The recent uptick in inversions—where a large U.S. corporation relocates to a lower tax country by merging with a smaller foreign firm to avoid paying their share of U.S. taxes—is threatening to cost the American taxpayer billions in lost revenue. In Policy Responses to Corporate Inversions: Close the Barn Door Before the Horse Bolts, EPI Director of Tax and Budget Policy Thomas L. Hungerford looks at the reasons why an increasing number of corporations are inverting or planning to invert, and discusses policy solutions to halt the exodus of U.S. firms.

While inversions are typically portrayed as a way of escaping the United States’ relatively high 35 percent statutory corporate tax rate, the reality is that few corporations pay 35 percent. Due to loopholes and tax breaks the average effective U.S. corporate tax rate is about 27 percent, and many corporations pay a rate even lower than that.

“Corporations have many ways of lowering their tax bill,” said Hungerford. “Despite what you hear in the media, inversions have never been primarily about fleeing high statutory corporate tax rates.”

The principal reason for inverting is to avoid paying taxes on foreign-sourced earnings held overseas—taxes already owed to the Treasury. AbbVie—a U.S. pharmaceutical company trying to become a U.K.—has approximately $21 billion held offshore, while Medtronic—a U.S. biomedical devices firm also trying to invert—has $18 billion. For these firms, inverting is a way of dodging their tax bill, not a natural result of the United States’ corporate tax rate.

For this reason, Hungerford argues, comprehensive tax reform will not fix the inversions problem. Not only is it unlikely that tax reform will pass before too many companies invert, but if tax reform is revenue neutral (as most proposals are), it will lower the statutory tax rate but not the average effective tax rate. Hence, corporate tax reform won’t reduce the incentive companies have to invert.

Instead, Hungerford recommends specific legislation to address inversions. He suggests rules that would require that current shareholders of the U.S. firm own less than 50 percent of the new merged foreign firm, and requiring that firms be treated as U.S. corporations if they are managed and controlled in the United States and have significant domestic business activities here.

“If companies want to become foreign entities, then they should have to actually become foreign entities,” said Hungerford.