By Michelle Hanlon, accounting professor at MIT’s Sloan School of Management:
Apple issued $12 billion of U.S. debt in April, which gave the company a domestic cash infusion that allowed it to keep more earnings overseas. Last month Pfizer attempted to acquire AstraZeneca, a transaction that would have made Pfizer a subsidiary of the U.K.-based company. These were useful examples in the taxation classes I teach at MIT’s business school, but the real-world implications of these decisions are troubling. Even worse, legislators have responded with proposals that seek to prevent companies from escaping the U.S. tax system.
The U.S. corporate statutory tax rate is one of the highest in the world at 35%. In addition, the U.S. has a world-wide tax system under which profits earned abroad face U.S. taxation when brought back to America. The other G-7 countries, however, all have some form of a territorial tax system that imposes little or no tax on repatriated earnings.
To compete with foreign-based companies that have lower tax burdens, U.S. corporations have developed do-it-yourself territorial tax strategies. They accumulate foreign earnings rather than repatriate the earnings and pay the U.S. taxes. This lowers a company’s tax burden, but it imposes other costs.
For example, U.S. corporations hold more than $2 trillion in unremitted foreign earnings, a substantial portion of which is in cash. This is cash that currently can’t be reinvested in the U.S. or given to shareholders. As a consequence, companies are borrowing more in the U.S. to fund domestic operations and pay dividends. Another potential effect is that companies invest the earnings in foreign locations.
In short, our international tax policy encourages U.S. multinational corporations to keep cash abroad, borrow more in the U.S. and invest more in foreign locations than they otherwise would. Everyone loses: The U.S. government gets little if any tax revenue from the foreign earnings, and shareholders and the U.S. economy are deprived of valuable resources.
Some firms have taken the next logical step to stay competitive with foreign-based companies: reincorporating as foreign companies through cross-border mergers. A prime illustration is Pfizer’s bid for AstraZeneca. There are strategic reasons for acquisitions like this, but the decision of where the merged entity should be located for tax purposes is clear: not the U.S.
In response, Sen. Ron Wyden (D., Ore.) has said he would support changes to the tax code that would require more foreign ownership of companies before they can escape the U.S. tax system. Sen. Carl Levin (D., Mich.) and Rep. Sandy Levin (D., Mich.) have introduced a bill that would impose such changes. The legislation would treat a foreign-based company resulting from a merger with an American company as a U.S. taxpayer unless headquarters are located overseas and the U.S. company was the smaller entity.
These proposals fail to address the reasons why global companies prefer to be incorporated outside of the U.S. Threatening corporations with stricter rules and retroactive tax punishments will not attract business and investment to the U.S.
The responses by the federal government and U.S. corporations are creating what in managerial accounting we call a death spiral. The government is trying to generate revenue through high corporate taxes, but corporations cannot compete when they have such high tax costs. So they find ways to reduce costs, including expatriating. The remaining corporations (and other taxpayers) are left to bear greater taxes, which causes more corporations to leave the country, perpetuating the cycle.
The real solution is a tax system that attracts businesses to our shores, and keeps them here. Members of both parties have acknowledged concerns about the competitiveness of U.S. corporations. Consensus on what to do, however, has been elusive.
The U.K. may be a good example: In 2010, after realizing that too many companies were leaving for the greener tax pastures of Ireland, the government’s economic and finance ministry wrote in a report that it wanted to “send out the signal loud and clear, Britain is open for business.” The country made substantive tax-policy changes such as reducing the corporate tax rate and implementing a territorial tax system.
Congress and President Obama should make tax reform a priority. That could end the death spiral and send out a signal, loud and clear, that the U.S. is also still open for business.