October 7, 2016

CIT vs ODT - Which is worse, a 35% tax that disappears, or a 25% tax that is charged regardless of profits?

The U.S. dollar, which according to the latest PIIE data exceeds its trade-balancing equilibrium exchange rate by about 25 percent, places a 25 percent overvalued dollar tax (ODT), not only on US exports, but on all goods manufactured in the United States that must compete with imports. Furthermore, the ODT has the same impact on US manufacturers of such "tradeable" goods as providing a 25 percent subsidy to foreign exporters.

This note demonstrates that the burden of this tax on America's manufacturing sector is actually far heavier than the widely despised corporate income tax (CIT).


A Simple Example

The fact that a good is tradeable internationally means that the 25 percent overvalued dollar tax (ODT) takes 25 percent off the potential selling price, not only of U.S. exports, but also of U.S. goods competing with imports in the domestic market.

If China can sell an automotive muffler in the United States for $24, an Indiana muffler manufacturer producing a functionally identical product will have to meet this “China price” or go out of business.

However, if today’s 25 percent overvaluation of the dollar were to be corrected by implementing a Market Access Charge, the Chinese muffler would cost 25 percent more, or $30, making muffler production in Indiana far more profitable and attractive.

The overvalued dollar tax is far more brutal than most manufacturers seem to realize because it is a tax on final selling price, not on profits. Assume, for example, that our Indiana producer’s all-in costs excluding taxes are $25, making it impossible for him to make a profit when faced with a “China Price” of $24. However, if the dollar’s overvaluation were corrected and the China price rose to $30 ($24 * 1.25), the Indiana producer could match this price and walk away with a $5 profit per muffler – a 17 percent profit on value of sales.

With a 35 percent rate corporate income tax rate (CIT), the tax owed as a share of selling price would be only 6 percent in this example -- far lower than the 25 percent of selling price that the ODT represents. Furthermore, the CIT disappears if profits disappear.

Other Costs of the Overvalued Dollar Tax

The ODT’s impact on America’s economy is made even worse by several other realities.
  1.  "Revenues" from the overvalued dollar tax do not go to the U.S. government, thereby reducing the budget deficit. Instead, they flow directly to foreign countries as additional profits to their exporters.  
  2. By causing trade deficits, the overvalued dollar slows economic growth, reducing GDP, the tax base, and budgetary revenues. 
  3. Trade deficits also create demands for additional government expenditures on bailouts for corporations and income support programs for families. 
  4. Points 2 and 3 combine to create even larger government budget deficits, leading to additional dependency on borrowing from foreign creditors.
  5. Such borrowing tends to drive up interest rates in the United States, and higher rates increase capital inflows.
  6. Increased capital inflows create upward pressures on the value of the dollar, leading to even larger trade deficits ... and the cycle begins again, with ever-higher overvalued dollars draining the life blood of America's manufacturing sector.

Conclusion


Why do manufacturers complain so bitterly about the corporate income tax, which goes to zero if there are no profits, but say nothing about the overvalued dollar tax that is "charged" even when no profits are earned?

The only reason seems to be the following: They simply do not understand what a terrible burden the overvalued dollar has been placing on them for the past forty years.

Nor do they understand that, although the headline CIT rate of 35 percent is high by international standards, the U.S. tax code is so riddled with exceptions, exemptions, and deductions that the net effective rate is considerably lower. For example, when the OECD countries are ranked by corporate income tax as a share of GDP, with the country with the highest share ranked #1, the U.S. comes in 25th out of 30.

If we look at the effective rate of tax on profits actually paid, the U.S. CIT average is actually lower than the average rate in all OECD countries as a group.  And when we look at total taxes of all kinds as a share of GDP, the U.S. comes in at 33 out of 35. Only Chile and Mexico have lower total taxes as a share of GDP according to Heritage Foundation data.

It is high time we stop listening to claims that lowering the CIT will lead to a manufacturing renaissance. It won’t.

We must focus instead on fixing the overvalued dollar – on moving the dollar to a trade balancing equilibrium exchange rate and keeping it there. This will make manufacturing profitable again, and profits are what America needs to trigger a true manufacturing renaissance.

America Needs a Competitive Dollar - Now!

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