Beware territorial tax proposals

The President’s Export Council as well as his Commission on Jobs and Competitiveness and the U.S. Chamber of Commerce are all calling for a major change of the U.S. corporate tax system. In place of the present system of a tax on the worldwide earnings of U.S. corporations, they want U.S. taxes to apply only to earnings in the United States with foreign profits taxed only in the territories where they were earned.

This is one of those ideas that at first sounds a lot better than it looks upon reflection. The president and Congress need to remember that those making these proposals are not making them in their role as American citizens, but in their role as CEOs of profit maximizing global corporations. They should recall the New York Times quote of a high ranking Apple executive to the effect that the company doesn’t "have an obligation to solve America’s problems."

Of course, the argument of the business leaders is that a territorial tax system would improve U.S. competitiveness by making it easier for U.S. corporations to operate abroad and that it would create more jobs in America by making it easier for U.S. corporations to repatriate their foreign earnings for investment and job creation at home. The truth is that such a system would be good for the global corporations, but of doubtful value to the United States.

Although the U.S. corporate tax is nominally levied on a worldwide basis, in fact, it is a kind of a hybrid system. U.S taxes on the so called "active earnings" (from actually doing business as opposed to rents, royalities,etc. which are considered passive earnings) of U.S. corporations in foreign countries can be deferred until such time as they are repatriated in the form of dividends from the foreign affiliate to the parent U.S. corporation. This has resulted in a tendency for U.S. corporations to invest and hold earnings abroad in places like Ireland, Singapore, Bermuda, and the Cayman Islands that have zero or very low corporate tax rates. A Fortune estimate (Stephen Gandel, June 6, 2012) puts the amount of deferred U.S. corporate earnings being held in such tax havens abroad at over $2 trillion.

For a long time it was argued that without the necessity to pay U.S. taxes upon repatriation of foreign earnings, U.S. global corporations would rush to move capital back to the United States where they would invest and become a job creation machine.  But in 2004, when Washington instituted a one year tax amnesty on repatriation of foreign earnings the results were disappointing. The total amount repatriated was about $360 billion, but the Congressional Research Service subsequently reported that the repatriated funds went primarily to shareholders in the form of dividends rather than to new investment and job creation. Indeed, the CRS calculated that the top ten repatriating U.S. corporations actually reduced employment by 447,000 after repatriating about $99 billion.      

A territorial tax system would only be a boon for the already thriving tax avoidance industry. It would encourage further investment in tax havens and complex intra -company transfer pricing schemes to move as much income as possible out of normally taxed countries into the well known low or zero tax havens. At the moment, in order to get the deferral, corporations at least have to certify that they need the funds being held abroad for continuing investment needs. Even that small discipline would be removed under the territorial proposal.

One sign that the territorial system is not the answer is the fact that the European Union is considering proposals to move away from the system.(European Commission, Common Consolidated Corporate Tax Base).

The answer is two-fold. First, the U.S. corporate tax, by far the world’s highest with a 35 percent marginal rate, needs to be reduced to a competitive level of say 15-20 percent but with a base broadened by elimination of a variety of deductions. Second, the U.S. tax deferral for un-repatriated foreign earnings should be abolished.

At the same time, the United States should become much more aggressive in responding to and in offering its own new direct investment incentives. As China, France, Singapore, and any others do, it should pro-actively work with the global corporate community to maximize direct investment in new facilities and ventures in the United States.