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Foreign Earnings and the New Protectionism

John Cummings April 22nd, 2009

Opponents of President Obama’s plan to reform the foreign-earnings deferral face a massive perception problem. The President himself hit it on the nose in a recent meeting with members of the Corporate Roundtable: “Look, it’s difficult, I think, for the average American if they feel as if businesses investing here are paying a higher tax rate than if they’re investing overseas. It’s just counterintuitive. I think people generally feel like, let’s encourage and motivate corporations to invest here at home, particularly at a time when there’s been significant job loss.”

The “average American” has good reason to feel that companies with large overseas investments are tax-advantaged.

The current rules enable such organizations to achieve massive reductions in their effective tax rate, according to a story in the Wall Street Journal today. Pfizer’s overseas tax deferrals, for example, enabled it to slash its effective rate by 20.2 percentage points last year.

General Electric Co. did even better. Favorable treatment of its overseas activity and exports lowered its tax rate by a jaw-dropping 26.9 percentage points. GE’s effective tax rate? A measly 5.5 percent.

To any company that operates wholly within the United States and pays a high effective rate, these are “counterintuitive” numbers indeed.

Still, there’s a good story to be told about the deferral rule, and companies are starting to tell it. Procter & Gamble CEO A.G. Laffley argues that overturning the rule would have disastrous consequences for American jobs and competitiveness, as I noted earlier this month.

And there’s an equally compelling, but much more difficult, story to tell about the danger of falling into a kind of covert protectionism that could delay the recovery of the global and domestic economies. In a new research paper, Harvard Business School professor Mihir A. Desai points out that the assumption that multinationals’ overseas activities cause domestic job losses — in other words, that companies “ship jobs overseas” — echoes the historical concern that international trade kills jobs at home. And we all know how that argument played out in the 1930s.

Desai examines two assumptions — that deferral represents a subsidy to American firms, and that multinationals’ foreign investments displace economic activity that otherwise would have taken place in the U.S. — and finds little evidence for either. But he does find evidence (citing some European studies) for a positive relationship between firms’ foreign expansion and domestic employment.

“Much as the formulation of trade policy requires resisting the tempting logic of protectionism, the appropriate taxation of multinational firms requires a similar fortitude,” Desai concludes.

Indeed. Let’s hope lawmakers can summon up that fortitude when the White House rolls out its tax overhaul.