Tax Analysts Blog

Sneak Peek: Obama's Big Idea

Posted on Jan 27, 2012

If you saw the State of the Union address you know that President Obama wants to change how we tax corporate profits. Here are his exact words from Tuesday night: "Right now, companies get tax breaks for moving jobs and profits overseas. Meanwhile, companies that choose to stay in America get hit with one of the highest tax rates in the world. It makes no sense, and everyone knows it."

What specific reforms does he have in mind? While we don't have a crystal ball, it is possible to connect the dots and offer a likely scenario. As I see it, there will be two key elements to his forthcoming corporate tax plan.

I. The Statutory Rate

The President agrees that the current statutory rate of 35% is too high. He's on record as saying he'd sign legislation to lower the rate, provided the overall reform package is revenue neutral. The backstory here is that statutory rates don't matter as much as one might think. Our statutory rate is the second highest in the world, but the effective rates that firms actually pay are much lower.

Prediction: Obama will propose to lower the corporate rate to 25% ... and the business community will hate it.

What's my reasoning? First, a 25% rate matches a recent proposal from Representative Dave Camp (R-Michigan), chair of the House Ways and Means Committee. Matching Camp's rate will diffuse Republican claims that President Obama is anti-business. If 25% is attractive when proposed by a conservative lawmaker, how can it not be just as appealing when proposed by the President? Second, 25% approximates the average rate among our leading trade partners. That helps rebut the claim our tax code leaves businesses unable to compete against foreign rivals. Third, Obama realizes the statutory rate isn't all that important, so why fight over it. Better to save your bullets for the real fight, which concerns the treatment of foreign profits.

Why will the business community disapprove of Obama's rate reduction? Because they'll absolutely detest the pay-for (see below). Remember, this is the era of revenue-neutral tax reform. There can be no pleasure without corresponding pain.

II. Deferral vs. Exemption vs. Accrual

Our corporate tax code is built around a worldwide framework. Resident firms generally must report all earnings, regardless of geographic source. That means foreign profits are included in taxable income, subject to a credit for foreign taxes paid on those same earnings. That said, current law allows firms to defer -- think "delay" -- U.S. taxation of profits earned through their foreign subsidiaries. Those earnings can escape U.S. taxation until the money is repatriated by means of an inbound dividend (paid from the foreign subsidiary to its U.S. parent company). Deferral is simply the timing difference between the year in which the foreign profits are earned, and the year when they're recognized as taxable income. Sounds simple, but the economic benefit is massive. Tax attorneys joke that "a tax deferred is a tax avoided."

Is the business community happy with deferral? Absolutely, but they want to go one better.

Deferral suffers from two unfortunate consequences. One of these is known as the lock-out effect. Because repatriation triggers tax liability, firms have an incentive to build-up enormous stashes of foreign profits that must be kept offshore ("locked out" of the U.S. economy). The common perception is that deferral, while otherwise attractive, penalizes firms when they attempt to bring foreign profits back home. Rather than merely postpone the tax hit, businesses want their foreign profits to be excluded from the U.S. tax net altogether. That would require abandoning our worldwide framework in favor of a territorial design that exempts foreign profits. Such an exemption regime would eliminate the lock-out effect since foreign profits could be repatriated free of any residual U.S. tax. Business groups argue that exemption is necessary to compete in global markets because many other countries have adopted territorial systems.

Prediction: The President will reject both the deferral and exemption models in favor of a third approach ... taxing foreign profits on an accrual basis.

Obama will push for accrual due to the second of the aforementioned problems with deferral. By allowing foreign profits to be taxed at a lower effective rate than domestic profits, deferral encourages foreign deployment of capital relative to domestic investment. The President reckons that deferral functions as a powerful subsidy for foreign investment -- and an exemption system would only magnify that subsidy. Accrual takes the tax code in the opposite direction as deferral or exemption; it would help level the playing field between our treatment of foreign and domestic profits.

Deferral is what Obama was referring to when he spoke about "tax breaks for moving jobs and profits overseas." He believes job creation follows investment patterns, thus a deferral or exemption regime would have negative implications for U.S. employment. [Note: Those who follow this issue professionally know there's a heated debate about whether tax incentives for foreign investment help or hinder domestic employment. Many will bicker over the point; but it seems clear Obama has made up his mind.]

Summary

Reducing the corporate statutory rate should be viewed as a given. The question is how to pay for the lost revenue. Do not be surprised if the White House seeks to repeal the deferral treatment of foreign profits. The plan might well resemble the bill co-sponsored by Senators Ron Wyden (D-Oregon) and Dan Coats (R-Indiana); or the earlier version co-sponsored by Wyden and former Senator Judd Gregg (R-New Hampshire). Or we might see a hybrid system that retains deferral in some circumstances, but kicks the taxpayer over to accrual treatment when the foreign profits are parked in a tax haven. For better or worse, a territorial corporate tax regime isn't even on the White House's radar screen.

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