Understanding the President's international tax proposal

Let’s look at three factories, each of which produces $100 of income.

  1. Your factory A is in the U.S. Your corporation pays a 35% U.S. corporate income tax rate ($35).
  2. Your factory B is in China. Your corporation pays a 15% Chinese corporate income tax rate ($15). You owe the U.S. government $35 in taxes, minus a credit for the $15 you paid to China. China gets $15, and the U.S. government gets $20.
  3. Your British competitor’s factory C is also in China. He pays a 15% Chinese tax rate ($15), and no taxes to his home government.

Factory B shows the effect of a worldwide tax system, in which the firm pays the same total tax wherever the income is earned. Taxes are based on the nationality of the payor, not the location at which the income is earned.

Factory C shows the effect of a territorial tax system. Income is taxed only where it is earned.

The U.S. actually has a hybrid. You can defer the taxes you owe from factory B until you bring that income back to the United States. This is an advantage relative to a pure worldwide system.

Left-leaning and other protectionist elected officials like to argue that a worldwide system “discourages U.S. firms from moving their factories overseas.” Senator Kerry argued this in the 2004 Presidential campaign. A worldwide system also raises more money for the home government to spend on other programs.

The territorial system creates a level playing field for American firms when they are competing overseas. Your factory B in China is at a severe disadvantage compared to the British factory C in China. You might consider moving your headquarters to London and turning your firm into a British corporation. As the global economy grows more interconnected this is increasingly easy to do.

The President’s new international tax proposal moves us toward a worldwide system. I think we should move in the opposite direction, toward a territorial system.

I think that lower taxes are good, and worldwide tax systems are a throwback to a time when the world economy was less global. Yes, in a territorial system companies can open factories overseas to avoid higher taxation in the U.S. But the more relevant comparison is whether Intel’s chip fabrication plant in China will be disadvantaged relative to the Malaysian, Brazilian, or French plant in China. If you are worried about a tax system encouraging U.S. firms to build factories overseas, you should worry that in a worldwide system, entire U.S. firms will move to a country with a territorial system.

A worldwide system fails if most other major economies are using territorial systems, and most are. Unless you think you can prevent increased globalization, or that you can convince other countries to change to a worldwide system, I think the international competitive pressure is inevitably toward a territorial system. In a world of increasingly mobile capital, it it both fair and smart for the U.S. to make sure we do not give firms based in other nations an unfair advantage. I also think that international competition to lower taxes is a good thing.

The President thinks this is good policy. He also needs revenues to offset his desired spending increases, especially for health care. (He has proposed that the revenues be used to offset the R&D tax credit, but that linkage will soon collapse in Congress.)

This issue does not break strictly on partisan lines, but instead more on an internationalist vs. economic isolationist split. The man to watch is Senate Finance Committee Chairman Max Baucus (D-MT), who has for years worked with Senator Orrin Hatch (R-UT) to move the U.S. toward a territorial system. Chairman Baucus’ Monday statement emphasizes that the business environment is increasingly global, and that American policymakers should not disadvantage American firms in that competition: “I want to make certain that our tax policies are fair and support the global competitiveness of U.S. businesses.”

Will Chairman Baucus be able to withstand pressure from the White House, Leader Reid, and his Democratic colleagues to raise these taxes to help pay for new health spending? The Senate Finance Committee has a longstanding tradition of bipartisan cooperation and an internationalist bent, and Chairman Baucus has worked harder and longer on this issue than anyone in the Administration. His key ally, Senator Hatch, will in 2011 replace Senator Grassley as the senior Republican on the committee, so it would be tactically smart for Chairman Baucus to renew and strengthen the Baucus-Hatch alliance on this issue and resist pressure from the economic isolationists who are looking for some money to spend. Ultimately this will become a test of Chairman Baucus’ strength.

If this issue excites you, start with pages 102-105 (284-287 in the Acrobat file) of this report from the tax reform panel created by President Bush.

Then read Bob Carroll’s papers here and here.

9 responses

  1. Pingback: Obama’s International Corporate Tax Proposal Explained « A Conservative Wanderer

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  3. I am not sure I fully understand – please compare

    Company Factory Sells-to Tax-Rate Notes

    US US US 35%
    US US China 15% Until money is brought home
    US China US 35%
    US China China 35%? US company at severe disadvantage
    China US US ?
    China US China ? Probably never happens
    China China US 15%?
    China China China 15%

    I was part of an IT team the restructured a company to lower taxes – there were lots of strange laws – I think a Chinese company cannot directly sell in the US, instead they create a legal entity in the US that sells for them and, I assume, pays taxes on the “income”. The problem is defining income, which equals selling_price-cost. There were endless arguments with tax authorities about what the cost was.

  4. Thanks for your post. I really like your blog. My question is this. You say that in response to this law change, entire US firms will relocate overseas, thereby escaping US taxation entirely. E.g., let’s say Chevron. But Chevron probably has a lot of assets with “built-in-gains”, i.e., with fair market value above tax basis, or call them appreciated assets. I think if they try to locate overseas the US government will just levy a tax on those gains. Or maybe they wouldn’t even need that excuse – they could just levy an arbitrary exit tax on the market cap value of the company. Can’t you picture the administration and congress doing that?

    I really wish these corporations could relocate overseas, b/c I feel like we have a very bad business climate right now. People need some kind of wake up call to understand that we are being economically damaged by relatively high corporate taxes.

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  6. If loopholes are closed and US domiciled companies really have to start paying one of the highest corporate income taxes in the WORLD on their worldwide income, why would any US based company not change their primary incorporation out of the US??

    All companies who earn income in the US are on the same footing, regardless of where their primary incorporation is located, in having to pay a very high corporate tax rate. But if your British, or French, or Korean competitor is paying 15% for their China based income and Mr US company has to pay 35%, then Mr US company won’t stay located in the US for very long.

    This reminds me of Pres Obama stating that he would want to raise capital gains taxes even if it meant lower taxes paid, all in the name of “fairness”.

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  8. >>If loopholes are closed and US domiciled companies really have to start paying one of the highest corporate income taxes in the WORLD on their worldwide income, why would any US based company not change their primary incorporation out of the US??<<

    If the US tax laws were reformed, a corporation would not escaping US taxation by merely incorporating overseas. Why? You cannot conduct business in the USA without at least being registered as a foreign corporation. If taxation is based on business activities conducted within the USA without regard to where the corporation is incorporated (much like the California system of global taxation) it matters very little where corporation has incorporated an set up a front office. The threat of businesses leaving US soil is way overblown IMHO. Moving business function away from the customers damages the business.

  9. I’ve been involved in taxations for longer then I care to admit, both on the individualized side (all my employed life-time!!) and from a legal viewpoint since passing the bar and following tax law. I’ve put up a lot of advice and rectified a lot of wrongs, and I must say that what you’ve put up makes complete sense. Please continue the good work – the more people know the better they’ll be outfitted to handle with the tax man, and that’s what it’s all about.

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