Obama Gets Tax Policy Backwards

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Few subjects offer more grist for populists and more opportunity for demagoguery than that of U.S. companies, their foreign earnings and their taxes.

Posturing by politicians on this subject revolves around the fact that American companies have increased their foreign investments over a period of time when domestic jobs have disappeared in certain industries, creating a facile (and misleading) correlation in the minds of many between overseas investments and U.S. job losses. President Obama drew on that popular misconception when he announced he would seek changes in our corporate tax code last week which he claimed were designed to ensure that the government doesn’t “reward our companies for moving jobs off our shores.”

But academic research on firms doing business overseas suggests that President Obama has it backwards. Overseas investments rarely cost jobs in a corporation’s home country. Instead, firms that expand overseas are generally businesses that are also growing in their home countries. They are businesses that make a country’s economy competitive worldwide. This is not only recognized by researchers who’ve studied the issue, but also by policy makers in other countries, which is why few other countries now try to tax their multinational corporations’ foreign profits in the manner that President Obama is proposing. The result, most experts concur, is likely to raise the risks of foreign expansion and discourage some firms from going abroad. That doesn’t increase jobs at home.

The notion that U.S. corporate expansions overseas drain jobs here is a vestige of the 1950s and the early 1960s, when American corporations dominated a global economy consisting mostly of European countries recovering from World War II, communist countries whose industries weren’t competitive internationally, and the developing world. In those days, economists believed, the most likely reason a firm would open operations overseas was to take advantage of lower costs in other countries, most especially lower labor costs.

But as global competition intensified, economists noticed something unusual: For the most part, corporations in richer countries, such as the U.S., or a recovering Europe and Japan, weren’t investing in poorer countries where costs were low. Instead, they were investing mostly in each other’s markets, where costs were comparable. This became known as the Lucas Paradox, the notion that overseas investment didn’t happen the way we would predict it should.

As the world economy has advanced in the last 35 years, this tendency of corporations based in wealthy countries to invest primarily in other wealthy countries has only grown: Despite the popular perception in the media that our global firms spend most of their effort opening up sweatshops in poor countries, in the latest period studied, between 1995 and 2000, multinationals in rich countries were five times more likely to invest in operations in other countries where labor costs were comparable, according to a 2005 study by economists from Harvard and the University of Houston.

What we’ve learned is that companies don’t expand overseas primarily to eliminate local jobs, but to tap into other appealing markets where, if they succeed, they only become stronger. And lots of research has confirmed this idea, not just about U.S. firms, but about multinationals in other countries too. Studies of the Italian, French and German economies have found that when a business in one of these countries makes a decision to expand overseas the move rarely results in a net loss in domestic jobs, according to research summarized by Harvard’s Mihir A. Desai in a new paper published by the National Bureau of Economic Research, “Securing Jobs or the New Protectionism?” In fact, a company’s successful overseas expansion brings advantages to a home country, according to a study of Japanese multinationals which found that firms that increased their overseas investments also increased their domestic employment at a growth rate from three-to-eight times quicker than job growth among purely domestic firms.

The same holds true for the United States and its shrinking manufacturing industry. Desai looked at who was responsible for the decline in manufacturing jobs in the U.S. from 1986 to 2003 and found that it wasn’t multinationals. In fact, they have been expanding their manufacturing jobs in the U.S. even as they have been investing overseas. Instead, “the rapid decline of manufacturing employment in the late 1990s and early 2000s might well best be understood as marking the exit of purely domestic, low-productivity players rather than the displacement of domestic activity abroad by multinational firms,” Desai writes.

This shouldn’t be surprising. It’s a difficult and risky leap to go from a domestic company to an international one, and for the most part companies that succeed at it are our strongest firms. In a global marketplace, they are the firms most likely to face down new foreign competitors entering the country. Short of high tariffs to punish foreign products and make them uncompetitive here, it is our multinationals that give us our biggest edge.

But for many politicians, the Lucas Paradox doesn’t exist. To them, the world is simple: Jobs that U.S. firms create overseas are jobs that they are not creating here. We shouldn’t reward firms for doing that with tax breaks.

And so, instead of cutting our corporate tax rate, the second highest among developed countries, to bring it in line with the rest of the world, or treating overseas profits in the same manner as most other developed nations which generally don’t tax overseas earnings, the Obama administration will make our corporate tax code more onerous. One result, the research suggests, will be less job growth here as some U.S. firms contemplating going international decline to do so because we’ve further reduced the returns from setting up foreign operations and increased the risks.

What the research tells us is that patterns of international investment by big companies defy easy characterization because firms behave in ways that surprise us. That’s not the kind of stuff that can be explained easily in a sound bite at a press conference or on the campaign trail.

For a president confronting a world that doesn’t conform to popular opinion, the options are clear. He can attempt to set the country on the policy path that makes the most sense and do his best to explain why. Or he can simply give people a policy that corresponds to their misconceptions. On corporate taxes, we know what course Obama is taking.

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