In the State of the Union, President Obama suggested that the foreign earnings of U.S. corporations should be subject to a "minimum tax" to prevent corporations from shifting earnings to tax havens. The White House has promised to release the details about the level and operation of such a minimum tax in the next few weeks.
If properly designed, the president's minimum tax could substantially improve the current system of taxing foreign profits of U.S. multinational corporations -- by both raising revenues and encouraging domestic investments.
The current system for taxing earnings of foreign subsidiaries controlled by U.S. corporations is counterproductive. Such foreign earnings are theoretically taxed at a 35% rate if brought back to the U.S., but not taxed at all by the U.S. as long as these earnings are kept abroad.
Faced with this stark choice, U.S. corporations are holding abroad over $1.5 trillion in foreign profits, and this amount is rising rapidly. The current tax system discourages U.S. corporations from using their foreign profits to build facilities in the U.S. or buy American companies. It also generates almost no tax revenues for the U.S. Treasury.
To replace the current system, business lobbyists have suggested that the U.S. follow the lead of other industrialized countries by adopting a "territorial" system for taxing foreign profits of domestic corporations. In such a territorial system, the foreign profits of U.S. corporations would be taxed only in the foreign country where they were earned, and not by the U.S.
However, none of our major trading partners has a pure territorial system for taxing foreign corporate profits -- for two good reasons. Almost all countries impose domestic taxes on "mobile" corporate income, such as investment interest or royalties, because it can be so easily shifted from one country to another.
More importantly, many of our major trading partners collect taxes on corporate income earned in tax havens where companies effectively pay little or no tax. These tax havens violate the fundamental premise supporting a territorial system -- that foreign profits are already effectively taxed where they are earned, so they should not be taxed again in the home country.
The president's proposal would fix this inherent problem in a territorial system by ensuring that all foreign profits of U.S. multinationals are taxed once at a minimum rate -- either by the U.S. or another country. To be workable, this proposal should have three main components.
1. Congress should enact a permanent tax exemption for U.S. corporate profits earned in countries with effective corporate tax rates above a specified minimum. The minimum rate should be no higher than 20% since that is the effective corporate tax rate in most of our major trading partners, according to a 2011 study by the National Bureau of Economic Research.
This general exemption should not apply to mobile income of U.S. corporations, such as investment interest, which should continue to be subject to U.S. taxes as it is currently under the Internal Revenue Code. More broadly, U.S. taxes should be assessed on foreign profits of a U.S. corporation if these profits were artificially transferred through complex transactions to countries exempt from US tax.
2. Congress should levy a minimum tax on U.S. corporate profits in any tax haven to prevent a "race to bottom" -- in which countries bid for corporate facilities by offering to minimize corporate taxes there. In other words, the U.S. would no longer allow its corporations to defer indefinitely U.S. taxes on any profits allocated to these tax havens.
This general rule should be subject to a major caveat for low-tax jurisdictions where corporations conduct actual operations. A U.S. corporation should receive a credit against the minimum tax for the taxes it actually paid in such a jurisdiction. For example, if the profits of an Irish subsidiary of a US corporation were taxed at 12.5% in Ireland and the U.S. minimum tax were 20%, these profits would be subject to a US tax of only 7.5% ( 20% -12.5%= 7.5% ).
3. Congress should allow all corporate profits earned overseas before 2012 to be repatriated to the U.S. at a low rate, such as 8% or 9%, for the next two or three years. This low rate would facilitate the transition to a better permanent system, and would not be part of a one-off tax holiday for repatriated corporate profits. Another tax holiday would merely reinforce the current counterproductive system for deferring U.S. taxes on foreign profits.
Such a transitional rule is needed because corporations reasonably relied on the current system in the past -- which allowed US corporations to defer U.S. taxes forever on all their foreign profits as long as they were kept abroad. It would be unfair to impose a minimum tax now on a corporate strategy that was perfectly legitimate for many years.
This three-part proposal would be clearly superior to the current system, which discourages U.S. multinationals from deploying their foreign profits in the U.S. and raises almost no tax revenues for the U.S. This proposal would raise revenues from U.S. corporate activities in jurisdictions with no or low taxes, while encouraging U.S. corporations to use their foreign profits to build facilities and create jobs in the U.S.
The critical political question is: what should be the minimum tax rate on foreign earnings of US corporations? Although 20% is the effective corporate tax rate in our major trading partners, business lobbyists might push for a lower rate -- such as the 12.5% rate in Ireland.
On the other hand, liberals might object to 20% as too low, relative to the 35% tax rate on domestic corporate profits. However, the effective U.S. tax rate on foreign profits of U.S. corporations is zero, so there should be strong incentives to reach a reasonable compromise.