The tax overhaul is a once-in-a-generation opportunity that will unleash economic growth, according to Republicans. They call the existing tax code a complex, costly, and unfair system that caters to special interest groups. They claim the new bill will encourage more investment and job creation.
“More products will be made in the USA. A lot of things are going to be happening in the USA,” said Trump at the White House on Dec. 22. “We’re going to bring back our companies. They’ve already started coming back.”
The primary economic goal of the Trump administration is to increase U.S. economic growth, which was stuck in the low 2 percent range since the 2008 financial crisis. It says higher growth can be accomplished by the tax reform, which cuts the corporate tax rate from 35 percent to 21 percent, a globally competitive level.
Critics say that tax reform won’t unleash growth, as they believe U.S. corporations are likely to use much of the windfall from tax cuts to reward investors with share buybacks and dividends.
However, the reactions in other countries gainsay critics’ concerns.
China and the major European countries are worried about the change in the investment landscape, as the tax overhaul bill will make the United States a more attractive country for investment.
The European Union, in particular Germany, is expected to lose ground in the competition for foreign direct investment. German economists are warning that significant amounts of new investment and jobs will shift from Europe to the United States.
Both France and Belgium recently announced sharp tax rate cuts from their current levels to 25 percent.
The ZEW study predicts that German companies will increase their investment in the United States after tax reform. Hence economists are urging the German government to develop a strategy for improving Germany’s competitiveness.
Beijing also sees Trump’s tax overhaul as a significant threat. China is becoming ever less competitive in terms of both taxes and wages, and Beijing fears the tax bill will make the United States more competitive. The bill will also make U.S. assets, like stocks and real estate, more attractive for foreign buyers again. This will boost the dollar and indirectly punish the yuan.
Corporate Tax Reform
Compared with other nations in the Organization for Economic Cooperation and Development (OECD), the United States currently has the highest corporate tax rate at 35 percent rate, far exceeding the rates of the UK, Canada, and Ireland.In addition, the United States has a 35 percent tax on repatriated foreign earnings.
The existing U.S. tax code thus created a strong incentive for American corporations to move their operations to low-tax countries and keep their foreign earnings abroad. U.S. companies have parked nearly $2.5 trillion overseas, according to estimates. Trump predicts this amount is now $4 trillion.
A lower corporate tax rate will restore the nation’s competitive edge and level the playing field for U.S. companies. In addition to lowering rates, the tax bill moves from a worldwide taxation system—which taxes income earned anywhere in the world—to a territorial system, only taxing income earned inside the home country.
The existing worldwide tax system double-taxes the foreign income of U.S. companies as soon as these earnings are repatriated. By contrast, in a territorial tax system, the companies would be taxed on their U.S. income only and would be exempt from paying taxes on most or all foreign income.
According to the new plan, companies will also be able to deduct 100 percent of the cost of their capital investments in the year the investment is made. This provision, which will phase out in five years, is expected to boost business investments in the short term.
“I think it is going to be one of the biggest things in the bill, frankly. I think people are going to go out and absolutely go wild over expensing,” Trump said.
Laffer Curve
While Republicans and some economists argue that reform would significantly boost economic growth and raise wages, critics have doubts about the growth effects of the legislation, given the large budget deficit. The theory is that as tax cuts lead to a growing deficit, interest rates rise and the amount of money available for investment in the economy shrinks.The Laffer Curve was developed by economist Arthur Laffer to show the relationship between tax rates and tax revenue collected by governments. Laffer argues that high tax rates hinder business investment and lead a company to find ways to protect its capital from taxation. Therefore, raising tax rates beyond a certain level is counter-productive for raising tax revenues, a relationship charted by the curve.
According to Kevin Hassett, chairman of the Council of Economic Advisers, the United States is on the wrong side of the Laffer Curve and can collect more revenues with a lower tax rate.
Old Code Hurts Companies
Due in part to the existing tax code, the United States lost about 4,700 companies and $510 billion in business assets between 2004 and 2016, according to a study released by the advisory firm Ernst & Young in September. The uncompetitive tax code contributed to increased foreign takeovers of U.S. companies.The adoption of a territorial system and a lower tax rate would revise this trend and boost cross-border acquisitions by U.S. companies, stated the report.
Mergers and acquisitions deals allow businesses to access new markets, new distribution channels, and new technologies. They can also strengthen the contribution of an American company to the U.S. economy.
“As the typical U.S. multinational company expands its foreign operations, it is estimated that for every 100 jobs added abroad, an additional 124 jobs are created by the U.S. parent domestically,” stated the report.
“Taxes and other government policies in host countries are important determinants of companies’ investment decisions,” stated the Ernst & Young report.
“U.S. tax reform could have a significant impact on the attractiveness of the United States for inward FDI.”