The Obama Administration Has the Wrong Approach to Preventing Corporate Inversions

by Veronique de Rugy

The more things change, the more they stay the same. This time, it’s the Obama Administration’s approach to a corporate-tax issue. As the Wall Street Journal reports, the administration is urging lawmakers to pass legislation to limit or stop the ability of corporations to reincorporate overseas for tax purposes, a practice called “inversions.” A similar debate took place back in 2002, when Congress was having a bipartisan freakout about U.S. corporations’ essentially renouncing their “citizenship” to escape the country’s insane tax system.

As was the case back then, the solutions offered to address the problem by loosening our corporate tax system are, at best, Band Aid solutions for a serious issue. The Obama administration, however, would prefer a straight-up coercive solution, essentially forbidding companies from doing they want with what belongs to them.

The Journal reports on the idea:

In a letter to leaders of the congressional tax-writing committees, Treasury Secretary Jacob Lew said lawmakers “should enact legislation immediately . . . to shut down [inversions].”  . . . 

Just this week, two U.S.-based drug firms— AbbVie Inc. ABBV -1.12% and MylanInc. MYL +0.06% —moved ahead with plans for foreign mergers that would allow them to move overseas and reduce their tax rates. They would join a growing list of about 50 U.S. firms that have reincorporated overseas through inversion in the last 10 years, most of them since 2008.

The trend appears to have accelerated in recent months, as Congress has come up short in an effort to pass a comprehensive tax-code rewrite that would address corporate concerns and make the U.S. system more business-friendly.

Meanwhile, the Obama administration in its budget earlier this year had proposed tightening the rules to substantially limit inversions. 

Back in 2002, I wrote a piece for the Cato Institute about the issue. I explained why inversions were taking place, noted that corporations doing inversions aren’t free-riding or evading U.S. taxes, and offered a way to fix it in two steps. Here is the first one:

Cut the corporate tax rate. The recent rash of corporate inversions is the warning that the U.S. corporate tax has become dangerously uncompetitive. While the United States led the world in 1986 by cutting the corporate rate from 46 to 34 percent, most major countries followed suit and some surpassed us by cutting even further. Meanwhile, the United States raised its rate to 35 percent and piled ever more complex tax rules on international businesses. At 40 percent (federal plus state), the U.S. corporate income tax rate is the fourth highest in the 30-country OECD.

A substantial cut in the corporate tax rate would greatly reduce the inversion problem and other corporate tax avoidance problems that have concerned policymakers recently. For example, the Treasury study focuses on “earnings striping,” which occurs when foreign parent firms lend excessively to their U.S. subsidiaries in order to lower U.S. taxable income with large interest deductions. By lowering the statutory tax rate, the incentive for earnings striping is directly reduced. In a global economy with 60,000 multinational corporations and trillions of dollars of investment funds searching for good returns, the high U.S. corporate tax rate is not sustainable. Unless the United States substantially cuts its rate, endless amounts of wasteful tax avoidance will be fostered, complex and uncompetitive legislative responses will ensue, and the performance of the U.S. economic engine will fall short.

It’s worth nothing that the U.S.’s corporate tax rate is even worse relative to its competitors now than it had been in 2002, meaning that the appeal of inversion has increased. 

Here is the second step:

Adopt a territorial tax system. Along with a lower rate, the U.S. should adopt a territorial tax system. That would eliminate the need for corporate inversions and allow U.S. firms to compete on a level playing field in 
foreign markets. A territorial system would be much simpler than the complex worldwide system that has been built piecemeal over decades without a consistent foundation. As the Treasury study notes, “The U.S. rules for the taxation of foreign-source income are unique in their breadth of reach and degree of complexity.”

Many of those rules would be done away with under a territorial system. The ultimate solution is to replace our income-based tax system with a low-rate territorial system that has a consumption base. That way, global corporations will be encouraged to move their operations and profits into the United States rather  than fleeing for lower-tax climates. 

The whole thing is here.

The Journal notes that some lawmakers on both sides of the aisle are in fact somewhat reluctant to follow in the administration’s steps and make things worse for U.S. companies:

As more firms are moving to reincorporate in countries with tax advantages, lawmakers remain divided over Washington’s response. So far, Republicans as well as some influential Democrats in Congress have favored limiting inversions through a comprehensive overhaul. Some of those lawmakers believe a quick fix could worsen U.S. companies’ position.

“I don’t want to be part of legislation that ramps up the competitive disadvantage of being a U.S.-based company or makes U.S.-based companies more attractive targets for foreign takeovers,” Sen. Orrin Hatch of Utah, the top Republican on the Senate Finance Committee, said in a recent statement.

Finance Committee Chairman Ron Wyden (D., Ore.) also hasn’t pushed for a quick fix. 

Let’s keep our fingers crossed that lawmakers will finally bite the bullet and reform the corporate income tax once and for all.

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