Corporate Taxation: A Piece of a Large Problem

Do taxes affect multinational decisions as to where multinationals locate for production and/or reporting purposes?

The GAO recently finished a study answering this question. While the answer to both parts is “Yes,” other decisions clearly affect business decisions, such as the cost of labor, proximity to market, etc. Nonetheless, the GAO report might been seen as good opening salvo in the discussion of trade, a subject many economists gloss over. Indeed, it is a good place to start in considering how the world has been fashioned as globalization proceeds apace.

At the request of the U.S. Senate Committee on Finance,

this report provides information on the average effective tax rates that U.S.-based businesses pay on their domestic and foreign-source income and trends in the location of worldwide activity of U.S.-based businesses.

Weighted effective average U.S. tax rate on U.S. multinationals reporting from within the U.S. is 24%.

Weighted effective average U.S. tax rate on U.S. multinationals reporting from outside the U.S. is 4%. Note the following:

First, the United States imposes only a residual tax on foreign income, after providing a credit for foreign taxes paid on that same income. Second, a substantial portion of the foreign income earned by U.S. multinationals is not taxed until it is repatriated to the United States.

As any good businessman knows: Taxes are death to profits. Before proceeding further, you should know that the GAO report is based on surveys of U.S. multinational corporations at 5-year intervals (1989, 1994, 1999, and 2004).

In short, while the report is recent, the data is not. We can assume through simple extrapolation that trends between 1989 and 2004 have continued–in all likelihood, accelerated.

If our multinationals are indeed using taxation as incentives to locate elsewhere, to return them to the states, some might suggest that we lower the effective U.S. tax rate.

Well, to be competitive, that corporate tax rate will have to be below 4%. Of course, that kind of reduction may raise more problems then we may want to think about. For example, are we trying to become tax-competitive with Bermuda? UK islands in the Caribbean? Are they the tails wagging the dog?

Effective tax rates on the foreign operations of U.S. MNCs vary considerably by country. According to estimates for 2004, Bermuda, Ireland, Singapore, Switzerland, the United Kingdom (UK) Caribbean Islands, and China had relatively low rates among countries that hosted significant shares of U.S. business activity, while Italy, Japan, Germany, Brazil, and Mexico had relatively high rates.

Clearly we have to look more closely at location. Perhaps we should modify the tax law in such a way that places like Bermuda are no longer available as havens. A simple way to do this is to insist that taxation be in the country (or state–sorry, Delaware) where production or service activity resides. In short, setting up a Bermuda mailbox no longer counts. Somehow that juicy umbilical cord has to be cut. (Personally, where possible, I would send in the Marines.)

Another problem is: Are we willing to pass the entire U.S. tax burden over to the individual?

Be all that as it may, consider the following:

With the exception of China, all of the countries with relatively low effective tax rates have income shares that are significantly larger than their shares of the three business activity measures least likely to be affected by income-shifting practices: physical assets, compensation, and employment.

Our multinationals in China are not using it for “income-shifting.” Like low wages, low taxation attracts. Indeed, as I have pointed out many times before: China used a two-tier taxation scheme to attract many multinationals, ours included. Indigenous Chinese firms were tax at twice the rate as foreign firms. In some cases, foreign firms received a ten-year tax holiday. Are we willing to engage in such practices? Are we willing to ask our firms to pay twice the rate as foreign firms on our soil? (Because of local cries of unfair, China is in the process of “equalizing” the tax rates.)

Anyone who tells you that our businesses have to compete with China’s firms is simply not looking at all the facts. In many cases, we are competing with ourselves. Our companies in China enjoy an enormous advantage over indigenous firms.

China has willingly put its own businesses at a disadvantage in order to attract ours. The rationale is simple. China acknowledges that industrially it is about one hundred years behind the U.S. and others. Attract the businesses, learn, start to encourage yours, and move up the value chain. Of course, both Chinese and foreign firms in China enjoy the enormous advantage of cheap labor.

Until 2007, China uses its tax system to encourage exports. Doing so was a major incentive for multinationals interested primarily in China’s major export market, i.e., the U.S.

Under processing trade arrangement, the materials and components [of goods for export] would be free of import customs duty and VAT under bonded conditions. The Chinese producers [any firm in China, including ours] would then convert the imported materials and components into finished goods and export the finished goods to overseas destination.

For some exported goods, the VAT tax is refunded. In short, on the production of some goods for export, there may be no taxation at all. China is continuously using taxation to increase the sophistication of its trade. A quick glance at the new 2007 arrangement for exported items tells can tell us a lot. Remember: Prior to 2007, many more export products were not taxed. China uses a sophisticated, changing scale of refunds, depending on the item for export. The following examples indicate where China is going as of 2007:

No VAT refund for many raw materials, i.e., coal, salt, cement, natural gas….Partial refund for some steel products, leather and glass products, textiles, furnishings…. Increased VAT refund for significant technical equipment, certain IT products, and bio-medical products as well as certain “encouraged” high-tech products….

China is using taxation to climb the value ladder. Smart.

Lest anyone think I am picking on China, I am not. China stands along side Bermuda, Ireland, UK Caribbean, Singapore, and Switzerland as having a relatively low effective tax rate. France, Canada, Mexico, Brazil, Japan, and Italy relatively high effective tax rates. Made in China, not America is the new motto.

According to the GAO, as of 2004,

A growing share of U.S. businesses’ activity is located abroad, and the sourcing income appears to be influenced by foreign country tax rates

All of the indices the GAO used to measure this increased activity abroad–value added (5%), sales(10%), physical assets(10%), compensation(5%), employment(3-4%), pretax income (15%), and pretax income (no equity(5%))–have shifted anywhere from 5% to 15%. Note: These percentages are the result my eyeballing an “ungrided” graph.

Remember: These percentages include the tax havens, i.e., Bermuda et al.

The GAO then addressed another issue: How are the various above indices distributed between foreign and domestic in terms of three major industries: Manufacturing, Finance and Insurance, and Wholesale Trade.

The GAO took a snapshot of 2004, measuring MNCs’ share of an industry; then seeing how the MNCs’ share was divided between foreign and domestic among the six indices.

For purposes of this discussion–and remember, this is for 2004–, 36.2% of manufacturing employment was foreign based; a good 10% of manufacturing’s physical assets were foreign based. Employment and physical assets are measured in U.S. dollars. One question we might ask is: What happens if we adjust those percentages in terms of the country in which they occur? For example, compensation goes a lot further in China and other “emerging markets”–covering many more employees than it would in the states– so, too, might the physical assets.

Finance, of course, has been our real bread and butter. And that is now on the ropes. It certainly is in no position to compete with the likes of some of the SWF’s.

My point is very simple. Because we can no longer count on rising property values and because we can no longer count on our financial institutions to drive our economy–what precisely do we do? Manufacturing is sliding away. Our tax system is like a sieve–at least as far as MNC’s are concerned. Some countries have outfoxed us in terms of taxes vis-a-vis production, i.e., China, with its tax breaks, subsidies, etc. Others provide great tax havens. The rich get richer–and the rest of us slide downhill.

Finally, when all is said and done, it is trade on which we must focus. And we simply are not doing it. I hear talk that America must save more. I laugh. Well, if Mattel ships its toys from China, shall we forgo Christmas this year? And because Walmart is “Made in China,” shall we close some Walmarts.

I am not worried about those with six-seven-or eight-digit incomes. I am concerned about those who now are struggling, Tell them to save? Easy for the six-or more-figured Joes to say. Easy for the economists to say, as well. The economists simply look at the credit and debit numbers.

Take a look around your house. How much is now “Made in America”? What items would you gladly forgo? (I am not talking about the silliness of Nike sneakers or such. Maybe the coming recession will drive the ad and PR men over the cliff, they who have been so very eager to squeeze the last buck in profits, they whose sole purpose in life is to create dreams that only Midas would believe. Consumerism? The dreams that feed it are now intimately connected to our conception of self, so much so that those dreams have become reasons for living. Cars become women; sneakers become athletic glory. The iPod becomes a necessity for social contact. Wire us up, Scotty. We will enter those dreams until death takes us away. What have we done?) But I digress.

Because of the rules governing its growth, globalization has now created a dangerous disequilibrium. I do not blame China–or Vietnam–or Columbia–or Mexico. They want their share.

For a while all I could hear was: “Well, Stormy, you’re not complaining about your cheap goods, I bet.” Or, “Look, Stormy, the U.S. needs to become more competitive. Better education is the key.”

Well, student loans are now on the ropes. Education in the states was not cheap–unlike in more socialized countries. And it just got even more difficult.

And just how are we going to compete with foreign engineers and professionals whose incomes would put them in the lower class in the states? Besides, not everyone can be an engineer or a professional. Are the rest–those who toil daily for 5-figures or less just to be forgotten?

And if those who can save have squirreled it away in tax havens, what then? Who is going to foot the bill? And we now talk about tax cuts. I did like my little refund check; but it was a silly effort to keep things afloat, just something else to keep the party going, the consumer buying, and the corporation happy–a futile gesture.

Meanwhile, the financial system is turmoil. The FED opens special windows to keep credit alive. Towering above us, great and powerful financial institutions, built, we thought, of granite are now tumbling down The debris of their huge stones have yet to hit the streets. I hope they do not. But it is getting a bit scary.

I hear today that Warren Buffet may be throwing in the towel. “Kansas Bankers Surety in Topeka is getting out of the business of backing deposits above the $100,000 limit.”

Can we not connect the dots? Can we not see how our financial crisis is intimately connected to how globalization has proceeded? Taxation is but a piece of the larger puzzle. Old bromides and old ideologies will not do, neither will old solutions. Until we actually look at the problems–see the mechanisms that drive them–, we will continue to move from one breathless act to the next.