“There’s only one problem,” the president added at a speech in Ohio last week. “The jobs wouldn’t be in America. They’d be in other countries.” That clever remark kicked off a week of sparring between the two candidates and their surrogates about the right way to tax corporations.
On this count, the president is wrong. Investment and job growth abroad don’t necessarily mean job losses in the U.S. And more importantly, Romney’s plan to tax multinational corporations only on the income they earn domestically is on the right track.
Properly structured, and combined with a lower corporate- income-tax rate, a so-called territorial system could make U.S. companies more competitive, simplify the tax code, reduce compliance costs, boost real wages and enable companies to repatriate the more than $1.2 trillion they are now holding abroad for fear of the tax man.
The U.S.’s current “worldwide” tax system is a mess. Large companies are taxed on all their income, domestic and international, at a top official rate of 35 percent (one of the highest in the world, although most pay a lower effective rate). When these companies earn money abroad, they pay taxes to the host government, then again to the U.S. when the profits are repatriated. They receive credits for what they’ve already paid in foreign taxes, and can defer U.S. taxes until the profit is brought home.
The rationale for such a system is known as capital-export neutrality: If companies are taxed equally at home and abroad, the thinking goes, they will make decisions about where to invest based on business considerations and not tax advantages. That reasoning no longer holds in a global economy in which a company’s foreign branches can grow by simply investing retained earnings and accessing capital markets on their own.
The current system also leads to a web of distortions. It puts U.S. companies at a disadvantage, since almost all other advanced countries have moved to some version of a territorial system. It encourages companies to take on debt. And compliance costs are enormous relative to what the government receives in revenue.
It also leads to gamesmanship. The tax can be deferred indefinitely as long as the earnings aren’t repatriated, so companies retain their profits abroad. Multinationals also use elaborate strategies to show that their income wasn’t really earned in the U.S., including a practice known as transfer pricing, by which they manipulate the way they value transactions between subsidiaries to allocate profit to low-tax jurisdictions.
A territorial system would go a long way toward improving this picture. Foreign profit would be exempt from taxation, so there would be no reason not to repatriate it. U.S. businesses looking to invest abroad would no longer be at a competitive disadvantage. And a vast amount of red tape would be eliminated in short order.
There are, of course, drawbacks. For instance, we’d still need to address transfer pricing. A good first step would be to beef up the Internal Revenue Service. The tax agency can do a better job of making sure the value companies ascribe to earnings in a given jurisdiction is consistent with the resources and employees they have actually devoted to the place. In other words, if you only have a mailbox in Bermuda, please don’t tell us that most of your profit is earned there.
Companies would also have an incentive to move their operations to lower-tax countries. But this is already happening, mostly because the U.S. has higher labor and overhead costs and companies want to be closer to customers in new markets. U.S. corporate tax rates and the ability to defer taxes surely play a role, too. Still, ending the tax disadvantages American companies face when investing overseas frees them to make sound business decisions on where to hire and locate facilities without having to consult a phalanx of tax lawyers.
That will make them more productive -- and able to hire more workers. And this is where the president is fundamentally off-base. When companies expand abroad, they don’t necessarily do so at the expense of American jobs. A 2008 study by Mihir Desai and Fritz Foley of Harvard University and James R. Hines Jr. of the University of Michigan found that when companies increase their foreign investment by 10 percent, they typically boost domestic investment by 2.6 percent. Increased employee compensation abroad also leads to better pay for American workers.
The economists N. Gregory Mankiw and Phillip Swagel found similar results: The evidence “actually suggests that increased employment in the overseas affiliates of U.S. multinationals is associated with more employment in the U.S. parent rather than less,” they wrote.
That’s hard to swallow if you’re a back-office worker whose job is shipped overseas. But the solution is for the government to do more to help displaced workers improve their skills -- not to prevent companies from becoming more productive.
Finally, ending the tax on companies’ foreign profits would undeniably mean lost revenue for the government. But the amount wouldn’t be huge, and there are several smarter ways to make up for it -- including pruning the more than 75 so-called tax expenditures that benefit special business interests, instituting a federal consumption tax, and taxing some noncorporate business income.
Reform on this score is in the air. We’ve argued for eliminating the corporate-income tax altogether. Although that’s unlikely in this political environment, both parties seem to be converging on a lower rate -- which is a very good start. Combined with a territorial tax regime, that would begin to rationalize a convoluted, inefficient and outdated system.
Today’s highlights: the editors on how to make air travel even safer; William D. Cohan on a merger gone very wrong; Albert R. Hunt on why this U.S. presidential campaign is tame; Simon Johnson on why HSBC should find a CEO who will break up the bank; Pankaj Mishra on the hidden history of state capitalism; Neil Barofsky on the failings of TARP.
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