Low-tax matchmaking

A $152 billion planned merger between Pfizer and Allergan, the large U.S. and Irish drug companies, is the latest example of a business trick we’ll be hearing a lot more about between now and the election next November. It’s called a corporate inversion, and it’s a clever way to make the unconscionably high U.S. taxes on corporate income disappear.

To appreciate the cost of the corporate tax—35 percent in the United States—keep in mind that corporate profits are taxed twice: The corporation is taxed when it earns the profits, and investors are taxed if the corporation makes a dividend or the investors sell their stock for more than they originally paid.

Corporate inversions work somewhat like a mail-order-bride service for corporations. To reduce its tax bill, a U.S. corporation like Pfizer looks for another corporation in a country whose corporate taxes are lower than the American rate, and then persuades the foreign entity to tie the knot. The two businesses structure their transaction so that the foreign corporation technically acquires its U.S. suitor. This way, the newly merged corporations can introduce themselves as a single foreign corporation, subject to the much lower foreign tax rate.

Pfizer and Allergan hope to do it, Walgreens and Chiquita wanted to do it, and Burger King did it (by merging with Tim Hortons in Canada).

President Barack Obama has denounced corporate inversions as “unpatriotic,” and there’s no question the transactions are often dubious. For instance, Pfizer and Allergan are pretending Allergan is the suitor and Pfizer is the bride, even though Pfizer is much bigger and Allergan will be changing its name to Pfizer after the transaction. And the merger definitely isn’t a match made in heaven: Other than the tax benefits, the two companies have little reason to merge.

The U.S. Treasury Department responded to last year’s wave of corporate inversions by tightening the tax rules to make inversions more difficult. The new rules forced Pfizer to abandon a proposed merger with British drug company AstraZeneca. The Treasury could change the rules again, to thwart Pfizer’s merger with Allergan.

But this won’t solve the problem. As long as U.S. corporate taxes are so high, executives will look for ways to get around them.

Corporate inversions aren’t the only strategy for escaping onerous taxes. American corporations that earn money in foreign countries often leave the earnings there, because they can avoid U.S. taxation if the money is “permanently” or “indefinitely” invested elsewhere. According to one estimate, $2 trillion of U.S. corporate earnings currently have this status. (Pfizer alone accounts for $74 billion.) That’s $2 trillion that might otherwise be invested here, creating U.S. jobs.

Compare our corporate tax rate to the rates in other countries: Tax havens like the Cayman Islands have no corporate tax at all, and the rate in Ireland, which Pfizer hopes to call home, is 12.5 percent, according to an August report from Deloitte. Even formerly communist countries like Hungary and Poland have much lower corporate tax rates (19 percent in each case).

It’s fine for the U.S. government to keep changing the rules to make it harder for corporations to avoid taxes. But that’s unlikely to do much good until Congress sharply reduces the corporate tax rate. If the tax burden weren’t so heavy, executives would spend less time trying to avoid it, and they could devote more time to investing their profits here in the United States.