ACT Tax Facts: To Fix the International Tax System, Harmonizing with the Rest of the World is the Answer, Not Repealing Deferral
“Unfortunately, as the importance of success in foreign markets has grown, the United States has become less competitive abroad because of its worldwide system of international taxation.”
– Senators Rob Portman and Charles Schumer on the need to fix our international tax system
There is widespread, bipartisan agreement that our system of taxing the global activities of American corporations is outdated and hurting the competitiveness of American businesses and their workers.
Today, U.S. corporations operate under a worldwide tax system which requires American businesses to pay taxes on the active business income they earn outside of U.S. borders when that income is reinvested in the United States. A vast majority of developed countries, including 80 percent (28 out of 35) of OECD member countries, have a different type of international taxation – a territorial tax system. In 2015, companies headquartered in OECD territorial countries accounted for 91 percent of the sales by all non-US OECD multinationals in the Forbes Global 500.
Under a territorial tax system, active business income earned abroad may be reinvested in the home country with little or no repatriation tax. Consequently, unlike the U.S. tax system, a territorial system does not discourage locally-headquartered multinationals from reinvesting their foreign earnings at home and allows them to compete abroad on a level tax playing field (i.e., paying the same foreign tax as foreign companies). The competitive benefits of a territorial tax system help explain why the only two OECD countries that shifted from a territorial to a worldwide system of taxation, Finland and New Zealand, have since switched back.
In congressional testimony, Dr. Laura Tyson, the Chair of the Council of Economic Advisers and Chair of the National Economic Council under President Clinton, noted how out of step the U.S. worldwide tax system is:
“With the adoption of territorial tax systems by the United Kingdom and Japan in 2009, and by thirteen other OECD member countries since 2000, the U.S. international tax system now lies far outside of international norms.”
Repealing deferral would make the United States an even less attractive jurisdiction for a global company to locate its headquarters. Rather than conforming to the international norm of territorial taxation, repeal of deferral would move in the opposite direction, by subjecting income earned by foreign affiliates of U.S. companies from the active conduct of their foreign business to immediate U.S. taxation (at the highest corporate tax rate in the developed world) even if reinvested in the foreign business. Repealing deferral would:
- Encourage foreign takeovers of American businesses doing business across the globe. Foreign operations of U.S. companies would be more valuable if owned by a foreign company because they would not face an immediate 35 percent tax. Repeal of deferral would exacerbate the spate of foreign acquisitions of U.S. companies and we would be more likely to see U.S. companies become headquartered abroad.
- Hurt American workers. Repealing deferral would hurt the competitiveness of U.S. companies in foreign markets, and result in fewer jobs at home. More than 76 million American jobs depend on U.S. global companies – either directly or through their supply chains. For every 1 million direct U.S. jobs with a U.S. global company, there are on average 2.3 million additional U.S. jobs that are supported by the supply chain or spending out of employee payroll. To explain the benefits to U.S. workers when an American multinational company is successful in the global market, Senators Portman and Schumer in the final report of the International Tax Reform Working Group pointed to a recent study by Mihir Desai, Fritz Foley and James R. Hines that found “every 100 jobs added abroad by U.S. multinational companies resulted in an average increase of 124 jobs added in the United States.”
- Put the U.S. even further out of step with the rest of the world. Operating under a worldwide tax system already puts American businesses behind the competition based in territorial countries; eliminating deferral would put U.S.-headquartered global companies at an even further competitive disadvantage relative to foreign-headquartered companies.
The devastating impact of repealing deferral is evident in the experience of the U.S. shipping industry. From 1962 until 1986, U.S. shipping companies were eligible to defer taxes on foreign shipping income earned by U.S. controlled foreign corporations. The 1986 tax reform law ended deferral for foreign shipping income. In an article for Tax Analysts, Ken Kies explains the devastating impact of this policy change and the decimation of the U.S. shipping industry:
“The results of the 1986 act ‘’experiment’’ were dramatic. In 1986 there were 429 U.S.-owned, foreign-flag ships serving international bulk shipping markets. By 2000 that fleet had shrunk to 273 ships. The decline was particularly pronounced in the tanker market. From 1988 to 2000, the number of U.S.-owned, foreign-flag tankers fell by nearly 50 percent, from 246 ships to only 126 ships. Overall, from 1988 to 1999, the number of U.S.-owned, foreign-flag ships as a percentage of the world merchant fleet dropped from 5.6 percent to 2.9 percent. Much of the decline was attributable to the acquisition of U.S.-based shipping companies by foreign competitors not subject to tax on their shipping income.”
In 2004, Congress and President Bush restored deferral for shipping income. Since then, the shipping industry in the U.S. has returned, with one of the largest shipping companies, the Overseas Shipholding Group (OSG), noting after the provision was reinstated, “The restoration of deferral dramatically improved OSG’s financial position, strengthening our balance sheet, increasing our profitability, and making us confident about our ability to compete going forward in the global shipping marketplace.”
THE SOLUTION: COMPREHENSIVE TAX REFORM
There is no question that our current international tax system is broken, and that includes the deferral policy. But ending deferral without bringing the entire international tax system in line with international norms would make it harder for American businesses to grow, compete and hire American workers.
The answer is a comprehensive tax reform approach that includes setting a more competitive tax rate, establishing a modern international tax system and simplifying the code by ending tax breaks and preferences. Anything short of this approach will still leave American businesses and workers standing on the sidelines while the rest of the world succeeds in the global market.