Corporate tax reform is one of the few issues that garner bipartisan support in a deeply divided US Congress. The current system, all agree, is deeply flawed: the corporate tax rate is too high by global standards, and the corporate tax base is too narrow, owing to numerous credits, deductions, and special provisions that distort economic decisions.
But there is significant debate about how to fix the system. One major area of disagreement is how to tax the foreign earnings of US multinational companies (MNCs), a disagreement highlighted by the recent proposals issued by Senator Max Baucus, the chair of the Senate Finance Committee.
The current US system is based on a worldwide principle: the foreign earnings of US companies are subject to US corporate tax, with the amount owed offset by a tax credit for taxes paid in foreign jurisdictions. Most other developed countries, by contrast, have adopted “territorial” systems that largely exempt their MNCs’ foreign earnings from home-country taxation.
MNCs headquartered in countries that employ a worldwide tax system are at a disadvantage when they compete in third-country markets with MNCs headquartered in territorial systems. Whereas US MNCs must pay the high US corporate tax rate on profits earned by their affiliates in low-tax foreign locations, MNCs headquartered in territorial systems pay only the local tax rate on such profits.
For example, when a US firm and a firm headquartered in a territorial system compete in a country where the local tax rate is 17%, the foreign firm owes 17% of its profits in taxes to the local country, while the US firm owes 35% of its profits in taxes – 17% to the local country plus 18% to the US. That difference translates into a sizeable cost advantage that allows the foreign firm to charge lower prices and capture market share from its US counterpart.
Current US law attempts to offset this competitive disadvantage through deferral: US MNCs are allowed to defer – potentially indefinitely – payment of US corporate tax on their foreign earnings until the earnings are repatriated to their US parent firms. Not surprisingly, most US MNCs take advantage of the deferral option for at least some of their foreign earnings.
As a means of bringing back this estimated $1.7 trillion in foreign earnings, the Senate Finance Committee’s draft proposals suggest the elimination of deferral. However, faced with the threat to their competitiveness that this would pose, many US MNCs would shift their headquarters to countries with lower corporate tax rates and territorial systems.
The global competitiveness of US MNCs and where they are based matter to the health of the US economy. Despite the rapid growth of foreign markets, US MNCs still locate significant shares of their real economic activities – about 65% of their sales, 68% of their employment, 70% of their capital investment, and 84% of their R&D – at home. Much of their domestic activity – particularly R&D, which has significant local spillover benefits – is related to their headquarter functions. And foreign direct investment by US MNCs is not zero-sum: it encourages rather than reduces employment, investment, and R&D in the US.
Deferral is essential to maintaining US MNCs’ competitiveness as long as the US relies on a worldwide corporate-taxation system. But deferral is not without significant costs for US MNCs and the US economy alike. Deferred earnings held abroad are “locked out” of the US economy, in the sense that they are not directly available for domestic use by US MNCs and their shareholders.
Moreover, deferral distorts corporate balance sheets and capital-allocation decisions. For example, firms may use earnings held abroad as collateral to take on more debt and incur higher borrowing costs at home. Or they may use these earnings to make investments abroad that yield a lower return than investments at home. Overall, such efficiency costs are estimated to be 1-5% of deferred earnings, rising as deferrals accumulate.
As the Senate Finance Committee’s draft proposals suggest, the US should jettison its worldwide approach to corporate taxation and adopt a territorial system for taxing US MNCs’ foreign earnings. Such a system would provide a level playing field that supports US MNCs’ global competitiveness. It would also eliminate the efficiency costs of deferral and boost US MNCs’ repatriation of foreign earnings, with significant benefits for output and employment.
Based on recent research that incorporates conservative assumptions, we estimate that under a territorial system US MNCs would repatriate an additional $100 billion a year from future foreign earnings, adding about 150,000 US jobs a year on a sustained basis. We also estimate that under a transition plan for taxing the existing stock of foreign earnings held abroad, similar to one proposed by US Representative Dave Camp, US MNCs would repatriate about $1 trillion of these earnings, adding more than $200 billion to US GDP and about 1.5 million US jobs over the next few years. These are significant gains for an economy that is still operating far below potential, remaining about 1.5 million jobs short of its pre-recession employment level.
A territorial tax system does have one potential disadvantage: it could strengthen US MNCs’ existing incentives to shift their profits to lower-tax jurisdictions. Competitive cuts in corporate tax rates, the spread of tax havens, and the rising importance of easily movable intangible capital have already made these incentives more powerful. Recent studies find growing segregation between where MNCs locate their real economic activities and where their profits are reported for tax purposes.
Income shifting and the resulting erosion of domestic tax bases pose serious challenges, and countries with territorial systems have adopted tough countermeasures to combat them. If the US moves to a territorial system, it should follow suit. A modern territorial system with adequate safeguards against income-shifting and base erosion is the right approach to taxing the foreign earnings of US MNCs.
