Bad Taxes at Home Cause Trouble Abroad
As the global economy becomes more integrated and capital flows more freely around the world, the need for fundamental tax reform in the United States becomes more evident. Just recently, the World Trade Organization (WTO) announced that the European Union could move forward with $4 billion in sanctions against the United States. The sanctions are a response to current tax policy in the United States, which provides tax credits to companies doing business overseas. These tax credits were claimed to be an unfair export subsidy for American companies. What’s really unfair is the federal tax code, which has become so burdensome and complex that other countries are becoming more attractive to investors.
And it is not as if the tax credits provided American corporations much help. The United States tax regime is a “worldwide tax” system, which means that American companies must pay U.S. taxes on income generated in other countries. The alternative, which roughly half of the developed nations follow, is a “territorial tax” system, which means that they only tax income generated within their respective countries. For corporations doing business around the world, this makes other nations more attractive places to incorporate. A German company, for example, can do business in Ireland, and enjoy the benefits of the low 10 percent corporate tax rate. An American company in the same situation would pay not only the 10 percent Irish tax, but would also owe the IRS corporate taxes at the much higher federal rate of 35 percent.
The U.S. worldwide tax system clearly puts American firms at a disadvantage. Yet rather than overhaul the code, Congress has tinkered with the code going back to 1962, when the pernicious “Subpart F” was added to the tax code to eliminate abuses in tax havens. Since then, Congress has adopted a piecemeal approach of creating deferrals and tax credits to offset the advantages enjoyed by foreign companies. The recent WTO decision dates back to a dispute over the foreign sales corporation (FSC) provisions of the tax code that were adopted in 1984 to create a tax exemption for certain export transactions. Because the provisions treated exports differently than foreign-produced goods, the European Union accused the United States of subsidizing exports in violation of trade agreements.
In response, the United States Congress enacted the Extraterritorial Income Exclusion Act in 2000 to phase out the FSC and modify the tax code in a way that complied with international trade agreements. Rather than revamping the broken tax code, the new law meddled with definitions of income to create exclusions from U.S. taxes for certain foreign income. Despite the changes, the European Union continued to claim that the U.S. tax code was providing export subsidies, and the WTO agreed, opening the door for $4 billion in sanctions.
The recent WTO decision and the increasing push to relocate corporate headquarters beyond the reach of the IRS are symptoms of a failed tax code. While the United States once may have been the premier location for doing business worldwide, that image has been tarnished, in large part, due to a tax code that puts American businesses at a competitive disadvantage. Rates that were low relative to other nations are no longer a draw to businesses; America’s advantage dissipated as other nations restructured their taxes and lowered their rates.
As Chris Edwards and Veronique de Rugy of the Cato Institute point out, “The average top corporate tax rate for national governments in the OECD fell from 41 percent in 1986 to 32 percent in 2000. The U.S. federal rate is 35 percent.” Germany, for example, dropped its top corporate tax rate from 56 percent in 1986 to 40 percent; Ireland’s aggressive tax cuts have established the Emerald Isle as a main landing spot for foreign investment. Competition for capital flows has forced a number of calcified economies to restructure into more dynamic markets that have shaken U.S. dominance in capital markets. As Peter Merrill of the National Economic Consulting Group noted in his testimony before Congress, “Of the world’s 20 largest corporations, the number headquartered in the United States has declined from 18 in 1960 to just 8 in 1996.”
In fact, corporate taxes in the United States are now among the highest in the developed world. Combining federal and state taxes, the corporate rate averages 40 percent—roughly 8 percent higher than the average 31.9 percent for OECD nations. Currently, the United States has the fourth highest corporate tax rate in the developed world. Even worse, compliance costs are extremely high in the United States, making the tax code inefficient and an administrative nightmare, particularly the rules governing foreign source income. A study for the Tax Foundation by Joel Slemrod and Marsha Blumenthal found that close to 40 percent of all corporate income tax compliance costs were attributable to foreign operations.
As other nations restructure their tax codes and capital becomes more mobile, the U.S. tax code has become a significant impediment to American businesses in the global market. Not only do higher taxes make U.S. companies less competitive, the arcane tax code threatens to restructure the global market in ways that could be disadvantageous to the United States. As economist Gary Hufbauer of the Institute for International Economics notes, the WTO decision opens provides the European Union leverage over the United States in future trade negotiations that could affect biotechnology and agricultural markets. And as Peter Merrill notes, as global corporations find it more convenient to operate in other nations, employment and research and development in the United States will suffer.
Real reforms are clearly necessary. In response to the WTO decision the United States has claimed that the subsidy was only equal to roughly $1 billion and that the laws are being changed so that the United States will be in full compliance. But this approach does little to ease the constraints the tax code places on American companies. The complexity and cost of the federal tax code must be addressed at a more fundamental level. At a minimum, the United States should consider moving toward a territorial tax system that allows American companies to compete more effectively in global markets while eliminating the unnecessary complexity of the current system. Better yet, Washington should view the WTO decision as a wake-up call to overhaul an ossified tax code. This should include basic reforms that replace the current incomprehensible code with a low, flat tax rate that avoids the need for questionable loopholes and exemptions while providing the incentives for corporations to choose America as the place to do business.
