A new study examines the likely effects of a change in the U.S. corporate tax system from the current worldwide system to a new hybrid system similar to the territorial systems used by other developed countries and concludes that such a change would increase the repatriation of foreign earnings by U.S. multinational companies.
The study, released Friday by the Berkeley Research Group, also found that a switch to a territorial system would enhance the global competitiveness of many U.S.-based multinational companies, increase corporate tax revenues—at least in the short run—and generate economic growth and jobs in the U.S. The research was sponsored by General Electric and a business trade group, the Alliance for Competitive Taxation, which supports lowering the corporate tax rate.
According to the study, the change to a hybrid territorial system would reduce the “lock-out” effect of the current worldwide system on the active foreign source earnings of U.S. multinational companies, while increasing the repatriation of these earnings to the U.S. The increase in repatriated earnings that would otherwise be held abroad in the current system would boost economic activity and job creation in the U.S., according to the study’s authors, Laura Tyson, Eric Drabkin and Ken Serwin.
The report was unveiled Friday after the Bureau of Labor Statistics delivered the latest monthly payroll report, showing that 204,000 jobs were added in October, although the unemployment rate edged up to 7.3 percent.
“Today’s jobs report was stronger than expected and there were some positive revisions in the last several months,” said Tyson, the former chair of the Council of Economic Advisers during the Clinton administration, and currently a professor of business administration and economics at the University of California Berkeley and an economic adviser to the Alliance for Competitive Taxation, during a conference call with reporters. “On the other hand, we still have a very depressed population ratio across all age groups. We have a low labor force participation rate and we are, by varying estimates, still missing 5 million jobs relative to what our potential would be. The Federal Reserve estimates are that we’re 7 percent below our GDP potential right now and on a slower trajectory because we have not been generating jobs at anything other than what you might characterize as an anemic pace. Therefore, in thinking about tax reform or any policy at this point, it seems essential to think about how a policy would affect employment and output. We feel, based on our work and other work that we have done, that reforming the U.S. Tax Code to allow American companies to invest their substantial foreign earnings in the United States now and in the future is an opportunity that should be considered as part of a set of measures to move the economy onto a higher growth trajectory.”
Changing to a Hybrid Territorial Tax System
The foreign subsidiaries of U.S. multinationals currently report about $2 trillion of accumulated foreign earnings as indefinitely reinvested abroad. The study assumes that the change to a hybrid territorial system would be accompanied by a transition plan comparable to that proposed by House Ways and Means Committee chairman Dave Camp, R-Mich. Based on this assumption, the study predicts that U.S. companies would repatriate about $1 trillion of these earnings that would otherwise be deferred and held abroad indefinitely. This increase in repatriations, in turn, would increase investment spending directly by some repatriating firms and increase consumption spending by shareholders. Together these increases in spending would increase U.S. gross domestic product by at least $208 billion and create at least 1.46 million jobs, the study claims.
The change to a hybrid territorial system would also increase repatriation of future foreign earnings by an estimated $114 billion per year, and the resulting increase in spending would increase U.S. GDP by $22 billion annually and create 154,000 new jobs on a sustained basis, the study found.
Changing to such a tax system would enhance the global competitiveness of many U.S. multinational companies, according to the study. The effects would vary among companies, depending on their ability to defer repatriation of foreign income and their ability to use excess foreign tax credits to shield foreign royalty income in the current system. The change would enhance the competitiveness of companies that have limited access to capital markets and could not indefinitely defer their foreign earnings abroad in the current system, according to the study’s authors.
Companies that have ready access to capital markets would be able to adopt a more efficient capital structure; however, the loss of foreign tax credits might offset the efficiency gains for some of these companies.
The researchers were asked by Accounting Today about why the tax holiday on repatriated foreign holidays generated relatively few jobs in the U.S. when it was tried in 2004, with much of the money going toward dividends and to fund M&A activity.
Tyson noted that Berkeley had done a study a few years ago on the effects of the 2004 tax holiday and didn’t agree with “the consensus view on the effects.”
“If you look at a lot of these studies, what they do is they assume when the money comes back and goes to shareholders, it disappears, and there are no effects,” she pointed out. “Do we believe that? No, we don’t believe that. That’s an error in terms of thinking about the channels by which money that would come back would be used.”
She pointed out that the repatriated funds can often help companies that are otherwise “capital constrained” put the money to use for new investment activity, including acquisitions. “That’s an efficient use of capital,” said Tyson. “A U.S. firm acquiring another firm, do we believe there’s no competitive effect to that? We think that the literature has significantly underestimated the beneficial effects to the U.S. economy from the flow of repatriation.”
Short-Term Increase in Corporate Tax Revenues
The change to a hybrid territorial system would increase corporate tax revenues in the short run, according to the study. The size of the increase would depend on the tax imposed on the current stock of accumulated foreign earnings held abroad by U.S. companies. Assuming a transition tax plan for these earnings comparable to the one proposed by Camp, the study found that the transition plan would result in a short-term increase in corporate tax revenues of $80 billion. In addition, $17 billion in new taxes are expected in the first year following the implementation of the new tax system from additional repatriation flows and on royalty income flows that are shielded from tax in the current system through excess foreign tax credits.
Under the current system, many U.S. companies have an incentive to shift taxable income from their U.S. operations to lower-tax foreign locations, and this incentive has become stronger over time as foreign corporate tax rates have declined. On balance, a change to a hybrid territorial system would increase the incentive for some companies to shift taxable income abroad to lower-tax jurisdictions, and this is likely to reduce corporate tax revenues over time. The study concluded that the magnitude of the additional income shifting in a hybrid territorial system is not likely to reduce corporate tax revenues significantly over time.
The study also challenges the belief that a change to a hybrid territorial system would cause U.S. companies to move additional jobs offshore for tax reasons. The study distinguished between income shifting by U.S. companies to lower tax foreign jurisdictions through transfer pricing and the relocation of intellectual property assets—referred to as “IP shifting”—and income shifting through the movement of real productive activities—referred to as “job shifting.” Both IP shifting and job shifting are sensitive to differences between U.S. and foreign corporate tax rates, the study noted.
But while the gap between the U.S. corporate tax rate and foreign corporate tax rates is the primary reason for IP shifting, non-tax factors including the access to foreign customers and the availability of lower-cost inputs are the primary reasons for job shifting. A change to a hybrid territorial system would not affect these factors. The study found that while such a change is likely to encourage additional IP shifting over time, it is not likely to result in a material increase in job shifting compared to the current worldwide system.
Many countries with both worldwide and territorial systems have policies to discourage income shifting. A change to a territorial tax system in the U.S. might be accompanied by additional anti-base erosion measures, such as those proposed by Chairman Camp.
The researchers were asked by Accounting Today about why other countries that are using territorial tax systems are also seeing their tax revenue going to low-tax countries.
“On the erosion of the tax base, our study does talk about the fact that there is already in the current U.S. system significant incentives for the shifting of income abroad to lower-tax locations,” Tyson responded. “We don’t get around that in the worldwide system, and the other countries don’t get around it in a territorial system. We have to come up with base erosion measures. The corporate tax reform under discussion in the Congress, we don’t have a lot of detail about it, but we do know that, for example, Representative Camp has put on the table several different ways to handle the base erosion issue. Yes, the base erosion issue is real, but the benefits to the U.S. economy of encouraging foreign earnings, both the stock out there right now and the flow over time, the U.S. economy would benefit from having more of that come back into the United States.”