January 8, 2013
Corrected: On February 28, 2013, this report was reposted with a correction (which appears on pages 1 and 29 of the printer-friendly version and pages 2 and 34 of the screen-friendly version) to the average combined tax rate for current OECD countries, excluding the United States.
In 2008, 12 percent of all federal revenues came from corporate income taxes; about half was paid by multinational corporations reporting income from foreign countries. How the federal government taxes U.S. multinational corporations has consequences for the U.S. economy overall as well as for the federal budget.
Tax polices influence businesses’ choices about how and where to invest, particularly the profitability of locating in the United States or abroad. The tax laws also can create opportunities for tax avoidance by allowing multinational corporations to use accounting or other legal strategies to report income and expenses for their U.S. and foreign operations in ways that reduce their overall tax liability. U.S tax revenues decline when firms move investments abroad or when they strategically allocate income and expenses to avoid paying taxes here.
This study examines options for changing the way the United States taxes multinational corporations or addressing particular concerns with the current system of taxation. All of those options would affect multinational corporations’ investment strategies and reporting of income, as well as U.S. revenues from corporate income taxes.
What Is the Difference Between a Worldwide and a Territorial Approach for Taxing Income of Multinational Corporations?
A country can take two general approaches to taxing the income of corporations that operate both domestically and abroad:
- Under a worldwide approach, the home country considers all of the income of its multinational corporations to be taxable, regardless of where that income is earned. But to avoid taxing income twice—in the home country and in the country where it is earned—a country would allow multinational corporations to claim a foreign tax credit against domestic tax liability for taxes paid elsewhere.
- Under a territorial approach, the home country taxes only the income earned within its borders.
No major developed country has adopted either approach entirely. Although many developed countries use a more territorial approach, the system in the United States leans toward a worldwide approach, but one that allows multinational corporations to defer or, in some cases, completely avoid paying U.S. taxes on some income they earn abroad.
How Does the United States Tax Multinational Corporations?
The U.S. government taxes both the domestic and the foreign income of businesses that are incorporated in the United States and that operate abroad. Often, such corporations also must pay income taxes to their foreign host countries. At the national level, the corporate tax rate on income in the highest bracket in the United States is 35. When combined with state and local corporate taxes, that rate rises to 39 percent—higher than that in any of the other 34 member countries of the Organisation for Economic Co-operation and Development (OECD). (However, because of the graduated rate structure, deductions, credits, and other provisions, the average tax rates that corporations pay are generally below the top rate.) Weighted by gross domestic product (GDP), the average statutory rate among OECD countries in 2011, excluding the United States, was about 19 percent.
Although the U.S. system is generally more worldwide than territorial, two important features of its tax system depart from the worldwide approach. First, a purely worldwide tax system would ensure that firms faced the same tax rate no matter where they operated. If the United States were to have such a system, it would not limit the credit granted to firms for the total taxes paid abroad, regardless of whether those taxes exceeded the domestic tax liability on the income. Under the U.S. system, however, the largest credit a corporation may take is one that matches amount the firm would pay in U.S. taxes on the same income. Thus, U.S. corporations that operate in countries that tax at a higher rate than the United States must pay the foreign tax rate on that income. Second, companies can defer U.S. taxes on income earned abroad by their subsidiaries until that income is remitted (or “repatriated”) to the U.S. parent company, thus allowing some foreign income to escape U.S. taxation—at least temporarily.
Those features of the U.S. tax system affect U.S. multinationals’ decisions about whether and how to invest at home and abroad. The current tax system provides incentives for U.S. firms to locate their production facilities in countries with low taxes as a way to reduce their tax liability at home. Those responses to the tax system reduce economic efficiency—the extent to which resources are allocated so as to maximize their value—because the firms are not allocating resources to their most productive use. Those responses also reduce the income of shareholders and employees in the United States, and they lead to a loss of federal tax revenue. As a result of such decisions, in the long run, total compensation for U.S. workers is lower, and employment may be concentrated in different industries and regions (even though total employment is not significantly affected).
What Are Some Options for Changing the Way the U.S. Tax Code Treats Multinational Corporations?
Policymakers and analysts have suggested a number of strategies for modifying the current system:
- Move closer to a purely worldwide system that limits or eliminates deferral of U.S. taxes on income earned abroad. On balance, curtailing or eliminating corporations’ ability to defer U.S. taxes until such income is repatriated would boost both efficiency and tax revenues. Although eliminating deferral entirely would strengthen the incentive for U.S. firms to incorporate abroad or to be acquired by or merge with foreign companies, such a change would boost U.S. tax revenues by more than $100 billion over a 10-year period, according to an estimate by the staff of the Joint Committee on Taxation; that would amount to the largest revenue increase attributable to the options discussed in this report.
- Move significantly toward a territorial system that exempts foreign income from domestic corporate taxation. Such policies could result in a less efficient allocation of resources among countries by increasing incentives to shift business operations and reported income to countries with lower tax rates. Nonetheless, some options for moving toward a territorial tax would increase U.S. tax revenues by restricting the ability of multinationals to shield some income from U.S. taxation and by preventing them from deducting costs incurred abroad from income earned in the United States.
- Limit opportunities to reduce U.S. taxes on foreign income from low-tax countries or to shift reported income abroad. Restricting the use of excess foreign tax credits, for example, could increase federal tax revenues and reduce the incentive to invest abroad. Such a restriction, however, might push some firms to take greater advantage of provisions that allow deferral of taxes on income that is earned—and retained—abroad. The net effects of such a restriction on investment and repatriation of income are unclear, but it could increase U.S. tax revenues. Other options would produce more incremental changes, generally limiting opportunities for corporations to shift reported income abroad and thus increasing the amount they must pay in U.S. taxes.