Topic: International Economics and Development

America’s High Corporate Tax Rate Hurts Competitiveness

As other developed nations race to cut corporate tax rates in order to attract jobs and investment, politicians in the United States are sitting on their hands. Kevin Hasset of the American Enterprise Institute explains how this hurts America:

Imagine you are the CEO of a major U.S. manu­facturing company. You are looking to locate a new domestic plant. All other factors being equal, would you locate the plant in the state with the highest taxes? Now, make that question international. Would you locate a plant in a country with high taxes or low? The obvious answer points to a growing eco­nomic problem for the United States. Among the 30 wealthy countries that make up the Organization for Economic Cooperation and Development (OECD), the U.S. ranks sec­ond, just below Japan, for the highest combined tax rate (federal and state) on corpo­rate profits. Our position in the world hierarchy is rela­tively new. In 1994, the U.S. ranked 18th. But since then, other nations have been cutting rates—from an average of 37 percent to 28 percent—while the U.S., at 39 percent, has main­tained its high level. …most foreign multinationals are head­quartered in countries that charge taxes only on domestic operations. If a French firm locates a plant in Ireland, then all of the profits of the Irish plant are taxable in Ireland, but are free from French tax­ation. So French firms have an enormous incentive to locate in the country with the lowest taxes they can find. That rules out the United States. …the latest literature suggests that relative tax rates are a big, big deal. Indeed, the dramatic flow of international capital to the lowest tax environment is one of the strongest and most reliable findings in the history of economic science. If a country lowers its rate below its rivals, as Ireland, now with a 12.5 percent rate, began doing more than a decade ago, then multinationals flood that nation with capital. It’s very much in the data. …The status quo—one of the most unfriendly tax policies toward business on earth—is unacceptable to anyone who cares about the future of American industry. No one should be surprised if our best firms continue to flee overseas and if foreign-based firms prefer locating their plants outside America.

What Goes Around Comes Around

Last week’s formal WTO challenge of certain Chinese tax laws by the United States should obviate an important reality. If China is running afoul of its commitments and the United States expects China to make amends, the United States must lead by example. That brings us to the zeroing dispute, with its latest twists and turns.

After much internal deliberation, the Commerce Department announced late last year that it would alter its antidumping calculation methodology by no longer “zeroing” dumping margins under the average-to-average comparison methodology in original investigations (described in this post). This decision was in response to a WTO indictment stemming from a complaint filed by the EC in 2003. January 17, 2007 was to be the effective date of the change, but implementation was postponed at the request of Sen. Max Baucus (D-MT) and Rep. Charles Rangel (D-NY), chairs of the Finance and Ways and Means Committees, respectively, who wanted more time to educate Congress about the ruling, the change in practice, and its implications.

Just before the announced postponement, another indictment was issued by the WTO Appellate Body concerning the zeroing practice in a complaint lodged by Japan in 2004. That ruling was much broader in scope, condemning zeroing under almost every conceivable comparison methodology and in both investigations and administrative reviews.

As a result of that latest ruling, the Ways and Means Committee has been soliciting comments from interested parties on how the United States should respond. Congress and the administration are said to be working closely, exploring U.S. options, one of which is simply NOT to comply. 

Noncompliance is a legitimate option, and that is part of the beauty of the rule of trade law within the WTO. Contrary to the view of some of its detractors, the WTO is not world government. It does not impose the will of some faceless bureaucracy on powerless countries. It does not usurp national sovereignty. On the contrary, the WTO is powerless as a stand-alone entity. Its rules are the product of the consensus of its members, and to establish new rules, consensus among all of its 150 members is required. (This helps explain the slow going of the Doha Round and the eight-year duration of the previously-concluded round of multilateral trade talks — the Uruguay Round). Members do not have to comply with rulings, which are always framed in the benign, “sorry-to-trouble-you” tone that “recommends” that rules or laws or measures be brought into conformity with this or that WTO agreement.

Despite this comply-if-you-will approach, the dispute settlement system has endured 12 years and 358 disputes with compliance or mutually-agreed resolution achieved in every case concluded thus far. One reason for this record of success is that, should members choose not to comply, the complainant whose gripe goes unresolved is often entitled to retaliate or “suspend concessions.” This retaliation often takes the form of raising tariffs, but could include other measures. 

Another incentive to comply is that noncompliance could be contagious. It’s nice to have the theoretical option of disregarding the verdict, but exercising that option can be costly and risky. If the United States chooses to ignore the Appellate Body’s findings in the Japanese zeroing case and fails to revise its zeroing practice, the Chinese may be more inclined to take this approach if and when its tax laws are found to violate its WTO commitments. One of the major justifications for encouraging and welcoming China’s membership in the WTO was that membership would improve prospects that Chinese policies going forward would be transparent, predictable, and fair. And that would encourage greater commercial engagement. If China comes to view its WTO obligations as optional, the economics of the trading system and the political support for it will suffer immensely.

Flat Tax in Romania

Romania’s flat tax is generating results that would make French politicians delirious with joy — huge increases in tax revenue. Income tax collections jumped 44.7 percent in 2005, the year the flat tax was introduced. (Sadly, the increased revenue isn’t keeping pace with Romanian government spending; as the country works to meet the various conditions for EU membership, its budget deficit is growing, which has led to complaints from Brussels.)

Rather than learn from this “Laffer Curve” example, the high-tax nations that dominate the EU are complaining about Romania’s “harmful tax competition.” A Hungarian news service reports:

Romania increased spending on roads, railways, pensions and other areas last year, mainly in December, to bring standards closer to those in the EU, which it joined on January 1.

…The Finance Ministry said today the government boosted revenue to 31.8% of GDP last year from 30.3% the previous year, helping meet a key EU recommendation. EU Monetary Affairs Commissioner Joaquin Almunia said last year that budget revenue as a proportion of GDP was lower than in any EU nation and recommended the country increase it. Economic growth, which the government has estimated at about 8% last year from 4.1% in 2005, also stimulated revenue collection, the finance ministry said.

…Romanian government spending increased 25% last year in nominal terms and accounted for 33.5% of GDP, from 31.2% in 2005, the ministry said. Income tax collection rose 44.7% to 9.8 billion lei ($3.8 billion). Romania has said income tax revenue has consistently increased since January 1, 2005, when it introduced a flat tax of 16% on corporate and personal income, the lowest in eastern Europe. It replaced a corporate tax rate of 25% and a personal income tax rate of as high as 40%.

Rule-of-law and U.S. Competitiveness

Policies such as Sarbanes-Oxley are reducing America’s competitiveness, but an equally worrisome problem is the erosion of the rule-of-law.

Stability and equal treatment are among the characteristics of an advanced legal system. Unfortunately, America’s legal system is now riddled with uncertainty, since investors and companies have no way of predicting outcomes.

The New York Sun has a column noting how America’s justice system is now an obstacle rather than an inducement to international investment:

[T]he American share of global initial public offerings declined to 5% from 50% in the last five years. Foreign companies are being scared away in part, both reports conclude, by soaring costs of American law.

The highwater mark for securities lawsuits was reached in 2005, with over $9 billion in class action settlements. The zeal of American prosecutors in corporate scandals is also of a different order of magnitude. In 2004, government fines in America totalled $4.74 billion, over 100 times more than in Britain, which had a total of $40.48 million. Sarbanes-Oxley, the federal law that imposes higher accountability standards on corporate boards, has almost tripled auditing costs for small public companies.

Perhaps the most chilling parts of the Bloomberg-Schumer report are the surveys of foreign business leaders who suggest, overwhelmingly, that they no longer trust American law. For most of the last century, trust in American commercial and securities law was one of our greatest competitive advantages. Investors flocked to our markets because securities laws guaranteed transparency and honesty. American contract law was the gold standard for world business, in part because of a long tradition of judges rigidly applying guidelines of liability and damages.

Economist Douglass North received a Nobel prize in part for his work on the vital role of legal stability in economic prosperity. An “essential element of the concept of justice,” legal philosopher H.L.A. Hart observed, “is the principle of treating like cases alike.” That’s why law is the foundation of freedom — people know where they stand. They can act freely instead of looking over their shoulders all day long.

But that trust has now capsized. Companies are afraid that if a few employees out of thousands do something wrong — even if not material to the bottom line — the company faces the prospect of ruin. An indictment, not a conviction, could put a company out of business. Why roll the legal dice in America when legal systems in Britain and elsewhere focus on punishing the individual wrongdoer, not shooting everyone in sight?

It’s impossible to measure how much distrust of law has contributed to declining competitiveness. But the evidence is all around us. Just talk with foreign business leaders.

The main victims of this trend, however, are employees and their pension plans. Drying up of markets means that countless people lose job opportunities and that innovation moves offshore. Trust, once lost, is hard to regain.

Tort reforms limiting damages don’t get close to the heart of the problem. American justice has a deeper flaw — it no longer reliably distinguishes right from wrong. Instead, decisions are made on an ad hoc basis, jury by jury, without predictable boundaries.

Hong Kong to Lower Flat Tax?

Thanks to strong growth, which is in part due to a tax system that minimizes the burden on productive activity, Hong Kong leaders are considering reducing the flat tax to just 15 percent.

Tax-news.com reports:

Donald Tsang has pledged to cut Hong Kong’s individual and corporate income taxes if re-elected as the Special Administrative Region’s Chief Executive next month. Tsang officially announced that he would seek election to a second term of office last week and said that one of his key policies would be to return some of Hong Kong’s fiscal surplus back to the population through a “gradual” reduction in salary and profit taxes to 15%.

Dutch Tax Haven Pressures Greedy Governments

The New York Times has a thorough article today detailing how both individuals and companies are using the Netherlands as a haven for productive activity.

This is good news for all taxpayers. The rich directly benefit, since greedy politicians are unable to seize as much of their money. And the rest of us benefit, since this puts downward pressure on tax rates as governments try to keep the geese that lay the golden eggs from flying away.

[L]ast August, according to details disclosed in documents maintained by the Handelsregister, the trade registry of the Netherlands, Promogroup helped the three [Rolling Stones] performers set up a pair of private Dutch foundations that will allow them to transfer assets tax-free to heirs when they die. Other Dutch shelters that Promogroup has arranged for the three have already paid off handsomely; over the last 20 years, according to Dutch documents, the three musicians have paid just $7.2 million in taxes on earnings of $450 million that they have channeled through Amsterdam — a tax rate of about 1.5 percent, well below the British rate of 40 percent.

The rock powerhouse U2 has transferred lucrative assets to Amsterdam, as have other pop singers and well-known athletes….

While old-school, offshore tax havens — the warm ones with tropical fish, off-the-shelf holding companies sporting post-office-box addresses, and scant regulation or transparency — still attract money, they are largely patronized, tax lawyers and entertainment bankers say, by hedge funds and private equity firms looking to protect lush trading profits from taxes. But for earnings derived from intellectual property such as royalties, the Netherlands has become a tax shelter of choice.

Many of the world’s multinational corporations, like Coca-Cola, Nike, Ikea, and Gucci, have set up holding companies here in recent years to take advantage of tax shelters nearly identical to the ones that the Rolling Stones and U2 use.

The Netherlands is home to almost 20,000 “mailbox companies,” Dutch shorthand for corporate shells set up by foreign companies and wealthy foreigners who use them to relieve taxes on royalties, dividends and interest payments….

Globally, some 1,165 companies use Dutch tax shelters to reduce or eliminate taxes on royalties and patents.

Not surprsingly, international bureaucracies and left wing groups despise tax havens — precisely because tax competition makes it more difficult to increase the size of government. The story in the Times elaborates, including completely unsubstantiated accusations that low taxes somehow facilitate dirty money:

Some experts see a darker side to the emergence of the Netherlands as a sought-after tax shelter. In 2000, the Organization for Economic Cooperation and Development, based in Paris, black-marked the country as one of the world’s top five industrialized tax havens for promoting “treaty shopping” for low-tax jurisdictions.

…In its report last fall, SOMO, the research group, said…that “tax haven features of the Netherlands also facilitate money laundering and attract companies with a dubious reputation.”

Endorsing the U.S. Trade Complaint Against China

On Friday, the U.S. Trade Representative initiated a formal challenge of various Chinese tax programs within the dispute settlement system of the World Trade Organization. It was only the third formal challenge of Chinese policies since that country joined the WTO in 2001.

Specifically, the United States alleges that Chinese tax policies that encourage production for exportation and that discourage the use of imported materials and components in the production process constitute subsidies that harm U.S. interests and violate the obligations China undertook when it joined the WTO in 2001.

I have been critical of the administration’s various trade policy errors of commission and omission over the years. Last week I lamented U.S. trade representative Susan Schwab’s failure to articulate the broad case for trade.  Today, I have only kudos for the USTR. Not only was the United States well within its rights to bring this case, it was the right thing to do, politically and economically. 

Free trade purists might disagree, arguing that if China wants to subsidize its exports to the United States, Americans should write the Chinese thank you letters for financially supporting our consumption. And accordingly, we shouldn’t intervene if the Chinese want to squander their resources that way. I think that argument holds water up to a point — a point that we are well beyond and where the costs of the status quo outweigh its benefits. 

Yes, we benefit as consumers from subsidized Chinese production, but only until the consensus for a liberal trading order collapses. At that point, retrograde protectionism threatens not only the benefits of that subsidized consumption, but the benefits of trade more generally, and the conditions that make relatively freer trade possible. Furthermore, the U.S. trade relationship with China is wealth-creating in both countries without need of subsidization. Safeguarding continuation of the flow of the benefits of trade to both countries by expecting China (and the United States) to play by the established rules seems a reasonable compromise to me.

The rules-based trading system has been remarkably successful at promoting trade and investment, and its continued success depends upon adherence to its rules and respect for its institutions — particularly by the world’s large economies.

China has demonstrated that it doesn’t respond well to bilateral threats — if for no other reason than its desire to avoid the appearance of being bullied. China knows what its obligations are. But it also knows that one of the many benefits of its membership in the WTO is that its policies are above board unless and until the dispute settlement body of the WTO finds against them. If China wants to drag its feet with respect to compliance and reform, bringing cases against China within the WTO might become fashionable.  

We are already witnessing a deterioration of support for trade and its institutions in the United States precisely because of perceptions that policymakers are doing too little to enforce the existing rules. I don’t advocate knee-jerk invocation of our rights to dispute settlement — there is plenty of room for deliberation and consultation (which is perpetually in play under the radar). 

To the extent that Friday’s actions serve as a release valve for some of the political pressure that has been building in Congress for unilateral actions against China, it is already a success. By bringing the case through formal WTO channels, Congress will see that there are, in fact, alternatives to dangerous, unilateral sanctions. In that sense, this case could reduce the likelihood that Congress intervenes and mucks everything up and it could actually improve long-term prospects for the U.S.-China trade relationship.