Editor’s Note: Co-authored by Arthur Laffer

The last several months have seen a wave of American companies merging with foreign companies, a process known as “inverting.” In effect, inversion is the corporate equivalent of a renunciation of American citizenship. By some estimates, about $250 billion of these deals have been consummated since the start of the year, and another $100 billion could be finalized soon.

As inversions have exploded onto the policy scene, Washington is scrambling to find ways to counteract a trend that could deprive the federal treasury of tens of billions of tax dollars, which Washington believes belong to the government. In President Obama’s own words, “My attitude is I don’t care if it’s legal, it’s wrong.”

Inversions vividly illustrate the amazing dysfunctions of the U.S. corporate tax code. The corporate tax raises $250 billion per year, or 1.5% of GDP, which is one of the lowest tax revenues in the world. And, the U.S. has the highest corporate tax rate in the world. If that’s not enough, compliance costs are huge and the corporate tax is a job killer.

An inversion occurs when an American company merges with a smaller company in a lower-tax jurisdiction such as Ireland. The deal is structured so the smaller company acquires the larger American company. Operations and management often remain in the U.S., but the legal headquarters is changed to the lower-tax jurisdiction.

By inverting, the company is no longer legally U.S.-based and thus is not required to pay U.S. taxes on profits earned abroad.

A notable requirement – IRS code 7874 added as part of the American Jobs Creation Act of 2004 – is that the shareholders of the smaller target company must end up owning at least 20% of the inverting company’s shares. Obama wants to raise this requirement to 50%.

U.S. Tax System Onerous

The rush to invert is a direct result of the 39.1% U.S. corporate tax rate, including state and local corporate taxes, compared with an average corporate tax rate for the rest of the world of 25%.

U.S. corporate taxes also apply to world profits, not just profits earned in the U.S., which makes an inversion cost-effective for an American company operating abroad. Anyone who is watching these inversions happen and still believes that tax rates don’t matter is living in a parallel universe.

The recent rush to invert is in part because other nations are cutting their corporate tax rates – the U.K., Japan and Spain most recently – making the cost savings much greater for U.S. companies. The other reason companies are rushing to invert now is to preempt discriminatory legislation proposed by the Obama administration.

The chart below encapsulates the problem. The U.S. was once a low corporate-tax rate nation; now we are the highest. The 39.1% U.S. rate has been effectively unchanged for 20 years, but the rest of the world has been slashing rates. This is a phenomenon we have called “supply-side economics goes global.”

We have also talked to CEOs who say they can negotiate sweetheart tax deals to bring their corporate tax rate below 10% and sometimes down to zero.

Blame Everyone Else

The administration’s response is simple: Blame everyone else for the dysfunctional tax code and then outlaw inversions retroactively. Because most inversions involve foreign minnows swallowing U.S. whales, a 50% foreign-ownership requirement, if made retroactive to May 2014, would make most of the mergers that have already taken place illegal and very expensive.

We believe the Obama proposal is pure demagoguery and would encourage multinational companies to avoid the U.S. altogether, meaning even fewer U.S. jobs. The Obama plan is like seeing a raging fire in a building and locking all the doors shut so no one can get out.

After the midterm elections, Congress and the White House could strike a bipartisan deal to slow down the inversion process, including some corporate-tax-rate reduction. A corporate tax rate of 28% could be “paid for” in part by closing corporate “loopholes” such as the wind tax credit and other energy subsidies.

Democrats will insist on repealing tax deferral on foreign-held profits. But even so, if the U.S. corporate tax rate is lowered enough, deferral will be less advantageous, and such a trade-off may be worthwhile.

In the longer term, Paul Ryan’s tax plan includes a swap of a value-added tax for a corporate profits tax. The Ryan plan is consistent with the Laffer Complete Flat Tax proposal. Because value added is essentially GDP and corporate tax revenues are between 1.5% and 2% of GDP, a full corporate tax switch from a tax base of profits to value-added would imply a corporate value-added tax rate in the low single digits.

We would put the odds of a partial corporate tax holiday on repatriated profits at 50-50. Companies with profits stored overseas could repatriate their earnings back to the U.S. at a lower tax rate. A tax holiday with a temporary tax rate of 5% to 10% could bring back to the U.S. as much as $1 trillion to $2 trillion parked overseas, raising as much as $50 billion for the Treasury.

Our view is simply that government doesn’t need more money; government needs to spend less. Thus, this $50 billion of additional taxes should be offset by permanent corporate-tax rate-reduction, dollar for dollar.

Tax On U.S. Jobs, Wages

We have always believed that the case for tax reform will catch on politically when American workers and unions start to see that this isn’t just a tax on corporate shareholders but on domestic workers as well.

The U.S. corporate tax sends jobs abroad by encouraging outsourcing, and it also lowers wages in the U.S. Kevin Hassett at the American Enterprise Institute finds that “corporate tax rates affect wage levels across countries. Higher corporate taxes lead to lower wages.”

Somebody please tell this to the Teamsters’ James Hoffa.

Another proposal would be to have the U.S. join other countries and move to a territorial tax system. American companies would simply pay the tax in the country in which their plant or facility is located. Republicans are skittish about this idea, worrying it would only further the incentive for businesses to move plants and jobs offshore.

Top Dems Urge Reform

The U.S. corporate tax is on the verge of complete collapse. Former Treasury Secretary Tim Geithner and former Fed Chairman Paul Volcker have advised Obama that the current corporate tax is an economic loser.

“The U.S. corporate tax incentivizes American businesses to move jobs offshore,” according to Volcker. “Unless the rate is cut substantially, this trend will continue and American workers will pay the price.”

Adds Geithner: “I do think there’s an overwhelmingly compelling case for broad-based corporate tax reform. The basic imperative is to get the incentives better and the fundamentals better for people creating and building things in the United States.”

We agree!

Republished from The Daily Signal.