Amid the tumult over looming tax hikes and spending cuts, a massive change to the corporate tax code is quietly gathering steam.
U.S. multinationals have spent years pushing for a reform of the tax code that would eliminate taxes on business profits overseas, just as these firms are banking their futures on growth abroad.
Now, with the debate over the country’s fiscal future in the spotlight, many executives, lobbyists and some on Capitol Hill are latching on to the “fiscal cliff” as a potential springboard for their cause.
To the companies, no other element of tax reform matters more.
They say that U.S. multinationals face a disadvantage against overseas competitors because unlike many other developed countries, the IRS collects taxes on foreign income when it’s brought back into the United States. These companies argue that if that tax were eliminated, they would be more likely to bring their overseas earnings back to the United States. It’s estimated that U.S. multinationals are holding $1.7 trillion in earnings abroad, largely to avoid being taxed at a 35 percent rate.
“At least it will be here and not circulating in other countries,” said Erskine Bowles, co-chair of a prominent White House commission that was tasked with addressing the country’s debt and supporter of eliminating taxes on foreign profits.
Some tax experts warn, however, that such a change could radically alter how companies behave and have broad implications for the economy. Without the right safeguards, they say, eliminating taxes on foreign profits and switching to what’s known as a “territorial” system would blow a hole in tax revenues, give multinationals more leeway to exploit tax havens and drive jobs overseas.
“The territorial tax system they envision would gut the entire U.S. corporate tax code,” said Edward D. Kleinbard, a professor of tax policy at the University of Southern California. “It would lose gigantic sums of money every year.”
Support for a territorial system has already appeared in a number of prominent places. It’s among the recommendations from both the National Commission on Fiscal Responsibility and Reform, co-chaired by Bowles and former senator Alan Simpson, and President Obama’s jobs council. It was part of presidential candidate Mitt Romney’s economic platform. And it has been a perennial on the wish lists of business groups like the Business Roundtable and the U.S. Chamber of Commerce, as well as many individual multinationals that are meeting with leaders in Washington this week.
So far, territorial tax reform has received little public attention in the fiscal cliff debate, as the Bush tax cuts that are scheduled on Dec. 31 to expire don’t affect corporate tax rates.
But policymakers are deliberating a potential compromise that could be attached to a bigger overhaul of the tax code in 2013.
Sen. Orrin G. Hatch (R-Utah), the ranking Republican on the Senate Finance Committee, wants to extend the Bush tax cuts for a year and “let Congress undertake comprehensive tax reform in 2013 with a shift to a territorial system as a part of that exercise,” according to Hatch spokeswoman Julia Lawless.
“It’s not going to do a whole lot to reform individual tax rates if you don’t reform the corporate tax rates,” said Sen. Tom Coburn (R-Okla.), who supports a territorial tax system and says the issue comes up “in every discussion where we talked about tax reform.”
In fact, House Republicans have already passed a budget that includes a transition to a territorial tax system, reflecting a framework first laid out by House Ways and Means Chairman Dave Camp (R-Mich.).
Democrats are largely opposed to a territorial tax system, often contending that it would encourage firms to move more operations overseas, as President Obama frequently argued on the campaign trail. The Obama administration has instead proposed a “global minimum tax” that would apply to income earned in any country.
But some prominent Democrats agree with Republicans that the fiscal cliff could be a golden opportunity for reforming the entire tax system, with some openly welcoming a debate on how to deal with overseas corporate earnings.
“I think that all of this has to be dealt with as a package — it’s the only way to make the trade-offs that are fair and transparent,” said Sen. Kent Conrad (D-N.D.), the outgoing chair of the Senate Budget Committee. Conrad isn’t sold on a territorial tax system, but acknowledges that “it deserves consideration and deserves a full debate and hearing.”
There is broad bipartisan agreement that the corporate tax code needs reform since it presents the worst of all worlds: rates that are relatively high and tax receipts that are too low. In the current system, a U.S. firm is supposed to pay a 35 percent tax on both domestic and foreign profits; taxes on foreign income can be deferred until companies use that money in the United States.
In reality, though, some multinational firms are able to pay a much lower rate by shifting their income to overseas tax havens and then defer taxes on that money indefinitely. As a result, revenues from corporations as a percentage of the country’s GDP is near its lowest point in the last 30 years.
Whether a territorial system would help fix these problems — or make them worse — depends wholly on the details, which have been scant from both the business lobby and the recommendations from Simpson and Bowles. Usually, advocates simply say they want “territorial” without defining what that might look like, when in fact small adjustments can have radical consequences.
A switch to a pure territorial system, for instance, could cost jobs, said Kimberly Clausing, an economics professor at Reed College, who calculates that as many as about 800,000 jobs could move to low-tax countries.
Another critical detail: How tough the U.S. government will be on overseas tax havens. Japan is often cited by business lobbyists as a model for the United States, since the country switched to a territorial system in 2009. But Japan’s new system also taxes a company’s foreign income if the other country’s tax rate is less than 20 percent.
This kind of system would slap a number of U.S. multinationals with much higher rates than they’re currently paying, raising the question of whether they would still support a switch to a territorial system if it looked like Japan’s.
The proposal from Camp offers some hints of what a territorial proposal from Republicans might look like. His plan would exempt 95 percent of overseas earnings from U.S. taxation when that income is brought back to the United States. It would also include “anti-abuse” rules to make sure companies don’t skip out on paying “their fair share of U.S. taxes.”
Individual corporations and advocates that favor such reforms have recently come into the spotlight in the current fiscal cliff debate. One group called Fix the Debt, which includes dozens of big business chief executives, has gained prominence recently as it has pressed Democrats and Republicans to compromise with one another on the fiscal cliff.
Fix the Debt said it wants to see comprehensive tax reform that tackles the country’s debt, but it does not advocate a specific plan.
The group includes a number of prominent advocates for a territorial system, though. The co-founders of Fix the Debt are Simpson and Bowles. Honeywell chief executive Dave Cote, who has been a high-profile business advocate of cutting taxes on overseas profits, sits on the steering committee. Officials at Caterpillar, whose chief executive Douglas Oberhelman is also part of the group, testified before Congress last year that a territorial system is critical to creating a “level playing field” for US companies at home and abroad.
In addition, a PowerPoint presentation on the group’s Web site mentions the possibility of territorial on a slide with the heading, “What can we do?”
Among the bullet points: “Use the fiscal cliff as an opportunity.” Under another heading of, “Budget basics that need to be addressed,” the number one item is a “simplified tax system that is territorial and collects more revenue.”
Alice Rivlin, a senior fellow at the Brookings Institution and a member of the Fix the Debt steering committee, said the two debt commissions she has participated in have diverged on the issue. The group headed by Simpson and Bowles, she said, advocated a territorial system because “the most articulate spokesperson on this issue” on the committee was Cote from Honeywell.
By contrast, the plan she helped develop with former senator Pete Domenici for the Bipartisan Policy Center did not include it because the group had a small business representative instead, and small businesses are less likely to operate overseas.
The Business Roundtable, a strong supporter of a territorial system, is also currently making the case for corporate tax reform on Capitol Hill as the fiscal cliff debate rages.
“If you don’t press the urgency, this can be pushed down the road for years and years,” said Matthew M. Miller, a vice president for the Business Roundtable.
The Chamber of Commerce is advocating for a “big deal” on the fiscal cliff that includes comprehensive tax reform, with the hope of moving to a territorial system in the process.
Some Democrats fear, however, that attaching a fiscal cliff deal to more sweeping changes to the tax code could undermine their own policy goals, particularly if Congress agrees to comprehensive tax reform without letting tax rates go up first on upper-income Americans. “I think it boxes us in,” says one Democratic aide, who spoke on condition of anonymity given the sensitivity of the ongoing negotiations. “Let’s do what needs to be done — let’s not complicate things here. Let’s use this time and let the high-end Bush tax cuts expire.”
An upcoming fight over the territorial issue also has the potential to split the business community between those whose operations are mainly domestic and thus pay higher taxes and the country’s biggest multinationals.
Tech and pharmaceutical companies in particular have an easier time reducing their taxes because they can pick and choose where they park profits associated with their intellectual property, a practice known as “income shifting.” Meanwhile, companies with brick-and-mortar operations mostly in the United States, like many retailers, are stuck with much higher tax rates.
Kleinbard, the USC tax professor, wondered why corporate tax reformers aren’t looking first at the higher rates paid by domestic firms that don’t have overseas operations.
“Of course we need a lower corporate tax,” he said. “If we’re going to start with lower tax rates, maybe we should start with lower taxes for domestic operating business so they can expand. Wouldn’t that be our first priority?”