The scramble for new sources of tax revenue in Washington could have repercussions around the world, including in India. Last week, US President Barack Obama announced proposed changes to the US’ corporate tax structure designed to raise in excess of $200 billion. “It’s a tax code that says you should pay lower taxes if you create a job in Bangalore, India, than if you create one in Buffalo, New York,” the President said.
This kind of argument is designed to appeal to American voters at a time of economic unease and rising unemployment. After all, it would be unfair for taxpayers to subsidize the creation of jobs outside US borders or shipping jobs overseas, thus destroying them at home. But is that really what’s happening?
Illustration: Jayachandran / Mint
Mihir Desai of Harvard University says it’s not. There is a fundamental misconception at work, he says, that clouds clear thinking about corporations, taxation and job creation. Overseas economic activity by American firms is popularly believed to be a diversion of domestic activity (hence, the jobs-for-Bangalore-not-Buffalo rhetoric). But this view is mistaken. Desai points out, “When firms invest and grow abroad, they tend to grow domestically. Separate researchers examining the experience of American, French, German, and Italian firms that invest outside of their home countries find no evidence that foreign activity is ‘lost’ from the domestic economy. Indeed, it would seem that growing abroad feeds the domestic operations of firms”.
In other words, it’s more likely that if an American firm creates a job in Bangalore, it ultimately creates a job (or jobs) in Buffalo or Boston or Baltimore as well. That’s because when firms invest overseas, they expand markets, and this “allows them to invest more in domestic activities such as increased R&D (research and development), production of intermediate inputs, and the centralized functions that every firm requires,” Desai says.
That said, there is good reason to be critical of the US’ corporate tax system, and changes to it would be helpful—particularly lowering the burden of corporate taxation. This is a lesson that applies to the US, India or any other country. The reason? The burden of corporate taxation rests in a surprising place. Former chairman of the council of economic advisers Glenn Hubbard says recent research demonstrates that the corporate income tax “may be borne not entirely (or even principally) by owners of capital, but by workers.”
Indeed, my colleagues at the American Enterprise Institute, Kevin Hassett and Aparna Mathur, studied the effects of corporate tax increases on workers in developed countries. They found that increasing corporate tax rates by 1% leads to a significant decrease—of 0.8%—in wage rates in the manufacturing sector.
And a team of economists led by Andrei Schleifer found in a study conducted with PricewaterhouseCoopers and published last year the deleterious effects of corporate taxation on investment and entrepreneurship. They found “a large adverse impact on aggregate investment, FDI (foreign direct investment), and entrepreneurial activity. For example, a 10% increase in the effective corporate tax rate reduces aggregate investment to GDP (gross domestic product) ratio by 2 percentage points”. What’s more, “corporate tax rates are also negatively correlated with growth, and positively correlated with the size of the informal economy,” a point to be noted by Indian policymakers who hope to expand the formal sector and minimize India’s informal sector.
To be fair, there is little doubt that globalization creates dislocations that can lead to temporary unemployment. But there are better ways of dealing with these problems than raising corporate income taxes, such as wage insurance programmes.
There are elements of Obama’s political coalition, including labour unions, that are sceptical of the merits of global markets, free trade and technology adoption. And so, some of the President’s rhetoric may be an effort to appeal to these interest groups. After all, Obama has generally been supportive of trade and globalization since he took office, despite domestic political pressures.
But Obama also needs to find funds for an ambitious and very expensive policy agenda, including universal healthcare, alternative energy projects, increased funding for education, and more. With the entitlement programme bills coming due as well, this explains the effort to find tax revenue wherever possible. It is easier politically to sell a tax hike that is presented as a job protection move. But while there is little doubt the move would be harmful to Bangalore, there’s no reason to think it would be of much help to Buffalo either.
Nick Schulz is DeWitt Wallace fellow at the American Enterprise Institute and editor of The American. He is co-author of the soon to be released From Poverty to Prosperity. Comment at firstname.lastname@example.org