Sufficient alarms have been raised in the Indian newspapers about Obama’s speech to the US Congress, specifically on sections of the speech that deal with outsourcing. While I agree that Obama’s made-for-the-gallery (just like Tamil kuthu songs made for front benchers) speeches take a long time to comprehend, it is irritating to see that almost all the newspapers have religiously confined themselves to the same text that was probably passed over to them by some news agency. The text that can found here (courtesy: Rediff), quotes the specific portion of Obama’s speech, arbitrarily gives the number of firms that will be affected, talks about what “certain” Democrats think, gives an arbitrary number of jobs that were “shipped” overseas, gives sketchy details of the “tax code”, safely names a few large US corporations that will be affected (now, these companies can generally be named for any set of criteria), gives some arbitrary dollar and tax percentage figures without indicating how much the companies that outsource will actually lose and then gives some unhelpful historical details. The only difference in the report in the Indian newspapers seems to be in the editing: some of them have trimmed the last portion of the news, and some have added a text in between the paragraphs on Indian IT companies getting severely affected. I have been trying to get sense of this news for the last one hour without great success.
Please find below my interpretation of the whole news. This may or may not be correct.
What is the relevant US tax code?
What the US tax code has is a decades-old provision that allows American companies to defer income tax payments on offshore profits until they are repatriated back home
(courtesy:
http://www.bworldonline.com/BW022609/content.php?id=003).
Another version from the text in Rediff:
“…proposed move to do away with a particular provision of the country’s tax code that allows them to pay lower taxes for profits repatriated from foreign shores….Back in 2004, the US Congress had allowed a one-year repatriation tax holiday which reduced the 35 per cent tax rate on foreign earnings of American companies to just 5.25 per cent.”
Based on the text above, who does it apply to?
Companies that outsource IT jobs to India (to other Indian outsourcing firms; i.e. say if Pepsico outsources part of its IT maintenance to Infosys), do not make profits offshore. IT is mostly a cost center, which by definition, does not make profits. Companies definitely increase their profits by outsourcing or offshoring, but this is because of lowered costs of offshore resources and not because of “profits from offshore”. Even companies that have India-based IT captives do not make profits in India, unless of course the Indian captives work for outside clients as well.
So, who makes “offshore profits”?
Only companies that have wholly owned subsidiaries in other countries, like India, that cater to the local market make offshore profits. For example, Pepsico sells bottled drinks in India and makes profits from its operations. If Pepsico India is owned by Pepsico US, which is most likely the case, then this law applies to Pepsico US.
What is the tax code?
Now, companies that make profits in other countries, in the absence of any favorable tax laws, will essentially be taxed twice on the profits they make in the other countries: first, by the country in which they earned the profits and second, by their home country. It appears to me that this was the case in the US due to a “Tax Reform Act of 1986” (courtesy: http://www.accf.org/publications.php?pubID=14; only some sections are relevant and I think the news report gets its 35% arbitrary number from here).
Now, this tax code seems to have been applied, taken-off, re-applied in other forms and taken off again several times, so it is hard to identify what was the original state. When the tax code applies, it means that companies no longer have to pay taxes for the profits they earn in another country as soon as they earn them. One version of the tax concession is that the taxes will be deferred until the profits earned in another country are repatriated to the home country. That version seems to have been repealed in 1986. The 2004 version seems to be that (from the news item in rediff above), companies get a one year flat tax holiday on the profits earned abroad. Since, both the news items above are contradictory, it’s hard to verify what the actual concession is. Whatever the concession is, from the companies’ point of view, it seems to be correct, since profits earned in another country could be re-invested in that country itself, for growing the company, which means profits didn’t make it to the parent company at all and the company will be unfairly taxed. This tax code, thus, appears to reduce the tax burden on multinational US companies, thus, making them more competitive with their competitors from other countries. The reasoning is that if a French company, for example, caters to US customers and competes with an American company, that is again multinational, double taxation would make the American company less competitive vis-à-vis the French company even in the US markets. Since, French company enjoys the tax concession from its Government (my assumption; may or may not be true), the US company should also enjoy the same just to be on equal footing.
So far so good. So, what are the arguments against the tax code? A lot of companies, as expected, abuse the tax code (i.e. the concessions provided to them by deferring tax on the profits they make outside their country) through tax haven operations and transfer pricing frauds (again, courtesy: http://www.accf.org/publications.php?pubID=14). It is easy to see how this happens. In their books, the companies would inflate, for example, the sales costs in foreign countries, so that while they show the profits in their income statements for their shareholders, they pay taxes only for the US portion of their profits, and claim whatever concession is available for the offshore portion of the profits. So, the argument against the tax code is that it is prone to a lot of abuses by rich corporations and hence, tantamounts to cheating the common man by taxing the cheating big corporations less.
Why is the concession being repealed now?
The easy reasoning is what Bobby Jindal calls “growing the government”. For all the stimulus packages that Obama is doling out every day, he needs as much money from taxes as he can get. Repealing the tax concession above is just one of the many ways to raise taxes. As I said earlier, this doesn’t seem to be the first time the tax concession is being repealed. This is just being related to outsourcing this time.
Is it anyway connected with job creation in America?
All the dollars raised by the government through taxation can be directly or indirectly linked to job creation. At least, that is what Obama is trying to portray with all the stimulus packages. Other way in which jobs could be created is, companies that were encouraged by the tax code to keep the offshore profits earned at offshore will now remit those profits back to the US sooner, which it could be claimed, will lead to more job creation. It could also be argued (admittedly, by some stretch of imagination) that some roles that apply for all subsidiaries and the parent company would have actually been offshored to show lower profits repatriated from offshore, even though these roles could be performed the best in the US (I’m not able to think of a very good example. This cannot be true in case the roles are direct costs to the company, as then they reduce the profits anyway.). By repealing this concession, may be these jobs may move back to the US.
I cannot think of any other case where this can be connected to job creation. I think this repeal is generally being associated with job creation just to avoid the negative publicity as another measure of increasing taxes (as he’s anyway increasing taxes for households and businesses earning above $250K).
So, will it not affect outsourcing in any way at all?
Not that I can think of.
So, is Obama’s tirade against outsourcing just empty rhetoric?
It is difficult to dismiss it that way as we don’t know what the other measures he’s thinking of to discourage outsourcing are. So, I think, at least in this case, this repeal of tax concession does not directly affect IT outsourcing.
