Finding new answers may involve looking in new places

May 2, 2011
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I was recently at an Easter egg hunt with my children. The eggs were hidden in a wooded section of a friend’s lot among pine needles, under leaves and behind trees. The hunt challenged the children to look in obvious and not-as-obvious places. As I watched, I thought about the current state of the economy and the future government budgets and deficits, and the need for many in Washington to think outside the box.

The threat of a government showdown went to the last hour until a deal was cut. Many felt a sense of relief as a government shutdown was averted. Many issues are still unresolved regarding the future budget and tax policy of the country. The upcoming 2012 budget may make for a long, hot summer in Washington.

The growth of spending, and how to reign in some of the spending, is a large component of the discussion. However, tax policy is a significant part of the debate. Some of the debate focuses on whether corporate tax rates should be adjusted in order to have corporations pay what many think is their fair share. At the same time, there is concern over the competiveness of the U.S. tax system. Also, there is the issue of how the tax code should be used to provide incentives for business expansion and job growth.

The U.S. is now considered a high tax jurisdiction (at least for corporate income taxes). The general trend in recent years has been for the U.S.’s major trading partners to reduce corporate income tax rates. Some of those countries — Canada, United Kingdom and Germany, for example — have reduced their corporate tax rates well below the U.S. top federal corporate tax rate of 35 percent. The combined federal and state tax corporate tax rate now hovers near 40 percent. The corporate tax rates in Canada, Germany and the UK are all below 30 percent. The difference is more than a nominal amount and will impact decision making.

The impact on taxes and economic growth has some connection. Tax rates and tax incentives often have been used to spur economic development. All we need to do is look at the competition among the states and localities here in the U.S. There is often heated competition between states and other units of government in offering incentives and tax breaks in an effort of “how low can you go” to bring business and jobs to a community or state. Targeted incentives are often used. In recent years, the Michigan experience with the film incentives demonstrates that tax incentives do provide economic activity. The unanswered question is whether such incentives generate long-term, high-paying jobs.

Low tax rates have brought some success over the years to many countries. Hong Kong has maintained a corporate tax rate between 15 and 17 percent for years, and has been seen as an engine of economic activity as well as a traditional gateway to mainland China. The recent European example is Ireland. Though it has had some recent economic issues, Ireland, with its 12.5 percent corporate tax rate, has attracted many businesses, including a large contingent of U.S. technology companies, many of which have significant operations there. The tax rate, along with an educated work force and its proximity to mainland Europe, are factors in Ireland’s economic success over the past 25 or 30 years.

Factors other than tax rates have impact on business decisions, and it may be foolish to gauge any economic success only on the rates of taxation. Taxes can enhance or detract from other factors that may incent a business to do business in a particular jurisdiction. There is a balancing act of using corporate tax rates to generate tax revenue while at the same time encouraging economic activity and development. Taxes are a cost of conducting business and, to the extent a business owner or company management has discretion on where to operate, tax rates and incentives may sway a decision.

The recent religious holidays have focused some attention on the Holy Land (Israel). From a business standpoint, I have paid attention to the corporate tax policy there. There has been very specific targeting of corporate tax incentives over the years and an intense focus on attracting technology businesses and other businesses that draw from the sciences. There are specific incentives enacted with lower tax rates for approved enterprises and for businesses that develop and manufacture product in Israel for export outside of Israel.

In 2009, Israel continued the tax reduction trend that it has engaged in for most of the past decade. The general corporate tax rate was reduced to 26 percent for 2008, with additional reductions scheduled through 2016, when the general corporate tax rate is set to be at 18 percent. Earlier this year, new tax reforms were enacted, including reduced tax rates for certain businesses that have exports that constitute more than 25 percent of revenues. If that export revenue threshold is met, corporate tax rates are set at 15 percent, with decreases scheduled to set the tax rate at 12 percent in 2015. In addition, the level of dividend withholding taxes on any dividends paid to foreign owners of such businesses is reduced to 15 percent. Lower corporate tax and withholding tax rates can apply to certain businesses located in specific targeted zones.

The governmental agency responsible for attracting business for Israel — Invest in Israel — touts its rankings in the IMD World Competiveness Yearbook as No. 1 for entrepreneurship, public expenditure on education and business expenditure spent on research and development; No. 2 in qualified engineers; and No. 3 in venture capital.

It is difficult to replicate any one country’s tax or fiscal policy to the U.S. Most of the major trading partners have higher individual income tax rates as well as value added taxes or similar taxes. Each situation is different and thus one situation cannot necessarily be replicated entirely. However, much can be learned by looking at the successes and missteps of others.

In the U.S., there has been some recent discussion on a longer-term economic policy and that tax reform is included in that process. Historically, Washington tends to focus on short-term incentives such as accelerated depreciation deductions for new equipment purchases or other short-term stimulus rather than longer-term incentives, policy or tax reform. In fact, in recent years, the research tax credit is renewed in two-year increments, often one year in arrears. It will probably surprise many that this credit is not permanently included in the tax code. It needs the benefit of the periodic renewal of the applicable tax code provisions. Short-term tax incentives may have their place at a specific point in time. Longer-term incentives are often more beneficial since they provide more certainty for longer-term decision making.

There are hopeful signs in Washington. There is discussion for the need for longer-term tax reform as part of a process that addresses some of the budget and deficit issues. There is some thought that a comprehensive economic policy that focuses on longer-term goals and not as much on short-term goals may aid in attracting more economic activity and jobs. The fact that we live in a global marketplace requires that the tax code consider the worldwide competitive landscape. There is an opportunity for tax policy to be a catalyst in spurring the desired economic activity and the resulting jobs and economic growth that result from such policy.

We may just need to find a few eggs in places we haven’t looked in in the past.

William F. Roth is a tax partner with BDO USA LLP. The views expressed are those of the author and not necessarily those of BDO. The comments are general in nature and not to be considered as specific tax or accounting advice.

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