Politics & Policy

If Outsourcing Is a Problem . . .

. . . it's a tax problem.

Not only has the extent of offshore outsourcing of American jobs been exaggerated, but — when motivated by underlying market fundamentals — offshoring actually benefits America. That said, much of the offshore outsourcing of jobs is driven by tax considerations — and this needs fixing.

Maury Harris of UBS Investment Research reports that “offshoring” by U.S. companies costs about 400,000 U.S. jobs per year. Putting this in perspective, 400,000 jobs constitute only 0.3 percent of the U.S. labor force. A million American workers leave their jobs every week, so these 400,000 displaced workers are a drop in the bucket. On net, offshoring benefits the economy.

Economist Matthew Slaughter of Dartmouth College shows how offshoring has created two U.S. jobs for every job created abroad. As offshoring lowers costs and expands access to overseas markets, greater sales create demand for more U.S. goods (computers, telecom equipment, software) and U.S. services (scientists, engineers, experts in law, finance, and marketing).

However, while offshoring is small and creates more value than it destroys, it is important that underlying market fundamentals drive it, not tax considerations.

Today’s tax code encourages U.S. companies to offshore American jobs. Suppose a U.S. corporation establishes a foreign subsidiary that earns $100 million. The foreign country has a 20-percent corporate income-tax rate, so it collects $20 million. If the subsidiary repatriates the earnings to the U.S. parent, it must pay an additional 15 percent, or $15 million, to the IRS (the difference between the foreign country’s tax rate, 20 percent, and America’s corporate tax rate of 35 percent). If the subsidiary keeps the money offshore and invests it in factories and jobs overseas, it can shield $15 million from Uncle Sam (known as deferral). So, the U.S. tax code actually encourages companies to invest in Bangalore and Dublin, and not in Dayton and Pittsburgh. It tilts the playing field against American workers.

John Kerry’s tax plan falsely promises a remedy to this situation. Kerry favors a special one-year, 10-percent tax on repatriated profits reinvested in America for companies with a “domestic reinvestment plan.” This tax rate would only apply to “repatriations in excess of average repatriations over a base period.” After one year, he would tax the profits of foreign subsidiaries that sell abroad at the same high rate as domestic profits, a proposed 33.25 percent, thereby ending deferral.

This plan would do little to help the economy. First, the plan’s vague language would be a field day for tax attorneys and litigators. Second, during Kerry’s one-year period, it would be cheaper for companies to borrow money in the United States at today’s low interest rates than to pay the 10-percent repatriation tax. Third, after the one-year period, if all profits were taxed at Kerry’s 33.25 percent, American firms would have a huge incentive to physically move their operations abroad since foreign corporate tax rates tend to be one-third lower than U.S. rates.

Congressional alternatives, although better, are still lacking. The House-passed American Jobs Creation Act and the Senate-passed Jumpstart Our Business Strength (JOBS) Act would provide one-year windows for American firms to repatriate foreign profits at a 5.25-percent tax rate. Both bills would lessen the tax distortion that prevents the efficient worldwide allocation of capital.

The Congressional Research Service pegs unrepatriated foreign profits at $639 billion. So the temporary 5.25-percent tax rate would bring $300 billion of that money back into the U.S., creating more than 660,000 jobs, according to J.P. Morgan. But both bills are temporary; they were crafted in the tradition of big-government planners who play politics with the tax code rather than set permanent rules to make America more competitive.

The best solution for America would be to eliminate corporate income taxes for domestic and repatriated profits. (France and Germany already exempt repatriated profits from taxation.) This would reduce the cost of capital for U.S. firms, make firms more globally competitive, and enable firms to plan based on market conditions, not tax considerations.

U.S. workers are paying the price for tax-induced offshoring. By backing a tax-code solution, President Bush would score big with American workers fearful of losing their jobs to foreign workers.

Lawrence J. McQuillan, Ph.D., is director of business and economic studies at the California-based Pacific Research Institute for Public Policy. He can be contacted at LMcQuillan@pacificresearch.org.

Lawrence J. McQuillan Mr. McQuillan is a senior fellow at the Independent Institute, the director of its Center on Entrepreneurial Innovation, and the author of California Dreaming: Lessons on How to Resolve America’s Public Pension Crisis.

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