Last month, the Treasury Department issued its third and most stringent set of regulations aimed at curbing corporate inversions (the process by which an American business capitalizes on lower tax rates overseas by merging with a foreign company). "It sticks the rest of us with the tab and it makes hardworking Americans feel like the deck is stacked against them," President Obama said.
There is no doubt corporate inversions are a serious problem. The maneuver could cost the United States economy $40 billion over 10 years, according to the Congressional Joint Committee on Taxation. But imposing burdensome regulations won't address the real culprit behind this phenomenon — that is, a U.S. tax code that is out-of-date.
Recently, the American Council for Capital Formation released "Capital Formation 101," a report I was privileged to author. In the report, a closer look at U.S. data reveals a grim picture: The U.S. economy is struggling with sluggish economic growth, investment is consistently weak and labor productivity growth is trending downward. For example, between 2007 and 2014, average gross fixed capital formation as a percent of gross domestic product (GDP) was just 19.4 percent, putting the U.S. behind its top 10 trading partners, except for the United Kingdom.
Research shows that one of the factors that contribute to this less-than-optimal investment is our outdated tax system. U.S. corporations face a 35 percent statutory federal corporate tax rate, which is the highest among developed countries. We are not only disadvantaged based on our high statutory corporate tax rate, but we also have the fifth highest effective marginal tax rate among Organization for Economic Cooperation and Development (OECD) and BRIC (Brazil, Russia, India, China and South Africa) countries.
Our competitors, one by one, have reformed their corporate tax system varying degrees to keep up with changing global economic realities. This often takes the form of a decrease in corporate income tax rate, like Japan has done in recent years, or by switching to a territorial tax system, where business income earned abroad by foreign subsidiaries is exempt from home country tax. The U.K. and Japan both enacted a territorial system in 2009. The U.S., on the other hand, follows a worldwide tax system by taxing income regardless of where our companies earn it.
Procrastination on reforming the tax code has put our companies at a competitive disadvantage, creating a domino effect which lowers investment and economic growth. Continuing to govern through the tax code, just as the Treasury Department seeks to do with its recent inversion regulations, may put a Band-Aid on corporate behavior, but it won't address the root issue. Even if federal agencies are able to force U.S. businesses to stay here at home, those companies won't operate at peak efficiency under a tax structure that stifles investment.
To provide industries the confidence they need to throttle up investment, lawmakers must undertake comprehensive tax reform. Serious reform should simplify tax code, lower rates, uniformly eliminate loopholes and ensure neutrality across all sectors of the economy. When those criteria are met, U.S. businesses will once again have an incentive to invest and grow, rather than to seek relief overseas.
Fortunately, several leaders on Capitol Hill have made clear they will prioritize tax reform, including House Ways and Means Committee Chairman Kevin BradyKevin Patrick BradyNunes to resign from Congress, become CEO of Trump media firm Five things to know about the November jobs report Economic growth rate slows to 2 percent as delta derails recovery MORE (R-Calif.). In a recent speech, he indicated the intention of the committee "to produce a consensus blueprint for comprehensive pro-growth tax reform" by June. He also confirmed that committee members are "looking at tax reform with fresh eyes, examining the whole range of tax ideas – consumption tax, cash flow tax, reformed income tax, and any other approach that will be pro-growth."
Research over the years has shown that switching from our current income tax to a consumption-based tax system which allows first-year write-off for all new investment could achieve the twin goals of stronger capital formation and much-desired economic growth. With the right design, it is possible to get a fair and progressive tax system that will satisfy the needs of a 21st-century economy.
The explosion of corporate inversions has shed a light on the burdens U.S. businesses face as a direct result of a complex and onerous tax code. While it would be easy to condemn these companies as anti-American, they are looking out for their shareholders, which every business has a responsibility to do. Their actions are an indictment of the system.
Stopgap measures may well force American businesses to stay put — the Treasury's announcement effectively killed a planned merger between Pfizer and Allergan and other deals are expected to fall through — but they won't address the alarming trends investment and savings. Long-term capital formation will only happen when lawmakers get serious about comprehensive tax reform.
Wilber, Ph.D., is a senior economist at the American Council for Capital Formation, a nonprofit, nonpartisan organization advocating tax, energy and regulatory policies that facilitate saving and investment, economic growth and job creation. Access her new report, "Capital Formation 101," here.