How Best to Prevent the Corporations from Leaving?

May 09, 2014

Writing in today’s Wall Street Journal about the recent spate of U.S. corporations such as Pfizer that are leaving or planning to leave the U.S., Senator Wyden, Chairman of the Senate Finance Committee, correctly traces the problem to the fact that the U.S. has the highest corporate tax rate in the developed world. The Senator proposes “comprehensive tax reform” that would lower the corporate tax rate, but first he would block companies like Pfizer from leaving, starting yesterday.

The problem is there is already a law on the books that was supposed to prevent companies from leaving. Eventually, companies found a way around it, as they always will.

Passed in 2004, the American Jobs Creation Act says U.S. corporations cannot “invert”, i.e. move their corporate headquarters abroad for tax purposes through a merger with a foreign company, unless the foreign company owns at least 20 percent of the combined company. Additionally, the law contains penalties on executive pay if the foreign company owns between 20 and 40 percent of the combined company. Senator Wyden proposes to raise the 20 percent threshold to “at least 50 percent”, i.e. only allow inversions in cases where the foreign company owns at least 50 percent or more of the combined company. President Obama proposed something similar earlier this year, and Senator Wyden would make it retroactive to yesterday.

Why stop at 50 percent? Why not raise it to 100 percent? That way all inversions would be illegal and any foreign company that buys a U.S. company would automatically be subjected to U.S. corporate tax on all of its earnings even if earned entirely outside the U.S. Sounds like a great way to “broaden the base.”

The problem is that the U.S. would become even less attractive as a corporate headquarters. Already the U.S. has lost 44 companies from the Fortune Global 500 list since the American Jobs Creation Act was passed. The Jobs Act itself wasn’t the principle cause, the high corporate tax rate was. But the Jobs Act added complexity to an already overly complex system of taxing U.S. corporations on their worldwide earnings. Meanwhile, most industrialized countries were simplifying their tax codes and attracting multinational corporations by a) lowering their corporate tax rates, and b) switching to territorial taxation, which largely exempts from domestic taxation the foreign earnings of multinationals.

Senator Wyden’s plan would lower the corporate tax rate to 24 percent, but it would move away from territorial taxation, subjecting the foreign earnings of U.S. multinationals also to 24 percent on a current basis, i.e. without deferral. New Zealand tried such a system of worldwide taxation without deferral and it ended badly, so they finally switched to territorial taxation in 2009. Every other developed country has either territorial taxation or deferral, so Wyden’s plan would put U.S. multinationals at a severe disadvantage. Further, Wyden’s plan would sharply raise taxes on U.S. manufacturers and other capital intensive industries by lengthening depreciation schedules. In the end, Wyden’s plan would raise the cost of capital, even after lowering the headline corporate tax rate.

This is how Senator Wyden describes it:

A corporate tax rate that creates a favorable investment climate and reduces the incentive to game the system is critical to successful reform. The bipartisan tax-reform bill I introduced in the Senate with Republican Judd Gregg in 2010, and reintroduced with Republican Dan Coats and Democrat Mark Begich in the last Congress called for a single flat corporate rate of 24%. Where the rate ends up depends almost entirely on the American business community's willingness to pitch in by closing loopholes. I continue to believe that reducing the current corporate tax rate by approximately one-third will bring the U.S. in line with other developed countries that long ago recognized the need to evolve their policies to compete globally while growing their domestic economies.

Senator Wyden is right to focus on the high U.S. corporate tax rate, but that is not the only feature of the corporate tax. The tax base matters. Cutting the rate by a third but doubling the base to which it applies is a tax increase. Most industrialized countries largely exclude foreign earnings from the corporate tax base. Most industrialized countries let businesses write-off investments faster than they can in the U.S. These are not “loopholes” but broad-based ways in which these countries compete for business investment and jobs. And, of course, these countries have also cut their statutory corporate tax rates. The combination has sharply lowered their effective corporate tax rates. If the U.S. wants to compete, it must do the same.

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