Strengthening Free Enterprise

This is the first of a four-part series written by Heritage Foundation Vice President of Government Relations Mike Franc discussing an agenda for the new Congress, balancing the need for bipartisan cooperation against the temptation to veer too far leftward on domestic and international policy issues.

The American tax code is a nightmare. It increasingly overwhelms citizens with its growing complexity, progressively stymies entrepreneurship and economic growth, and threatens to prevent future generations of Americans from enjoying the sort of upward mobility that their parents and grandparents took for granted.

Likewise, federal regulation is a hidden tax on American consumers and the U.S. economy. According to a recent study conducted for the Small Business Administration, the total cost is a staggering $1.1 trillion — about the same amount the federal government collects in income taxes every year.

Weight of Regulation

These costs come in various forms: the paperwork requirements, environmental burdens that hamstring manufacturing firms, higher prices at stores, hampered innovation, and sometimes even reduced health and safety. Some regulatory regimes are so counterproductive they even convince innovative entrepreneurs to move their investment capital to more benign regulatory environments overseas, taking jobs and wealth with them.

Finally, a cornerstone principle of conservatism is free trade, dating to Adam Smith’s fundamental economic theories, which have been substantiated by centuries of experience. Lowering tariff and non-tariff barriers to the free flow of goods and services generates higher national productivity, individual prosperity and, history teaches us, encourages nations to open up other avenues of freedom, such as recognition of private property rights, rule of law, and a commitment to limited government.

What, then, should Congress and the President do to restore the unassailable competitive advantage the U.S. once enjoyed over the rest of the world?

Punitive U.S. Corporate Taxes

First, it’s instructive, and exceedingly sobering, to look at our corporate tax policies and compare them to those of our top trading partners. In its annual survey of corporate tax rates around the world, KPMG International found a “consistent and dramatic” reduction in corporate tax rates since 1993. The pattern is clear: “Once one major industrialized economy cuts its rates, others seem compelled to do the same, in a process of international tax competition that continues and intensifies over time.”

Indeed, KPMG’s researchers found that the average corporate tax rate in the 86 countries it surveyed has fallen from 38% in 1993 to 27% today.

Not surprisingly, this competition is beneficial. “It appears,” KPMG says, “that countries that adopt comparatively low tax rates tend to do better in terms of growth and inward investment.” Low tax countries, moreover, derive considerably more revenue from corporate entities than do those with the most punitive rates.

Unfortunately, the U.S. imposes a combined (federal plus state) top corporate rate of 40% on our corporate sector. That is the second highest rate in the industrial world (trailing only economically moribund Japan). Yet U.S. corporate tax receipts are unusually low among industrialized countries.

This punitive tax rate limits the ability of U.S. firms to compete. “Since nearly all other countries reduced their taxes during the past decade,” KPMG concludes, “the United States now faces increased economic competition, especially since improved transport and communication links mean that corporations now have a greater choice than ever before of where to site their operations.” Indeed, studies examining the effect of tax rates on foreign direct investment have found that a 1 percent reduction in the rate on capital causes the stock of foreign direct capital to increase by 3.3%. Case in point: the American Jobs Creation Act of 2004 (which included a dramatic one-year reduction in the tax rate on repatriated income, from 35% to 5.3%) induced U.S. companies to bring home some $300 billion, considerably more than originally projected.

Alarmingly, the competitive disadvantage U.S. firms face is nearly universal — 29 of our 30 top trading partners tax corporate profits at lower rates, and the gap continues to widen. In November, Germany committed to dramatically reduce its top rate on corporate profits — from nearly 40% to less than 30%. More recently, French President Jacques Chirac has moved to place France at the head of the line — calling for reducing his country’s top corporate rate to 20% within five years.

Our tax policy places the economic equivalent of an ankle weight on U.S. exports (over $800 billion in 2005), and encourages firms looking to expand to shun the U.S. and create those jobs in any of a growing number of friendlier tax climates. Foreign firms, from which we imported over $1.4 trillion in goods last year, are happy to see the U.S. unilaterally cede this crucial competitive advantage.

To give U.S. businesses an unassailable competitive edge, Congress and the President should do several things.

First, make it a policy goal to align the top tax rate on corporate profits with the norm that prevails throughout the industrial world. This means dropping the top rate (state plus federal) to somewhere between 25% and 30%.

Second, Congress and the President should embrace the principle of taxing only income earned inside the borders of the United States. That means eliminating the practice of taxing income earned (and already subject to tax) in other countries by U.S. citizens and corporations, which seriously harms U.S. competitiveness abroad.

Third, encourage international tax competition. This means protecting national sovereignty over tax matters by limiting the ability of international organizations such as the OECD to pressure individual nations to maintain punitive levels of taxation on businesses and individuals. Tax competition inhibits the inherent tendencies of politicians to over-tax and over-spend.

Fourth, eliminate self-imposed regulatory burdens that hamstring U.S. competitiveness.

First and foremost, fix the draconian Sarbanes-Oxley Act. This 2002 law imposes draconian new financial reporting requirements on public companies, and requires top corporate executives to certify all financial reports. According to a recent report by a blue-ribbon commission of experts, Sarbanes-Oxley has wrecked havoc on U.S. public financial markets. The percent of worldwide initial public offerings placed in U.S. markets has all but disappeared, plummeting from 50% in 2000 to only 5% in 2005.

Last year, John Fund reports in The Wall Street Journal, only one of the 25 largest public offerings in the world took place in the U.S., with London and Hong Kong benefiting handsomely from U.S. overregulation. Companies, meanwhile, are abandoning the public markets and de-listing at a frightening rate. In 2004, over one-quarter of the companies involved in public takeovers went private, a dramatic increase from 1995, when the comparable figure was only 2.2%.

Rep. Tom Feeney (R.-Fla.) and Sen. Jim DeMint (R.-S.C.) have introduced sound legislation to exempt smaller public companies from the most burdensome requirements in Sarbanes-Oxley. Congress should intervene and repeal the anti-competitive provisions in Sarbanes-Oxley before the damage is irreversible.

Exert Trade Leadership

Elsewhere, the country seems to have “free trade fatigue,” leading to a renewed wave of protectionist sentiment. To fight back, Congress should first hold the line against new trade barriers, and second, advance more trade agreements.

The three cornerstone policies requiring the Bush Administration to exert U.S. leadership are: World Trade Organization (WTO) negotiations in the current Doha round, bilateral and regional free trade agreements (FTAs), and the early 2007 extension of Trade Promotion Authority (TPA).

Congress and the President should:

  • Lead the WTO to a successful conclusion of the current Doha round. There’s just enough time to push for completion of the Doha round in early 2007, and the U.S. Trade Representative deserves energized support. A key step for free trade is to reduce agricultural subsidies inside the U.S. so the vital test of free trade principles in Congress is passing genuine reform of the Farm Bill. Congress’ recent decision to grant Vietnam most-favored nation status was a positive step in this direction.
  • Advance bilateral Free Trade Agreements, ratify concluded agreements, and seek additional partners. The Bush Administration and Congress should strive to ensure the timely ratification of concluded agreements with Colombia and Peru. FTA negotiations with Panama, Ecuador, South Korea, Malaysia, and the United Arab Emirates are pending and merit fast action.
  • Renew TPA. Trade Promotion Authority expires on June 30, 2007, and without it the credibility of U.S. negotiating power is neutralized. The President simply must have the ability to sign good trade deals that expand U.S. access to overseas markets and strengthen international trade norms.