Tuesday, February 13, 2007


In an outstanding article, Mr. Kevin Hassett of the American Enterprise Institute sets a question challenged by many company CEOs:

"Imagine you are the CEO of a major U.S. manu­facturing company. You are looking to locate a new domestic plant. All other factors being equal, would you locate the plant in the state with the highest taxes? Now, make that question international. Would you locate a plant in a country with high taxes or low? ... Total lobby­ing spending in 2005 was about $2.3 billion, but almost none went toward per­suading Congress to lower the corporate tax rate. Businesses instead prefer to push for their own narrow breaks"

High corporate tax rates have signficant effect on economic activity in the business environment. As the most important thing, when companies are required to pay a very high fraction of their income, their strategies, performance and business models adjust to cautious features as productivity, investment and other productive behavior are attached to more external uncertainty and risk. As high corporate tax rate reflects a tight rigidness of the business environment. This is commonly associated with several difficulties in doing business.

As countries compete global, tax competition among high-tax and low-tax countries reflects the attractiveness of business environment. Multinational headquarters and holdings are moving their facilities to countries where the aggregate tax burden is low and where low tax penalties on productive behavior coexist with favorable market indicators and business environment parameters. The most recent examples are Google and Kraft Foods. Google chose Switzerland to be its top European destination, while Kraft Foods has moved their European facilities from Vienna and London to Switzerland as well. Low corporate tax rates and favorable business conditions have forced companies to retreat from harmful business environment as high corporate tax rates causes significant costs of doing business.

There are several reasons why high corporate tax rates harms the economy:

(1) Low-tax countries have sighted a significant growth of net foreign direct investment. If a U.S. company, for example, sets a subsidiary in Ireland rather than in France or Italy, then its income created in Ireland will not be taxed under the U.S. legislation. It will be done so only if the money is mailed back to the U.S. The taxation of corporate income will be significantly lower in Ireland (12,5%) than it would be in the U.S (39,2%). Residual income from productive activites in Ireland will boost the company to invest further as well as to increase its stock market penetration while in the U.S. there would be only 60,8 percent of income left compared to 87,5 percent of residual income in Ireland. The elimination of double taxation of savings and investment can rapidly stimulate businesses and companies to move their headquarters to low tax countries in order to increase the residual income from risk, saving and investment (returns) and thus the level of capital gains.

(2) Multinational headquarters locate themselves in international business environments where corporate tax rate is charged only on domestic operations. It means that escaping oppressive high tax jurisdiction enables companies to improve their performance, rapidly lower corporate costs and operate free from high tax wedge. In a high-tax country, investment insourcing can easily decline completely unexpectedly as global counterpart countries reduce the corporate tax burden and thus lower the corporate tax rate.

(3) High productivity rate and the size of consumer market may largely determine the growth of output but high corporate tax rates can be a significant problem. Periodically adjusted observations and recent economic trends have shown that capital inflows largely increased as the corporate tax burden dropped. Swiss cantons, where the corporate tax rates are among the lowest in the world, are the most recent example. When small cantons in the heart of Switzerland, namely Zug and Obwalden, signficantly cut the corporate tax rates, the inflow of international capital investment skyrocketed. When Ireland set one of the lowest corporate tax rates in Europe, the capital inflow rate reached high double-digit levels. Low level of the corporate tax burden coupled with low tax wedge reflects an amazing 10 percent annual economic growth rate.

(4) Low corporate tax rates has a very positive effect on the manufacturing sector. Significantly lower proportion of income paid to the government may importantly ease the burden of the labor cost. Low taxes stimulate the ability of the firm to sustain or achieve high rates of productivity. In recent years, low level of productivity has been the main reason why many companies in the manufacturing sector left the U.S. and headed towards China and Asia. Wedging corporate taxes at such a rate could prolong the agony of low productivity. Further, taxing capital gains reduces the ability of the company to obtain much needed funding on the capital market to engage in risk, saving, innovative entrepreneurship and, of course, investment.

(5) Fifth, high corporate tax rates significantly affect the competitiveness of the economy. Deep corporate tax cuts may dramatically change the favorability of the tax environment. Lower tax rate will attract numerous international investors to setup their holdings and headquarters there. Ireland is an example of the company that went from rags to riches. In the early 90s, the economy grew by 80 percent a year. Low corporate tax rate seemed favorable to investors from abroad and they decided to set their facilities in Ireland. The growth of foreign investment in Ireland generally reflects favorable business conditions and propitious tax climate that drastically galvanized the Irish economy at its turmoil when it became a Celtic tiger.

The status quo is the most unfriendly form of tax policy toward the real business sector. The effect is twin-tracked. Capital flight is often the result of oppresive and almost confiscatory corporate taxation. Trade surplus correlates with investment deficit, but trade deficit is actually a sign of the vitality of the economy. It means that favorable business environment and conditions have attracted foreign-based companies to invest in that country. Trade surplus means that it's impossible to have a foreign direct investment surplus at the same time. Trade deficit means that economic conditions and indicators are marvelous. Tax policy of the status quo may cause the diminishing insource capital flows. It may, as well, negatively affect the competitiveness of the economy in the long-run when economic growth rates are usually anemic as a consequence of high corporate tax burden which results in a lack of productive behavior, capital and job creation and entrepreneurship while there is a conventional wisdom that there is no output growth without risk-taking and investment and the engine of human capital creation.

1 comment:

ilanit said...

In September I would have speculated that MS would not be treating a first-tier Orange County equity investment like Blackstone this way. But as the Fall has progressed and the potential liability increased it is clear that banks are willing to risk even their largest clients to wriggle away from some of these deals.