What are the options for reforming our international tax system?
On its face, reforms that would remove the incentive for US corporations to move abroad and lower corporate tax rates to make US corporate activity more competitive seem straightforward. In fact, unraveling the Gordian knot created by taxation-as-usual would be far from simple.
Flaws of Current US International Tax Rules
There’s seemingly no end to complaints about the impact of the US corporate tax in the context of an increasingly integrated global economy. Among them are the following:
Deferral of foreign-source income until it is repatriated encourages multinationals to locate business activity and to report profits in low-tax countries.
The taxation of foreign-source income of US-based firms when repatriated, along with the controlled foreign corporation (CFC) rules that tax some foreign-source income as it is accrued, place US-resident multinationals at a competitive disadvantage with firms resident in countries that exempt most foreign-source income and have weaker CFC rules.
The timing of tax liability when income is repatriated, combined with rules that allow US firms to report their accumulated foreign profits as permanently invested overseas, have in recent years encouraged US resident multinationals to accumulate substantial assets abroad, some of which could be more effectively deployed if invested in the United States or paid as dividends to shareholders.
The complexity of the various rules apportioning income by jurisdiction and preventing tax avoidance by limiting deferral and the use of offsetting foreign tax credits raise compliance costs. Yet they still offer substantial opportunities for legal tax avoidance.
Taxes on foreign-source income of US multinationals raise relatively little revenue, even though the US corporate tax rate exceeds the tax rate in other countries in which US firms report profits.
Reform Option: Elimintate Deferral
Eliminating the deferral of US tax liability on the non-repatriated foreign-source income of US-based multinationals would increase revenue and substantially reduce firms’ incentives to earn income in (or to shift profits to) low-tax countries. However, eliminating deferral could put US-based multinationals at an additional competitive disadvantage by raising the tax rate they pay on income earned in low-tax countries compared with taxes paid by foreign-based multinationals. And that, in turn, would create greater incentives for US firms to change their tax residence through mergers with foreign-based firms.
Congress could enact additional rules to discourage these “inversion” transactions. But they could not foreclose every option that allows US firms to shift corporate activity to foreign-resident multinationals.
Competitiveness concerns could be allayed, but only in part, by combining the elimination of deferral with a large (but still revenue-neutral) reduction in the US corporate income tax rate. Indeed, that is the centerpiece of tax reform plans introduced by Senate Finance Committee ranking Democrat Ron Wyden along with current and former Republican senators Dan Coats and Judd Gregg. It would have eliminated deferral while substantially reducing the top corporate tax rate.
Reform Option: Territorial System
A territorial system would exempt the foreign income of US multinational firms from US taxation. Such a system would likely enhance the competitiveness of US-based multinationals compared with foreign-based firms and reduce (but not entirely eliminate) the incentive for inversions.
The most important argument against a territorial system is that by exempting foreign income, it would reinforce the already strong tax incentive to locate economic activity and to report profits in low-tax countries. Such tax-motivated changes in behavior are generally economically inefficient and could further erode the US corporate income tax base.
That’s a fair point: Depending on its design, a territorial system could bring in less tax revenue than the existing system. Harry Grubert and John Mutti (2007) have suggested, however, that revenue could actually increase under a territorial system if royalty income from abroad were defined as domestic-source income and interest allocation rules were changed.
A territorial system could simplify taxation of international income because exempting foreign income from taxation would reduce the sort of tax planning now needed to optimize the use of foreign tax credits to shield repatriated foreign income from US taxes. However, under the new system, firms would still have to distinguish between foreign and domestic income, identify passive income that is subject to CFC rules, and appropriately allocate expenses to their operations in different countries. In addition, the stronger incentives to shift income produced by eliminating the repatriation tax would further strain the rules in place to prevent bogus profit shifting through inappropriate transfer pricing.
Reform Option: Improved Hybrid System
President Obama and congressional leaders from both parties have proposed variants of a “hybrid” system that would continue to impose a lower effective tax rate on foreign-source income than domestic-source income of US multinationals but eliminate the tax on repatriated profits. These proposals, while different, have three main elements in common:
They would eliminate taxation of repatriated foreign-source profits of US multinational corporations.
They would impose a one-time transition tax on currently accrued overseas profits of US multinationals, to be collected over several years.
Going forward, they would impose a low rate tax on accrued foreign-source “intangible” profits of US multinationals in order to discourage the sort of income-shifting to low-tax countries that a pure territorial system would encourage.
On the plus side, the hybrid proposals would remove the incentive for US corporations to accrue assets overseas by eliminating taxation upon repatriation. But they would not resolve the tension between reducing the incentive for US companies to invest and report income overseas and improving the competitiveness of US-based multinationals. Depending on design details, a proposal in this form could either raise or lower the effective tax rate on foreign-source income.
Reform Option: Destination-Based Taxes
A more fundamental reform option would replace the current corporate income tax with a destination-based tax. A destination-based tax is based on where a corporation’s products are purchased rather than where they are produced, where the corporation is located, or where the corporation records its income. The major benefits of a destination-based tax from an international point of view is that it would eliminate incentives under the U.S. corporate income tax for firms to invest and report income overseas instead of at home and eliminate incentives for U.S. firms to “re-domicile” themselves as foreign-based firms.
Some examples of destination based taxes are a value added tax (VAT) or a business cash-flow tax. Under a VAT, border adjustments would impose the tax on imports but exempt exports by rebating any VAT previously collected at earlier stages of production. Under a destination-based business cash-flow tax border adjustments would exempt export sales from tax and not allow firms to deduct the cost of imports. The destination-based cash flow tax, however, raises its own issues, including whether the border adjustments would be acceptable to the World Trade Organization and whether it would be politically feasible to pay large rebates to export firms who would experience tax losses under the plan and impose large new taxes on importers.
Altshuler, Rosanne, and Jonathan Z. Ackerman. 2005. “International Aspects of Recommendations from the President’s Advisory Panel on Federal Tax Reform.” Presentation for the International Tax Policy Forum, December 2.
Altshuler, Rosanne, and Harry Grubert. 2006. “Corporate Taxes in the World Economy: Reforming the Taxation of Cross-Border Income.” Working paper 2006-26. New Brunswick, NJ: Rutgers University.
Auerbach, Alan J. 2010. “A Modern Corporate Tax.” Center for American Progress and the Hamilton Project. December.
Grubert, Harry, and Rosanne Altshuler. 2013. “Fixing the System: An Analysis of Alternative Proposals for Reform of International Tax.” National Tax Journal 66 (3): 671–712.
Grubert, Harry, and John Mutti. 2001. Taxing International Business Income: Dividend Exemption versus the Current System. Washington, DC: American Enterprise Institute for Public Policy Research.
———. 2007. The Effect of Taxes on Royalties and the Migration of Intangible Assets Abroad. National Bureau of Economic Research working paper 13248. Cambridge, MA: National Bureau of Economic Research.
Kleinbard, Edward D. 2015. “Why Corporate Reform Can Happen.” Tax Notes. April 6.