Corporate Governance

In the competition to attract and retain global corporate investment, tax policy is often seen as one of the most immediate and potent levers that legislators can pull. This is especially true given the ability of multinational companies to move business and capital across borders. These transnational flows often take with them the jobs, the R&D, and the innovations that drive and sustain long-term growth. Intellectual property (IP)—including copyrights, trademarks, and patents—is particularly mobile as an intangible asset. In April of next year, the United Kingdom will become the latest country to introduce a corporate tax incentive known as a “patent box,” a policy that grants companies a significant tax break on profits attributed to IP. The policy's name refers to the box that is physically checked on the tax form. The UK patent box, which hopes to attract innovative industries and all their economic fruits, will allow corporations to apply a reduced 10 percent rate to income from patents- versus a headline rate of 23 percent. Patent box policies have also been deployed recently in Holland and Belgium (2007), as well as in Spain and Luxembourg (2008). The Dutch “innovation box” goes even further by including a broader class of IP and a lower rate of 5 percent. As other nations jockey for position, the United States has slipped well behind. The current U.S. corporate tax regime hasn’t undergone a major facelift since 1986. And the current system is doubly flawed, combining the highest top tax rate in the world, at 35 percent, with a host of complex subsidies and loopholes that add to inefficiency. While both parties have acknowledged a need to cut the top rate and end many of the tax subsidies, one incentive that most policymakers—including President Obama and Mitt Romney—would like to preserve is the Research and Experiment (R&E, sometimes R&D) tax credit. Most economists agree that unlike many other corporate tax incentives, the R&D credit deserves special treatment because it provides a wellspring of growth and has social returns that are not captured by businesses—a market failure. But despite the near consensus, Washington has proved unable to make the R&D tax credit a permanent fixture of the U.S. code. It has expired and been renewed thirteen times (often retroactively) since 1981, sunsetting yet again last January. The impermanence of the credit in the U.S., as with many tax policies, has made it less effective as businesses are reluctant to change behavior given uncertainty. "What’s happened traditionally every year is that in the fourth quarter or maybe even beyond the fourth quarter, the R&D credit is enacted and we have to then figure out the deduction for the whole year’s credit," said Bruce Lassman, vice president of international tax at IBM. "So that’s kind of a nerve-wracking thing. It’s difficult to manage your affairs when you have a legislative situation like that.” While there is broad consensus that the R&D tax credit should be made permanent, the  idea of adding a patent box tax incentive has not been part of the debate in the United States. If adopted in concert with the R&D credit, a U.S. innovation box could supply a back-end incentive in the so-called innovation value chain. In other words, it would target the back end, the income from innovations, while the R&D credit incentivizes the front end, or the underlying research. While the latter is more important because the R&D provides spillover social benefits, the revenue incentive provided by an innovation box would likely sweeten the deal and encourage companies to maintain or expand IP-intensive activities in the United States. There are big questions, however about the costs of such an approach.  An innovation tax incentive, depending on the reduced rate and a host of other specifics, would certainly hit the Treasury hard if it's not implemented as part of broader reforms to the tax code.

The United States has not had a comprehensive overhaul of its tax code since the 1986 Tax Reform Act signed into law by President Reagan. Nearly twenty-six years and over 15,000 special tax provisions later, many critics say the time for another round of reform is long overdue. Both parties are calling for a reduction in the headline corporate rate--now the highest in the world at 35 percent-- and an end to many of the corporate tax expenditures (tax breaks) that litter and complicate the code. However, stark differences persist over how to tax U.S. multinational corporations, the firms most sensitive to global competition. President Obama's proposal would largely maintain the current U.S. system that taxes the overseas profits of these companies, while Republicans favor a shift to a territorial system--like most of the industrialized world--that only taxes domestic profits. The outcomes of this debate will have significant consequences for the ability of these firms, and the United States as whole, to compete on the international playing field. This CFR backgrounder puts the debate in context and outlines several plans for reform.

In 1992, the price of a gallon of gasoline in the United States averaged $1.13; in Maryland, the state tax on that gas was 23.5 cents per gallon, roughly 20 percent of the pump price. Most other states set their taxes at similar levels, while the federal government levies its own separate tax of 18.4 cents. Almost all the funds have gone into paying for repair, maintenance, and expansion of the roads used by all those drivers paying the tax. Today, the price of a gallon of gas averages more than $3.50 per gallon; the Maryland tax is still just 23.5 cents per gallon, which is only 7 percent of the pump price. Nor has the federal tax increased. So what is the reaction to a proposal by Democratic Governor Martin O’Malley that would roughly double the state gas tax over the next three years, still leaving it well below the level of two decades ago? A growing chorus of protest that appears likely to defeat the tax hike. The gas tax is perhaps the clearest, most understandable example of that old maxim: you get what you pay for. People understandably do not like taxes where it is unclear what they are getting in return. The gas tax is the opposite: it pays for the roads we all drive on. Pay more, and the result is less congestion and fewer potholes; pay less and, well, don’t complain over flat tires and traffic jams. Some state governments have figured this out, and are proposing modest hikes in gas taxes to fill yawning holes in their transportation infrastructure budgets. Iowa, Virginia, and Michigan are all considering higher gas taxes to pay for roads, and are facing similar political opposition, though some states like Oregon and North Carolina have managed to approve tax increases. The Maryland reaction shows why it is so difficult. According to a poll conducted at the behest of the petroleum distributors, seventy-six percent were opposed to an increase in the gas tax, including 68 percent of Democrats and an astonishing 90 percent of Republicans. National polls show similar results, with roughly three-quarters of Americans opposed to higher gas taxes. There are certainly legitimate criticisms of the Maryland proposal. A weak economy in which pump prices are already rising sharply may not be the best time to raise the tax. Much of the funding would go to expanding mass transit systems, which benefit drivers only indirectly. But the poll results mostly underscore one of the real dilemmas that make effective governance so difficult. At the end of three years, O’Malley’s proposal is estimated to cost the typical two-car commuting family about $400 extra per year, or $200 per driver. According to research compiled by my colleague Becky Strauss for a forthcoming Renewing America report on transportation infrastructure, the economic costs of traffic congestion, including wasted fuel, averaged $710 per commuter in 2010, more than three times as expensive. But try being the politician arguing for small sacrifices now in exchange for greater benefits later. Building the U.S. economy for the long haul, however, is going to require a change in that mentality. Whether in infrastructure, education, or research and development, longer-term economic growth requires some reasonable level of government, or joint public-private, investment. And that means taxing now for future benefits. There are many reasonable debates to be had over investment priorities, timing, and appropriate taxation levels. But if the answer is always and everywhere no, that is a recipe for more potholes, poorer schools, and declining innovation.

There is no morally defensible reason for cutting corporate taxes at a time of deepening national debt that will require greater burdens for all Americans, either through higher taxes on income and consumption or lower spending on entitlements, defense, or other government programs. Unfortunately, it is a practical necessity. Technology and trade liberalization have created a global competition for investment. Multinational companies considering their investment alternatives weigh many factors, but the tax burden is high on the list. It is no coincidence, as the chart below published today by the Treasury Department shows, that corporate tax rates began to fall in the 1980s as global trade accelerated, and then fell even more sharply in the mid-1990s, coincidental with the creation of the World Trade Organization and big advances in transportation and communications technology. The United States was one of the few countries that did not jump on the bandwagon. It has refused to recognize what has been obvious for many years to smaller countries with fewer of their own multinational companies--corporate capital is a “mobile factor” that forces countries to compete for investment. Chart source: The President's Framework for Business Tax Reform That mobility is at the heart of why President Obama’s Framework for Business Tax Reform, spelling out the Obama administration’s corporate tax priorities, is such a disappointing proposal. Except at the margins in relation to the manufacturing industry, there is little in the proposal that would make the United States a more profitable place to invest, and some that could do the opposite. In the first place, as the Treasury acknowledges, the Obama administration is not really proposing a corporate tax reduction. It would lower the statutory federal corporate tax rate from 35 percent--soon to be the highest in the developed world--to 28 percent by closing an array of loopholes and tax deductions and increasing taxes on overseas profits. Even if the rate reduction were a real tax cut, it would be modest. As it is, the result would only be to benefit some industries that pay high effective rates under the current system, such as transportation and manufacturing, at the expense of others that pay lower effective rates, such as drug and biotech companies. While this could well be fairer and less distortive than the current system, it would do nothing to close the broader U.S. competitive disadvantage. Even more disappointing is the president’s proposal to discourage overseas investments by U.S.-headquartered multinational companies. As it now stands, the United States nominally has a worldwide tax system in which companies are taxed at the U.S. rate on their global profits (minus deductions for taxes paid abroad). In reality, the United States has a distorted territorial system in which, because the U.S. tax is only imposed when companies repatriate their profits, there is an enormous incentive to earn and/or shift profits offshore. Irwin Jacobs, co-founder and former chairman of Qualcomm, the San Diego technology giant, noted at a Brookings forum that the company currently has about $22 billion of cash on its books, $16 billion of which is held abroad. The domestic cash can be used for a variety of purposes, including dividends to shareholders or buybacks. The foreign cash can only be invested abroad, or returned home and taxed heavily. Guess which the company will likely choose? The Obama administration’s proposal to deal with this dilemma is not to follow most of the rest of the world by moving to a proper territorial tax system, in which profits are taxed only in the country where they are earned, but to impose a minimum global tax on U.S.-headquartered companies whether or not they repatriate their profits. If it could be enforced effectively, which is doubtful, the only consequence would be to encourage more companies to place their headquarters somewhere other than the United States. What this proposal primarily does is to highlight the difficulty of trying to move discretely on any single aspect of tax reform. A tax system that is both more competitive and more fiscally responsible would require an array of changes. There are many ways reform could be sliced (which is why it’s so hard to do). My preference would be for significantly lower corporate tax rate to encourage investment, coupled with a Value Added Tax to raise revenue, discourage consumption, and boost exports, and a more progressive income tax system to offset the regressive VAT. Yet in the current political environment, two out of the three are deemed topics not worthy of serious debate.

While it’s only February, I feel safe in making the following prediction: the new issue of the Harvard Business Review contains the most important thinking on the issue of U.S. competitiveness that will be published this year. It should be read in every corporate boardroom, by every member of Congress, by every senior official in the Obama administration, and by every economic adviser to the Republican presidential candidates. The debate over competitiveness is often muddied because the word is used in so many different and often incompatible ways. Economist Paul Krugman famously dismissed the notion entirely as a “dangerous obsession” in a 1994 Foreign Affairs piece, arguing that “the world’s leading nations are not, to any important degree, in economic competition with each other.” Krugman doesn’t appear to have changed his mind recently, but perhaps a careful reading of this issue will cause him to reconsider. Michael Porter, who has led much of the Harvard Business School’s work on this issue, offers the best definition I have seen. He writes: “The United States is a competitive location to the extent that companies operating in the U.S. are able to compete successfully in the global economy while supporting high and rising living standards for the average American.” What this means is that “competitiveness” is not a synonym for “economic growth.” It refers only to the ability of the United States to succeed as a high-wage location for operations in internationally-traded sectors. Competitiveness so defined is not an issue for much of the U.S. economy. Most jobs are still in non-tradable sectors (health care, retail trade, government) that do not face significant import competition. But the share of the U.S. economy exposed to international competition--not just in manufacturing but in service sectors as well--has grown immensely over the past several decades, and the pace will only accelerate. And these sectors really matter. As my colleagues on the recent CFR Independent Task Force on Trade and Investment Policy, Laura D’Andrea Tyson and Matthew Slaughter, point out in the issue, the 27 million U.S. employees of multinational companies are well-paid, with compensation 25 percent higher than average. Yet they write, building on the work of the Task Force, that U.S. employment in these companies has fallen sharply in the United States over the past decade even as it has grown abroad. Porter and his colleague Jan Rivkin penned the key article in the issue, entitled “Choosing the United States.” Based on surveys of some 10,000 Harvard Business School alumni, it concludes that the United States is attracting a far smaller share than it should of high-value-adding activities. The reasons are varied, including corporate misperceptions of the gains that come from outsourcing, but two stand out: U.S. policymakers “are not addressing weakness in the national business environment and are doing little to fight economic distortions that disfavor location in the United States.” And for those skeptical of the importance of manufacturing, like my CFR colleague Jagdish Bhagwati, I would recommend the article by Gary Pisano and Willy Shih that builds on their work showing that economies that do not make things also tend to lose the ability to innovate in manufacturing. While they are quite rightly opposed to targeted industrial policies, they recommend a big increase in government support for R & D in the manufacturing sciences, as well as tax, regulatory, and training policies that encourage investment in manufacturing. Porter and Rivkin raise another important point. While the United States must do far more to attract and retain investment, our standard of living will fall if the primary means for doing so are wage cuts, a weaker dollar, or boosting productivity by firing workers and demanding more of those who remain. This is the “race to the bottom” that globalization skeptics have long feared, and there is some evidence that the otherwise encouraging recent uptick in manufacturing employment is in part the result of falling U.S. wages, coupled with rising wages in China and other offshore locations. Instead, the goal must be to make the United States a compelling investment location despite its relatively high costs compared with emerging markets. Much of the rest of the issue is concerned with how best to do this, in areas such as education and skills training, finance, fiscal policy, entrepreneurship, and the green economy. There is too much here to summarize easily, and some of the ideas are better than others. Read it for yourself. Restoring American competitiveness, as Harvard Business School dean Nitin Nohria writes in the introduction, matters to all of us.

One of the encouraging developments under the Obama administration has been its willingness to use export credit financing more aggressively to ensure that U.S. companies, where they are otherwise competitive, do not lose out on export contracts abroad. The expansion of lending by the U.S. Export-Import Bank has been part of the administration’s push to double exports under the National Export Strategy. But inaction by the Congress could undermine even the modest role that it currently plays. The Ex-Im Bank is one of those government agencies that is hard to love. It is periodically denounced, with some justification, as “corporate welfare,” and is colloquially known as “Boeing’s bank” because the aircraft manufacturer is the single largest beneficiary of Ex-Im support. In an ideal world, it would not exist: export contracts would be won solely on the basis of low-cost, high quality products and commercially available financing. But in the real world, there are many countries, as well as companies with close ties to governments, that are able and willing to offer cut-rate financing in order to win big contracts. The gain from these deals is not just jobs and revenue, but often a “first-mover” advantage as well. A company that wins the first contract to build planes for a foreign airline or rail cars for a foreign rail network, for example, is often assured a reliable stream of future orders. One of the misunderstandings about export credits is that they are a drain on taxpayer dollars. In fact, the bank has been self-financing for years, relying on the good credit of the federal government to offer financing support that is below commercial terms but still profitable. The Government Accountability Office (GAO), the superb oversight arm of Congress, delivered a major report on the bank this week, and the conclusions are generally encouraging. Like most foreign export credit agencies, Ex-Im only supports a tiny volume of overall exports, roughly one percent. But it played a significant role in propping up U.S. exports during the global financial crisis, when trade volumes plummeted in part due to the drying up of commercial financing. Ex-Im’s direct loans jumped from just $350 million in FY2008 to $6.3 billion in FY2011. In 2010, the bank’s medium and long-term assistance to exporters was behind only France and Germany. But a number of challenges loom. The biggest is that large developing countries like China, India, and Brazil are getting into the game. China is now thought to be the largest provider of export credits in the world. Unlike Europe, Canada, and the United States, however, these countries are not party to a two-decade old arrangement in the OECD that prevents export credit agencies in these countries from offering overly generous terms. As a result, U.S. exports are facing increasingly subsidized competition. A senior Ex-Im Bank official recently signaled that the United States will start aggressively matching financing from these countries, which is permitted under the OECD arrangement.  The bank is currently backing GE in its effort to secure a sale of 150 locomotives to Pakistan in competition with China; the railcars would be made in Erie, Pennsylvania. The goal should be to fight fire with fire and persuade these countries that there is nothing to be gained by remaining outside the OECD pact. To match its competitors, however, Congress urgently needs to pass a new authorization bill for the agency, which failed to pass last year. The bank’s current loan exposure is capped by Congress at $100 billion, and nearly $90 billion of that is already exhausted. The issue ought to be an easy one in a still-weak economy, but the conservative Club for Growth has come out strongly against reauthorization, and is including the vote in its influential congressional scorecard. “The Export-Import Bank's actions are nothing more than market-distorting subsidies that pick winners and losers in the private sector,” the Club says. “Market forces should dictate trade flows, not bureaucrats and politicians.” Indeed, they should. But does it make sense for the United States to be the only country pretending they do?

Reading the New York Times wrenching investigation into unsafe and inhumane working conditions in the Chinese factories that make Apple’s iPhones and iPads--and Apple’s indifference to the problem--made me recall a forgotten footnote in the recent history of U.S. trade policy. Twice during the George W. Bush administration, in 2004 and 2006, the AFL-CIO filed what is known as a Section 301 petition asking the U.S. government to take action against China over persistent violations of labor rights. The petition charged that China had failed systematically to adhere to such basic international requirements as barring child labor, permitting free association, and enforcing minimum wages, working hours and occupational health and safety standards. Twice, the Bush administration refused even to investigate the allegations. The AFL-CIO petition was thorough, with voluminous documentation of labor rights abuses in China, and a sophisticated analysis of the impacts of those violations on U.S. workers. Section 301(of the U.S. Trade Act of 1974) requires evidence that an allegedly unfair foreign practice “burdens or restricts U.S. commerce” before the government can take action. While it is certainly possible to quibble with the petition’s methodology, it clearly demonstrated that workers’ rights violations in China had played some significant role in losses of employment and wages by U.S. manufacturing workers. The past five years, during which nearly 3 million manufacturing jobs disappeared in the United States,  have only reinforced that conclusion. Recent work by economists David Autor, David Dorn and Gordon Hanson, while it does not look specifically into the effects of lax labor standards, found that Chinese import competition accounted for a sizable percentage of that job loss. Low wages, poor working conditions, and weak safety standards are all ways for companies to save money and gain cost advantages over other potential suppliers. While investments in new technology can narrow the cost difference, U.S. companies too often are forced out of business, or must cut wages and workers to remain competitive -- precisely what the AFL-CIO petition alleged. But the Bush administration refused to pursue an investigation that, at the least, could have resulted in stepped up pressure on the Chinese government to improve working conditions in its factories, and at the most might have led to some sort of temporary trade sanctions against China to force action on the problem. Instead, enforcement has been left in the hands of the private sector, of the U.S. multinationals that source from China. As the Times story notes, some companies like Nike, Intel and Hewlett-Packard, have better records in overseeing their suppliers. But the story, and a similar investigation last year by Wired magazine, underscores the basic problem in leaving enforcement to the private sector. Even for Apple, the most profitable brand in the world and one that basks in public adulation, the costs of enforcement are seen as too high. It would mean policing hundreds of suppliers, and refusing to buy from those that persistently fail to adhere to proper standards for their workforce. That could raise costs for Apple and make it more difficult to keep delivering new generations of products to consumers with the same regularity. As one former Apple executive is quoted in the NYT story: “We’ve known about labor abuses in some factories for four years, and they’re still going on. Why? Because the system works for us. Suppliers would change everything tomorrow if Apple told them they didn’t have another choice.” President Obama, in this week’s State of the Union address, announced the launch of new internal task force to investigate unfair trade practices in China and other countries. The AFL-CIO should dust off and update its petition and present it again to the administration. And this time, it deserves a serious investigation.

The conventional wisdom when I first came to Washington in the early 1990s was that nothing ever got done in a presidential election year. And then the sage advice became that nothing much got done in congressional election years either. And of course the last 18 months or so of an administration constitute a “lame duck” period, so nothing really happens then as well. And then President George W. Bush--announcing after his 2004 re-election that he had “earned political capital and I intend to spend it”--failed miserably in his signature effort to force reforms to Social Security the next year. So what’s left? The first 100 days? All this is by way of saying that, election year or not, the United States cannot afford yet another year of inaction in Washington. President Obama will surely use the State of the Union speech tonight to draw a sharp contrast with the Republicans on the big issues of taxation and the government’s role in the economy. The Republican presidential candidates and GOP leaders in Congress have drawn their own rather sharp contrasts with the President on those same issues. These are, quite appropriately, the types of questions on which elections are fought. But there is plenty of governing that can still take place, and compromises that can be made, outside of the glare of campaign year drama. Here is my list of areas where progress should be possible: • Immigration. After the long gridlock over comprehensive immigration reform, both Republicans and Democrats appear willing to consider incremental measures. A bill sponsored by Rep. Jason Chaffetz (R-UT) to remove national quotas on green cards and speed up family reunification got 389 votes in the House late last year before it was blocked in the Senate by Iowa’s Chuck Grassley. Similar legislation, including a bill expected to be introduced by Rep. Tim Griffin (R-AR) to offer permanent residence to foreign MA and PhD grads with science, math and engineering degrees from U.S. universities, should also draw strong support. • Infrastructure. There is a range of specific measures that could free up funds for transportation infrastructure spending. And even the more ambitious idea of creating a National Infrastructure Bank to encourage public-private partnerships, which was part of the President’s ill-fated Jobs Plan in the fall, enjoys some bipartisan support. Kay Bailey Hutchison of Texas has been a key Senate supporter of some versions of the bank proposal. • Attracting foreign investment. The President plans to propose in his next budget $12 million to expand SelectUSA, the Commerce Department program for attracting foreign investment, to 35 full-time employees. This is part of a broader effort to encourage "insourcing" to create jobs in the United States. This would still be a fraction of the effort made by competitors like Canada and Germany, but a step in the right direction. • Taxation. This one is a long shot for obvious reasons, but both the administration and congressional Republicans have shown interest in reforming U.S. corporate taxation by lowering tax rates and limiting deductions, bringing the United States more in line with its major competitors. The U.S. share of foreign direct investment has fallen sharply over the past decade, and corporate tax rates are one culprit. President Obama has talked about tax measures to encourage investment in the United States, while Rep. Dave Camp (R-MI), who chairs the House Ways & Means Committee, has also proposed an overhaul. There are grounds here at least for a serious conversation. Other ideas? This is just a suggestive list, and there are surely many other important policy initiatives on which Democrats and Republicans could find common ground without sacrificing core principles. Even as the country is consumed yet again by a lengthy national election (anyone else in favor of month-long elections, like they have in Canada and the UK?), there are many policy challenges that can and should be tackled. It takes more than 100 days once every eight years.