In two recent posts on the Foreign Policy blog, Clyde Prestowitz has come down hard against territorial taxation (background on territorial vs. worldwide taxation here and here). On Monday, he argued that territorial treatment of foreign business income would result in greater levels of 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. avoidance and shifting of profits into tax havens. As evidence of its failure, he claimed that the European Union is moving away from territorial taxation with its Common Consolidated Corporate Tax Base plan.
On Tuesday, he opined that the federal government has “not only a right, but an obligation” to tax worldwide income, because U.S. companies benefit from trade treaties and the stability of the global security blanket. His policy proposal is to eliminate deferral, but lower tax rates to 15 or 20 percent.
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. , territorial taxation may slightly increase the incentive to shift profits to low-tax countries, but the evidence is not conclusive. The Joint Committee on Taxation notes that “the fundamental transfer pricing issues in countries with territorial taxing systems are similar to transfer pricing issues in the United States,” and Kevin Markle has found no statistical difference in profit shifting between territorial and deferral-based worldwide systems. Because the revenue cost of this legal avoidance is somewhere around $30-60 billion, new rules or administrative measures are in order regardless of the system type.
The EU’s Common Consolidated Corporate Tax Base plan is intended to reduce the obstacles to cross-border activity. Currently, businesses are required to calculate their 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. in up to 27 different jurisdictions with different rules. The CCCTB would simplify this process, providing a uniform definition of taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . Nothing about the consolidated base would detract from the territorial nature of the subscribing tax systems, and foreign-earned income would remain exempt. Plus, the EU has proposed that participation be elective, meaning that companies could choose whether to file under the new or existing system. How is this a sign of territoriality’s demise?
To argue that U.S. companies owe tax on foreign income because of treaty relations and the global “security blanket” of U.S. defense spending ignores that foreign companies benefit equally from such international public goods. Because the federal government cannot tax a South Korean company, an equal beneficiary, it is inequitable to tax a U.S. company on its South Korean profits from the same activity. This inequity translates into loss of competitiveness for U.S. firms, and those firms must make up the difference with greater productivity just to stay relevant. When firms cannot compete in the U.S. tax climate, they invert as affiliates of foreign parents to minimize tax costs, or they die (Tax Notes subscription required).
Prestowitz advocates for ending deferral, lowering the tax rate to 15 or 20 percent, and targeting incentives for domestic production. He’s right on one of those recommendations: the tax rate. Ending deferral would only be feasible from a competitiveness standpoint if the U.S. indexed its tax rate to match the lowest among its trading partners. In Ireland, where the tax rate is 12.5 percent, a U.S. rate of 20 percent would be very uncompetitive—much more uncompetitive than the current option to defer tax until 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. . This would not promote foreign jobs “moving back” to the U.S.; it would only constrict U.S. business activity abroad. And regarding “targeted” domestic investment incentives, we already know the government’s record on picking winners.
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