James Kvaal*
Income earned in tax havens and other low-tax countries should be fully taxed by the U.S. Such a system would greatly reduce incentives to invest overseas, reward countries that adopt responsible tax systems, and raise substantial resources that could be used to strengthen the competitiveness of American workers.
It’s no secret that many American workers are struggling. Global competition is increasingly intense. Median household income has fallen in recent years, despite a growing economy.1 Meanwhile, middle-class workers bear a larger share of the tax burden.2 More surprising is that the tax code’s special breaks for multinational corporations exacerbate these problems.
Multinationals often pay little or no taxes on their foreign profits. In some cases, tax benefits for foreign investment are larger than the actual tax, meaning that in some cases Uncle Sam actually pays corporations to invest overseas. As a result, the tax code encourages multinationals to invest outside the United States rather than within it. Shifting business investment abroad can reduce American economic growth and wages. Even solely paper transactions to exploit these rules erode the tax base, shifting the tax burden from corporate profits onto wages and other sources.
Reformers should begin by recognizing that not all countries are alike. Major industrialized nations like France, Germany, and Japan generally have tax systems comparable to our own. Taxing profits earned in these countries is difficult, raises little revenue, and is unnecessary to prevent incentives to move offshore. The story is different in tax havens and low-tax countries like Bermuda, the Cayman Islands, and Ireland. These are the countries that are undercutting our tax base, diverting investment from the U.S., and creating opportunities for abusive tax shelters.
The tax code should ensure that all foreign income is taxed once at a reasonable rate. If the income is taxed by the country where it is earned, fine – no U.S. tax need be collected. However, income earned in tax havens and other low-tax countries should be fully taxed by the U.S. Such a system would greatly reduce incentives to invest overseas, reward countries that adopt responsible tax systems, and raise substantial resources that could be used to strengthen the competitiveness of American workers.
Tax Distortions in a Globalizing World
The integration of the world economy has magnified the impact of tax disparities. As other costs of moving offshore decline, remaining cost differences – including taxes – become more important. Tax havens pose three threats to the American economy.
First, tax disparities distort investment decisions, diverting capital from its most productive use. Not surprisingly, companies invest more in countries with lower taxes.3 Tax havens account for less than one percent of the world’s population but more than eight percent of American multinationals’ foreign investments in property, plants, and equipment.4
Second, a loss of U.S. capital to foreign economies can reduce wages of American workers, while increasing the return to remaining capital.5 Downward pressure on wages comes when real wages are stagnant or falling for most workers.6
Finally, even if corporations keep their actual business activity within the U.S., they may stretch the rules to characterize as much income as possible as earned in low-tax countries, thereby eroding the U.S. tax base. Indeed, U.S. multinationals now claim to earn almost half of their foreign profits in tax havens, suggesting that they are taking advantage of these laws.7
Due to these three factors, each nation has an incentive to cut corporate taxes below their neighbors’ rates to attract foreign investment. The resulting race to the bottom undermines countries’ sovereignty by preventing them from fairly taxing corporate income. Rates in OECD countries have fallen by a third over the past two decades, suggesting that the race has already begun.8 The result has been an increasing reliance on regressive consumption and wage taxes.9
Making Matters Worse: The U.S. Tax Code
In principle, the U.S. taxes American companies on all of their worldwide earnings. Worldwide taxation would eliminate any incentives to move offshore. However, two major exceptions swallow this rule.
First, American multinationals can defer U.S. taxes indefinitely as long as profits are held in a foreign subsidiary. Taxes are only due when the money is returned to the U.S. parent corporation.10 The result is like an IRA for multinationals’ foreign investments: foreign profits accumulate tax-free. U.S. taxes are effectively voluntary on foreign investments.
Not surprisingly, then, few corporations choose to pay taxes. Only about seven percent of all income earned in low-tax countries was returned to the U.S. in 1992.11 At the end of 2002, American companies held more than $639 billion in profits in foreign subsidiaries, roughly three-quarters of which would be subject to U.S. tax if repatriated.12
Second, when multinationals choose to return profits to the U.S., they can offset any foreign taxes against their U.S. tax.13 The foreign tax credit is intended to prevent any double taxation on income simultaneously taxed by two governments. It appropriately attempts to equalize the taxation of foreign and domestic income. However, it means that – where foreign taxes are higher than U.S. taxes – multinationals pay no U.S. taxes at all.
As a result, the effective tax rate on foreign non-financial income is below 5 percent, well below the statutory rate of 35 percent.14 Even when combined with foreign taxes, the total taxes on foreign income are often substantially lower than taxes on U.S. income. By one estimate, a typical investment in a low-tax country faces a total (foreign and U.S.) tax of only 5 percent.15
At times, the U.S. even affirmatively subsidizes foreign investment. In other words, multinationals’ foreign profits not only go untaxed, they reduce the U.S. taxes otherwise due on other income.16 It is a negative tax: the more they earn overseas, the smaller their tax bill.
The existence of untaxed foreign subsidiaries open up massive new opportunities for tax planning. Multinationals can greatly reduce their tax bill by reporting that their U.S. profits were actually earned in a tax haven. One common tool is transfer pricing: When exchanging goods and services among subsidiaries, corporations can set their prices artificially high or low to increase domestic expenses and increase foreign income.17 The I.R.S. struggles to prevent this common abuse.18
In addition, credits and deductions generated by foreign investment can be larger than the resulting U.S. tax.19 For example, multinationals can deduct expenses of their foreign investment – such as interest, administrative overhead, and research — against their U.S. taxes.20 However, they may never pay U.S. taxes on the resulting profits.21 They can also use foreign tax credits to shield income essentially earned within the U.S. from U.S. taxation through allowances for exports and royalty income.22
A Better Way: A Partial Exemption System
International tax reform should begin with the principle that American corporations should pay a similar tax rate, no matter where in the world they invest. A partial exemption system would tax foreign income only if a foreign government failed to tax it under a comparable tax system. As a result, all corporate income would be taxed at a reasonable rate once and only once.
There are several advantages to this approach. First, a partial exemption system would reduce incentives to invest in low-tax countries. Income earned in a tax haven would be taxed just as if it were earned at home. It would also eliminate the incentive that exists under the current deferral rules to park foreign profits overseas.
Second, the system would greatly simplify the taxation of corporate profits earned in most other large industrialized nations. U.S. corporate tax rates are close to the average among G-7 countries.23 Our current system collects little revenue from these and similar countries, while creating opportunities for the abuse of foreign tax credits.
Third, the system would reduce tax competition. It would remove the benefit of tax havens for U.S. corporations. It would reward countries that adopted responsible tax systems by making their countries more attractive for U.S. investment. And by reducing the rewards of aggressive tax planning, it would relieve the pressure on overmatched anti-abuse rules.
Finally, by reducing subsidies for foreign investment, the proposal would raise a significant amount of revenue. Other international tax reform proposals have raised between $5 billion and $12 billion a year.24 These resources could be invested in initiatives to improve the competitiveness and productivity of American workers, such as education, research, and technology.
Designing a Partial Exemption System
A foreign tax system would be considered “comparable” if its tax rate were close to or higher than the U.S. rate. For example, a foreign rate of 28 percent or higher could be considered comparable to the U.S. rate of 35 percent. Twenty-five of the 30 OECD countries have corporate rates of at least 28 percent.25 Adjustments may be necessary for the treatment of depreciation and interest expense, effectiveness of tax collection, and variations in sub-national taxes.
Although a partial exemption would not achieve full tax neutrality, it would greatly limit tax disparities. A corporation might still be able to choose the British tax rate of 30 percent instead of the American rate of 35 percent, but it could no longer claim the Irish rate of 12.5 percent or the Bermudan rate of zero.26
A similar proposal was advanced by the Treasury Department under President George H.W. Bush.27 Other nations commonly treat income differently depending upon where it was earned.28 France only taxes foreign income that is subject to foreign taxes below half of the French rate, while Japan imposes additional taxes on income earned where foreign taxes are below 25 percent.29
No doubt, U.S. multinationals will argue that any higher taxes will hurt their competitiveness. However, American economic welfare is not improved by favoring foreign investment over domestic investment. Instead, the preferences for foreign investment embodied in the current tax regime distort investment decisions and undercut the competitiveness of American workers.
In a world with diverse tax systems, it is impossible for the U.S. to ensure a completely level playing field. We must work with other countries to reduce economic distortions. In the meantime, however, we should act immediately to ensure that our tax code no longer exacerbates incentives to move offshore.
Conclusion
Tax competition is a threat to American prosperity, and the problem is exacerbated by the U.S. tax code. Foreign countries attract U.S. investment by undercutting American tax rates, and the U.S. imposes little or no tax on the resulting income. In some cases, the U.S. affirmatively subsidizes foreign investment by providing tax benefits without any tax.
Taxing all worldwide income once, and only once, at a responsible rate would remove incentives for U.S. multinationals to move to tax havens and other low-tax countries. Exempting income earned in other countries would reward responsible tax systems and reduce cross-crediting. Finally, a partial exemption system would reduce the rewards from paper transactions that shift income for tax purposes.
* James Kvaal is a third-year student at Harvard Law School. He previously worked as a policy adviser in the Clinton White House and for Democratic members of Congress.
[1] See Jared Bernstein & Elise Gould, Income Picture: Working Families Fall Behind, ECONOMIC POLICY INSTITUTE, Aug. 29, 2006, http://www.epinet.org/content.cfm/webfeatures_econindicators_income20060829.
[2] See Dana Milbank & Jonathan Weisman, Middle Class Tax Share Set to Rise, WASH. POST, June 4, 2003, at A1.
[3] See U.S. DEPARTMENT OF THE TREASURY, THE DEFERRAL OF INCOME EARNED THROUGH U.S. CONTROLLED FOREIGN CORPORATIONS 178 (2000); Harry Grubert & John Mutti, Do Taxes Influence Where U.S. Corporations Invest?, 53 NAT’L TAX J. 825, 835 (2000) (“Host country average effective tax rates appear to have a highly significant effect on the location and investment decisions of U.S. manufacturing companies”); James R. Hines, Jr.,Lessons from Behavioral Responses to International Taxation, 52 NAT’L TAX J. 305 (1999).
[4] James Hines, Director of Tax Policy Research, Int’l Tax Pol’y Forum, Effects of Tax Reform on Foreign Direct Investment, Presentation at the Brookings Institution 37 (Dec. 2, 2005) (transcript available at http://www.brook.edu /comm/events/20051202tax.pdf).
[5] See CONGRESSIONAL BUDGET OFFICE, CORPORATE INCOME TAX RATES: INTERNATIONAL COMPARISONS 6 (2005),
http://www.cbo.gov/ftpdocs/69xx/doc6902/11-28-CorporateTax.pdf; Jane G. Gravelle, Foreign Tax Provisions of The American Jobs Act Of 1996, 96 TAX NOTES 167 (1996).
[6] See Jared Bernstein, What’s Wedged between Productivity, Living Standards?, PROVIDENCE J.-BULL., Feb. 28, 2006.
[7] See Martin A. Sullivan, The IRS Multibillion-Dollar Subsidy for Ireland, 108 TAX NOTES 287 (2005); Martin A. Sullivan, Economic Analysis: Latest IRS Data Show Jump in Tax Haven Profits, 105 TAX NOTES 151 (2004).
[8] See CONGRESSIONAL BUDGET OFFICE, supra note 5, at xi. The 30 nations that are members of the Organization for Economic Cooperation and Development (OECD) are all democracies with market economies.
[9] See Reuven S. Avi-Yonah, Globalization, Tax Competition, and the Fiscal Crisis of the Welfare State, 113 HARV. L. REV. 1573, 1577 (2000).
[10] See U.S. DEPARTMENT OF THE TREASURY, supra note 3, at ix.
[11] HARRY GRUBERT & JOHN MUTTI, TAXING INTERNATIONAL BUSINESS INCOME: DIVIDEND EXEMPTION VERSUS THE CURRENT SYSTEM 2 (2001).
[12] DAVID BRUMBAUGH, CONG. RESEARCH SERV., TAX EXEMPTION FOR REPATRIATED FOREIGN EARNINGS 7 (2004). The figure is probably lower today due to a tax holiday enacted in 2004, which temporarily reduced taxes on foreign profits returned to the U.S. However, corporations are expected to immediately resume stockpiling profits overseas. See J. Clifton Fleming, Jr. & Robert J. Peroni, Eviscerating the Foreign Tax Credit Limitations and Cutting the Repatriation Tax — What’s ETI Repeal Got to Do with It? 104 TAX NOTES 1392, 1412 (2004); Alex Berenson, Drug Makers Reap Benefits of Tax Break, N.Y. TIMES, May 8, 2005, at A11.
[13] See I.R.C. §§ 901, 902, 960, and 1291(g) (2000).
[14] See GRUBERT & MUTTI, supra note 11, at 2.
[15] See Rosanne Altshuler & Harry Grubert, Where Will They Go if We Go Territorial? Dividend Exemption and the Location Decisions of U.S. Multinational Corporations, 54 NAT’L TAX J. 787, 790 (2001).
[16] See U.S. DEPARTMENT OF THE TREASURY, supra note 5, at 45-46 (“[T]he effective rate of the residual U.S. tax on foreign earnings is often negative. That is, the total foreign and U.S. tax on repatriated earnings (including dividends, interest and royalties) may be less than the taxes imposed by the foreign host country.”)
[17] See Lee A. Sheppard, News Analysis: Looking at the Tax Reform Plan’s International Provisions, 109 TAX NOTES 1002 (2005).
[18] See American Bar Association Section of Taxation, Report of the Task Force on International Tax Reform, 52 TAX LAW. (forthcoming 2006); Lee A. Sheppard, Draft Senate Finance APA Report Shows Incompetent IRS, 2005 TAX NOTES TODAY 119 (2005); Martin A. Sullivan, Democratic Senators Eye Offshore Profits, 110 TAX NOTES 590 (2006).
[19] See U.S. DEPARTMENT OF THE TREASURY, supra note 3, at 45.
[20] John Buckley & Al Davis, Extraterritorial Income/Corporate Inversion Debate: Will Myths Prevail? 96 TAX NOTES 289, 291 (2002); American Bar Association Section of Taxation,supra note 18 (manuscript at 244-55, on file with author).
[21] See John Buckley & Al Davis, supra note 20, at 291; STAFF OF JOINT COMM. ON TAXATION, 109TH CONG., REPORT ON OPTIONS TO IMPROVE TAX COMPLIANCE AND REFORM TAX EXPENDITURES 186-97, 427 (Comm. Print 2005).
[22] See Letter from Rep. Charles B. Rangel & Rep. John Buckley to Democratic Members of the House Comm. on Ways & Means, Current International Tax Rules Provide Incentives for Moving Jobs Offshore, (Mar. 22, 2004), available athttp://www.house.gov/waysandmeans_democrats/trade/3_22_dear_colleague.pdf.
[23] See CONGRESSIONAL BUDGET OFFICE, supra note 5, at x-xi, 14, 22.
[24] See STAFF OF JOINT COMMITTEE ON TAXATION, supra note 21, at 186-97, 427; Press Release, John Kerry for President (Mar. 26, 2004), available at
http://releases.usnewswire.com/GetRelease.asp?id=28000 (last visited Sept. 9, 2006).
[25] See CONGRESSIONAL BUDGET OFFICE, supra note 5, at 22.
[26] ERNST & YOUNG, WORLDWIDE CORPORATE TAX GUIDE 86-88, 391-410, 966-87 (2005) (summarizing the tax systems of Bermuda, Ireland, and the United Kingdom).
[27] See U.S. Department of the Treasury, International Tax Reform: An Interim Report, 93 TAX NOTES 15 (1993); see also H. David Rosenbloom, From the Bottom Up: Taxing the Income of Foreign Controlled Corporations, 26 BROOK. J. INT’L L. 1525 (2001) (making similar proposal).
[28] See An Examination of U.S. Tax Policy and Its Effects on the International Competitiveness of U.S.-Owned Foreign Operations: Hearing Before the S. Comm. on Finance, 108th Cong. 98-100 (2003) (statement of H. David Rosenbloom, Caplin & Drysdale, Chartered).
[29] See Ambroise Bricet, French Finance Act Contains Major Corporate Tax Changes, 2005 TAX NOTES INT’L 294 (2005); JAPANESE MINISTRY OF FINANCE TAX BUREAU, AN OUTLINE OF JAPANESE TAXES 2005 121 (2005); ERNST & YOUNG, supra note 26, at 451-57 (2005).
A longer version of this article appeared in the June 12, 2006, issue of Tax Notes.