A staple of President Obama's stump speech during the 2008 Presidential campaign was a promise to end tax breaks for corporations that ship jobs overseas. On May 4, the Obama administration rolled out its proposal to do just that. While Obama is correct that US tax policy discriminates against corporations that produce in the United States, his proposed solution should be called "The Outsource Corporate Headquarters Act of 2009."
On the surface, Obama's plan sounds like a good idea. Currently, US corporations can defer, indefinitely, paying US taxes on profits produced abroad while deducting foreign investment expenses from their US income taxes. As a result, they pay lower tax rates if they produce abroad than if they produce in the United States.
America's 35% corporate tax rate is the second highest in the world. Emerging markets have much lower rates. Ireland's corporate tax rate, for example, is only 12.5%. If an American corporation produces in Ireland, it only pays 12.5% tax on its income, while if it produces in America it pays 35%.
President Obama is correct that current tax policy creates inefficient incentives for outsourcing. Suppose that the US-based Widget Corporation is trying to decide whether to build a factory in the US or in Ireland. Based on the cost of production, distribution, and shipping, producing widgets in the US will earn a profit of $10 per widget. Producing in Ireland will earn a profit of only $8 per widget. The economically efficient thing to do is to produce widgets in the US. Except for the tax consequences! Ireland has lower corporate tax rates. Consequently, the after-tax profits in Ireland are $7 while the after-tax profits in the US are $6.50.
President Obama's proposal is that all Widget Corporation profits should be taxed at America's 35% corporate tax rate. Widget Corporation would get to deduct its corporate tax paid to Ireland, but it would still have to pay the remainder of the 35% to the United States. Production in Ireland would now return a mere $5.85 per widget. Profits for the US-based Widget Corporation from producing in the US, $6.50, would exceed that.
But in the effort to solve one problem, Obama's proposal creates a greater one. In order to slow the outsourcing of American jobs, it would encourage the exodus of US corporations. The US government can only tax overseas profits of US-based corporations. If Ireland has its own locally owned widget producers, they will be able to undersell the US-owned Widget Corporation because their after-tax profit margin of $7 exceeds that of the Widget Corporation. The only way for the Widget Corporation to survive would be to move its headquarters to Ireland so that it too would be exempt from US taxes.
The Way to solve Both Problems
There is a simple way to solve both problems. We should reduce or eliminate the US corporate income tax. Doing so would not only end tax incentives to outsource, but it would invite foreign corporations to invest here, and make a great contribution to ending the recession. There are two good proposals on the table that would replace the US corporate income tax with a consumption tax:
- The FairTax. Replacing all of our federal income and payroll taxes with a national sales tax on goods and services.
- The Value-Added Tax. Replacing just the corporate income tax with a Value-Added Tax (VAT) on goods.
Both the FairTax and VAT are border-adjustable, meaning that they would be paid on imports to America, but not paid on exports from America. American products are currently at a tremendous disadvantage in world markets because most of our trading partners charge VATs ranging from 15% to 25%. (Ireland's VAT rate, for example, is 21%.) These taxes function as a duty whenever American producers export. It's time that we leveled the playing field.
In essence President Obama's proposal would eliminate the inefficient incentives for US corporations to partially move (i.e. outsource) by reinforcing incentives for US corporations to completely move. It would make US-based corporations less competitive without helping US workers compete in US and world markets. Replacing the US corporate income tax with a border-adjustable consumption tax, on the other hand, would make American products more competitive in both US and world markets.
The three Dr. Richmans represent three generations of social scientists from the same family and are co-authors of the 2008 book, Trading Away Our Future, published by Ideal Taxes Association.