Business tax reform is the keystone of the Republican agenda. Whatever else the Republican White House and Congress do, unless they enact business tax reform, they have failed — not only their campaign pledge but also the American people.
Without business tax reform, the prospect of boosting U.S. growth towards 3% will vanish. The broken U.S. tax code has stifled productive investment and the American economy for decades.
Both President Trump and Congressional leaders have made comprehensive tax reform a centerpiece of their platforms. Jamie Dimon, CEO of JPMorgan Chase and chair of the Business Roundtable, said it straight: “We have to do this. It’s been hurting our country for a long time.”
While they differ in details, the president’s plan and the House blueprint share two critical elements: slashing the corporate tax rate and adopting a territorial system. By concentrating on these elements, and compromising on the details, the White House and Congress could make fast work of tax reform.
But time is running out in the current legislative session.
Much of the tax reform debate has focused on the absurdly high U.S. statutory corporate rate of 40% (combined 35% federal and 5% state average). This is the highest in the world among advanced countries.
To be sure, the U.S. average effective corporate rate is lower, but still around 30% for American firms that compete internationally. The high rate puts U.S. business at a disadvantage relative to foreign counterparts. When firms have a choice whether to produce in the United States or elsewhere, and when tax rates are the deciding factor, “elsewhere” gets the nod.
In short, the U.S. tax system encourages American companies to move operations overseas.
A less discussed, but equally important, element of business tax reform is the transition from a worldwide tax system to a territorial system. Under the current worldwide system, the U.S. taxes all business income, including income earned abroad by corporate subsidiaries, of companies headquartered in the United States.
But the tax is not imposed until the income of corporate subsidiaries is returned (mainly as dividends) to the U.S. parent firm. In these respects, the U.S. tax treatment of international business is an outlier.
In fact, the United States is the only country in the G7 that still operates a worldwide tax system. Indeed, 26 of the 34 advanced economies in the world employ territorial tax systems.
What effect does this abnormal tax structure have on American businesses?
For starters, the worldwide system encourages reincorporation abroad and traps trillions of dollars overseas that might be put to work in the American economy.
Most notably, it makes other nations — not only Britain and Switzerland, but also China and India — more desirable tax locations for corporate headquarters than the United States.
This jeopardizes an incredible financial boon for larger American cities such as New York, Chicago and Los Angeles. Consider that in 2005, 38% of global Fortune 500 companies were headquartered in the United States; just ten years later, that figure had dropped to 28%. High taxes, and an outdated worldwide tax system, have tarnished the U.S. luster as a site for corporate headquarters.
As part of the drive toward business tax reform, legislation in 2017 should transition the United States to a territorial tax system, as Japan and the United Kingdom recently did. This is a critical part of spurring capital investment, creating jobs, and unlocking trillions of dollars that are trapped overseas.
Territorial taxation represents a marked departure from policies pursued by President Obama, who attempted to raise the tax burden on U.S. multinational corporations.
Optimism runs high that the Trump White House and the Republican Congress will advance the cause of business tax reform this year. Legislation should lower the absurdly high tax rate and put the United States on a equal footing with foreign competitors by adopting a territorial system.
The political stars for meaningful tax reform seemingly align only once in a generation. The last time was 1986. We cannot afford to let the 2017 opportunity pass by.
- Hufbauer is the Reginald Jones Senior Fellow at the Peterson Institute for International Economics.