For more than a century, the United States has had a worldwide tax system whereby U.S. taxpayers were subject to federal taxation on all of their income “from whatever source derived.” In what would be a sharp break from longstanding practice, The Tax Cuts and Jobs Act, H.R. 1, would shift the United States from a worldwide to a largely territorial tax system by exempting the foreign source income of U.S. corporations from federal taxation. That change, which has been estimated to reduce U.S. tax revenues by more than $200 billion over 10 years,[1] would more closely align the U.S. tax system with those of its major trading partners.
Not surprisingly, given the large sums of money involved, and the immediate distributive effects of the shift, which would mostly benefit wealthy Americans, large institutions, and foreign investors, the proposal to exempt U.S. corporations’ foreign income from tax has been highly controversial. It is very popular among large U.S. businesses, which have long complained that high U.S. corporate tax rates and the U.S. worldwide tax system place them at a competitive disadvantage relative to their foreign rivals when it comes to making investments in overseas markets.
U.S. corporate managers frequently claim that their tax-induced disadvantage is equal to the difference between the statutory U.S. corporate tax rate, 35 percent, and the local tax rate, often zero. In simple form, the argument is that U.S. and non-U.S. businesses compete in global markets for goods and services and for capital. U.S. worldwide taxation ultimately subjects U.S. corporations to a 35 percent tax rate on their overseas earnings, whereas their competitors, mostly domiciled in territorial jurisdictions, pay only the source country tax, often close to zero. Thus, in order to be able to raise capital in the global equity market and invest it in the globally competitive market for goods and services, the U.S. domiciled corporation has to make enough more than its rivals to pay the 35 percent U.S. corporate tax on non-U.S. earnings. Not surprisingly, U.S. corporations are likely to benefit from lowering the corporate tax rate and moving towards territoriality, which is one possible explanation for the stock market run-up.
Among many U.S. academics, territorial taxation is a much less desirable policy. Some of these academics argue that because U.S. corporations can defer federal taxation on their overseas earnings until those earnings are repatriated, U.S. firms experience no disadvantage relative to their foreign rivals from low-taxed territorial countries. As long as the U.S. parent does not need access to the overseas cash earnings held abroad those earnings can be accumulated overseas without incurring any U.S. tax obligation. In the view of these academics, firms’ desire to invert – to change their legal domiciles to countries with low corporate tax rates – is an attempt to get their hands on their large stocks of untaxed overseas cash, estimated in aggregate at over $2 trillion.
The question at the center of the current international tax debate – whether the U.S. worldwide tax system disadvantages U.S. domiciled firms relative to their foreign rivals – is not new. The same question has been at the center of the 20-year long debate over inversions. By inverting out of the United States and domiciling in another country with territorial taxation or a lower corporate tax rate, the inverting corporation avoids the high U.S. tax rate on foreign source income. Leaders of inverted businesses have frequently claimed that an uncompetitive U.S. tax system forced them to invert in order to maintain their competitiveness against foreign domiciled rivals.
In an influential 2014 article, Competitiveness Has Nothing to do with It, Professor Edward Kleinbard responded to the business leaders’ arguments. He contended that they are “almost entirely fact-free,” and that “international business ‘competitiveness’ has nothing to do with the reasons for these deals.” “In practice, U.S. firms,” Kleinbard claimed, “capture the benefit of operating in lower-tax jurisdictions, both as a cash matter and more importantly for the purpose of U.S. {GAAP], which is the lens through which investors and corporate executives measure a firm’s performance.” And Kleinbard concluded that although the existing U.S. international tax system “is highly distortive and inefficient . . . one of the few deficiencies it has avoided is imposing an unfair international business tax competitiveness burden on sophisticated U.S. multinationals.”
In Taxation, Competitiveness and Inversions: A Response to Kleinbard and Before International Tax Reform, We Need to Understand Why Firms Invert, I respond to Kleinbard’s arguments. I argue that although the disadvantage is not as large as business people often argue — the excess of the U.S. statutory rate over zero – it is also not zero, as Kleinbard claims. It cannot be precisely quantified, but the available evidence strongly suggests that U.S. multinational corporations (MNCs) are at a tax-induced competitive disadvantage relative to their foreign rivals, from a financial accounting and a cash flow standpoint, and in overseas markets as well as domestic ones.
The evidence for the financial accounting claim includes the higher effective tax rates (ETRs) generally reported by U.S. based MNCs than by MNCs based in most other countries (except Japan); the relatively high ETRs reported by U.S. firms in some industries with many inversions, such as healthcare, relative to their non-U.S. competitors; early inversion studies showing significant tax savings from inverting, much of which came from stripping earnings out of the United States; and managements’ expectations about the effect of inverting on their ETRs.
As for the cash flow claim, the idea that it costs firms nothing to accumulate earnings overseas is belied by some unconstrained firms having repatriated and paid U.S. tax; the large sums repatriated during the 2004-05 tax holiday, when the tax rate was reduced to 5.25 percent (which is low, but not zero); and the imposition of U.S. corporate taxes on the offshore interest earnings of U.S. corporations. In addition, there is indirect evidence that suggests that there is a cost from holding earnings offshore. These include the tendency of capital markets to discount overseas cash holdings and downgrade the credit ratings of corporations that borrow in the United States against cash held overseas.
The current U.S. worldwide income tax with deferral is, thus, not equivalent to a territorial income tax. It is not as burdensome as a worldwide tax system without deferral, but neither is it as benign as a territorial tax system. It seems likely that the U.S. international tax system will soon be revamped. Whether the new tax system eliminates incentives for U.S. MNCs to invert and for foreign MNCs to acquire U.S. businesses as promised by its proponents is an open question, the answer to which will have important consequences for the U.S. economy.
ENDNOTE
[1] JCX-46-17; JCX-59-17.
This post comes to use from Professor Michael Knoll at the University of Pennsylvania Law School and The Wharton School. It is based on his recent articles, “Taxation, Competitiveness, and Inversions: A Response to Kleinbard,” available here, and “Before International Tax Reform, We Need to Understand Why Firms Invert,” available here.