Obama’s corporate tax reform

February 27, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

On February 22, U.S. President Barack Obama’s administration brought out a white paper on corporate tax reform which, if enacted, will make a significant difference not only to America but also to many other countries.

The white paper offers the first major tax reform since 1986 when the corporate tax rate was increased to 35 pct. This reform has two main components. First, it proposes to reduce the rate of corporate taxation to 28 pct while knocking down some of the tax breaks; second, earnings from abroad will be subjected to tax.

The underlying singular objective is job creation, a penchant for which Obama had displayed right from his campaign days four years back. Over time, he has perhaps been more convinced that U.S. companies should invest to create jobs in America.

“Right now companies get tax breaks for moving jobs and profits overseas,” he said on February 16 during his tour of Milwaukee factory. “Companies that choose to stay in America get hit with one of the highest tax rates in the world.”

Surely, the tax system has to be competitive. With 35 pct tax, American companies may find it advantageous to invest and earn profits abroad because the average rate of taxation in the rest of the world is 25-27 pct. With 28 pct tax, companies may be tempted to divert at least part of their investment from other countries to the U.S. That is more likely in respect of manufacturing for which the tax rate is proposed at 25 pct and more so ‘advanced manufacturing’ for which it is even less.

However, the tax liability cannot be the only consideration in business investment. Companies have to be at the market place to gain competitive advantage. If American companies restrict investment to the U.S. they will lose a chunk of the world market. Take a company like Coca-Cola. Had they not invested abroad, they would have stopped investing altogether a long time ago.

The other significant component of tax reform is the proposed minimum tax on earnings from abroad. There is no other country that indulges in a tax like that. For, it amounts to double taxation. Tax on foreign earnings would make American companies uncompetitive and confine them to America; or it would force American companies operating abroad to retain their profits outside the U.S.

The combined effect of lowering the corporate tax rate and of imposing a minimum tax on earnings from abroad would be to reduce foreign direct investment by American companies particularly in emerging market economies. American companies will prefer to operate only in the U.S. where investment opportunities will progressively shrink.

In India, foreign direct investment since 2000 was $223 billion with America being the third largest investor after Mauritius and Singapore. The Obama reform, if enacted, will reduce American investment in India and other countries. However, with a divided Congress, reform this year is unlikely but there are chances it may reappear in the future.

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