The Obama administration recently signaled to the business community that it could countenance some version of a territorial tax system for income earned abroad by U.S. businesses. Tax reform enthusiasts have seized on this perhaps a little too desperately, as evidence that reform will occur this year. It’s a thin reed, however: If any tax reform does pass Congress it will happen in spite of, and not because of, this administration.
The administration’s position on a seemingly arcane tax issue is important because it’s ground zero for the tax battle between unions and corporations. How we tax the profits U.S. corporations earn in other countries has profound consequences for the U.S. economy.
We could tax those profits so that the effective tax rate that GM and other multinationals face is the same abroad as it is here. This is called a worldwide tax regime. Another option would be not to tax those profits at all (meaning companies only pay taxes to the country in which they do business) so that U.S. businesses pay the same tax rate as their competitors in that country. We call this a territorial tax regime.
The right tax policy depends on why we think U.S. companies have overseas operations. If we fear that U.S companies push operations overseas mainly to take advantage of lower taxes and labor costs, then we want to increase their taxes abroad to deter them from operating abroad. If we think that they do so in order to service foreign markets, and that U.S. businesses that are successful in doing so thereby create jobs in the United States, then we want to keep their taxes on overseas income low.
Most countries (including every member of the G-7 save the United States) have a territorial tax system of some sort. The United States has a hybrid approach: Companies must pay taxes on their overseas profits at U.S. rates (minus a credit for foreign taxes paid), but they can defer the tax until the money returns here. As a result most companies with significant overseas operations have substantial money invested abroad, a total of well over $1 trillion.
The president’s position on how to tax foreign profits has changed repeatedly. When he first ran for the White House in 2008 Obama promised that he would not only stick with our current worldwide system for taxing foreign income but also get rid of deferral, a position that Tim Geithner, his Treasury secretary, reiterated early in the new administration. However, during the 2011 negotiations over the debt limit the president signaled that he could live with territoriality, and the business community got enthused about the prospect.
As the presidential campaign ramped up and unions needed to get engaged, the administration reversed course and attacked Republicans for supporting the idea of a territorial tax system, pretending that the president’s dalliance with territoriality had never occurred. The recent shift back to territoriality makes three shifts in four years for those of you keeping score at home.
President Obama is not unique in changing his position after a campaign, although few have gone back and forth so many times on the same issue as he has. He probably had little choice but to flip back in 2012, given how much unions hate the idea of U.S. corporations paying a lower tax rate on overseas profits than on their domestic earnings. No matter how eloquently it’s explained to them that a business doing well abroad creates domestic jobs as well, unions perceive that most of these domestic jobs created aren’t union jobs.
In some respects the administration has no choice but to say it could live with territoriality: Senate Finance Committee chair Max Baucus is largely supportive of a move towards territoriality, as is ranking Republican Finance Committee member Orrin Hatch, along with House Ways and Means chairman Dave Camp. If the administration were to announce that under no circumstances would it sign any tax reform that included territoriality, tax reform would be dead. And without corporate tax reform, the odds that a reform of the personal tax code would transpire are nonexistent.
There is little evidence, though, that the administration wants tax reform—that is, unless all of the money raised by the elimination or diminution of the plethora of tax deductions, credits, and exemptions goes into Treasury’s coffers or is spent on new “stimulus,” rather than to lower tax rates. If the rates on middle- and upper-income households and small businesses aren’t coming down, then the impact of reforming the personal tax code will be minor, so the remaining motivation for reform would be the additional growth from lowering corporate tax rates and ending our current convoluted tax system for international income.