This article was originally published in the Illinois Business Journal June 2009 print edition.
The Obama administration with good reason wants to limit the ability of unscrupulous individuals and shrewd multinational corporations to avoid U.S. income taxes and to reduce incentives for corporations to ship jobs overseas. The permissiveness of the tax code currently allows more and more income to elude taxation through legal tax sheltering and illegal tax evasion, leaving those who aren’t in a position to take advantage of these tax schemes paying a larger share.
Efforts to end these overseas tax dodges are painted by big multinational corporations as unfair, but take a look at what practices will end by enacting these changes. On personal income tax, the Obama administration proposes tougher rules for financial institutions that help tax-dodging Americans slip their income to foreign hiding places. Penalties also are increased on tax-evaders themselves. These steps would curtail scams where well-off individuals take advantage of the secrecy of financial institutions in other countries.
Case in point: A former Cayman Islands bank owner testified that 100 percent of his clients engaged in tax evasion and took elaborate measures to avoid detection by the U.S. Internal Revenue Service. The administration’s proposals make this harder to do.
Most of the reforms, however, are on the corporate side and focus on legal loopholes. Corporations argue that the United States has a higher corporate tax rate than other countries. And if that rate were applied to all of their income, then they might have a fair gripe. But there are so many ways for U.S. corporations, especially those with cross-border operations, to keep their taxes down that the rate is a poor measure of the level of tax.
Here are the facts multinational corporations will never tell you. The U.S. ranks quite low in corporate income tax collections– they’ve dropped to 2.9 percent of U.S. gross domestic product in 2006 from 4.0 percent of GDP in 1965. The average for economically advanced countries rose to 3.8 percent from 2.2 percent over that same period, the latest for which data are available.
One reason for this is the generous provisions for corporate debt-financing, which results in U.S. taxation of debt-financed investments which is much lower than other countries. Another is low taxes available in foreign tax shelters. Of the 100 largest U.S. corporations, 83 have subsidiaries in tax havens. By various manipulations, corporations can, on paper, shift income to low-tax jurisdictions and duck paying taxes.
How lucrative are these shelters? In 2004, U.S. multinational corporations paid about $16 billion of U.S. tax on about $700 billion of foreign active earnings for an effective rate of 2.3 percent. One result of the decline in revenue from the corporate tax is that everyone else pays more. The percentage of federal revenues coming from the tax has declined to 12 percent in 2008 from 22 percent in 1965. Other taxpayers pick up the difference.
The problem isn’t only the shift to individuals. The playing field has tilted among corporations as well, with those operating exclusively in the United States having less of an opportunity to game the system.
Then there’s the problem of the current tax code encouraging U.S. corporations to move manufacturing and service jobs overseas. Companies with more overseas operations have more ways to avoid taxation using the various games the tax code permits.
The way the big corporate lobbyists want to fix things is to give all corporations the same pass on taxes that those currently taking advantage of all the loopholes get. That, of course, would leave the rest of us holding the bag.
Under U.S. corporate tax law, tax isn’t paid until overseas income is brought to the United States. This “deferral” rule delays the payment of tax (sometimes forever) and thus is a significant tax break for corporations. There has been much agitating for a long time to eliminate it—to make U.S. corporations pay U.S. tax as they earn their overseas profits. This would be a clean way to reduce tax dodging schemes and would eliminate any incentive to keep income overseas instead of investing it in the United States.
The lobbyists were clearly geared up to defend an attack on deferral. But what the administration proposes is instead a set of common-sense reforms aimed at making the current system, with deferral, operate more rationally. The administration, for example, proposes that expenses in support of overseas investments be deducted at the same time income is repatriated. Sensible enough—a company shouldn’t get a deduction when the income the expense generates may never be taxed because of deferral.
Another provision deals with the foreign tax credit. This credit reduces a corporation’s U.S. tax liability by the amount of tax it pays to other governments so that the same income isn’t taxed by two different national governments. The problem is that under current law there are tricks that corporations can play to essentially get the credit for foreign taxes that aren’t actually paid. The administration limits these games. Other provisions further limit corporations’ ability to take advantage of tax havens.
It’s a pretty modest list of common sense reforms. These are reasonable policies that will raise revenue as the recession recedes and make the tax system more fair. Of course, big multinational corporations are upset because the new rules will upend their cherished corporate loopholes. But with the many challenges our nation faces, these companies need to contribute their fair share.
Michael Ettlinger is Vice President for Economic Policy at the Center for American Progress. To read more of the Center’s economic analysis and policy recommendations please go to the Economy page on our website.