As jobs vanish and Washington mulls a vast range of economic policy options, one that's conspicuously absent is corporate tax reform. That alarms many business advocates, who fear that current tax policy is outdated and will cripple U.S. companies if global growth resumes later this year or early next. "At this pivotal moment in history," warns David Lewis, chief tax executive for Eli Lilly and Co., "the U.S. must embrace an internationally competitive corporate tax system."
Exactly how badly higher tax rates harm U.S. companies is hard to measure and has long been a point of contention because the gap between nominal and effective rates can be substantial. But critics say that rapid globalization makes reform more urgent. More than two decades have passed since Congress overhauled corporate taxes. During that time global competition has surged and the United States has seen a fourfold increase in imports and an even larger jump in exports, two vital signs of a much more interconnected globe.
Canada, Germany, New Zealand, Spain, Italy, Switzerland, the United Kingdom, the Czech Republic, and Iceland all chopped their corporate tax rates last year. The U.S. business sector now grapples with the second-highest statutory income tax rates among the 30 industrialized nations in the Organization for Economic Co-operation and Development (OECD). Only Japanese companies face higher rates, by a slim margin. (To see the tax rate for all 30 OECD countries, click here.)
Failure to align U.S. tax policy with reality imperils our industrial base, experts warn. "Ultimately, it means U.S. multinationals are probably going to lose market share to foreign multinationals," says Peter Merrill, director of the National Economics and Statistics Group at accounting firm PricewaterhouseCoopers. "And they may become takeover targets of foreign multinationals."
Partisans of sweeping corporate tax reform insist the math should end any debate. Uncle Sam taxes U.S. corporate income at a top 35 percent rate, while states, on average, tack on 4.3 percentage points. The average among OECD countries is 26.6 percent. Thus, for every dollar earned in the global marketplace, U.S. companies appear to surrender nearly 13 cents more than a typical OECD member.
As mentioned, it's not quite that simple: the U.S. tax system rests on a vast hodgepodge of incentives, credits, exemptions, and loopholes that can lower rates to a more competitive level. Eli Lilly's effective U.S. income tax rate was 23.8 percent in 2007, 22.1 percent in 2006, and 26.3 percent in 2005.
So why complain? Because an idiosyncratic corporate tax code filled with exceptions imposes widespread inefficiency and inequality. The resulting friction, critics say, erodes business income, shrinks tax revenues, hampers strategic planning, and impedes competition. Some tax exceptions stem from the best intentions, to be sure, but more often they owe much to political clout.
At best, the effects are uneven. "If you do everything the IRS requires of you to take advantage of certain types of incentives, you can reduce your tax rate significantly," concedes Mark Weinberger, global vice chairman and head of the tax practice for accounting firm Ernst & Young. "But," he warns, "those incentives are for particular industries and particular size companies, so there are a lot of winners and losers depending on what type of company you are."
As international tax inequities go, the combination of high statutory corporate income tax rates plus the taxation of U.S. corporations' overseas income at those higher rates garners perhaps the loudest complaints. Only three OECD nations, including the United States, impose a tax on active corporate income outside their borders. The other two, Japan and the United Kingdom, are mulling an end to the practice.
The biggest reason to adopt a system that taxes U.S. multinational corporations on income earned at home and apply only foreign tax rates to income earned overseas is because it would help U.S. corporations to compete on equal footing with their global counterparts. Moreover, encouraging U.S. companies to repatriate profits stored overseas might inject some badly needed liquidity into the domestic economy for payrolls and capital expenditures.
As rules stand now, Uncle Sam imposes U.S. taxes on top of taxes paid in the foreign jurisdictions when that money is brought home. In 2004, when the tax rate on repatriated earnings was cut to a low 5.25 percent on a one-time basis, the impact was significant: some $362 billion of an estimated $804 billion domiciled offshore was lured home. "It could be very helpful in relieving some of the stress," says Lewis at Eli Lilly. "Even if companies just deposited their repatriated dollars in banks, it would help the financial system."
Regardless of the tax breaks it may enjoy as a pharmaceutical company (a sector that has benefited from a number of perks, such as incentives to invest in Puerto Rico), Eli Lilly kicks less money into U.S. coffers than it might, in large part because, like many of its multinational counter- parts, it simply finds ways to keep the money earned overseas working there. As of the end of 2007, according to Lilly's 2008 annual report, the company had $8.8 billion of unremitted earnings in foreign subsidiaries, all of which, it said, had been or were intended to be permanently reinvested in foreign operations. That may help to keep the tax bill low, but it limits flexibility, thus granting a competitive advantage for its global rivals.
Seeking a remedy, Sen. John R. Ensign (R–Nev.) proposed another tax-repatriation window as part of the economic stimulus package. Had it been adopted, the proposal would have matched the 5.25 percent rate applied in 2004. Economist Allen Sinai estimates that reopening the window would eventually retrieve around $545 billion. While that might be a boost to the stalled (domestic) economy, some skeptics say it could prompt companies to stash even more profits offshore in anticipation of periodic tax holidays.
Glimmers of Hope
Determining an optimal U.S. tax rate challenges international economists. Jack Mintz, Palmer Chair in Public Policy at the University of Calgary (Canada), estimates that if the United States could trim its effective tax rate to 25 percent, it would more than double investment in the United States by non-U.S. companies (that is, inward direct investment) to 2.3 percent from 1.3 percent of GDP.
Rep. Charles Rangel (D–N.Y.), the influential chairman of the House Ways and Means Committee, has proposed a rate almost as low as Mintz advises. In 2007, Rangel introduced a 30.5 percent top corporate tax rate that did not become law. Recently he pledged to reintroduce the bill with a top rate of 28 percent. A spokesman says Rangel would entertain a lower threshold if Republicans work with Democrats to close tax loopholes.
That raises the tantalizing possibility that U.S. rates would move down sharply enough to align with those of other OECD nations. And there are hints that, despite current stagnation, the issue may ultimately win serious attention in Washington. Newly installed Treasury Secretary Timothy Geithner has confirmed that the Obama Administration intends to haul the entire corporate tax system into the 21st century. And the stimulus package that Congress passed in mid-February features a few tax cuts for business, some aimed at sustainability, although none is sweeping or likely to become permanent.
That should not dissuade advocates of major change, some say. In matters of tax reform, scope helps, says Weinberger, the former assistant secretary of the Treasury for tax policy under President George W. Bush. "It's easier to do something big than something small." Smaller bills come and go without gathering momentum or excitement for change, and vocal critics can smother them. Despite inevitable opposition, Weinberger says, a massive tax bill is more likely to succeed than incremental change.
Public perception, however, may be a major obstacle. When Congress and the Administration do finally turn their attention toward taxes, they will do so mindful that the ever-increasing cost of the country's major entitlement programs — Social Security, Medicare, and Medicaid — will demand (absent benefit cuts) ever-higher levels of federal revenues in the decades ahead. That could mean trouble for any initiative that resembles a tax cut for corporations, even if the net result actually adds tax revenue.
Accordingly, Rangel's bill is expected to pair a lower corporate income-tax rate with measures aimed at rescinding some credits, incentives, and other exceptions in the current tax code. His 2007 bill, for example, proposed raising hundreds of billions of dollars by repealing the domestic manufacturing deduction, getting rid of LIFO (last in, first out) accounting, deferring expenses on foreign income, and limiting foreign tax credits. This time, according to an analysis by PricewaterhouseCoopers, he also might look at adding new limitations on accelerated depreciation.
In the Senate, Finance Committee chairman Max Baucus (D–Mont.) is pressing the search for fresh tax revenue, and profits earned offshore are a key focus. Baucus will reportedly target tax rules that govern deferral of taxes on foreign profits, international transfer pricing, and earnings stripping (a tax arbitrage between higher and lower tax jurisdictions that ducks U.S. tax liabilities). "We'll look at a variety of issues," a Baucus spokesman promised in late January. Details to follow, he said.
William Blaylock, vice president and senior tax counsel for $12.5 billion semiconductor maker Texas Instruments Inc., says those efforts should proceed with caution, because removing incentives could endanger gains. In 2007, TI's effective tax rate on continuing operations was about 29 percent, reflecting, among other things, the benefits of the manufacturing deduction, the research credit, and the ability to defer paying U.S. taxes on foreign-generated income.
"From a competitive standpoint, eliminating deferral would be a very troublesome issue for global companies," Blaylock says, though he concedes it would largely disappear if the tax rate were brought into line with the global competition. If the United States simply stopped taxing foreign profits completely, of course, the issue of deferral would disappear entirely.
Blaylock also would like to see Congress make permanent the research-and-development tax credit that was first introduced in 1981 but has survived only by virtue of annual extensions. President Obama is reportedly committed to making it permanent. His Administration could do even more to help U.S. manufacturers, Blaylock adds. "If people wanted to look at doing something about [increasing] manufacturing capacity in the U.S., an investment tax credit would be attractive as well," he says.
During the Presidential campaign, Obama said he wanted to change tax laws that reward companies for shipping jobs offshore and retaining earnings overseas. But whatever legislation along those lines becomes law, notes Rosanne Altshuler, co-director of the Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution, it is almost certain to unleash fierce protest from multinational corporations.
And there you have it: widespread dissatisfaction with the status quo versus fears that any changes will be for worse rather than better. No wonder the stalemate has persevered for so long. That's certainly good news for tax experts, who seem unlikely to be disintermediated by a simplified system any time soon. But the prognosis for companies is far less clear. They pay a large price to win and maintain their breaks. While some might come out ahead if the system were changed, it could be hard to get them to accept that, particularly when Washington vows to make U.S. companies more competitive even as it prowls for more tax revenue.
But a quarter century is a long time to go between major rewrites of something as critical as the corporate tax code. Given all that has changed, and all that needs to change, it seems high time to go beyond the usual give-and-take.
Randy Myers is a contributing editor of CFO.
To see the tax rate for all 30 OECD countries, click here.