Jacob Barnard: The Great Inversion

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I am pleased to host another student guest post, this time by Jacob Barnard. This is the 9th student guest post this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.

Deciding to invert a corporation is a logical choice resulting from high corporate taxes, not from being a “bad corporate citizen.”

Recently, U.S.-based firm IHS Inc. and U.K.-based Markit Ltd. announced a merger to create a $13 billion data firm. The issue this brings up isn’t an anti-trust matter though, but rather, where its new headquarters is going to be. The current plan is for the new firm to be based out of London, which means it would only have to pay the 20% corporate tax rate used by the U.K. instead of the 35% corporate tax rate in the U.S. This process, known as inversion, has come under fire from many politicians. President Obama has even called corporations that undergo this process unpatriotic and likens it to not being a good corporate citizen. The process is completely reasonable, however, and is popular because of a high corporate tax rate, not a lack of patriotism.

The process of corporate inversion has been made more difficult by a law put in place in 2004, which was meant to eliminate the favorable tax treatment of “surrogate foreign corporations.” These occur if the stockholders of a former U.S. corporation own 60% of the stock in a merged foreign corporation as a result of their previous holdings in the U.S. corporation. The new parent country’s corporation must also account for less than 25% of the merged corporation’s employees, wages, assets, and income for it to be considered a surrogate. That amount is open to interpretation, however, and can be re-interpreted to make inversions harder, which is what the IRS did in 2015.

Clearly, the US government wants to fight inversion. Despite these efforts, however, corporations are still trying to leave. The reason is obvious: the corporate tax rate. The United States has the highest of all OECD countries and third-highest among all reporting countries. The federal corporate income tax rate combined with the average rate paid in each state is 39.1%. The world-wide average is 22.9% and has been dropping for over a decade. The U.S. rate, on the other hand, has stayed the same. As a result, corporations in the U.S. lose more and more money each year by not inverting and already pay an extra 16%. A corporation’s shareholders have the right to hire and fire directors, so they are, and should be, the directors’ main concern, not a country.

The argument some people like to make is that inverted corporations don’t pay their “fair share” because they are receiving the benefits of the U.S. government, military, markets, and infrastructure without paying taxes to the U.S. to pay for these things. The problem with that reasoning is quite simple: they are actually required, by law, to pay their fair share. Foreign corporations pay the U.S. tax on profits earned by their U.S. subsidiaries in the U.S. What is their fair share if not the amount that actually results from business generated in the U.S.? If anything, corporations that stay in the U.S. pay more than their fair shares because, unlike most other OECD countries, the U.S. requires corporations to pay the corporate tax on foreign-earned income in order to repatriate it, minus however much they already paid in foreign corporate taxes. This means the U.S. is taxing corporations on profits earned because of the benefits provided by foreign governments, military , markets, and infrastructures. If foreign corporations aren’t using accurate, “arms-length” transfer prices in order to artificially move income out of the U.S., then that’s a problem, but it’s a problem for almost all multinational corporations with subsidiaries in the U.S., not just inverted ones.

The problem comes right back to our significantly higher tax rate then. If our tax rate is high enough to cause firms to change their behavior this much, perhaps we should start considering whether it might be too high, possibly even decreasing our tax revenue. Even if it isn’t, lowering it would probably be a good idea at this point. Stricter inversion requirements might be enough to keep current corporations in the U.S., but how are we going to convince future corporations to incorporate in the U.S. if the only way to convince current ones to stay is by forcing them to?