The U.S. government taxes American corporations on all income earned worldwide. With the highest top marginal tax rate in the developed world, if not the entire world, at nearly 40%, counting state corporate taxes on average, this U.S. taxation is very burdensome, even with tax credits allowed for taxes paid to foreign countries on corporate income earned in those countries.
The top corporate rate worldwide averages 22.5%. In Asia, the average top rate is 20.1%, half the U.S. top rate. In Europe, the top rate averages 18.9%.
If American companies earn income overseas through foreign operations, paying applicable taxes on that income to the country where it is earned, when they bring that money back to America, they must pay taxes on the income again, up to the 39.2% top marginal rate. This has led American companies to hold rapidly accumulating funds offshore, now totaling over $2 trillion.
The Tax Foundation explains that it is only that deferral on U.S. taxation until repatriation back to the U.S. that enables American companies to compete in the global economy with the enormous U.S. tax disadvantage of the world’s highest marginal tax rates.
The Tax Foundation writes, “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.”
Tax reform would modernize the U.S. tax system to resolve the international tax disadvantage of American businesses, and their workers. The House GOP’s Better Way proposal, supported by House Speaker Paul Ryan and Ways and Means Chairman Kevin Brady, R-Texas, would cut the federal corporate rate to 20%, with a special rate of 25% for pass-through businesses, such as partnerships, S corporations and sole proprietorships.
Computer simulations by an economics team led by Boston University Professor Laurence Kotlikoff estimate that this tax reform would increase U.S. wages and GDP by up to 8%, and actually increase annual federal revenues on a dynamic basis by $38 billion. President Trump’s reform proposal would reduce both the corporate rate and a special pass-through rate to 15%, which would likely boost jobs, wages and the economy even more.
Both reform plans would also change taxation of U.S. businesses from a worldwide basis to “territorial” basis, where business income is only taxed by the country where it is earned. This follows the global trend of tax reform, especially among developed countries.
In 2000, half the countries in the OECD still taxed their companies on worldwide income. With Britain and Japan switching from worldwide taxation to territorial taxation in 2009, all the major economies in the OECD have now become territorial, except for the U.S.
That change in policy would free the over $2 trillion now held by U.S. companies overseas to return to America to create jobs and increase wages here. That same motivation regarding Japanese companies moved Japan to make the switch in policy for that country, which caused a surge in repatriated investment to Japan. U.S. tax reformers would adopt a one-time 10% rate to apply to all future repatriated funds back to America.
These tax reforms would increase both foreign and U.S. domestic investment, which economic studies show are complements, not substitutes. Experience shows that foreign investment and employment by U.S. companies follows sales and demand for the companies’ products primarily produced back home in the U.S. Such foreign investment and employment increase U.S. output and GDP.
The case of Otis Elevator is highly instructive. In one recent year, 15,000 Otis elevators were sold in the U.S., while 380,000 were sold in China. Otis needed to be present in China to compete for these sales, reduce transportation costs, and gain maintenance contracts. That caused an expansion in domestic U.S. production employment, which was served by the foreign investment and employment in China.
Such foreign investment and employment has resulted in a pattern where low value-added work has shifted to developing countries, while increased high value-added work has been added to the domestic U.S. labor market, as shown by studies by McKinsey and the Brookings Institution.