One campaign 2014 kerfuffle concerns the previously arcane issue of “inversion,” the process by which a U.S. corporation merges with a foreign one so as to pay taxes at the other country’s lower rates. If ever a tax loophole were designed to provoke inflammatory rhetoric, this is it. Senate Finance Committee Chairman Ron Wyden, D-Ore., labeled a recent wave of corporate reflaggings a “plague”; Treasury Secretary Jacob Lew took to The Washington Post’s op-ed page to demand “economic patriotism.” For their part, Republicans are playing this as a simple story of corporate escape from the allegedly oppressive U.S. corporate tax rate.
Both sides have a point. It takes chutzpah for U.S. corporations to claim foreign identities so they can pay less to finance the U.S. patent laws and other government protections from which they benefit. But when the United States taxes corporate income at the highest rate among major developed nations, 35 percent, it’s unrealistic to expect multinational firms to adhere to “patriotism” rather than their bottom-line interests.
Lew’s plan seeks to end inversions, at a potential savings of $19.5 billion over the next decade. But the means he has chosen — raising the minimum foreign ownership of newly merged companies to 50 percent — would probably prove no more permanent than the previous minimum of 20 percent. The unintended consequence could be to decrease the number of mergers while increasing their size, as tax expert Mihir Desai of Harvard Law School told the Senate Finance Committee at a July 22 hearing.
As Lew argued in his op-ed, the problem is not cross-border mergers per se; it’s mergers driven by tax avoidance rather than economic fundamentals. The wave of tax inversions is therefore symptomatic of a U.S. tax code that rewards system-gaming rather than productive activity. All participants in the inversion debate acknowledge this. But there’s a partisan impasse, due in no small measure to Republicans’ refusal to entertain reform plans that raise more revenue.
The key to genuinely resolving the inversion problem, as opposed to patching it up — or exploiting it — in an election year, is to shift the focus of corporate taxation to the people who actually own a given company: shareholders. It’s harder for individuals to “reflag,” so it’s more efficient to tax their dividends than it is to chase corporate income streams around the globe.
Prof. Michael Graetz of Columbia Law School proposes cutting the corporate tax rate to 15 percent and taxing dividends at the (higher) rate for ordinary income (with an offsetting credit for taxes paid at the corporate level so as not to hurt the stock market). To be sure, Graetz’s idea is not meant to be viewed in isolation but as part of a larger tax overhaul plan that would also raise revenue via consumption taxes. Still, it illustrates the point that a truly durable reform would make it cost-effective for U.S. firms to stay, not prohibit them from leaving. Congress and the Obama administration should turn to that task when, or if, the political furies die down.