Wednesday, May 06, 2009

The Worst Of All Worlds

Almost everyone agrees that the current U.S. tax-deferral rules are a complicated mess that are difficult for American companies to follow, inefficient at collecting revenue, and create accounting distortions. But as an editorial in today's WSJ makes clear President Obama's proposed solutions are only going to make a bad situation even worse:

The President's argument is that U.S. tax-deferral rules make it more expensive for American companies to reinvest overseas profits at home than abroad. This, he claims, creates a perverse incentive for companies to "ship jobs overseas" and reduces investment and job creation in the U.S.

He's right, except that his proposals would only compound the problem. His plan would limit the tax deferral on income earned abroad by tightening the rules, limiting allowable deductions and restricting eligibility for foreign-tax credits. This "solution" is antigrowth, job-destroying, protectionist and unlikely to raise the tax revenue Mr. Obama predicts. Other than that...

But it sounds good. And since most Americans will only hear about a plan to stop companies from shipping jobs overseas without having an understanding of the economic fundamentals of the matter, I expect it will prove quite popular. The reality of tax-deferral is that rather than being a "loophole" or "tax break" for big business, it's more of a effort to ease tax burdens on U.S. companies that their global competitors don't carry:

The current tax-deferral system is a clumsy attempt to deal with the fact that most other countries don't tax their companies' overseas profits. A German firm doing business in Ireland, say, pays no German income tax on its Irish profits, but it does pay Ireland's corporate income tax at its 12.5% rate. The U.S. company competing with that German business in Ireland, by contrast, pays Ireland the same 12.5% on its profits -- and it then pays Uncle Sam up to 35%, minus a credit for what it paid the Irish. And because almost everyone else's corporate tax rates are lower than America's (see nearby table), U.S. companies end up paying higher taxes than their international competitors.

Congress long ago created the corporate tax deferral to compensate for this competitive disadvantage. Under deferral, a company doesn't have to pay the U.S. corporate rate until it repatriates its earnings. It can retain them overseas or reinvest them abroad with no penalty. But if it brings them home or pays them as dividends, the tax bill comes due.

The German company faces no such quandary. It pays the Irish tax, and it's free to invest that money in Ireland or Germany or anywhere else. This territorial tax system, embraced by most of the world, eliminates the perverse incentive to hold money abroad that America's deferral system creates. Adopting a territorial system would be the most obvious and simplest way to eliminate the distortion that tax deferral creates. Alternatively, Mr. Obama could lower the U.S. corporate tax rate to a level that is internationally competitive.

Yes, we know: Few major U.S. companies pay 35% of their profits in taxes because of the foreign tax-deferral and other deductions, credits and loopholes. But that's precisely why Mr. Obama should want to take the better path to corporate tax reform by reducing the rate and removing loopholes. America now has the worst of both worlds -- a high statutory rate and a tax code so riddled with complexity that it is both expensive to administer and inefficient at collecting revenue. And yet Mr. Obama's proposal to limit deferral only layers on the complexity.

And reduces the ability of U.S. companies to compete globally. But hey, at least they won't be shipping jobs overseas, right?

But even as a revenue raiser, this is likely to fail. Fewer companies will keep their headquarters in the U.S., especially small or mid-sized firms that can slip away without becoming a political target. Those companies that can't flee will sooner or later demand relief from Congress, which will be happy to create even more loopholes.

Think that can't happen? Think again.

UPDATE--Further ponderings: When it comes to issues such as crime or terrorism, the Left is always eager to talk about the need to address the "root causes." We can't just lock up criminals or kill terrorists. No, we must delve deep into the root cause of these problems (poverty) and come up with solutions (more government spending).

But when it comes to matters of economic nature, this embrace of solutions to the root cause is nowhere to be found. If the problem is U.S. companies using tax-deferral to avoid paying U.S. corporate taxes, the Left's answer is to limit their ability to do so.

Hmmmm...I wonder what the root cause of this problem really is. Could it possibly be the onerous U.S. corporate tax rates (some of the highest in the world) that drive companies' attempts at avoidance? If you really wanted to address the root cause, that's what you would change.

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