Research

The Need For Tax Reform: Evaluating Recent Proposals

Introduction

The United States is in dire need of sweeping tax reform. The House and Senate are both in the nascent stages of considering tax reform, characterized by committee-level working groups, discussions, and hearings. Both the House and Senate budget resolutions are based on a fundamental rewrite of the tax code. While promising, history indicates that there have only been a handful of tax overhauls of the modern code, which underscores tax reform as an intrinsically difficult and low-probability event. 
 
At the same time, the administration and some members of Congress have advocated using overseas funds of U.S. multinational corporations to fund infrastructure spending. These proposals vary in nature, with the administration seeking to apply a one-time levy on these funds, while others have advocated for a “repatriation holiday.”
 
In this short paper, we review the need for tax reform, characteristics of a successful tax reform, and the policy merits of recent tax proposals. We conclude that the leading recent tax proposals fall well short of true fundamental tax reform, may impede progress toward tax reform, and suffer specific policy flaws as well.

The Need for Tax Reform

The United States is suffering from subpar economic growth and reduced long-term potential for growth. In part, this stems from a corporation income tax that includes a very high rate and worldwide base, two features that put it at odds with international norms and harm the growth and competitiveness of the U.S.  A corporate tax reform that lowered the U.S. tax rate would return the U.S. to international tax norms, ridding it of the dubious distinction of having the highest statutory tax rate in the world. U.S. firms are increasingly at a disadvantage competing for the vast majority of world consumers and international markets as other nations adopt more favorable tax treatment of foreign-source income. 

Policy Criteria for Tax Reform

In light of the deficiencies of the U.S. code, tax reform should meet three key criteria:
 
  1. A permanently lower, statutory business tax rate that returns the U.S. to international norms.
  2. A permanent move toward a territorial-style treatment of overseas earnings that would reduce or eliminate taxes on repatriated earnings.
  3. A permanent broadening of the tax base to reduce economic distortions in the context of rate-reducing, overall tax reform.
 
In addition, recent tax proposals have linked the tax treatment of overseas earnings to funding infrastructure; the Highway Trust Fund (HTF) in particular. This suggests a fourth criterion for sound policy:
 

4.  A permanent, adequate funding source for the HTF.

Current  Proposals

Two divergent approaches characterize the existing proposals for the tax treatment of foreign-source income.  The first is specified in the administration’s budget. The administration would seek to impose a “one-time” tax of 14 percent on accumulated overseas earning through 2015. The tax would be payable over 5 years and is estimated to raise $268 billion over the budget window. The administration would use the added revenue to fund the projected shortfall in the HTF and additional surface transportation spending. This proposal is similar to a provision of former Ways and Means Chairman Dave Camp’s tax reform proposal of 2014. The Camp bill would have required owners of 10 percent or more of foreign subsidiaries to determine their share of the subsidiary’s earnings and profits, based on their share of ownership, on which they would pay a rate of 8.75 on cash or cash equivalents or 3.5 percent on any remaining earning. The tax would be payable over 8 years.  So, essentially if Shareholder A owned 20 percent of the foreign subsidiary, it would have to pay the 8.75 and 3.5 percent rates on the foreign subsidiary’s earnings. If the foreign subsidiary had 100 million in earnings, with half in cash and half in other forms of earnings, then Shareholder A would face a tax liability of $6.125 million ($50 million x 8.75 percent + $50 million x 3.5 percent = $6.125 million). Revenue raised from this proposal would be credited to highway trust fund accounts.  
 
While the administration argues that its one-time tax should be imposed as part of an overhaul of the business tax code, the revenues are excluded from the administration’s reserve for business tax reform and devoted instead to the administration’s highway bill proposal. This is quite different than the Camp provision, which was proposed strictly in the context of an overhaul of the U.S. tax code.
 
A similar approach, The Infrastructure 2.0 Act, sponsored by Rep. John Delaney, would also impose a deemed repatriation to fund infrastructure spending. The Delaney bill would impose a deemed repatriation at an 8.75 percent rate on existing overseas earnings.
 
Another approach to using foreign-source income to fund transportation spending is a “repatriation holiday,” wherein the overseas earning of foreign subsidiaries can be repatriated at a reduced tax rate for a certain period of time. For example, Senators Rand Paul and Barbara Boxer have advocated for this policy. They have proposed to allow companies to voluntarily return their foreign earnings to the United States at a tax rate of 6.5 percent, provided the repatriations are in excess of the firm’s historic average repatriations. The proposal would devote the new funds to the HTF accounts. 
 

Evaluating the Proposals

Outside of tax reform, the “one-time,” levy supported by the Obama administration lacks a policy rationale beyond constituting a revenue source. Any meaningful corporate tax reform must permanently address the currently flawed international tax regime. Within the logical confines of the administration’s overall business reform, the one-time tax as a transition rule has a policy rationale. Absent an overall reform, it does not.  
 
The repatriation holidays embody several flaws as well. To begin, they are temporary and do not permanently reform the tax treatment of foreign-source income. In addition, the Joint Committee on Taxation has estimated that, relative to current law, similar proposals would lose revenue (although some dispute this conclusion).  If true, this is hardly an appealing feature for a HTF funding mechanism.
 
A previous repatriation holiday was included in the American Jobs Creation Act (AJCA) of 2004, and may provide additional insight.  The AJCA allowed a temporary 85 percent tax deduction on dividends received from foreign subsidiaries for one year, effectively lowering the tax rate on repatriated foreign subsidiary earnings from 35 percent to 5.25 percent. The Act, along with subsequent IRS guidance, approved the use of repatriated funds for hiring and training, infrastructure, research and development, capital investments, and financial stabilization for the purposes of job retention and creation, and disallowed using repatriated funds for executive compensation, dividend payouts, share repurchases, tax payments, and debt instrument purchases.
 
The AJCA certainly increased revenue coming into the U.S.; companies repatriated $362 billion in 2004 out of an estimated $804 billion of foreign earnings available for repatriation. However, there is no official report on how the repatriated earnings were actually spent, since the AJCA did not require companies to trace or segregate their use of repatriated funds. In 2008 John R. Graham, Michelle Hanlon, and Terry Shevlin addressed this question in a survey of tax executives at over 400 firms. They found that 23 percent of repatriated funds went toward job creation, 24 percent toward capital investment, and 12.4 percent to pay down domestic debt. 
 
Finally, from the perspective of highway spending both approaches to a stand-alone foreign-source tax policy are flawed. The Highway Trust Fund is actuarially unsound – gas tax revenues are projected to fall well short of projected expenditures in perpetuity. A temporary repatriation would not fundamentally address this imbalance. 

Economic Policy Considerations

Some argue that focusing narrowly on the tax policy aspects of a repatriation holiday misses broader economic benefits. Economic assessments of the AJCA offer varied conclusions as to its net economic effect. Shapiro and Mathur find that repatriated funds were used to create or retain over 2.14 million jobs, and generated $34.5 billion in new federal revenues. On the other side of the spectrum, Dharmapala, Foley, and Forbes find no increase in domestic investment, employment, or R&D, and emphasize instead increases in share repurchases, and evidence of round tripping.
 
During the early stages of the recovery from the Great Recession there was considerable slack in labor markets and a case could be made for well-designed counter-cyclical policy. Indeed, a 2011 estimate, when the unemployment averaged about 9 percent, found that a repatriation holiday would have beneficial short-term impact and would increase GDP by $360 billion and create approximately 2.9 million new jobs. The analysis was based on many of the assumptions that underpin the Congressional Budget Office’s (CBO) estimates of the economic effects of the American Recovery and Reinvestment Act (ARRA). The CBO estimated that ARRA would have a large near-term, positive effect, but would actually reduce economic output in the long-run. 
 
At present, however, the economic setting has changed considerably.  The labor market displays relatively low unemployment and GDP is returning to its potential level of output. Thus, any near-term economic benefits of a stand-alone repatriation policy would be muted.  Instead, the U.S. tax code should ultimately be reformed permanently to encourage long-term economic growth. Reforms should encourage firms to headquarter and invest in the United States, minimize expensive and unproductive tax-planning strategies, improve economic competitiveness, and enhance high-quality jobs. Lowering the corporate tax rate while scaling back the myriad targeted deductions, credits, and carve-outs currently found in the corporate tax code would increase U.S. competitiveness, stimulate the economy, and introduce a greater degree of simplicity. 
 
Among the most clearly stated observation of the growth implications for corporate tax reform is from Gordon and Lee, who found that cutting the corporate tax rate by 10 percentage points can increase the annual growth rate by between 1.1 percent and 1.8 percentage points. The Tax Foundation also published estimates of the potential growth effects from corporate rate reduction, finding that reducing the “federal corporate tax rate from 35 percent to 25 percent would raise GDP by 2.2 percent, increase the private-business capital stock by 6.2 percent, boost wages and hours of work by 1.9 percent and 0.3 percent, respectively, and increase total federal revenues by 0.8 percent.”

Conclusion

The current administration has proposed a one-time levy on overseas earnings to pay for highway spending, while other policymakers have proposed stand-alone tax holiday as a financing mechanism for the same spending. These proposals suffer from a number of flaws, the most significant of which is that they are proposed separately and distinctly from a pro-growth reform of the broken U.S. tax code. Addressing the broken code offers long-term economic growth, whereas a temporary policy offers little economic benefit in the current climate, and fails as an effective financing mechanism for the unsound Highway Trust Fund. 

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