Fill out the brief form below for access to the free report.

The Tax Reform Chasm Widens

Article by Ike Brannon December 26, 2013 //   9 minute read

If the cliché is true that D.C. is simply high school writ large, then the annual dinner of the Tax Foundation is its party for nerds who can’t get dates to the prom.  Every November the wonkiest of the tax wonks don rented tuxedos and gowns to celebrate their own over cocktails and gossip about the latest developments in depreciation schedules.

Most years the party is a fun one — tax geeks (I count myself among their number) seem to take an even greater pleasure from an open bar than most people, in my experience. However, this year’s event was an uncharacteristically somber affair, largely owing to the release of the Senate Finance Committee’s draft document on international business tax reform by Senator Max Baucus earlier in the day.

Even with only a few hours to digest the report, everyone attending the shindig realized that for a tax reform effort already on life support, this proposal amounted to a pillow placed over its gasping face. The report laid out a number of proposed changes to the tax code that would, if enacted, dramatically increase the burden on companies that do business abroad and raise substantial revenues for the Treasury. Neither of these outcomes even remotely comports with what Republicans want out of tax reform, which is first and foremost to make U.S. businesses more competitive.

While members of both parties can agree on the broad generalities of tax reform, comity dissipates when the discussion gets into the specifics. The Baucus document laid bare the fact that disagreements on tax reform between the two parties go beyond merely the desire to protect various constituencies (although there’s plenty of that) and touch upon some fundamental philosophical distinctions between the two political parties. Nowhere are these differences more stark than when it comes to taxing U.S. multinationals.

Does Global Expansion Create Domestic Jobs?

U.S. companies that do business abroad currently face higher tax rates than their global competitors. Not only does the U.S. have the highest business tax rate in the developed world, but it also imposes that rate on the income U.S. businesses earn abroad, unlike most other developed countries. Whether it makes sense to tax U.S. businesses on foreign income, above and beyond the taxes they pay to the foreign governments of countries in which they operate, depends on why one thinks U.S. businesses locate operations abroad in the first place. Is it mainly to dodge high tax rates or wages at home, or because it’s a cost-effective way to service overseas markets? Senator Baucus and most Democrats believe it’s the former. After all, most Democratic campaign proposals to “bring jobs back home” involve increasing taxes on the foreign activities of U.S. corporations. 

The problem with imposing the high U.S. tax rate on all operations by U.S. businesses across the globe is that it results in U.S. companies facing sharply higher taxes than their foreign competitors.

To ameliorate this cost disadvantage, the tax code allows U.S. companies to defer paying U.S. taxes on foreign profits until the money is repatriated. Consequentially, there is a lot of money (an estimated $2 trillion) that U.S. companies have invested abroad — some permanently, in the form of factories, research facilities and the like, and the rest parked in banks or short-term securities.

The Baucus plan would essentially abolish companies’ ability to defer taxes on their overseas profits and impose a tax of 20% both on future profits as well as the $2 trillion parked abroad. The revenue from the tax on foreign income in future years would be dedicated to lowering the corporate tax rate, but the tax on the $2 trillion would not be used to offset taxes elsewhere.

U.S. multinationals get socked in other ways as well. For instance, most major multinationals have their own financing arms to supply credit to foreign customers in countries without well-developed financial markets. The Baucus proposal would sharply increase the domestic tax obligation for these entities as well.  Ditto companies that have significant research and development facilities abroad — something that restrictive U.S. immigration laws has inadvertently encouraged, incidentally.

They Took Our Jobs

While taxing multinationals for “shipping jobs abroad” may have a nice populist ring to it, there’s plenty of evidence to suggest companies move operations overseas mainly because it is often cost-effective to produce goods close to the markets where they will be sold.

This is plainly evident for low-cost, low-margin goods. Pepsi’s market ascendancy in Eastern Europe, for example, would have been stillborn had the company been forced to ship soda and potato chips a few thousand miles to sell to those markets, adding greatly to costs.

But transit costs matter much less for high-margin, high-value-added goods, and that is where the U.S. has a comparative advantage. For example, while Caterpillar has opened up plants in Asia to build low-end tractors for the Asian market, it continues to produce its high-cost equipment near its research and development center in Mossville, Illinois.

There’s also no real evidence that using the tax code to punish U.S. companies for locating operations overseas will result in net new jobs in America. For starters, jobs are created in the U.S. by the overseas activities of domestic companies — but they’re not union jobs. The problem for Democrats is that the domestic jobs that result from overseas production — jobs in IT, marketing, logistics, and other highly-skilled tasks that would be done at a corporate headquarters — don’t consist of their usual constituencies.

Also, expanding the market in low-margin goods made abroad can increase demand and sales for the high-margin goods made domestically.

A natural economic response from domestic companies to a punitive corporate tax code in the U.S. is to evade it entirely by ceasing to remain a U.S. company. The increasing prevalence of foreign countries buying U.S. firms — an almost weekly occurrence in the biotech field these days — is a direct response to the tax advantages of basing operations outside the U.S. for research-intensive industries.

While blue-collar, traditionally economic voters may not appreciate the presence of the types of high-paying, high-skilled jobs that come with having a major corporation’s headquarters in their community, they are almost assuredly cognizant of the civic benefits of having such a presence amongst them. Residents of St. Louis and Milwaukee — cities that saw their most iconic employers purchased by foreign entities in the last decade — have noticed a decline in the corporate subsidies that Anheuser-Busch and Miller have infused their communities with in the past.

In the last couple of years the OECD — whose members include the 32 most developed economies on the globe — have been quite aggressive in finding and closing various tax loopholes that the wealthy all over the world have exploited to hide their income. The days of stashing money in a Swiss bank account and keeping it far from the eyes of the IRS are over. The OECD has also been systematically identifying and fixing the myriad loopholes that various multinationals have become adept at exploiting to keep their own tax rates artificially low. If we want to extract more money from companies who do business abroad, this is the best way to do it — in a multilateral way that doesn’t disadvantage domestic companies.

Instead, Senator Baucus borrowed a page from the Obama Administration’s proposed budget and offered a path that furthers the gap between the tax burden of U.S. corporations and their international competitors.

It’s become a trite cliché to mock Congress for its inaction and suggest that sensible Republicans and Democrats could resolve their differences by getting in a room together and earnestly discussing the issues at hand. However, the difference between the parties on tax reform, as well as how the economy works, is a chasm, and the Baucus proposal has made that abundantly clear to everyone paying attention. It is hard to see how this gets narrowed any time soon.

Up Next:

Environmental Solutions by Fiat Ike Brannon on December 23, 2013