Congress is About to Botch International Tax Reform

The Highway Trust Fund will be insolvent by the first week of September and faces a $169 billion budget shortfall in the next ten years, but Congress has been slow to find a long-term fix. In the last two weeks, Congress finally came to a consensus that a repatriation tax holiday may be the only way to raise the necessary revenue for a highway bill. 

The House Ways and Means Committee Chairman, Paul Ryan (R-WI), has thrown his support behind a repatriation plan and the Senate Finance Committee Chairman, Orrin Hatch (R-UT), has grudgingly given his approval as well. A repatriation tax holiday would allow multinational companies to return their profits to the United States at a 6.5 percent tax rate, compared to the current 39.1 percent state and federal top marginal tax rate. This would encourage companies to bring their profit back to the United States, where it can be taxed, rather than leave it overseas as multinational corporations do now.

But Senate Majority Leader Mitch McConnell (R-KY) does not want to move forward with the repatriation plan unless it is part of a broader push for international tax reform. That is why Senators Chuck Schumer (D-NY) and Rob Portman (R-OH) have released what they call a framework for international tax reform that would include a bailout of the Highway Trust Fund. 

Their plan currently has few of its details fleshed out, but it would include the one-time 6.5 percent repatriation tax holiday to fund highways, followed by a phase out of the repatriation tax, which would be replaced with an annual single digit tax on foreign earnings. This means that corporate profit would be taxed at a lower rate abroad whether it comes back to the United States or not, unlike current law that taxes profit at a high rate but only when it is repatriated. The plan would also create patent boxes, tax carve-outs to prevent companies from wanting to register their intellectual property overseas. However, Portman's and Schumer’s framework would leave the federal corporate tax rate at 35 percent and keep depreciation schedules untouched. 

The Portman-Schumer plan, while an improvement over the status quo, has glaring holes and is unlikely to make much headway in Congress before the highway funding deadline two weeks from now. But if a debate about international corporate tax reform gains momentum, the Portman-Schumer framework is likely going to be the starting point of the debate. Paul Ryan has already signaled his tacit support and with it, given the plan instant legitimacy.

The fundamental question congressional tax reformers need to answer is whether the United States should use a territorial tax or a worldwide tax system. The United States currently uses a worldwide tax system, meaning that it taxes profits U.S.-based companies earn overseas on top of the foreign tax rate. In contrast, twenty-seven of the thirty-four OECD states use a territorial tax system, meaning that they do not tax profits earned abroad. 

The problem with a worldwide tax system is that it encourages companies to move their base of operations abroad. If companies are based in the United States but receive much of their income from overseas, the current tax code encourages them to move their base of operations abroad because they not only have to pay a high corporate tax rate in the U.S., but also have to pay the same rate on their operation in all foreign countries. 

If corporations change the locations of their headquarters, they would pay a lower rate in their new home country and pay the U.S. tax rate on their operations in the United States. This means that corporations face lower tax liabilities when they relocate abroad. While the Portman-Schumer plan will lower taxes for American companies operating abroad, they will not be eliminated. As long as the United States levies a worldwide tax, this incentive will always remain in place. 

The Portman-Schumer framework also fails to lower the corporate tax rate, which is 39.1 percent (federal and state) at its top marginal rate. In comparison, the OECD average is 25.2 percent, and the European average is 18.6 percent. America’s high corporate tax rate drives away businesses. Between 2012 and 2014, twenty American companies “inverted”, or moved abroad to avoid high American tax rates. 

If the United States were to switch to a territorial tax system without lowering the corporate tax to competitive levels, as the Portman-Schumer plan proposes, up to 80,000 jobs could be lost. This is because the worldwide tax makes it inefficient for corporations to seek out lower tax rates in other countries. If the United States concurrently lowered the corporate tax rate in the U.S. and switched to a territorial tax system these jobs would be retained and America would become a much more attractive place for business.

The Portman-Schumer framework does get one thing right, though. It recognizes that only taxing companies that repatriate their profits creates an incentive for corporations to leave profits overseas. Their plan would tax profits whether or not they come back to the United States, solving a problem that has left nearly $2.1 trillion in corporate profits stranded overseas. If this money were to be brought back to the United States, it would equate to a potential cash injection worth nearly two and half times more than the 2009 stimulus package. Not all of this money would make it back to the United States, but if only a fraction returns home, the results would boost growth. Of course, switching to a territorial tax system would also bring this money back to the American economy without the previously mentioned costs that come with the Portman-Schumer plan.

Perhaps the largest flaw with the Portman-Schumer framework for tax reform lies in its origin as a solution to the Highway Trust Fund’s insolvency. To fund the Highway Trust Fund, Portman and Schumer would temporarily lower the repatriation tax to 6.5 percent to induce companies to bring some of the $2.1 trillion in overseas profit back to the United States. This idea was tried in 2004 in order to spur corporate growth and it was an utter failure. A 2009 NBER paper claimed, “repatriations did not lead to an increase in domestic investment, domestic employment, or R&D.” Likewise, tax revenue also decline according to a 2011 report from the Senate Permanent Subcommittee on Investigations because the tax holiday encouraged companies to leave their profits overseas in order to wait for the next tax holiday when they would be able to repatriate at the standard rate. Any revenue increase from a repatriation tax holiday is an illusion.

The Portman-Schumer framework fails to address underlying problems with the American corporate tax system that must be dealt with in any comprehensive reform package. A repatriation tax is not the way to solve the long-term problems of the Highway Trust Fund. Congress must do better.