Reform of corporate tax levels has emerged as a major election-year issue, with both sides battling to prove that their proposals will restore America's competitiveness.
America's corporate tax rate is currently one of the highest in the world. Republican presidential nominee Mitt Romney has proposed shifting to a territorial system, under which corporations would be assessed the domestic rate only on income from domestic operations. Foreign affiliates of American companies would take advantage of lower-tax jurisdictions abroad and compete on equal footing with foreign-owned companies.
Romney's critics claim his proposal is little more than a way to reward businesses for "shipping jobs overseas." Indeed, at Tuesday night's town hall debate, President Obama said as much: "One of [Gov. Romney's] big ideas when it comes to corporate tax reform would be to say, if you invest overseas, you make profits overseas, you don't have to pay U.S. taxes ... [a]nd it's estimated that that will create 800,000 new jobs. The problem is they'll be in China. Or India. Or Germany."
To put it mildly, the president was mistaken. The incentive for investing abroad rather than at home is already embedded in the American system, and Romney's proposal would weaken it.
The Tax Foundation announced on March 30 that combined state and local rates gave the United States the dubious honor of having the highest corporate tax rate in the Organisation for Economic Co-operation and Development -- 35 percent at the federal level and 39 percent if you add in state and local taxes. But that's not all. We are also one of only seven OECD countries with a system that taxes a corporation's worldwide profits at the domestic rate. Britain, Germany and Switzerland have corporate tax rates at 24 percent, 15 percent and 8.5 percent, respectively. And each maintains a system of territorial taxation.
Under the American system, all of a company's worldwide profits are subject to the U.S. tax rate once they are repatriated, with credits for tax payments to foreign governments. It makes little sense, then, for an American company ever to bring back money earned abroad, since that would mean paying the very high U.S. rate. This has resulted in $1.7 trillion in undistributed earnings being held abroad by foreign affiliates of U.S. companies. Needless to say, these funds contribute little to the American economy or to job growth here at home.
Combined with an unnecessarily high tax rate, this worldwide system makes the U.S. an extremely unattractive location for global headquarters and acts as a barrier for capital repatriation -- the $1.7 trillion sitting abroad being the clearest indication. Indeed, volumes of economic literature support the notion that relieving American multinationals of this double tax burden would spur growth domestic investment and job creation.
To be fair, the Obama administration has proposed reforms as well. At the core of these reforms is a minimum global tax on corporate profits as they are earned, not repatriated. If the members of this administration are truly concerned about American jobs flowing abroad, they should take a second look at their own proposals.
The idea that a territorial system would create jobs abroad at the expense of domestic investment is simply wrong. Tax reform that cuts the top rate to the OECD average or lower, and moves America to a territorial system with a bare minimum repatriation tax, is the way forward.
Yevgeniy Feyman is a research associate at the Manhattan Institute.