Over the past decade, a parade of poorly conceived proposals has threatened to change the way American worldwide companies are taxed on their foreign profits. This week, Rep. Mark Pocan (D-Wis.) continued this proliferation by introducing the “Putting America First Corporate Tax Act,” which, like the efforts of former Sen. Carl Levin (D-Mich.) and the administration before him, increases taxes on American companies trying to compete globally by limiting their ability to defer the income tax on profits earned abroad.
In light of this, let’s once again revisit the historical context of what deferral is designed to do, why it exists in the code, and what impact on economic and job growth this limitation may cause.
What Is Deferral?
The United States employs a worldwide tax system, meaning American worldwide companies are taxed here on their U.S. profits (just like domestic companies), taxed abroad on their foreign profits, and then taxed again when those foreign profits are brought back home.
By contrast, virtually all foreign companies are taxed under a territorial system in which they pay taxes on their home country profits in their home country and on their foreign profits in the foreign country, but foreign profits are not taxed a second time when they are brought home. Thus, the double taxation of foreign profits is avoided.
To offset the advantage of a territorial tax system and help level the playing field between American companies and their foreign competitors, the U.S. government employs a system of tax credits and tax deferral. Deferral allows American companies to delay paying tax on foreign earnings until that income is repatriated.
Debunking the Deferral Myths
Why does Congressman Pocan want to get rid of deferral?
Deferral is a complicated concept that is easy to demagogue and misrepresent. As a result, a number of myths, mistruths and misunderstandings surround it. Let’s take a closer look at a few of these.
One prevalent half-truth is that deferral creates a tax advantage for investing and reinvesting overseas and, as such, restrictions on deferral are needed. The reality is that deferral is a vital mechanism needed to offset the advantage of a territorial tax system used by the rest of the industrialized world. Without deferral, American companies would be subject to double taxation and placed at a global disadvantage. Ending deferral would hinder the global competitiveness of American companies, impede U.S. economic growth, and result in the loss of jobs—both at the companies directly impacted and at the companies in their supply chains.
In reality, the worldwide operations of American companies are overwhelmingly domestically concentrated at the American parents, not at foreign affiliates. According to data from the Bureau of Economic Analysis (BEA), in 2012:
- American parent companies accounted for 73% of global capital expenditures at $584.4 billion versus about $219.8 billion from foreign affiliates. For every $1 in foreign affiliate capital expenditures, American parents invested $2.66 domestically.
- American parent companies accounted for 70% of worldwide output (in terms of value added), over $3.2 trillion, versus about $1.4 trillion from foreign affiliates.
- American parent companies employment accounted for about 2/3 of worldwide employment – 23.1 million U.S. parent workers compared with 12.1. million workers at foreign affiliates.
- American parent companies performed 84% of worldwide research and development (R&D) done by American worldwide companies.
What Would Happen if We Repealed Deferral?
Congress has given us a case study of what happens when you repeal deferral — in 1986, it eliminated deferral for American shippers. As a result, American shippers saw a dramatic erosion of their market share, as many became acquisition targets for foreign-owned carriers. American shippers moved their operations abroad, including jobs and capital investment.
In 2004, Congress reinstated deferral for American shippers. The Joint Committee on Taxation (JCT) explained that because other countries did not tax foreign shipping income and because the United States had denied deferral, a “steady and substantial decline” of the American shipping industry had occurred. The JCT said that reinstating deferral allowed American shippers to “be competitive with their tax-advantaged foreign competitors.”
The Bottom Line
If the goal is to make the already antiquated and anti-competitive U.S. tax system worse by impeding U.S. economic growth and causing domestic job loss, then proposals limiting or repealing deferral are the way to go — just ask American shippers. But if we are looking for ways to keep American companies competitive worldwide (while also encouraging inbound investment into the United States), the real answer is comprehensive tax reform that lowers rates for all businesses while shifting to a more internationally competitive system. Then, and only then, should we discuss repealing deferral.