Washington policymakers can be forgiven for focusing on the low-hanging fruit when it comes to corporate tax reform. When Congress hasn’t managed any kind of major reform since 1986, we should probably be happy with any tax reform progress, no matter how small.
This is what is going on with the latest fervor to end corporate inversions—which is when a corporation is bought by a foreign company to move formal ownership abroad. The government is right to clamp down on those corporate inversions that are done purely for tax avoidance. But there are much graver cost and fairness problems with the corporate tax code that need addressing as well.
This summer a few medium-sized U.S. corporations (Medtronic, Abbvie, and Applied Materials) inverted into countries with much lower corporate taxes like Ireland, the United Kingdom or the Netherlands. Even Burger King, a brand that's as American as it gets, is heading north to lower-tax Canada in a merger with Tim Hortons. Two much larger U.S. corporations, Walgreens and Pfizer, considered inverting, though the deals eventually fell through.
To any Average Joe, these deals look fishy. Often the foreign companies doing the buying are one-quarter the size of the target U.S. companies, akin to the minnow eating the whale. The U.S. companies, meanwhile, keep their U.S. headquarters and go about business as if nothing has changed. The only difference is their official mailing address. And the only advantage of the deals is lower tax bills.
It all stinks of tax avoidance. Individual taxpayers could never get away with this, so why should corporations?
Unsurprisingly, there are loud and (mostly bipartisan) rumblings in government to do something about these inversions. Fortunately Congress need not get too involved; the Department of Treasury has legal authority to adopt some regulations that should do much of the job. It could, for example, make it harder for corporations to make tax deductions on debt held by an affiliated company abroad.
Secretary Jack Lew has also asked Congress to require foreign acquirers be at least 50 percent the size of their U.S. targets. Right now, the bar is just 20 percent. U.S. corporations would have much more difficulty finding foreign companies that would make the cut. Lew has recommended the new regulations be retroactive, capturing all the recent inversions that have dominated headlines. Here there is a precedent for bipartisan support. A Republican-led Congress passed a similar retroactive statute in 2004, which first set the bar at 20 percent.
But before we declare a major victory for corporate tax reform, let’s put all this into perspective. There are plenty of other areas where the corporate tax code is equally unfair and more costly, as we argue in our report on federal corporate tax policy.
With corporate inversions, not a lot of tax revenue is at stake and not a lot of companies are involved either. The government estimates corporate inversions cost the U.S. Treasury perhaps $2 billion a year in lost revenue. It may sound like a lot, but it's actually only half of one percent in annual corporate tax revenue. And while it is true that the pace of inversions has increased recently, we’re still talking about a tiny share of all corporations. In the past thirty years, fifty corporations have inverted, of which twenty occurred in the past two years. Keep in mind there are 1.7 million U.S.-based corporations.
Let’s compare that to profit-shifting, or when corporations fiddle with their profits so that they appear to have been earned in low-tax countries even though other indicators, such as the location of investments and personnel, suggest they were earned in high-tax countries. Tax havens, which account for just 1 percent of the world’s economy, hold about 24 percent of U.S. corporate foreign profits. The culprits are some of the most valuable and recognizable U.S. brands (including Apple, Microsoft, and Caterpillar) and virtually every U.S. corporation with foreign profits, except for extractive industries like oil and mining whose profits are steeply taxed and harder to shift. Profit-shifting costs the Treasury an estimated $60 billion a year in lost revenue—thirty times the cost of inversions.
Or look at unfairness in tax treatment among corporations. The U.S. tax code allows corporations to indefinitely defer taxes on foreign profits as long as those profits are retained abroad. This means that U.S. multinationals who earn big foreign profits end up paying an effective tax rate that is far below the U.S. statutory tax rate of 39 percent. U.S. corporations in the retail industry, in contrast, whose profits are mostly domestic, pay close to the official top rate. Also, many large businesses that resemble corporations in everything but name end up paying the lower income tax rate instead of the corporate tax rate. Were these businesses subject to the corporate tax, the Treasury would receive about $76 billion in additional revenues a year—forty-three times what stopping inversions would bring in.
Solving these far more serious corporate tax problems probably requires more substantial congressional action, which explains the reform holdup. Corporate inversions do indeed need to be addressed. But let’s keep our eye on the ball and also focus on the many other corporate tax unfairness and tax avoidance issues at hand.