TCS Daily

Kerry and Me

By Kevin Hassett - April 15, 2004 12:00 AM

Imagine my surprise when I discovered that Senator Kerry's campaign cites me -- "conservative economist Kevin Hassett" -- as an "expert" in support of its plan to change the U.S. corporate tax code. Had the Democratic presidential candidate immersed himself in my often tedious writings on corporate taxation and seen the light? About time!

Alas, it was not to be. Kerry doesn't get it. In fact, his proposal makes a bad system even worse for most U.S. multinational corporations. But the story does not end there. He also shamelessly included a loophole that is designed to give billions of dollars in tax breaks to the few companies -- including HJ Heinz Co. (as in Teresa Heinz, his wife) -- that are organized in a particular way.

Recent scholarly research on international taxation has explored the impact of the tax code on the competitiveness of U.S. firms. Two factors that significantly undermine our competitiveness have been identified. The first is that we tax corporate income on a "worldwide" basis. If a company makes a profit in France, it will have to pay U.S. tax on that profit when it mails the money home, after receiving a credit for foreign taxes paid. Most other countries do not tax foreign profits at all. Any multinational firm that earns money in France, after all, pays French tax immediately. Why should we add a second tax on top of that?

The other factor that harms U.S. competitiveness is the very high rate of U.S. corporate tax. Most other countries have reduced their corporate tax rates sharply in recent years. The U.S. has not, and the result is that we are now one of the highest tax countries on earth. In a recent paper I coauthored with my colleague Eric Engen, for example, we found that the U.S. corporate tax rate was 18 percent higher than the non-U.S. average in 2001.

So how do U.S. multinational firms stay competitive despite these disadvantages? Under current law, they can locate production and profits abroad and avoid paying the very high U.S. taxes by letting profits sit in bank accounts overseas. This strategy does not avoid foreign taxes, but since those are much lower than ours, the playing field is leveled somewhat. A U.S. manufacturer can produce a good in Ireland for sale in Europe and be competitive despite our high tax rates.

Senator Kerry plans to end this. If a multinational makes money abroad, it must pay U.S. taxes immediately. This will make the negative impact of high U.S. taxes impossible to avoid and force U.S. firms to significantly increase prices. That should lead to sharp reductions in market share and employment both at home and abroad, and a likely wave of foreign acquisitions of U.S. companies. The plan's second measure, a 1.75 percent reduction in the corporate tax rate on all worldwide profits, would not begin to offset the lost benefit of tax deferral.

The Kerry team clearly recognized the possibility that they were causing significant harm, because they added a loophole. If a U.S. multinational produces a product in a foreign country for consumption in that country, then they will continue to allow the firm to avoid U.S. tax until the money is mailed back home.

Think of all of the needless and duplicative activity this will generate. Multinationals will be forced, in pursuit of tax savings, to introduce newer and smaller production facilities in every country they serve. Transportation costs are low enough, and scale economies large enough, that most multinationals operate a few production facilities located in attractive hubs around the world.

So why would anyone propose such a thing? Some industries, like food production, already operate that way. Because of local food regulations, and concerns about spoilage, it is often the case that food companies locate a separate plant in each country that they serve. Chief among these is Heinz, which owns 57 plants outside of North America that, as the company states, "provide products to consumers in those markets."

Heinz is so successful at capturing local markets that, according to form 10-K, almost 84 percent of its income from continuing operations came from foreign markets in 2003. Accordingly, the impact of the Kerry plan on that company's value would be tremendous. If we assume that deferring U.S. tax on their foreign income saves them the difference between the U.S. tax and the average foreign tax, then that adds up to annual savings of about $43 million. With a P/E ratio of 19.35, that means that absent the loophole, the firm's market value would drop by about $832 million upon passage of the Kerry tax plan. Assuming that the Kerry-Heinz family's share of the company is four percent, which is the upper limit of what has been reported, then this loophole saves Mr. Kerry's family around $33 million. It is easy to see why they might support this loophole, but hard to see why anyone else would.

It would be preferable, of course, to save all U.S. multinationals from the share price declines that will follow if they lose the ability to defer U.S. taxes, not just Heinz and the few other companies with this specific organizational form. An easy way to accomplish that would be to drop the Kerry plan.

Better still, lawmakers could outdo Senator Kerry's paltry corporate tax rate reduction and reduce our corporate tax at least 18 percent to return it to the world average. That would be the best way to encourage our firms to locate more activity at home.

Mr. Hassett is director of economic policy studies at the American Enterprise Institute.


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