Weekend Economists American Bad Boys Part 1 July 12-13, 2014

[Demeter]

2. Pretend Manufacturing In The Tax System

http://www.forbes.com/sites/leesheppard/2014/07/08/pretend-manufacturing-in-the-tax-system/

Public Citizen is complaining that a group of federal agencies propose to redefine manufacturing so that it would include employees and firms that are not actually bashing metal in the United States. The IRS beat the other agencies to this dubious result...The Economic Classification Policy Committee, a group of federal agencies, proposes to change the North American Industry Classification system, a classification system for data analysis by NAFTA governments, to amend the definition of manufacturing for many purposes, including labor statistics and economic indicators.

The object of this exercise is to reclassify companies that have outsourced production from the United States as US manufacturers. Some federal classification systems, including standard industrial classification, already do treat offshored manufacturing as US manufacturing. Public Citizen argues that the proposal would artificially reduce the manufacturing trade deficit while artificially raising the number of jobs classified as manufacturing jobs. The tax law has been indulgently defining US-contracted offshore manufacturing in ways that benefit US companies for many years. The tax code contains a number of special benefits for manufacturing. Hardly anyone would qualify if manufacturing were strictly defined as metal bashing in the United States. So the IRS has been liberal in its interpretations, helping companies qualify for these breaks. Indeed, a desperate Congress told the IRS to interpret qualification for the domestic production deduction generously. Enacted a decade ago, the deduction allows companies to deduct nine percent of their income from domestic production, provided the deduction does not exceed taxable income or 50 of associated US wages (section 199). In the infamous “Starbucks example” in the regulations, the IRS said that domestic production includes roasting coffee beans in the United States (reg. section 1.199-3(o)(3), Example 1). Oh, refining imported oil in the United States and making movies that are not pornographic are also included (reg. sections 1.199-3(g)(5), example 1 and 1.199-3(k)).

As it happens, the domestic production deduction is the largest tax expenditure in the corporate income tax. Its cost exceeds even such boondoggles as LIFO, which allows oil companies to report artificial inventory profits. It is so expensive that when House Ways and Means Committee Chair Dave Camp, R-Mich, staked his legislative career on rewriting the tax code to achieve a 25 percent corporate income tax rate within congressional budget rules, he had to propose that it be gradually repealed.

The policy committee proposes to redefine manufacturing to include US-designed products that are manufactured in China. The US design activity would be redefined as “factoryless goods” production. US executives would be redefined as factoryless goods producers, increasing reported manufacturing wages. The fabrication activity in China would be redefined as a service. And the imported Chinese goods would be redefined as imported services. The policy committee hopes to get the EU to accept the products as US-manufactured exports The policy committee’s argument is that the person putting all the factors of production together should still be considered a manufacturer. Requiring transformation in the United States was regarded as too restrictive, because it would prevent companies from offshoring to chase lower wages. Yes, the policy committee really did say that.

Let’s take the Apple/Foxconn setup. Apple owns the relevant design rights and patents. All of Apple’s R&D is conducted in the United States, where costs are deductible. Foxconn, which is independent of Apple’s multinational group, does the fabrication of Apple products. Foxconn gets paid a fee for this activity. Apple’s principal company, located in Ireland, arranges for the Foxconn manufacturing...Multinationals engaging in contract manufacturing in China and other low-wage locations would not be able to claim that the resulting income was manufacturing income on which US tax could be deferred because they are not doing the actual fabrication. So the IRS helped them out with a set of regulations that said they could attribute Chinese manufacturing to principal companies in tax havens that were set up to strip income from European markets (reg. section 1.954-3(a)(4)(iv))...The premise of the IRS rules is that the principal company in Switzerland supervises and materially participates in Chinese manufacturing. Usually this company has title to the raw materials and the product, and pays a cost-plus fee to the Chinese toll manufacturer. The regulation has seven fluffy factors–like oversight, logistics, quality control and product design–to determine whether the Swiss principal company can be considered a substantial contributor to the manufacturing.

Some readers may wonder how a handful of executives in Switzerland could effectively supervise manufacturing in China. But corporate fictions in the tax law are so expansive that some companies have claimed supervision could occur without the principal company having any employees! So IRS auditors require that there be some warm bodies in Switzerland pretending to supervise Chinese manufacturing.

BUT WAIT, THERE'S MORE! TALK ABOUT BAD BOYS...AND THE GOVERNMENT COMPLICITY!