The United States of America's ability to defend its people, territory and interests in the world depends on both hard and soft power. Hard power is defined as military strength and capacity, and soft power is defined by Joseph Nye as "the ability to get what you want through attraction rather than coercion or payments. It arises from the attractiveness of a country's culture, political ideals and policies."
Both hard and soft power are greatly affected by the strength, vibrancy and growth of the American economy. And how our government chooses to tax its trade, citizens and businesses shapes and limits our economic growth and strength.
Long story short: In 1745, North American colonists paid an average of 1 or 2 percent of their annual incomes in total taxation. British citizens living in London at the time paid 20 percent of their income in taxes to support the British state and empire. The American economy grew more rapidly than Britain's. It attracted labor and capital, immigration and investment.
Soft power flowed from economic strength. Immigrants poured into the United States from Europe and later Japan and China to build our factories, railroads and farms. Those immigrants were a vast public-relations machine communicating to the old country, promoting American ideals, values and virtue. Our exports spoke well of our skills and technology. Our ability to import was a tangible demonstration of our wealth. Hard power flowed from the capacity of our nation's factories. While many nations drained their economic strength in taxes to fund armies and navies and wars, the United States in 1940 spent only 4.8 percent of GDP on the army and navy but had a skilled workforce and manufacturing base that would shortly flood the world with weaponry.
When president Reagan was elected in 1980, inflation stood at 12.7 percent, interest rates were 15.5 percent, unemployment in the 1970s averaged 6.2 percent and annual growth in GDP averaged only 3.2 percent. The Reagan tax cuts phased in a 25 percent reduction in marginal tax rates, taking the top income tax rate from 70 percent to 50 percent. The Tax Reform Act of 1986 dropped the top individual rate from 50 to 28 percent and the corporate income tax rate from 46 to 34 percent. When the tax cuts took full effect in 1983, economic growth that year was 6.3 percent, and 3.4 percent million jobs were added.
At the height of the Reagan Cold War military buildup in 1985, defense spending was 6.1 percent of the economy. Reagan's tax policies grew the U.S. economy by 75 percent over his eight years.
How did the world view the United States in the 1980s and early 1990s? As strong, powerful, growing and likely to be more so in the future. That soft-power impression as well as hard-power capacity is weaker today.
Why? The Obama recovery from the bottom of the recession in June 2009 to August 2012 added 2.8 million jobs and increased GDP by 11 percent. In Reagan's first thirty-eight months of recovery from the bottom of his recession in November 1982, the economy added 9.9 million net new jobs and GDP grew 30 percent. Where Reagan reduced taxes and regulations and tried to limit nonmilitary spending, he added 7.1 million more jobs and 56 percent more GDP than Obama did with the opposite approach.
The overall tax burden and marginal tax rates for businesses and individuals have a powerful effect on our ability to grow, create jobs and innovate. That changes how the world sees us. For most of our nation's history we have outperformed the rest of the world. There is, however, one policy of American taxation, copied only by North Korea, Zimbabwe and Eritrea, which slows overall growth and particularly weakens America's capacity to project soft power through person-to-person contact.
A New Territorial Tax Regime
America does not limit its taxation of its citizens and businesses to activity within its borders. An American citizen working in the United States pays American income taxes. A German working in the United States pays American income taxes and is not taxed by his home country while he works abroad. But when an American takes a job in Germany or any other nation, he pays first the taxes of the nation where he works and then likely owes American taxes as well. (There is foreign-earned income exclusion from U.S. taxation for the first $100,000 or so paid overseas, but this does little to reduce the tax burden for highly trained and therefore highly compensated workers.)
This means that a firm looking to hire engineers to work in the Saudi oil fields has to pay American workers more than European engineers in order to cover the additional cost of American taxes. Today some six million Americans work overseas. They are truly day-to-day, person-to-person ambassadors for our nation. Chris Fussner, an American working largely in Singapore and the leader of Republicans Abroad, estimates that five hundred thousand more Americans would be working overseas if the United States simply adopted the territorial tax system imposed by nations other than the United States, Zimbabwe and North Korea.
The best counter to anti-American propaganda or simple media bias by foreign radio and television outlets is the knowledge of real live American citizens in day-to-day contact.
Fortunately for voters and policy makers, there's a way to both increase U.S. economic growth and directly impact U.S. power overseas at the same time. The United States is one of the few nations left in the world that taxes on a "worldwide" basis. This means that an American citizen or company earning money overseas has to account for taxes both to the foreign tax jurisdiction and the IRS. Most countries (including our biggest trade competitors) have a "territorial" tax basis. Under that system, only money earned inside the borders of a country can be taxed by that country—no more having to report to two countries' tax authorities.
From a tax-policy perspective, territoriality makes sense. If money is earned in France, for example, it's just that the tax bite should flow to Paris, not Washington. Similarly, if money is earned in the United States, taxes should be paid there since that's where the nexus is applied.
Why is this even an issue? After all, shouldn't foreign tax credits even everything out? The problem U.S. taxpayers run into is that America now has the highest corporate-income tax rate in the developed world—over 39 percent when state corporate-income taxes are included— according to the OECD. Sure, U.S. companies can credit the (on average) 25 percent corporate rate they face in other developed nations, but that still leaves a double tax of 14 percent to pay to the IRS and state capitols. Territoriality is nothing more than eliminating this second layer of taxation on income earned overseas—a layer that is not faced by our multinational competitors.
There's also the issue of what to do with all the money that's already been earned overseas but has yet to face this second layer of U.S. taxation. Back in 2005, Congress created a one-year "repatriation" period where this money could be brought back at a lower rate. Companies could pay 5.25 percent instead of the 14 percent or more they would typically face. Employers jumped at the opportunity, as $320 billion in overseas cash came pouring in that year. Not only did this money boost tax revenue (it would have been deferred indefinitely, but instead it's exposed to the 5.25 percent tax), this was a shot in the arm to the American economy. It was the equivalent of a one-time hike in GDP of 2 percentage points. This money went to fund pension plans, reward shareholders, create jobs, invest in plant and equipment, pay down debt, and strengthen corporate balance sheets.
Today, a similar opportunity exists, only bigger. Companies arguing for another round of repatriation claim that there's well over $1 trillion sitting overseas, and up to this amount could easily flow back to the United States. Repatriation as the kick-start to a new territorial tax regime makes sense from both a tax and foreign-policy perspective.
Grover G. Norquist is president of Americans for Tax Reform and coauthor, with John Lott, of Debacle: Obama's War on Jobs and Growth and What We Can Do Now to Regain Our Future.