Tax reform is a really good idea. The U.S. needs a tax policy that has incentives for businesses and entrepreneurs to locate in America and spend at a faster rate on innovation, workers, repairs, and new plants and equipment.
The place to start is the corporate income tax, which harms our international competitiveness in two important ways. First, the 35 percent rate is far too high: when combined with state-level taxes, American corporations face the highest tax rates among our developed competitors. The rate should be reduced to 25 percent or lower. Ways and Means chairman Dave Camp recently articulated a goal of having a maximum rate of 25 percent for both individuals and businesses. He should be applauded for that objective.
Second, the United States remains the only developed country to tax corporations based on their worldwide earnings. Our competitors follow a territorial approach in which, say, a German corporation pays taxes to Germany only on its earnings in Germany, to the U.S. only on its earnings here, and so forth. If we were to adopt the territorial approach, we would place our firms on a level playing field with their competitors.
Proponents of the worldwide approach argue that because it doesn’t let American firms enjoy lower taxes when they invest abroad, it gives them no incentive to send jobs overseas. Imagine two Ohio firms, they say: one invests $100 million in Ohio, the other $100 million in Brazil. The worldwide approach treats the profits on these two investments equally, wisely giving the company that invests in Brazil no advantage over its competitor.
But this line of reasoning ignores three points. First, because firms all over the world will pay lower taxes than the two Ohio companies, the likeliest outcome of the scenario is that both firms will fail, unable to compete effectively with global rivals. Second, when American multinational firms invest and expand employment abroad, it is usually done to sell to these new markets. By expanding markets abroad they tend also to invest and expand employment in the United States. In the end, healthy, competitive firms grow and expand, while uncompetitive firms do not, meaning that our goal should be to make sure that American companies don’t end up overtaxed, uncompetitive, and eventually out of business. And finally, because the U.S. is the holdout using a worldwide approach, it is at a disadvantage as the location for the headquarters of large, global firms. As the U.S. loses the headquarters, it will lose as well the employment, research, and manufacturing that typically is located nearby. As one U.S. CEO told me recently, “Our headquarters are here solely because of an historical accident.”
All of this makes perfect sense. Unfortunately, change is unlikely to happen quickly. The United States has had an income tax for nearly 100 years. During that period you can count on one hand the number of significant, broad-based reforms that have been enacted. Simply put, tax reform is hard. It requires consensus-building and significant presidential leadership.
President Obama is unlikely to provide that leadership, at least in the near term. To begin, he has staked out too narrow a corner by focusing exclusively on corporate reform. Obviously, I agree that a lot has to be done in that area, but in the end good tax policy requires that pass-thru businesses that are taxed at the individual rates should face the same taxes as C-corporations. As Chairman Camp recognizes, this requires broader reform than the administration is discussing.
These issues suggest that comprehensive reform is more likely to be a 2013 legislative item than a 2011 initiative. At the same time, there are rumors that Congress and the administration are interested in moving a tax bill to support economic growth (and which will not be called “stimulus”). How does this fit into the reform picture?
The obvious requirement is that anything done in 2011 should be consistent with the long-run goals for 2013 reform. To my eye, there are two candidates. The first is an immediate rate cut to 25 percent. Unfortunately, to get it right, both the corporate rate and the individual top rate would have to come down. I just can’t see any hope of Democrats lining up to support “tax cuts for the rich.”
The second option is to immediately move to a territorial base, which would permit tax-free repatriation. In its best form, the repatriation rule change would be permanent because it is part of the pathway to fundamental reform and because permanent tax changes have better incentive effects. The U.S. would immediately become a better location for headquarters and benefit from the ability of companies to move trillions of dollars from offshore investments to domestic expansion. If even a single dollar of investment moves into the U.S., our economy benefits.
The U.S. needs broad-based tax reform and Congress is looking for near-term changes in tax incentives. Moving toward a territorial corporate-tax system is the sensible reform that would support the recovery in the short run and pave the way for increased economic growth in the long run.
— Douglas Holtz-Eakin is president of the American Action Forum.