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The Tax Policy Center's

Briefing Book

A citizen’s guide to the fascinating (though often complex) elements of the US tax system.

Tax Policy Center Briefing Book

Key Elements of the U.S. Tax System

  • Briefing Book
  • Taxes and Multinational Corporations
  • How would formulary apportionment work?
  • Chapters
    • Introduction
      • Introduction
        • Introduction
    • Some Background
      • Federal Budget
        • What are the sources of revenue for the federal government?
        • How does the federal government spend its money?
        • What is the breakdown of revenues among federal, state, and local governments?
        • How do US taxes compare internationally?
      • Federal Budget Process
        • How does the federal budget process work?
        • What is the history of the federal budget process?
        • What is the schedule for the federal budget process?
        • What is reconciliation?
        • How is a budget resolution enforced?
        • What is PAYGO?
        • What are rescissions?
      • Federal Budget Outlook
        • How accurate are long-run budget projections?
        • What have budget trends been over the short and long term?
        • How much spending is uncontrollable?
        • What are tax extenders?
        • What options would increase federal revenues?
        • What does it mean for a government program to be off-budget?
        • How did the TCJA affect the federal budget outlook?
      • Taxes and the Economy
        • How do taxes affect the economy in the short run?
        • How do taxes affect the economy in the long run?
        • What are dynamic scoring and dynamic analysis?
        • Do tax cuts pay for themselves?
        • On what do economists agree and disagree about the effects of taxes on economic growth?
        • What are the economic effects of the Tax Cuts and Jobs Act?
      • Economic Stimulus
        • What is the role of monetary policy in alleviating economic downturns?
        • What are automatic stabilizers and how do they work?
        • What characteristics make fiscal stimulus most effective?
      • Distribution of Tax Burdens
        • How are federal taxes distributed?
        • Are federal taxes progressive?
        • How should progressivity be measured?
        • What is the difference between marginal and average tax rates?
        • What criticisms are levied against standard distributional analysis?
        • How should distributional tables be interpreted?
        • Who bears the burden of the corporate income tax?
        • Who bears the burden of federal excise taxes?
        • How do financing methods affect the distributional analyses of tax cuts?
        • How do taxes affect income inequality?
      • Tax Expenditures
        • What are tax expenditures and how are they structured?
        • What is the tax expenditure budget?
        • Why are tax expenditures controversial?
        • What are the largest tax expenditures?
        • How did the TCJA affect tax expenditures?
      • Tax Gap and Tax Shelters
        • What is the tax gap?
        • What does the IRS do and how can it be improved?
        • What is a tax shelter?
      • Recent History of the Tax Code
        • What did the 2008–10 tax stimulus acts do?
        • What did the American Taxpayer Relief Act of 2012 do?
        • How did the Tax Cuts and Jobs Act change personal taxes?
        • How did the Tax Cuts and Jobs Act change business taxes?
    • Key Elements of the U.S. Tax System
      • Individual Income Tax
        • What is the standard deduction?
        • What are itemized deductions and who claims them?
        • How did the TCJA change the standard deduction and itemized deductions?
        • What are personal exemptions?
        • How do federal income tax rates work?
        • What are tax credits and how do they differ from tax deductions?
        • How do phaseouts of tax provisions affect taxpayers?
      • Capital Gains and Dividends
        • How are capital gains taxed?
        • What is the effect of a lower tax rate for capital gains?
        • What is carried interest, and how is it taxed?
        • How might the taxation of capital gains be improved?
      • AMT
        • What is the AMT?
        • Who pays the AMT?
        • How much revenue does the AMT raise?
        • How did the TCJA change the AMT?
      • Taxes and the Family
        • What is the child tax credit?
        • What is the adoption tax credit?
        • What is the earned income tax credit?
        • Do all people eligible for the EITC participate?
        • How does the tax system subsidize child care expenses?
        • What are marriage penalties and bonuses?
        • How did the TCJA change taxes of families with children?
      • Taxes and the Poor
        • How does the federal tax system affect low-income households?
        • What is the difference between refundable and nonrefundable credits?
        • Can poor families benefit from the child tax credit?
        • Why do low-income families use tax preparers?
        • How does the earned income tax credit affect poor families?
        • What are error rates for refundable credits and what causes them?
        • How do IRS audits affect low-income families?
      • Taxes and Retirement Saving
        • What kinds of tax-favored retirement arrangements are there?
        • How large are the tax expenditures for retirement saving?
        • What are defined benefit retirement plans?
        • What are defined contribution retirement plans?
        • What types of nonemployer-sponsored retirement savings accounts are available?
        • What are Roth individual retirement accounts?
        • Who uses individual retirement accounts?
        • How does the availability of tax-favored retirement saving affect national saving?
        • What’s the difference between front-loaded and back-loaded retirement accounts?
        • What is an automatic 401(k)?
        • How might low- and middle-income households be encouraged to save?
      • Taxes and Charitable Giving
        • What is the tax treatment of charitable contributions?
        • What entities are tax-exempt?
        • Who benefits from the deduction for charitable contributions?
        • How would various proposals affect incentives for charitable giving?
        • How large are individual income tax incentives for charitable giving?
        • How did the TCJA affect incentives for charitable giving?
      • Taxes and Health Care
        • How much does the federal government spend on health care?
        • Who has health insurance coverage?
        • Which tax provisions subsidize the cost of health care?
        • How does the tax exclusion for employer-sponsored health insurance work?
        • What are premium tax credits?
        • What tax changes did the Affordable Care Act make?
        • How do health savings accounts work?
        • How do flexible spending accounts for health care expenses work?
        • What are health reimbursement arrangements and how do they work?
        • How might the tax exclusion for employer-sponsored health insurance (ESI) be reformed?
      • Taxes and Homeownership
        • What are the tax benefits of homeownership?
        • Do existing tax incentives increase homeownership?
      • Taxes and Education
        • What tax incentives exist for higher education?
        • What tax incentives exist to help families pay for college?
        • What tax incentives exist to help families save for education expenses?
        • What is the tax treatment of college and university endowments?
      • Tax Complexity
        • Why are taxes so complicated?
        • What are the benefits of simpler taxes?
        • What policy reforms could simplify the tax code?
      • Wealth Transfer Taxes
        • How do the estate, gift, and generation-skipping transfer taxes work?
        • Who pays the estate tax?
        • How many people pay the estate tax?
        • What is the difference between carryover basis and a step-up in basis?
        • How could we reform the estate tax?
        • What are the options for taxing wealth transfers?
        • What is an inheritance tax?
      • Payroll Taxes
        • What are the major federal payroll taxes, and how much money do they raise?
        • What is the unemployment insurance trust fund, and how is it financed?
        • What are the Social Security trust funds, and how are they financed?
        • Are the Social Security trust funds real?
        • What is the Medicare trust fund, and how is it financed?
      • Excise Taxes
        • What are the major federal excise taxes, and how much money do they raise?
        • What is the Highway Trust Fund, and how is it financed?
      • Energy and Environmental Taxes
        • What tax incentives encourage energy production from fossil fuels?
        • What tax incentives encourage alternatives to fossil fuels?
        • What is a carbon tax?
      • Business Taxes
        • How does the corporate income tax work?
        • What are pass-through businesses?
        • How are pass-through businesses taxed?
        • Is corporate income double-taxed?
      • Tax Incentives for Economic Development
        • What is the new markets tax credit, and how does it work?
        • What is the Low-Income Housing Tax Credit and how does it work?
        • What are Opportunity Zones and how do they work?
      • Taxes and Multinational Corporations
        • How does the current system of international taxation work?
        • How do US corporate income tax rates and revenues compare with other countries’?
        • What are the consequences of the new US international tax system?
        • How does the tax system affect US competitiveness?
        • How would formulary apportionment work?
        • What are inversions, and how will TCJA affect them?
        • What is a territorial tax and does the United States have one now?
        • What is the TCJA repatriation tax and how does it work?
        • What is the TCJA base erosion and anti-abuse tax and how does it work?
        • What is global intangible low-taxed income and how is it taxed under the TCJA?
        • What is foreign-derived intangible income and how is it taxed under the TCJA?
    • How Could We Improve the Federal Tax System?
      • Comprehensive Tax Reform
        • What is comprehensive tax reform?
        • What are the major options for comprehensive tax reform?
      • Broad-Based Income Tax
        • What is a broad-based income tax?
        • What would and would not be taxed under a broad-based income tax?
        • What would the tax rate be under a broad-based income tax?
      • National Retail Sales Tax
        • What is a national retail sales tax?
        • What would and would not be taxed under a national retail sales tax?
        • What would the tax rate be under a national retail sales tax?
        • What is the difference between a tax-exclusive and tax-inclusive sales tax rate?
        • Who bears the burden of a national retail sales tax?
        • Would tax evasion and avoidance be a significant problem for a national retail sales tax?
        • What would be the effect of a national retail sales tax on economic growth?
        • What transition rules would be needed for a national retail sales tax?
        • Would a national retail sales tax simplify the tax code?
        • What can state and local sales taxes tell us about a national retail sales tax?
        • What is the experience of other countries with national retail sales taxes?
        • What did the President’s Advisory Panel on Federal Tax Reform say about the national retail sales tax?
      • Value Added Tax (VAT)
        • What is a VAT?
        • How would a VAT be collected?
        • What would and would not be taxed under a VAT?
        • What would the tax rate be under a VAT?
        • What is the difference between zero rating and exempting a good in the VAT?
        • Who would bear the burden of a VAT?
        • Is the VAT a money machine?
        • How would small businesses be treated under a VAT?
        • What is the Canadian experience with a VAT?
        • Why is the VAT administratively superior to a retail sales tax?
        • What is the history of the VAT?
        • How are different consumption taxes related?
      • Other Comprehensive Tax Reforms
        • What is the flat tax?
        • What is the X-tax?
      • Recent Comprehensive Tax Reform Proposals
        • Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System, Report of the President’s Advisory Panel on Federal Tax Reform, November 2005
        • The Moment of Truth: Report of the National Commission on Fiscal Responsibility and Reform, December 2010
        • Debt Reduction Task Force, “Restoring America’s Future,” Bipartisan Policy Center, November 2010
        • The Tax Reform Act of 2014: Fixing Our Broken Tax Code So That It Works for American Families and Job Creators, House Ways and Means Committee
        • The Graetz Competitive Tax Plan, Updated for 2015
      • Return-Free Tax Filing
        • What is return-free filing and how would it work?
        • What are the benefits of return-free filing?
        • What are the drawbacks of return-free filing?
        • How would the tax system need to change with return-free filing?
        • Who would qualify for return-free filing?
        • Would return-free filing raise taxes?
        • What was the experience with return-free filing in California?
        • What other countries use return-free filing?
    • The State of State (and Local) Tax Policy
      • State and Local Revenues
        • What are the sources of revenue for state governments?
        • What are the sources of revenue for local governments?
      • Specific State and Local Taxes
        • How do state and local individual income taxes work?
        • How do state and local sales taxes work?
        • How do state and local property taxes work?
        • How do state and local corporate income taxes work?
        • How do state estate and inheritance taxes work?
        • How do state earned income tax credits work?
        • How do state and local severance taxes work?
        • How do state and local soda taxes work?
        • How do marijuana taxes work?
      • Fiscal Federalism and Fiscal Institutions
        • How does the deduction for state and local taxes work?
        • What are municipal bonds and how are they used?
        • What types of federal grants are made to state and local governments and how do they work?
        • What are state rainy day funds, and how do they work?
        • What are tax and expenditure limits?
        • What are state balanced budget requirements and how do they work?
    • Glossary
      • Glossary
        • Glossary

How would formulary apportionment work?

Taxes and Multinational Corporations

<5/11>
Business Taxes
Q.

How would formulary apportionment work?

A.

Under the current global system, multinational firms determine their profits separately in each tax jurisdiction in which they operate. An alternative system would allocate a firm’s worldwide income across countries using a formula based on some combination of its sales, assets, and payroll in each jurisdiction.

HOW FORMULARY APPORTIONMENT WORKS

Under formulary apportionment, a multinational corporation would allocate its profits across countries based on its sales, payroll, and capital base in each jurisdiction. The corporation would pay US corporate tax on the share of its worldwide income allocated to the United States. An alternative formula would base a corporation’s US taxes only on the fraction of its worldwide sales destined for domestic consumers, a so-called “destination-based” corporate profits tax.

Many states in the United States use a formulary apportionment system to determine their taxable share of US-source corporate profits. The formulas have been historically based on a weighted average of the shares of sales, payroll, and assets in the state. But some states have shifted to a sales-only apportionment system to remove any incentive to shift employees or facilities to other jurisdictions.

The adoption of formulary apportionment by states was motivated by the widespread perception that states are so highly integrated economically that it is impractical to determine using a separate-entity system how much of a firm’s income is earned by an affiliate in one state and how much by an affiliate in another.

ADVANTAGES OF FORMULARY APPORTIONMENT

Formulary apportionment would remove the current artificial incentive for multinationals to shift reported income to low-tax locations. Tax liabilities, instead, would be allocated by a measure (or measures) of their real economic activity in each location. These measures are far more difficult to manipulate for tax purposes than the division of profits among separate entities within a firm.

Formulary apportionment would also reduce the tax system’s complexity and the administrative burden it imposes on firms. Firms would no longer have to allocate income or expenses across countries for tax purposes. Because intra-firm transactions would not affect the measure of domestic profits, there would be no need for transfer-pricing rules for intra-firm transactions, which would remove a major source of dispute between corporations and tax authorities.

There would also no longer be a need for controlled foreign corporation rules because all profits assigned to foreign activities would be exempt. For this reason, there would also no longer be a need for foreign tax credits, so firms with deemed profits from intangible assets (GILTI) would have no incentive to earn taxable profits in high-tax foreign countries to increase the availability of offsetting tax credits in low-tax countries.

Absent behavioral responses, the United States and countries with similar tax rates would gain revenue under formulary apportionment: firms’ shares of real economic activity in these countries typically exceed the shares of income they now report as originating there instead of in tax havens. The move to formulary apportionment could therefore be made revenue neutral by reducing corporate tax rates. Moreover, formulary apportionment would make a multinational corporation’s tax liability independent of both its legal residence and its legal form (for example, branch or subsidiary). Formulary apportionment would thus remove any incentive for corporate inversions in which firms from two countries merge and establish their residence in a low-tax country to reduce their tax liabilities.

PROBLEMS AND DISADVANTAGES OF FORMULARY APPORTIONMENT

Significant issues, however, emerge in designing and implementing a global formulary apportionment system. And such a system would create new incentives for tax avoidance and could increase the incentive to shift real investments to low-tax countries.

Formulary apportionment would require an agreement among the major economies to scrap the current separate-entity system and to agree on how to allocate corporate income among jurisdictions. It would also require agreement on common accounting methods for measuring corporate profits.

A unilateral move by the United States to formulary apportionment would result in double taxation of some multinationals’ income and exemption of other income. That’s because different countries would use radically different methods of allocating income among jurisdictions.

A formulary apportionment system would introduce new boundary problems between high-tax and low-tax activities. While the current separate-entity system creates incentives to shift reported profits among firms within a multinational corporation, formulary apportionment provides incentives to shift profits between multinationals and separately owned firms. For example, if physical assets help determine the location of a multinationals’ profits, a firm might well have an incentive to contract its low-margin manufacturing activities in high-tax jurisdictions to independently owned firms instead of establishing a manufacturing subsidiary within the firm to reduce its share of capital assets allocated to high-tax countries.

Further, formulary apportionment could worsen the incentive to shift real activities to low-tax countries because intangible assets—a large share of value for many leading multinational companies—are part of a firm’s total profits but are absent from the allocation formula. Intangible assets magnify the effects on the firm’s tax liability of putting more real capital in low-tax countries. They increase the share of both the firm’s return to real capital and its return to the intangible profits taxed at lower rates.

Some analysts and commentators favor sales- or destination-based allocation of corporate profits because firms are least likely to reduce sales in a jurisdiction simply to reduce tax liability. A problem with a sales-based allocation, however, is that multinationals can then avoid tax on the profits from their intangible assets by selling their products to independent distributors in low-tax countries, who would then resell them throughout the world. Although rules could be written to prevent such abuses, they would be cumbersome and hard to enforce. Most multinationals sell most of their output primarily to other companies in complex supply chains rather than directly to final consumers.

A modified version of the sales-based allocation approach would combine a separate entity approach with transfer pricing to allocate a company’s routine profits among countries with a sales-based formula allocation approach for allocating so-called “residual” profits. This Organisation of Economic Cooperation and Development (OECD) has released a public consultation document describing an approach of this type as Pillar One of a new effort to reform global rules for allocating profits of multinational corporations.

Updated May 2020
Further Reading

Altshuler, Rosanne, and Harry Grubert. 2010. “Formula Apportionment: Is It Better Than the Current System and Are There Better Alternatives?” National Tax Journal 63 (4): 1145–84.

Avi-Yonah, Reuven S., and Kimberly A. Clausing. 2007. “Reforming Corporate Taxation in a Global Economy: A Proposal to Adopt Formulary Apportionment.” Discussion paper. Washington, DC: The Hamilton Project.

Devereux, Michael. 2016. “Residual Profit Allocation Proposal.” Presentation at Urban-Brookings Tax Policy Center conference “A Corporate Tax for the 21st Century,” Washington, DC, July 14.

Graetz, Michael, and Rachael Doud. 2013. “Technological Innovation, International Competition, and the Challenges of International Income Taxation.” Columbia Law Review 113 (3): 347–446.

OECD. 2019. "Secretariat Proposal for a "Unified Approach" under Pillar One." Public consultation document. 9 October-12 November.

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