Closed for Business
From the January/February 2007 Issue
We’re driving companies offshore with a corporate tax rate higher than every European nation, writes economist Kevin Hassett. And wages are suffering.
Imagine you are the CEO of a major U.S. manufacturing company. You are looking to locate a new domestic plant. All other factors being equal, would you locate the plant in the state with the highest taxes? Now, make that question international. Would you locate a plant in a country with high taxes or low?
Total lobbying spending in 2005 was about $2.3 billion, but almost none went toward persuading Congress to lower the corporate tax rate. Businesses instead prefer to push for their own narrow breaks.
The obvious answer points to a growing economic problem for the United States. Among the 30 wealthy countries that make up the Organization for Economic Cooperation and Development (OECD), the U.S. ranks second, just below Japan, for the highest combined tax rate (federal and state) on corporate profits. Our position in the world hierarchy is relatively new. In 1994, the U.S. ranked 18th. But since then, other nations have been cutting rates—from an average of 37 percent to 28 percent—while the U.S., at 39 percent, has maintained its high level.
There is a powerful academic consensus that high corporate rates significantly harm the U.S. economy, for two reasons:
First, most foreign multinationals are headquartered in countries that charge taxes only on domestic operations. If a French firm locates a plant in Ireland, then all of the profits of the Irish plant are taxable in Ireland, but are free from French taxation. So French firms have an enormous incentive to locate in the country with the lowest taxes they can find. That rules out the United States.
Second, U.S. firms themselves can defer or even avoid U.S. taxes if they locate their operations offshore. If a U.S. firm locates a foreign subsidiary in Ireland, then the profits that it earns in Ireland are taxed in the U.S. only when the money is mailed back home. If the money is left in a bank account in Ireland, then U.S. tax is avoided.
So both foreign and domestic firms have good reason to steer clear of the United States. We might as well hang up a sign at our border with the words, “Closed for Business.”
We are feeling the effects. A September survey by the Organization for International Investment found that insourcing—that is, international firms doing business in the United States—is now actually on the decline. After rising 43 percent between 1994 and 2000, the number of U.S. workers on the payrolls of foreign-based companies dropped 9.6 percent, to 5.1 million, between 2000 and 2004, the most recent year for data.
Sure, the U.S. has a highly productive workforce and the world’s largest single consumer market, but the latest literature suggests that relative tax rates are a big, big deal. Indeed, the dramatic flow of international capital to the lowest tax environment is one of the strongest and most reliable findings in the history of economic science.
If a country lowers its rate below its rivals, as Ireland, now with a 12.5 percent rate, began doing more than a decade ago, then multinationals flood that nation with capital. It’s very much in the data.
And the capital attracted by low taxes leads to amazing economic growth—about 10 percent annually for Ireland in the late 1990s.
In a recent paper, my colleague Aparna Mathur and I found that manufacturing wages for blue-collar workers soar when a country lowers its corporate rate. A reduction merely from 35 percent to 30 percent produces an increase in real blue-collar wages over five years of about 11.5 percent. It takes a lot of capital to have such a strong positive effect on wages. Taxes are a big deal.
Why has the U.S. found itself in this sorry position? One explanation might be that our politicians have been far more anti-business than popularly perceived. But another reason is the short-sightedness of businesses themselves. According to OpenSecrets.org, total lobbying spending in 2005 was about $2.3 billion, but almost none of that money went toward persuading Congress to lower the corporate tax rate. Businesses instead prefer to push for their own narrow breaks. The U.S. Chamber of Commerce does not even include corporate taxes in the list of positions on 15 economic and taxation issues on its website.
Many factors affect a nation’s competitiveness, from average wage rates to education. The irony is that tax policy is the easiest to fix. Certainly, lowering the rate requires showing Americans that benefits don’t flow simply to fat cats. But how hard can that be? The Europeans did it. If we lower one rate a significant amount, the tax climate will change dramatically.
The status quo—one of the most unfriendly tax policies toward business on earth—is unacceptable to anyone who cares about the future of American industry. No one should be surprised if our best firms continue to flee overseas and if foreign-based firms prefer locating their plants outside America.
Image credit: Graph by MacNeill and MacIntosh
Image credit: Graph by MacNeill and MacIntosh