Democratic members of Congress are interested in changing 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. rules for foreign earnings of U.S. multinational companies. They claim the current rules incentivize U.S. businesses to outsource and offshore what would otherwise be U.S. jobs and investment. However, closer inspection shows these claims do not fit with the way the rules have been working.
Some lawmakers are focused on a policy introduced in the 2017 Tax Cuts and Jobs Act (TCJA)The Tax Cuts and Jobs Act in 2017 overhauled the federal tax code by reforming individual and business taxes. It was pro-growth reform, significantly lowering marginal tax rates and cost of capital. We estimated it reduced federal revenue by .47 trillion over 10 years before accounting for economic growth. known as Global Intangible Low Tax Income (GILTI). U.S. taxes on GILTI result in a minimum tax on foreign earnings. Lawmakers claim that because GILTI can be taxed by the U.S. at a rate as low as 10.5 percent, businesses may prefer to invest abroad and pay the tax on GILTI rather than pay taxes in the U.S. at 21 percent.
Lawmakers also look at the 10 percent deduction for foreign assets that is part of the GILTI calculation and suggest that the deduction and the lower tax rate on GILTI provide incentives to offshore investment and jobs.
When considering these arguments, it is worth looking into the way taxes on GILTI work in the context of the entire 2017 reform.
First, the U.S. tax on GILTI is in addition to foreign taxes that U.S. businesses pay on their foreign profits. Usually, businesses can claim foreign tax credits to reduce their tax liability to the IRS. However, taxes on GILTI are only eligible for credits up to 80 percent of the value of foreign taxes paid. A business that pays $5 in foreign taxes and then owes $5 under GILTI will only be able to claim a $4 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. , leaving the company with a total tax burden of $6. GILTI was designed to have a lower effective tax rate to avoid full double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. of foreign earnings, but U.S. businesses that pay both foreign taxes and taxes on GILTI are subject to two layers of tax.
Additional foreign tax rules can mean much higher effective tax rates on GILTI, even in the high teens. Just looking at the potential tax rate on GILTI of 10.5 percent does not reveal the full picture.
Second, GILTI was a net tax increase in the Tax Cuts and Jobs Act. The Joint Committee on Taxation (JCT) estimated that the tax on GILTI would raise $112 billion over the period of 2018 to 2027. If the preference was so favorable to businesses relative to prior rules, the estimated revenue increase makes little sense. In the context of tax reform, GILTI broadened the U.S. tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. significantly. Rather than the previous rules that taxed foreign income from royalties or dividends and when foreign income was repatriated, GILTI now applies broadly and annually to the foreign earnings of U.S. companies.
Third, the 10 percent deduction for foreign tangible assets in GILTI is not a clear incentive for businesses to choose to invest or hire abroad instead of in the U.S. The GILTI tax base excludes profits that amount to a 10 percent return on tangible assets. Critics point to this and say that increasing foreign tangible assets reduces the amount of foreign profits taxed under GILTI and therefore businesses have an incentive to offshore their investment. However, a business choosing to invest abroad rather than in the U.S. would have to believe that the foreign tax treatment of that investment—not just the GILTI treatment—would be better if it put its investment outside the U.S.
The Tax Cuts and Jobs Act significantly cut taxes on business profits. But the tax cut was targeted at profits in the U.S. rather than foreign profits. A recent study by accounting professor Scott Dyreng and his coauthors found that the effective tax rate on the foreign earnings of U.S. companies was roughly unchanged following tax reform. In fact, they estimate that the combined U.S. and foreign effective tax rate on foreign earnings is roughly 28 percent. Meanwhile the estimated effective tax rate on domestic income has fallen to 17 percent.
To put it bluntly, the Tax Cuts and Jobs Act made investment in the U.S. much more attractive for companies. The incentives for U.S. multinational businesses to offshore jobs and investment or artificially avoid paying U.S. taxes have changed significantly since tax reform.
Recently appointed Deputy Assistant Secretary for Tax Analysis Kimberly Clausing at Treasury recognizes this in a paper evaluating the impact of the Tax Cuts and Jobs Act’s international rules. She finds that GILTI’s impact on profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. will result in a reduction of profits booked in tax havens by 12 to 16 percent. This means that tax reform will lead to companies reporting more taxable profits to the U.S. Department of Treasury rather than avoiding U.S. taxes.
However, Clausing also suggests the deduction for foreign tangible assets in GILTI will encourage U.S. businesses to invest more abroad. Her points are like the arguments made by some members of Congress. Though a company could increase its foreign tangible assets to partially offset the impact of GILTI, that is different than saying a company would do that by choosing to put a factory in another country instead of the U.S.
Profits from a factory in the U.S. would be taxed at a 21 percent rate, and deductions for investment costs would benefit from U.S. rules for depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. , including full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. for machinery. If the company looked abroad for an investment opportunity, it would have to compare the U.S. tax rules with corporate tax rules in foreign jurisdictions.
Investment decisions are not necessarily zero-sum, though. If an investment would be profitable in the U.S. but a company chooses to invest elsewhere, that still means there is a potential for another firm to make a profitable investment in the U.S.
With respect to GILTI, U.S. companies could acquire foreign businesses that have low profit margins and lots of tangible assets. Such acquisitions could reduce a company’s GILTI exposure. A U.S. company that contracts with a distribution facility in France to get its products to European customers may choose to acquire that distributor. This would not be a net loss of U.S. jobs because the distribution facility is serving a foreign market and it could make business sense from both a geographic and a tax perspective.
There is some recent evidence of U.S. multinationals making foreign acquisitions like this. Accounting professor T.J. Atwood and her coauthors have recent research showing that companies that are more likely to be exposed to taxes on GILTI have increased their acquisitions of foreign firms with more tangible assets. A company that has significant GILTI exposure is likely in that position because it earns its foreign income mainly from intangible assets. By acquiring foreign entities with more tangible assets like factories, processing plants, or distribution facilities, a company could dilute its GILTI liability to some extent.
Many members of Congress have taken issue with the 2017 tax reform. However, the reasoning that has led some to believe that GILTI provides a path to offshoring investment and jobs is flawed.
That is not to say that GILTI is flawless. Problems with the way GILTI works in practice tend to inflate the tax burden on GILTI. Policymakers should focus on ways to improve U.S. international tax ruleInternational tax rules apply to income companies earn from their overseas operations and sales. Tax treaties between countries determine which country collects tax revenue, and anti-avoidance rules are put in place to limit gaps companies use to minimize their global tax burden. s rather than develop convenient narratives supporting raising taxes on U.S. companies.
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