Click to see the Video: Business policy reporter Jia Lynn Yang sits down with Brook Silva-Braga to discuss why CEOs of multi-national companies are pushing for tax reforms as the United States nears the fiscal cliff and what, exactly, they’re hoping for.

Ever Wonder What’s Behind the Politics?

If you said “money, of course,” you’d be spot on.  and  write in The Washington Post about why the fiscal cliff debate has to happen. It seems that all the discussion of  tax hikes and spending cuts conceals a number of hidden agendas: a “massive change to the corporate tax code is quietly gathering steam.” One of these is pressure from U.S. multinationals to change the tax code to eliminate taxes on business profits overseas, since they are increasingly banking their futures on growth abroad.

TheLobbying Machine Is In Gear

Corporations and advocates that favor these tax changes (called a “territorial” system) have entered the fiscal-cliff debate. One group, Fix the Debt, comprised of big-business CEOs, wants comprehensive tax reform, and includes a number of advocates for a territorial system. The group’s clout can’t be underestimated, since its co-founders are Simpson and Bowles, and Honeywell CEO Dave Cote, an outspoken advocate of cutting taxes on overseas profits, sits on the steering committee. The group’s web site advocates: “Use the fiscal cliff as an opportunity.” The No. 1 item it lists among “budget basics that need to be addressed” is a “simplified tax system that is territorial and collects more revenue.”

Corporate Income Tax Receipts Since 1950

U.S. corporate income tax receipts since 1950.

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The Pros

Lobbyists are latching onto the “fiscal cliff” as an opportunity to eke out political concessions. Their argument is that U.S. multinationals are at a disadvantage against overseas competitors because the IRS collects taxes on foreign income when it is brought back into the United States, whereas other nations don’t do this. They maintain that if the tax were eliminated, they would be more likely to bring their overseas earnings back to the U.S. instead of just holding them abroad largely to avoid being taxed at a 35 percent rate:
  • U.S. multinationals are holding $1.7 trillion in earnings abroad.
There is some support for this “territorial system” in Washington, and has been promoted business groups including the Business Roundtable and the U.S. Chamber of Commerce, and numerous multinational company CEOs. It was among the recommendations from the National Commission on Fiscal Responsibility and Reform, co-chaired by Bowles and former senator Alan Simpson (R-Wyo.), and President Obama’s jobs council, and part of presidential nominee Mitt Romney’s economic platform.Sen. Orrin G. Hatch (Utah), the ranking Republican on the Senate Finance Committee, wants to extend the Bush tax cuts for a year and “let Congress undertake comprehensive tax reform in 2013 with a shift to a territorial system as a part of that exercise,” according to Hatch spokeswoman Julia Lawless.

The Cons

Yet some tax experts warn that, without safeguards,this would in fact encourage multinationals to exploit tax havens even further to drive more jobs overseas. Economists, such as Kimberly Clausing of Reed College, calculate that as many as 800,000 jobs could be added to low-tax countries instead of to the U.S. under a pure territorial system. Edward D. Kleinbard, professor of tax policy at the University of Southern California, says:

The territorial tax system they envision would gut the entire U.S. corporate tax code. It would lose gigantic sums of money every year.

Democrats are largely opposed to a territorial tax system, believing, as President Obama has argued, that it would encourage firms to move more operations overseas.
The Obama administration has proposed an alternative: a “global minimum tax” that would apply to income earned in any country.

Why Change Is Inevitable

There is bipartisan agreement that the corporate tax code must change, because it combines rates that are relatively high with tax receipts that are too low.

Today, U.S. firms pay a 35% tax on domestic and foreign profits, but can defer taxes on foreign income until they use that money in the U.S. Of course,  multinationals manage to pay a much lower rate by shifting their income to overseas tax havens, deferring taxes indefinitely. For this reason, revenues from corporations as a percentage of the country’s gross domestic product is near its lowest point in the past 30 years.

What’s the Answer?

So far, none of the advocates of a territorial system has provided any details, which is where the devil lurks.

Japan is often cited by lobbyists as a model since it switched to a territorial system in 2009. But Japan’s system is not a pure territorial model, since it has protective measures, such as taxing foreign income when the other country’s rate is less than 20%, which would actually cause many U.S. multinationals to pay much higher rates than they are now.

Colliding Priorities

According to The Washington Post,  the fight over the territorial issue may split the business community between those whose operations are mainly domestic — and thus pay higher taxes — and the largest multinationals. Senior Brookings Institution fellow and  member of the Fix the Debt steering committee Alice Rivlin,  said the two debt commissions she has participated in diverge on the issue:

The group headed by Simpson and Bowles, she said, advocated a territorial system because “the most articulate spokesperson on this issue” on the committee was Honeywell’s Cote. By contrast, the plan she helped develop with former senator Pete Domenici for the Bipartisan Policy Center did not include it, because the group had a small-business representative instead, and small businesses are less likely to operate overseas.

Big business groups like The Business Roundtable and The Chamber of Commerce are strongly advocating a territorial system. Tech and pharmaceutical companies have less at stake because  a practice known as “income shifting.” already makes it easy for them to reduce their taxes because they can park profits associated with their intellectual property anywhere they like.
One thing that the discussion ignores is the burden of higher taxes that falls on companies without overseas operations – domestic U.S. operations, like retailers. USC tax professor Kleinbard points out that we need to examine our priorities:
Of course we need a lower corporate tax. If we’re going to start with lower tax rates, maybe we should start with lower taxes for domestic operating business so they can expand. Wouldn’t that be our first priority?

Real Priorities: The Deficit Isn’t That Important

Whenever there is budget and tax reform, there are financial interests lobbying for special advantages. Over the course of several decades those advantages have solidly favored those powerful corporate interests that have exported jobs and suppressed labor costs and benefits. It is not surprising that this has resulted in a hollowing out of the middle and lower economic classes and the Great Recession.
The budget deficit is much less onerous than it has been presented to be by politicians, especially Republicans, who are pressured by their corporate sponsors to use it as a springboard to further tilt the economic advantages in their direction. An article by By Chris Baines at The Motley Fool explains that we’re not bankrupt and we’re not Greece. The deficit is rather insignificant in comparison to other nations, and relatively worse U.S. deficits have been satisfactorily resolved in the past. The Motley Fool explains why the deficit and the “fiscal cliff” is actually a political/economic smokescreen, and a comparatively minor priority:

It’s common to hear politicians on both sides proclaim that the U.S. is bankrupt. If we are, that’s news to millions of institutional investors who are eagerly lending hand-over-fist to the U.S. government. So why does the market expect inflation to be so low when it seems like all the federal government ever does is spend money it doesn’t have?

The answer is that the market thinks economic growth and unemployment are the real problem, and not the deficit. And the market knows that unemployment means slower growth, which means relatively fewer dollars chasing the same goods.

The basic problem with the economy right now is that businesses not named Apple are facing a dearth of customers. And without customers, there are few reasons to hire people and plenty of reasons to fire them, creating unemployment. And with unemployment there is even less spending, and with less spending even less employment, and so on and so forth in a vicious cycle.

What the government should do in such a situation is one of two things (or both). Either cut taxes to give people more of their own money to spend, or spend money it doesn’t have via government projects. As presidents Reagan and Franklin Delano Roosevelt would attest, both ways can work wonders, and both ways expand — not contract — the deficit.

What won’t work is the way of President Hoover, and what is rapidly becoming the way of Speaker Boehner and President Obama: raising taxes and/or cutting spending. It hasn’t worked in Europe, and it won’t work here.

I think the market intuitively understands this: The reason why stocks fell and Treasuries paradoxically rallied on the day of the S&P downgrade was fear that it would cause Congress to do something about the deficit. And doing something about the deficit is almost certainly bad news for the economy and stock market (less spending, more unemployment, less economic growth).

But don’t just take my word for it. Ken Fisher, in his 2007 book The Only Three Questions That Count: Investing By Knowing What Others Don’t, points out that stocks have actually done better during times of deficit spending than during budget surpluses (i.e., 2000). Fisher also points out that the federal government may be underleveraged, a view he reconfirmed postcrisis, but I won’t deny him well-deserved book sales by divulging the details.

There will come a time — when the economy is booming — that the deficit (via inflation) will become a real threat. But right now the deficit is a red herring that Congress, the president, and investors should ignore.