In the Corporate Tax Race, America's Pulling Up the Rear

Over the last year, I've frequently lamented the United States' increasingly absurd position on corporate taxes - maintaining one of the highest corporate tax rates in the world and routinely demonizing standard international business tax practices, while other countries (like Canada) are racing to eliminate tax burdens in order to enhance their domestic companies' global competitiveness.  Unfortunately, the last few weeks have produced a depressing cavalcade of similar news.

First, Sen. Carl Levin (D-MI) and Rep. Loyd Doggett (D-TX) introduced legislation to stop "tax haven" abuse by US multinational corporations:

The U.S. government loses $37 billion per year in tax revenues because multinational corporations stash money in overseas tax havens, Democratic Senator Carl Levin and a group of small businesses said in a report on Tuesday.

Levin, who for years has pushed for a tough law to fight tax evasion among corporations, has enlisted some small businesses to back his so-far unsuccessful proposal to close loopholes letting companies legally avoid taxes by keeping income abroad.

"There are too many small businesses now paying more than their fair share," Levin told reporters on a conference call. "It creates a very unfair competitive situation."

Levin wants to attach some of his proposals to help fund a bill that sets up a $30 billion fund for small business. Levin has tried to attach his initiative to other bills in the past without success....

Policy changes sought include a ban on transferring intellectual property abroad to evade taxes, and repeal of a rule letting companies pay no U.S. taxes when 80 percent of their revenue is earned overseas.

A couple days later the House Ways and Means Committee held a hearing on "transfer pricing" - the prices charged by one affiliate to another in an intercompany transaction involving the transfer of goods, services, or intangibles. In his opening statement, Chairman Sander Levin (D-MI) warned that "multi-national companies are potentially gaming the current system to shift assets and funding within foreign-based entities to avoid paying U.S. taxes."  He blamed the misuse of transfer pricing rules for American job losses: "[W]e must be using the U.S. tax code to promote job creation and strengthen economic security for workers and businesses here in America."

At the same hearing, Deputy Assistant Treasury Secretary Stephen Shay told the Committee that "there is evidence of substantial income shifting through transfer pricing."  He was frequently asked about the United States' high corporate tax rate of 35 percent (second highest in the world!) and how that contributes to income shifting.  He agreed that the corporate tax rate in the United States is high in comparison to other OECD nations, but he attempted to assuage the Committee's very real concerns by saying that the effective US tax rate (after deductions, credits, etc.) is closer to the average OECD member nation.

Closer, maybe.  But still higher - by a very significant margin.  And, as I've previously noted, a recent Cato Institute paper shows that the effective US corporate tax rate on new business investments is the highest in the OECD.  The paper's authors also concisely explain how such taxes harm US companies' bottom lines:

[T]he lack of reform in the United States is likely reducing both tax compliance and inward foreign investment. During the 1980s, the United States enjoyed larger direct investment inflows than outflows, but during the 1990s and 2000s, the situation reversed and outflows became larger than inflows.6 Both tax and non-tax factors probably caused this reversal, but it does not help that the United States is near the top of the 80 nations.... The nations with the highest effective tax rates, such as Argentina, Brazil, Chad, India, and Uzbekistan, generally have high statutory rates and taxes on capital or gross revenue that add to the burden on investment.

The excessively high U.S. corporate tax rate reduces economic growth by discouraging both domestic capital formation and inward foreign direct investment. Less investment means slower wage growth and reduced living standards over the long run.

A further problem is that the high U.S. corporate tax rate is applied to worldwide profits, which places the overseas operations of U.S. multinational corporations at a tax disadvantage compared to businesses based in countries that have both a lower corporate tax rate and a tax exemption for repatriated foreign profits.

Finally, the high U.S. corporate tax rate reduces government revenues because it increases tax avoidance. Empirical studies have found that the revenue-maximizing corporate income tax rate is about 25 percent today and has declined over time.  The U.S statutory and effective corporate rates are much higher than the revenue-maximizing rate, thus both the government and the economy would gain from a major rate cut.

Given these facts, the Treasury Department's argument about US corporate tax rates is, in a nutshell, "we still stink, but less than you think."  As catchy as that motto might be, it's hardly a good defense.

But what about all of those evil tax loopholes that corporations are "abusing"?  Well, as mentioned above, onerous American tax rates actually encourage evasion (and often lead to lower tax revenues).  But more importantly, most things that congressmen and senators have described as "abuse" are routine business practices.  And as Cato's Dan Griswold noted last year, contrary to Chairman Levin's claims, these legitimate offshore tax moves actually increase US jobs:

The biggest tax exemption for U.S. companies that invest abroad is the deferral of tax payments for "active" income. U.S. corporations are generally liable for tax on their worldwide income, whether it is earned in the United States or abroad. But the relatively high U.S. corporate tax rate is not applied to income earned abroad that is reinvested abroad in productive operations. U.S. multinationals are taxed on foreign income only when they repatriate the earnings to the United States. Not surprisingly, the deferral of active income gives U.S. companies a powerful incentive to reinvest abroad what they earn abroad, but this is hardly an incentive to "ship jobs overseas."

Such deferral may sound like an unjustified tax break to some, but every major industrial country offers at least as favorable treatment of foreign income to their multinational corporations. Indeed, numerous major countries exempt their companies from paying any tax on their foreign business operations. Foreign governments seem to more readily grasp the fact that when corporations have healthy and expanding foreign operations it is good for the parent company and its workers back home.

If President Obama and other leaders in Washington want to encourage more investment in the United States, they should lower the U.S. corporate tax rate, not seek to extend the high U.S. rate to the overseas activities of U.S. companies. Extending high U.S. tax rates to U.S.-owned affiliates abroad would put U.S. companies at a competitive disadvantage as they try to compete to sell their goods and services abroad. Their French and German competitors in third-country markets would continue to pay the lower corporate tax rates applied by the host country, while U.S. companies would be burdened with paying the higher U.S. rate. The result of repealing tax breaks on foreign earnings would be less investment in foreign markets, lost sales, lower profits, and fewer employment and export opportunities for parent companies back on American soil.

And speaking of global tax competition, it seems that every other country understands these basic facts and has thus jumped on the corporate tax-reduction bandwagon.  I've already blogged about Canada's great tax moves as it attempts to become a top destination for multinational business investment, but in recent weeks we've seen other countries embark on similar paths.  For example, the new government in Japan - site of the highest corporate tax rate in the developed world - announced that it was strongly pushing a significant corporate tax cut:

The [Japanese] government pledged in its medium-term economic plan released last month to bring the corporate tax rate down to a level “commensurate” with other leading nations to spur growth. At around 40 percent, Japan’s corporate tax rate is among the highest in the OECD.

Countries with lower tax rates may enjoy a higher share of revenue because a smaller levy stimulated economic growth or they broadened the tax base, the report said, citing research.

Companies in Tokyo pay a levy, including local taxes, of 40.7 percent. The burden is higher than China’s 25 percent, Seoul’s 24.2 percent and France’s 33.3 percent, Finance Ministry data show. The OECD’s average is around 26 percent.

Not to be outdone, the United Kingdom announced plans to lower its corporate tax rate from 28% to 24% over the next four years.  And Australia's doing the same.

So to recap: In 2010, the United States government uses lame excuses to defend its ridiculously high corporate tax rates, and seeks to end corporate "abuse" of tax rules that actually benefit American businesses and workers - abuse that is often caused by the very same ridiculous tax rates.  Meanwhile, major industrial powers (and US competitors, of course) Japan, Canada, the UK and Australia are furiously racing to lower their corporate tax rates in order to encourage domestic investment and jobs.

No wonder so many of our campaigning politicians routinely demagogue globalization - they obviously don't understand it.

The Large and Obvious Risks of Currency Devaluation

There's an interesting story in the WSJ today (subscription) about the perils of trying to devalue your way out of a debt-laden financial crisis.  The story focuses on Hungary's troubled currency, the forint, which took quite the tumble last week after some rather, umm, clumsy remarks from Hungarian officials about the chances that their country might default on its debt.  Here are the key passages:

The forint lost 4.8% against the euro and 7.3% against the Swiss franc last week. Pledges by the new Fidesz government that it will stick to a budget-deficit target equal to 3.8% of gross domestic product failed to reverse much of the losses Monday. That suggests the market has lost confidence in government policy and communication. But the decline also risks triggering a downward spiral: at the public debt level, around 45% of Hungary's debt is denominated in foreign currencies, so a sharp fall in the forint immediately causes the debt-to-GDP ratio to rise.

Hungarian debt-to-GDP at 78.3% in 2009 is already far above its Czech and Polish peers. For the heavily indebted private sector, things are even worse. As of April 2010, 63% of individuals' residential mortgages were denominated in foreign currency, according to the National Bank of Hungary. That means declines in the forint versus the euro and especially the Swiss franc directly translate into increased debt burdens and reduced household spending power.

There is also the question of timing. Exchange rate shifts can take time to work through; witness the U.K. where the Bank of England has been puzzled by the failure of the steep decline in sterling at the end of 2008 to boost exports as much as hoped. If the problem is demand, rather than price, then the impact of devaluation on growth may be muted. But the effect on debt and spending is much swifter. 

Although it's blatantly obvious that there are huge, systemic differences between the United States and Hungary, I think that we still can learn a couple lessons from Hungary's mess and the WSJ article about it.  First and foremost, globalization and its attendant interdependence have made apparently "simple" fiscal moves like currency devaluation a lot more complicated and unpredictable.  For Hungary, its foreign-denominated debt (publicly and privately-held) makes devaluing its way out of any debt obligations pretty much impossible, and any forint devaluation will just pummel residential mortgage-holders (among others).  While this certainly isn't the case in the United States, our import consumption habits mean that a US dollar depreciation will have painful ramifications for lots and lots of American families and businesses.  In other words, a cheap dollar means that American families' paychecks won't stretch as far for basic necessities (e.g., energy, clothing and footwear - most of which is imported these days), and that American companies will pay more for imported inputs.  Considering that almost 60% of all imports are these industrial inputs, a cheaper dollar will end up hurting a lot of American manufacturers' bottom lines.  Ouch.

Second, the UK experience referenced above demonstrates that any currency devaluation doesn't guarantee an instant boost in a country's exports either.  As the article mentions, you also need overseas demand for the stuff that you make.  This is certainly going to be a problem for US exports to Europe for the foreseeable future (although the US dollar couldn't depreciate against the Euro right now if it tried).  In the case of the US-China trade relationship, there's likely demand in China for sure, but a significant amount of stuff that the US specializes in, like high-tech goods, can't (by law) be exported there because of our export controls.

In sum, Hungary's and the UK's own devaluations provide further proof of something that I've been trying to show here for a long while now: you should immediately stop listening to anyone who argues that a weaker dollar is abso-tively going to resuscitate the US economy.  Because they just don't know what they're talking about.

UK to US: Your Mercantilist Trade Policy Is Bollocks

I stumbled across a recent blog entry by British Trade Policy Adviser Patrick Thomas that lauds recent US efforts to expand trade but, in typical British fashion, politely explains why the UK's new trade policies are far better (emphasis mine, silly UK spelling his):

[I]t is encouraging that here in Washington, policymakers are talking seriously about engaging with the world through trade. After a year in which trade policy did not feature prominently, President Obama used his State of the Union Address to announce an ambitious plan to double US exports in five years. His Commerce Secretary, Gary Locke, claims that the plan would also support two million jobs in the United States.

Expanding trade is a way to boost economic growth and create jobs, and one that I recommended in my last blog. And in fact, the UK has a comprehensive strategy called 'New Industries, New Jobs', which sees an important role for exports as a driver of growth. What's interesting about the strategy is that it emphasises that exports are only one piece of the puzzle. It recognises that the UK cannot efficiently produce everything by itself. What's key is preparing workers for the high-paying jobs in the industries of tomorrow. To pursue this agenda, it is necessary to recognise that both inward and outward trade flows figure in greater prosperity.

Indeed, modern trade theory tells us that imports are just as important as exports...

The UK has long embraced open trade as a policy, which has played a key role in making Britain a wealthier, more dynamic and more diverse society. So let's promote exports, but let's not forget the benefits of imports as well....

The loud *thud* sound you hear is me falling our of my chair.  Thomas even cited the iPod as an example of how nations benefit from, and thus should embrace, specialization and modern global supply chains.  Good for him.  And great for the UK for adopting a commonsense, 21st century trade policy and (again, politely) calling attention to the asininity of American mercantilism.

If only the White House were listening.