Thursday, November 27, 2014

Modernizing Corporate Taxation

BERKELEY – How to tax the income of multinational corporations (MNCs) was an unlikely headline topic at the recent G-8 summit in Ireland. It will be a key agenda item at the upcoming G-20 summit in Russia as well. Given these companies’ significance to national and global economic performance, world leaders’ focus on the arcane intricacies of corporate taxation is easy to understand – perhaps nowhere more so than in the United States.

As the US embarks on the difficult path of corporate tax reform, it should heed the United Kingdom’s example. Even as it champions multilateral cooperation to ensure that MNCs pay their “fair” share, the British government has slashed its corporate rate, exempted the active foreign income of British MNCs from the national corporate tax, and enacted a “patent box” that stipulates a 10% tax rate on qualified patent income.

As a result of years of cuts in corporate tax rates by other countries, the US now has the highest rate among the advanced economies. Reducing the top US federal rate, currently at 35%, to a more competitive level – the OECD average is around 25% – would encourage investment and job creation in the US by both domestic and foreign MNCs.

Paying for a rate cut by eliminating various corporate credits and deductions would simplify the code and trim the cost of compliance. It would also enhance efficiency by curbing tax-based distortions in companies’ investment decisions (what and where) and their choices concerning how to finance investments and which organizational forms to adopt. The Obama administration and Congressional leaders from both parties agree that a cut in the corporate tax rate should be revenue-neutral.

Other advanced industrial countries have paid for corporate rate reductions partly by restricting depreciation and other deductions. Despite lower tax rates, corporate tax revenues have not declined in these countries and represent a larger share of GDP than they do in the US.

In addition to reducing its corporate tax rate, the US needs to reform the way it taxes its MNCs’ foreign earnings. All other G-8 countries (and most OECD countries) boost their MNCs’ competitiveness by taxing only their domestic income, exempting most of their foreign earnings from domestic taxation (an approach known as a territorial system). The US, by contrast, taxes its MNCs’ worldwide income, with taxes paid elsewhere credited against their US tax liability to avoid double taxation.

The worldwide system puts US-based MNCs at a competitive disadvantage. They must pay the high US corporate rate on profits earned by their affiliates in low-tax foreign locations, while foreign MNCs headquartered in territorial systems pay only the local tax rate on such profits.

Current US law blunts this disadvantage by allowing US companies to defer paying US tax on profits earned abroad by foreign affiliates until they are repatriated to their US owners. As a consequence of both the high US tax rate and deferral, US-based MNCs have a strong incentive to keep their foreign earnings abroad. Indeed, their non-US affiliates currently hold an estimated $2 trillion in accumulated foreign earnings.

These earnings are “locked out” and unavailable to finance investment and job creation in the US, without incurring significant additional US taxes. Moreover, US companies incur efficiency costs from the suboptimal use of deferred earnings and higher levels of debt, as well as the burden of maintaining worldwide tax strategies. And these costs, estimated at 1-5% of deferred earnings, have been rising rapidly in recent years, in line with the growing share of foreign markets in US-based MNCs’ revenues.

A territorial system would address the competitiveness disadvantages, the “lock-out” effect, and the inefficiencies of the US’s worldwide approach. But it would not reduce incentives for US corporations to shift their reported profits to low-tax jurisdictions; on the contrary, such incentives would be even stronger in a pure territorial system. Given increasing globalization of business activity; the rising importance of intangible capital that is difficult to price and easy to move (for example, patents and brands); competitive cuts in national corporate tax rates; and the spread of tax havens, income shifting and the resulting tax-base erosion have become a major policy concern throughout the OECD.

In response, other developed economies have used a variety of techniques to create “hybrid” territorial systems aimed at countering tax-base erosion. Such systems include transfer-pricing rules based on OECD guidelines (used by the US as well), limits on interest deductibility, and domestic taxation of some kinds of income earned in low-tax locations where companies report large earnings but carry out little real economic activity.

As part of comprehensive corporate tax reform that includes a revenue-neutral rate cut, the US Congress is currently considering a hybrid territorial reform and evaluating several measures to counter tax-base erosion and income shifting, including those used by other advanced countries. Republican Congressman David Camp, who is leading the legislative effort in the House of Representatives, has proposed an innovative alternative that rests on the “destination principle”: MNCs’ taxable earnings should be based largely on where their products are sold, rather than on where the companies are headquartered, where their production and financing occur, or where their profits are reported.

Camp’s proposal would significantly reduce incentives to move manufacturing abroad for tax reasons. By contrast, both America’s worldwide system and other countries’ hybrid territorial systems rely on an “origin or source principle” that bases taxation largely on where input costs and production activities are located.

The US last reformed its business tax code in 1986, when it had one of the lowest corporate tax rates in the world and the competitive dynamics of the global economy were very different. It is time for another comprehensive corporate tax reform, one that reduces the tax rate, broadens the tax base, and adopts a hybrid territorial approach with effective base-erosion safeguards.

The author is currently serving as an outside economic adviser to the Alliance for Competitive Taxation, a coalition of 42 American companies. The views expressed here are her own.

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    1. Commentedjracforr jracforr

      Be careful what you wish for,in wanting to bring the estimated $2 trillion back to the US.If our revent financial calamity was caused by excess liquidity speculating in the real estate sector maybe this off shore bounty should stay wherever it is !!??

    2. CommentedG. A. Pakela

      The ideal corporate income tax would be none or zero. Corporate income taxes place a hurdle to investment, resulting in fewer employment opportunities. Taxes should be levied once - when dividends and interest are paid to investors, and when investors realize capital gains. The rate on investment should be flat and reasonable. The immediate loss of tax revenue would eventually be replaced as the increased investment caused by lowering the cost of capital would increase employment and dividend income and capital gains.

    3. CommentedGary Tucker

      I am a staunch liberal in almost all matters but I could not agree more with all the points made in Laura Tyson's article. The US Corporate Repatriation Tax is by far the most idiotic tax in the entire code. While much still needs to be done to close domestic loopholes, refine tax revenues at home and promote both domestic and international business growth, moving to a territorial tax system would be a major first step.

      There is no other issue in which I get in more heated debate with almost all liberal voices than pressing for just the kind of rational thinking that is needed and presented in this article.

      If there is any issue in which the Left and the Right should be able to agree upon a major tax policy that moves the country forward in a very rapid and dramatic fashion, this would be the issue.

      I am afraid that until the rational arguments can override the "anti multinational corporate world greed" mentality of most liberal thinkers it will be a long and uphill battle. But one that must be won.

      Again Laura Tyson I commend your advancement so logically and precisely.

    4. CommentedFrank O'Callaghan

      This is just a way of getting the rest to pay for the rich. It is unsustainable unless we have a world wide police state.