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Outsourcing Jobs and Taxes

Author: Roya Wolverson
Updated: February 11, 2011
This publication is now archived.

Introduction

The current U.S. corporate tax code incentivizes companies to move their business operations overseas, and by extension the offshoring of jobs that would have based in the United States. The debate over outsourcing--the effect it has on U.S. job creation, and the tax regime needed to rein in the practice--has become an important issue on the 2012 presidential campaign trail. Many policymakers and analysts, including President Barack Obama, have repeatedly criticized the outsourcing of jobs abroad by U.S.-based multinational corporations, arguing that it not only reduces job opportunities for U.S. workers at a time of high unemployment, but also hurts U.S. competitiveness in the global economy. The Obama administration has proposed policies to encourage companies to move back to the United States, while closing corporate tax loopholes that make it easier for multinationals to pay limited taxes on their overseas operations. Some Democratic lawmakers, along with union representatives, believe Obama's proposals will help address a weak job market and troubling budget deficits. But Republicans, some Democrats, and industry representatives fear higher taxes on U.S.-based multinationals will lead to an exodus of business, investment, and jobs.

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The Role of Multinationals in the U.S. Economy

The influence of U.S.-based multinationals on U.S. jobs and tax revenues has become an increasing concern for U.S. policymakers and the public. A 2006 paper (PDF) by Kenneth Scheve and CFR's Matthew Slaughter noted over two-thirds of Americans think companies sending jobs overseas is a major reason why the economy is ailing. In a March 2009 paper (PDF), Harvard economist Mihir Desai said more recent polling data suggest those feelings have heightened. In September 2010, the U.S. Senate Democrats introduced legislation to eliminate tax breaks that ship jobs overseas (TheHill). The bill was voted down by Republican lawmakers.

"A lot of jobs are shifting to developing countries like China because a company doesn't want to pay American wages and benefits or operate under health and safety regulations." -- Thea Lee

Employment by U.S. firms in emerging economies including China, Malaysia, and Singapore has grown rapidly in recent years, according to the non-partisan Congressional Research Service (PDF). Employment by U.S. firms in China, for example, grew 153 percent between 2003 and 2008, the most recent year available. U.S. jobs in Asia account for about one-fourth of total employment by U.S. firms abroad. However, multinationals' share of U.S. GDP has remained relatively constant (PDF) since the early 1990s, accounting for roughly $3.5 trillion in goods and services in 2006, about 26 percent of U.S. gross domestic product, according to the U.S. Bureau of Economic Analysis (comprehensive data on U.S. multinational companies generally lags current events by several years).

Multinationals' Impact on U.S. Jobs

Obama's tax proposals are based on the idea that multinational tax changes can improve U.S. job growth, with a portion of the tax revenues raised by removing multinationals' overseas tax advantages going to create a permanent tax credit on domestic research and innovation.

But many economists and tax experts see no direct link (PDF) between these issues. "The connection between tax policy and jobs is pretty tenuous. The proposals are more political," says director of New York University's International Tax Program David Rosenbloom. While foreign direct investment may create jobs abroad that substitute for jobs at home, that investment may in turn create more domestic jobs. A 2009 study (PDF) by economists Desai, C. Fritz Foley, and James Hines found that a 10 percent increase in foreign investment was associated with 2.6 percent of additional domestic investment. In a February 2010 Wall Street Journal op-ed, CFR's Slaughter argues that successful foreign operations by U.S. multinationals expand both foreign and domestic employment, since more activity abroad leads companies to provide more domestically based research, development, and management. Slaughter adds that "insourcing" companies (WSJ)--the U.S. operations of multinational firms based abroad--now employ more than twice the number of Americans they employed in 1987, accounting for 4.7 percent of total private-sector employment in 2008.

U.S. labor representatives and some economists, however, argue that increasing investment and jobs abroad often eliminates them at home. Thea Lee, policy director for the AFL-CIO, says much of the economic data supporting the link between overseas investment and domestic job growth fails to distinguish between foreign investment used to serve market demand for U.S. goods and services and foreign investment used to buy cheaper labor abroad. "A big chunk of investment goes to wealthy countries. But a lot of jobs are shifting to developing countries like China because a company doesn't want to pay American wages and benefits or operate under health and safety regulations," she says. Outsourcing is not a major driver of U.S. employment, says the Center for American Progress' Michael Ettlinger, but it does contribute to job losses in some cases. In a March 2010 New York Times op-ed, the U.S. Business and Industry Council's Alan Tonelson and Kevin Kearns argue that--in addition to diminishing U.S. jobs--corporate off-shoring distorts gains in U.S. productivity.

Multinationals' Impact on Public Revenues

Another concern is whether U.S.-based multinationals transfer economic production (as measured by GDP) to other countries. The federal government loses individual and corporate income tax revenue when multinational firms shift profits and income to low-tax countries. Companies like Microsoft and Google, for example, can lower (NYT) their effective tax rates by moving certain operations overseas to countries like Ireland, which has a nearly zero rate on royalty income and a 12.5 percent corporate tax rate, the lowest among OECD countries. The average tax rate on multinational corporations among OECD countries is about 27 percent, compared to 39 percent in the United States. Only Japan has a higher overall corporate tax rate at 39.5 percent. Obama's 2011 State of the Union address echoed these concerns. "Over the years, a parade of lobbyists has rigged the tax code to benefit particular companies and industries. Those with accountants or lawyers to work the system can end up paying no taxes at all. But all the rest are hit with one of the highest corporate tax rates in the world," he said.

Many economists argue this discrepancy discourages foreign investment in the United States and incentivizes U.S.-based multinationals to go abroad. A 2008 OECD study (PDF) found that foreign direct investment increases by 3.7 percent for every one percentage point decrease in the corporate tax rate, and that, as cross-border capital flows increase, foreign direct investment is increasingly swayed by countries' tax rules.

"Under the current system, taxes are driving a lot of [corporate] decisions, which creates distortions." -- Rosanne Altshuler

However, U.S.-based multinationals typically pay far less than the nominal U.S. tax rate due to various tax credits and incentives that push income overseas. According to the Obama administration (Bloomberg), these tax breaks make the effective corporate tax rate about 2.3 percent. In a June 2009 Illinois Business Journal article, Ettlinger cites data indicating that U.S. corporate income tax collection dropped to 2.9 percent of U.S. GDP in 2006, compared to 4.0 percent of GDP in 1965 due to lower U.S. taxation of debt-financed investments and use of foreign tax shelters. By White House estimates, corporate tax breaks cost (NationalJournal) the federal government $1.1 trillion annually. Others, including the Peterson Institute for International Economics' Gary Hufbauer, argue that estimate is far too high (PDF). A recent New York Times/Capital IQ report found that thirty-nine of five hundred S&P companies paid less than 10 percent of their revenues in taxes last year.

Difficulties in Globally Coordinating Tax Evasion Efforts

Foreign countries and territories that have no or nominal corporate tax rates are considered so-called "tax havens" in that they incentivize multinational corporations to transfer income abroad. The OECD created an initial list of tax havens in 2000, which has changed over time as offending countries pledged increased transparency and political considerations evolved.

Crisis Guide: The Global Economy A January 2010 Government Accountability Office report (PDF) found eighty-three of the one hundred largest U.S.-based multinationals had subsidiaries in tax havens. The tax-evasion issue has attracted increasing international attention as cash-strapped countries attempt to replenish government revenues and after several prominent international tax evasion scandals (Guardian). A July 2009 Congressional Research Service report (PDF) cites studies suggesting little progress has been made in international efforts to coordinate countries' tax evasion efforts, partly due to the OECD's inability to force compliance.

Obama's Proposed Tax Reforms

President Obama's 2011 State of the Union address called on Congress to "simplify" the system by getting rid of corporate "loopholes" and leveling the playing field, which would aid the country's competitiveness and growth potential. He asked for "revenue neutral" reforms, meaning they would neither increase nor decrease tax revenues. New York University tax expert Daniel Shaviro says that approach may leave some companies paying more at a lowered tax rate even if the tax code is simplified (Bloomberg). Many Republican lawmakers and business groups support comprehensive tax reform but view any tax break closures as "job-destroying taxes."

Obama's 2011 budget proposed similar measures to limit offshore "loopholes" or tax-avoidance techniques, outlined below. These include deducting expenses from tax payments on profits earned abroad, using tax credits to offset the taxes paid to foreign governments for overseas operations, and shifting income from high- to low-tax countries via so-called "transfer payments." The administration said the plan would raise roughly $190 billion in tax revenues over the next ten years.

Tax Deferral: The United States taxes both domestic and foreign earnings of U.S. multinational firms. Firms time the payment of taxes on their foreign profits based on how their parent company organizes its foreign operations. If a parent company is organized through subsidiaries (separately incorporated in the foreign country), the subsidiaries' profits generally are not taxed until they are paid to the U.S.-based parent.

Parent companies do pay U.S. tax immediately on dividends, interest, or royalties paid by one subsidiary to another. But delayed payments, referred to as "tax deferrals," often do not occur for years. According to a May 2009 Bloomberg article, for example, General Electric has deferred tax on a cumulative $75 billion over the past decade; Hewlett-Packard has deferred $12.9 billion since 2005. Once foreign income is sent back to the United States, the U.S. government imposes a residual tax. Obama's reforms would defer the deductions U.S.-based multinationals take on foreign income until the U.S. tax is paid on that income, effectively raising the cost of delaying those tax payments.

Tax Credit: To prevent multinational firms from being taxed twice, the United States allows firms to claim tax credits for income taxes paid to foreign governments. If the foreign tax rate is lower than the U.S. rate, the firm receives a credit to reflect the foreign tax paid. If the foreign tax rate for a subsidiary exceeds the U.S. tax rate, the parent firm has so-called "excess credits," which can sometimes be used to offset U.S. tax payments on income from another subsidiary, a procedure called "cross-crediting."

According to the Obama administration, some multinationals use cross-crediting to glean foreign tax credits for taxes paid on deferred foreign income, before that income is repatriated to the United States. In essence, the tax code allows firms to "blend their repatriations to minimize or avoid U.S. taxes on foreign source income," according to the Urban Institute and Brooking Institution's Tax Policy Center. Obama's proposals would limit "cross-crediting" by requiring firms to account for the foreign tax they pay on foreign earnings in calculating their foreign tax credits. Now they only account for the U.S. tax they pay on foreign earnings.

Transfer Pricing: Transfer pricing is the practice of allocating profits for tax purposes between parts of a multinational corporation. Differences in tax rates between the United States and other countries incentivize multinational companies to alter the prices they charge for goods transferred to their subsidiaries. Multinationals try to set prices at levels that minimize their overall tax liability by, for example, under-pricing sales to their subsidiaries in low-tax countries and overpricing purchases from them. This move effectively shifts reported profits to the lower-tax countries.

Consider this example, based on an OECD observer article: If a profitable U.S. computer company buys microchips from its own subsidiary in a foreign country, the transfer price determines how much profit the subsidiary reports and how much local tax it pays. Most governments require firms to use an "arm's length" standard to set transfer prices equal to what they would pay if the transactions occurred between two separate companies. However, it is still possible to manipulate transfer prices for certain intermediary goods and so-called "intangible properties" such as patents and trademarks, since their value is unique to the firm and thus difficult to quantify. A 2006 study (PDF) by Rutgers University's Rosanne Altshuler and Treasury economist Harry Grubert estimated such abuses may reduce U.S. tax revenues by roughly $7 billion each year.

Obama proposed two measures to prevent inappropriate shifting of income abroad. First, the government would more carefully monitor transfers of "intangibles" such as patents, tax them appropriately upon deeming the transfer price excessive, and not allow deferrals on those taxes. Second, the administration would give more flexibility to the Internal Revenue Service in valuing intangible assets.

Risks and Alternatives to Obama's Proposals

Free-trade advocates and industry representatives argue Obama's tax changes would reduce the competitiveness of U.S.-based multinationals.

IIE's Hufbauer says the increased tax burden would encourage U.S. firms to sell their foreign subsidiaries to foreign-based firms in countries not subject to taxes on foreign income. He proposes lowering the U.S. statutory tax rate to 25 percent or less to compete with other OECD countries, which he argues have been lowering their corporate tax rates for several decades. CFR's Slaughter says passing already negotiated trade agreements with Colombia, Panama, and South Korea--and stopping trade barriers against key partners like China--would prove more effective at boosting U.S. exports and related investment and jobs to help close fiscal deficits. Tonelson disagrees. U.S.-based multinationals actually increase deficits, he argues, because they are net importers. "And contrary to what multinationals often claim, they are astonishingly meager magnets for U.S. exports," he says.

The AFL-CIO's Lee, who supports Obama's proposals, says there are other ways to attract foreign investment without lowering corporate tax rates. She suggests introducing a so-called "value-add tax" (VAT)--which is levied at each stage of production based on the value added to the product at that stage and rebated at the border. "If you're based in a country with VAT, it's a big advantage, because your exports are tax-free. Unlike most of our competitors, like China and European countries, we don't have a comparable offsetting rebate on exports, which creates a disadvantage for American-based producers," she says.

Rutgers University's Altshuler says the administration should take reforms further by eliminating deferrals and simplifying the tax code, whose complexities compared to other countries cost both multinationals and the government time and money. "Under the current system, taxes are driving a lot of decisions, which creates distortions," she says. Ultimately, corporations "should be making decisions based on economic reasons."

--Eric Gardner contributed to this report.

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