The prospect of Burger King becoming Canuck King has fueled the political frenzy surrounding so-called “tax inversions.” As with other recent mergers and acquisitions – Medtronic/Covidien, AbbVie/Shire, etc. – Burger King proposes to acquire Tim Horton’s, a Canadian-based firm. The acquisition makes sense for both parties as Tim Horton’s has sought to expand its U.S. footprint and Burger King has faced relatively stagnant growth. This is characteristic of the recent spate of inversions; they begin as sensible business propositions in a global market. However, when the management runs the numbers, it becomes obvious that the merged firm should be headquartered in the foreign country. Thus, the firm “inverts” as the smaller, acquired firm becomes the headquarters and the larger, acquiring firm becomes its U.S. subsidiary.
Burger King is moving its headquarters to Canada following its acquisition of Tim Horton’s.
Why? The culprit is the U.S. corporation income tax, which has two key competitive disadvantages. First, the 35 percent federal rate (exacerbated by state and locality taxes) is the highest in the developed world. Second, the U.S. tax applies to the worldwide earnings of U.S. firms, while our competitor countries largely restrict themselves to taxing profits earned within their borders (so-called territorial taxation). To take the Burger King example, if the merged firm stayed with its U.S. headquarters, it would pay U.S. tax on both U.S. and Canadian income. Switching the headquarters to Canada still means paying U.S. tax on U.S. income, but switches to the Canadian tax for Canadian earnings. Firms quickly reach the inevitable conclusion that it is a competitive disadvantage to be based in the U.S.
What lessons can be learned from the recent inversions?
Lesson 1: The only real solution is to fix the broken U.S. tax code. If the U.S. moved toward a system of territorial taxation it would cease to overtax the overseas earnings of U.S. firms and mitigate the competitive disadvantage that is driving firms overseas. If it simultaneously moved its tax rate to the mid-20s, it would put its tax burden in line with competitors. Tax-driven inversions would cease.
Lesson 2: In the absence of tax reform, firms will self-engineer a territorial system. The basic insight of the recent inversions is that the firms are doing self-help tax reform by moving to a country with a more modern and competitive income tax.
The inversions episode is a great lesson in the capacity for short-term politics to damage long-run policy objectives.”
Lesson 3: Living in the past is dangerous. The president and other politicians have bemoaned the patriotism of inverting firms, arguing that they have always been U.S. firms and should continue to be so. Why? Unlike the 1950s and 1960s when the remainder of the globe struggled to recover from the devastation of World War II, the U.S. faces strong international competition. Appeals to patriotism are essentially appeals to continue to be at a disadvantage, grow more slowly (or even fail) as a company, and harm the futures of American workers. The U.S. no longer has a lower corporation income tax (as it did right after the Tax Reform Act of 1986) as other countries have chosen to compete aggressively and created better climates for business location and investment. The debate must be centered on the realities of the present and the need for a better future; not the past.
Lesson 4: Good policy is not automatically good politics. The best policy is tax reform, and there is strong evidence that Democrats think it is better politics to demagogue firms than to pass a tax reform.
The second best policy is, in fact, to do nothing. Why? One feature of the U.S. code is that it tries to minimize its uncompetitive nature by not taxing overseas earnings until they are brought back to the U.S. (“deferral”). This is an incentive to keep funds parked offshore. When a firm inverts, it can gain access to overseas earnings, which can be brought back to the U.S. to hire, train workers, innovate, and invest. That is the benefit to an inversion, and it helps in the United States.
Critics argue that the U.S. is losing the tax on those repatriated funds and – because they instinctively equate a bigger government with good policy – bemoan the inversion. But U.S. firms now have trillions parked offshore and the evidence is increasing that the funds may never come back. No real losses of taxes are at stake.
The worst policy is the proposals to “fix” inversions by requiring (a) that the foreign shareholders control at least 50 percent of the firm, and (b) the merged firm be primarily managed and controlled in the foreign country. The first feature means that U.S. firms must find larger foreign firms to acquire. This cedes the market for the small, enterprising growth firms to foreign competitors and harms the U.S. workers and firms. The second feature means that instead of moving the headquarters abroad on paper, firms will actually ship the management and headquarters staff to a foreign location, costing the U.S. jobs.
The inversions episode is a great lesson in the capacity for short-term politics to damage long-run policy objectives. One can only hope that the episode fades quickly before irrevocable harm is done, and that attention turns to improving the environment for business location and growth decisions in the United States.