The President’s Tax on Offshore Earnings Represents the Worst of Retroactive Policy

February 2, 2015

Part of the President Obama’s fiscal year 2016 budget is a 14 percent tax on foreign corporate income currently reinvested overseas. This proposal would retroactively tax income being held offshore in order to fund more than $400 billion in new infrastructure spending.

Retroactive taxation, such as the president’s deemed repatriation proposal, is bad tax policy. It is unfair to taxpayers, brings instability to the tax code, and could hit some cash-strapped corporations hard. Furthermore, using this one-time influx of revenue is a poor way to fund infrastructure spending.

The current U.S. tax code taxes U.S. corporations on their worldwide income at 35 percent minus a tax credit for foreign income taxes already paid on that income. However, U.S. corporations can defer the additional taxes paid to the IRS as long as they reinvest their earnings overseas. This deferral lasts as long as the earnings are reinvested overseas. Currently, there is nearly $2 trillion of overseas reinvested earnings.

The president’s plan would deem all of that income as being repatriated and tax it at a 14 percent rate.

This deemed repatriation tax in Obama’s budget is a retroactive tax. Foreign income has been earned and reinvested overseas by U.S. corporations with the understanding that the U.S. tax on this income would be deferred. This proposal would subject decades' worth of past economic decisions by these businesses to taxation.

There are several problems with this proposal.

1) Retroactive policy unfair.

Suppose a bank suddenly altered the interest rate you are paying on your home mortgage, but not just the interest going forward, the interest that you paid in the past. You had been paying 3 percent for 10 years. Now you need to pay 5 percent. So not only do you have to pay 5 percent going forward, you need to pay all the interest you would have paid in the past ten years if you had a 5 percent interest rate the whole time. Most people would think this is not fair.

The President’s deemed repatriation tax is similarly unfair. U.S. corporations have been reinvesting their income overseas with the understanding that the tax on this income would be deferred. This proposal goes back on that promise to allow a deferral by taxing the trillions of reinvested earnings that have been overseas for decades as if that income was subject to a 14 percent tax the whole time.

2) Retroactive taxes affect future decisions.

Many see retroactive taxation as an efficient way to raise revenue. Taxes affect behavior. Specifically, taxpayers will alter their behavior in order to minimize their tax bill. This sort of behavior can adversely affect economic growth. However, this doesn’t hold if taxpayers are unexpectedly hit with a tax on past behavior. The taxpayer cannot do anything to avoid the tax, thus economic output isn’t changed.

However, this may only hold once. Once a massive retroactive tax is imposed, such as the president’s proposal, it may make taxpayers question the stability of tax laws and regulations going forward. A business may be much less likely to pursue an investment if it expects that the government could impose a future retroactive tax on its investment. This undoubted will negatively affect future economic output.

3) This tax may financially strain corporations who need to pay.

Many proponents of repatriation are very loose with their language regarding deferred foreign income. They typically give the impression that these U.S. corporations simply have trillions of dollars—in cash—sitting in bank accounts. This is typically not the case: these earnings are reinvested in ongoing operations. This means that they are used to finance a factory in China or an office building in the United Kingdom.

If the tax is levied unexpectedly—as is the goal of retroactive taxation—many corporations may not have the means to liquidate their investments to cover the costs of the tax.

4) Funding Projects with One Time Revenue Raisers is Short-sighted

Another issue with the president’s proposal is that the new revenue would be used to fund new infrastructure projects. According to the Budget, the deemed repatriation tax will raise $238 billion once. This will be used to fund $478 billion in new infrastructure spending. While there is nothing wrong with new infrastructure spending, the way the president proposes paying for it is short-sighted.

Currently, the highway trust fund is running out of money. The taxes (mainly the gas tax) that fund infrastructure are not keeping up with the spending. Instead of fixing the current issue by either reducing spending or raising the gas tax, the president is proposing more spending paid for by a one-time stream of revenue. Once this stream of revenue has been used up to pay for the new infrastructure, we will be right back where we were: a trust fund running out of money.

If new spending is desired, a stable source of income would be the best way to fund it, not an influx of revenue from a retroactive tax.

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