International Taxation: What are the options for reform?
The current U.S. system of international taxation has four significant flaws: it provides artificial tax incentives for firms to locate real economic activity and report profits in low-tax countries; it places U.S.-headquartered firms at a competitive disadvantage; it is unworkably complex; and it raises relatively little revenue, even though the U.S. corporate tax rate exceeds that in most other advanced industrial countries.
Two proposed (and mutually exclusive) changes might improve the situation: the first would eliminate deferral of U.S. taxation on the foreign income of U.S.-based multinational firms, and the second would replace the current tax system with a territorial system that exempts foreign income from taxation altogether. A third option, formulary apportionment, would involve a more fundamental reform and is discussed in a separate brief.
- Eliminating deferral of U.S. taxation on unrepatriated income would substantially reduce the incentive to earn income in or shift profits to low-tax countries and would thus increase revenue. Presidential candidate John Kerry proposed a similar, but partial, change in 2004.
- Eliminating deferral could, however, reduce the international competitiveness of U.S.-based multinationals by increasing their tax disadvantage in low-tax markets relative to firms based in other countries. U.S. firms would face a greater incentive than under current law to shift their residence overseas, although Congress could try to discourage such inversions through legislative action. Competitiveness concerns could be allayed by combining elimination of deferral with a large, revenue-neutral reduction in the U.S. corporate income tax rate.
- Roseanne Altshuler and Harry Grubert have proposed a "burden-neutral worldwide taxation" plan that would tax all foreign income currently, would require no allocation of expenses to foreign income, and would lower the U.S. corporate tax rate to maintain the current overall tax burden on foreign income. This system would effectively end deferral for U.S. resident multinationals and thus dramatically reduce incentives to shift income.
- Altshuler and Grubert estimate that the U.S. corporate tax rate on foreign income would have to be cut to 28 percent (the top rate is now 35 percent) for their proposal to be burden neutral. This, however, is a "static" estimate that does not account for behavioral responses, such as changes in income shifting behavior or reduced incentives for firms to lower their foreign tax liability.
- The proposal would not completely eliminate incentives for foreign-based multinationals to shift income, and U.S. multinationals would still have an incentive to change the location of corporate ownership through inversions. In addition, U.S. multinational firms with excess foreign tax credits would still benefit from income shifting.
- A territorial system would exempt the foreign income of U.S. multinational firms from taxation. Such a system would likely enhance the competitiveness of U.S. firms in low-tax countries, potentially increasing the external benefits associated with multinationals’ activity in the United States.
- The most important argument against a territorial system is that, by exempting foreign income, it would reinforce an already strong tax incentive to locate both economic activity and profits in low-tax countries. Such tax-motivated changes in behavior are generally economically inefficient and could further erode the U.S. corporate income tax base.
- Depending on its design, a territorial system could bring in less tax revenue than the existing system. One recent study found evidence that, among industrial countries, those with territorial systems raise less corporate income tax revenue than countries with a tax credit system, all else equal. Harry Grubert and John Mutti have suggested that revenue could increase, however, if taxes are raised on interest and royalty income from abroad and interest allocation rules are changed.
- A territorial system could simplify taxation of international income, because exempting foreign income from taxation would reduce the need for tax planning regarding foreign income repatriation. However, firms under the new system would still have to distinguish between foreign and domestic income, identify passive income, and appropriately allocate expenses to their operations in different countries. In addition, stronger incentives to shift income would exert even greater pressure on existing transfer pricing rules.