Orlando's Outlook: The debates are over; let the real debates begin

10-21-2016

Bottom Line The ugliest presidential debates in history are now behind us. The final one on Wednesday night was more of the same, with Donald Trump and Hillary Clinton gleefully trading nasty barbs about their opponent’s respective character flaws and ethical lapses. American voters, however, are the worse for it, as we’re starved for policy details on how the candidates plan to address the most pressing issues of the day, such as boosting economic growth, creating a more muscular defense to combat terrorism, fixing a broken health-care system and putting entitlements on a sustainable financial path.

At the top of our list is comprehensive corporate tax reform, which could fund much-needed infrastructure spending and also resolve the worsening inversion problem. By solving all three of these issues simultaneously, we could see stronger economic growth, increased corporate-profits, accelerated job creation, higher wages, reduced income inequality, increased federal-tax revenue and rising financial-market performance. It’s all good, of course, which is why we’re hopeful that this bipartisan solution will be adopted by whichever party wins control of Washington next month.

Why do we need corporate tax reform? The U.S. has, by far, the highest federal corporate tax rate in the world at 35%, which rises to 39% when we include statutory taxes. That compares with an average of only 22% for the 35 industrialized nations (including the U.S.) that comprise the Organization for Economic Cooperation and Development (OECD). The European average is only 18.7%. At the other end of the tax spectrum from us is Ireland, with a 12% corporate tax rate.

In addition, the U.S. is one of only six OECD nations that still maintain a world-wide taxation system. Most countries have already shifted to a territorial system, which taxes income only once, in the country where it was earned. To be sure, there are many U.S. companies that pay taxes at a substantially lower rate—some even pay nothing—because our complicated tax code is riddled with loopholes and deductions that benefit some industries and companies, but certainly not all.

Consequently, U.S. companies continue to defer the repatriation of their foreign-sourced income, which now totals an estimated $2.6 trillion in cash equivalents on overseas balance sheets, according to the Joint Committee on Taxation. While many companies would love to bring their overseas cash home to spend and invest, they have no interest in doing so at a usurious tax rate of 39%.

What might corporate tax reform look like? There are a half-dozen key elements that we would include in a comprehensive reform of the corporate tax code:

  • Lower corporate tax rates to at least 20% That would reduce the U.S. rate to a level below the OECD average, eliminating the global competitive disadvantage facing our U.S.-based companies.
  • Eliminate tax loopholes This would make the tax code fairer by leveling the playing field.
  • Broaden the corporate-tax base Cleaning up the tax code would create a situation in which more companies will pay taxes, particularly if a minimum rate is established. We could actually generate more federal tax revenue by lowering the rate and eliminating the loopholes.
  • Reduce regulations Washington has gummed up the works over the past eight years by piling on mountains of unnecessary regulations that have grounded corporate investment spending.
  • Territorial tax system Tax companies only once, in the country in which the revenue was earned, and then allow them to bring that net income home without additional domestic taxes.
  • Repatriation Bring home $2.6 trillion in cash sitting on overseas balance sheets.

Repatriation tax holiday With the creation and implementation of a territorial tax system that resolves the problem of how to tax companies doing business overseas, we then need to unleash the cash that’s currently stuck on their overseas balance sheets. At a proposed mandatory repatriation tax rate of 7.5% (within an estimated range of 5-10%), Washington’s corporate-tax windfall would approximate $200 billion. With interest rates near record low levels, we could then lever that $200 billion into a trillion-dollar infrastructure bank that we could then use to invest in meaningful construction projects to fix our crumbling infrastructure: a national GPS-based air traffic control system, new airports, roads, bridges, tunnels, trains, ports, electrical grids, and water and sewage facilities.

That leaves $2.4 trillion in available cash for these multinational, U.S.-based companies to bring home. How might they spend their money? We have a few thoughts:

  • Mergers & acquisitions
  • Share repurchases
  • Dividend increases
  • Research & development
  • Corporate capital expenditures
  • Hiring and wage increases

The combination of government-sponsored infrastructure spending and the corporate use of the cash would, in our view, collectively boost economic and corporate-earnings growth and financial-market performance. For those concerned that companies would use all of their repatriated cash to pay dividends or repurchase shares, we could simply set some limits as to how the cash can be deployed. For example, we could mandate that no more than half of it can be used for financial engineering, or that no less than half must be used for enhancing operations.

Fixing the inversion problem Because of the wide disparity in corporate tax rates here compared with the rest of the world, a U.S.–based company will often acquire a foreign company in a low-tax country, such as Ireland, convert it into a subsidiary and then transfer all of its patents and other intellectual property (IP) to it. Then, the foreign subsidiary “lends” the IP back to the domestic parent company, so that the parent company can legally retain its IP at a significantly lower tax rate.

Treasury Secretary Jack Lew has been complaining that such companies are unpatriotic. But the reality is that the senior management teams of these companies have a fiduciary obligation to enhance the value of their company. According to the Wall Street Journal, in 1986, 218 of the world’s 500 largest corporations as measured by revenue were based here in the U.S. In 2016, that number is down to 128 companies. That corporate exodus has been accompanied by a loss of jobs, economic activity and tax revenue. We believe there is bipartisan support in Congress to change the tax code to lower the threat of inversions. But we need to reduce tax rates to fix the problem. Secretary Lew’s solution, which is to raise tax rates, increase rules and regulations, and introduce new penalties for noncompliance, would exacerbate the problem.

Conclusion U.S. GDP has grown at only a 2.1% run rate since the Great Recession ended in June 2009, the weakest stretch of economic growth in the post-war history. In fact, over the past three quarters, GDP is limping along at a stall speed of about 1%. That compares with trend-line economic growth in the U.S. over the past half century of 3.1% and expectations from the National Bureau of Economic Research (NBER) that the current economic recovery should be closer to 4-5% growth. Why is the economy growing so slowly? Ineffective corporate tax policy is certainly one contributing factor. So we’ll be watching closely for clues from the candidates running for president and Congress as to how they plan to tackle and resolve this problem in 2017 and beyond— to unshackle corporate animal spirits and get GDP growth back on track.

To see Phil Orlando’s thinking in action, click here.