CQ WEEKLY
– COVER STORY
April 11, 2009 – 4:44 p.m.
Tax Code Changes: Industry in the Cross Hairs
By Joseph J. Schatz, CQ Staff
Energized by a global summit meeting two weeks ago where world leaders called for a crackdown on abusive tax havens, Congress seems likely this year to debate significant elements of the federal income tax code as it affects corporations. But it’s not likely to be the debate those companies had been hoping for.
In a budgetary environment that seems to get worse every day as the government expands its spending to battle the recession and financial crisis, President Obama and his allies on Capitol Hill are looking for new sources of money. And corporations have become a prime target. Not only is talk increasingly focused on ways to clamp down on offshore tax abusers, but revenue hunters also have their sights on scaling back the so-called deferral rules that permit companies to put off paying taxes on their foreign profits.
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For all this, businesses will probably get little in return. Instead of negotiating the trade-offs that would be part of a broad overhaul of the corporate tax system, multinational corporate icons that employ millions of Americans — from Microsoft to Sara Lee — find themselves struggling not to be lumped together with shadowy tax offenders. And they are scrambling to distinguish their perfectly legal tax deferrals from questionable practices for the purpose of tax avoidance.
“Those are two really different things, said Alan Auerbach, director of the Robert D. Burch Center for Tax Policy and Public Finance at the University of California at Berkeley, raising a warning flag about legislatively conflating these very different concepts. “Clearly we need revenue,” Auerbach said. “On the other hand, I wouldn’t necessarily react to a weak economy by raising corporate taxes.”
Exceptionalism in Recession
This newly intensified debate about corporate taxation comes at a time when Japan and the United Kingdom are overhauling their laws in ways that will leave the United States as the last major industrial country with a so-called worldwide tax system — one that imposes levies on corporate income earned not only inside the United States but also in other countries. The U.S. government’s increasing “exceptionalism” — as tax wonks have come to call it — on the corporate tax front is almost the opposite of what experts have advocated for some time. And it’s a marked change from the direction in which the debate appeared headed just a year ago, when discussions centered on a potential overhaul that would minimize the picking of winners and losers.
This change in approach came just as the economy fell off a cliff and is clear evidence of the way that responses to the financial crisis have unsettled the U.S. tax debate, shoving likely compromises to the back burner and putting the business community on edge in a time of economic and political uncertainty.
Indeed, just two years ago, when Democrats won back total control of Congress for the first time since 1994, business leaders were heartened by what they heard from the new majority. Charles B. Rangel of New York, the new Democratic chairman of the House Ways and Means Committee, proposed a corporate tax trade-off that many of them would have accepted, if not embraced outright.
In a bid to update the tax code for the first time since the landmark 1986 overhaul, Rangel suggested what amounted to a scaling back of deferral and a host of other business tax breaks while lowering the overall tax rate on corporate income to a point close to the international norm. His idea was to level the playing field by stripping away many of the tax code’s revenue-losing, and arguably economically distorting, special benefits while simultaneously making the United States a more competitive place for companies to do business — all the while not costing the Treasury any money.
This year, however, few lawmakers other than Rangel are talking about such a grand bargain. Additional revenue is too critical when budget deficits are forecast to exceed $1 trillion annually.
“We are going to be a permanent target, and we understand that,” said Catherine Schultz, vice president for tax policy at the National Foreign Trade Council. And if the law on deferrals is altered very much, the “corporate bottom line is suddenly going to be changed significantly,” she said.
Ending Deferral
Complicating the task for multinational corporations trying to hold back the tide is the fact that deferral of taxes on profits earned overseas is a hard concept to articulate clearly — and even harder, politically, to defend. At the same time, it’s an easy issue for critics to seize upon.
Today’s deferral laws, whose basic structure dates to the early 1960s, allow U.S.-owned multinational companies to put off paying taxes on the income of their overseas subsidiaries until they send the money back to the parent company.
But the United States is one of the few economically powerful nations with such a corporate income tax system. U.S. corporations contend that their ability to at least defer tax on income earned abroad is vital if they are to remain competitive against companies based in the vast majority of countries that use so-called territorial tax systems, in which levies are assessed only on income earned within their borders.
The transformation of the U.S. economy in recent decades has made the concept behind deferral an objectionable idea to many Americans, however. From the decline of manufacturing and the rise of the service economy to the recent uncertainty that’s seen even white-collar technology jobs move overseas, corporate tax deferral has become code for outsourcing. Many Democrats argue that deferral encourages companies to move their operations to lower-tax countries; Obama joined that chorus in the campaign by pledging an “end to tax breaks for companies that ship our jobs overseas.”
And while U.S. companies operate in other countries for reasons other than taxes — including cheaper labor and shipping for goods intended for sale abroad — critics can blame deferral and make voters angry at a situation in which the government has few viable options for changing policy.
Hoping to counter the critics, U.S. corporations have seized on arguments such as those made by Mihir Desai, a professor at Harvard Business School who has written extensively on corporate taxation and international investment. Desai disputes the oft-heard claim that U.S. corporate investment overseas comes at the expense of operations at home. Rather, international investment usually complements domestic investment, he says.
Worried about the Obama administration’s intentions, U.S. companies are trying to make the case that foreign investment actually creates and supports U.S. jobs.
“We have this ‘here or there’ argument,” said Schultz of the NFTC — an organization that generally spends its time trying to win support for free trade but is now among the many groups banding together to combat changes to the tax deferral rules. The reality is that companies invest abroad for many reasons and the overall health of U.S. companies is dependent on their ability to create jobs both “here and there,” she said.
“Without deferral, it is extremely difficult for some companies that are living on the edge to do business overseas,” Schultz said.
Groups on both sides of the debate are studying what happened after 2004, when Congress gave multinational corporations a tax “holiday” on overseas profits that they returned to the United States. Hoping to encourage domestic investment of that money, lawmakers opened a one-year window in which companies could bring their profits home at a 5.25 percent tax rate — a pittance compared with the normal 35 percent corporate rate.
What happened isn’t exactly clear, but critics of the tax holiday have used the experience to argue that a territorial tax system — essentially no tax at all on income earned abroad — wouldn’t necessarily benefit the U.S. economy by allowing companies to repatriate foreign profits tax-free.
That’s essentially a point made by Michigan Democrat Carl Levin , chairman of the Senate government affairs panel’s Permanent Investigations Subcommittee. He has been looking into the effects of the tax holiday and has introduced wide-ranging legislation to crack down on offshore tax avoidance, which he says costs the Treasury $100 billion in revenue each year.
In fact, there’s some evidence the tax holiday wasn’t all that beneficial, in terms of creating domestic employment. Most of the money repatriated was used to buy back stock from shareholders, not to invest in domestic operations, according to Dhammika Dharmapala, a professor at the University of Connecticut who spoke to an American Enterprise Institute audience in April.
Dharmapala’s argument was countered by former Rep. Bill Thomas, the California Republican who was chairman of Ways and Means when he wrote the tax holiday law. He argued that any returned profits benefit the U.S. economy, no matter how they are spent. “If the money comes in, it’s in,” Thomas said after the same event.
The Enforcement Approach
What Obama might want to do about corporate tax deferral, and what Congress might accept, are far from clear. What is clear is that corporations are likely to be hit with a bigger tax bill soon.
Obama’s fiscal 2010 budget outline, released in February, called for raising $210 billion in the next 10 years with policies that “implement international enforcement, reform deferral and other tax reform policies” — without giving any more detail.
The math becomes relatively simple when the budget expects spending of more than $3.5 trillion and projected tax receipts are about two-thirds of that. But the specifics get complicated quickly. The revenue from changing the deferral rules would vary based on how the rules are altered, how much income would be affected and how corporations would respond.
Beyond his vague budget language, Obama is expected to announce a series of new international tax enforcement measures in the coming months, and agreement this month by the Group of 20 countries to publish a list of abusive tax havens may add fuel to that fire.
Whether Congress might go as far as Levin wants on enforcement is uncertain, however. Montana Democrat Max Baucus , the Senate Finance Committee chairman, is pursuing a less aggressive course that focuses on strengthening the ability of the IRS to detect and deter offshore tax abuses. Regardless, there is strong support in Congress for doing something on tax havens.
But by lumping together deferral and international tax enforcement — and leaving out the details — the White House has sparked a flurry of corporate lobbying as well as push-back from some members of Congress eager to sever the linkage.
“Deferral is not avoidance, and I think that message has to be driven home,” Richard E. Neal of Massachusetts, a senior Democrat on House Ways and Means, said at a recent tax forum. He said he had pressed White House Chief of Staff Rahm Emanuel on the issue and is hopeful the administration will change its approach.
Like Rangel, Neal sees deferral as an issue to be dealt with in the context of a broader tax overhaul — a stick to complement the carrot of a lower corporate rate. While there are different points of view in the business community on this issue — some companies favor retaining deferral and declining a rate reduction — the Rangel-Neal approach is generally looked on as fair.
But the prospect of losing their corporate income deferral benefit without winning any offsetting sweetener has the business community up in arms. A group of 200 corporations and business groups, including heavyweights such as Johnson & Johnson, IBM and McDonald’s Corp., wrote congressional leaders last month urging them to spurn Obama’s as-yet-unspecified proposal or else face the possibility of further job losses in a recession.
Given that the administration isn’t expected to release the details of its budget proposal for several weeks, many corporations are hopeful Obama will back off. They point to recent comments where he sounded amenable to using a scale-back of deferral as a trade-off in a larger revision of corporate tax law.
Yet even Rangel is resigned to the notion that the deferral issue may be resolved this year, meaning that he’ll need to find other ways to generate revenue if he wants to pursue broader tax revisions after that. Rangel introduced a bill in 2007 that would have reduced the tax rate on most corporate income to 30.5 percent from 35 percent and maintained current deferral law, while requiring corporations to also defer certain deductions that are tied to overseas operations. Now, he says, he may be forced to do “first things first.”
That’s exactly what has corporations worried: that at the end of the day, budgetary constraints will trump economic arguments that the U.S. tax system might be made less competitive internationally.
“I wanted to raise the revenue to reduce the corporate rate,” Rangel said recently, although he conceded that he might have to forgo that idea in the name of advancing Obama’s agenda: “I’m not going to get uptight if he wants to use the revenue to promote his programs, which I support.”
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