Tax policy colloquium on 3/27/12 - Steve Shay paper on shifting to a territorial tax system

On Tuesday, Stephen Shay of Harvard Law School presented his paper (c0-authored with Clifton Fleming and Bob Peroni), Unpacking Territorial. It was an early draft that they rushed out for our convenience, so it isn't posted and hence no link here.

The article addresses the case for (and in particular against) having the US shift to a territorial system in which foreign source income is more or less (though not quite entirely) exempted. More particularly, it critiques the approach taken in the Camp bill, which attempted to be revenue-neutral (at least in the short term) and to address concerns about domestic base erosion that are important in any case but would be made even more pressing by the adoption of a more territorial set of rules.

I believe the paper scores some very powerful blows against the structure of the Camp bill, and shows that it would need substantial modification even assuming sympathy with the basic idea. But that critique should probably wait until the authors are far enough along to post their work, which I am sure they plan to do with all deliberate speed.

We used the occasion, however, to discuss both that critique and the underlying merits of a shift to exemption, since both are discussed at some length in the paper.

The following is a modestly amended version of the first half of the notes I prepared for the session, aimed at discussing the merits of territoriality versus present law.

(1) The case against exemption – If start with positive rate (say, 25% or 35%) for U.S. source income and zero for foreign source income (FSI), isn’t revenue-neutral lowering of the domestic rate + raising of the foreign rate likely to increase efficiency? Note that deadweight loss increases more than proportionately with the rate. National ownership neutrality (NON) as self-refuting re. the case for exemption; why seek distortion at one margin among many, rather than seeking to minimize overall distortion?

But even proponents of WW consolidation agree that the U.S. should impose a lower effective tax rate net of foreign tax credits (FTCs) on FSI than on domestic source income.
Suppose all foreign countries had a 20% rate, causing US companies that invested there to pay $15 of US tax on each $100 of earnings (assuming a 35% US rate and allowance of FTCs). WW proponents would be arguing for an effective US tax rate 18.75% (15/80) on after-foreign-tax earnings.

Given this example, is “double taxation” really the problem to be addressed in international taxation? E.g., suppose the US denied only allowed foreign taxes to be deducted, not credited, but lowered the tax rate for FSI to 10%. Then we apparently would be “double-taxing” FSI, yet the above company would only be paying $8, instead of $15, of US tax.

(2) Some dubious arguments against exemption

--Would reduced domestic investment be a first-order result of adopting exemption? – Depends on whether US multinationals face a fixed budget constraint despite access to world capital markets; why assume here that CEN, not CON, assumptions are correct?

--Why label territoriality a tax expenditure? Arithmetical equivalence to worldwide taxation plus specified “spending” proves nothing. After all, allowing business deductions is arithmetically equivalent to taxing gross income plus providing “spending” to replicate the lost tax benefits, but no one would say that this is a useful application of tax expenditure analysis. Need an agreed “normative tax base” (or at least treatment of a particular item) to make TE analysis potentially useful.

(3) Possible advantages of exemption (vs. present law)

--It repeals deferral (although so could a WW approach).

--It might improve repatriation incentives. Under the new view, the repatriation tax rate doesn’t have to be zero for deferral not to induce lockout – it just has to be constant over time. But the real issue here is repatriation tax rate volatility, which exemption might reduce.

--It replaces foreign tax credits with foreign tax deductibility (implicit under 0% tax on FSI, explicit with respect to foreign dividends under the Camp bill with its 5% rate), thus inducing US taxpayers to equate $1 of foreign tax liability with any other $1 cost or forgone income.

--Isn’t any system with deferral and foreign tax credits likely to have a horrible ratio of deadweight loss to US tax revenue collected? (Note that deadweight loss includes paying more foreign taxes by reason of the credit.)

--Of course, the tax rate on FSI need not be 0% (or 5%) to achieve these benefits.

--Adopting exemption would induce the accountants to change the “permanently reinvested earnings” rule that distorts behavior (in addition to being bad accounting). To be sure, one could address this rule directly without changing substantive US income tax law.