On February 22 the Obama administration released a framework for reforming the U.S. corporate tax system. The joint White House-Treasury Department document is a serious first step toward a very difficult objective—improving the tax code as it applies to American business. The president’s framework contains many important ideas and proposals, but its most important contribution is to fundamentally refocus the policy discussion surrounding corporate taxes on the most important national priorities, including domestic job creation.
It’s worth examining how the president’s framework would advance those priorities, starting by looking more closely at how it addresses important issues in corporate tax reform. We begin with the president’s framework for reforming international tax rules.
A pro-growth tax code would encourage job creation in the United States—or at least not subsidize offshoring. But our current tax code rewards companies for moving their operations and jobs overseas. It also includes loopholes and porous rules that companies use to artificially shift their profits offshore to avoid paying U.S. taxes, even if those profits are created by American workers and consumers. The international corporate tax rules are sorely in need of reform to reverse the offshore bias and protect our revenue base.
One of the most important elements of the president’s framework for business tax reform is a “corporate minimum tax” on global profits, which directly addresses the outflow of jobs and revenue. The president’s framework expressly rejects the “territorial” approach sought by many U.S. multinationals, which could worsen these problems. But overall it addresses the main objections that U.S. corporations have with the current system.
In sum, the president’s framework outlines a balanced approach that would be an enormous improvement to the current system—one that would better serve our national interest than the kind of territorial system envisioned by the corporate lobbying community and many leading conservatives.
A broken system
It is often said that the United States has a “worldwide” tax system—a system where U.S. corporations pay U.S. taxes on their profits wherever in the world they earn them. If we actually had such a purely “worldwide” system, then U.S. corporations would pay the same level of taxes whether they reported their global profits in the United States or elsewhere. They would pay their U.S. taxes, less any foreign taxes owed, and insofar as taxes affect their bottom line, it would not matter where the investments or the income were located.
The reality, however, is much more complicated. Under our current system foreign profits are taxed more favorably than domestic profits. U.S. multinationals pay U.S. taxes on domestic profits in the year they are earned. But overseas profits are taxed only when and if they are returned to the United States (and often not even then). This treatment of foreign profits, called “deferral”, can be extremely valuable because it allows U.S. companies to reinvest profits overseas indefinitely without paying U.S. tax. As the White House-Treasury document correctly notes, the U.S. tax system is often described as “worldwide,” but “opportunities for deferral can make it effectively much closer to a territorial system—a system in which taxes are never paid on foreign income—for many companies.”(1)
For some companies the existing system is even better than a worldwide or a properly conceived territorial system because it allows them not only to defer U.S. taxes but to also avoid foreign taxes by reporting profits in tax haven countries. In a recent issue brief, we outlined some of the complex legal and accounting techniques that result in outsized amounts of corporate profits being reported in no-tax or low-tax countries like Bermuda and Luxembourg. To be clear, these profits are not actually earned in these small countries in any meaningful sense—rather, they are shifted there on paper for tax purposes.
Profit shifting by multinational companies is becoming more pervasive because of changes in the economy and more permissive tax rules. It is decimating the U.S. corporate tax base. Mounting evidence, some of which is cited in the White House-Treasury report, shows that hundreds of billions of corporate profits are being artificially reported in a handful of small, low-tax countries.(2) The use of tax havens drained an estimated $90 billion in revenues in 2008, up from $60 billion in 2004.(3) To put that in perspective, corporate revenues averaged $300 billion over fiscal years 2006–2010.
But it’s not just an issue of lost revenue. The allure of tax havens reinforces the fundamental bias toward foreign over domestic investment, which ultimately impacts jobs. Our current tax code’s permissiveness toward tax havens encourages companies to move jobs and investment offshore—even to relatively high-tax foreign countries—because the resulting profits can ultimately be shifted into tax havens.
It simply makes no sense for the U.S. tax code to subsidize overseas investment in this way.
A corporate minimum tax: An essential element of corporate tax reform
The president’s framework proposes to address these issues through a minimum tax on corporations’ foreign profits and other reforms.(4)
A corporate minimum tax helps level the playing field between foreign and domestic investment by providing a backstop ensuring that all corporate profits, wherever they are earned, are subject to at least a minimum level of tax in the year they are earned.
Let’s suppose a subsidiary of a U.S. multinational is reporting profits in Bermuda on which it pays zero (or negligible) corporate tax. The minimum tax would require that the subsidiary pay the U.S. minimum tax on a current basis, with the remainder of the regular U.S. tax imposed when those profits are returned stateside—for example, as dividends to the U.S. corporate parent. As under current rules, companies would still be entitled to a foreign tax credit for any foreign taxes paid.
The minimum tax would reduce several harmful distortions caused by the current system. It would help level the playing field for domestic investment by reducing the disparity between how foreign and domestic income is taxed. Because the current system provides a hidden, unintended subsidy for large multinationals in certain business sectors, including pharmaceuticals and software, the minimum tax would also level the playing field for other types of businesses both large and small. Further, the minimum tax would exert U.S. influence to prevent an international “race to the bottom” on corporate tax rates.
The president’s framework does not detail the design of the minimum tax, including the minimum effective rate and how it would be measured. Those details are important. Nevertheless, in asserting that a minimum tax should be part of any corporate tax reform, the administration has placed the correct emphasis on the biggest failings of our current system.
As proposed in President Barack Obama’s reform framework, the corporate minimum tax would complement other international reforms he has previously proposed. These include reforms to the “transfer pricing” rules intended to ensure that the U.S. tax base includes profits associated with intangible assets, including drug patents, computer code, and? intangible business assets such as goodwill, and others, which are now relatively easy to move offshore. In addition, the framework reiterates the president’s proposal to close the loophole allowing companies to take immediate tax deductions when they borrow funds to earn tax-deferred overseas income—another nonsensical subsidy for overseas investment.(5)
Addressing the concerns of U.S. multinationals
The president’s proposal also addresses the two main issues often cited by U.S. multinationals when it comes to corporate taxes:
- The assertion that the United States’s relatively high statutory rate and “worldwide” system of taxing corporate profits puts them at a disadvantage in world markets
- The complaint that the current system imposes a “toll charge” on the repatriation of profits from abroad, preventing them from investing those profits in the United States
U.S. multinationals propose that we address these issues by exempting their foreign profits from U.S. tax entirely. And some have even claimed that the president’s proposal “goes in the other direction,” implying that it would make U.S. multinationals less competitive or exacerbate the lockout effect. In fact, however, the president’s framework would significantly alleviate the problems cited by the companies lobbying for a territorial system—to the extent that they are in fact problems.
The evidence for the oft-repeated claim that U.S. multinationals pay higher taxes than their foreign rivals is uncertain at best. This year the United States will indeed have the highest statutory rate among advanced economies. But to the extent that taxes bear on multinationals’ competitiveness, the important measure is the effective tax rate that corporations expect to pay. Numerous studies show U.S. corporate effective rates to be closely in line with those of other major economies, and a recent study revealed that in the aggregate, the 100 largest U.S.-based multinationals faced lower effective rates over the past decade than their EU counterparts, largely because of our permissive rules concerning tax havens.(6) (Japanese companies pay even higher effective tax rates.)
To be clear, when it comes to a company or a country’s competitiveness, the tax system is not the end-all and be-all. Taxes are only one factor bearing on firms’ cost of capital, which in turn is only one factor bearing on their ability to compete globally. Even more importantly, the ability of U.S. multinationals to compete abroad is only one aspect of our economy’s competitiveness.(7) Also important are the tax incentives to locate investment in the United States. What’s more, public investments in areas like education, infrastructure, and scientific research that boost our economy’s competitiveness depend on having an adequate national tax base.
Nonetheless, if the United State’s 35 percent statutory rate is hampering U.S. companies in world markets, they should welcome a framework that reduces that rate for the first time in more than 25 years. Lowering the corporate rate to 28 percent as President Obama now proposes would put the U.S. rate (federal and state combined) below the weighted average for the other G-7 economies. And it would close 60 percent of the gap between the United States’s combined statutory rate and the weighted average for the other 33 countries in the Organization for Economic Cooperation and Development.(8)
The president’s framework also addresses the other concern often cited by multinationals—that the current system imposes a “toll charge” on the repatriation of profits from abroad, preventing them from investing foreign profits in the United States. The so-called toll charge is not a special tax on repatriation but rather is the normal corporate tax that our system allows companies to defer paying, reduced by the amount of foreign taxes they have paid. It is dubious whether this residual U.S. tax truly poses an obstacle to investment in the United States, especially under current economic conditions.(9) But it probably does affect corporate financing decisions.(10)
Under the president’s framework, the so-called toll charge would be reduced in two ways. First, a lower corporate rate directly reduces the tax upon repatriation. If under the president’s framework, for example, a U.S. company earns business profits in the United Kingdom and pays a 26 percent U.K. rate, it would only pay a tiny 2 percent U.S. tax on repatriation—the regular 28 percent tax minus a foreign tax credit worth 26 percent.(11) If a company pays taxes at a higher rate in the foreign country, as it would in countries such as Japan and France, there would be no residual U.S. tax.
Second, the not-so-obvious way that the president’s framework reduces the toll charge is by ensuring that corporate income is subject to at least some minimal level of tax—either U.S. or foreign—when the income is first earned. Currently, for example, if a company shifts profits to tax-haven Bermuda and pays zero corporate taxes on them, the toll charge could be the full 35 percent rate because there would be no foreign tax credit available. This is precisely why the companies advancing a “repatriation” tax holiday are those that tend to have large profits in low-tax countries. But suppose Bermudan profits are subject to a 15percent to 20 percent minimum tax when earned. Upon repatriation of those profits, the company would only pay a modest additional tax of 8 percent to 13 percent—the lower 28 percent rate minus the 15 percent to 20 percent already paid.
Therefore, to the extent that the toll charge distorts the financing decisions of U.S. multinationals or deters investment in the United States, the president’s framework alleviates that problem in two significant ways.
In sum, the president’s framework substantially addresses the concerns raised by U.S. multinationals—even if it doesn’t exempt their foreign profits, as they would like.
Rejecting a “territorial” system
The president’s balanced framework contrasts with the approach advocated by lobbying groups representing U.S. multinationals and embraced by leading conservatives, including all of the major Republican presidential candidates. They would move the United States toward a “territorial” or “exemption” system that would fully exempt corporations’ overseas profits from U.S. tax.(12)
Moving in this direction—especially without other safeguards—would exacerbate the worst features of the corporate tax code. A “territorial” system would:
- Increase rather than decrease the incentives for locating investment overseas instead of in the United States
- Enhance the rewards for profit shifting to tax havens by removing the residual tax on repatriation
- Cost billions in lost revenue, unless done in tandem with other reforms that are not what most territorial advocates in the corporate community appear to have in mind(13)
To his credit, House Ways and Means Committee Chairman Rep. Dave Camp (R-MI) acknowledged the need to address profit shifting in a “discussion draft” on international tax reform that he introduced in October 2011 (the first part of what Rep. Camp says will be a larger tax reform proposal) and provided three potential options for doing so—albeit while moving to an exemption system that worsens the underlying problems.(14)
Conclusion
On international tax issues the president’s framework is a significant step forward toward reform. It focuses on and addresses the two most important issues—the bias for overseas investment and the draining of revenues through profit shifting. Further, it recognizes that there are broader national interests involved in international tax reform other than the competitiveness of U.S. multinationals in foreign markets, including boosting domestic investment and protecting our revenue base. At the same time, the president’s framework substantially addresses the major concerns raised by U.S. multinationals. It is a balanced approach that would be an enormous improvement over our current broken international tax system.
Seth Hanlon is Director of Fiscal Reform at American Progress.
(1) U.S. Department of the Treasury, The President’s Framework for Business Tax Reform: A Joint Report by the White House and Department of the Treasury (2012), p.13.
(2) U.S. Department of the Treasury, Report to the Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties (2007); Michael McDonald, “Income Shifting from Transfer Pricing: Further Evidence from Tax Return Data.” Technical Working Paper 2 (Department of Treasury, Office of Tax Analysis, 2008); United States Government Accountability Office, “U.S. Multinational Corporations: Effective Tax Rates Are Correlated with Where Income Is Reported” (August 2008); Martin A. Sullivan, “Extraordinary Profitability in Low-Tax Countries,” Tax Notes, August 25, 2008; Harry Grubert, “Intangible Income, Intercompany Transactions, Income Shifting, and the Choice of Location,” National Tax Journal 56 (1) (2003).
(3) Kimberly A. Clausing, “The Revenue Effects of Multinational Firm Income Shifting,” Tax Notes, March 28, 2011. Economist Martin Sullivan cites $28 billion annually as a “lower bound” estimate. See Martin A. Sullivan, Testimony before the Committee on Ways and Means, “Hearing on Transfer Pricing Issues in the Global Economy,” July 22, 2010.
(4) U.S. Department of the Treasury, The President’s Framework for Business Tax Reform, pp. 14-15.
(5) Ibid. See also U.S. Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals (2012), pp. 85-100.
(6) Reuven S. Avi-Yonah and Yaron Lahav, “The Effective Tax Rate of the Largest US and EU Multinationals.” Working Paper 25 (University of Michigan Public Law, 2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstractid=1949226; Jane G. Gravelle, “International Corporate Tax Rate Comparisons and Policy Implications” (Washington: Congressional Research Service, 2011).
(7) Eric Toder, “Who Competes Against Whom and for What” (Washington: Urban Institute, 2012), available at http://www.urban.org/publications/412477.html; J. Clifton Fleming, Robert J. Peroni, and Stephen E. Shay, “Worse Than Exemption,” Emory L.J. 59 (79) (2009): 117, available at http://www.law.emory.edu/fileadmin/journals/elj/59/59.1/FlemingPeroni_Shay.pdf.
(8) U.S. Department of the Treasury, The President’s Framework for Business Tax Reform, pp. 2-3.
(9) Large multinationals with substantial offshore profits are hardly cash constrained on the whole; they can borrow funds relatively cheaply nowadays and in fact are already holding high levels of cash. See Chuck Marr and Brian Highsmith, “Tax Holiday for Overseas Corporate Profits Would Increase Deficits, Fail to Boost the Economy, and Ultimately Shift More Investment and Jobs Overseas” (Washington: Center on Budget and Policy Priorities, 2011). Corporations have generally found numerous ways to repatriate foreign earnings free of tax under the current system. See Jesse Drucker, “Dodging Repatriation Tax Lets U.S. Companies Bring Home Cash,” Bloomberg, December 29, 2010. More commonly corporations can repatriate profits selectively from high-tax countries, which carry with them foreign tax credits that offset the residual U.S. tax while leaving profits in low-tax countries offshore. They can even use “excess” foreign tax credits from high-tax countries to offset the residual U.S. tax on repatriations from low-tax countries (so-called crosscrediting).
(10) Edward D. Kleinbard, “Stateless Income,” Fla. Tax Rev. 11 (699): 763-769.
(11) These examples ignore corporate taxes at the state level.
(12) Most “territorial” proposals retain a nominal amount of U.S. tax on repatriation, sometimes called a “haircut.” For example, the Camp proposal would retain a 1.25 percent tax.
(13) Some estimates have found that moving to a territorial tax system could actually raise revenue, but those estimates were based on the critical assumption that expense deductions apportioned to exempt foreign income would be denied. The territorial system that MNEs envision and are currently lobbying for does not have such a feature. See National Foreign Trade Council, Written Testimony for House Ways and Means Committee, “Hearing on the Need for Comprehensive Tax Reform to Help American Companies Compete in the Global Market and Create Jobs for American Workers,” May 26, 2011, available at http://www.nftc.org/default/Tax%20Policy/Statement%20for%20the%20Record%20to%20WMs%20Committee%20May%202011.pdf.
(14) House Ways and Means Committee, Discussion Draft §§ 331A-C, 112th Congress, October 26, 2011, available at http://waysandmeans.house.gov/taxreform/. Legislation introduced by Sen. Michael Enzi (R-WY) to exempt foreign profits also includes a provision to address low-taxed foreign income. See S. 2091, 112th Congress, § 201.