Obama's Faulty Corporate Tax Fix

President Obama says our nonsensical corporate federal income tax system encourages big companies to move jobs overseas. On that point, I agree wholeheartedly. Guys like me have been griping about the problem for years. Unfortunately, Obama’s proposed cure (being rolled out this week as part of his budget initiative) is to simply raise corporate taxes on offshore earnings. That's where the president and I part ways. Such a move, I believe, would cause more problems than it would solve and could result in even more jobs heading overseas.

The real fix is pretty easy to see -- that is, once you eliminate all the unhelpful emotion. Here's my take on how to reform the corporate tax system and keep jobs in the U.S. But first, you need some background.

The stated U.S. tax rate on world-wide income earned by big, profitable domestic corporations is 35% -- one of the highest rates across the globe. This is a big reason why so many companies have spent the last few decades busily moving operations overseas to places with lower taxes, like Ireland and Asia. Of course, when operations are moved overseas, the jobs go with them.

And, as long as companies leave earnings from their overseas operations overseas, they don’t have to pay U.S. taxes. The taxes are deferred until the foreign earnings are repatriated (brought back) to America. Naturally, companies are not very interested in repatriating earnings and triggering higher taxes, and you wouldn’t be either if you were them. After all, higher taxes cut into profits.

By leaving foreign earnings overseas, taking advantage of various legal loopholes in our horrific 10,000-page Internal Revenue Code, and using every other trick in the book, big U.S. corporations are able to drastically reduce their “effective tax rates” (the rates they actually pay on world-wide income). According to information gathered by The Wall Street Journal, Pfizer’s (PFE) effective tax rate for 2008 was only 17% and General Electric’s (GE) effective rate was an astonishingly low 5.5%. Solely by refusing to repatriate foreign earnings, Hewlett Packard (HPQ) and Cisco (CSCO) cut their effective tax rates by over 16%, while Coca-Cola (KO) slashed its rate by 14.3%, and Google (GOOG) saved 17.4%. You get the picture. The net effect of all this was that U.S. corporations paid about $304 billion in federal income taxes last year -- far less than if they had actually paid the nominal 35% rate.

So in order to pay much-lower-than-advertised tax rates, U.S. companies are moving lots of operations and jobs overseas. Not good! As President Obama rightly notes, the current tax system actually encourages these things. But his solution, as I explain below, is not the change we need.

Obama wants to reduce or eliminate the ability of big companies to indefinitely avoid U.S. taxes by leaving foreign earnings overseas. In other words, he wants them to start paying current taxes on their foreign earnings whether they bring them home or not. Fair enough. But here’s where it gets punitive and counterproductive: The president also wants companies to pay current taxes on overseas earnings at today’s unsustainably high 35% rate. Such a move could turn what is now a significant problem into an outright disaster by making the U.S. an even more antitaxpayer place to do business than it is already.

Guess what folks? If a company reacts to this punishment by moving all its operations overseas, it won’t have to pay a dime in U.S. taxes, and it won’t need any employees in this country either. If Obama’s proposal becomes law, do you think companies are going to stick around and take it when they can easily go somewhere else? I don't think so.

The constructive solution is simple: Make the Obama-recommended change to force companies to start paying current U.S. taxes on foreign earnings while simultaneously lowering the corporate tax rate to the 15% to 20% range. This would encourage American companies to locate more operations, and more employees, right here in the U.S. of A. Would this hurt tax revenues? I doubt it. They would probably go up, because 15% or 20% of a big and growing pie would almost certainly be more than 35% of an ever-shrinking pie. Compared to the $3.5 trillion budget for the government’s upcoming fiscal year (including an estimated trillion dollar-plus deficit), lowering the corporate tax rate is a relatively safe stimulus bet that we should be happy to make.

At the same time, we need to simplify the Internal Revenue Code to get rid of billions of dollars worth of corporate welfare in the form of crazy tax loopholes and subsidies. For instance, did you know the movie and TV production industries benefit from a major tax break for “domestic manufacturing activities” while the restaurant industry doesn’t qualify at all? Whose lobbyists do you think Congress listened to here? Getting rid of this kind of nonsense should be a key element of any effort to reform the corporate tax system.

Let’s be constructive rather than punitive. Cut the corporate tax rate to create jobs, and root out the corporate welfare hiding in our absurdly complicated tax rules (including the ability to endlessly defer taxes on foreign earnings). This is stimulus we can believe in.

Side Note: The president is also proposing to crack down on individuals and organizations that are evading U.S. taxes by hiding income and assets in offshore tax havens. No argument there! Done right, this is something that is long overdue.