6 How the Tax Code Subsidizes Businesses that Move Jobs Elsewhere

“Made in China with the benefit of US tax subsidies”

Economists assume that US jobs move elsewhere because costs are lower elsewhere. Sometimes this is true, sometimes not.

What few understand is that our own Internal Revenue Code, in interaction with other countries' tax systems, actually encourages businesses to move American jobs to other countries.

Bear with me. This is a little complicated. But it’s really important.

The problem is most easily explained by comparing our income tax with a water’s-edge value-added tax (or “VAT”).  A VAT is simply a tax on the value each business adds to the economy, regardless of whether it makes or loses money. Almost every developed country except the US uses a VAT.

So what’s the problem? When you fight through the details, ultimately our system taxes by place of business activity, both production and sales. A water’s-edge VAT, by contrast, taxes by place of sales.

Why is this a problem?

Put yourself in the shoes of a business trying to decide where to locate its plant and jobs – the US or Country A. Country A, let’s assume, uses a VAT.

If our hypothetical business locates in the US to sell into the US, all of its profits will be subject to US income tax. If it locates in Country A to sell into the US, it will pay will pay US income tax only on the portion of its profits attributable to sales and no VAT to Country A. (Remember, a VAT taxes by place of sales.)

Where to locate, all else being equal? Country A, obviously.

What if it plans to sell into Country A? If it locates its plant and jobs in Country A, it will pay full VAT on its sales. If it locates in the United States, it will pay the same full VAT to Country A plus US income taxes on profits attributable to its production activities.

Where to locate? Again, Country A.

Not all countries use VATs. Some use income taxes or a mix of income taxes and VATs.

Comparing income taxes is more complex because income taxes are more complicated and vary more widely. But there are ways to make an income tax system effectively tax by place of sale. If our competitors do so and we do not, businesses face the same incentives to move jobs elsewhere that I’ve described above with respect to a VAT.

Even if a competitor’s income tax system looks exactly like ours, a competitor that raises half its revenue from a water’s-edge VAT and half from a US-style income tax still gives multinational businesses significant reason to locate jobs and plant there, not here.

At this point, you may be wondering why our government does this to us. The answer is that, for the most part, it doesn’t yet understand what I’ve just told you.

Back before NAFTA, GATT and free trade, the problems I’ve described didn’t matter. If you wanted to sell into the United States, you produced in the United States. If you didn’t, you faced major customs duties.

When the US joined the free trade movement, however, it neglected to think about whether the tax system it had been using for the better part of a century was up to the challenge. Our system is so complex that even experts sometimes have a hard time seeing the forest for the trees. (It took me a quarter century of working and teaching in the area to figure things out.)

A further part of the problem is that those who understand our international tax system best have a vested interest in keeping it around. Every multinational has decided where to locate its productive capacity based on existing subsidies. If we were to level the playing field, they’d have to move jobs back here. Moving jobs costs money. They'd also have to give up the tax breaks they now get for moving jobs out of the US.

As a result, I’m one of very few people pushing this issue. (Obama has now promised to fix the problem. So far, McCain is sticking with the status quo.)

But the bottom line is still the bottom line. Our tax system, in interaction with the systems of other countries, gives tax breaks to businesses that move jobs and plant out of the US.

Result? Fewer jobs, lower average wages for American workers.

Comments

[PM]

So why can't US based firms sell to other countries and reap a higher profit from markets where the VAT artificially raises prices? Wouldn't most of what constitutes the VAT come back to the US based company as profit in such an environment? I assume that this does not happen because other countries won't allow it to happen, i.e. direct or indirect protectionism.

[GM]

PM,
US firms selling to other countries are subject to the VAT on those sales. The VAT is charged at the point of sale so, for example, if Ford exports a Mustang to France the VAT is added on when the friendly Frenchman writes the check to buy the car. Then Ford pays corporate income tax here in the US on profits from the sale of the Mustang.

By some estimates the US corporate tax rate is the second highest in the developed world. It amazes me we have any manufacturing jobs left in this country.

One thing that bothers me about popular discussion of this issue is that politicians make it sound like there is some sort of explicit job-exporting tax credit written into our tax code and that we need to repeal it and charge our domestic manufacturers more. This is not the case, it is simply that many other countries have tax codes better designed for competitiveness in a free market world.

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