Corporate America’s latest public relations disaster comes under the banner “tax inversion.” In an inversion, a U.S. company shifts its legal headquarters to a country with a lower tax rate. Just last week, the U.S. drug maker AbbVie agreed to buy a foreign firm, Shire PLC, in part to reduce its corporate tax rate, which is expected to drop from 22 percent to 13 percent. In most inversions, companies keep their HQ’s physical activities – the people, the buildings – in the United States, as would AbbVie. Still, the practice has understandably provoked a furious backlash.
These companies “have deserted our country to avoid paying taxes but expect to keep receiving the full benefits that being American confers,” fumes Fortune magazine writer Allan Sloan in the Washington Post. The tax flight “turns my stomach.” Treasury Secretary Jack Lew accuses these companies of lacking economic “patriotism.” Millions of Americans probably feel the same way. I certainly do. But we need to balance this revulsion with some stubborn – and not well-understood – realities.
First, the issue is easy to hype. Companies that shift their legal status abroad will still pay American corporate taxes, based on profits earned in the United States, which – for most U.S. multinational firms – remains the largest market. What’s mainly at issue is taxes on foreign profits. Even here, it’s easy to exaggerate. For example, the White House proposal to curb inversions would save $19.5 billion in taxes from 2015 to 2024, reckons the congressional Joint Committee on Taxation. That’s less than 1 percent of estimated corporate taxes over the same period.
Second, corporate taxes had declined significantly as a source of federal revenue long before inversions. In 1950, corporate taxes were 26.5 percent of the total. Now, their share bounces between 10 percent and 12 percent. The slide has many causes.
Higher Social Security and Medicare payroll taxes have reduced other taxes’ share of the total. The Tax Reform Act of 1986 also squeezed corporate taxes by discouraging smaller businesses from organizing as traditional corporations. Before the 1986 law, the top personal tax rate (50 percent) exceeded the top corporate rate (46 percent). After the law, the personal tax rate was lower. Many firms reacted by organizing as “pass through” entities (example: subchapter S corporations) whose profits are taxed as individual income. “More business income showed up as personal income,” says economist Kimberly Clausing of Reed College.
Third, U.S. multinationals are doing more and more business abroad – a trend likely to continue because many foreign markets are outpacing the American market. From 1970 to 2013, the share of U.S. profits earned abroad rose from 8 percent to 20 percent. Under U.S. law, American firms receive a credit on foreign taxes paid and pay the U.S. corporate tax only when the remaining profits are repatriated to the United States. Not surprisingly, U.S. companies hoard foreign profits abroad. The stash now is about $2 trillion, estimates Citizens for Tax Justice, a left-leaning research and advocacy group.
There’s an obvious dilemma. Facing chronic budget deficits, the United States can’t afford to lose tax revenues. But high U.S. taxes encourage American firms to locate activities abroad or to manipulate business practices to concentrate profits in low-tax countries. “Tax departments are considered profit centers,” says Clausing. One common tactic: Firms sell patents to subsidiaries in low-tax countries to reduce the tax bite on royalty payments. The top U.S. corporate tax rate (35 percent) is already the highest among major nations. Also, the United States is the only advanced nation that taxes profits earned abroad.
An “inversion” allows firms to take advantage of lower foreign taxes and to move some profits to the United States without paying the 35 percent tax. (The tax doesn’t apply to the non-U.S. profits of a foreign firm.) The administration would frustrate inversions by requiring that, after a U.S. company bought a foreign firm, at least 50 percent of the surviving firm’s stock would be foreign-owned. Otherwise, the firm would be considered American for tax purposes. The high level of required foreign ownership would probably deter some inversions.
But the Peterson Institute’s Gary Hufbauer argues that this would have perverse results. By frustrating inversions now, it would relieve pressure for a more sweeping corporate tax overhaul to improve U.S. multinationals’ global competitiveness, he contends. Hufbauer would cut the corporate rate to about 20 percent, end the taxation of foreign profits (the practice of most countries) and recoup lost revenues by raising individual taxes on corporate dividends and capital gains.
I favor this approach. Let’s lower taxes on corporations that can move from the United States; let’s raise taxes on the people who own their stock. Although the odds against this bargain are long, it would be a true act of economic patriotism.