Pfizer-Allergan Inversion Failure and Corporate Tax Reform: Time for a Territorial Tax Code?

The US Treasury announced two rules on April 4th 2016 in an effort to stem business practices, such as so-called “corporate inversions,” rooted in perverse incentives of harmful economic policies to the delight of many and the chagrin of others.  Designed to eliminate the tax benefits corporations can derive from renouncing their US citizenship and relocating their headquarters to a foreign land where taxes are lower, these rules almost immediately resulted in the cancellation of a $152 billion merger between Pfizer and Allergan.   The apparent targeting of Pfizer over a legal business deal can seem unjust, but this kind of damaging correction is what happens when unhealthy regulations are embraced.
 
Tax loopholes, which reward corporations for leaving the US, exemplify public policies that favor special interests over US interests and must inevitably be changed.  No longer can US subsidiaries of inverted companies take a loan from their foreign parent and use interest payments as tax deductions to reduce their US tax liability.  US companies must also own less than 60% of the combined company’s stock, excluding any acquisitions of US companies within three years, to derive any tax benefits.  Frankly, these changes should have been made years ago.  Consequently, the Pfizer-Allergan deal, which just happened to be affected by these changes, is just one among many high-profile inversions that forced necessary changes.

Furthermore, a great deal of the criticism against the US Treasury’s changes is rooted in the Executive Branch acting without significant reforms to the US tax code.  In reality, the fault rests on the shoulders of lawmakers for failing to do their job in a timely manner.  That said, many advocates for corporate tax reform want to see the introduction of a territorial tax system.   Thanks to the efforts of people like Senators Rob Portman and Chuck Schumer, the US may well be nearing the adoption of a territorial tax code.   The threat of corporate inversions aids this ongoing push to transform the US tax system, but that does not necessarily mean a territorial tax system actually serves US interests.
 
Portman and Schumer want to replace US taxation of corporate profits earned overseas with a transition tax that would be used to pay for badly needed highway and infrastructure programs.  The Portman-Schumer even offers a much lower rate than an earlier proposal from President Obama, which would have imposed a one-time tax of 14% on current profits stashed overseas and a 19% tax on future foreign earnings.  The Portman-Schumer framework also seeks to reduce taxes on intellectual property, which is the true engine of growth and should be favored.  Although the American People would love to have a 14% or 19% income tax, critics feel 14% is even too much for corporations. 
 
In many respects, the laws of competition do make this corporate tax rate too much.  Required to pay the highest corporate tax rate in the world of 35%, when corporation repatriate their overseas profits, there is clearly a perverse incentive that explains why US-based companies keep more than $2 trillion in profits overseas while other corporations feel compelled to change their citizenship.  On the other hand, effective US corporate tax rates are in the single digits, which are on par with most US trade partners.  The advantage of a low tax rate, versus the use of tax breaks to reduce a high rate, is that corporations are better able to predict their annual tax burden, which fosters economic stability. 

When advanced economies like Japan and the United Kingdom switched to a hybrid territorial tax system, they gained a competitive advantage over other countries.  With the territorial tax system becoming a norm around the world, they started to lose some of that advantage.  If the US switches to a territorial tax system as the world’s largest economy and competitor, however, all of that advantage will be gone.  In turn, suppressed taxes will simply make it easier for corporations and individuals, who have an advantage in shifting their wealth around the globe, to make more money overseas and safeguard their wealth in stable economies without paying neccessary taxes to support stability.
 
The “free trade” and territorial tax system craze creates a perverse inventive to abandon one’s domestic economy in favor of a more “competitive” environment, i.e. the lowest bidder economy while harming businesses that cannot abandon their own ship for a cheaper one.  The only reason many economies have not suffered directly from these policies is that they have derived a competitive advantage.  Unfortunately, the liberalization of domestic tax codes does not create a level playing field for international taxation that, in theory, should favor healthy competition and innovation. 
 
Before American workers paid federal income taxes, the US Government was largely funded by tariffs and other fees imposed on those looking to access the American economy.  As the world grew more complicated and expensive, the Federal government passed the Sixteenth Amendment in order to collect a "fair share" of revenue from American citizens.  Because the cost of the government is only going up, governments must increase their revenue.  As the “free trade” movement favors the elimination of tariffs, this means taxes must be increased for domestic taxpayers, which will increase the pressure for those most financially mobile to seek overseas safe havens.  

The root of the problem is that policies like these do not allow for the disproportionate funding needs of governments.  Considering issues like the Islamic State threat, Russian dominance, and Chinese aggression, governments provide valuable services that help keep the global economy stable and functional.  Because the US economy is the largest and its military budget is also the largest, it must collect the largest amount of revenue.  When countries are forced to compete by taxing less, particularly when the burden is too great for their increasingly poor citizens to bear, they cannot afford to invest in global security, which has largely been subsidized by the United States.

The developed countries under economic liberalization have seen their national debt balloon and the wealth of their citizens concentrated into the pockets of the few, which will eventually lead to crippling instability.  As such, simply imposing a territorial tax system without major reforms in the US tax code and US trade relations will only hurt the global economy in the long-run.  Maintaining the status quo will, of course, only hurt the US and the global economy in the long-run.  The US Treasury is trying to recalibrate US tax policies to better serve US interests, but it is no substitute for necessary and proper tax reforms.