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For growth, both rate reduction and a territorial tax system

Oct 17, 2012

Wouldn't it be nice to have a full presidential debate devoted solely to taxation, where time allowed substance and accuracy?* 

Tuesday's presidential debate featured the usual shorthand and mischaracterizations that tend to mark these events. Absent a tax-only debate, perhaps the best the public can hope for are substantive papers on why the current U.S. corporate tax system discourages growth and job creation.

Thankfully, the economist Diana Furchtgott-Roth, a senior fellow with the Manhattan Institute, has given us such a paper, "The Merits of a Territorial Tax System." She begins with a discussion of the high, anti-competitive corporate tax rate in the United States and then compares the two systems of taxing overseas revenues, "worldwide" -- which the United States uses -- versus "territorial," preferred by the vast majority of U.S. competitors.

A global (or worldwide) tax system is uncompetitive, especially with high tax rates, because it imposes a high income-tax rate on all income, regardless of where it is earned. If an American company operates in the United States and Switzerland, its domestic affiliate pays U.S. taxes at 35 percent. But its foreign affiliate pays U.S. taxes at 35 percent and Swiss taxes at 8.5 percent, putting it at a disadvantage vis-à-vis its foreign competitors. America allows companies to deduct the taxes paid to foreign governments from U.S. taxes owed to the Internal Revenue Service, but corporations always pay the full U.S. rate and are unable to take advantage of low-tax jurisdictions.

By contrast, a territorial tax system, common to most U.S. competitors, taxes only income earned domestically. In the example above, the American company operating in Switzerland and America would pay U.S. taxes on its domestic income and Swiss taxes on its Swiss income. In this way, companies can take advantage of low-tax jurisdictions. Business decisions can be made more efficiently, since repatriating income will not result in those profits being taxed again—thus, capital can go where it is most needed.

Critics of a worldwide system rightly assert that companies will not return income to America when profits face a high tax rate. Corporations operating under a global tax system are less competitive if their domestic tax rate is higher than their foreign tax rate, as their profits will always be subject to the higher domestic rate.

Proponents of a worldwide system, however, argue that corporations benefit from being able to headquarter in America, so taxing their global income simply amounts to “paying their fair share.” The advantage to having an American headquarters is rapidly disappearing, though, as the difference between American and foreign tax rates widens. Regulations, such as those contained in the Dodd-Frank and Sarbanes-Oxley laws, are becoming more burdensome. Markets are expanding, and headquarters can be located nearer to a firm’s client base. And countries such as Britain, Germany, and Japan have stable legal and financial systems, making them satisfactory headquarters for multinationals.

Furchtgott-Roth drew on the paper for a column on last night's presidential debate here. Bloomberg provides a brief "fact check" on the debate's discussion of the territorial tax here.

BRT President John Engler also argued for a territorial system last Friday in a Wall Street Journal  op-ed, "Corporate Taxes, the Myths and Facts." He noted:

According to J.P. Morgan, U.S. companies today control $1.7 trillion in foreign earnings held outside the U.S., earnings they don't plan to repatriate. If the U.S. were to adopt a territorial system, it would eliminate the tax barrier that discourages American companies from bringing their money home where it could be used for capital investment, R&D dividends or other ways to support economic growth.

* Yes, we know. You could ask the same question about energy development, regulatory excess, global trade or a million other topics. But at least the last debate will be devoted to a single topic, foreign policy, thus allowing for substance, clarity and accuracy. Right?


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