The current system for taxing the international profits of U.S. corporations is highly flawed. It raises very little revenue and encourages companies not to invest in the United States. But Democrats and Republicans disagree about how to fix the broken system.
Current tax policy penalizes corporations when they reinvest their foreign profits in the United States. Corporations currently pay the 35 percent U.S. tax rate on the profits of their foreign subsidiaries, but they can defer those taxes until they bring those profits back to the United States.
Even though a corporation is eligible for a tax credit equal to foreign taxes paid, the decision to repatriate earnings typically requires that corporation to incur a significant tax cost. As a result, corporations usually find it more attractive to defer U.S. taxation by reinvesting their foreign earnings abroad.
One proposed fix, a temporary tax holiday for repatriated profits, is a bad idea. In 2005, corporations were allowed to repatriate their foreign earnings at a tax rate of 5.25 percent. Corporations did indeed bring home over $300 billion in foreign profits that year, five times as much as normal. But very little of that income was reinvested in the United States to create jobs: a National Bureau of Economic Research study suggested that a majority of that income went to shareholders, mostly in the form of share buybacks.
Even worse, another tax holiday would cause corporations to conclude that Congress would allow further tax holidays in the future. This would likely lead corporations to hold cash abroad and wait to repatriate their income until the next tax holiday comes along.
Many Republicans have called for a more fundamental transition to what’s known as a “territorial system” for international taxation. Under such a system, foreign-source income would be taxed only in the country where it was earned, and would not be taxed at all by the United States. This approach would reduce the tax burden on American corporations and eliminate the disincentive for corporations to repatriate their foreign profits.
Arguments in favor of a territorial system are based on the premise that profits should not be taxed twice. However, Democrats point out that certain profit would not be taxed at all under a territorial system.
In particular, corporations can fairly easily shift earnings attributable to intangible sources-patents, brand names, or know-how-to tax havens that collect little or no tax. Under a territorial tax system, the U.S. would never collect taxes on that income either.
Although existing tax laws try to prevent such shifting, they are imperfect at best. An IRS study found that U.S. corporations’ subsidiaries in Bermuda reported income in 2004 equal to a whopping 646 percent of Bermuda’s GDP. Presumably, most of that profit was actually earned in a higher-tax jurisdiction; U.S. corporate profits are roughly equal to 10 percent of U.S. GDP.
To address the income-shifting problem, President Obama has called for an “international minimum tax.” Under his proposal, all income of U.S. corporations must be immediately taxed-by the U.S., or some foreign country – at a rate greater than or equal to the (as yet unspecified) international minimum tax rate. So, if a corporation reported profits in a country that collects no corporate tax, the United States would immediately tax those profits at the international minimum tax rate-greatly reducing the appeal of the tax haven.
Though the territorial tax system and Obama’s proposed international minimum tax represent vastly different policy objectives, a combination of the two could result in a plausible, coherent compromise position. Here’s how it should work:
First, we should adopt the GOP-favored territorial tax system for profits reported in any country that taxes corporate profits at an average effective rate above some minimum threshold, approximately 15 to 18 percent. With that threshold, U.S. corporations would no longer incur an additional tax burden when repatriating profits from most countries where they legitimately conduct business.
Second, we should adopt President Obama’s proposed “international minimum tax,” equal to that 15 to 18 percent threshold, to minimize profit shifting. Corporations should still be allowed to claim a credit against any actual foreign taxes paid; if a corporation paid 13 percent in taxes to, say, Switzerland, it should only owe to the U.S. the difference between 13 percent and the international minimum tax rate.
In combination, such a compromise would ensure that all foreign profits of U.S. corporations are taxed consistently at a reasonable rate. If foreign profits were reasonably taxed by a legitimate tax-collecting country, such as France, Brazil, or Japan, they would be taxed only by that country. But if other foreign profits were allocated to a tax haven, they would be taxed, at a reasonable rate, by the United States.
Such a policy would require transition rules. Specifically, we should allow corporations to repatriate any existing profits currently held overseas at a low rate, such as 10 percent-not as a one-off repatriation holiday, but rather a transition to a better, permanent approach. Such a transition is needed because it would be unfair to suddenly impose a 15 to 18 percent tax on what had previously been a perfectly legitimate strategy.
In short, no one likes our current system of taxing the foreign profits of U.S. corporations. However, there is little agreement between Republicans and Democrats on reforming this system. Fortunately, we can achieve both parties’ policy priorities by combining their two best ideas: a territorial tax system for legitimate tax-collecting nations, and an international minimum tax rate for those nations which collect little corporate tax. Such a policy would be fairer, raise more revenue, and encourage corporations to invest in the United States.