April 7, 2004

Finally, the campaign has generated a new economic policy idea.  Senator John Kerry believes the current corporate tax code encourages companies to invest abroad.  He wants to alter corporate taxes to stop this purported bias. 

At issue is the ability of multi-nationals to defer taxes paid on earnings abroad until those earnings are repatriated in the U.S.  According to Kerry’s staff, the U.S. loses $12 billion per year because of these deferred taxes. 

Moreover, companies may be searching for ways to invest abroad in order to continue the tax deferral.  After all, any tax liability that is deferred is the equivalent of receiving a zero interest loan on the tax liability. 

(This is one of the reasons that I encourage everyone who can to fully utilize their individual tax deferred opportunities.  Over time, individuals should be able to earn more than zero on their tax deferred savings.)

Companies also can earn more than zero by building facilities abroad.  As they do, jobs that might have been created in the U.S. instead are growing in international subsidiaries of U.S. companies. 

By taxing earnings as they accrue abroad rather than when they are repatriated, Kerry hopes to be able to lower the domestic corporate tax rate to 32.5 percent.  Thus, by eliminating tax deferral abroad and lowering the tax consequences of doing business at home, the Senator hopes to encourage more domestic job creation at the expense of international job growth. 

In principle, the Senator is correct in his assertions.  The corporate tax code is biased toward globalization. 

However, the impact is not substantial.  After all, most large corporations in the international arena can get loans near the Libor rate, which currently is about 1.25 percent.  The gap between zero and 1.25 is not that great. 

Therefore, the job loss created by this “bias” in the corporate tax code currently cannot be large.  (It is unlikely that corporations are making decisions that are altered by such a small difference in financing.)

If inflation ever again becomes substantial, the zero interest loan on deferred tax liabilities might make a difference in determining whether international earnings will come home.  Therefore, it is useful to decide whether the globalization bias in the tax code should be changed. 

As a rule, I believe distortions from market solutions should develop only if there are market imperfections that require some degree of intervention.  Even then, the intervention needs to be useful. 

For example, reducing pollutants may be socially desirable.  However, requiring that any investment in polluting facilities cannot be approved until all such facilities are brought to best practices may lead to many such facilities never being brought up to better practices.  Thus, such requirements are not useful because they do not create beneficial results. 

Of course, the tax code is distorting market solutions by allowing a benefit to companies with earnings abroad that is not available to domestic producers.  So, changing the code as Kerry suggests would re-establish the rule of market forces without bias. 

But why was this bias allowed to enter the code?  Apparently, most nations have much lower corporate taxes than our nation does.  If taxes needed to be paid on earnings abroad, American companies would be at a competitive disadvantage.  Therefore, the bias was established to make a more level playing field between American owners of production abroad and international owners of similar production. 

However, in treating international production of domestic companies differently than domestic production, the playing field became uneven between the local and international production of domestic firms. 

On the principle I outlined above (interfere with the market only when there is a market imperfection), the case for retaining this tax bias is based upon what market imperfection is greater.  Do we care more about our international production being competitive with other international producers or with our domestic production being competitive with our international production?

In the current frenzy over outsourcing of jobs, I think I would opt for reducing the imperfection between domestic and international production.  Therefore, I would favor the Kerry proposal.  Nevertheless, we must realistically expect that it will have little impact upon the location of world production under current economic conditions. 

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