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The Republican tax proposal now pending in Congress has many provisions that change who will pay what taxes. This tax bill will change economic incentives and tax revenues—some for the better, some for the worse.
A tax overhaul could be great if it made our economy more efficient. This is an argument that Republicans are making: Our collective future debt burden may not end up that much higher, because our companies will invest more and we will all be better off. And, indeed, our current corporate income tax system is very inefficient and there is much to improve. However, the proposed tax bill changes one important and relatively overlooked aspect that will turn out to be disastrous.
A little economics lesson: To understand the tradeoff between tax collection and revenues, consider a 100% tax on Coca-Cola. The result would likely be that almost all Coca-Cola drinkers switch to PepsiCo—and the government would not even collect any taxes. All it would have done is to make all of us (Coca-Cola drinkers) worse off.
Companies are engaging in many practices that lower their tax bills—like Coca-Cola drinkers trying to escape a Coca-Cola tax. As a result, our U.S. government is not collecting much, and we are all worse off for wasteful taxes, a worse economy and (perhaps) worse soda drinks. Consequently, lowering the corporate tax rate could help us all IF it indeed improved the incentives of our corporations to invest here in smarter and better ways.
But there is one “little” provision in the current proposal, which will turn out disastrous, if enacted (and it looks like it will be). This is the little provision that plans to turn the U.S. tax code into a territorial one. Simply put, this means that U.S. companies will no longer have to pay U.S. taxes on their foreign subsidiaries.
It is not difficult to guess where U.S. companies will invest in the future if and when this tax proposal becomes law. It will not be in the United States. If companies have any brains and tax lawyers (and our tax lawyers are the best in the world!), the CEOs will honor their fiduciary duties to shareholders and appropriately move their operations to the lowest-tax domicile. Within a few years, Canada and Mexico will realize that they can set up reduced-tax trade zones near our border, charging “only” 10% in corporate income tax. Aggressive corporate lobbying in Washington will prevent any legal changes back to our old system that late in the game.
We really have only one smart choice: whatever we decide to make our domestic corporate tax rate, it should be at least as high, if not higher, for our foreign subsidiary tax rates.
Proponents of this “little” change sometimes argue that many other countries also have such territorial tax systems. However, this is not a good argument. First, it is not a good reason why it makes sense for us to follow the least self-serving ideas in other tax codes—ideas that help explain why so many European car manufacturers now happily produce in the United States. Second, these countries often have other institutional aspects that make it possible to entertain such a system. For example, Germany is embedded in the European Union, just like its neighbors; and transport costs and other barriers prevent German companies from operating out of Montenegro or Uzbekistan.
Their second argument is that we need to have our U.S. companies remain competitive. The problem is indeed that some U.S. companies have tried to leave the U.S. altogether. This is a problem that is better solved by taxing these (then formerly domestic, now foreign) companies more when they then seek to retain access to our domestic U.S. markets. Solving it by exempting their subsidiaries from U.S. taxes is like throwing the kid out with the bathwater. For all we care, in such cases, we would have effectively allowed these foreign subsidiaries of our companies to effectively become extraterritorial, anyway.
Making taxes on U.S. profits higher than taxes on foreign subsidiary profits will give us the worst of all worlds. We will obtain less in U.S. tax revenues. And our U.S. corporations will shift their new investments from domestic subsidiaries to foreign subsidiaries. While this may benefit the bottom lines of our U.S. corporations (and their shareholders), it will not benefit us.
Ivo Welch is the J. Fred Weston Professor of Finance and Economics at the UCLA Anderson Graduate School of Management