The merger between U.S.-based pharmaceutical company Pfizer Inc. and the Irish-based Allergan has sparked the predictable outrages and gnashing of teeth. For example, Senate Minority Leader Harry Reid—whose home state of Nevada has neither a corporate nor individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. and may benefit more from domestic “inversions” than nearly any other state—was quoted by the Washington Post as saying “It’s time for Congress to get serious, close the loopholes, and prevent these kind of inversions from happening in the future.”
While lawmakers like Reid are busy decrying Pfizer’s self-help taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform, they really have no else to blame but themselves for this and other recent inversions. After all, it has been well known that the U.S. corporate tax rate levies the highest in the industrialized world since April 1, 2012 when Japan—which previously levied the highest corporate tax rate—lowered its rate well below ours.
But the signs of America’s declining corporate competitiveness goes back to at least 1992. That was the year in which the simple average corporate tax rate of the other nations within the Organization for Economic Cooperation and Development (OECD) first fell below the combined federal-state U.S. corporate tax rate of 39.1 percent. Even when we account for country size, the U.S. rate has been above the weighted average of the other OECD nations for nearly a generation.
But as Tax Foundation economist Kyle Pomerleau has shown, the U.S. corporate rate is now miles above the global average, not just the OECD nations. The U.S. now has the third highest corporate rate in the world, only Chad and the United Arab Emirates levy higher tax rates on corporations. Chad? How embarrassing is that?
One of the reasons the U.S. tax system ranked 32nd of the 34 OECD countries scored the Tax Foundation’s International Tax Competitiveness Index is that we are one of the remaining few countries to impose a worldwide tax systemA worldwide tax system for corporations, as opposed to a territorial tax system, includes foreign-earned income in the domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. , which taxes the foreign profits of American companies at our uncompetitive tax rate even after those profits have been taxed by another nation where they were earned. Meanwhile, the global trend is toward territorial tax systems that impose domestic taxes only on a firm’s domestic profits, and doesn’t try to double-tax that firm’s foreign profits.
The solution truly is simple, we need to cut the corporate rate immediately to 20 or 25 percent and move to a territorial tax systemA territorial tax system for corporations, as opposed to a worldwide tax system, excludes profits multinational companies earn in foreign countries from their domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. .
As I have written elsewhere, it is misguided to claim that cutting the corporate tax rate is “too expensive,” meaning, it will cost the Treasury too much money. The flight of Pfizer and other U.S. companies seeking friendlier tax environs is proof that our 35 percent corporate tax rate is already costing the Treasury revenues.
A recent paper by my colleague Gavin Ekins, Ph.D. highlights several studies that have tried to measure the amount of revenues the Treasury loses because of profit-shifting by multinational firms. Some have estimated that the profit-shifting caused by our high corporate tax rate has reduced federal tax revenues by as much as 35 percent.
If that is true, then it is also true that cutting the corporate tax rate would reduce the amount of profit-shifting and, thus, keep more profits in the U.S. to be taxed. In other words, the Walmart approach to tax policy could actually lead to more revenues than the Neiman Marcus approach.
Indeed, using the methodology employed in these academic studies, Ekins estimates that cutting our corporate tax rate to 25 percent could increase the amount of corporate income retained in the U.S. to such an extent (by as much as $278 billion), that the lower rate would actually raise as much as the current higher rate. As in retail, volume sales can generate more profits than higher prices.
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Table 1. Estimated Annual Revenue Impact of a Corporate Tax Cut with Income Shifting (Model 1), in Billions of Dollars |
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| Corporate Income Tax Rate | Baseline Corporate Revenue | Income Shifted Due to Lower Rate | Additional Corporate Revenue Due to Income Shifting | Total Corporate Tax Revenue |
| 35% | $242 | $0 | $0 | $242 |
| 30% | $208 | $143 | $43 | $251 |
| 25% | $173 | $278 | $70 | $243 |
| 20% | $138 | $369 | $74 | $212 |
| Note: Tax rates are statutory corporate tax rates. Tax revenue and income estimates are in millions of 2012 dollars. Source: Author's calculations. |
To those who worry about moving to a territorial system, the fact is that the U.S. already has a territorial tax system, but for foreign-based companies only. The U.S. taxes foreign-based companies only on their U.S. sales and does not tax their international profits. So by maintaining a worldwide tax system in the U.S.—or even the “hybrid” system advocated by the White House—Washington is, by definition, putting American firms at a competitive disadvantage. Moving to a territorial system levels this playing field.
I’m sure we are going to hear more calls to enact legislation to prevent these kinds of mergers. But this would be a lot like the New York legislature trying to prevent retirees from moving to Florida to escape New York’s high taxes. There is just something unseemly about building legal walls to prevent people and companies from voting with their feet—especially when the real solution is so obvious and achievable. All it takes is political will.
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