Manufacturing in America – Impact of Taxing the Profit

20/10/2011

The topic of taxes on Manufacturing in America is a vast and complex one. As I mentioned in my earlier post about shareholder returns, I am not a tax expert. But, have dealt enough with taxes as a consultant and as an executive that I can shed some light on this discussion.

Also, note that this article only deals with the overall taxes on the profit of a manufacturing company and not various other taxes like payroll, import duties etc. They are all important to this discussion but for now let’s focus on overall taxes on profit.

To start, take a look at the shareholder equation again. (I am repeating it here for the sake of clarity.)

Profit = Money coming in (Sales) – Money going out (Cost of manufacturing, logistics etc.)

Share holder returns = Profit – taxes on profit

As you can see from the second equation, lower the taxes on the profit the better the shareholder returns. So, a CEO of a manufacturing (or otherwise) company has to aim for the lowest possible tax structure. Whether it is achieved by locating the plant in America or elsewhere.

A lower tax on profit helps a company enhance shareholder return but does not create an incentive to locate the plant in America. Note that we are strictly referring to to the taxes on profit here and not the taxes related specifically to manufacturing operations.

Consider a case where a company has two location choices for a plant. The output (the widgets) will be sold in US. In one scenario, the company makes the widget in US, and in other, outside the US. If the taxes on profit are lower in outside location then a company can split the profit in two parts – between US and other location to enhance the overall returns to shareholders. This can be repeated across multiple countries to find a balance between total supply chain cost (various stages of manufacturing, logistics, warehousing etc.) and the overall tax burden.

You may be thinking that we would need to lower the taxes compared to any and all alternative locations. Fortunately, that is not the case. The taxes on profit may help determine the what percent of profit is realized in which geography but not necessarily the location of plant. Many other variables play a far greater role in that decision.

{A hint for CEOs, spreading your supply chain across multiple geographies could potentially help with overall tax structure.}

So, should we increase taxes? Not really. Wealth of shareholders and a company gives them the freedom and incentive to introduce new products, open new factories, venture into new markets and more. A high tax burden could inhibit such growth.

What I intend to convey is that contrary to popular belief just lowering the taxes on the profit of manufacturing companies may not help bring manufacturing back to America. It has to be much more targeted where the first equation above is directly impacted or the taxes help lower the total supply chain cost or improve profit.

As an example consider simple and often used policy tools like import duties and export tax incentives. If the product manufactured outside is taxed but not the home made product than the supply chain favors manufacturing at home. Similarily, giving a tax incentive for exports would favor locating the manufacturing plant in US.

This is a rather complex topic. The reciprocity between various countries and how they tax each others products comes into play. I intend to explore these in more detail like how they affect manufacturing in America in another article. For now let me end this article with a thought for policy makers.

{How about creating a targeted tax incentive based on the percentage of product that is manufactured in US?}

Something to think about!

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