The US international corporate tax system is tied up in a Gordian knot, which is why we see hearings and not a fix.
Caterpillar took its turn April 1 before Senator Carl Levin’s Permanent Subcommittee on Investigations to defend its offshore tax strategy—following in the footsteps of Apple, HP, Microsoft and others—to show that it is not just tech firms that are avoiding US taxes by shifting profits offshore. The tax planning prowess and tax advantages found in a multinational corporation is not news. Nor is the fact that the US international tax system is a mess and encourages the sort of tax planning Caterpillar is accused of. This same mess also requires deft liquidity and off-setting debt management by US MNC treasurers in response to having domestic free cash flow and more tax-restricted liquidity offshore, as a result of the system and the planning. The real question is what should be done about it. Political theatrics and accusations of tax-dodging do very little.
In Need of a Fix
Fixing US International Taxation (Oxford University Press), a new book by Daniel Shaviro, Wayne Perry Professor of Taxation at New York University School of Law, seeks to address this question by providing a timely and rather apolitical look at US international tax rules and their main effects, while also laying out a framework for how to go about fixing what clearly needs fixing. Unfortunately, what Mr. Shaviro also describes in detail is a Gordian knot, so difficult to cut through, much less unravel, that he does not end up providing a definitive answer.
“Unfortunately, near-universal consensus that the existing US international tax system is horrendously bad has failed to induce change, given the continuing dissensus about what to replace it with,” Mr. Shaviro writes.
The true objective of his book, therefore, is to advance discussion toward a better system by reexamining the principles underlying the problems with the current tax system and the trade-offs involved in solving them.
No Simple Trade-offs
Effective US international tax reform, as Mr. Shaviro makes clear, will not be a simple choice between a worldwide or residence-based system and source-based or territorial taxation. Making the case for a residence-based system isn’t so easy when you consider the challenges for establishing residence for a multinational affiliation of corporate entities. Plus, there is the inherent trade-off between the desire to tax both the US corporation and its foreign rival at home, but then see that US corporation taxed in the foreign rival’s homeland with a likely differential between the two tax burdens. The same can be said for identifying the source of taxable income earned by a multinational corporation. If one country claims to be the source of the income, another country potentially loses out on the taxable revenue and thus may define sourcing differently.
Examining these challenges starts to explain why the US system has become a cumbersome compromise between these two approaches—taxing worldwide income, but deferring the tax until the income is realized in the US—and why it has been complicated further by additional compromises made without careful consideration of the tradeoffs.
Another encumbrance is that preventing double taxation has become entrenched in international tax rules and tax treaties between countries. Thus, taxation of income subject to residence-based taxation in one country has to be reconciled with the fact that it may be subject to source-based taxation in another, and in any case, subject to different effective tax rates. This has led to the US system of foreign tax credits that provide a credit against US tax for taxes paid abroad, which are sometimes in excess of the US corporate tax rate.
It is the combined effects of deferral and foreign tax credits (plus double taxation restrictions in tax treaties) that create the “iron box” that make it so difficult to reform US international corporate taxation.The full Gordian knot is exposed when you consider the tax implications for individual taxpayer owners of a multinational corporation.
If reformers end deferral and all US MNCs foreign source income becomes immediately subject to US taxation, then foreign tax credits kick in immediately, exacerbating US corporate indifference to foreign taxes, and with this the transfer payments from the US Treasury to their foreign counterparts for taxes paid by US corporates in excess of the US rate. End foreign tax credits and the incentives to create and defer foreign source income indefinitely only increase.
End both, as Mr. Shaviro suggests you have to, then you need to think carefully about the rates set to tax domestic (e.g., lower than now) and foreign source income (somewhat higher than zero, but still acceptable to treaty restrictions). This comes close to the trade-off in the House Camp proposal as well as the recent Senate Finance Committee discussion draft. However, Mr. Shaviro also says reformers will have to accept some double-taxation and even limited non-taxation for a simpler system that brings in more revenue (from US and non-US resident MNCs) at less cost.
You could also go further, Mr. Shaviro acknowledges, and eliminate corporate income taxes entirely: either deal with the residence, source and realization compromises at the individual level and/or impose some form of consumption tax system. This may be fairer to employees that tend to bear the brunt of corporate-level taxation, as well as shareholders. Employee welfare may warrant more study alongside Mr. Shaviro’s summaries of academic work on the global (think economics of comparative advantage) and national welfare perspectives (encouraging corporate investment in and benefiting the national economy while meeting public fiscal needs) on optimal international corporate taxation. But there is even less of a chance of ending corporate taxation than reforming it, internationally or domestically. In short, a fix that will make things better is not likely soon. It is much easier to hold hearings.