Ever since Barak Obama assumed office at the White House, he has been trying very hard to jump start job creation in the US. While several policy announcements have been made in the last couple of months, the recently announced international tax policy reform on May 4 has certain serious implications for the US multinationals? business abroad.
According to the new provision, those US companies not paying tax on their profit made abroad will not be entitled to take tax deductions on the expenses. Apparently, many companies comfortably avoided paying billions of taxes by taking advantage of the existing provisions that permit deductions on their US tax liability ?for expenses supporting their overseas investment?. This was found to be an ?unintended loophole? that the administration wanted to eliminate for quite some time, but it has now come in handy in the background of its present economic crisis.
Withdrawal of such tax deduction provisions would eventually increase tax liability for firms having overseas investment and so they are expected to invest more at home. Thus, tax policy reform is likely to affect foreign direct investment (FDI) of the US multinationals. As long as the intent is to remove ?unintended loophole?, it may less likely to cause harm. If not, as argued below, it can be detrimental to competitiveness of the US firms.
Notwithstanding the beneficial impact of FDI on recipient countries, the FDI has /certain ill effects on home country, as standard textbook suggests. Policy makers can thus view limiting outward FDI of domestic companies as a viable option for creating more jobs at home.
The accompanying table presents trends in FDI flows, both outward and inward, pertaining to the US, developed economies and world. Inward FDI flows of the US was more than its outward FDI flows till 2006. For developed economies as a whole, however, outward FDI flows outperformed inward FDI flows. While the same trend continued for developed economies in 2007, it has reversed for the US which had more outward flows than inwards flows in that year.
At the same time, one should also view the proposal from US companies? point of view. Undoubtedly these companies would have several motives for taking their capital away from their home. The need for internalization cannot be over emphasised in this context. That is, the US firms may desire to transact with their owned foreign subsidiaries rather than with other foreign firms.
One major advantage of internationalization is that it helps to avoid transferring technology to a foreign firm. This is a desirable option, especially in those economies where property right regime is weak.
Secondly, vertical integration strategy certainly underlines outward FDI of the US firms such that these firms may own foreign subsidiaries, which are engaged in upstream activities. In fact, rising intra industry trade at the global level and trade amongst subsidiaries is a point in case.
Viewed thus, the proposed tax policy reform may harm US multinationals in two important ways. Firstly, the forced technology transfer, for whatever consideration, particularly to firms in weak property right regions, will cause technology advantage of US firms to wither away. And, secondly, forced procurement from upstream foreign firms, will increase their cost of production. Both will affect profitability of US firms. This is likely to reduce incentives for innovations and thereby hampering their competitiveness.
Moreover, it is not the US alone that cries for solutions for jump starting job creation. Most of the economies around the globe face similar problems. Limiting capital mobility of domestic firms is not the solution. It only points to the lop sided approach of the US administration. Being one of the largest open economies in the world, such tax policy reform carries seeds for further destabilising rather than stabilising the economy.
?The writer teaches economics at the Icfai Business School, Bangalore, dennisraja@hotmail.com