A taxing idea

Long ago, some sage observer of American politics remarked that for every difficult, complex problem there is an easy, straightforward solution — that is wrong.

Few subjects are more difficult or complex than the taxation of U.S. businesses that operate globally, and few policy proposals are more misguided than Sen. John Kerry’s proposal to hurt U.S. competitiveness by raising taxes on U.S. companies competing in international markets.

U.S. tax law places U.S.-based companies operating internationally at a disadvantage in two fundamental ways. First, the United States has an “extraterritorial” tax system, that is, we tax U.S.-based businesses on their worldwide income. By contrast, many of our principal competitors — such as France, Germany and Canada — have a “territorial” system — that is, they do not tax income that subsidiaries of domestic companies earn abroad. Second, we tax corporate income at a higher rate than most of our competitors: According to the Cato Institute, the U.S. corporate tax rate is higher than all but three of the 30 Organization for Economic Cooperation and Development members.

U.S. policy-makers have long understood that taxing U.S. businesses on more of their income at higher rates puts them at a tremendous competitive disadvantage. As far back as the early 1960s, President Kennedy and a Democratic Congress enacted a framework allowing limited deferral of U.S. tax on certain types of “active” income earned abroad through operating subsidiaries until that income was repatriated through dividends to the U.S. parent. Since then, the rules providing for limited deferral have been repeatedly refined and expanded with broad bipartisan support.

Mr. Kennedy understood that it was crucial for U.S. companies to be competitive in global markets. The ensuing decades have shown how right he was. The value of goods traded to and from the United States increased more than three times faster than GDP between 1960 and 2000, and now exceeds 20 percent of GDP. Over that period, the flow of cross-border investment also rose, from 1.1 percent of GDP in 1960 to 15.9 percent of GDP in 2000.

As U.S. companies do more business in foreign markets, they have established more foreign operations. Significantly, those operations generally serve foreign, not U.S., markets, and support, not replace, U.S. jobs. In 2000, U.S. non-bank multinationals and their majority-owned affiliates generated about 27 percent of U.S. GDP — about $2.7 trillion. The vast majority of their employees, about 23 million workers, were in the United States, compared to about 8 million abroad.

Mr. Kerry proposes to subject all foreign earnings of U.S.-based employers to immediate taxation. No other major economy imposes such a burdensome tax regime on its companies. Although Mr. Kerry also proposes a modest reduction in the top corporate tax rate, the U.S. rate would remain above the OECD average, and would not allow U.S. companies to overcome the competitive disadvantage imposed through the elimination of deferral.

If deferral were eliminated, U.S.-based employers with significant international operations would have only three options, each of which would have an adverse effect on the U.S. economy.

First, U.S. businesses could try to continue competing overseas, but at a significant disadvantage. For example, if an American subsidiary competed with an Irish company in Ireland, both companies would pay taxes at a 12 percent tax rate to Ireland. However, the American company also would be subject to an additional 23 percent U.S. tax (35 percent less 12 percent tax credit) on earnings generated in Ireland. The Irish company could take the savings from its 23 percent lower effective rate to reduce prices, increase wages, or reinvest in the business. (Irish subsidiaries of German and French companies would enjoy the same advantage because those countries do not tax extraterritorial income.) Over time, that tax differential would prove devastating to the U.S. company, and the jobs in America that depend on those foreign operations.

Second, U.S. businesses could relocate their foreign operations to the United States. Yet that scenario, which Mr. Kerry contemplates, is based on a fundamental misunderstanding of the nature of the overseas operations of U.S. companies. Further, it assumes that companies would voluntarily place themselves at a severe competitive disadvantage. More likely, U.S. companies trying to compete in low-tax foreign markets would cease serving those markets.

Third, and most likely, U.S. businesses would relocate abroad or be acquired by foreign companies, turning U.S.-based companies into subsidiaries of foreign parents. If deferral was eliminated, U.S. companies would be more valuable if their headquarters were abroad. Jobs not essential for serving the U.S. market would be jeopardized, and American executives would rarely lead global companies. Instead, they would lead U.S. subsidiaries of foreign companies — with high-level decisions about where to produce goods made elsewhere.

If Mr. Kerry is interested in creating U.S. jobs, he should heed the example of the first JFK: American workers benefit most when they are permitted to compete in international markets on a level playing field. Increasing the tax burden on U.S. employers doing business abroad is a surefire recipe to destroy jobs at home.

Jeffrey Paravano is former senior adviser to the assistant Treasury secretary for tax policy. Matthew Dolan is a former Senate tax counsel.