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How to Stop Corporate Inversions and Make U.S. Businesses More Competitive

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How to Stop Corporate Inversions and Make U.S. Businesses More Competitive

August 1, 2014

The food fight over corporate inversions – whereby a U.S. company moves its domicile overseas to avoid paying U.S. taxes on future income earned abroad – shows no sign of diminishing in the near future. For good reason. Democrats are in dire need of a winning campaign issue, and the dispute underscores stark philosophical differences between the two parties.

Democrats say that the response to the uptick in corporate inversions ought to be to merely outlaw them – or at least make them much more difficult to do. It is easy to see why they would try to turn this into a campaign issue. The specter of major U.S. corporations leaving the U.S. naturally bothers people – even though that is not what actually occurs in a corporate inversion – and attacking obstreperous Republicans for resisting attempts to outlaw such activities ought to score points with the voters.

Republicans argue that the way to stop corporate inversions is to reduce the corporate tax rate and move to a territorial tax system, which would obviate the tax benefits of a company moving its domicile overseas. More broadly, they hope that the recent skirmish might kick-start serious discussions on tax reform, which has been dormant since Ways and Means Committee chair Dave Camp released his reform plan earlier this year.  

If the fight over inversions were to start the ball rolling on reform, it might make sense to begin by looking at another developed country, the United Kingdom, that until recently had a high corporate tax rate, a raft of corporate inversions, and a moribund economy. A simple, three-pronged reform helped move the economy into a higher gear.  

UK tax reform began in 2009 when the country repealed its worldwide tax regime, which required companies based in the UK to pay taxes on income they earned all over the world.  A worldwide tax regime meant that UK firms effectively faced a higher tax rate than most of their competitors when competing in a foreign market, since most other developed countries do not tax the foreign profits of domestic companies. The move to a territorial tax regime ended corporate inversions in the UK, and led some companies to move their headquarters back. A worldwide tax regime is still in place in the United States, one of the few developed countries to still have one.

The second thing the UK did was lower its tax rate, which at the time was 28 percent, by one or two percentage points a year, so that by 2015 the rate will be 20 percent. It is now at 21 percent.

But the UK wanted to also attract new business and investment, especially in high-tech industries. It implemented a specific tax break for patents so that the government taxed profits accruing to any patents developed by the company at just 10 percent.

The change increased the investment of UK industries that do a lot of research and experimentation, and encouraged entrepreneurs to either start such businesses or move ones they already have to the UK. The hope was that such companies already in the UK would shift more of their research back to the UK from wherever they had placed it to take advantage of lower taxes elsewhere.  And along with more research and development, these companies might be inclined to locate future production near their research and development, since there are natural advantages having the two near one another for many industries.

These reforms were not without detractors: The Financial Times warned that the UK could not afford such tax cuts, and the OECD forecast that the country would go into recession for eschewing demand-side stimulus. However, the corporate tax changes have been a success.

The country has outperformed the rest of the G-7 nations and has been enjoying above-trend economic growth over the last year. Above-average growth is forecast to continue.  The OECD actually took the rare step of apologizing for its harsh criticism of the UK’s tax reforms, acknowledging that its predictions were far off the mark.

There are long odds that Congress will have the temerity to try to broker a bipartisan tax reform, especially this close to an election. But it is worth noting that another country with the same problem as the United States engineered a simple but elegant reform that has increased economic growth.

 

Ike Brannon is a Senior Fellow at the George W. Bush Institute and president of Capital Policy Analytics, a consulting firm in Washington DC.

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