Policy

Here is the problem – the U.S. tax code treats U.S. companies less favorably than foreign companies operating in the U.S. Foreign corporations pay U.S. corporate income taxes but only on the income they earn in their U.S. operations. U.S. companies, in contrast, have to pay taxes on all of their worldwide income, but the taxes on the income earned outside of the U.S. are due only when the company brings those profits back home.

Most other developed countries have a simpler system, where all companies, foreign and domestic, pay taxes only on the income earned from operations within the country. And then, of course, there is the issue of corporate tax rates, which in the U.S. reach 35 percent, much higher than in most other developed countries.

This situation creates a host of unfortunate incentives. First, there is an obvious disincentive for U.S. companies to return foreign profits to the U.S. And they don’t – there are reports that U.S. corporations have about $2 trillion parked in their foreign subsidiaries. Incentivizing companies to invest their profits in foreign countries instead of domestically is clearly not a desirable outcome.

Second, there is an incentive for U.S.-based corporations to become “foreign.” A recent publicized example of this was the failed attempt of Pfizer to merge with Ireland-based Allergan, thereby becoming an Irish company operating in the U.S.

In a corporate inversion like this, a U.S. company is “acquired” by a foreign one, and its corporate home moves to the foreign country. The company retains access to the U.S. market and still pays U.S. corporate taxes on the income it earns in the U.S. But it does not have to worry about paying U.S. taxes on its worldwide income. Ireland is a favored destination, primarily because it has a very low 12.5 percent corporate tax rate.

In general, there are two ways to prevent corporate inversions. One is to remove the incentive—mimic other countries and only tax the profits that companies earn in the U.S., lowering their tax rates nearer to levels they would pay elsewhere. Various people, including Donald Trump, have proposed some version of this. Or, create disincentives to invert. Hillary Clinton proposes such a policy in the form of an “exit tax” that U.S. companies would have to pay on their deferred profits if they relocate outside of the U.S.

Mathematically, the two approaches seem to be equivalent. But their consequences would be quite different.

If the U.S. choses an exit tax, it would be an open admission that a form of economic coercion is needed to prevent companies from fleeing U.S. jurisdiction. And, what’s even worse, the entire world would see just how much companies are willing to pay to leave. If an exit tax of, say, 5 percent, ends up being enough to prevent companies from leaving, it would not be bad. But what if even a 40 percent tax does not stop them?

The other solution—easing the U.S. corporate tax code—has no such negative side effects and has the potential to attract companies to the U.S. Opponents, however, point out that giving up taxing worldwide profits and lowering corporate tax rates would drastically reduce the tax revenues collected from corporations.

This, however, is far from certain. Ireland, with its 12.5 percent corporate tax rate, collects more in corporate taxes (relative to GDP) than the United States (Chart 4). It is hard to imagine that the United States would not be able to attract at least as many companies as Ireland if it lowered its corporate tax rates.

Companies currently engage in lobbying and other legal and accounting tactics to lower their effective tax rate far below the statutory 35 percent. Wouldn’t they still do it even if tax rates were lowered?

Consider the incentives that companies face. To avoid paying the 35-percent tax rate, companies hire scores of lawyers, consultants, and lobbyists. But if the tax rate were lowered, it may prove cheaper, easier, and simpler to just pay the tax and let go of all the high-priced help. This would be better for the economy too, as these intelligent people could then find something productive to do instead of wasting their human capital on devising ways to avoid taxes. 

Next/Previous Section:
1.Overview
2. Economy
3. Inflation
4. Policy
5. Investing
6. Pulling It All Together/Appendix