Bringing it back home

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Bringing it back home

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Martin Feldstein

CAMBRIDGE, Massachusetts - An increasing number of American companies are making plans to shift their headquarters to Europe. These so-called inversions would reduce these companies’ total tax bill by allowing them to escape from the United States’ uniquely unfavorable corporate tax rules. So what should U.S. policy makers do?

President Barack Obama’s administration is seeking to block corporate inversion through administrative measures that may not hold up in U.S. courts. It would be far better to develop a bipartisan legislative plan aimed at removing the temptation to shift corporate headquarters in the first place. Such a plan, if attractive to U.S. multinational corporations, could result in a shift in employment and production to the United States and higher tax revenue.

Under current law, U.S. corporate profits are taxed at a rate of 35 percent - the highest rate among OECD countries, where the average is 25 percent. That tax is paid on profits earned in the US and on repatriated profits earned by U.S. companies’ foreign subsidiaries.

For example, the subsidiary of a U.S. firm that operates in Ireland pays the Irish corporate tax of 12.5 percent on the profits earned in that country. If it repatriates the after-tax profits, it pays a 22.5 percent tax (the difference between the 35 percent U.S. rate and the 12.5 percent tax that it already paid to the Irish government). But if it reinvests the profits in Ireland - or in any other country - no further tax must be paid.

Not surprisingly, American firms prefer to leave those profits abroad, either in financial instruments or by investing in new or existing subsidiaries. As a result, American companies now hold abroad roughly $2 trillion in profits that have never been subject to U.S. tax.

All other OECD countries treat the profits of their companies’ foreign subsidiaries very differently, relying on the so-called “territorial” method of taxing foreign earnings. For example, a French firm that invests in Ireland pays the 12.5 percent Irish corporate tax but is then free to repatriate the after-tax profits with a tax of less than 5 percent.

America’s current tax system adversely affects the U.S. economy in several ways. The extra tax that U.S. firms pay if they repatriate profits raises their cost of capital, thus reducing their ability to compete in international markets. Foreign firms can also outbid their U.S. counterparts in acquiring new high-tech firms in other countries. And when a foreign firm acquires a U.S. company, it pays U.S. tax on the profits earned in the United States but not on the profits earned by that firm’s other foreign subsidiaries, thus lowering its total tax bill.

A shift to a territorial system of taxation would remove the disadvantages faced by American multinational corporations and encourage them to reinvest their overseas profits at home, increasing U.S. employment and profits. Because only a small share of overseas profits is now repatriated, the U.S. government would lose very little tax revenue by shifting to a territorial system. A few years ago, the U.S. Treasury Department estimated that shifting to a territorial system would reduce corporate tax revenue by only $130 billion over 10 years.

It would also be desirable to reduce the U.S. corporate tax rate gradually, bringing it closer to the 25 percent OECD average. That, too, would encourage more repatriation of overseas earnings.

Given that American companies have large amounts of profits abroad that have never been subject to U.S. tax, the transition could even be carried out in a way that raises net revenue. In exchange for shifting to a territorial system and reducing the tax rate, the federal government could tax all of these untaxed past earnings at a low rate to be paid over a ten-year period. Companies would then be free to repatriate their pre-existing earnings without paying any additional tax, while future foreign earnings could, as in other countries, be repatriated by paying a low 5 percent tax.

A 10 percent tax on those existing accumulated foreign earnings would raise about $200 billion over the ten years. A 15 percent tax would raise $300 billion. The choice of tax rate would be part of the negotiation over how far to reduce the overall U.S. corporate tax rate.

For example, with a 10 percent tax, a company with $500 million of accumulated overseas earnings would incur a tax liability of $50 million, to be paid over ten years. It could repatriate $500 million at any time with no additional tax liability. Repatriation of any earnings in excess of $500 million would be subject to a 5 percent tax.

The shift to a territorial system and a lower corporate tax rate would appeal to American multinational corporations even if they had to pay a 10 to 15 percent tax on accumulated past earnings. If Obama is looking for an opportunity to negotiate a bipartisan deal that would strengthen the U.S. economy and increase employment, he should seriously consider such a package of reforms.

Copyright: Project Syndicate, 2014.

*The author, a professor of economics at Harvard University and president emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984.

BY Martin Feldstein

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