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Thursday, August 16, 2012

Tax Foundation: A Global Perspective on Territorial Taxation

Tax Foundation logoTax Foundation:  A Global Perspective on Territorial Taxation:

Catherine the Great is supposed to have said, “A great wind is blowing, and that gives you either imagination or a headache.” In Washington, winds are stirring for corporate tax reform. But while there is broad bipartisan agreement that tax rates should be reduced, there is less consensus regarding what the tax rate should be, how to pay for a tax cut, or generally how to treat international business income. These considerations are inextricably intertwined because the U.S. assesses its corporations on worldwide income.

Beyond imposing the highest top marginal tax rate in the developed world, the U.S. tax system’s treatment of international business income is exceptionally burdensome. It inflicts tremendous compliance costs, creates enormous distortions of economic activity, deters companies from headquartering in the U.S., awards tax preferences to politically connected industries, and traps huge amounts of U.S. corporate profits overseas. To add insult to injury, despite these punitive features, the system captures a meager stream of tax revenue.

To address these structural flaws, recent years have witnessed a steady march of tax reform proposals from both sides of the aisle and from several independent advisory boards and agencies. Though reform plans vary widely in their specific provisions, they follow one of two general approaches to taxing international business income: “worldwide” basis versus “territorial” basis.

Under the worldwide approach, all income of domestically-headquartered companies is subject to tax, including income earned abroad. To avoid double taxation of the same income base, worldwide systems provide credits for taxes paid to foreign governments. The overarching purpose of the worldwide design is to “create equality among resident taxpayers,” so as not to distort the investment decisions of domestically headquartered companies toward low-tax countries.

Under the territorial approach, a country collects tax only on income earned within its borders. This is typically accomplished by exempting from the domestic tax base the dividends received from foreign subsidiaries. The territorial design thus equalizes the tax costs between international competitors operating in the same jurisdiction, so that all firms may compete on a level playing field, and capital may flow to where it can achieve the best after-tax return on investment.

Figure 1. Territorial and Worldwide Systems in the OECD

Territorial Systems

Transition Since 2000

Worldwide Systems

Top Marginal Tax Rate

Australia

 

Chile

20%

Austria

 

Greece

20%

Belgium

 

Ireland

12.5%

Canada

 

Israel

24%

Czech Republic

2004

Korea

24.2%

Denmark

 

Mexico

30%

Estonia

2005

United States

39.2%

Finland

 

France

 

Germany

 

Hungary

 

Iceland

2003

Italy

 

Japan

2009

Luxembourg

 

Netherlands

 

New Zealand

2009

Norway

2004

Poland

2007

Portugal

 

Slovak Republic

2004

Slovenia

 

Spain

 

Sweden

 

Switzerland

 

Turkey

2005

United Kingdom

2009

The U.S. system is considered a worldwide system though like other worldwide systems it allows its companies to defer tax liability on foreign “active” income until it is repatriated (i.e., returned) to the United States. Deferral has been noted as critical to the stability of the U.S. international business tax system because it enables U.S. companies to compete on a near-level playing field with companies domiciled within more favorable tax climates, as long as those companies can afford to keep the resulting earnings abroad.

Overwhelmingly, developed economies are turning to the territorial approach. While as recently as 2000, worldwide systems represented 66 percent of total OECD GDP, this figure has dropped to 45 percent heavily weighted by the U.S. Now, 27 of the 34 OECD member countries employ some form of territoriality, which is up from 17 just a decade ago (Figure 1, above). Additionally, every independent U.S. advisory board, working group, and federal agency tasked with exploring tax reform has recommended that the U.S. pivot toward a territorial system. These include President Obama’s Economic Recovery Advisory Board, Council on Jobs and Competitiveness, and Commission on Fiscal Responsibility and Reform. The House Committee on Ways and Means last year issued a draft bill for comprehensive tax reform which includes territorial taxation.

It is not by coincidence that the territorial system has gained so many adherents; it provides very real economic advantages over its worldwide counterpart. In the case of the U.S., a transition to territorial taxation would free the $1.7 trillion dollars currently locked out of the U.S, place U.S.-based companies on equal footing with competitors in every market, reduce complexity and compliance costs, reduce the incentive to reincorporate abroad, and could be accompanied by improvements to anti-abuse protections.

Yet President Obama and like-minded lawmakers want to purify the worldwide elements of the U.S. system. They see foreign investment by U.S. companies as displacing investment in the U.S. and seek to increase the U.S. tax penalty for investing abroad by repealing or further limiting deferral. Accordingly, advocates of the worldwide system consider territorial taxation an egregious concession to multinational corporations and claim it would result in a transfer of jobs, investment, and tax revenue to foreign countries.

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