It is common wisdom that the world economy is becoming increasingly competitive. This puts enormous pressure on U.S. companies to lower their prices. Anything that adds extra cost to the production of U.S. goods and services threatens their viability against foreign firms. It is also common knowledge that the United States has the highest corporate tax rate in the developed world. When state and local jurisdictions are added, American companies face an average statutory rate of 39.1 percent. The weighted average of other OECD countries is 29 percent and the rate in the United Kingdom, where a lot of U.S. headquarters are ending up, is 21 percent.
Some opponents of corporate rate reduction argue that this comparison is misleading, because effective tax rates, the amount of tax that companies actually pay divided by their profits, are much lower, and in some cases even negative. The implication is that U.S. companies do not suffer from a disadvantage and tax rates are not high enough to discourage economic activity.
A new study by PwC compares the effective tax rates of 320 international companies in six industries by looking at their annual reports. The study also examines the discrepancies between actual and effective rates, and the burden of tax administration. To minimize the impact of extreme cases, the study computed a trimmed average in which 15 percent of the top and bottom values were excluded from the analysis. It shows that, although effective rates vary widely from company to company and from year to year, U.S. companies consistently pay a higher effective tax rate than their overseas competitors. The study also shows that this handicap is lessened by the existence of foreign subsidiaries and the accumulation of unrepatriated earnings. If these factors were reversed, as would be the case if Congress ended deferral of foreign source income, U.S. companies would suffer from an even greater disadvantage.
In theory, a company should be motivated by its marginal tax rate, the amount of tax it would have to pay if it earned an additional dollar in profit. This rate is largely determined by the statutory rate, but can also be affected by deductions, credits (such as for research and development), and the application of tax rules (such as those governing unrepatriated profits). The effective tax rate at any one time for any one company is a relatively poor measure measurement of marginal rates because it is so heavily influenced by the business cycle. For example, a company that loses money typically pays no tax. If it is entitled to credits from past years, its effective rate might even be negative.
The study found that the 143 U.S.-based companies paid an average effective rate of 31 percent, second only to Japan’s 34.2 percent. Using a three-year average rate to reduce the impact of economic conditions, U.S.-based companies paid an effective tax rate of 28.6 percent versus a non-U.S. average of 25.9 percent. Effective rates were substantially lowered by the presence of equity earnings (where the company recognizes the gain from a company in which it has a minority interest), tax incentives, and foreign operations. Tax incentives lowered the 2014 effective tax rate of U.S. companies by only 3.2 percentage points while the ownership of subsidiaries in lower-tax countries reduced it by another 1.6 percentage points. However these factors varied significantly by industry.
The report also looked at tax factors specific to U.S. companies and found indications of the administrative burden that tax complexity creates. Unrecognized tax benefits (UTBs) represent the difference between the amount of money that a company allocates for taxes and the amount that it is certain that it owes. Because corporate operations and the tax code are extremely complex, there can be a great deal of uncertainty about what a company owes. In many cases, the position that the company takes may be disputed by the government. This amount can therefore serve as a measure of uncertainty. UTBs averaged $253 million per company in 2014, an increase of 1 percent over the prior year. Depending upon the company, this figure could represent a significant portion of potential profits.
The report also looked at how many tax years each company still had open. It typically takes the Internal Revenue Service years to agree that a corporation has paid the correct amount of taxes and can close its books on a fiscal year. The report found that the average U.S. company had over six prior years open. A number of companies were still trying to resolve tax issues from more than a decade ago. The result of these long review periods is continued uncertainty and higher compliance costs.
U.S. companies continue to pay higher effective tax rates than their foreign competitors. It is clear that this disadvantage would be even greater if they were not allowed to defer foreign income that has been permanently invested overseas. This ability partially makes up for the fact that the United States, unlike other countries, taxes all of a company’s profits wherever they are earned. As indicated above, were it not for this provision, effective rates would be 1.6 percentage points higher. The disadvantage would also be even higher if it were not for key incentives and deductions like the R&D tax credit.
These statistics confirm the continued need not just for corporate tax reform, but for reform that lowers the effective rate. Reform that is revenue neutral and that only lowers the statutory rate without lowering the effective rate will do little for U.S. competitiveness. Therefore, while reform should lower the statutory rate it should not come at the expense of key incentives for productive investment, including research and development and investment in machinery and equipment (and the creation of a patent box). At the same time reform should tax only income in the United States. Until this happens, U.S. companies will continue to pay higher statutory and effective rates than their competitors.