Donald Trump’s campaign to become the next president of the U.S. has thrown up two far-reaching proposals to reform the taxation of corporate profits: reducing the tax rate on domestic profits to 15 per cent, and taxing foreign profits of U.S. corporations at 15 per cent each year.
The first proposal, a budget buster, is a poorly designed way to tax business; the second proposal, a revenue raiser, is a reasonable way to fix the current system for taxing foreign profits.
The current tax rate of 35 per cent is almost the highest in the world, so it should be lowered to make the U.S. a more competitive location for corporate facilities and jobs.
However, according to the estimates by the Tax Policy Center, the non-partisan think-tank, reducing the corporate tax rate on domestic profits to 15 per cent would mean lower U.S. tax revenues of almost $2.4tn over the next decade.
The Trump proposal would partially offset these revenue losses by closing business loopholes in the Internal Revenue Code. Depending on what exactly would be repealed, this could raise $500bn in tax revenues over 10 years.
On the other hand, the proposal allows companies to elect to deduct most of their expenses for new business investments, such as equipment costs, immediately from their taxable income.
This is much more favourable to business than current law, and the incremental cost of these expenses being immediately tax deductible would probably exceed $500bn over the next 10 years.
Even more dramatically, the proposal would lower the tax rate for business income distributed to owners of so-called “pass through” entities, such as partnerships or limited liability companies.
Currently these entities allocate their income annually to their owners, who are taxed at the applicable individual rates. Despite a general top individual rate of 33 per cent, the proposal has a special lower rate of 15 per cent for business income received by owners of such entities.
This lower rate for income generated through these entities could lose more than $1.5tn in tax revenues over 10 years.
By contrast, the Trump proposal for taxing foreign profits of U.S. corporations is better than the current approach. Currently, US corporations are taxed at 35 per cent on foreign profits, but this tax is collected only when those profits are brought back to the U.S. As a result, U.S. companies have kept roughly $2.5tn squirrelled away overseas.
Mr. Trump proposes to impose a one-time tax on these past foreign profits of U.S. corporations: 10 per cent on past profits held in cash or liquid securities, as well as 4 per cent on other past foreign profits.
These taxes could raise as much as $150bn, which could be devoted to infrastructure projects in the U.S. After paying these taxes on past foreign profits, U.S. corporations would be free to use them to build facilities, purchase technologies or pay dividends in the U.S.
Thereafter the proposal would tax foreign profits of U.S. corporations at the same 15 per cent rate as their domestic profits. Although Democrats would surely fight for a higher tax rate on foreign corporate profits, they should recognise that the corporate tax rates of many competitive jurisdictions have fallen sharply during the past decade. The UK’s corporate tax rate is now 20 per cent, for example.
Moreover, Mr. Trump’s proposal is far superior to the destination-based system for taxing foreign profits, which has been advocated by House Republicans. In that system, foreign profits of a U.S. corporation would be taxed only in the country where sales occur. Therefore, the U.S. would not collect any taxes on profits of U.S. multinationals on sales in any other country.
The main problem is the relationship between these two proposals. If Congress reduces the corporate tax rate on domestic income to a more realistic 25 per cent, instead of 15 per cent, then there would be a higher tax rate on domestic income than on foreign income.
Though this differential would provide some incentive for U.S. corporations to shift facilities abroad, the differential is much smaller than under current law. In practice, U.S. corporations today can choose between paying 35 per cent on foreign profits to the U.S., versus paying 12 per cent to Ireland or zero to the Cayman Islands.
Congress should use Mr. Trump’s proposal as a starting point towards improving the U.S. system for taxing foreign corporate profits, while fundamentally rethinking his approach to reforming the tax system for domestic corporate profits.
Pozen has been a nonresident senior fellow at Brookings since 2010. In 2015, he generously committed to endow the Director’s Chair for the Urban-Brookings Tax Policy Center. Until 2010, Pozen was executive chairman of MFS Investment Management and, before 2002, served in various positions at Fidelity Investments. He did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. He is currently not an officer, director, or board member of any organization with an interest in this article.