Obama and GOP: What's holding up corporate tax reform?

Obama and GOP leaders are in agreement on many corporate tax reform policies. But on the question of how foreign earnings of U.S.-based multinationals should be taxed, the gap remains wide. 

At first glance, it looked like President Obama and congressional Republicans were miraculously headed in the same direction on corporate tax reform.

Reform plans by Obama and GOP leaders such as House Ways & Means Committee Dave Camp (R-MI) seemed simpatico. Both sides embraced lower rates. Both endorsed ending business tax subsidies, through neither had much to say about which ones.  But on one fundamental issue the gap between Obama and the GOP remains wide.

How would they tax foreign earnings of U.S.-based multinationals? Both sides agree that the current system is the worst of all worlds: It is immensely complicated, wildly distorts economic decisions, and collects little revenue.

But when it comes to the solution, Obama and the Republicans seem headed down different roads. Obama wants to force U.S. companies to pay more tax on their overseas profits. Many Republicans would exempt offshore earnings from U.S. tax liability.

To understand where reformers are headed, think about today’s system. Under our current worldwide structure, foreign subsidiaries of U.S.-based firms must pay U.S. tax no matter where they earn their income. To prevent profits from being taxed twice, those firms get a credit against their U.S. tax for the levies they pay to other countries.  

Those foreign tax rates are nearly always lower than in the U.S. But because U.S. rates are relatively high, companies game the system to avoid domestic levies on their overseas income, and even to reduce U.S. tax on domestic income.

Under a practice known as deferral, U.S. firms don’t pay U.S. tax until they bring their profits home. This allows them to reinvest earnings in foreign subsidiaries and, in effect, never pay those high U.S. rates.

Firms also use sophisticated accounting gimmicks to shuffle income to low-rate countries while shifting deductible expenses back home, where they can offset domestic profits and lower their overall U.S. tax liability. Sometimes, they actually move their production—and their jobs—overseas to avoid U.S. tax (though that’s rarely the most common reason).

All of this allows many multinational firms to pay effective tax rates well below the 35 percent statutory rate that is getting all the attention. Often they pay less less than they might under a territorial system.

What to do?

Obama would impose a minimum tax on multinationals—effectively forcing them to pay immediate tax on foreign income even if they never return the money to the U.S. But Obama’s plan would be incredibly complicated and may drive more companies to move overseas, since the minimum tax would only apply to U.S.-based firms.

Some Republicans would shift the U.S. to a territorial system and effectively abandon efforts to tax active overseas income of U.S. multinationals. All companies—foreign or domestic– would pay tax on U.S. profits. But domestic firms would owe no U.S. tax on overseas income, either when their foreign subsidiaries earn it or when they pay it as dividends to their U.S. parent.

This would move the U.S. closer to the territorial systems used by most of the world. But such a shift might encourage some domestic companies to move more of their operations—and shift both jobs and more reported income– to low tax countries. Preventing such an exodus would require a complicated new set of rules.

Is there some middle ground between the Obama view and the GOP position? Maybe.  Perhaps there is a way to increase taxes on foreign profits as they are earned but lower the additional tax companies pay once profits are returned to the U.S. This could raise U.S. taxes on income earned in tax havens but reduce the penalty for bringing foreign earnings home.    

But this is complicated, vexing stuff. And it will require honest cooperation among serious tax mavens, not the sort of political one-upmanship that infects most everything else in Washington.