Baucus International Tax Plan is Uncompetitive

 
 
December 05, 2013

Senate Finance Committee Chairman Max Baucus has released a detailed proposal for international corporate tax reform, which we summarized earlier this week. While there are some improvements to current law, the proposal is mainly a step backward in terms of business competitiveness and will harm investment, job creation, and wages.

The Baucus plan essentially eliminates deferral, taxing the foreign earnings of U.S. multinational corporations (MNCs) on a current basis. It provides limited exemptions of those foreign earnings – 20 percent under Option Y or 40 percent under Option Z. In contrast, most developed countries, and all of the G7, exempt between 95 and 100 percent of foreign earnings. This level of exemption is what defines a “territorial”, or participation exemption, tax system. Of the 34 most advanced countries, 28 use a territorial tax system, while only 6, including the U.S., use a worldwide tax system with deferral (see the graphic below). No developed country imposes a worldwide tax system without deferral, though some have tried it with near disastrous effects. Senator Baucus’s plan is somewhere between that failed experiment in New Zealand of no deferral and the fully modern territorial tax systems employed in most developed countries. 

Sen. Baucus’s plan to take away deferral without offering full exemption subjects U.S. MNCs to an uncompetitive level of taxation. The table below illustrates what would happen to $100 of foreign earnings by a U.S. MNC when those earnings are brought back to the U.S., under current law and Baucus’s Option Y and Option Z. It also shows how that compares to a MNC based in a country with a territorial tax system.

First, in all cases foreign corporate taxes are due. The corporate tax rate in Ireland is the lowest in the developed world, at 12.5 percent, so profits earned there result in $12.50 due the Irish government. France has one of the highest corporate tax rates, at 34.43 percent, so profits earned there result in $34.43 due the French government. Then U.S. federal taxes are due on top of that, minus foreign taxes paid.

Under current law, the federal rate is 35 percent, but companies may indefinitely defer any additional U.S. tax as long the profits remain abroad (which companies can use to reinvest abroad). Sen. Baucus proposes to end deferral and exempt either 20 or 40 percent of foreign income, amounting to a minimum tax of either 24 or 18 percent. Baucus’s proposal would be a big tax increase for any U.S. company operating in a low-tax country. Finally, state corporate taxes are due.

In the table below, total worldwide corporate taxes are shown under the various scenarios. Current law with deferral is equivalent to territorial taxation, so long as companies never bring profits home. This restriction makes territorial taxation more competitive than deferral. Baucus Options Y and Z are the least competitive of all, i.e. worse than current law.

Worldwide Corporate Taxes on $100 in Foreign Income for a MNC based in the U.S. versus an MNC based in a Country with a Territorial Tax System

 

 

International Tax System

 

Current Law for U.S. MNC (35% minus foreign tax rate)

Current Law for U.S. MNC (using indefinite deferral)

Baucus Option Y for U.S. MNC (24% minus foreign tax rate)*

Baucus Option Z for U.S. MNC (18% minus foreign tax rate)*

Taxes For Foreign MNC under a Territorial Tax System

$100 Foreign Income Earned in a Low-tax Country

Foreign Corporate Taxes (Ireland = 12.5%)

$12.50

$12.50

$12.50

$12.50

$12.50

Home Country Federal Corporate Taxes

$22.50

$0.00

$11.50

$10.50

$0.00

Home Country State Corporate Taxes (U.S. State Average = 4.13%)

$4.13

$0.00

$4.13

$4.13

$0.00

Total Worldwide Corporate Taxes

$39.13

$12.50

$28.13

$27.13

$12.50

 

 

 

 

 

 

 

$100 Foreign Income Earned in a High-tax Country

Foreign Corporate Taxes (France = 34.43%)

$34.43

$34.43

$34.43

$34.43

$34.43

Home Country Federal Corporate Taxes

$0.57

$0.00

$0.00

$0.00

$0.00

Home Country State Corporate Taxes (U.S. State Average = 4.13%)

$4.13

$0.00

$4.13

$4.13

$0.00

Total Worldwide Corporate Taxes

$39.13

$34.43

$38.56

$38.56

$34.43

 

         

 

* Assumes Baucus would reduce the standard federal corporate tax rate from 35 to 30%.

UPDATE: This table has been updated to reflect the fact that Option Z does not allow foreign tax credits on the 40% of foreign income that is exempt. In the case of foreign income in a mid-tax country such as the UK (corporate rate of 23%), Option Z results in higher taxes than Option Y, due to the limitation of foreign tax credits, and both Baucus options result in higher taxes than current law. Hat tip to Chris Javens for pointing this out.

In addition to these tax increases, Baucus proposes to raise about $200 billion by taxing at 20 percent the roughly $2 trillion in past foreign earnings that have accumulated under the system of deferral. This one-time “deemed repatriation” has many economists excited because it is thought to affect only past investment with no impact on investment going forward. Marty Sullivan of Tax Notes describes it as an “ideal tax” that is “non-distortionary and does not affect behavior.” By that argument, why not tax those past earnings at 100 percent? Because you can’t. Common sense tells us that companies will not put up with it. They have other options, like moving to countries with stable laws and low corporate tax rates, such as most countries in Europe. Sullivan’s argument that it “makes no difference to the economics” forgets that capital is mobile, especially corporate capital.

Sullivan and others also praise Baucus for solving the “lock-out” effect, whereby profits are trapped abroad due to the combination of the high U.S. corporate tax rate and deferral. However, the Baucus plan will merely replace “lock out” with “move out”, as companies find it more welcoming abroad.

Finally, the Baucus plan proposes more than a dozen provisions aimed at making it more difficult for companies to shift profits abroad for tax purposes. The provisions include elimination of the “check the box” rule that allows U.S. parents to determine the business form of its foreign subsidiaries. Other provisions include limits on intangible property transfers, interest deductibility, and foreign tax credits. Many of these are used in countries with territorial systems, but no country uses all of them. Mainly these provisions would further complicate the U.S. corporate tax code, increase business compliance costs, and make the U.S. less competitive.

There are many other complex features of this plan, and some of the more minor provisions may improve things. One improvement that is not so minor for banks is the permanent extension of the active financing exception, which allows banks to use the active foreign income exemptions described above. This is simply about equal treatment under the law, and this temporary provision should have been made permanent years ago.

Overall, Baucus’s plan represents a huge tax increase on U.S. MNCs, who are already subject to the least competitive corporate tax system in the developed world (ours). It will dramatically reduce foreign investment and hiring by U.S. MNCs, which will in turn reduce investment and hiring at home by those MNCs, according to the latest research. More dramatically, it will cause an uptick in the already alarming rate of corporate inversions and other relocations abroad.  In the end, it is U.S. workers who will pay the price.

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