Should Obama Close Loopholes on Overseas Profits?

The Obama administration recently unveiled a proposal which would make changes to international tax law in the United States tax code. The general thrust of this effort would be to reduce tax avoidance by American companies for overseas investments and resources and reduce the incentive for expatriating profits and jobs. An excellent nine point summary of the plan can be found in this International Business Law Services article. Here are a few of the key bullet points:

Supporters of such a measure point out that international tax law hasn’t been given as much as a cursory look since the Fowler commission in the 1960’s. American corporations (as with most individuals) don’t exactly bend over backward to ensure they pay every penny of tax they may justly owe and they’ve had more than half a century to figure out every possible way to dodge their debts and game the system.

Opponents of such reform in the business community, however, have been quick to point out that imposing the equivalent of a tax hike on American companies doing business overseas would have dire, unintended consequences here at home. A coalition of American CEOs, including Steve Ballmer of Microsoft, and the Technology CEO Council have penned editorials arguing against these changes.

For years, some politicians have proposed to increase the tax burden on the profits earned by American companies outside the United States, and Congress is now considering legislation that would sharply limit the “deferral” rules that protect U.S. businesses from bearing much higher tax burdens on their earnings abroad than their foreign competitors. Economic research has established, however, that in the global networks of America’s international companies, these foreign investments and jobs do not cut into investment and jobs at home, but rather increase them. As a result, the current proposal to substantially restrict “deferral” would end up reducing American jobs and investment and could impair our economic recovery.

There are two sides to every story, of course, and the Section of Taxation prepared a report for a bipartisan committee in Congress in June of this year with very different conclusions. For one thing, they found that current international tax laws are more full of holes than a swiss cheese, and corporations avail themselves of these loopholes with great vigor.

At year-end 2006, U.S. foreign direct investment was valued at $2.89 trillion.While roughly one third the size of foreign portfolio investment, foreign direct investment is an important part of the U.S. economy. The current U.S. tax rules provide more alternatives for taxation of foreign business income than what might be expected in a straight-forward foreign tax credit system. They allow cross-crediting of foreign taxes, so that high foreign taxes may be credited against U.S. taxes on low-taxed foreign income, they allow current deductibility of expenses allocable to deferred income, and, subject to certain anti-deferral rules,they allow deferral from U.S. tax on foreign business income earned in lower taxed countries.

I was also heartened to see them note that currently, both incentives and loopholes make it so lucrative to do business elsewhere that it actually rewards American companies for avoiding domestic investment and growth.

Excess foreign tax credits even can be used to offset U.S. tax on royalty income and income from export sales that is treated as foreign-source income for U.S. tax purposes (though this income generally would not be taxed by the source country). The overall effect of the current rules can be more beneficial to taxpayers than an exemption system.To the extent that the United States taxes foreign income less than domestic income, there is an incentive to make investments outside the United States that might have been made in U.S. assets.

Upon hearing something which seems so completely counterintuitive as the argument from the CEOs, I decided to do some more digging to get to the bottom of this argument. I spoke with Mihir A. Desai, the Mizuho Financial Group Professor of Business Administration at Harvard Business School. He is the author of a number of papers on the subject, including, Securing Jobs or the New Protectionism?

[M]odern welfare norms that capture the nature of multinational firm activity recommend a move toward not taxing the foreign activities of American firms, rather than taxing them more heavily. Similarly, the weight of the empirical evidence is that foreign activity is a complement, rather than a substitute, for domestic activity. Much as the formulation of trade policy requires resisting the tempting logic of protectionism, the appropriate taxation of multinational firms requires a similar fortitude.

His entire paper, linked above, lays out a comprehensive case for the argument against Obama’s proposed reforms. While I do not personally agree with the conclusions, I invite you to read the entire article for that side of the story.

During our discussion, one thing Professor Desai and I managed to agree on was that the tax code needs reform across the board. A common talking point among Republicans is the complaint that America has “one of the highest corporate tax rates in the world.” That’s certainly true, at least on paper. The reality, of course, is that American corporations rarely if ever actually pay anything close to those rates because of all the flaws in the tax code. I agreed with the professor that having the appearance of such a high corporate tax rate, both domestic and foreign, acts as a disincentive to business, but we split on what to do about the fact that government isn’t actually collecting that revenue in most cases.

I also asked Professor Desai to comment on the more ethereal, humanist view on these foreign tax schemes. If these are American companies, largely owned and operated by Americans who enjoy all the benefits of living in this nation, do they not owe something more to the country which provided them with this opportunity? Even if it means slightly less profit in the short term, should they not be seeking ways to create more jobs and invest more resources here at home, particuarly in times of economic distress? Or was that all silly rainbows and unicorns talk?

The professor told me that it was not all rainbows and unicorns, but the real question is what would happen if the companies were not engaged in all of this foreign investment and hiring? The effect, he said, would lead to additional loss of jobs at home due to decreased competitiveness and reduced profits.

I’ve heard this argument before, but honestly, I remain unconvinced. America provides the framework and the bedrock upon which all of this opportunity and success is found, as well as the lifestyles afforded to those who are most successful. Particularly in this period of economic turmoil, hiring and investing here at home should be the priority, not the afterthought.

One of the people I talked to about this pointed out that this type of “tinkering” with the tax code really amounts to nibbling around the edges of a larger problem. Rather than trying to pluck a few threads out of an outdated and easily abused system, such a plan should be discarded in favor of comprehensive tax code reform. I’ll be the first to raise my hand and say I heartily agree, but I’m also trying to be realistic here. This is a subject which seems to have permanently woven itself over the last two decades or more into a Mark Twain analogy… everyone talks about tax reform, but nobody ever does anything about it. This is one area where we might actually be able to do something about it, even if the solution is imperfect, and if the President is willing to take a crack at it, I’ll back him up on it.