We finally get some good details about Sen. Kerry's economic plan, and his campaign told us how they arrived at the 10 million jobs figure. I have good and bad comments on all of it.
The plan has three parts: a change in the repatriation of profits, a 1.75 percentage point reduction in corporate taxes, and a one-year wage subsidy that is refunded to employers. Let me try to deal with the first two now and get the last part and remaining details later this week.
The first part of the proposal is kind of strange to me. It coves this obscure section of tax code that most people don't know about, raising revenues from $5 billion to $17 billion. Tiny, tiny, tiny. I find it odd that he would make it such an important part of his economic recovery plan.
"At the same time, the system raises relatively little revenue: $5.2 billion on all repatriated nonfinancial business income in 1996. Those revenues were equivalent to a 5 percent tax rate on all repatriated nonfinancial income, compared with the standard U.S. corporate tax rate of 35 percent." (From a paper cited in Kerry's proposal)
First think about family though. Parents try and treat all their kids equally. They try to give them equal opportunities, providing for both of them, and trying not to favor one over the other. However, when they send their children out to compete aginst the rest of the world, they try to give them every advantage they can, knowing that other parents are doing the same thing. A level playing field between their kids and others isn't what they desire. After all, that was why they paid for the best education they could afford in the first place; they want their kids to have that step on the rest.
Profit repatriation
This first part is kind of an obscure thing to run on. It deals with how foreign coporations owned by US corporations (CFCs, controlled foreign corporation) remit profits back to the parent. A CFC is always going to be taxed by the host country (where the subsidiary is located), but the question is if the controlling country (the country that the parent in incorporated in) should tax too. There are basically two models. A territorial model taxes economic activity within its borders. So a CFC in Germany owned by a US corporation wouldn't be taxed by the IRS on whatever it does, but it would still be taxed by Germany of course. A worldwide model taxes all economic activity regardless of where it takes place. That German CFC would be taxed by Germany and the IRS. These two models can be considerably blurred by various means.
The US falls to the worldwide side of the spectrum, but it uses a mechanism called deferrals to allow our multinations to compete a little better against those countries that have a more territorial regime, such as Ireland and France. This allows the CFC to not be taxed by the US until profits are distributed back to the parent company. Another way we keep the tax burden down is by allowing foreign taxes to be used as a credit against US taxes. So if taxes in Germany were $80 and taxes in the US came to $100, the CFC would pay Germany $80 and when the profits were sent back to the parent, it would pay the US $20.
Obviously this can be abused by pushing money through subsidiaries incoporated in low-tax countries. To stem this abuse, Subpart F was created in 1962 to define anti-deferral source of income (that is, income that cannot be deferred and must be taxed immediately). Since then it's been ammended numerous times, twisted and contorted, and now it is far too complex.
Kerry's proposal I: eliminate deferral and have a tax holiday
Kerry's proposal would eliminate deferral so that all profits, whether repatriated or not, would be taxed. Eliminating deferral would by extension eliminate Subpart F.
To encourage capital to be sent back to America, there would be a one-year tax holiday. During that year, a parent would only need to pay a 10% repatriation tax. This seems really odd to me. Because of the foreign tax credit, corporations only pay about an average of a 5% additional tax on their profits when remitted (most American taxes are captured by the host country). If they wanted the profits back in America, they would have already sent it at the lower rate.
In order to allow US businesses to remain competitive, deferral would actually still be allowed for subsidiaries that serviced their national market. This part is actually a little vague. In the release, it is worded on a company-wide basis, but that doesn't seem to make sense. One of the examples given is a car factory in India. If it sells cars in India, then it will be allowed to defer income. What if it only sells a fraction of cars in India, like half to Indian and the other half to surrounding countries. Would it be allowed to only defer income that came from India, or would it be allowed to defer all its income? Or what about the call center opened up in Poland to service Europe, a legitimate reason to open up operations overseas.
Kerry also says that he will close certain international loopholes, but it is kind of vague and handwavey. Under his worldwide proposal of course a number of loopholes would be closed because of the more stringent taxation demands, but I really wouldn't count on much beyond what is inherent in the taxation changes.
Kerry's proposal II: lower the corporate tax rate
I love marginal rate cuts, and I love reductions in the cost of capital. Mmm mmm good. Kerry would cut the corprate tax rate by 5%. That would be a 1.75 percentage point drop in the rate: from 35% to 33.25%. (Corporations essentially pay a 35% flat rate, except a little bit is taken off the lower end, and a surtax is applied in the middle of the schedule to make up for it. It creates a very odd looking schedule, produced below for your amusement.)
This should only cost about $4-$6 billion, and my only complaint is that it isn't big enough. It's a paper cut kind of cut, not a good slashing. It seems more like it was intended to be a signal more than a serious effort at reduction.
An important thing to remember though is that most small businesses are not taxed at these rates. They are organized as LLCs or S corporations, and they are taxed on the personal income tax schedule (they call them pass-though entities).
Over | Old Rate | New Rate |
$0 | 15% | 14.25% |
$50,000 | 25% | 23.75% |
$75,000 | 34% | 32.3% |
$100,000 | 39% | 37% |
$335,000 | 34% | 32.3% |
$10,000,000 | 35% | 33.25% |
$15,000,000 | 38% | 36.1% |
$18,333,333 | 35% | 33.25% |
Gains and losses
If you are somebody that sees any offshore investment and jobs as a bad thing (that is, you essentially dislike most forms of multinational corporations), then you should be pleased with the junking of the deferral regime. It will not stop international investment. It might not even slow it down much, but at least the government will take in some extra scratch. However, if you place more value on the productivity and investment returm of America's MNCs or about their competitiveness against MNCs based on other countries, then things are a little more complex.
The claim is that with deferrals there is an incentive to take and keep capital overseas, and with it jobs. Deferral builds a wall between parent and subsidiary. Money cannot flow freely back to the US for redeployment since it will then be taxed.
The problem with this is that currently the repatriation costs are already discounted into the investment decision. The only way a corporation gets anything out of the subsidiary is when the money comes home. One of the sources in Kerry's proposal, Grubert and Mutti, whom Kerry calls "two leading tax economists", points this out more formally by referring to Hartman (1985) (damn, and I thought I had a new idea).
(This is kind of techinal stuff you might want to skip.)
Hartman looks at a single year and asks where a CFC should invest its next dollar, back home or where it is at. If it decides to invest back home, the total return relies on the repatriation taxes (R), the marginal product of capital in the US (MPKus, basically the pre-tax return on investment, and no that is not MKP raised to a power... Kos apparently has a vendetta against the sub tag, not allowing it, so I need to make do with the sup tag instead), and the tax rate in the US (Tus): (1-R)MPKus(1-Tus). If it decides to invest where it is at, then the return relies on the marginal product of capital in that country (MPKf), the tax rate there (Tf), and the repatriation taxes (R): MPKf(1-Tf)(1-R). The Repatriation taxes in both instance cancel, leaving the decision based on the marginal product of capital and taxes of each country. Grubert and Mutti point out that Sinn (1993) extends this to a multi-year model. With deferral the parent can invest less than what is needed without deferral, relying on the deferred income generated by the CFC until it matures (more technically, a steady-state is reached in the capital stock). After that, all its earnings are repatriated. This seems to be born out in practice too, as they point out that CFCs in low-tax countries repatriate very little until after about ten years.
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So it might not affect investment decisions too much. Given the large wage discrepancy between the US and the nations we send capital to, taxes might not play a measurable role in the decision process either. However, even if taxes don't change the decision to open an overseas location, there is still an issue of US-controlled corporations competing against other nation's CFC once the investment has been made. It would be difficult for a US-controlled firm in Hong Kong being taxed at 35% to compete against domestic or other international firms that only pay the the coporate 17.5% tax.
And the question of how many jobs are lost because a company doesn't repatriate its profits is still open. None of the studies Kerry's proposal cites even attempt to answer the question.
Corporate invertions
A little more worrying is that there is an escape for corporations who feel that the bite of worldwide taxation is a little too much for them. They can just move. Not literally, but on paper. The process is called a corporate inversion. A subdiary is formed in a low-tax country, like Bermuda, and the company sells itself to the the subsidary, making it the new parent. This isn't cheap for public companies. It requires all stockholders to sell their shares, and they will have to pay (either long-term or short-term) capital gains taxes on them. The new parent issues stock in itself back to the investors. (When the stock market is up this becomes less attractive.) Private companies can invert far easier and with much lower costs.
There are two implications. First, the U.S. loses the parent, any chance to regulate it, and any claims to all non-domestic sources of profits. All income generated in the U.S. is still taxed normally, but this at least dodges being taxed by two governments for profits made outside the country. For corporations that derive a large amount of their earnings from across the globe, this can be a substantial savings. Second, now the U.S. needs to worry about income stripping, a process where the subsidary (now in the US) sends money back to the parent (in the low-tax country) without paying any taxes on it. This most often takes the form of a loan or purchase from the parent. For example, suppose the subsidiary took out a loan from the parent for $100 at 5%. The subsidary would be able to deduct the $5 loan interst from its taxes and send it back to the parent without paying any taxes on it at all. There have been laws passed to try and prevent income stripping, but nothing has been terribly effective. There have been some attempts at legislation to prevent inversions, but they never pass. The effectiveness of them would be dubious, and it isn't really a big enough problem yet (however, if deferral were eliminated, it would become more attractive). Although Kerry's plan mentions legislating laws against this in passing, it doesn't seem like much serious effort will be directed at the process.
An alternative
Kerry's "two leading tax economists" Grubert and Mutti present an alternative in the paper he cites. They offer a territorial solution similar to France where profits from other countries are not taxed. This accomplishes many of the same goals as Kerry's proposal — simplification, competitiveness, unlocking capital flows back into America, and revenue gain — but put American companies on equal footing with their foreign competitors. Kerry's proposal brings in an estimated $12 billion, but the Grubert and Mutti proposal brings in a little less at $8 billion. I think that the $4 billion difference is probably worth it though.