In an effort to make common cause with congressional Republicans, the president is proposing an overhaul of the corporate tax code to finance increased spending on infrastructure and training programs. It’s not clear why the White House believes that this deal will prove attractive to conservatives, as the corporate tax overhaul the president has in mind isn’t terribly attractive and the spending proposals he has in mind have already met with resistance.
In 2012, Bloomberg View contrasted Mitt Romney’s call for a territorial tax system with Barack Obama’s defense of worldwide taxation of U.S. multinationals:
The U.S.’s current “worldwide” tax system is a mess. Large companies are taxed on all their income, domestic and international, at a top official rate of 35 percent (one of the highest in the world, although most pay a lower effective rate). When these companies earn money abroad, they pay taxes to the host government, then again to the U.S. when the profits are repatriated. They receive credits for what they’ve already paid in foreign taxes, and can defer U.S. taxes until the profit is brought home.
The rationale for such a system is known as capital-export neutrality: If companies are taxed equally at home and abroad, the thinking goes, they will make decisions about where to invest based on business considerations and not tax advantages. That reasoning no longer holds in a global economy in which a company’s foreign branches can grow by simply investing retained earnings and accessing capital markets on their own.
The current system also leads to a web of distortions. It puts U.S. companies at a disadvantage, since almost all other advanced countries have moved to some version of a territorial system. It encourages companies to take on debt. And compliance costs are enormous relative to what the government receives in revenue.
It also leads to gamesmanship. The tax can be deferred indefinitely as long as the earnings aren’t repatriated, so companies retain their profits abroad. Multinationals also use elaborate strategies to show that their income wasn’t really earned in the U.S., including a practice known as transfer pricing, by which they manipulate the way they value transactions between subsidiaries to allocate profit to low-tax jurisdictions.
A territorial system would go a long way toward improving this picture. Foreign profit would be exempt from taxation, so there would be no reason not to repatriate it. U.S. businesses looking to invest abroad would no longer be at a competitive disadvantage. And a vast amount of red tape would be eliminated in short order.
While it is true that a territorial system might increase employment levels at overseas affiliates of U.S. multinationals, the editors cited Greg Mankiw and Phillip Swagel’s finding that “increased employment in the overseas affiliates of U.S. multinationals is associated with more employment in the U.S. parent rather than less.” The president, however, seems keen to double down on a worldwide tax system. Moreover, the president’s proposal entails a more favorable tax rate for manufacturing, which seems unwise.
In March, Ramesh Ponnuru touted Rep. Devin Nunes’s business consumption tax proposal, which would tax cashflow rather than income, thus leaving investments tax-free:
Even if the rate were left at the 35 percent that currently applies to corporations, the shift to the new tax would still be a boon for the economy. The statutory rate would be higher than that of other countries, but the number that matters — the effective tax rate on investments — would be a very competitive zero, thanks to companies’ ability to write off their costs immediately. Eliminating the deduction for interest, meanwhile, would end a destabilizing distortion in the economy: the federal tax code’s preference for corporate financing via debt rather than equity. That preference also gives an advantage to established firms that have greater borrowing capacity than startups.
This debt bias in the corporate tax code, which we’ve discussed in the past, has contributed to excessive debt levels, which have in turn exacerbated the fragility of the financial system. So Nunes’s proposal represents a substantial improvement over the status quo on many levels.
Encouragingly, Josh Barro suggests that there might be room for compromise between the president’s approach to corporate tax reform and Dave Camp’s. But it would be nicer still if Republicans and Democrats united behind Nunes’s BCT.