The corporate rate cut to 21 percent and the inversions it brought to an end

A tax system has failed when its best customers pack up and move to Canada to get away from it. That is not a figure of speech. In 2014 a fast-food company known for flame-grilled burgers bought a Canadian coffee-and-doughnut chain, and critics said one of the reasons was the address on the new company's letterhead.

For decades the United States taxed its corporations at a rate that nobody in the developed world thought wise, and under rules that punished a company for bringing its own profits home. The 2017 tax law changed both. Let me walk through what it replaced, what it did, and how to answer the charge that all of it simply went to stock buybacks.

Define the terms

A corporate income tax is a tax on a company's profits. The statutory rate is the headline rate on the books. Before 2018 the top federal rate was 35 percent, and with state corporate taxes layered on, the combined rate was higher, among the highest in the developed world.

A worldwide system taxes a company on its profits wherever in the world they are earned. The United States had one. A company headquartered here owed American tax on the profits of its foreign subsidiaries, though not until the money was brought home. That is called deferral, and it meant an American company that earned profits abroad had every reason to leave the money abroad.

A territorial system taxes only the profits earned inside the country's borders and leaves foreign profits to the foreign government. Most of the developed world's major economies used one by the 2010s.

An inversion is a company's decision to change its legal home to a lower-tax country, usually by merging with a foreign firm and reorganizing so the foreign firm becomes the parent. The business, the employees and the customers need not move. Only the mailing address on the legal paperwork does.

The system before 2018

Put those two facts together: a 35 percent statutory rate at home and a worldwide system that taxed the foreign profits of American firms when they came home. The result was a double bind.

First, a company with profits abroad had no incentive to repatriate them. If it brought the cash home, it paid the difference between the foreign rate and 35 percent. If it left the cash in the foreign subsidiary, it paid nothing more. So trillions of dollars in profits piled up offshore. They could be invested abroad, but they could not easily be used to build a plant in Ohio or pay a dividend in Texas without a large tax charge.

Second, a foreign competitor had no such problem. A company headquartered in a country with a territorial system could earn profits in the same markets, pay the local rate and take the money home untaxed. The foreign firm was playing on a tilted field in its own favour, and American firms could see it.

That is why inversions happened. The rational response of a company's directors was to buy or merge with a foreign firm, redomicile there and escape the worldwide system. Boards were not hating America. They were reading the code.

Two famous cases

The case most people remember is Burger King and Tim Hortons. In 2014 Burger King agreed to combine with the Canadian company Tim Hortons in a deal worth around eleven billion dollars, creating a new Canadian-domiciled parent, Restaurant Brands International. The company's backers said the deal was about growth, and many observers believed the tax rate was part of the arithmetic. The deal drew criticism in Washington, and it went ahead anyway.

The case that mattered more in policy terms was Pfizer and Allergan. In late 2015 the American drug company Pfizer announced a merger with the Irish-based Allergan, a deal valued at about $160 billion that would have made Pfizer a foreign-parented company. In April 2016 the Treasury Department issued new rules aimed at making inversions harder to do. Within days Pfizer and Allergan called the deal off. The episode showed how much tax was riding on a corporate address, and it showed the limits of fixing the problem by regulation. Treasury was patching a leak in a pipe that needed to be replaced.

What the 2017 law changed

The Tax Cuts and Jobs Act, signed on December 22, 2017 and effective in 2018, did several things relevant to this story.

One: it cut the federal corporate rate from 35 percent to 21 percent. A flat 21, permanent in the law, not scheduled to expire. The same law repealed the corporate alternative minimum tax.

Two: it moved the system toward a territorial one. Foreign earnings of foreign subsidiaries could now be brought home through a dividend that was largely exempt from additional American tax. That is the heart of the territorial idea. There were guardrails, including a new minimum tax on certain foreign income and a provision aimed at payments that shift profits to foreign affiliates, and critics argue about whether those guardrails go too far or not far enough. But the basic structure changed. The incentive to leave cash offshore went away.

Three: it imposed a one-time tax on the profits that had piled up abroad. To move to the new system, the law taxed accumulated foreign earnings once, at 15.5 percent on cash and cash equivalents and 8 percent on other assets, payable over eight years. It was a transition charge, and it also let firms bring the money home without a further tax.

Four: it allowed businesses to deduct the full cost of many new investments immediately, a temporary provision known as full expensing, phased down over several years under the law as written.

The inversion wave stopped. After 2017 the headline-grabbing deals to move a company's tax address abroad largely disappeared, which is what you would expect when the reason for the move is gone. I want to be careful here: other rules and other events contributed, and I am not going to claim a clean experiment. But the direction is unmistakable, and the law removed the incentive that drove the trend.

The steelman: "it only funded buybacks"

Here is the strongest case against the law, the way its critics state it.

One, the corporate rate cut was sold as a way to raise investment and wages. Two, in 2018 companies announced record buybacks of their own stock. Three, a buyback does not build a factory or raise a paycheck. It transfers cash to shareholders, who are disproportionately wealthy. Four, therefore the cut mostly enriched shareholders and did little for workers. Five, the promised gains in household income, which the White House's economic advisers projected in 2017 in the thousands of dollars per household, did not materialize on any scale that anyone can point to.

I do not want to wave that away. The honest conservative position is that the wage-gain projections were optimistic, that they were not met on the timescale the projections implied, and that it is hard to isolate the effect of one law from everything else that happens in an economy. A conservative who claims that every worker got a $4,000 raise from the law is making a claim the record does not support.

The answer, in numbered points

One: a buyback is not a bonfire. When a company buys its shares from the market, the cash does not vanish. It goes to the people who sold, and those people reinvest it, spend it or save it. Shareholders include the pension funds, the retirement accounts and the index funds that hold the retirement savings of ordinary people. A buyback returns capital to the owners and frees it to find a better use elsewhere, which is how an economy is supposed to reallocate money from mature firms with little left to build to young firms with plenty to build.

Two: the cash that was returned was often cash that had been stuck offshore. A good deal of the money paid out in 2018 was money that had been trapped by the old system and was now free to move. Before the law, the choice was to leave it abroad or pay a large tax to bring it home. After the law, it could come home, and some went to shareholders, some to investment, some to debt paydown, some to acquisitions. Whether it came home as a dividend, a buyback or a new plant, the old system had made it unusable, and the new one did not.

Three: investment did respond, at least at first. Business fixed investment rose in 2018 and the full-expensing provision gave an explicit incentive to buy equipment. The gains cooled later, and economists disagree about how much to credit the law and how much to credit other forces, but the notion that nothing was invested is incorrect.

Four: the incidence of the corporate tax is on people, not on a legal fiction. A corporation is a legal person; it does not pay a tax out of nothing. The tax falls on shareholders, on workers in lower wages, on customers in higher prices, or on some mix. Economists argue about the split, and I explain the mechanism in why the corporate income tax is paid by people, and the only question is who. If workers bear a part of the burden, as many studies of the corporate tax suggest, then a lower rate relieves part of it. That is not a handout to the rich. It is the removal of a tax on a thing that ultimately lands on people at every level.

Five: the real question is competitiveness. The question for the country is not whether a handful of shareholders did well. It is whether an American firm can compete for the world's customers on equal terms with firms from countries that tax their companies on a territorial basis at lower rates. A country that taxes its firms at a higher rate than its rivals will see its firms move or be bought. The corporate tax rate is a price in a global market, and a high price loses customers.

Where the argument is strongest and where it is weakest

I will give both.

The argument for the 2017 law is strongest on the structure. The old system, with a rate near the top of the world and a worldwide reach, had two plain flaws: it trapped capital offshore and it pushed headquarters abroad. The law fixed both. Those are the kind of changes a conservative should be proud of, because they reduce a distortion without adding a new program.

It is weakest on the promises. Politicians sold the law with figures for wages and growth that were more confident than the evidence allowed. And the budget cost was real: the law reduced federal revenue relative to the previous baseline, and it was not paired with spending restraint. That is the point where my fellow conservatives should be most honest, because a tax cut without a matching spending discipline raises the national debt, a topic I take up in do the arithmetic on $40 trillion and the interest bill it carries. The case for lower rates does not depend on pretending otherwise; see where tax cuts pay for themselves and where they honestly do not for how much of a cut comes back and where.

The Founders and the corporation

The Founders were wary of concentrated corporate privilege, and they remembered the East India Company and its tea. But they were also keenly aware that commerce was the engine of a free republic, and Alexander Hamilton's Report on Manufactures argued that government should clear the path for American enterprise, a case I discuss in Hamilton's Report on Manufactures and the conservative case for tariffs. Article I, Section 8 gave Congress the power to "regulate Commerce with foreign Nations" and to lay taxes, and it required that "all Duties, Imposts and Excises shall be uniform throughout the United States." The way to read those clauses together is that the government may tax, and the tax must be a rule that applies equally and that the country can live with.

A corporate rate set so high that it drives firms to renounce their citizenship is not that kind of rule. It is a penalty on loyalty. A government that wants to keep its companies ought to be the kind of place that a company would choose to stay.

The case in brief

1. Before 2018 the United States had a 35 percent federal corporate rate and a worldwide system that taxed foreign profits when they came home, so firms left profits offshore and some moved their legal homes abroad.
2. Inversions such as Burger King's 2014 merger with Tim Hortons and the abandoned Pfizer-Allergan deal of 2016 showed that the address on the paperwork was worth billions.
3. The 2017 law cut the rate to 21 percent, moved toward a territorial system, taxed accumulated foreign profits once, and removed most of the reason to invert.
4. The buyback charge is weaker than it sounds, because buybacks return trapped capital to owners who reinvest it, though the wage promises of 2017 were overconfident.
5. The honest conservative position keeps the structural reform and insists on matching spending restraint.

What you can do: read the section of the 2017 law on foreign earnings at Congress.gov, then write to your representative asking whether the territorial rules should be kept, tightened or loosened, and why.