TCS Daily

High Hurdles

By Stephen W. Stanton - September 3, 2002 12:00 AM

The world record for the 400-meter dash is a lot faster than the world record for the 400-meter high hurdles. There is a very simple reason for that: Hurdles slow people down. It has nothing to do with fairness, and everything to do with common sense.

But common sense is a rare commodity on Capitol Hill. Our tax laws create hurdles for American businesses that foreign competitors do not face. As a result, foreign competitors do not need to be better to win.

The US tax system is unique among developed nations in that it taxes all worldwide income. In contrast, most other nations do not tax income earned outside their borders. Interestingly, foreign companies operating in the US get preferred treatment, as only their US operations are subject to US income tax.

Look at a hypothetical company with locations in the United States and France. If that company were French, it would pay US taxes on its US operations and French taxes on its French operations. Both countries treat the two branches as if they were two separate businesses, each only paying taxes to its host nation.

If that same company were to relocate its headquarters to the United States, the tax bill would be much higher. France would still only tax the French operations, but the IRS would tax both French and US operations.

Foreign tax credits are supposed to prevent double taxation by reducing US taxes on previously taxed income. However, the foreign tax credit system provides only a partial offset of U.S. taxes in most cases. American companies, then, usually bear a higher total tax burden than other companies in foreign markets.

Even worse, US businesses are at an extreme disadvantage in low tax jurisdictions. A profitable US company will always be subject to US taxes of up to 35% on overseas income, even as foreign competitors often pay no income taxes at all.

So how does this hurt the American economy? We find the answer in Corporate Finance 101: The "hurdle rate".

Companies only invest in projects that will earn more than their hurdle rate, also known as "cost of capital". Simply put, the hurdle rate is the highest financial return investors can make elsewhere by taking similar risks. If a project will return more than the best alternative use of money, it "clears the hurdle" and the investment is made.

Taxes raise the hurdle rate. For example, an individual investor may have three equally risky investment options: a bond yielding 6.5%, or stock in either one of two identical companies, one American and one French, operating overseas in a tax-free jurisdiction.

Since the American corporation faces a 35% tax rate on foreign income, it must earn at least 10% just to match the 6.5% after-tax return on the bond. The French company faces no income taxes on its overseas operations and needs only to earn 6.5% to match the bond.

Both companies compete for the few projects with returns in excess of 10%. However, only the French company will invest in the many projects generating returns between 6.5% and 10%. The French company will grow faster. In addition, the average return on French projects will far exceed 6.5%, and the French stock will outperform its American peer.

Bottom line: The tax code creates hurdles to American businesses, which hurts corporate growth and profitability. American workers and investors suffer. Slightly higher tax receipts do not adequately offset this sizeable detriment.

To compete with foreign firms on an equal footing, entrepreneurial American executives are now taking their companies offshore. Corporate law requires CEO's to maximize shareholder wealth. Taxes reduce that wealth. Executives, then, are legally obligated to minimize company taxes.

Companies like Accenture reincorporated in Bermuda to achieve the same preferential US tax treatment as foreign competitors. The executives should be commended for sound tax planning in the best interest of shareholders.

Instead, they are rebuked. The same politicians that created the perverse laws are attacking companies for obeying them. They accuse these companies of being un-American and unpatriotic, using the terms and tactics of McCarthyism to harass law abiding people and organizations.

When you take your home mortgage interest deduction, are you "un-American"? Are you cheating your fellow citizens by putting your savings in a 401(k) instead of a taxable account?

The Supreme Court answered these questions with an unqualified "no." In a landmark decision, the Supreme Court held that "nobody owes any public duty to pay more taxes than the law demands."

Unfortunately, Congressional rhetoric imposes real financial costs. A company wrongly labeled "unpatriotic" will likely lose customers. To avoid the label, a company must remain on-shore, and face a significantly higher tax bill. Congress has given CEO's a tough choice: lower revenues or higher costs. Through their words and actions, Congressional leaders stifled American businesses and harmed American investors.

Then, without admitting the slightest hint of hypocrisy, the same members of Congress demand action to stimulate our economy. They voice "genuine concern" over anemic economic growth and an overdue return to corporate profitability. They claim themselves the saviors of the investor class.

If Congress is serious about competing to win, then members should not raise the hurdles for their own teammates. If Congress chooses to keep the hurdles high, then members should not claim that they are doing everything in their power to spur the economy. Either way, stop the neo-McCarthy "un-American" rhetoric. Your victims are only following the laws you passed. Admit the truth. For what's truly unpatriotic is for an elected official to lie to the American people.

The author is a tax consultant and small business advisor living in New York.

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