Senate Finance Committee Chairman Max Baucus offered some good ideas last week for improving how the U.S. taxes American multinational corporations. The current system could certainly stand some improvement. It’s so bad, Congress might actually do something.
Under the current rules, profits these companies earn overseas are subject to American taxes, but only once a company brings the money back to the United States. Companies therefore try to move their operations, or at least shift their earnings, to countries with lower tax rates, then leave them there. At 35 percent, the headline U.S. corporate tax rate is high by international standards, so the incentive to keep earnings abroad is all the greater. The result is some $2 trillion in accumulated profits held abroad and corporate taxes that have fallen to less than 10 percent of federal tax revenue last year, down from 22 percent in 1965.
The simplest way to solve this problem would be to abolish the corporate income tax altogether and replace that lost revenue by taxing capital gains and dividends as ordinary income. Setting up a shell subsidiary in Bermuda is one thing; moving all your shareholders to Bermuda is another.
That’s too radical a reform to be at all likely to happen soon. In the meantime, Baucus’ proposal is a good first step. He wants to tax the pool of profits currently held abroad at a reduced rate of 20 percent and apply a new minimum tax to U.S. companies’ future foreign earnings. (Companies could deduct what they have to pay in foreign taxes.) This would reduce the incentive to shift profits abroad. There’d be more revenue as well, and that could be used, Baucus says, to pay for a lower corporate tax rate.
Multinationals are resisting, which isn’t necessarily a bad sign. (The whole idea is to bring more of their earnings into the U.S. tax base.) They say the proposal is too complicated. They’d prefer what’s called a territorial tax, in which only profits earned in the U.S. are subject to U.S. taxes. That’s the international norm, and it would end the incentive to park previously accumulated foreign earnings abroad. But it wouldn’t end the incentive to book new earnings in those same low-tax jurisdictions. What Baucus is proposing makes better sense than this.
Here’s another possibility: Baucus could propose a version of the system the multinationals are suggesting, in which only U.S. activity is subject to U.S. taxes — but instead of basing the tax on how much income a company earns in the U.S., he could base it on the portion of sales that are made in the U.S.
This approach, called formulary apportionment, is how most U.S. states levy taxes on companies that operate across state lines. Its appeal is straightforward: While earnings can be booked where taxes are lowest, goods and services follow the customer. Apportionment would therefore eliminate the tax incentive for U.S. companies to move earnings offshore. The European Union is considering a similar system for its members.
This approach wouldn’t be pain-free. For instance, tax treaties with other countries would have to be renegotiated. But it would be worth the effort if the current Baucus proposal gets bogged down and a more politically robust alternative to the status quo is needed. The worst outcome would be to do nothing, leaving in place a system that makes no sense at all.