The Corporate Tax: Republicans Versus Democrats

The practice of U.S. corporations keeping hundreds of billions of dollars in profits overseas to escape onerous American taxes has become a political issue in this presidential election. Both candidates have expressed concern and proposed changes to the current tax system that include reducing corporate income tax and ending various deductions. There the similarities end, however.

Mitt Romney proposes a shift to "territorial" taxes, whereby companies would be taxed only in the jurisdictions in which profits are made. Obama rejects the territorial system and wants to continue to tax corporations on everything they make, everywhere they make it, by introducing a worldwide minimum tax. Their contrasting approaches reflect a fundamental difference in political philosophy: The territorial system relies on the right incentives to encourage companies to bring back their overseas income. Obama's relies on police power and American might.

My colleague Matt Welch has written a series of brilliant articles on how Uncle Sam is hounding Americans with overseas earnings. But America's treatment of companies also deserves attention, not least because they are already receiving undue attention from the IRS. And that attention is encouraging them to move their assets offshore.

To understand how the current system works, consider a U.S. company with operations in the U.K. paying standard rates of corporate taxes in both countries and unable to take advantage of any deductions. If the company were to bring back any profits from its U.K. activities to the U.S., it would have to pay the difference between the 24 percent it pays in the U.K. and the 35 percent charged by the American government. That's a difference of 11 percent. So the expected returns on reinvesting those profits in the U.S. would have to be about 11 percent greater than the expected returns on reinvesting the profits in the U.K. in order to justify repatriating the profits.

But it gets worse. If some of the goods the company is selling in the U.K. are produced in the U.S., it can game the system by undercharging its U.K. subsidiary for those goods. That way, more of the profits are earned in the U.K., where taxes are lower, and less in America. Since governments cannot know what the correct internal "transfer price" should be, they cannot realistically police such transactions (though they do try). All perfectly rational, utterly perverse, and borne out by the evidence.

That companies have been shifting their profits overseas is not in doubt. In a working paper published by the U.S. Government's Office of Tax Analysis in February this year, Harry Grubert analyzed data from 754 large multinational companies (MNCs) and found that the share of aggregate pre-tax worldwide income earned abroad increased 14 percent, from 37.1 to 51.1 percent, between 1996 and 2004. This was almost identical to the increase in the share of total income that was not repatriated, which rose from 17.4 percent to 31.4 percent. Grubert also found that companies with lower effective foreign tax rates had both higher foreign profit margins and lower domestic profit margins. In other words, they appear to be using "transfer pricing" to keep some of their U.S. profits overseas.

This is no small problem. A March 2012 assessment by Bloomberg of 70 U.S.-based companies showed that in the previous year their offshore holdings of retained profits increased by $187 billion, or 18.4 percent, to over $1.2 trillion. According to a May 2011 assessment by JPMorgan Chase & Co., those 70 companies represented approximately three quarters of the then-total U.S. corporate holdings of $1.375 trillion. So, if we presume that those 70 companies still represent around the same proportion of total overseas retained profits, the current total is likely at least $1.8 trillion.

Under a "territorial" system of corporate taxation as proposed by Romney, companies would have strong incentives to repatriate their profits, since they would no longer pay any penalty for so doing. Indeed, the interests of shareholders and management would once again be aligned, since investment decisions would be governed by an evaluation only of where the best returns could be obtained. With lower corporate taxes in the U.S., the result would be increased domestic investment--and job creation--in the U.S.

The Democrats accept that the current system has perverse incentive effects. But they claim that the introduction of a "territorial" system would largely benefit multinational companies, encouraging them to continue to invest and earn profits overseas. Vice President Biden said last week that, according to "experts," the territorial tax "will create 800,000 jobs, all of them overseas." He went on to talk about the President's commitment to, "creating jobs in America--keeping jobs in America--and bringing jobs back to America."

And how will they achieve that? Reduce U.S. corporate taxation to 28 percent and demand a global minimum tax.

Now that you've stopped laughing at the idea that Holland, Ireland, the U.K. or Switzerland, let alone China or India would agree to tax companies at a higher rate just because Joe Biden says so, let's look at the evidence on territorial taxes and investment. It certainly true that one "expert", Kimberly Clausing, an economics professor at Reed College in Portland, Oregon, wrote a study which concluded that a territorial tax system would create 800,000 jobs overseas and result in job losses in America. But in that study Clausing, who has donated over $1,000 to Obama's campaign this year, assumed that the U.S. would keep its domestic tax rate about the same as it is today. However,Romney proposes to cut the U.S. corporate tax to 25 percent; that's lower than the rate proposed by Obama and closer to rates charged by the governments of other large economies, so it seems highly likely that the rate of investment in the U.S. would increase, not decrease.

Meanwhile, even if U.S. corporations with substantial overseas assets decided to continue to invest their profits predominantly overseas--presumably because they see greater opportunities from such investments--the evidence suggests that they and their shareholders would still invest in the U.S., creating growth and jobs. A 2006 study by Romney advisor and Harvard economics professor Greg Mankiw and then-Treasury economist Phillip Swagel surveyed the literature on the impact of offshore outsourcing and concluded that such investments tended to increase American employment, not reduce it. One explanation is that if offshoring generates improvements in the rate of return on capital, then profits will rise; some proportion of those profits will go to shareholders in the form of dividends or share buybacks; and some of those monies will in turn be used to invest in the U.S. economy, leading to job creation.

In a 2009 paper, Harvard Professor Mihir Desai and colleagues studied the impact of foreign investment by U.S. multinationals on domestic investment and employment. They showed that from 1982 to 2004, a 10 percent increase in foreign investment led to a 2.6 percent increase in domestic investment. Meanwhile, a 10 percent increase in foreign employee compensation led to a 3.7 percent increase in domestic employee compensation.

The case seems to be clear: a pure territorial tax system, combined with a significant cut in federal corporation taxes, would remove perverse incentives to keep profits offshore. Companies would repatriate profits, resulting in more investment--and more jobs--in the U.S. Romney's approach to the problem is in some respects like Ronald Reagan's approach to the Berlin Wall, who at a speech in Berlin in 1987, called upon President Gorbachev to "tear down this wall!" Obama's is more like Erich Honecker's, who said in January 1989, "The Wall will be standing in 50 and even in 100 years."