In the past decade, there have been about 50 business inversions, which is when an American business relocates its headquarters overseas following a merger. Because the U.S. tax code is the most complex and has the highest rates, it makes no business sense to remain headquartered in America, when they have the option to relocate to a more competitive tax regime.
While there is consensus among leading Democrats and Republicans that the best way to address the inversion issue is by reforming this failing code, others propose complex new regulations as the cure.
This is a mistake, they would do nothing to fix the problem and would only double down on this ineffective system.
One proposal, legislation introduced by Ways and Means Ranking Member Sandy Levin (D-Mich.) would stop any inverting company from using earnings stripping. While announcing the legislation, Rep. Levin boasted that it will “aggressively limit tax-motivated inversions.”
Earnings stripping is a commonly used tool to allocate debt among subsidiaries. While it is potentially open to misuse, it also has legitimate, important uses and is regulated by the Treasury Department to ensure it is not abused.
In fact, regulations have already been tried in 2004 and have done little to fix the problem, and there is no consensus that earnings stripping regulations will do anything.
For instance, an analysis on earnings stripping by Kyle Pomerleau of the Tax Foundation found that it did not have a significant revenue cost for U.S. taxpayers and new regulations would do little to address current challenges. Similarly, research by Curtis Dubay of the Heritage Foundation concluded that there was no way to know whether new regulations on earnings stripping would reduce inversions.
Even a past report examining earnings stripping by the Treasury Department was unable to find any conclusive evidence on its impact.
The problem with regulating this practice is it is akin to treating the symptom rather than the root cause. Rather than waste time pushing complex new regulations, members of Congress should work toward updating the out-of-date tax code, with two simple reforms.
First, America must bring its corporate tax rate to a globally competitive level. Currently, the U.S. has a combined state and federal average of 39 percent, far above the average rate in the developed world, which is just 25 percent.
While other countries have pro-actively reduced business taxes to compete in the global economy, the U.S. has remained stagnant since the Tax Reform Act of 1986. Unsurprisingly we are falling behind.
Second, lawmakers must scrap the outdated worldwide tax system and move toward a territorial system. Of the 34 countries in the Organisation for Economic Co-operation and Development, the U.S. is just one of six that retains the worldwide system.
This means that any U.S. business with operations overseas must first pay taxes in the country it earned this income and then pay U.S. taxes when bringing this income back. Because most countries do not impose this double taxation, it leaves American businesses at a substantial disadvantage.
Together, these two problems make the U.S. home to the world’s most uncompetitive tax system.
Rather than attempting to score political points with gimmicky legislation, Ranking Member Levin should work toward solutions that will actually reduce business inversions. Indeed, the only way to truly address the inversions issue is through reforming the tax code to lower business income taxes to a competitive rate and ending the outdated worldwide system of taxation.