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.

By | 2017-05-23T19:08:13+00:00 Wednesday, 6 May 2009|