How to fix Jeb’s plan for corporate tax reform

The corporate aspects of the tax plan recently announced by presidential candidate Jeb Bush are aimed at achieving the worthwhile goals of economic growth and job creation. However, these goals are likely be undermined by the plan’s treatment of foreign profits of U.S. multinationals and unrealistic projections of tax revenues from rate cuts.

Almost everyone would agree that the current U.S. system for taxing foreign profits of U.S. multinationals is seriously flawed. In theory, such profits are taxed by the U.S. at its standard corporate tax rate of 35 percent — one of the highest in the industrialized world. In fact, such profits are NOT subject to any U.S. corporate tax as long as they are held overseas. As a result, such profits of U.S. multinationals are effectively “trapped” overseas — they are generally not repatriated to build US plants, buy U.S. start-ups or pay dividends to their American shareholders.

The Plan on taxing PAST foreign profits of U.S. multinational is sensible — a one-time tax of 8.75 percent paid over a period of years. That could raise close to $180 billion in revenues. Since U.S. multinationals reasonably relied on the existing U.S. tax rules for foreign profits by holding them abroad, these corporations should be taxed at a modest rate on such past profits.

In the future, however, Jeb’s plan calls for a pure territorial system — foreign profits will be taxed only in the country where they are “earned.” This plan, if adopted, would strongly encourage U.S. multinationals to transfer their intellectual property (patents, copyrights and trademarks) — which can be moved easily at minimal cost — to tax havens, like the Bahamas, where they pay little or no corporate taxes.

The company could further lower its global tax burden by licensing this IP for a significant fee to its operating subsidiaries in countries with relatively high corporate tax rates, like Japan. The Japanese subsidiary would reduce its corporate taxes there by deducting licensing fees received in the Bahamas — where they would not be subject to corporate tax.

Although the U.S. tax code now includes various anti-abuse protections that limit such transfers and cross-licensing, these protections would all be eliminated if the U.S. adopted a pure territorial system for taxing foreign profits of U.S. multinationals, as Jeb’s plan would do. For this reason, other leading Republic tax thinkers — like former head the House Ways and Means Committee David Camp — suggested a minimum tax on corporate revenues related to IP. Jeb’s plan needs similar types of anti-abuse protections for IP income.

By contrast, manufacturing or research facilities of multinationals cannot be moved so easily; they have to be located in a country with skilled labor and well-developed infrastructure. To be attractive, many countries with relatively low corporate tax rates, including Switzerland and Singapore, are very willing to offer additional tax incentives, luring major U.S. multinationals with effective tax rates below 10 percent.

Suppose General Electric solicited bids to locate its new factories for wind turbines. In a territorial system, this bidding would turn into a “race to the bottom” — with the winning country almost certainly offering a corporate tax rate substantially below 10 percent and the U.S. rarely winning. To prevent such a race, the U.S. and other industrialized countries should recognize that these tax subsidies undermine free and fair trade so they should be limited by international trade agreements.

These bidding challenges would remain even if the U.S. corporate tax rate fell from 35 percent to 20 percent as Jeb proposes. Yet a 15 percent decrease in the corporate tax rate would cost the federal government approximately $1.8 TRILLION over 10 years. The already large federal debt would rise markedly if we reduced the corporate tax rate without replacing the lost revenue by closing down existing tax loopholes and preferences.

Despite once working on Wall Street, Jeb Bush boldly proposes to tax incentives fees earned by hedge fund managers as ordinary income rather than capital gains. While this change would hit those managers hard , it raises less than $20 billion in tax revenues over 10 years.

Even bolder, Jeb proposes to stop businesses from deducting most of the interest they pay on their debt — which unfortunately encourages corporations to take on too much debt and thereby increases the likelihood of bankruptcies. Moreover, allowing deductions for interest, but not for dividends on stock, distorts the capital allocation process — it particularly hurts newer firms without hard assets to back loans. And putting strict limits on corporate interest deductions would raise a lot of tax revenue — perhaps as high as $600 billion in 10 years.

However, these limits on interest deductions are paired by Jeb’s plan with a big revenue loser — “expensing” all corporate investments in the first year, instead of spreading these deductions across their useful life as we now do. For instance, if Google spent $15 billion on an electric car factory with a useful life of 15 years, the company would currently be permitted to deduct on average $1 billion per year for 15 years. Under Jeb’s plan, by contrast, Google would be allowed to deduct the full $15 billion in the initial year of the factory’s operation.

The immediate deduction of all capital spending reflects an economic philosophy of taxing consumption rather than investment. However, in my view, expensing of capital investments should be retained and expanded only for small businesses — on fairness grounds. Most small businesses would not benefit from a sharp reduction in the corporate tax rate because they are generally not corporations. Instead, most small businesses are organized as pass-through partnerships from a tax perspective and do not pay a corporate tax as an entity.

In short, I would embrace the two revenue raisers in Jeb’s plan, expand expensing only for small businesses, and reduce the corporate tax rate from 35 to 25 percent. That 10 percent rate reduction would cost roughly $1.2 trillion over 10 years — a feasible number without the expensing of all capital investments. The rest of the plan raises roughly $800 billion in tax revenues over 10 years — $180 billion from the one-time tax on past foreign profits, $20 billion from taxing incentives fees as ordinary income and $600 billion by strict limits on interest deductions.

Jeb would have to find another $400 billion in revenue raisers to offset a corporate rate reduction from 35 to 25 percent. These might include spreading out deductions for advertising, moving to different tax accounting for inventory, and eliminating tax preferences that mainly benefit one industry or set of firms. Although these reforms will not be easy politically, they are worth the effort to make the Plan into a fiscally realistic proposal.

Editor’s Note: This post originally appeared on Real Clear Markets.