uk-and-canada.

[5] Bostock, Michael, et al., “Across U.S. Companies, Tax Rates Vary Greatly,” The New York Times,” May 25, 2013. http://www.nytimes.com/interactive/2013/05/25/sunday-review/corporate-taxes.html.

[6] Mintz, Jack and Chen, Duanjie, “U.S. Corporate Taxation: Prime for Reform,” Tax Foundation, February 4, 2015. http://taxfoundation.org/article/us-corporate-taxation-prime-reform.

[7] Mintz, Jack and Chen, Duanjie, “The U.S. Corporate Effective Tax Rate: Myth and the Fact,” Tax Foundation, February 6, 2014. http://taxfoundation.org/article/us-corporate-effective-tax-rate-myth-and-fact.

[8] Mintz, Jack and Chen, Duanjie, “U.S. Corporate Taxation: Prime for Reform,” Tax Foundation, February 4, 2015. http://taxfoundation.org/article/us-corporate-taxation-prime-reform.

[9] Crain, W. Mark and Crain, Nicole V., “The Cost of Federal Regulation to the U.S. Economy, Manufacturing and Small Business,” National Association of Manufacturers, September 10, 2014. http://www.nam.org/Data-and-Reports/Cost-of-Federal-Regulations/Federal-Regulation-Full-Study.pdf.

[10] Citizens for Tax Justice, “Fortune 500 Companies Hold a Record $2.4 Trillion Offshore,” March 3, 2016. http://ctj.org/pdf/pre0316.pdf.

[11] Marples, Donald J. and Gravelle, Jane C., “Tax Cuts on Repatriation Earnings as Economic Stimulus: An Economic Analysis,” Congressional Research Service, December 11, 2011. Accessed at https://www.fas.org/sgp/crs/misc/R40178.pdf.

[12] Pomerleau, Kyle, “How Much Do U.S. Multinational Corporations Pay in Foreign Income Taxes?,” Tax Foundation, May 19, 2014. http://taxfoundation.org/article/how-much-do-us-multinational-corporations-pay-foreign-income-taxes.

[13] Marples, Donald J. and Gravelle, Jane C., “Corporate Expatriation, Inversions, and Mergers: Tax Issues,” Congressional Research Service, November 30, 2015. Accessed at https://www.fas.org/sgp/crs/misc/R43568.pdf.

[14] U.S. Treasury Department, “Fact Sheet: Treasury Issues Inversion Regulations and Proposed Earnings Stripping Regulations,” April 4, 2016. https://www.treasury.gov/press-center/press-releases/Pages/jl0404.aspx.

[15] U.S. Census Bureau, Business Dynamic Statistics, Establishment Characteristics Data Tables, accessed March 6, 2016. http://www.census.gov/ces/dataproducts/bds/data_estab.html.



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