Will Obama's International Tax Changes Succeed?

We all know that healthcare is at the top of Congress' agenda when it returns from recess next week. But central to healthcare reform is keeping it budget neutral. Most agree that funding such an endeavor will almost certainly require more tax revenue, as Congress isn't likely to cut spending by trillions to compensate. Few additional sources of tax revenue have been proposed, and even most Democrats are pretty uneasy talking about tax hikes until the economy is in the clear.

But one potential measure was mentioned months ago: changes to how U.S. companies are taxed on revenues from overseas. A few of the central changes in this proposal include limiting multinationals' ability to defer taxes on profit from abroad or claim a tax credit based on overseas taxes already paid. This proposal has business leaders, especially those in the technology industry, very wary.

The Obama administration has characterized these tax changes as reform that seeks to get rid of corporate loopholes in the tax code. But portraying these changes as reform, rather than tax hikes, isn't exactly right. If it were reform, it would necessarily target abuses, but it goes far beyond that.

As I've mentioned, I'm all for the government cracking down on individuals or corporations who cheat on taxes. But in the case of international tax deferrals and foreign tax credits, there are legitimate reasons why current policy is in place, beyond creating loopholes for multinationals to get out of their duty of paying taxes to the U.S.

Howard Gleckman from the Tax Policy Center does a good job of explaining the legitimacy of the foreign tax credit and deferral:

It is all very complicated, but boiled down to its essence, the tax regime works like this: You open a plant in Ireland and pay the top Irish rate of 12.5 percent on your profits. If you bring your earnings home, you must pay the U.S. rate of 35 percent, which you then offset with a U.S. credit for those Irish taxes you already paid.

If you are like many CFOs, however, you never bring the money home. Instead, you reinvest those profits back into your Irish business or, perhaps, build a new plant in Thailand and avoid that 35 percent U.S. tax. The problem is not that companies won't repatriate the money back to the U.S. It is that most countries tax only local profits while we persist in trying to tax worldwide income, offset by those complex credits. That's the part where my head starts to throb.

Essentially, U.S. firms are at a disadvantage in most foreign territories due to the very high U.S. corporate tax rate. The foreign tax credits and deferral offset this competitive disadvantage. The tax credit allows firms to only have to pay the equivalent of the very high U.S. tax rate -- not the high U.S. rate plus whatever rate is required in the territory the firm collected the revenue. In the example above, what U.S. firm could compete with Irish firms if it has to pay 47.5% in taxes when its Irish competitors only have to pay 12.5%?

These tax changes scare a lot of people. Even some Democrats. The "New Democrat Coalition," a moderate group of Democrat members of Congress, sent a letter (opens .pdf) to House Democrat leaders Pelosi and Hoyer in June expressing its concern about the effect these tax changes will have on U.S. firms.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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