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The Right Way to Stop Offshoring Jobs

Yahoo! Finance
The Exchange

By Douglas Holtz-Eakin, Gordon Gray and Cameron Smith

In recent years the U.S. has witnessed a vigorous debate over the role of federal policies in shifting employment from the U.S. to competitors like China. At the heart of this debate is the corporate income tax. The Obama Administration regularly promises to crack down on U.S. companies that "ship jobs overseas" by raising taxes on the international earnings of U.S. firms.

Research shows that this is exactly the wrong thing to do — in fact it is a perfect recipe to ship jobs overseas to places like China. Instead, we find that a comprehensive, revenue-neutral tax reform that eliminates taxes on those earnings would yield important benefits: an internationally competitive rate of 25 percent, 1 percentage point faster growth, a near-term gain of roughly 1 million jobs and, over the longer run, $10 trillion of higher income and wages.

The Trouble With Corporate Tax Rates

How can this be? The U.S. corporate tax is out of line with international competition in two important ways: it features a very high rate and "worldwide" tax base. The combined federal-state U.S. corporate tax rate of 39.2 percent is the highest among major developed economies — eclipsing Japan, which recently lowered its combined rate to 38 percent.

A high tax rate discourages investment and hiring in the United States, not only for domestic firms but also by our international competitors. In effect, the high rate automatically offshores jobs that could be in the U.S. to China, Brazil, and other locations.

But isn't the high rate offset by the myriad credits, deductions, rifle-shots, and special favors in the tax code? Not so. According to a study by PricewaterhouseCoopers, "companies headquartered in the United States faced an average effective tax rate of 27.7 percent compared to a rate of 19.5 percent for their foreign-headquartered counterparts. By country, U.S.-headquartered companies faced a higher worldwide effective tax rate than their counterparts headquartered in 53 of the 58 foreign countries."

It's About "Automatic Offshoring"

The U.S. is also out of line with its competition in how foreign-source income is taxed.  This is crucial as 95 percent of the world's potential customers and 75 percent of the world's purchasing power falls outside the U.S. The U.S. tax applies to the worldwide earnings of U.S. headquartered firms.

Take China for example. U.S. companies pay any Chinese tax and then the additional U.S. tax when the earnings are brought back to the U.S. This has three detrimental effects. First, since German, British, French and other competitors pay only the Chinese tax, the U.S. firms are at a disadvantage. Second, firms looking at the systematic disadvantage of being headquartered in the U.S. often conclude it is better to have their headquarters — and many other jobs — in our competitor countries. And, finally, for those U.S. firms that stick it out and compete abroad, there is an incentive to not bring the earnings back to the U.S. Those funds are invested abroad and create jobs abroad. Again, the tax is automatically offshoring U.S. jobs.

Our competitors understand the flaws with this system and have shifted to a territorial system, a system that exempts entirely, or to a large degree, foreign source income. Of the 34 economies in the OECD for example, 26 have adopted such systems, including recent adoption by Japan and the United Kingdom.

The Wrong Solution

The Obama Administration's "solution" would tax foreign earnings immediately, rather than when they are brought back. The immediate, higher level of taxation goes the wrong way in leveling the competitive playing field.

The U.S. has a better option. In recent research, we show that aggressive base-broadening can simplify the U.S. tax, move to a territorial system, and lower the rate to 25 percent.  In the process, the tax continues to provide the same revenue to federal coffers, augments growth, and creates jobs — in the United States.

Douglas Holtz-Eakin is the President of the American Action Forum and most recently was a Commissioner on the Congressionally-chartered Financial Crisis Inquiry Commission. Gordon Gray currently serves as the Director of Fiscal Policy at the AAF and previously served as senior policy advisor to Senator Rob Portman and as policy director on the Senator's campaign. Cameron Smith is the AAF's COO and previously worked for DHE Consulting.