The United States Congress is likely to enact a major tax reform sometime during the next six months. Although the new rules will apply only to American taxpayers, they will have important consequences for companies and markets around the world.
The most important changes will apply to US corporations rather than to individual taxpayers. Of these reforms, the one with the most obvious and direct international impact will be the change in the taxation of US corporations’ foreign subsidiaries.
The current US rule is unique among all major advanced economies. Consider the example of a subsidiary of a US corporation that earns profits in Ireland. That subsidiary pays the Irish corporate tax at Ireland’s low 12% rate. It is then free to reinvest the after-tax profits in Ireland, in financial securities, or in operating businesses anywhere in the world – except the US.
If the foreign subsidiary’s parent company brings the after-tax profits back to the US to invest or distribute to its shareholders, it must pay the current US corporate tax rate of 35% on its original pre-tax Irish profits, with a credit for the 12% that it has already paid.
Because of this 23% penalty on repatriation, US companies generally choose not to repatriate the profits of their foreign subsidiaries. The Treasury Department estimates that these subsidiaries have accumulated $2.5 trillion of offshore profits.
Congress is now likely to adopt the “territorial” method of taxing the profits of US corporations’ foreign subsidiaries. Under the territorial method, which virtually every other advanced economy uses, US corporations will be able to repatriate their foreign subsidiaries’ after-tax profits with little or no extra tax.
Congress is also likely to enact a “deemed repatriation tax” on the $2.5 trillion of profits that have been accumulated abroad but never subject to US tax.
Although the details of this provision have not been decided, the basic idea would be to levy a tax of about 10% on the untaxed overseas profits, to be paid over a period of years. In exchange for this new tax liability, a US corporation could repatriate those accumulated profits whenever it wanted to do so.
The shift to a territorial tax system is likely to have important effects on US corporations’ behavior. A large share of their foreign subsidiaries’ future profits, which would be retained abroad under current law, are likely to be returned to the US, reducing investment in Europe and Asia. A portion of the $2.5 trillion of past profits now held abroad would be repatriated as well.
Moreover, US corporations will no longer have an incentive to shift their country of incorporation to other countries in order to be able to distribute their foreign-earned profits to their shareholders. At the same time, foreign companies will have an incentive to shift their headquarters to the US, where they could enjoy the advantages of being a US corporation without incurring the current tax penalty.
Although the shift to a territorial system of taxation would have the most obvious foreign impact, the planned reduction in the corporate tax rate may have an even larger effect. The 35% statutory tax rate on corporate profits is one of the highest among all developed countries. The congressional proposal would reduce the corporate rate to 20%. President Donald Trump has called for a 15% rate.
A lower corporate tax rate and the shift to a territorial system would increase the flow of capital to investment in US corporations from abroad and from capital investments in owner-occupied housing and in agriculture. This would raise productivity and GDP, leading to increases in tax revenue that would partly offset the direct effect of the corporate rate reduction.