The Obama administration is cracking down on corporations who engage in a practice called “inversion.” Inversion is a process in which a corporation in one country purchases a smaller corporation headquartered in a different country, and then declares that country to be the new location. Burger King recently made the news after their decision to purchase Tim Hortons and relocate to Canada.
According to a CNN report, 47 American corporations have undergone inversion in the last decade. That is nearly five each year.
President Obama and many policymakers are upset about the legality of this maneuver. They believe that a corporation should not be allowed to reap American benefits while escaping American taxation.
The president said, “You shouldn’t get to call yourself an American company only when you want a handout from American taxpayers.”
Meanwhile, his secretary of the Treasury, Jacob Lew, called for a “new economic patriotism” and urged congress to pass legislation to prevent inversion from happening.
While the battle for legislation rages on, it might be useful to take a step back and ask some questions.
What is inversion, and why is it happening?
As already stated, inversion is a process in which an American corporation purchases a smaller corporation headquartered in a different country, and then declares that country as its new location.
Why would a corporation do this? What is the incentive?
For corporations, inversion provides an efficient way to escape heavy taxation inside of the U.S. by relocating to lower tax countries such as Canada or Ireland. After all, the U.S. currently has the highest effective corporate income tax rate in the developed world, at 35.3%.
It should be no surprise that a 10.1% effective rate in Ireland or an 18.6% rate in Canada is pulling businesses away from the 35.3% rate in America. The only mystery is why it is taking so long.
From a corporation’s viewpoint, inversion is a beneficial process. With less money taken from them in taxes, more money is available to take care of business activities. However, the policymakers have a justified reason to fear this practice.
In the short run, the loss of American-born companies means the government will lose revenue to fund programs, and will be obliged to receive extra revenue from other sources in the form of higher taxes or more borrowing and higher deficits.
In the long run, if the U.S. continues its course of heavy taxation and regulation, less business investment in America will lead to lower levels of production. This means fewer jobs than otherwise would exist if the American economic system was more competitive with many other countries.
Since inversion poses significant problems to the U.S. economy, what is the best way to solve it?
The answer to this question depends on the incentives facing the person responsible for answering it.
Many impartial viewers, who have no election at stake, could glance at the data and come to a solution relatively quickly. After all, it appears that corporations who move out of the U.S. do so because they desire to be located in a country which will not tax them as much. Therefore, the impartial viewer is likely to conclude that cutting tax rates might not be a bad place to start.
For proof, the impartial viewer can say that the 34 member countries of the Organization for Economic Co-operation and Development (OECD) together have an average effective corporate income tax rate of 19.6%. The U.S. effective rate is 35.3%. If companies can find lower prices elsewhere, why would they not take them?
The situation is different, however, when the policymaker is considering how to solve inversion. His major priority is to get votes. At the present time, proposing “tax cuts for the rich” is not a recipe for votes. Advocating for a “fair share,” however, is politically profitable.
To this point, the legislative reaction appears to consist of passing legislation to prevent firms from engaging in inversion. This is a little like a university solving its dropout problem by preventing students from transferring to another school. It ignores the underlying causes, and is likely only to spread even more problems.
Consider secretary of the Treasury Jacob Lew’s reaction. His solution called for a “new economic patriotism” to oblige companies to stay here based on loyalty to the U.S.
It shouldn’t take a sophisticated Harvard professor to point out the fact that patriotism is impertinent to running a business. Competition, on the other hand, is vitally important for business decisions.
If Lew is going to promote policy based on something that doesn’t exist—patriotism in business—while utterly ignoring a prime factor contributing to the problem—competition among tax rates—then no problem will be solved, and more problems are likely to come up which will take another round of brilliant legislative action.
In addition, what is so admirable about patriotism (loyalty to country) in the first place? In the 1770s those people who today would be considered patriotic were then called Tories, and they were tarred and feathered.
Lew is not the only policymaker interested in preventing firms from inverting. President Obama remarked that companies shouldn’t be allowed to call themselves American only when they want handouts from American taxpayers.
Again, it shouldn’t take a Harvard professor to see that the best way to solve the problem of taxpayer funded bailouts would be to not have taxpayer funded bailouts. This is the crazy notion that businesses should rise and fall on merit, not political connection.
President Obama also condemned the practice because he doesn’t like how the loss of tax revenue sticks his beloved middle-class taxpayers with the tab.
Since the president is so concerned with the welfare of the middle-class and poor, he might come to the conclusion that raising taxes on anybody changes behavior, especially among the people who can afford to move their money all over the world to escape it. If he came to this conclusion, he might realize that his desires to raise taxes on “the rich” and to add more regulation-heavy federal programs have negative consequences which harm others.
The fundamental issue with inversion resides in discovering the source of the problem. It seems straight-forward that tax competitiveness in other countries is leading companies away from the U.S.
Carl Menger, an influential economist who helped found the Austrian School of Economic thought, said that “All things are subject to the law of cause and effect,” and that this law’s growing recognition is closely tied with human progress.
The concept of countries with high tax rates driving corporations away to countries with low tax rates seems like a plausible cause and effect situation. The common sense solution would be to cut tax rates down to more competitive levels, which would eliminate the incentive for corporations to leave the U.S. in the first place.
However, fashionable slogans such as “corporate greed” and the rich “paying their fair share” are politically expedient, and often win more support than proposals for tax cuts.