Save the golden goose: Way to reduce outsourcing of American jobs - revise the nation's tax policies

Feb 1, 2005

Maytag's recent decision to close its plant in Galesburg and send a major portion of the work 1,600 Illinoisans had been performing to a new factory in Reynosa, Mexico, is the most recent example of the down side of globalization of the economy. 

After a decade of tax breaks and union concessions, Maytag shuttered its factory, which had been making refrigerators in that western Illinois town for more than 50 years. The company also decided to outsource other jobs to Daewoo, a Korean multinational subcontractor that is expected to build a plant in Mexico.

Galesburg isn't alone, though. A study for the U.S.-China Economic and Security Review Commission by Kate Bronfenbrenner of  Cornell University and Stephanie Luce of the University of Massachusetts found that the number of jobs lost during the first three months of 2004 exceeded by five times the U.S. Bureau of Labor Statistics' estimate of 4,633. The study estimated that in 2004 more than 400,000 jobs were shifted from the United States to other countries. That's nearly twice the number in 2001 and represents about one-fourth of all mass layoffs in 2004.

Generally, as is the case for Maytag, higher-paying manufacturing jobs that are transportable are outsourced to developing countries, leaving lower-paying nontransportable service jobs to American citizens. Job outsourcing is the result of  "labor arbitrage," which involves movement of jobs to other locations where the same product can be made at a lower cost. 

Such globalization of the "free" market is the product of advancements in education and training in developing countries, technical advances, cheaper communication systems, more cost-efficient transportation systems and the portability of capital emanating from increasingly efficient worldwide banking and capital markets.

  Job outsourcing from developed to less-developed countries will persist as long as realizable differences in production costs exist. Economic equilibrium, where job movements are solely attributable to natural comparative advantages and such factors as the price of nontraded goods and the level of exchange rates, will occur when production costs across countries throughout the world are essentially on par.  

The cost of labor, however, is only one factor affecting overall production costs. Another is the cost of corporate taxes and the personal taxes on dividends, capital gains and interest payments to individuals. Thus, I recommend the elimination of corporate taxes and the creation of a flat 28 percent tax rate on personal income. 

The burden of current taxes on corporations and their stockholders and bondholders is literally killing — taxing to death — the goose that is laying the golden egg. Drastically changing the current tax structure in the United States might substantially reduce the cost of production, lessening the incentive to outsource jobs. It might also increase the incentive to create new high-paying American jobs.

Yet, current discussion focuses on using a stick rather a carrot. The United States and other developed countries are considering legislation aimed at retaining at-risk jobs. Here in the United States, Congress is considering legislation that would block companies from using foreign workers on state or federal contracts, create and enforce tax penalties on firms engaged in outsourcing and require foreign call-center employees to identify their locations. However, these restraints are likely to be ineffective and may result in lowering living standards in the United States and in other developed countries that adopt similar constraints and penalties. 

Because current job growth in the United States has been predominately in the lower-paying service sector, job creation in and of itself should be considered, along with the goal of achieving the highest possible standard of living for Americans. Instead, prevailing wisdom in the United States calls for penalizing firms for exporting jobs and attempting to require domestic firms to produce products in this country. The problem with this policy is that, with the current tax structure at home and cheaper labor available in developing countries, products manu-factured in the United States will be relatively more expensive than competing products from abroad. 

Forcing U.S. consumers to buy higher-cost domestically manufactured products will, in turn, prompt this country to place import duties and restrictions on similar products that are otherwise importable from lower-labor-cost countries. Forcing American consumers to buy higher-priced products made in the United States will reduce consumer buying power and, in effect, reduce America's standard of living. 

Rather than using a combination of restrictions and penalties (the stick approach), the United States and other developed countries would fare better with economic incentives (the carrot approach) by fostering a healthier economic climate for private sector business. This approach might ameliorate the impact on Illinois and the United States from globalization during the transitional period toward normalization of worldwide living standards. 

In the recent past, U.S. communities and states have used lucrative financial and tax incentive packages to lure and retain businesses. These communities feel a sense of betrayal when, subsequently, such companies bail out. The betrayal is even more acute when those companies move operations and jobs to a developing country. 

Instead of reacting vindictively, though, the most effective solution for reducing the foreign outsourcing of jobs due to globalization would be cooperation between the public and private sectors to improve the general economic climate rather than focusing on subsidies for individual projects or companies. 

 This cooperative effort would require government to examine its current regulatory and business incentive and tax structures, which businesses use to balance short-term interests against the long-term common good. Unlike the current emphasis on shorter-term goals, strategic longer-term planning in both the public and private sectors must be emphasized. The economic climate and its effect on the dynamic, longer-term economy must be considered.  

Most analysis by individuals in the public and private sectors treats the nation's economy as a static entity that is unaffected by the business environment and tax structure. Accordingly, these analysts are induced to propose short-term deficit-reducing and job-creating policies. Indeed, current tax policies in the United States demonstrate the short-term perspective of both federal and state governments.

Of course, fundamental to a market economy is the concept that providers of capital to a firm (stockholders and debtholders) must be paid a return that will justify the use of capital. For example, long-term nominal returns for stockholders of corporations have been between 10 percent and 12 percent. Profitable firms usually generate returns higher than the minimum required, thus increasing the value of the firm to stakeholders. Government provides no direct capital input to the firm; however, through income taxes, government extracts part of the firm's value. As a result, government benefits from corporate profits along with stockholders.  

Using an extension of a theory devised by Franco Modiliani and Merton Miller, both Nobel Prize-winning economists, we can estimate the components of a firm's value, which is divided among stockholders, debtholders and the government. Beginning with the assumption that there were no corporate or personal income taxes (a very unlikely event), the total value of the firm would be divided between stockholders and debtholders. However, under our current tax system, corporations must pay taxes on revenues after operating expenses and interest expenses have been deducted. Stockholders, in turn, must pay personal taxes on dividends and realized capital gains, and debtholders must pay taxes on interest received. Thus, government receives revenues from four separate taxes on the profits of the firm.

By doubly taxing corporate earnings and collecting personal taxes on interest payments, taxing authorities (federal and state governments) have a relatively large financial stake in private firms that ranges between 38.5 percent and 49 percent, depending on the capital structure of the firm. In turn, the stockholders' stake ranges between 11.5 percent and 51 percent. In the case where stockholders own only 11.5 percent, debtholders would own a 50 percent stake and government would own 38.5 percent. Under the current tax system, firms can reduce the government's stake only by increasing the amount of tax-deductible debt. 

However, adding debt will, in turn, reduce the stockholders' stake and create more financial risk.

 A fundamental premise essential to formulating a more favorable economic environment is that private business is better at using capital to create and retain jobs — and that it reinvests a higher percentage of its revenues than government. In short, government, through taxes, takes revenues from businesses that they could use to expand and create new jobs. Meanwhile, government will do little to create high-paying, highly productive jobs. Thus, a larger government financial stake in a company (high taxes) combined with a smaller stockholder stake creates an economic environment that significantly reduces incentives for capital formation, job creation and job retention.  

I argue that U.S. firms are choosing to export jobs not only because of differences in labor costs, but because of the adverse U.S. tax structure and the high stake government extracts from private business. U.S. firms in many sectors of the economy where jobs are transportable cannot compete with foreign competitors. Domestic firms are even required to pay taxes on foreign operations — whereas, foreign competitors are not — thereby increasing the disadvantage to U.S. firms.  

We have policy choices in dealing with this problem. A sensible one is to eliminate corporate taxes and create a tax-free business environment that will provide economic incentives for firms to retain and create higher-paying jobs. Retained earnings that are used for foreign capital expansion could be taxed. Eliminating corporate taxes in favor of taxes paid as personal income by stockholders and debtholders would increase the amount of capital businesses have available for investment and reduce the cost of capital for firms.  

Because of the reduction in government's percentage stake in the firm and the resulting lower capital and operating costs, the long-term effect of eliminating corporate taxes would be to allow domestic firms to make products at lower costs, thereby increasing exports, reducing the imbalance of trade and effectively increasing the standard of living for the American people.

 Another advantage of eliminating U.S. corporate taxes is that developing countries cannot afford to follow suit because their populations' personal incomes are insufficient to provide tax revenues to finance badly needed infrastructure improvements and government services. Thus, developing nations will be required to retain corporate taxes, thereby equalizing production costs with developed countries and reducing the incentive for moving jobs to these countries.

Further, by implementing a 28 percent flat tax system for personal income taxes, the government could continue to raise revenues comparable to the current system. A flat tax system could be designed to allow each person a standard deduction of, for example, $10,000. 

Thus, a family of four would pay no taxes until its income was greater than $40,000. A tax rate after the personal deduction might be in the neighborhood of 28 percent. Currently, Russia has had considerable success with its flat 13 percent personal income tax that is devoid of personal deductions.

A tax policy that eliminates corporate taxes and establishes a flat personal tax rate of 28 percent would still result in a 28 percent government's stake in private business when calculated in total dollars raised, though the government's percentage stake would be lower. Almost 90 percent of the up to $500 billion in such compliance costs as record keeping would also be saved. Such a policy is reasonable and workable and could go a long way toward  keeping businesses such as Maytag from pulling up roots and moving jobs to Mexico. 

 

Ronald Spahr is a professor of finance at the University of Illinois at Springfield. He holds the National City Distinguished Professorship in Banking and Finance. Spahr based this essay on a technical paper he plans to present.

 

Illinois Issues, February 2005