With his corporate tax reform “framework,” President Obama today added another element to his ultimately harmful economic agenda.
Previously announced anti-growth policies include massive budget deficits, a huge tax hike on individuals and small businesses in 2013, and his proposal to nearly triple the dividend tax rate.
His new proposal starts strong by reducing the federal corporate income tax rate to 28 percent from the current 35 percent. This is a good and long-overdue policy change. Regrettably, he marries rate reduction to a net corporate tax hike based in part on extending his policy to hammer and ultimately deconstruct U.S. multinational companies. The net effect is that his corporate tax reform would do more harm than good, representing yet another missed opportunity to help American workers.
The U.S. corporate tax rate is the world’s second highest—and soon to be highest in the world by far. The average of the OECD nations (nations considered to have developed economies) excluding the U.S. is just over 25 percent. The combined state and federal U.S. rate is nearly 40 percent. It is miraculous that U.S. companies can compete at all in the global economy with such a tremendous handicap.
At the same time, economists and policymakers increasingly understand that while the tax is paid almost exclusively out of profits that would otherwise go to the shareholders, the true economic burden falls primarily on workers. The reason is simply that the higher the effective corporate tax burden, the higher the hurdle rate on corporate investment. (The hurdle rate is the minimum rate a business must earn on investment to make the investment.) The higher the hurdle rate, the less investment takes place. The less investment takes place, the slower labor productivity grows, and the slower labor productivity grows, the slower wages grow.
This may seem a long chain of events, but every link in the chain is solid steel. In the end, it means the higher the corporate tax is, the lower workers’ wages are. This is why Democrats like President Obama and Senator Ron Wyden (D–OR) are now joining with Republicans anxious to see a lower corporate income tax rate. It’s certainly not to reward corporate executives or shareholders but to protect workers from further degradation of their wages.
Unfortunately, President Obama marries this extremely important policy to two very bad policies. He calls this corporate tax reform. But tax reform is revenue neutral. His policy is to expand the tax base—the measure of income subject to tax—by closing “loopholes and subsidies” so that the net effect is to increase corporate taxes substantially. That’s not tax reform. That’s just another tax hike in disguise. So Obama argues that we need corporate tax reform for economic growth and then proposes corporate tax hikes that would inhibit growth. Go figure.
There’s no doubt the corporate income tax code is laden with loopholes and subsidies, just as there is no doubt the President’s recently released budget adds to the list some of his own. His framework lists a handful of minor proposals carried over from his budget and then references three areas for reform without providing any details. Specifically, he references depreciation schedules, suggesting significantly higher taxes on business investment. He suggests paring back the deduction for interest expense, again raising the hurdle rate on business investment. And he suggests “establishing greater parity between large corporations and large non-corporate counterparts,” which is generally assumed to be code for levying a dividend tax on distributed profits of these non-corporate businesses.
Debating tax deductions is a Washington parlor game. However, suppose Obama chose wisely and that every such subsidy or loophole mentioned is a valid target for repeal. Rather than raising tax burdens, he should then cut the corporate tax rate further. Recall that the average of the OECD (excluding the U.S.) is just over 25 percent. At a 28 percent federal rate, the combined federal and state tax rate would then be nearly 33 percent, still well above that of the nation’s competitors. The U.S. federal rate needs to come down further, and Obama’s additional base broadening would permit it. But instead, Obama takes a pass on further rate reduction in favor of taking the cash for the federal government.
Raising corporate taxes is his first big mistake. Targeting U.S. multinationals specifically for higher taxes is his second. The issue is complicated, but it boils down to some simple points. U.S. multinationals compete on a global stage, earning income at home and abroad. Income earned abroad is taxed by the foreign government. The U.S. also taxes income earned abroad and employs some complex rules to prevent double taxation. In contrast, most of the rest of the world now recognizes the folly of adding domestic tax to the tax their companies pay overseas. This would just make their companies and their workers less competitive at home and abroad, as it does for U.S. companies today.
President Obama, however, wants to make an economically harmful policy worse by taxing U.S. companies’ foreign earnings even more heavily. The vision Obama outlines is to punish firms that outsource jobs and incentivize “insourcing.” The net effect, however, would be quite different. The net effect is to put a “for sale” sign on every profitable U.S. multinational company. The buyers, however, won’t be U.S. companies. The buyers will all be foreign companies.
The reason for this tax-induced fire sale is fairly simple: The reach of U.S. tax policy into income earned overseas extends only when it applies to U.S. companies. The U.S. has no taxing jurisdiction when it comes to the foreign earnings of foreign companies. For example, the U.S. taxes Toyota on what Toyota earns in the U.S. But the U.S. does not tax Toyota on what Toyota earns in Japan.
Suppose a U.S. company like HP earned all of its foreign income through a single foreign subsidiary called Globalsub. Now suppose Globalsub were taxed under Obama’s plan. Globalsub’s foreign profits would then be subject to foreign tax and an even more punitive U.S. tax.
If a foreign company like Sony were to buy HP, shifting Globalsub out of HP into its own foreign operations, then all of Globalsub’s profits would immediately be exempt from U.S. taxes. This sort of tax arbitrage would be very big business. It would also substantially reduce U.S. tax revenues.
Sound far-fetched? It isn’t. Remember when Mercedes-Benz bought Chrysler in 1998? Had Chrysler bought Mercedes instead, all of the German company’s profits would have been subject to U.S. tax, rendering the entire operation uncompetitive. This was all laid bare by John Loffredo, then the tax counsel for Chrysler, in testimony before the House Ways and Means Committee.
Another high-profile example occurred when the Belgian company InBev bought Anheuser-Busch in 2008 for $52 billion. The more U.S. tax policy in this area gets out of step with worldwide norms, the more U.S. companies become natural targets for foreign acquirers. President Obama’s tax policies would make matters much, much worse.
The right solution is to pursue a revenue-neutral corporate tax reform, reducing the corporate tax rate as far as sound base broadening will allow. At the same time, in international matters the U.S. should move in exactly the opposite direction from what President Obama proposes so that U.S. companies can compete globally and not become tax-induced targets for foreign acquirers.