A Better Tax Policy

Getting tax policy right - particularly for encouraging investments in R&D and job creation - is critical for growing the American economy.  So it was discouraging that in his speech at the Democratic National Convention in Charlotte, North Carolina, Vice President Biden attacked Governor Romney's call for a territorial tax system:

"Governor Romney['s]...budget proposal...calls for a new tax. It's called a territorial tax, which the experts have looked at and they acknowledged it will create 800,000 new jobs. All of them overseas. All of them."

At first glance, it appears to be a devastating indictment of a territorial tax system (if true). The implications of Biden's argument are that American jobs would be siphoned off to our competitors, as Joe and Suzy Smith try to make ends meet.

And the study from which the vice president draws his numbers does find that switching to a territorial tax system (one where corporations' profits are taxed only domestically instead of internationally as they are now) would create 800,000 new jobs in foreign countries; moreover, it finds that such a tax system would cost the treasury $90 billion a year in lost revenue. This is due to marginal tax incentives - the ability to move more investments into lower tax jurisdictions without facing any form of US taxation is certainly appealing.

This is where Biden's charge gets more than a little hazy, however. Nowhere in the study does the author, an economist at Reed College, say that foreign job creation will result in lost US jobs.  And it also ignores the other critical prong of the Romney tax strategy: lowering the U.S. corporate tax rate to a more competitive level.  This is critical to remember since the U.S. has one of the highest corporate tax rates in the world. (Japan used to be higher, but they recently reduced their rates.)

In fact, a recent study by the Tax Foundation cites several economists who argue that foreign direct investment abroad (FDI) will actually stimulate demand domestically, though perhaps at a lower rate. This happens because investment, regardless of whether it is domestic or foreign, boosts firm productivity. Productivity gains are not geographically constrained, and will resonate firm-wide, spurring demand for labor in other regions.

You could also wonder why switching to a territorial system would increase foreign investment abroad compared to today's system, because taxes on profits earned by  U.S. corporations abroad are only taxed when they are returned to the U.S. So the current system - through tax deferment - already encourages U.S. based corporations to invest more of those profits abroad, as opposed to returning them to the U.S., where they would be taxed twice (i.e., a U.S. company operating in France is taxed once by French authorities, and then again on any remaining profits repatriated to the U.S.).

Not only that, but the author acknowledges that her analysis does not take into account the impact of a lower corporate tax rate - this would act as a counter-incentive, encouraging firms to keep earnings and assets domestically - a key part of Romney's budget proposal (and a part of President Obama's proposal for tax reform as well).  Biden strategically ignores this fact. 

Lastly, and this is touched on briefly in the study, 27 out of 34 OECD countries have switched to a territorial tax system - and the ones that maintain worldwide systems have corporate tax rates significantly lower than the United States' rate of 39.2 percent (not including the potential dividend rate).

Other studies have addressed directly the merits of a territorial tax system (or at least a repatriation tax holiday), arguing that the resulting infusion of capital back into the economy could stimulate economic growth and employment. The merits of shifting to a territorial tax system are clear - reducing unnecessary distortions between the US and foreign markets, accessing the $1.7 trillion in capital locked in foreign jurisdictions, and spurring economic growth domestically and abroad.  In particular, these benefits can help the U.S. based biopharmaceutical industry, where the U.S. has a long-time competitive advantage versus its foreign competitors.


The chart above shows the allocation of 2011 earnings for the 5 largest US-based pharmaceutical companies. The tendency to keep earnings abroad means that these foreign earnings do not generate tax revenue for the US (remember that they can be deferred until repatriation - though most are not repatriated due to the high cost of doing so), and so, despite our worldwide system's long theoretical reach, we see little benefit from it.

Johnson & Johnson for instance, had an effective worldwide tax rate of around 21.8 percent in 2011. That simple, low number belies its huge domestic tax burden - a whopping effective rate of 46.8 percent on its domestic operations, compared to a foreign burden of only 11 percent; in 2010 these were 32.2 percent and 14.7 percent, respectively. (Admittedly, it is rare for a company to pay rates higher than the statutory rate, but generally, the U.S. leads in effective tax rates for pharmaceutical companies.)

What would switching to a territorial tax system with a lower corporate tax rate mean for American biopharmaceutical companies?  Companies like Johnson & Johnson could repatriate more profits, invest in job creation, expand its manufacturing base in the U.S., or increase R&D.  Tax distortions between the US and foreign markets would start to disappear as the U.S. became an even more attractive destination for capital. 

It is possible that companies might move some capital outside the U.S., to avoid paying U.S. taxes on that income.  But they can do this already, and it would be based on decisions about the highest returns for working capital.  Arguably, we have the worst of both worlds now: an uncompetitive tax rate and a tax system that encourages America's most innovative companies to invest more abroad than at home. 

Shifting to a territorial tax system and a lower corporate tax rate would encourage job and investment growth at home, and make U.S. companies more competitive in the global market. 

What's not to like about that?

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