The Self-Defeating Corporate Income Tax
For many years, policy makers have criticized the strategies that American corporations use to reduce their taxes by shifting income and capital offshore. The impetus behind these strategies is the U.S. corporate income-tax rate -- at 35 percent, the highest of any industrialized nation, easily surpassing countries such as the U.K. (20 percent) and Canada (15 percent).
Reducing this rate would end a self-defeating policy that distorts corporate behavior, weakens domestic companies and ultimately harms the U.S. economy.
The insurance industry offers a good example of how this tax can have unintended consequences. Over the past 20 years, the wide disparity in international corporate income-tax rates has encouraged property and casualty insurers to shift capital offshore.
In part, this has been made possible by a provision in the federal tax code that permits insurers to move future earnings and capital associated with premiums paid domestically to more favorable tax jurisdictions by reinsuring their U.S. policies with foreign-based affiliates. This has created a threat to the domestic insurance industry, warranting congressional action to safeguard the competitiveness of American insurance companies and encourage investment in the U.S.
Reinsurance is insurance for insurance companies. An insurer will pay some of its premium revenue to the reinsurer, which in turn will take on some of the risk and liability associated with a set of policies. Reinsurance is important: It adds capacity to the market, diversifies the industry's overall risk pool and enables insurers to offer competitive premiums.
But the equation changes significantly when U.S. insurers purchase reinsurance from their own foreign affiliates. When this occurs, there is no real transfer of risk outside the corporate family. All liability remains shared among related companies. What's being transferred are the premiums -- and all taxable revenue and capital associated with the reinsured business -- from one tax jurisdiction to another. This is a clear competitive advantage for insurers located outside the U.S.
The benefit is not limited to this form of "income stripping." Foreign-based affiliates are also able to reinvest the premiums offshore at lower tax rates -- at the expense of U.S. taxpayers and insurers.
The results are clear. It would be difficult to identify any major property and casualty insurance company that has been formed in the U.S. in the past 25 years. Yet more than 10 new insurers have started up over the same period in Bermuda alone. Even the venerable Chubb Corporation, a storied American insurer, is set to come under foreign ownership when it's acquired by Ace Limited, now headquartered in low-tax Switzerland.
Recouping this lost income and ensuring that U.S. insurance companies remain competitive should be a priority for Congress. As an initial matter, lawmakers should disallow deductions for reinsurance premiums paid to foreign-affiliated reinsurers. President Barack Obama has proposed this commonsense solution in his last four budgets, but it hasn't gained sufficient support to win passage.
A much better fix is to lower the tax rate. A recent study commissioned by the Business Roundtable, a trade group, found that at a 25 percent corporate tax rate, U.S. companies would have acquired $590 billion in cross-border assets over the past 10 years instead of losing $179 billion in assets -- a net shift, potentially, of $769 billion from foreign countries back home.
Thoughtful management teams should continue to act in the best interests of their shareholders. In that regard, taxes are a cost of doing business, much like any other, and as a consequence companies will continue to make decisions to lower their effective rate. Over time, that means reduced U.S. tax revenue, fewer U.S. jobs and less competitive American industries as companies move income and capital overseas.
Given the significant competitive advantages of being domiciled in the U.S. -- such as a reliable judiciary system and world-class universities -- and the added costs associated with being domiciled offshore, leveling the playing field doesn't mean rivaling the lowest foreign corporate income-tax rate. But it does mean significantly narrowing the differential.
It's true that this proposal would increase the federal budget deficit in the short term, a topic that my company has been quite vocal about over the past several years. But corporate income taxes contributed only about 10 percent of total federal receipts in the last fiscal year. And it will be interesting to see whether resulting heightened economic activity will more than offset this increase. Reducing this rate is a relatively low-risk investment with very high potential returns.
Unless Congress acts, we should expect more U.S. companies to use existing tax laws to level the playing field themselves, including by moving their operations or investments offshore. And, sadly, we should expect more foreign corporations to acquire iconic U.S. companies like Chubb.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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