At a time when more than 8 million Americans are unemployed, business investment has stalled and the recovery is still tentative, Congress is considering a tax hike. Even more surprising, the misguided proposal is sponsored by Republican Rep. Bill Thomas of California, who heads the Ways and Means Committee, and by the White House.
The tax increase is aimed at a key source of economic growth over the past decade: U.S. subsidiaries of companies that are headquartered outside the United States – companies like Swiss-based Nestle, which owns Ralston Purina, employs 37,000 American workers and generates $15 billion in sales, and DaimlerChrysler, whose 120,000 U.S. employees generate about one percent of U.S. gross domestic product.
In all, there are 10,000 of these firms, and they are critical to American economic health. They have 6 million employees in this country, concentrated in manufacturing, where foreign subsidiaries account for roughly one out of every seven U.S. jobs. In 2000, the most recent year for statistics, they reinvested $17 billion of their earnings back into the U.S. – more than one-third of their total profits.
According to the Organization for International Investment (OFII), a trade group, these U.S. subsidiaries export $150 billion worth of merchandise, or more than one-fifth of all goods exported from the United States. In the most recent year for IRS data, 1998, they paid $18 billion in taxes, more than double the level of five years ago.
But that’s not enough for the Treasury Department and for legislators. They have included the tax increase in a complicated bill that was mainly inspired by a World Trade Organization decision that declared certain U.S. tax subsidies in restraint of trade. The legislation tries to compensate companies hurt by the WTO ruling. That’s all well and good, but the bill then goes much further: It boosts taxes on U.S. subsidiaries of foreign-based companies by disallowing deductions that are legitimate under today’s laws.
All of these machinations are a roundabout way to make up for what the Treasury calls “U.S. rules for the taxation of foreign-source income [that] are unique in their breadth and degree of complexity.” This country definitely needs to reform its system of international taxation and lower overall rates, but a measure boosts taxes on subsidiaries does just the opposite.
And talk about bad timing! The tax initiative “would penalize foreign investors at precisely the time when the U.S. economy needs them most,” wrote the National Journal’s Bruce Stokes recently. In 2001, foreign direct investment in the U.S. plummeted 60 percent, and this year foreigners have grown even more sour on America. The Thomas bill will give them another reason – in addition to accounting scandals, economic sluggishness and terrorist threats – to send their funds elsewhere.
U.S. subsidiaries of foreign-based companies are already subject to the same corporate taxes as U.S.-based companies. In fact, to more: Current law limits tax deductions to U.S. subsidiaries whose borrowings from their parents are considered excessive under arcane rules established in 1989.
The worry is something called “earnings stripping.” Say a U.S. subsidiary makes $1,000 in profits. To avoid U.S. taxes, it could borrow $10,000 from its foreign parent and pay $1,000 in deductible interest. So, under certain circumstances, such deductions are not allowed. The idea now is to raise another $5.5 billion over the next five years by tightening these already restrictive rules further, even attacking loans that are merely guaranteed by the parent.
But are subsidiaries really avoiding taxes by cynically pumping up their debt? There’s no evidence. All “related-party” loans represent just 7 percent of the liabilities of U.S. subsidiaries. And, while the interest deductions of the subsidiaries totaled $128.8 billion, their taxable interest receipts (including interest on loans to foreign parents) totaled even more – $129 billion. Also, the debt levels of U.S. subsidiaries of foreign-based companies are about the same as the debt levels of foreign subsidiaries of U.S.-based companies.
So where did this crazy tax hike come from? Partly from the aftermath of the WTO decision and partly because members of Congress want to go after companies, like Stanley Works, based in Connecticut, that want to practice “inversion” – that is, move to a tax haven like Bermuda. In a venue with little or no corporate taxes, earnings stripping may be a plausible threat, but, for a company like DaimlerChrylser, it would not make sense anyway: So what if the U.S. subsidiary gets deductions for interest on loans from the parent – if the parent itself has to pay taxes in Germany on interest from the subsidiary?
Frankly, I like the fact that inversion puts pressure on U.S. policymakers to compete with Bermuda by cutting taxes at home. But that’s not really the issue here. Instead of focusing on potential inverters with a scalpel, Thomas and the Treasury are going after legitimate U.S. taxpayers with a sledgehammer. These taxpayers – U.S. subsidiaries of companies like Nokia, Honda and Unilever – can just as well fire their workers here, move somewhere else and have Americans import their products.
The threat is not just the tax increase itself. It’s the signal it sends: that an unhealthy chauvinism and the desire for more federal revenues are blinding American politicians to the value of foreign direct investment. Foreign firms that were thinking of investing here must now be thinking twice. If U.S. subsidiary employment drops merely from 6 million to 5 million, then U.S. unemployment will rise by a full percentage point. That’s a recession.
What we really need is a comprehensive strategy that would move in the opposite direction. Taxes on all corporations doing business in the United States are clearly too high. Instead of targeting some of them – in this case, mainly manufacturers – for tax hikes, Congress and the administration should be giving all of them tax reductions. That’s the way to get the economy moving.
