Special Report No. 174
The Congress and Administration decided to postpone action on major changes in international 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 until this year. While the preoccupation with health care reform was undoubtedly a major factor, the concern that the Administration’s proposals might undermine the competitiveness of U.S. companies operating abroad was also reported to be a major consideration.
The main tax provision targeted for repeal by critics in the Administration and the Congress is what’s called deferral, the ability of U.S. multinational corporations to defer tax liability on active foreign earnings until those earnings are repatriated to the United States. Both the Obama Administration and Chairman Rangel have proposed to limit deferral of U.S. tax on active foreign earnings.
The premise underlying this policy shift is that taxing U.S. multinational corporations on their worldwide income would remove any incentive for firms to keep foreign earnings abroad. That is, it would remove any bias that favors foreign production over domestic production.This approach, however, fails to recognize that, with the U.S. corporate tax rate as high as it is, U.S.-based multinational corporations operate at a distinct tax disadvantage, and deferral is the principal provision that makes the differential tolerable. Over the past two decades, our trading partners reduced their corporate tax rates repeatedly, growing the gap between their low rates and the high U.S. rate, increasing the importance of deferral immensely.
Another tax reform trend abroad has been a shift towards 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. s. In those systems, a country only taxes active income earned within its borders. As the U.S. approach of taxing worldwide income loses favor internationally, the Administration’s preference for strengthening the worldwide approach threatens to further undermine the competitiveness of U.S. firms operating abroad. Over 80 percent of OECD nations now have territorial systems; only half of them had territorial systems a decade ago. During 2009, both Great Britain and Japan switched from worldwide to territorial systems. This has left the United States in the position of being the only large economy with both a worldwide system and a corporate tax rate exceeding 30 percent.
But whether the U.S. reforms its international tax system by following the territorial trend or by strengthening its worldwide system, all parties need to more fully recognize the importance of the high U.S. corporate tax rate. It is increasingly an outlier on the international scene, and tax reform proposals that do not reduce it will not substantially improve the position of U.S.-based firms.
• The United States is the only large economy that taxes corporate income worldwide with a tax rate exceeding 30 percent.
• During 2009, both Great Britain and Japan enacted territorial systems, giving their multinationals a major tax advantage over U.S.-based firms that are saddled with a worldwide system. Over 80 percent of developed nations now have territorial systems.
• Whether the U.S. moves to strengthen its worldwide system by repealing deferral or follows the international trend by adopting a territorial system, there will be unfortunate incentives created. In both cases, though, lowering our corporate tax rate will mitigate them.
• A reasonable upper-bound target might be a combined federal-state rate of roughly 25 percent, implying a federal corporate tax rate of roughly 20 percent.