Stuck in the Middle with our International Tax System
President Obama took aim at multinational corporations last May at a press conference on international tax policy. I’ll leave out the details here, lest I put you to sleep or explode your brain. Let’s just say that the current system is a mess that drastically needs fundamental reform.
Economists describe two contrasting “pure” approaches to taxing the income U.S. companies earn abroad. A “worldwide” approach would apply our domestic tax rules to all income (with a foreign tax credit to protect against double-taxation). In theory, that system would tax U.S. business income the same, whether it’s earned at home or overseas, so firms shouldn’t care where they invest. In contrast, under a “territorial” or “dividend exemption” system, the U.S. wouldn’t tax active business income earned overseas; American firms would pay only the taxes of the country where they earn income, just like any non-U.S. business operating there. In theory, that puts U.S. businesses that invest abroad on equal tax footing with foreign firms.
Which system do we use? We’re stuck in the middle and it’s not pretty. A 2005 Joint Committee on Taxation Report labeled the current system a “paradox of defects” and recommended that the U.S. adopt a dividend exemption system. The 2005 President’s Advisory Panel on Federal Tax Reform came to the same conclusions. Its November 2005 report said that the current system “likely distorts economic decisions to a greater extent and is more complex than a system that simply exempts active foreign business income from U.S. tax.”
In 2006, Harry Grubert of the U.S. Department of Treasury and I carefully studied three different systems for taxing the cross-border income of U.S. multinational corporations: the current hybrid system, which combines worldwide and dividend- exemption systems; a “burden neutral” variant of a worldwide system that increases the tax base by taxing all foreign source income currently but lowers the rate to keep the burden on foreign source income the same; and a dividend-exemption system. We concluded that either fundamental reform delivers a better system than the current one and recommended the “burden neutral” worldwide system over dividend exemption.
President Obama has proposed several incremental reforms to cut back on deferral—the current policy of taxing foreign earnings only when U.S. corporations bring them home. If he’s simply looking for revenue, however, the president would do better to move in the other direction. In recent blogs, Bob Williams and I have been examining the revenue and spending options in the new CBO Budget Options report. CBO includes a dividend exemption option—indefinite deferral—that would raise $76.2 over ten years. That’s $11 billion more than the CBO option of ending deferral entirely! Again, I’ll spare you the details. But you know a tax system is broken when not taxing a form of income raises more money than taxing it today. We definitely need serious, principled, international tax reform.
So what’s the bottom line? We’re in a mess. We’re stuck between two inconsistent systems with no obvious way to get out. We need reform and we need revenue. The two aren’t necessarily incompatible but change will be hard. Many firms benefit from the status quo — the worst of all worlds is the best of all worlds for them. Whatever we do, there will be losers everywhere.