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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
  • What is a territorial tax and does the United States have one now?
  • 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

What is a territorial tax and does the United States have one now?

Taxes and Multinational Corporations

<7/11>
Q.

What is a territorial tax and does the United States have one now?

A.

Under a territorial tax, the United States would not tax profits earned overseas by US-resident corporations. The Tax Cuts and Jobs Act effectively exempted some of these profits, but retained taxation on some categories of foreign profits and imposed a new minimum tax on another.

When corporations based in one country earn profits from production in other countries, the countries involved must decide on the appropriate tax base. Such rules should prevent multiple layers of taxation from impeding international trade and investment flows while providing that corporate profits are taxable somewhere.

One option is a territorial tax system that taxes only the portion of a corporation’s income originating within the country’s borders. This prevents double taxation of cross-border flows because resident corporations’ foreign-source income is exempt from tax.

Another option is a worldwide system that taxes all domestic-source income, as well as the foreign-source income of resident corporations. To prevent double taxation, countries with worldwide systems allow their resident corporations to claim tax credits to offset their foreign income taxes. They also typically allow their resident companies to defer tax on active profits earned by foreign affiliates (controlled foreign corporations, or CFCs) until those profits are repatriated to the parent company. This feature of tax systems—known as deferral—substantially reduces effective tax rates on foreign-source income in countries with worldwide systems, making them not that different from territorial systems.

Territorial and worldwide systems would be the same if all countries had the same tax rates. Then, credits under a worldwide system would exactly offset otherwise-payable taxes on foreign-source income. But the systems are different if countries have different corporate tax rates. Territorial systems encourage a country’s resident multinational corporations to shift real investment and reported profits to low-tax foreign countries. Worldwide systems (with deferral) reduce this incentive because resident corporations pay the domestic tax rate when they repatriate profits earned in low-tax countries. But worldwide systems place resident corporations at a disadvantage compared with companies based in countries with territorial systems that impose no domestic tax on the profits their resident companies earn in low-tax foreign countries. Most countries have moved closer to territorial systems by eliminating taxation of the repatriated dividends their resident companies receive from their CFCs.

Implementing Territorial Taxation

Implementing territorial systems requires defining the source of a multinational corporation’s profits. This was straightforward when most profits were attributable to physical assets with a fixed location, such plant, equipment, and structures. Today, however, an increasing share of profits comes from returns to intangible assets, such as patents, trademarks, and copyrights. Firms in technology, pharmaceuticals, and other sectors have been able to reduce their tax liability by shifting ownership of and profits from intangible assets to low-tax jurisdictions where little real economic activity occurs. By charging affiliates in high-tax jurisdictions a royalty for these intangible assets, such firms lower their overall tax bills. Also, firms can often allocate corporate debt and overhead costs among jurisdictions in ways that reduce their tax burdens.

Countries have two basic strategies to prevent companies from eroding the domestic corporate tax base by assigning reported profits to low-tax foreign jurisdictions. The first approach is to enact detailed rules that define the source of profits. These include rules to determine the “transfer prices” companies can report on goods traded within a multinational group; rules for allocating interest, overhead, and research costs; and provisions to limit interest deductions on debt between related parties. The recent report on base erosion and profit shifting by the Organisation for Economic Co-operation and Development includes a long list of recommendations for how to curb income shifting.

The second approach applies limited worldwide taxation as a backup to territorial taxation. Most advanced countries have enacted so-called CFC rules that subject some forms of “passive” income (such as interest and dividends) their resident multinationals earn within CFCs to current taxation. The subpart F rules in the US Internal Revenue Code, enacted in 1962, are an example of such a provision. By taxing certain types of easy-to-shift income on a worldwide basis, CFC rules limit the benefit of income shifting. CFC rules, however, only apply to a country’s resident multinationals and therefore do not prevent foreign-resident companies from shifting profits earned within a country’s borders to low-tax jurisdictions.

The Current US Tax System

The current US system is a hybrid between a territorial and a worldwide system. The Tax Cuts and Jobs Act (TCJA) eliminated taxation of repatriated dividends but expanded taxation of income accrued within CFCs. The current system can be characterized as a territorial system for normal returns from foreign investment, defined in the US tax law as return of up to 10 percent on tangible assets, because these returns face no US corporate income tax. The result is that US companies investing overseas and foreign-resident companies from countries with territorial systems both pay only the local corporate income tax rate in countries where they place physical capital assets. In addition, US companies no longer have an incentive to avoid US taxation by contracting production to locally owned firms, as they would under worldwide taxation.

The new tax law, however, departs from territorial taxation in its treatment of intangible profits, which represent the bulk of profits for some of the largest US multinational corporations. Because TCJA eliminated the tax on repatriated dividends, it increased the rewards for income shifting: profits now not only accrue tax-free overseas, but are also tax-free when brought back to the US parent. To counter this, TCJA included GILTI, the tax on global intangible low-taxed income. This low-rate tax on intangible profits as they accrue reduces the incentive to shift these profits out of the United States.

Finally, the new tax law retains the long-standing rules in subpart F for taxing the passive income US firms accrue within their foreign affiliates. These rules, and similar rules in other countries, have long been viewed as a needed backstop to prevent base erosion in territorial systems.

Bottom line—the US system is a hybrid between a territorial and a worldwide system. It still retains some incentives of a pure territorial system to invest in lower-tax foreign countries instead of at home and to shift reported profits to lower-tax jurisdictions. And it still retains some features of a worldwide system that may place US multinationals at a competitive disadvantage compared with multinationals resident in other jurisdictions. But the hybrid nature of the system makes the problem of income shifting smaller than it would be in a pure territorial system and makes the competitiveness problem smaller than it would be in a pure worldwide system. And the lower 21 percent corporate rate in the new tax law makes both problems smaller than under the previous corporate rate of 35 percent.

Finally, the system continues to be extremely complex. How companies will adjust their behavior in response to revised incentives, how new Treasury regulations will affect these incentives, and how effective the IRS will be in enforcing the new rules remains to be seen.

Updated May 2020
Further Reading

Clausing, Kimberly A. 2020. "Profit Shifting Before and After the Tax Cuts and Jobs Act." January 20, 2020.

Gravelle, Jane G., and Donald J Marples. 2018. “Issues in International Corporate Taxation: The 2017 Revision (P.L. 115-97).” CRS Report R45186. Washington, DC: Congressional Research Service.

Grubert, Harry, and Rosanne Altshuler. 2013. “Fixing the System: An Analysis of International Proposals for Reform of International Tax.” National Tax Journal 66 (3): 671–712.

Organisation for Economic Co-operation and Development. 2018. OECD/G20 Inclusive Framework on BEPS: Progress Report July 2017–June 2018. Paris: OECD.

Shaviro, Daniel N. 2018. “The New Non-Territorial U.S. International Tax System.” Tax Notes. July 2.

Toder, Eric. 2017a. “Is a Territorial Tax System Viable for the United States?” Washington, DC: Urban-Brookings Tax Policy Center.

———. 2017b. “Territorial Taxation: Choosing among Imperfect Options.” AEI Economic Perspectives. Washington, DC: American Enterprise Institute.

  • ‹Read Previous What are inversions, and how will TCJA affect them?
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