No Inversion Is Not Unpatriotic. Yes We Need Corporate Tax Reform

Several recent high profile deals have directed media and public attention to the topic of “tax inversion,” whereby a company moves its headquarters overseas (usually in an M&A deal) in order to reduce its tax burden. According to the Wall Street Journal (citing Thomson Reuters) there have been 22 such deals since 2011, with the majority of them being in pharmaceuticals. For instance, earlier this year, drugmaker AbbVie entered into a $55 billion deal to purchase U.K.-based Shire Plc, a move expected to slash their tax rate to 13 percent from 22. Even earlier, Pfizer sought (but failed) to buy U.K.-based AstraZeneca, with the same goal in mind.

American Exceptionalism

But why is inversion even necessary? This has to do with two elements of the American tax system.

For one, the U.S. has the highest statutory corporate tax rate in the OECD, a combined rate of about 39 percent when taking into account federal and state taxes. Effective tax rates are harder to come by, but a report from the Tax Foundation found that the U.S. had the highest marginal effective corporate tax rate among developed country groups. It can be profitable then for U.S. firms to move offshore to reduce tax liabilities.

But there is another factor at play here as well. Most developed economies use what’s known as a “territorial” tax system. Under such an approach, income is only taxed when it’s earned domestically. So a U.K.-headquartered company will only pay U.K. taxes on its British income. The United States, however, employs a hybrid between a territorial and worldwide system. U.S. citizens and corporations are required to pay U.S. taxes on all income – even if that income is earned outside of the country. (The tax system provides credits for foreign taxes paid, which reduce or eliminate double taxation of income.) But foreign income is only taxed upon repatriation – when it is brought back to American shores. At this point the incentives should be fairly clear – companies have every reason to avoid bringing their earnings back to the U.S. if they were earned in a lower corporate tax rate country. So it’s not hard to see why firms hold somewhere around $2 trillion abroad in unremitted earnings, according to the Center for Budget and Policy Priorities.

Simply put, a worldwide tax system puts American firms at a significant competitive disadvantage. In a paper I co-authored with my Manhattan Institute colleague, Diana Furchtgott-Roth, we explained how this plays out:

“If an American company operates in the United States and Switzerland, its domestic affiliate pays U.S. taxes at 35 percent. But its foreign affiliate pays U.S. taxes at 35 percent and Swiss taxes at 8.5 percent, putting it at a disadvantage vis-à-vis its foreign competitors. America allows companies to deduct the taxes paid to foreign governments from U.S. taxes owed to the Internal Revenue Service, but corporations always pay the full U.S. rate and are unable to take advantage of low-tax jurisdictions.”

This is an especially important issue for the biotech/pharma sector. As the CBPP paper notes, among the top 10 companies ($609 billion) with unremitted earnings, pharmaceutical firms’ holdings make up about 29 percent. But because of the high penalty of bringing the earnings back, this money remains abroad, rather than being invested in the domestic economy.

Inversion Concerns And Remedies

In a move reminiscent of McCarthy politics, the President Obama has taken to shaming these firms by invoking economic nationalism, accusing them of being “unpatriotic.”

“The best way to level the playing field is through tax reform that lowers the corporate tax rate, closes wasteful loopholes, and simplifies the tax code for everybody. But stopping companies from renouncing their citizenship just to get out of paying their fair share of taxes is something that cannot wait. That’s why, in my budget earlier this year, I proposed closing this unpatriotic tax loophole for good.”

Simply put, there’s nothing “unpatriotic” about cutting costs to running your business. Restructuring to reduce tax burdens is no more than unpatriotic than corporations incorporating in Delaware to take advantage of the simple incorporation process. More importantly, the idea that companies aren’t “paying their fair share” – at least relative to companies in other countries – is equally disingenuous.

The chart above illustrates average corporate tax rates as a share of GDP for four different time periods – while revenue has fallen slightly in the U.S., it’s well within the range of other, similar advanced economies. The high OECD average is drive mainly by Australia, Norway, New Zealand, and Sweden. Moreover, the U.S. is expected to be a somewhat low-tax domicile – this is a simple tradeoff for a more dynamic economy.

Critics also point to the loss of revenue resulting from tax inversion, claiming that continuing to abide by this practice would exacerbate budget deficits. Literally speaking, yes, tax inversions reduce revenue (of course, they can also lead to greater capital investment domestically because earnings can be repatriated tax-free). But an estimate from the Joint Committee on Taxation indicates that this is likely to be minimal – only about $20 billion over 10 years.

Nevertheless, it’s clear that some reform is necessary. That companies are willing to go out of their way to avoid incurring taxes (this isn’t cheap) indicates that there are some basic problems with our tax system.

Unfortunately, the White House’s proposals for reform have focused on moving the country closer to a pure worldwide tax system, by limiting deferrals on taxation of foreign income. An even more short-sighted approach came from the Senate – the “Stop Corporation Inversions Act of 2014” would, for two years, increase the threshold allowing companies to move overseas. Currently, 20 percent of a company’s shareholders have to be foreign – the bill would increase that to 50 percent temporarily.

A more recent reform proposal from House Ways and Means Committee Chair Dave Camp would do a bit more by cutting the corporate tax rate to 25 percent, and reducing the taxes firms have to pay on foreign dividends.

This would help somewhat by lowering the statutory rate, but would still leave the system of worldwide taxation in place.

Who Actually Pays?

What most reform proposals, and critics of tax inversion tend to ignore is that the legal incidence of taxes, is very different than the economic incidence. For all intents and purposes, corporations are a legal fiction. A long strand of literature, for some time, assumed that corporate taxes fell predominantly on the owners of capital. This intuitively makes sense, as the taxes would eat into corporate profits, reducing investor returns. But other analyses throw a wrench into the conventional wisdom.

A 2007 literature review finds that a substantial portion of corporate taxes may be borne by labor, through a long-run lower capital stock. A CBO analysis, however, still maintains that owners of capital bear the biggest burden.

Whatever the true answer is, this debate underlies the inelegance of the corporate income tax. Long-term tax reform should focus as much as possible on not just lowering, but replacing the corporate income tax (and perhaps the individual income tax as well) – with a progressive consumption tax. Short-run “fixes” that predicated on economic nationalism are likely to do more harm than good, and ultimately fail to actually address the problems with our tax system.