Center for Freedom and Prosperity
Date: Wednesday, May 1, 2002
To: Supporters of Tax Competition
From: Daniel Mitchell, Heritage Foundation Senior Fellow
Re: Fighting Fiscal Protectionism, Helping Companies Compete
Supporters of tax competition and fiscal sovereignty face an important challenge. At issue is whether U.S.-chartered companies should have the right to escape America's
anti-competitive "worldwide" tax system by re-domiciling in low-tax jurisdictions like Bermuda (a process known as expatriation). The outcome of this battle could be pivotal in the conflict between tax harmonizers
and supporters of market liberalism.
The Big Picture
The U.S. taxes companies on their "worldwide" income. In addition to imposing high compliance costs, this system makes American-based companies less competitive. A U.S. firm competing against a
Dutch firm for business in Ireland, for instance, would have to pay a 35 percent tax on its income – with the lion's share going to the IRS. The Dutch firm, by contrast, only pays the 10 percent Irish tax on its
Irish-source income because Holland has a "territorial" tax system (the common-sense notion that a government only taxes income earned inside a nation's borders).
In an effort to remain competitive and protect the interests of shareholders and workers, some U.S. companies are re-chartering in low-tax jurisdictions. Bermuda is a popular choice because of
its strong legal system and zero-tax environment. The Cayman Islands has attracted several companies for similar reasons. A company that expatriates to one of these jurisdictions no longer has to pay U.S. tax on its
overseas income. This enables the company – which still maintains substantial U.S. operations and pays taxes to the U.S. government on all income earned in America – to compete on a level playing field with foreign
On one side are those who argue that it is a good thing when governments face competitive pressure to improve their tax systems. They argue that if America's worldwide tax system is
making U.S. companies less competitive, the economically rational and morally sound answer is tax reform. Specifically, the United States should follow the lead of most other nations and shift to a territorial tax
regime, meaning that the IRS would tax only income earned inside America's borders. And if politicians refuse to enact this reform, proponents of tax competition argue that businesses – like people – should be
allowed to choose a more attractive jurisdiction.
On the other side, opponents of tax competition want to increase tax and regulatory barriers so that companies will have a harder time re-chartering in a jurisdiction with more attractive laws.
Some politicians, such as Senators Max Baucus (Democrat from Montana) and Charles Grassley (Republican from Iowa) even have sponsored legislation that would arbitrarily declare that certain companies are based in
the United States regardless of where they are chartered. This legislation already is being referred to as the "Dred Scott Tax Bill."
Emotion is the driving force behind the Baucus-Grassley legislation. Politicians assume that an expatriating company will take jobs out of America and that the new foreign-based
company will not pay any taxes to the U.S. government. As explained below, both of these assertions are completely false.
If this issue is decided in a rational manner, the proposed legislation will die a quiet death. A broad coalition of free market groups already is working hard so that facts triumph over emotion and
good economic policy crowds out bad economic policy. The Coalition's main arguments will be:
- Allowing companies to choose where they are chartered promotes economic liberalization. In America, for instance, many major corporations are chartered in Delaware. Yet very few of these
companies operate factories in Delaware and very few of them have their headquarters in Delaware. They choose to be chartered in Delaware because the state has attractive incorporation laws. This encourages
other states to improve their incorporation laws, leading to lower costs and bureaucratic streamlining. The same competitive forces should be allowed to operate at the international level.
- Companies should be allowed to flee bad economic policy. High-tax California should not be allowed to stop companies from moving to low-tax Nevada, for instance, and Washington politicians
likewise should not be able to stop companies from escaping bad U.S. tax law. Any effort to interfere with expatriation is a violation of free trade in goods and services. This fiscal protectionism should be
- Don't blame the victim. American-chartered companies face punitive tax laws, including a tax on their worldwide income. Companies based in America also are subject to the fourth highest corporate
tax rate in the developed world – higher even than France and Sweden. Additionally, companies in the United States are subject to the Alternative Minimum Tax, and are not permitted to fully deduct investment
expenses. Adding insult to injury, dividends are tax at both the corporate and individual levels. Combined with a capital gains tax, this makes it harder for corporations to attract equity investment. Is it a
surprise that some of them want to move?
- Expatriation is not tax evasion. All corporations, regardless of where they are based, pay tax to the IRS on all profits they earn in the United States. This includes U.S.-based companies, and it
includes companies chartered in other jurisdictions. An expatriating company does not reduce its tax bill on U.S. profits by one penny. The only significant change is that the firm no longer would be obliged to
pay taxes to the IRS on income they earn outside America's borders – which is precisely what would happen under every tax reform plan.
- Expatriation protects American jobs. Current tax law makes it very difficult for U.S.-based companies to compete internationally. If they do nothing, they will slowly but surely lose market share
to firms that are based in more attractive jurisdictions. This means a reduction in earnings for shareholders and a loss of jobs for workers. If politicians refuse to fix the flaws in the tax code, companies
must take steps to protect the interests of shareholders, workers, and consumers. Expatriation provides that opportunity. The newly formed foreign company still maintains its U.S. operations, but now is able to
more effectively compete with businesses that operate overseas.
- Expatriation protects American companies. Because the internal revenue code places U.S.-based companies at a competitive disadvantage, this makes them vulnerable to being taken over by a foreign
company. The merger may be voluntary, or it may be the result of a hostile takeover, but the end result is that the company becomes a subsidiary of a foreign firm, much as Chrysler is now a subsidiary of
German-based Daimler. This is a form of expatriation since the new foreign-controlled company is not subject to the IRS's anti-competitive worldwide tax regime. There is nothing wrong with foreign ownership of
U.S. assets, of course, but cross-border purchases should be driven by market forces and not indirectly subsidized by bad U.S. tax law.
- The Baucus-Grassley legislation creates a precedent that will be used against America. If American politicians enact protectionist tax law, other nations will respond in kind. France, for
instance, may decide to arbitrarily declare that Microsoft is a French company because it controls "too much" of the software market. Germany may declare that General Electric is a German company because it has
"too many" sales. There are an endless number of possibilities, all of which will mean bad news for U.S. companies.
The Tax Reform Solution
America should not be taxing income earned in other nations. Most other nations – even those with high tax burdens – do not hamstring their companies with extra-territorial taxation. This
is one of the reasons why all tax reform plans, including the flat tax, end worldwide taxation. The Baucus-Grassley legislation is a step in the wrong direction. It expands government control over the economy and
gives the IRS more power. This further worsening of the tax code will make tax reform more difficult and increase compliance costs.
Fundamental tax reform is the ideal solution, but incremental reforms also can address the problem. Lawmakers can choose to adopt territorial taxation. This is the common-sense notion that countries
only tax the income earned inside their borders. As mentioned above, this is standard practice for most European nations. This single reform would dramatically reduce the incentive for companies to re-domicile in
The corporate expatriation battle is very important because it is a test for U.S. policy makers. Many legislators understand that tax competition is a liberalizing force. But tax
competition is like free trade: It is a theory that people appreciate, but people sometimes are willing to abandon good policy if they happen to be less competitive than their neighbors.
The Bush Administration and Congress should reject fiscal protectionism. The Baucus-Grassley Dred Scott Tax Bill is contrary to America's interests. Higher taxes and bad tax policy are not patriotic,
notwithstanding the demagogic rhetoric of House Minority Leader Dick Gephardt.