Corporate Tax Encourages Firms to Invest Elsewhere

Last week, the Senate held a hearing to investigate why Apple wouldn't voluntarily turn over to the U.S. Treasury more tax revenue than the company actually owes.

The freshman Republican that Kentucky voters sent to Washington in the Tea Party's smashing 2010 election told his colleagues during the hearing that he was "offended by a four-trillion-dollar government bullying, berating and badgering one of America's greatest success stories. ... I'm offended by the spectacle of dragging in executives from an American company that is not doing anything illegal. If anyone should be on trial here, it should be Congress."

There are many reasons for us to rethink what this hearing signals to businesses and investors. But the silver lining of this ridiculous witch hunt (which, as always with such legislative affairs, boils down to the attempt by Big Government to squeeze even more cash out of the private sector than it already does) is that it allows us to focus more attention on what is wrong with the U.S. corporate income tax system.

First, the rate is too high. After a reduction of the federal corporate tax rate to 34 percent in 1986, the U.S. was reasonably competitive with other major economies. It didn't last. In the 1990s, while other countries cut their tax rates, U.S. lawmakers decided to raise the federal corporate rate to 35 percent for a combined (federal plus state) tax rate of 38.7 percent.

Today, that combined U.S. rate is 39.1 percent, the highest among all developed nations.

Economists agree that cutting the corporate rate should be a priority. For instance, in a 2003 study, American Enterprise Institute economists Kevin Hassett and Eric Engen explained that the most efficient rate for the corporate tax is zero.

More interesting, while counterintuitive, those who stand to benefit the most from corporate tax-rate cuts are workers. That's because corporations do not really pay taxes. What they do is collect taxes from individuals (i.e., workers, consumers and shareholders).

In a 2006 study, economist William C. Randolph of the Congressional Budget Office estimated winners and losers under the corporate tax. He concluded that "domestic labor bears slightly more than 70 percent of the burden."

Second, the United States taxes corporations under a worldwide tax system. That means companies are subject to taxation on all income regardless of where it is earned. For example, the profits of U.S.-owned plants based overseas are subject to U.S. taxes -- even though those profits already are subject to tax in the countries where they are earned.

Most other major countries do not tax "foreign-source" business income as aggressively as the United States does. In fact, more than three-quarters of Organization of Economic Cooperation and Development member nations have "territorial" tax systems that tax firms on domestic income only. The combination of high corporate tax rates and a worldwide system makes the U.S. corporate tax system extremely punishing and anti-competitive.

These differences have important implications for U.S. competitiveness in foreign markets. Because of higher tax costs, U.S.-based firms may lose foreign market share, generate lower returns for American shareholders, sell fewer products to foreign subsidiaries and hire fewer skilled workers domestically.

Under these conditions, it's not a surprise that U.S. multinational companies who want to sell their goods on non-U.S. markets try to keep as much cash out of this country as they are legally allowed. It's a survival skill.

Other countries seem to understand this logic. Several nations, including most recently Japan and Britain, are moving to territorial systems that tax only corporate profits earned within their borders.

By contrast, the hearing put on by some in the Senate last week suggests that they want to move in the opposite direction. Let's hope Sen. Paul can convince them otherwise.