A recent report by the GAO comments on the tax expenditureTax expenditures are a departure from the “normal” tax code that lower the tax burden of individuals or businesses, through an exemption, deduction, credit, or preferential rate. Expenditures can result in significant revenue losses to the government and include provisions such as the earned income tax credit, child tax credit, deduction for employer health-care contributions, and tax-advantaged savings plans. s on the table with Congress’s recent focus on 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. reform. The report identifies corporate tax deferral on foreign earnings as one of these expenditures, and suggests it distorts investment decisions, and also provides multinationals a special benefit over U.S. corporations who only operate domestically or export without foreign subsidiaries. However, the report mischaracterizes why these problems exist with deferral.
The U.S. taxes corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). s on a worldwide basis, which means the 35 percent federal corporate tax rate applies to foreign earned income as well as domestic. When foreign subsidiaries of US corporations make profits abroad, they first pay income taxes in the country they were earned in. Any profits that are not reinvested in the subsidiary are then taxed at the 35 percent rate when they are repatriated to the U.S. To eliminate double-taxation, a tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. is provided for the foreign taxes paid to ensure the overall rate does not exceed 35 percent. Deferral is the option taken to pay taxes when the profits are repatriated to the US, rather that immediately when they are earned.
Deferral is necessary in our current system of corporate taxation. If corporations were not able to delay paying the U.S. tax on foreign earnings, they would be at a competitive disadvantage with foreign corporations that don’t have to pay domestic tax rates on their foreign earnings. However, as the GAO report claims, there is a perverse incentive with deferral to keep earnings abroad.
The GAO report characterizes this as a distortion caused by deferral, when more realistically it is a reflection of the US having the highest corporate tax rate in the OECD. Since under the U.S. tax system taxes are owed on the difference between the foreign income taxes paid and the US rate, there is only this distortion if the US rate is significantly higher. This bias against being able to invest foreign earned income in the US would also exist without deferral, since foreign subsidiaries would face a higher tax rate than their counterparts, and would not be able to compete.
The GAO’s report also portrays this obstacle to bringing foreign earned income to the US as an advantage multinationals receive over domestic corporations. To equalize the treatment of multinationals and domestic firms, it is far more effective to lower the rate than remove deferral. A corporate tax rate that is closer to the OECD average of 25 percent would make deferral obsolete and would also make all US corporations more competitive versus foreign based firms.
It is important to point out that the US also falls behind the OECD when it comes to how it taxes corporations internationally. It is one of the remaining few who tax on worldwide income, a large majority (28 out of 34) now use a territorial system, which taxes only income earned within the country’s borders. Most countries have moved beyond the need to have any sort of deferral system (see the attached chart).
There is also a wider point here about tax reform. Ending deferral in an attempt to raise revenue would make foreign subsidiaries of US corporations unable to reinvest at the same rate as their competitors and remain viable. The economic damage caused could easily outweigh the benefits of the lower rates this move could finance, which is also the case with other ‘expenditures’ that are designed limit the tax bias against savings and investment.