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Corporate Tax Reform Can Wait – The Recovery Can’t

IN the waning days of the 111th Congress last December, an extraordinary tax deal was reached between the Obama administration, the outgoing Democratic majority, and the resurgent Republicans that extended the Bush-era tax cuts for two years in addition to unemployment benefits. The $900 billion agreement that also lowered payroll taxes by 2% for 2011 was hailed as a “second stimulus” and led to upward revisions in GDP growth forecasts.

The bill also kicked off President Obama’s efforts to reset his relationship with the business community, whose support President Obama and his strategists feel is vital to sustaining the economic recovery and, hence, his reelection prospects. The tax bill was followed up by the naming of William Daley, a former banker, as his permanent replacement for Rahm Emmanuel as chief of staff and General Electric CEO Jeffrey Immelt as the head of a new advisory board on economic recovery and job creation, and an executive order ordering the review of unjustifiably costly regulation – all major steps for an administration criticized for having had no one with business experience in the top ranks.

In his State of the Union address President Obama opened up another front in his efforts to repair ties with the business community by calling for a streamlining of the corporate tax code with a lower overall rate in exchange for reducing numerous loopholes that companies currently exploit.

As is oft-pointed out by the business community, the US has the second highest combined statutory corporate income tax among OECD nations at 39 (which includes an average of US states) – some 13 percentage points above the 2010 OECD average. But the reality is more subtle: the loopholes that are the target of President Obama’s ire mean that for some favored industries like biotechnology, the effective federal tax rate is only 4.5%, with the banking and petroleum industries also reporting effective rates of 17.5% and 11.3% respectively. The trucking industry by contrast pays an effective federal tax rate of 30.9 percent.

But two factors diminish the likelihood that reform will be achieved. First, President Obama has insisted that any corporate tax reform be revenue neutral – meaning that as a whole, business would see no cut in their taxes. (Simplification of the tax code would provide some gains for corporations in the form of savings on the costs of tax compliance.) Second, the wide variation in effective taxation by industry means that the possibility that reform would overcome the objections of industries that would be hurt by a rise in their effective tax rate (including those like biotechnology and information technology that the president has cited are vital to “winning the future”) quite unlikely.

But there exists another possibility for a addressing a feature of the obtuse US corporate tax code whose prospects for political success would be considerably higher: temporarily cutting taxes on the foreign earnings of American companies.

As the Congressional Joint Economic Committee report on tax competitiveness explains, there are two basic types of international tax systems: worldwide and territorial. In the latter, employed by most major economies including France, Japan, and Germany, companies pay taxes to their home country only for the income generated in that country. Thus, a German company pays German corporate taxes only on the income generated in Germany but will also pay French taxes only for the income earned in France.

The US is one of a handful of major countries that instead practices a worldwide system in which US-registered companies pay taxes not only on earnings from within the US but also on foreign earnings at the US rate less the taxes that they pay to the foreign countries. But US companies only encounter this tax when they repatriate these foreign earnings back to the US. Thus, unwilling to bring back their earnings from abroad by sacrificing it to the United States, corporations are holding an estimated $1 trillion overseas.

By doing so, companies are consciously holding back billions of dollars in profits that could instead be injected into the US economy. And all the while, the US government is collecting no income from these offshore dollars because of its self-defeating policy. It is these reasons that make a temporary cut in taxes on foreign earnings so compelling: unlike the revenue-neutral streamlining proposal, this alternative would simultaneously unleash a tremendous store of untapped stimulative potential to the economy and raise realized government revenue from corporate taxes.

A similar deal holiday, known as the Homeland Investment Act, was reached in 2004 as part of the American Jobs Creation Act, reducing repatriation taxes from 35 to 5.25 percent. U.S. multinationals repatriated about $300 billion in 2005 as a consequence of the holiday, up from an average of $60 billion over the past five years. When the Homeland Investment Act of 2004 was proposed, J.P. Morgan Chase estimated that businesses would increase capital spending by 2-3% and a survey of firms indicated that they would use the funds to pay down debt, finance capital spending, and fund R&D, and acquisitions.

But the reality of how significant the temporary cut was for job-creating domestic investment was muted: a 2009 study found that every $1 in repatriations under the 2004 cut resulted in an increase of almost $1 in payouts to shareholders. Instead of implying that the temporary tax cut was a failure, it means that the direct impact of the injection of the repatriated funds into the economy was concentrated exclusively in dividends and buybacks, raising personal income.

The Obama administration has made much of how it has sought to structure middle class tax cuts in such a way that it subtly boosts take home pay and increases consumption, as opposed to large one-off transfers that are more likely to be saved. The impact of dividends, while largely to the benefit of the already well-off, works in a similar way. Baker et al’s study on the effect of dividends found that households have a high propensity to withdraw ordinary dividends, meaning that a $1 difference in dividend income between households explained a 16c difference in nondurable expenditure and a 75c difference in total expenditure. The top 20 percent of income earners (those most likely to hold dividend paying stocks) account for an estimated 40-50% of spending. As higher potential dividends as a consequence of repatriation translate into spending, the entire economy stands to benefit.

Finally, a lower repatriation rate that induced corporations to bring their cash back to the US would mean that the government would actually realize tax revenue that otherwise would have remained indefinitely beyond its reach overseas or slipped passed the IRS via complex accounting maneuvers. If the repatriation tax was again reduced to 5.25% and all $1 trillion were repatriated, the government would realize $52.5 billion in revenue. This is a better figure than the estimated $25 billion in annual revenue the US loses through a maze of complex repatriation tax avoidance strategies.

Currently 80% of OECD nations (a group of 34 big economy democracies) have territorial tax systems, up from half a decade ago; in 2009, both the United Kingdom and Japan converted to territorial systems. Why, then, should the US not simply abandon the worldwide tax system entirely? Doing so now and permanently would mean that US companies, faced with lower taxes overseas compared to the United States, would have a long-term incentive to invest in foreign production capacity at the expense of the US. Were comprehensive corporate tax reform that lowered statutory rates to internationally competitive levels politically viable, this would not be a problem. But streamlining the messy difference in statutory versus effective tax rates and their variances by industry will be a much longer campaign – perhaps as long as “two or three years” according to the National Journal if talks do not break down before then in the wake of the 2012 election. Such a reform is the ultimate prize – but it should not prevent policy makers from tapping the sizable low-hanging fruit in the form of a temporarily lower repatriation tax at a critical time for the economic recovery.

As late as two years ago, the Obama Administration had considered going against the momentum in favor of territorial systems by proposing tougher restrictions on the deferral of foreign earnings. Undoubtedly some of these proposals, targeted at the most egregious accounting loopholes, are rightfully justified. But the Obama Administration should recognize that a temporary cut in taxes on foreign profits, coupled with a modest decline in nominal tax rates, is likely his administration’s most realistic chance for achieving tax reform. In the future, the inevitable return of the stockpile in deferred earnings can be used as a bargaining chip for broader reform, but it should not be done so now at the expense of bolstering the economic recovery. The far grander prize of rationalizing the corporate tax system will take time – the recovery can’t.

Kyle Hutzler is a freshman in Calhoun College.

 

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