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I am pleased to host another student guest post, this time by Adam Aldeen. This is the 13th student guest post this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link. 

On Thursday, the US Treasury Department revealed new rules to prevent U.S. companies from doing corporate tax inversions to reduce their tax bills. The rules aim to make it harder for any American company to avoid paying taxes by relocating to another country. I think this is an unwise decision because it fails to address the underlying issue that causes firms to leave in the first place.

The American tax code is unnecessarily complex, and recent merger and acquisition activity has been high as companies have rushed to take advantage of lower tax jurisdictions. Right wing critics contend that the solution is to lower corporate tax rates, while those on the left tend to want to make it more difficult to leave in the first place. Evidence suggests, that although the U.S. has one of the highest marginal corporate tax rates in the world—at 35 percent—high corporate tax rates are not the driving factor in a firm’s decision to locate overseas. Indeed, because of tax holes in the U.S. tax code, American firms pay an average of 20.3 percent on domestic profits. The real issue is that companies have to pay U.S. tax rates on income earned abroad but can avoid paying taxes on that income until they repatriate it. The end result is companies having stashed  $2.1 trillion of earnings with their foreign addresses. This is a problem because it erodes the US tax base and we should instead be thinking about how to encourage companies to stay here and pay a guaranteed minimum tax.  

The tax on income earned abroad makes US firms less competitive than foreign counterparts because most nations only tax domestically earned profits. Therefore, a foreign owned firm identical to a US firm pays less in overall taxes than an American corporation. This is just a shame because it means that companies are incentivized to not pay American taxes and contributes to a massive loss of tax revenue to the government. Indeed, the OECD estimates that cash hoarding and inversions cost the government nearly $90 billion a year in lost tax revenue.  

A potential solution would be to stop taxing that income earned abroad. After all, almost every other country in the world does not tax its firms on income earned abroad, and doing so would dissolve the major reason firms leave in the first place. An article from the Economist explains that “Making it hard for American firms to invert does precisely nothing to alter the comparative tax advantages of changing domicile; it just makes it more likely that foreign firms will acquire American ones.” I completely agree with this; instead of indirectly addressing this issue, let’s just get at the heart of it and let companies retain their earnings earned abroad while ensuring some sort of minimum tax in the US through a territorial tax system. Moving to a territorial system, explains the Economist, would result in trapped foreign earnings coming back to America and would stem the flow of jobs overseas because American firms would be buying foreign firms instead of foreign firms buying American firms. This would increase the US tax base, and would be a driving force in stimulating an economy in recovery.

Update: There are some interesting comments on Miles’s Facebook page on this post.