The Obama Administration's new international tax proposals

I'm still trying to get a preliminary handle on the Obama Administration's international tax proposals. The fullest description I've yet been able to find, from a White House fact sheet, is available here.

The fact sheet opens by stating that the White House's key concern is about jobs fleeing the U.S. However, recent empirical literature about U.S. international taxation on balance supports skepticism that jobs really "flee" the U.S., on a net basis, when U.S. companies invest abroad due in part to the lower tax rates available there. The two main reasons for doubt are (a) at the firm level, complementarity rather than substitution as between home and overseas investments; (b) what I call the "musical chairs" point. If there are good slots for business investment in the US (e.g., available workers, nearby resources & consumer markets, etc.), then one prospective user's deciding against using a particular slot may induce someone else to go there.

I thus think of it as more of an efficiency and revenue issue. Raising taxes on outbound investment to be closer to those on domestic investment has the potential - subject to the problems discussed below - to be more attractive on efficiency grounds than alternative means of raising the same revenue.

The efficiency gains from equalizing domestic and foreign tax rates faced by U.S. taxpayers might verge on being a slam dunk argument for the Administration's general position if not for one further problem. When we impose business taxes on legal entities such as corporations, rather than directly on individuals, we can only impose the U.S. tax rate, for investment abroad, on companies that are classified as U.S. residents. Unfortunately, corporate residence is an extremely weak reed for the imposition of U.S.-level rather than tax haven-level taxes. For new investments (as distinct from those already out there, which are hard to shift without paying a tax price), it is quite easy for investors to use non-U.S. entities.

Anyway, onto the Administration's proposals after one last bit of background. The Administration is proposing to use legislation even for changes that it could accomplish purely by revising Treasury regulations. This, in turn, may be an artifact of budget rules that only permit it to claim credit for extra revenues when achieved through legislative changes. That's really too bad insofar as changes that one deems desirable end up being blocked by the vociferous opposition that clearly will emerge in the legislative process.

And fight the opponents will. Herewith a quote from a newly posted article by Ryan Donmoyer at Bloomberg:

“'This is bad stuff,'” Kenneth Kies, a tax lobbyist at the Washington firm Federal Policy Group, said of Obama’s plans. “'This is going to be the biggest fight for the corporate community in the next two years.'” Kies represents General Electric Co., Anheuser-Busch Cos. and Microsoft Corp., among others."

But don't worry about Ken, who I'm sure will find the fight lucrative as well as stimulating. Think of all the other corporate lobbyists in different areas who wish they could say with a straight face that THEIR issues are the biggest ones.

Anyway, back to the White House press release, which opens with the following fun facts:

--In 2004, U.S. multinationals paid $16 billion of tax on $700 billion of foreign active earnings, an effective U.S. tax rate of 2.3%. Comment: Given foreign tax credits, this would be true even without the benefits of deferral and their enhancement by tax planning, if foreign rates were close enough to U.S. ones. It would be interesting to see the pre-credit "gross" tax liability, although that requires a grain or two of salt as well given foreign tax credit planning games. Note, however, that if we can't do much better than this (and I'll suggest below that perhaps we can't even with aggressive anti-tax planning rules), one wonders if the game is worth the candle. Lots of tax planning, compliance, and administrative costs relative to the revenue that's being raised.

--83 of the 100 largest U.S. corporations have subsidiaries in tax havens. Comment: What could possibly be holding back the other 17? Are their operations purely domestic?

--One address in the Cayman Islands hosts 18,857 corporations. Comment: I've always wanted to visit that building, especially if there are nice beaches nearby.

--Nearly one-third of all foreign profits reported by U.S. corporations in 2003 came from Bermuda, the Netherlands, and Ireland. Comment: One dismaying fact one learns from this is that, of the two pillars of international taxation, residence and source, BOTH lack fundamental economic meaning and thus invite extensive game-playing. This helps explain why there are no really good answers in U.S. international taxation. Disposing of the corporate residence concept and taxing income based purely on source (e.g., via an exemption system) would be far more clearly correct if source were a less slippery and manipulable concept.

Anyway, on to the Administration's proposals with very brief comments based on what I understand so far:

1) DENY DEDUCTIONS ASSOCIATED WITH UNTAXED OVERSEAS INVESTMENT UNTIL THE INCOME IS REPATRIATED TO THE U.S. - This amounts to a partial repeal of deferral, just as denying home mortgage interest deductions would amount to a partial repeal of the imputed rent exclusion. Note also that allowing the deductions (as under present law) arguably goes beyond putting U.S. and foreign companies on a level playing field. Suppose a U.S. company deducts domestic expenses at 35 percent so it can earn abroad at 10 percent. This is a better outcome than a company that was purely in the source jurisdiction would get from both deducting and earning at 10 percent.

Deferral creates massive distortions in tax planning by U.S. companies. A burden-neutral repeal of deferral (as proposed by Rosanne Altshuler and Harry Grubert) therefore strikes me as all to the good. They propose to get there by lowering the rate to offset the effective base-broadening. But non-burden-neutral, revenue-raising repeals of deferral run into the problem that companies may simply respond by reallocating their investments so that companies classified as U.S. residents aren't the ones doing these things. Over the long run, certainly, it's not going to be very sustainable to impose a worldwide tax on U.S. companies that exceeds the taxes owed if the same owners invest through non-U.S. companies.

Since it's really a transition issue, involving revenues from taxing existing profits that we might be able to get while companies are in the process of shifting around to beat the rules, my preferred proposal, which I realize is politically unrealistic, is to impose a one-time transition tax on the unrepatriated earnings of U.S. multinationals, accompanied by a change in regime to show that we don't plan to do it again. If credible, this would avoid affecting incentives regarding whether new investments starting tomorrow should be made through U.S. companies or foreign ones.

2) CLOSING FOREIGN TAX CREDIT LOOPHOLES - According to the White House fact sheet, "current rules and tax planning strategies make it possible to claim foreign tax credits for taxes paid on foreign income that is not subject to current U.S. tax." Agreed that this is not supposed to happen under the current rules, though I'm not surprised to hear that it does. Offhand, I'm not up on exactly what sort of tax planning strategies they have in mind. The Administration proposes to respond by changing the rules so as to determine allowable FTCs based on the ratio of total foreign tax to total foreign earnings. If I understand this correctly, it's a pretty big shift from basing FTCs purely on the income brought home this year and the foreign taxes associated therewith. This one is pretty interesting, and, like proposal (1), sounds like it's potentially a big structural improvement, only, subject to the same concern that, in the long run, the optimal U.S. tax burden on outbound investment by our multinationals is greatly lowered by the ease of investing through non-U.S. entities. Hence, same comment about preferring a transition tax to increasing the tax burden on outbound investments that might be made tomorrow.

FTCs are a really lousy instrument design, and I'd support extending Altshuler-Grubert to include burden-neutral repeal of FTCs as well as deferral. This idea couldn't be done the Altshuler-Grubert way, however, since they propose lowering the domestic corporate tax rate to match their burden-neutral reduced foreign rate. Doing this for FTCs would lower the burden-neutral rate too much for it to apply domestically as well as on outbound.

3) USE THE REVENUES RAISED ABOVE TO MAKE THE RESEARCH & EXPERIMENTATION CREDIT PERMANENT - Companies are going to laugh at this one, since they expect to have the credit extended anyway. (It's always ticketed for phase-out in a couple of years but is always extended again.) That said, extending the credit arguably gets some support from R&E's positive externalities - though I suspect that, in practice, the credit also covers a lot of junk. Making it permanent has additional virtues in that it adds certainty and reduces the need for ongoing lobbying expenses by the companies that want it, and financing the extension is a step in the right direction given the U.S. fiscal gap.

4) PREVENT U.S. COMPANIES FROM USING THE "CHECK-THE-BOX" REGULATIONS TO SHIFT INCOME TO TAX HAVENS WITHOUT BEING SUBJECT TO U.S. TAXATION UNDER SUBPART F - This recoups a blunder that the Treasury made during the Clinton Administration when it adopted "check the box" without thinking through the international ramifications. I'd think they could do this through regulations alone, apart from the budgetary scoring problem I noted above (though companies might complain and try to get Congress involved). Main problem is simply that the subpart F rules that companies evade by using check-the-box are subject to the same concern that I keep repeating here, i.e., limited ability to keep on imposing higher taxes based on U.S. corporate residence.

The remaining Administration proposals in the press release mainly pertain to individuals and compliance problems using tax havens. In general, I'm strongly in favor - these often involve fraud, and taxing resident individuals on outbound investment lacks the fundamental conceptual problem of doing so for legal entities such as corporations, since it's actually economically meaningful (and hence less tax-elastic) to live in the U.S. and/or be a citizen.