Why Obama is right, and wrong, on Bangalore
by Virendra Parekh on 15 May 2009 0 Comment

Say no to Bangalore and yes to Buffalo. That neatly sums up the logic underlying US President Barack Obama’s tax reform proposals unveiled on May 4. With characteristic flourish, he lashed out at companies “shirking” their responsibilities and the iniquities of a “broken” tax system that rewarded firms for creating jobs in Bangalore rather than Buffalo, New York. Indians were quick to pore over the fine print to figure out the likely impact on American business of Indian IT companies and Indian operations of American companies -both IT and others.

This is not the first time Mr. Obama has invoked Bangalore as an all-encompassing metaphor to describe everything from job loss to globalization, to rally Americans for a protectionist cause.

Mr. Obama’s grouse is not really against Bangalore, but with US firms and their wily ways. Under the current US tax code, American corporations with subsidiaries in foreign countries can defer paying US taxes on the profits of those subsidiaries until the money is transferred back to US. As long as those earnings are ploughed back into the foreign subsidiaries (which firms do, creating more jobs there), they can avoid paying taxes indefinitely. If the money is brought back to the US, corporations can subtract foreign taxes already paid.

At the same time, however, they are allowed to claim a set-off on the expenses related to such investment. This has been an open invitation to invest overseas and not in the home market, especially if the money is routed through tax havens so that the firms pay no tax on their profits anywhere. Indeed, effective tax rate on such investment has been as low as 2-3 per cent, compared with the statutory rate of 35 per cent, depriving the US treasury of tens of billions of dollars in tax revenue.

Clearly, there are many loopholes to be plugged. One such is the permission available now to “shift” taxable income from a subsidiary abroad to low- or no-tax jurisdictions - tax havens - which then wipes out your tax obligations.  It is argued that this and other similar practices might protect multinationals from double taxation. But that argument does not always make sense; and if you want to affirm that tax heavens are on their way out, a crackdown on their use is hard to fault.

Moreover, at a time when US is running a gigantic deficit and needs money for other programmes, corporate America’s foreign profits are an appealing pot of cash for its President. As a first step - ‘down payment’ - towards a “simpler, fairer and more efficient” tax system, which would also raise $210 billion over ten years, Mr. Obama has promised tighter rules on the taxation of businesses’ foreign earnings and a crackdown on the use of tax havens. He wants to make it harder for multinational firms to shift income to subsidiaries in low-tax countries, stiffen the rules on the credits American firms can claim for the foreign taxes they pay, and limit how much companies can defer tax payments on their foreign earnings.

More problematic among these changes is the removal of tax deferral. Obama’s tax plan says that companies will be allowed to deduct the cost of investments abroad from their tax bill only after they have paid taxes in US on foreign profits. His argument is that you should not be claiming tax set-offs on expenditure that is used to earn profits on which you do not pay tax under the same tax regime. Mr. Obama views this move as ending a “tax break for companies that move jobs overseas”; and claims that it would move jobs “from Bangalore to Buffalo”.

This looks somewhat simplistic. For all the noise made about it in the US and in India, the truth is that no Indian tech or BPO companies are going to be affected by this. American clients of Infosys or TCS are unlikely now to find that it pays to cancel their contracts with Indian IT Majors. “The current proposal, as we understand, is to close corporate tax loopholes for US multinational corporations. We do not believe it has anything to do with IT outsourcing done by US corporations,” India's second-largest IT services provider, Infosys Technologies, said in a statement.

Yet the worries persist. A top executive of an Indian IT company said the US president’s utterances will impact sentiment and ‘vitiate the atmosphere’. With the US accounting for over half of India’s software exports, any initiative to curb off-shoring will make things worse for Indian IT companies which are already struggling to cope with lower demand for services because of the ongoing recession. 

Really hit hard will be those American companies which have large back-office operations in India. They may well find that their tax burden goes up in the US as a result of Mr. Obama’s proposal. US companies have over the last decade or so shifted low value to highly skilled jobs to countries such as India to cut their operating costs and remain competitive. US multinationals such as IBM, Accenture, GE, Caterpillar and big American banks such as Bank of America, JPMorgan Chase and Goldman Sachs, have established their captive back-office and engineering centres in Bangalore, Chennai and Delhi in order to lower their operational costs and take advantage of available skilled professionals here.

IBM employs over 70,000 professionals in India, Accenture around 45,000. Most companies have high growth rates outside of the US and more than half their revenues come from outside. Citigroup, for example, earned 74 percent of its revenues in 2008 outside the US and 60 percent of its workforce operated from abroad. Intel, the world’s largest chip maker, regards emerging markets as the next growth area. And as part of increasing their hold in these markets, all US IT firms have invested both in terms of finance and people. According to research firm Everest Group, these captive organisations exported back-office projects worth $4.8 billion from India last year.

Although these companies are going to be hit hard by removal of tax deferral, they are unlikely to pull up their socks and go back to the US. It is more than likely that it makes economic and business sense for these companies to locate their operations in India, even without the tax breaks. Some marginal operations may possibly be affected, but that should not blur the larger picture.

Moreover, tax breaks are not the only reason for outsourcing. These companies continue to hire more workers here because traditionally they find it difficult to get enough professionals with adequate skills within the US. The vast talent pool in India cannot be matched by the US, either in numbers or cost.

However, the loss of tax breaks may affect their expansion plans abroad. If at all the new legislation comes into effect, many American companies having development centres and captive operations in overseas markets such as India will need to analyse if outsourcing benefits outweigh the tax benefits.

Mr. Obama’s goal of moving jobs from Bangalore to Buffalo is unlikely to be achieved in the given circumstances. Nor will US jobs be saved. On the contrary, his tax proposals will push up the tax burden on American multinationals and put them at a disadvantage against their rivals in Europe and Japan. Indeed, this will serve as an inducement to move corporate headquarters offshore.

As The Economist has pointed out, this plan is less an economic down payment than a political one. Obama’s administration is already viewed as suspiciously right-wing in its economic thinking by the core base of Democratic voters due to its reluctance to nationalise banks and clamp down more firmly on crooked bankers. Outsourcing is a softer target for left-wing populism than Wall Street. Unfortunately for it, the maximum damage of this policy change will be borne by US firms.

Whether the corporate giants will take it lying down is another matter. Obama’s plan needs the approval of Congress, and not all lawmakers are in its favour. Past attempts to pass similar laws have failed. The multinationals may yet torpedo it with stealthy lobbying.

The author is Executive Editor, Corporate India, and lives in Mumbai

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