This week, legislation in the House and the Senate was introduced aimed at stopping tax-driven corporate inversions. This is in response to recent news that a few U.S. corporations have looked to purchase foreign corporations as a means of moving their operations offshore and avoiding the additional U.S. taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. on their foreign earnings.
This bill would arbitrarily change a rule regulating inverted corporations. In general, it would make it harder for corporations to invert.
Rather than setting arbitrary rules that affect corporate behavior and make the tax code even less competitive, Congress could alter two existing policies that would completely remove the tax incentive to move operations offshore.
Move to a Territorial Tax SystemA territorial tax system for corporations, as opposed to a worldwide tax system, excludes profits multinational companies earn in foreign countries from their domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation.
The United States’ currently has what is called a “worldwide” tax system. This means that U.S. multinational profits are taxed at the 35 percent U.S. federal corporate tax rate no matter where they are earned, domestically or abroad. For example, if a subsidiary of a U.S. firm earns $100 in profits in England, it pays the United Kingdom corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rate of 21 percent (or $21) on those profits. When those profits are brought back to the United States, an additional tax equal to the difference between the U.S. tax rate of 35 percent and the UK corporate rate of 21 percent ($14 in this case) is collected by the IRS. Between the two nations, the U.S. firm will have paid a total of $35, or 35 percent, in taxes on its foreign profits.
The incentive to invert in our current system is in the additional tax due upon repatriationTax repatriation is the process by which multinational companies bring overseas earnings back to the home country. Prior to the 2017 Tax Cuts and Jobs Act (TCJA), the U.S. tax code created major disincentives for U.S. companies to repatriate their earnings. Changes from the TCJA eliminate these disincentives. of foreign earnings. Moving to the more superior territorial system would exempt foreign earnings from domestic taxation. The United States would no longer levy a toll charge on repatriating foreign-earned income. Not only would this lessen the incentive to invert, it would be more economically efficient, fairer, and bring us in line with most of the industrialized world.
Lower the Corporate Income Tax Rate
However, just moving to a territorial system would not be enough. Lowering the corporate income tax rate would also be necessary. Currently, the United States’ has the highest corporate income tax rate in the industrialized world. Our 39.1 percent rate is far higher than the average rate across the OECD (25 percent; 28 percent weighted by GDP). Even if we moved to a territorial system, our high corporate income tax rate would still drive investment overseas due to this tax differential.
Lowering the rate to 25 percent would get rid of this tax differential and would reduce the benefit of inversions and income shifting. But even more, a more competitive rate would attract foreign investment to the United States.
Corporate Investment moving overseas is a problem. Fixing it, however, does not require us to restrict our competitiveness even more. Moving to a territorial tax system and a lower corporate tax rate would go a long way in reversing this trend of corporate inversions.
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