Race to the bottom
The debate on taxes has just begun.
President Biden is scheduled to deliver his first address before a joint session of Congress on Wednesday, two days before his milestone first 100 days in office. His speech will not be designated as an official “State of the Union” address, but as a “National Special Security Event.” Pandemic protocols will remain in place, no guests are allowed and the number of Senators and Congress people will be limited, with social distance seating on both the floor and the gallery of the House of Representatives.
Biden is expected to address both the pandemic and the economy, laying out his ambitious $6 trillion spending plans for this year. As such, he floated an important trial balloon last week, proposing to restore the top marginal personal tax rate to 39.6%, and to more than double the tax rate on capital gains from 20% to 43.4% for individuals making more than $1 million per year. No word yet if he plans to treat taxes on dividends comparably.
Earlier this month, Biden also proposed an aggressive increase in corporate taxes, which included: raising the corporate tax rate from 21% to 28%; creating a minimum 15% book tax rate; and doubling the global minimum tax on offshore profits (GILTI) from 10.5% to 21%, among other increases. To be sure, Biden needs to identify exactly how he plans to pay for his fiscal-policy largesse, either through revenues from stronger economic growth, more federal debt or higher tax rates. Our concern is that the size of his proposed corporate tax hikes may reintroduce the corporate inversion problem that we thought we had fixed nearly four years ago.
Inversion revisited? When President Obama left office in 2016, we had a 35% federal corporate tax rate (and a 39% statutory rate including state taxes), which was the highest in the developed world. In sharp contrast, the global corporate Organization for Economic Cooperation and Development (OECD) average was only 22%. That significant gap had created a problem known as corporate inversion. Companies were offshoring jobs, manufacturing and intellectual property, with some even choosing to redomicile elsewhere in the world, such as Ireland, with its attractive 12% corporate tax rate.
Consequently, U.S. GDP grew at a tepid pace of only 2.1% from 2009 through 2016, which was below trend-line growth of 3% and well below the 4-5% growth rate that we should have enjoyed as we exited the depths of the Great Recession in 2007-09, according to estimates from the Federal Reserve, the National Bureau of Economic Research and the Congressional Budget Office. It appeared to us at the time that the U.S. economy was on a slow glide path to recession.
Tax Cuts and Jobs Act of 2017 When former President Trump took office, he correctly recognized that we are in a competitive global environment and reduced the federal corporate rate from 35% to 21% (statutory rate at 25%), a level just below the 22% (24% statutory) global corporate average. Trump’s tax cuts, which sought to solve the inversion problem, were successful, as jobs, intellectual property and manufacturing began to flow back into the U.S.
Cornerstone Macro reports that in Obama’s last two years in office, an annual average of 258 companies redomiciled into the U.S. But during Trump’s four years, that number surged by a third to an average of 343 companies annually, given the more competitive tax code. It’s early, of course, but in Biden’s first quarter in office, only 42 companies moved to the U.S. If we annualize that to 168, that’s a 51% decline from Trump’s four-year average.
Moreover, Strategas reports that because of Trump’s tax policies, $1.6 trillion of overseas profits were repatriated back into the U.S. Aside from boosting federal and state tax revenues, companies used their repatriated cash in many different ways: they hired more workers and increased their wages and benefits; increased capex spending by building new plants and investing in new equipment and technology, particularly with automatic expensing; delevered their balance sheets; topped off underfunded pension obligations; increased dividend payments to shareholders; and increased share repurchases.
It’s all good, of course, as the stock market rose 60% under Trump before the pandemic hit, and the unemployment rate fell to 3.5%, the lowest level in half a century.
Switching horses The risk now is that a reversal of Trump’s favorable corporate tax policies under Biden—whose policies are much more like Obama’s—could trigger a new inversion problem. If, for example, Biden and Congress successfully increase the federal corporate tax rate back up to 28% (with a statutory rate at 32%), then the U.S. would reclaim its status as having the highest corporate tax rate in the OECD world. This could potentially have a negative impact on GDP growth, corporate profits, employment, wage growth, inflation and share prices.
False choice? To be sure, the Biden administration points out that their proposed corporate tax hikes poll very well, with 70% of Americans approving of higher corporate tax rates. But there’s no free lunch. The American Action Forum, a center-right policy institute headed by former Congressional Budget Office Director Douglas Holtz-Eakin, thinks every dollar of higher corporate taxes will be passed on in the form of higher consumer prices, less hiring, lower wages and benefits, reduced dividend growth and lower share prices. In fact, more than half of the U.S. owns stocks in their college and retirement investment accounts, so we suspect that corporate tax hikes would poll much less well if the question was phrased differently.
‘Race to the Bottom’ Treasury Secretary Janet Yellen is now working with her counterparts in developed countries around the world to push for global coordination on an international tax rate that would apply to all multinational companies, regardless of where they are domiciled. Yellen believes that such a coordinated international tax rate would short-circuit the so-called race to the bottom, in which countries attempt to outdo one another by cutting their tax rates to attract foreign businesses. Critics argue that Yellen is tacitly admitting that Biden’s corporate tax hikes will make America less competitive. “Unless they can get 90% of the world’s countries to adopt it, countries will view exempting themselves from the system as a great way to create a potentially significant advantage,” according to Peter Barnes, a senior international tax lawyer at Caplin & Drysdale.
Importantly, Ireland has already opted out.