One of the hottest questions in U.S. politics today is, “Does the high U.S. corporate income tax rate relative to other countries, act as a disincentive for multinational firms to invest in the U.S.?” “Has the U.S. corporate tax rate make American firms less competitive globally and cause them to export jobs and capital overseas?”
To examine these questions, it is important to know just how much U.S. corporations must pay in total corporate income tax. According to the Organization for Economic Development’s Centre for Tax Policy and Administration, the United States has one of the highest marginal corporate tax rates in the OECD. The current statutory corporate income tax rate in the United States is 35%. The U.S. sub-central rate, or the weighted average state corporate income tax rate, is 6.4%. Due to the fact that corporations must pay federal and state taxes in the U.S., they are allowed to deduct some of their state taxes from their federal payments, so the adjusted statutory corporate income tax rate is around 32.7%. Therefore, the OECD calculates that U.S. based corporations in 2011 will pay an average of 39.2% in combined (federal and state) corporate income tax.
In comparison, Switzerland’s statutory corporate income tax rate is 8.5% and its combined rate is 21.2%. Ireland’s statutory rate and combined rate is 12.5%. Indeed, of the 34 countries in the OECD, all of which share a commitment to democracy and free markets, only Japan has a higher combined marginal corporate income tax rate of 39.5%. The average combined rate for all of the countries is 25.5%.
A recent 60 Minutes segment titled “A Look at the World’s New Corporate Tax Havens” explores the effect of the tax rate on multinational investment. In the segment, John Chambers, CEO of Cisco Corporation, argued that the high American corporate tax rate is prohibitive to firms, and that to maximize shareholder value, he is forced to move operations overseas. As a result of moving subsidiaries abroad, Cisco’s average tax rate over the last three years was a mere 20%. Where does Cisco move? Ireland is one popular destination for Cisco and over 600 other U.S. companies, including well-known American pharmaceutical and high-tech companies. Collectively, these companies employ more than 100,000 people in Ireland and have helped the outskirts of Dublin develop into a mini Silicon Valley.
Clearly, 60 Minutes is of the opinion that the answer to the two questions we posed earlier is yes; the high U.S. corporate income tax rate disincentivizes investment in the United States. To more fully understand the implications and nuances of the American corporate tax rate on foreign investment, we must delve under the hood and examine the academic underpinnings of American tax philosophy and policy as they apply to multinational firms. This is undoubtedly a complicated topic, but Mihir Desai, a professor at Harvard University and an expert on international and corporate finance, has distilled the relevant issues into a few salient principles.
To begin with, in the philosophy of taxation, every country must decide whether it will tax its people and corporations based on domestic or worldwide income. The United States, along with the United Kingdom, is one of the few countries in the world that taxes its corporations based on worldwide income. For instance, if GE makes profits in Spain, those profits are subject to both Spanish and U.S. taxes.
Naturally, this implies that American profits gained overseas are subject to double taxation. As a result, the United States provides some relief for foreign taxes paid by American multinational firms by providing tax credits to the companies up to the U.S. statutory rate. This implies that in countries with corporate income tax rates lower than the U.S., the maximum total tax rate that firms will pay is the U.S. statutory rate. In countries with taxes higher than the U.S., the companies would pay at most the local tax rate.
But, this tax is imposed only when those profits are returned to the United States, known as repatriation. If, however, those profits are not repatriated and instead are held overseas, they are not subject to American taxes. In this way, profits earned abroad become more or less “stuck” overseas indefinitely and cannot be used to finance projects in America or create domestic jobs. 60 Minutes estimated that $1.2 trillion of such profits is locked away overseas. One may still wonder, “If given the opportunity, would multinational firms actually move profits from overseas tax havens back to America.” A natural experiment conducted in 2004 gives us the insight that firms most likely would. In 2004, the American Jobs Creation Act allowed firms a “one-time” reduced tax on any profits repatriated back to the United States. As a result, about $350 billion was repatriated to take advantage of the incentive, which was a huge increase over what economists were expecting.
Corporations have saved billions of dollars by utilizing loopholes in the tax code that allow them to move operations to overseas tax havens and then choose not to repatriate their profits. Swiss Tax Attorney Thierry Boitelle explained that it is all too easy now for large multinational corporations, which hold most of their assets on paper, to relocate to other countries by simply transferring their paper assets to these countries. For example, Transocean is incorporated in Zug, Switzerland for the tax advantages, even though only 12 or 13 employees actually work there.
Furthermore, U.S. companies have developed sophisticated ways to shield against tax payments. For instance, firms can transfer patents to subsidiaries in foreign countries and claim that revenues from those patents are foreign, even if most of the sales due to those patents occur domestically. Texas Congressman Lloyd Doggett and other politicians have tried to close these loopholes by authoring legislation, such as a law that requires the management of corporations incorporated abroad to actually live in that country. In response to the threat of this law, Transocean sent its ten highest C-level executives to live overseas. In short, it has been extremely difficult to write legislation to close these loopholes because there are almost always workarounds.
So, what must be done? A reduction in the American corporate tax rate to around 25.5%, the international average, would be prudent policy in the long run because it would incentivize multinational firms to invest in the United States and would eliminate the inefficiencies created by the time, energy, and money American firms must invest to leverage loopholes in the tax system in order to remain competitive globally. But, lowering the corporate tax rate so dramatically now when the American deficit is ballooning is probably not politically feasible given the fact that it would reduce the taxable base by between $1.5 and $2 trillion.
Alternatively, the United States could set an extended low repatriation rate. If foreign profits could be repatriated cheaply, then the amount of funds that are “stuck” overseas would flow back to the U.S, providing a huge economic stimulus that would work in conjunction with current expansive monetary and fiscal policies to help move the economy towards recovery.
Ultimately, I believe that the U.S. should move to the global trend of only taxing domestic income. This would simplify the American tax process and increase transparency, which would decrease inefficiencies and motivate investment in America. Plus, I do not believe that corporate income taxes are the only determining factor of where a firm chooses to incorporate. Other factors, such as quality of human capital and access to resources are more important. Therefore, I think that the advantage of foreign tax havens would be eroded as more countries, including especially the U.S., adopted similar corporate tax policies.
One final point for consideration is that in the discussion thus far, it is important to note that much of the economic theory behind current international tax policies is based on the fact that firms choose to either invest here or abroad. Recent research, however, suggests that firms that grow abroad are also more likely to also grow domestically. This means that we aren’t really “losing” jobs to foreign countries because those companies are creating as many or more jobs here as they create abroad. If this hypothesis is true, then the rationale behind the current tax policy may have the relationship between foreign and domestic activity exactly backwards, and therefore the whole corporate tax structure on foreign activity would have to be reevaluated.
Tim is a Junior in the Gabelli School of Business and can be reached a firstname.lastname@example.org