Observers widely agree that the US corporate tax system is a mess—whether seen from the vantage point of competitiveness, efficiency, or fairness. A perception has also taken root, as enunciated by President Obama and many Democrats, that the corporate tax in particular has encouraged big globalized firms to ship operations and jobs overseas, where they supposedly escape taxation. Identifying the problem in this fashion, however, has not helped lawmakers find acceptable solutions.
The latest attempt, a 67-page "discussion draft" entitled "Foreign Tax Provisions," together with two lengthy options for taxing controlled foreign corporations, was released by Senator Max Baucus (D-MT), chairman of the Senate Finance Committee, on November 19, 2013. The Baucus draft, summarized in this overview , is troubling. In terms of global competitiveness, it would make the US corporate income tax worse, not better.
Historically US multinational corporations (MNCs) have operated abroad without paying US corporate income taxes until their foreign affiliate earnings are repatriated as dividends to the US parent firm. When foreign earnings are repatriated, the US tax liability is offset by a foreign tax credit for corporate income taxes and dividend withholding taxes that were previously paid to foreign jurisdictions. The practice of delayed taxation of unrepatriated income is known as deferral. This practice enables US MNCs to operate abroad on an approximately level tax field with foreign competitors that are largely exempted from home country taxation of foreign earnings (the territorial system).
The Baucus draft makes two major substantive changes to the practice of deferral. First, MNCs would be subject to a one-time tax, at a rate of 20 percent, on accumulated unrepatriated foreign income, now estimated at around $2 trillion. The foreign tax credit would be allowed to offset the one-time 20 percent rate. Assuming the foreign tax credit averages 10 percent, the residual US tax would also work out to 10 percent. At a one-time rate of 10 percent on $2 trillion, the new tax might raise $200 billion, payable over eight years, or $25 billion a year. This change, taken on its own, would be painful but not devastating to the competitive position of US MNCs in the world economy. If MNCs believed that the one-time tax would not be repeated, then their incentive to invest abroad would not be curbed, even though their cash reserves would be reduced.
But the one-time tax is the beginning, not the end of what is in the legislation. In the Baucus draft, the one-time tax is coupled with the virtual end of deferral. In the future, US MNCs would be required to pay US tax currently (allowing for the foreign tax credit) on 100 percent of earnings attributable to their affiliate sales in the United States and on 100 percent of earnings of "tax haven" affiliates. Depending on the option, between 60 and 80 percent of all other foreign affiliate earnings would also be taxed currently under this proposal (again allowing for the foreign tax credit).1 The foreseeable revenue raised from future overseas earnings would be used to lower the US corporate tax to a range between 25 and 30 percent, an improvement by comparison with the current 35 percent statutory rate.
The adverse effects of these proposed changes on US competitiveness would be dramatic. The lower corporate rate is certainly welcome. But US MNCs would be compelled to pay significantly higher overall tax rates on their earnings abroad than MNCs based in almost any other country. The excess tax burden would apply not only to what US MNCs sell in the United States but also what they sell in foreign markets. Thus a US company like Intel that owns an affiliated factory in Ireland and sells computer chips across the European Union would have to pay US tax currently on the Irish income, unlike its Japanese or European competitors with similar Irish affiliates.
Chairman Baucus's statement accompanying the "discussion draft" claims the goal is to "modernize" the US corporate income tax. But what would a truly "modern" corporate income tax look like? As far as corporate income earned abroad is concerned, the vast majority of advanced industrial countries in the Organization for Economic Cooperation and Development (OECD) have adopted territorial tax systems. Under these systems, the home country collects, at most, a small tax on foreign income. The territorial approach has one big advantage: It doesn't handicap domestic firms when they compete abroad against foreign firms that pay a lower tax rate. Now that Japan has switched to a territorial system, the United States has by far the highest corporate tax rate on repatriated foreign earnings among OECD countries. The Baucus draft would essentially extend this high rate to all foreign earnings, whether or not repatriated, thereby ensuring that US MNCs operate at a competitive disadvantage worldwide.
Outward direct investment by US multinationals has become a frequent target of White House criticism, and the Baucus draft plays to this sentiment. From a mercantilist perspective, the argument is concise: Investment dollars spent abroad generate jobs and economic activity abroad rather than at home. This perspective assumes that investment is a zero-sum game; hence investment in one country substitutes dollar-for-dollar for investment in another country. Recent research paints a very different picture. When a US MNC invests abroad, its foreign employees and capital serve to complement the MNC's US operations, rather than substitute for them. The outward expansion of US MNCs is strongly associated with greater US employment, higher US capital expenditures, more US R&D, and greater US exports. With those effects in mind, tax measures that penalize overseas earnings are likely to reduce economic activity in the United States.
Senator Baucus should have coupled his one-time tax on past accumulated unrepatriated earnings with a territorial system for taxing future overseas earnings, as we recommended in a recent study . That combination would both raise revenue and provide the proper incentive structure for US MNCs in the world economy. If the "discussion draft" moves forward, other senators and representatives have their work cut out.
1. The partial or total end of deferral would be accomplished by characterizing the earnings in question as Subpart F income, which by its definition is subject to current US taxation, whether or not repatriated. As a companion to this change, dividends paid from foreign affiliates to their US parents would no longer be subject to US taxation.