International Taxation: How does the current system of international taxation work?
The federal government taxes U.S. resident multinational firms on their worldwide income, at the same rates as purely domestic firms. (The current maximum U.S. corporate tax rate is 35 percent.) U.S. multinationals may claim a tax credit for taxes paid to foreign governments on income earned abroad, but only up to their U.S. tax liability on that income. Firms may, however, take advantage of cross-crediting, using excess credits from income earned in high-tax countries to offset U.S. tax due on income earned in low-tax countries.
U.S. multinationals generally pay tax on the income of their foreign subsidiaries only when they repatriate the income, a delay of taxation termed deferral. Deferral, the credit limitation, and cross-crediting all provide strong incentives for firms to shift income from the United States and other high-tax countries to low-tax countries.
Suppose, for example, a U.S.-based multinational firm facing the 35 percent maximum corporate income tax rate earns $800 in profits on its Irish subsidiary (figure 1). The 12.5 percent Irish corporate tax reduces the after-tax profit to $700. Suppose the firm then repatriates $70 of this profit and reinvests the remaining $630 in its Irish operations. The firm must then pay U.S. tax on a base of $80 (the $70 plus the $10 in Irish tax paid on that portion of its profits), or $28, but it claims a credit for the $10 Irish tax, leaving a net U.S. tax of $18. If the firm has excess foreign tax credits from operations in high-tax countries, it can offset more, possibly all, of the U.S. tax due on its repatriated Irish profit. Meanwhile deferral allows the remaining profit ($630) to grow abroad free of U.S. income tax until it is repatriated.
- Some countries (such as the United Kingdom and Japan) use a worldwide system with a foreign tax credit similar to the U.S. system. Others (such as France and the Netherlands) use a territorial system that exempts foreign income from taxation. Still others have hybrid systems that, for example, exempt foreign income only if the foreign country’s tax system is similar to that in the home country. In theory, such an exemption system provides an even stronger incentive than a pure worldwide system to earn income in low-tax countries, but some analysts argue that cross-crediting and deferral blur the distinction between these two systems.
- The U.S. statutory corporate tax rate has changed little since 1986. Meanwhile most other advanced industrial countries have lowered their tax rates, with the result that the U.S. rate is now substantially higher than the average tax rate among member countries of the Organization for Economic Cooperation and Development (OECD; figure 2).
- Despite its relatively high corporate tax rate, the United States raises less revenue from corporate income taxes as a share of GDP than other countries in the OECD. In recent years, revenue has increased as a share of GDP in most OECD countries because base-broadening measures that subject more income to tax have more than offset lower tax rates. In the United States, revenue from the corporate income tax declined sharply in the most recent recession (2000-2002), but has since rebounded as corporate profits have surged. The U.S. share of corporate revenues in GDP remains relatively low, however, because of a narrower corporate tax base compared with other countries, an increasing share of business activity originating in businesses not subject to corporate tax (partnerships and subchapter S corporations) and increased incentives to shift reported income outside the United States to avoid the relatively high U.S. corporate tax rate.
- The American Jobs Creation Act of 2004 replaced existing tax subsidies for exporting with new corporate tax benefits. Most prominent is the domestic production deduction, which effectively lowers the corporate tax rate by 3 percentage points on income from the domestic production activities of U.S. firms. A temporary 5.25 percent tax rate on dividend repatriations from low-tax countries provided a substantial one-year incentive to repatriate funds from such countries. Other provisions permanently reduced the taxation of foreign-source income by facilitating cross-crediting and changing the rules governing how interest expense is allocated across the countries in which a firm operates.