“The nation should have a tax system that looks like someone designed it on purpose.”
– William Simon, former U.S. Treasury secretary
In the ongoing debate over how to reform our tax system, one important question involves how to treat income U.S. corporations earn from their work overseas. This paper examines the two major ways countries answer this question: territorial and worldwide tax systems.
How Worldwide Taxation Works
The U.S. has a worldwide tax system. A corporation headquartered in the U.S. must pay the corporate income tax on all its income, regardless of whether it is earned in the U.S. or overseas. The corporation pays this tax when the foreign earnings are “repatriated” by bringing the income back to the U.S. This is known as “deferral,” because the income tax owed can be deferred until a later date when the income is repatriated.
When a corporation chooses to repatriate earnings and pay the U.S. corporate income tax, the law allows a foreign tax credit to offset a portion of the amount of U.S. tax that the corporation would otherwise have to pay.
Example: A corporation in the 35 percent tax bracket repatriates $1 million of income earned abroad, it would owe $350,000 in U.S. tax. But it has already paid $200,000 in tax to the country where the income was earned at that country's 20 percent rate. It would owe the U.S. government another 15 percent ($150,000) in order to bring the total tax paid on the $1 million of income to the U.S. 35 percent tax rate.
The U.S. waits to tax most foreign earnings when they are repatriated, but it does tax some foreign earnings immediately. This is known as “passive” income and includes many types of investment income. For example, interest earned on a bond held by a foreign subsidiary could be immediately taxable in the U.S.
How Territorial Taxation Would Work
Under a territorial tax system, the U.S. would tax only the U.S. income of a corporation and would exempt most or all foreign income. By doing this, a territorial system would allow U.S. corporations to compete with foreign corporations on a level playing field. In order to prevent erosion of the tax base, a territorial system could still cover income from financial assets held by a foreign subsidiary that could easily be held by the U.S. company.
Territorial Systems Are the Norm
Most countries have a territorial system. Among G-7 countries, only the U.S. has a worldwide tax system. Among OECD nations, 26 have territorial systems including Australia, Canada, France, Germany, Japan, Spain, and the United Kingdom. Eight OECD nations have worldwide systems, including the U.S., Greece, Ireland, South Korea, and Mexico. The other OECD nations with worldwide tax systems have top tax rates far below the top U.S. corporate tax rate.
Worldwide System Disadvantages U.S. Corporations
The current U.S. tax system places U.S. corporations at a disadvantage compared to their foreign competitors.
The U.S. worldwide system of taxation leaves an American business with less after-tax income than its foreign competitor. In a highly competitive global economy, this can be the crucial difference between an American company being able to compete or not.
Effects of a Worldwide System
Taxes at the highest corporate rate in the world. By having a worldwide tax system, the U.S. is subjecting its companies to the highest corporate tax rate in the world not only on income earned in the U.S. but for all income it earns and repatriates back to the U.S.
Encourages companies to keep income overseas. Because U.S. corporations are taxed only when they repatriate earnings, the current tax system encourages companies to keep their foreign income overseas. According to one study, U.S. multinational firms have over $1.7 trillion in foreign earnings parked overseas. Even if an American company plans to repatriate the income eventually, it is advantageous to delay repatriating the income as long as possible, since the company can invest and earn income on that foreign cash until the time comes to repatriate it. Using the example above, $80 kept overseas and invested in a bond earning a five percent return is more valuable than $65 in the U.S. invested in the same bond.
Rewards foreign investment over U.S. investment, part I. A company can reinvest foreign income overseas without paying the U.S. tax. So for a U.S. company to repatriate the money to invest here, the expected return must be higher than the foreign return on investment plus the U.S. tax on the repatriated money. This is a high hurdle for any investment to achieve.
Rewards foreign investment over U.S. investment, part II. Because a U.S. corporation’s interest payments are deductible, an American company could borrow in the U.S. to finance investment overseas. If the foreign income is not repatriated, the federal government has just given a tax deduction to finance foreign investment, but would impose a tax if that income were brought back to the U.S. to be invested.
Increases compliance costs. The complex rules associated with worldwide tax encourage companies to invest heavily in tax preparation services instead of directing those resources elsewhere. For example, General Electric’s tax department has nearly 1,000 employees.
Results in fewer global business being headquartered in the U.S. Because the U.S. has the highest corporate tax rate in the world and an incredibly complex tax code, fewer companies will put their headquarters in the U.S. That means fewer high-skill, high-wage jobs.
Worldwide taxation is bad economics. The Obama Treasury Department concedes that “[m]ost experts agree that the current hybrid U.S. system … embodies the worst features of both a pure worldwide system and a pure territorial system from the perspective of simplicity, enforcement and compliance.” In The Wealth of Nations, Adam Smith laid out four principles tax systems should follow: equality; clear and plain rules; convenience; and efficiency. The U.S. worldwide tax system fails every one of these principles. It is not equal, since it disadvantages American companies compared to foreign companies, and it is not clear, plain, convenient, or efficient.
Benefits of a Territorial System
A territorial system would match most of the world’s developed economies. American businesses should be able to compete with foreign competitors on a level playing field.
Moving to a territorial system would make American firms more competitive, allow them to bring overseas income back to the U.S. without being taxed, remove the tax disincentive for domestic investment with foreign income, decrease the influence that tax considerations have on business decisions, lower compliance costs, make it more likely that global businesses are located in the U.S., and result in a tax system more in line with basic economics.
The President’s own Export Council reported in 2010 that business “operations abroad expand domestic operations.” The Treasury Department has also reported that “moving to a territorial system that reduces American multinational corporations’ costs and increases their shares in foreign markets would boost their production, investment, and employment in the U.S.”
President Obama Should Listen to His Advisory Groups
President Obama recently ignored the advice of several of his advisors by opposing a shift to a territorial system of international taxation.
President Obama’s Fiscal Commission: “A territorial tax system should be adopted to help put the U.S. system in line with other countries, leveling the playing field.”
President Obama’s Export Council: “A competitive territorial tax system for the United States should broadly follow the practice of our trading partners … to make the U.S. tax system more competitive with its major trading partners.”
President Obama’s Jobs Council: “Many members of the Council agreed that the United States should move to a territorial system of taxing corporate income akin to the practices of the other developed economies.”
Commerce Secretary’s Manufacturing Council: “Move the United States from a worldwide to a territorial tax system…to allow manufacturers to make greater investment in expansion, innovation and job creation.”
Treasury Secretary Geithner: “‘The goal is territorial,’ Geithner said, starting to pull back. ‘I’m not sure we can commit to completely territorial. Maybe 95 or 96 percent.’” (Quoted in The Price of Politics, by Bob Woodward)
The current tax code encourages businesses to invest in tax preparation in order to lower their tax bills, instead of investing in innovation and expansion. But just this month in Charlotte, North Carolina, Vice President Biden mocked the territorial tax. We cannot blame businesses for complying with the tax law to lower their tax bill as much as possible. The real blame lies with the U.S. government for designing such a complicated tax system.
The time has come to fix our tax code. With a move to a territorial system, the U.S. can have an international tax code “that looks like someone designed it on purpose.”