An earlier version of this article was posted in ITEP’s Just Taxes Blog.
In recent days, presidential candidates Sen. Kamala Harris and New York Mayor Bill DeBlasio have called for taxing corporate profits the same whether they are earned in the United States or abroad. These calls echo the position of Sen. Bernie Sanders, who has long had a proposal along these lines. As ITEP has explained, correcting this inequity is not a mere detail but rather a sweeping reform that could end incentives for companies to shift profits and jobs offshore.
A longstanding problem with the nation’s tax code is that it taxes offshore profits of American corporations more lightly than it taxes their domestic profits. This was true prior to the passage of the Tax Cuts and Jobs Act (TCJA) and is still true under the new rules.
As is often the case with tax policy, the details are complicated, but the overall story is simple. If you tell companies that their offshore profits will be taxed less than their domestic profits, they will report earning more of their profits offshore. If you tax all profits the same way, they have little incentive to shift profits offshore.
The Nation’s Current International Corporate Tax System
Before TCJA, the United States technically had a worldwide tax system, meaning an American corporation had to pay U.S. taxes on its profits no matter where it earned those profits. But companies also could defer paying U.S. taxes on offshore profits until they officially brought those profits to the United States, which did not happen often. Companies could officially hold those profits offshore indefinitely.
TCJA introduced something more like a “territorial” tax system, which only taxes profits generated in the United States. The current rules impose a minimum tax on some offshore profits, but it’s half the rate that applies to domestic profits.
While TCJA is different from the old tax system, it has the same effect of providing more generous tax treatment to profits ostensibly generated offshore. This means that companies still have an incentive to use accounting gimmicks to make their profits appear to be earned in countries with a much lower corporate tax rate or no corporate tax at all.
In some ways, TCJA could be worse than the previous tax law because it encourages companies to move actual operations and jobs offshore. Under the complicated rules in place now, no U.S. tax is imposed on offshore profits that do not exceed 10 percent of tangible assets (assets like machines, stores, oil wells) the company holds offshore. For example, if a corporation holds $100 million in tangible assets offshore, it can have up to $10 million in offshore profits that are not subject to U.S. taxes at all. This means that an American corporation might reduce its tax bill by moving more tangible assets – and the jobs that go with them – offshore.
The Solution: A Real Worldwide Tax System
Of the three candidates who are essentially calling for a true worldwide tax system, only Sen. Sanders has drafted legislation. But Sen. Harris and Mayor DeBlasio seem to be thinking along the same lines. Another bill in Congress, the No Tax Breaks for Outsourcing Act, introduced by Sen. Sheldon Whitehouse and Rep. Lloyd Doggett, would have a similar result.
Here is how a real worldwide tax system would work. For the moment, assume that the 21 percent corporate tax rate stays the same. An American corporation would pay 21 percent on its profits no matter where it earns those profits.
American companies have always been allowed to take a tax credit against what they pay to foreign governments, and that would continue to be the case. So, if an American company has profits in a country where it pays corporate income taxes at a rate of 10 percent, it would receive a foreign tax credit against its U.S. taxes equal to 10 percent of those profits. Instead of paying U.S. taxes at a rate of 21 percent on those profits, it would pay U.S. taxes at a rate of 11 percent. The combined U.S. and foreign tax rate would be 21 percent.
In other words, the company would pay a 21 percent rate on its profits whether they are earned in the United States or abroad. (It could pay a higher rate only if it does business in a country with a rate higher than the U.S. has.) The foreign tax credit would prevent double taxation but provide no benefit beyond that.
Companies would have no tax incentive to shift business offshore or use accounting gimmicks to make their profits appear to be earned offshore — no incentive to use offshore tax havens. Some American corporations might try to escape these rules altogether by recharacterizing themselves as foreign companies if allowed. But, as we have already explained, Congress can easily block such “inversions.”
Reforming Offshore Corporate Rules Is an Important Part of Progressive Tax Agenda
Many politicians are finally responding to the public’s demand for more progressive tax policies, and closing loopholes that reward corporations for playing accounting games and offshoring profits should be high on the list.
While much of the focus has been on tax rates paid by high-income individuals and by corporations, shutting down special breaks and loopholes is at least as important, and this is true in the context of the corporate income tax, just as it is true in the context of the personal income tax.
If Congress raises the corporate tax rate but makes no other changes, corporations could largely avoid that tax increase by shifting more profits offshore. Shutting down the breaks that allow that profit-shifting — taxing domestic and offshore profits in the same way — is key to raising revenue fairly and equitably.
Steve Wamhoff is Director of Federal Tax Policy at Institute on Taxation and Economic Policy (ITEP).