Which Corporate Taxation for America?
BERKELEY – Corporate tax reform is one of the few issues that garner bipartisan
support in a deeply divided US Congress. The current system, all agree, is deeply
flawed: the corporate tax rate is too high by global standards, and the corporate
tax base is too narrow, owing to numerous credits, deductions, and special
provisions that distort economic decisions.
But there is significant debate about how to fix the system. One major area of
disagreement is how to tax the foreign earnings of US multinational companies
(MNCs), a disagreement highlighted by the recent proposals issued by Senator Max
Baucus, the chair of the Senate Finance Committee.
The current US system is based on a worldwide principle: the foreign earnings of US
companies are subject to US corporate tax, with the amount owed offset by a tax
credit for taxes paid in foreign jurisdictions. Most other developed countries, by
contrast, have adopted “territorial” systems that largely exempt their MNCs’ foreign
earnings from home-country taxation.
MNCs headquartered in countries that employ a worldwide tax system are at a
disadvantage when they compete in third-country markets with MNCs headquartered in
territorial systems. Whereas US MNCs must pay the high US corporate tax rate on
profits earned by their affiliates in low-tax foreign locations, MNCs headquartered
in territorial systems pay only the local tax rate on such profits.
For example, when a US firm and a firm headquartered in a territorial system compete
in a country where the local tax rate is 17%, the foreign firm owes 17% of its
profits in taxes to the local country, while the US firm owes 35% of its profits in
taxes – 17% to the local country plus 18% to the US. That difference translates into
a sizeable cost advantage that allows the foreign firm to charge lower prices and
capture market share from its US counterpart.
Current US law attempts to offset this competitive disadvantage through deferral: US
MNCs are allowed to defer – potentially indefinitely – payment of US corporate tax
on their foreign earnings until the earnings are repatriated to their US parent
firms. Not surprisingly, most US MNCs take advantage of the deferral option for at
least some of their foreign earnings.
As a means of bringing back this estimated $1.7 trillion in foreign earnings, the
Senate Finance Committee’s draft proposals suggest the elimination of deferral.
However, faced with the threat to their competitiveness that this would pose, many
US MNCs would shift their headquarters to countries with lower corporate tax rates
and territorial systems.
The global competitiveness of US MNCs and where they are based matter to the health
of the US economy. Despite the rapid growth of foreign markets, US MNCs still locate
significant shares of their real economic activities – about 65% of their sales, 68%
of their employment, 70% of their capital investment, and 84% of their R&D – at
home. Much of their domestic activity – particularly R&D, which has significant
local spillover benefits – is related to their headquarter functions. And foreign
direct investment by US MNCs is not zero-sum: it encourages rather than reduces
employment, investment, and R&D in the US.
Deferral is essential to maintaining US MNCs’ competitiveness as long as the US
relies on a worldwide corporate-taxation system. But deferral is not without
significant costs for US MNCs and the US economy alike. Deferred earnings held
abroad are “locked out” of the US economy, in the sense that they are not directly
available for domestic use by US MNCs and their shareholders.
Moreover, deferral distorts corporate balance sheets and capital-allocation
decisions. For example, firms may use earnings held abroad as collateral to take on
more debt and incur higher borrowing costs at home. Or they may use these earnings
to make investments abroad that yield a lower return than investments at home.
Overall, such efficiency costs are estimated to be 1-5% of deferred earnings, rising
as deferrals accumulate.
As the Senate Finance Committee’s draft proposals suggest, the US should jettison
its worldwide approach to corporate taxation and adopt a territorial system for
taxing US MNCs’ foreign earnings. Such a system would provide a level playing field
that supports US MNCs’ global competitiveness. It would also eliminate the
efficiency costs of deferral and boost US MNCs’ repatriation of foreign earnings,
with significant benefits for output and employment.
Based on recent research that incorporates conservative assumptions, we estimate
that under a territorial system US MNCs would repatriate an additional $100 billion
a year from future foreign earnings, adding about 150,000 US jobs a year on a
sustained basis. We also estimate that under a transition plan for taxing the
existing stock of foreign earnings held abroad, similar to one proposed by US
Representative Dave Camp, US MNCs would repatriate about $1 trillion of these
earnings, adding more than $200 billion to US GDP and about 1.5 million US jobs over
the next few years. These are significant gains for an economy that is still
operating far below potential, remaining about 1.5 million jobs short of its
pre-recession employment level.
A territorial tax system does have one potential disadvantage: it could strengthen
US MNCs’ existing incentives to shift their profits to lower-tax jurisdictions.
Competitive cuts in corporate tax rates, the spread of tax havens, and the rising
importance of easily movable intangible capital have already made these incentives
more powerful. Recent studies find growing segregation between where MNCs locate
their real economic activities and where their profits are reported for tax
Income shifting and the resulting erosion of domestic tax bases pose serious
challenges, and countries with territorial systems have adopted tough
countermeasures to combat them. If the US moves to a territorial system, it should
follow suit. A modern territorial system with adequate safeguards against
income-shifting and base erosion is the right approach to taxing the foreign
earnings of US MNCs.
Laura Tyson, a former chair of the US President’s Council of Economic Advisers,
is a professor at the Haas School of Business at the University of California,
Berkeley. Eric Drabkin and Ken Serwin are directors at Berkeley Research Group.
Source: Project Syndicate, 2013.