Inversion Hysteria

If you are looking for reasons why the stock market is tanking, you might turn your eyes toward Washington. The anti-corporate frenzy is stopping helpful policies, such as tort reform, and igniting harmful ones. The lynching frenzy is so intoxicating that traditional respect for the rule of law has been cast aside.

Under new amendments that have passed both the House and the Senate, companies will find themselves penalized retroactively for lawful actions they took years ago. If these new laws are allowed to stand, they will have a significant chilling effect on an already cold financial climate. Under the new precedent, companies will not only have to follow existing law, but will also have to predict future law. Entrepreneurs without a crystal ball may just decide that doing business in the U.S. is not worth the trouble.

The starting point of this particular fiasco was the frenzy over "inversions," a process that some U.S. corporations have used to lower their U.S. tax by transferring their official residence to another country (often Bermuda). This transfer is a response to a Byzantine tax system that actually rewards such behavior for imponderable reasons.

In the past year, members of Congress have decided that such actions are unpatriotic, even though they are often taken by near-bankrupt firms looking for a lifeline. House Democrat Rosa DeLauro (Conn.), for example, recently argued that these companies deserve punishment because they " have abandoned our country at a critical time in our history."

And what a punishment it is. The House and Senate both recently approved amendments offered by Sen. Paul Wellstone (D., Minn.) and DeLauro that would impose a new form of procurement penalty on companies that reincorporated — or in some cases originally incorporated — in any of about a dozen so-called "tax havens." Such companies would be permanently barred from competing for contracts with the new Department of Homeland Security. This measure would be part of the law authorizing the new department, but several members of Congress have signaled their intent to offer similar amendments to other pending appropriations bills, spreading the purchasing prohibition well beyond Homeland Security to all government contracts.

It is important to keep in mind that these corporate actions were — and for that matter still are — in full compliance with the U.S. tax laws and regulations. The amendments are intended to retroactively penalize companies that engaged in "paper reincorporations" aimed at establishing a foreign address for tax purposes, even though the companies involved continue to operate factories in the U.S. and pay U.S. taxes.

Inversion activities are just as lawful as those of homeowners who use tax-deductible home-equity loans to finance purchases. But if one finds inversion unpleasant, then the rational thing to do is to revise the law so that it is no longer attractive. But to retroactively punish firms who obeyed the law opens a new and troubling chapter in the tax books.

If Congress can punish a company for setting up its legal headquarters offshore, what other legal corporate behavior can it choose to penalize? Would companies be denied the right to bid for government contracts because they advertise on television programs that senators or representatives believe contain too much sex or violence? Would a company be cut out of the procurement process because it is owned by a corporation that also owns a tobacco company? Billions of dollars in contracts can buy government a great deal of compliance. But should it buy compliance? If senators and representatives want to penalize an activity should they first not be required to prohibit it?

Sen. Wellstone's amendment would impose its procurement penalties on any company that ever reincorporated itself in targeted countries — at any point in our country's two-century-plus history. It is one thing to impose disincentives. It is a radically and dangerously different thing to apply a disincentive against a move that took place years ago.

The inversion controversy is far more complex than hysterical elected officials let on. A forthcoming study in the National Tax Journal by Mehir Desai of Harvard Business School and James Hines of the University of Michigan documents that debt-ridden firms often use inversions to stave off financial difficulties. The temporary tax break helps troubled firms take a step away from bankruptcy. Since incorporation abroad lowers the domestic tax rate it increases the competitiveness of the firm, and may even increase U.S. employment as well.

It's not obvious that inversions, therefore, are bad for the U.S. But it is obvious that the political response to inversions is. Americans often get on their high horse about the important effect that a strong rule of law has on economic competitiveness. Such arguments have a great deal of merit. The rule of law is indeed important, and retroactive penalties of this type make a mockery of it.

Kevin A. Hassett is resident scholar at the American Enterprise Institute.

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