More on the White House-Treasury Framework: domestic manufacturing and international taxation

Here is what the White House Treasury document proposes under the heading of "II. Strengthen American Manufacturing and Innovation":

1) Cut the top corporate tax rate on domestic manufacturing income to 25%, with an even lower rate for "advanced manufacuring activities" - To this end, they propose to "reform," rather than repeal, the much-reviled (among experts) domestic production activities deduction. About the only good thing one can say about this is that the gap between 25% and 28% isn't all that great. But it's a terrible idea and makes a bit of a mockery of discussion elsewhere in the Framework of how we should have a more neutral tax system.

2) Expand, simplify, and make permanent the research and experimentation (R & E) tax credit - As I noted in relation to the Romney plan, which states a similar objective, I accept the theoretical case for subsidizing innovation that has positive externalities, but am skeptical about how well this argument matches the actual use of the tax benefit in practice.

3) Higher tax incentives for clean energy - Once again, there is an externalities argument, but one wonders about the desirability of this stuff in practice (plus again advocating these sorts of things can undermine the rationale for general base-broadening).

Overall, the domestic manufacturing piece is by far the most distressing element in the Framework. It is bad enough to cast an ugly shadow on everything else. Bad stuff that the Romney plan doesn't have.

This brings us to the last part of the Framework that I will consider here: "III. Strengthen the International Tax System to Encourage Domestic Investment."

This features a noteworthy table, courtesy of Jane Gravelle's research, entitled "Select Small Countries - U.S. Foreign [Subsidiary] Profits Relative to GDP." We learn here that U.S. companies' claimed profits in Bermuda equal 646% of Bermuda's GDP, while those in the Cayman Islands equal 547% of the Caymans' GDP. Wow, I guess everyone else there must be suffering staggering losses. (Just kidding; that is not in fact what the chart suggests.)

The actual proposals in this section are as follows:

1) Require companies to pay a minimum tax on overseas profits - Using some inference and guesswork, I believe this proposal might work as follows. Suppose the minimum tax rate that we identify is, say, 20%. And suppose further that a U.S. company reports (a) $10 million of U.S. earnings and profits from a Caymans subsidiary, on which it has otherwise paid zero tax, and (b) $10 million of U.S. earnings and profits from a German subsidiary, on which it paid $3 million of German tax. Assume zero taxable repatriations to the U.S. during the year.

If the 20% rate applies to each subsidiary separately, the U.S. company would have to pay $2 million of tax with respect to its Caymans subsidiary, and zero with respect to its German subsidiary. If the minimum tax applies on a worldwide consolidated basis, then the U.S. company has $20 million of foreign subsidiary income, on which it paid $3 million of tax, so it would owe just $1 million overall. In effect, the choice between these two options is equivalent to the choice, under foreign tax credit limitations, between allowing and trying to impede "cross-crediting."

International tax is a normatively complicated area, on which I am still hoping to complete a substantial book sometime this year (though I also have as many as 3 new articles, only one of them in international, that I may want to write). Suffice it to say for now that this proposal is:

(a) good in the sense that it is probably increasing the U.S. tax burden on actual (as opposed to reported) U.S. source income. (We know that the Caymans income didn't actually arise there economically, and it's plausible that some or a lot of it was shifted through tax planning from the U.S., though it's also plausible that there was income-shifting from Germany to the Caymans).

(b) bad in the sense that this indirect improvement of the source rules only applies to U.S. companies, while having no effect on income-shifting outside of the U.S. by companies that are incorporated abroad. This raises issues concerning the effective tax-electivity of U.S. corporate residence, which I admit to having written about (see here).

(c) good in the sense that the proposal reduces the tax benefit from deferral, which becomes tax-irrelevant to the extent that one will face the minimum tax.

(d) bad in the sense that it treats foreign taxes paid as a dollar-for-dollar substitute for U.S. taxes paid, notwithstanding that we get the money from our own revenues but not, say, from German revenues. This, of course, is my by now familiar (?? - to some readers, at least) critique of foreign tax credits, such as here. The proposal has bad effects on U.S. national welfare insofar as it discourages U.S. companies (owned by U.S. individuals) from trying to save German taxes by shifting income from Germany to the Cayman Islands, albeit potentially good effects (see above) insofar as the income showing up in the Caymans actually was U.S. source.

One complexity in the foreign tax credit area that I perhaps have not sufficiently acknowledged in the past is as follows. As I keep saying, there is no direct reason for us to want U.S. people (through companies they own) to pay higher taxes in Germany rather than lower taxes in the Caymans. But on the other hand, the fact that we observe taxable income in the Caymans tells us that it has been economically shifted from somewhere else - possibly from the U.S., though also possibly from Germany. By contrast, if we see reported taxable income of U.S. multinationals arising in Germany, we have much less reason to think that it actually arose at home. So targeting U.S. multinationals' income that arises in tax havens is indeed a kind of filter for finding that which is relatively likely to actually come from the U.S., although, again, it is a filter that has bad incentive effects since it discourages U.S. companies from trying to save foreign taxes.

One last point about this "minimum tax" is that it isn't actually a "minimum tax" (in the sense of a shadow tax system with a parallel tax base) of the sort that the individual and corporate AMTs have rightly made infamous. Rather, it is a partial repeal of deferral, albeit with a lower tax rate for unrepatriated foreign source income than for that which has been repatriated, subject to providing foreign tax credits.

So it's drawing misguided rhetorical heat for purely semantic reasons, since it is called a "minimum tax." But at the same time, it is inferior to my own preferred approach, which would be as follows:

Step One, repeal deferral and foreign tax credits (making foreign tax credits merely deductible), but accompany this change with a rate cut for foreign source income that makes the overall package [placeholder]-neutral - for example, burden-neutral, or revenue-neutral, or resulting amount of outbound investment-neutral. This results in a no-brainer giant improvement in U.S. national welfare, because it eliminates the distortions associated with deferral and the foreign tax credit.

Step Two, since there is no reason to think that this change applies the optimal rate to foreign source income (a critique that is, however, equally true about present law), raise or lower the rate based on a broader analysis, a key factor in which would be how much market power we have at the U.S. corporate residence margin.

The worst omission in my proposal as stated so far is that it doesn't address the horrendous problems with the U.S. source rules, which would have feedback effects on both the Step One and Step Two determinations. But that needs to be done in any event. My preference is that this be done on a corporate residence-neutral, worldwide consolidation basis. But enough about my own proposals, when I had started writing this post with the Administration's Framework mainly in mind.