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Obama’s Transition Tax on Offshore Profits Is Sound, But a Higher Rate Would Bring More Revenue Without Adverse Economic Effects

President Obama’s budget will propose a 14 percent tax on multinational corporations’ existing offshore profits and invest the $238 billion in revenues in infrastructure, Bloomberg reports.   That’s a sound way to address corporations’ huge stock of foreign profits, much of it in low-tax jurisdictions like Bermuda and Luxembourg, in transitioning to a reformed international tax system. But setting the rate above 14 percent would produce more revenue without affecting firms’ decisions about where and how to invest.

Multinationals don’t face the 35 percent U.S. corporate tax until they declare those profits “repatriated” to the United States. That’s why many multinationals use accounting maneuvers to report as much of their profits offshore as possible. Multinationals have about $2 trillion in “foreign” profits, much of it actually earned in the United States, stashed offshore to avoid U.S. tax.

Any enacted corporate tax reform will likely include a one-time transition tax on existing foreign profits like the Obama proposal to clean the slate of existing tax liabilities.  Such a tax would be mandatory: multinationals would have to pay U.S. taxes on their existing foreign profits whether they repatriate them or not.  Future overseas profits would be treated differently.

The President proposes to use the transition-tax revenues for infrastructure. That’s sound for two reasons.

First, it helps ensure corporate tax reform doesn’t increase deficits. Using the one-time revenues for infrastructure investments means policymakers couldn’t devote them to permanent corporate rate cuts, which would boost long-run deficits. That reflects the President’s standard that corporate reform shouldn’t increase long-run deficits.

While we would prefer that corporate tax reform reduce deficits, we agree that any proposal should meet revenue standards over the long run as well as the ten-year budget window. Otherwise, policymakers could use timing gimmicks to craft a reform package that’s revenue neutral over the first ten years but swells deficits and debt after that.

Second, it’s a sound way to finance infrastructure investment. The revenues generated by a one-time transition tax are real. In stark contrast, proposals to pay for infrastructure spending with a “repatriation tax holiday” for offshore profits, such as Senators Boxer and Paul proposed last week, are a charade. As the Joint Tax Committee has shown, a repatriation tax holiday loses substantial revenue and hence couldn’t “pay for” highway construction or anything else.

While the President’s approach is sound, setting the 14 percent rate somewhat higher would raise more revenue without adverse incentive effects. As a leading expert on international taxation, University of Southern California law professor and former Joint Tax Committee staff director Edward Kleinbard, told Congress recently, taxing past profits held offshore wouldn’t distort firms’ decisions about where and how to invest:

In ordinary situations all taxes incur “deadweight loss” — the cost to the economy of the transaction [that isn’t] undertaken because its returns after tax are too low, even though its pre-tax returns would have cleared the hurdle. But the $2 trillion in offshore permanently reinvested earnings occupies a different place, because taxing those earnings as part of the transition to an entirely new international tax system will have no effect on future behavior, since the earnings hoard relates entirely to the past. Thus demands for a very low transition tax rate on the repatriation of existing foreign earnings in the context of tax reform are precisely backwards as an economic matter.

The President’s budget also will include a permanent 19 percent minimum tax rate on U.S. multinationals’ future foreign earnings as part of a reformed international tax system, Bloomberg reports. We’ll analyze that proposal when we see more details. It’s crucial that international tax reform as a whole, including any minimum tax, shrink the incentives for corporations to shift profits and investment offshore.