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.

The proposal also has the tech industry very worried. The Business Software Alliance also sent a letter to Congress in July expressing concern. Its members include companies like Apple, Cisco, Dell, HP, IBM, Intel, Microsoft and others. In fact, in June Microsoft's Steve Ballmer told Bloomberg that the proposal would move U.S. jobs overseas:

Ballmer said that, while the Obama proposals would preserve expense deductions related to research and experimentation costs, the overall deduction limits for companies that defer tax on foreign profits would raise the cost of employing U.S. workers. Fiduciary responsibility to shareholders would require Microsoft to cut costs, he said, meaning many jobs would be moved out of the country.

And then, there's the hit profits would take:

Ballmer estimated that higher taxes under the proposal would reduce profits for companies that comprise the Dow Jones Industrial Average by between 10 and 15 percentage points.

"It's just a question of how much will the Dow come down," Ballmer said. "It's not about companies anyway; we're talking about shareholders."

Rep. Dave Reichert (R-WA), the Congressman from Microsoft's district has also been a vocal opponent of the proposal. In a speech on the House floor, he said:

In the middle of a downturn it makes no sense to eliminate a tax incentive like deferral that American employers need to compete in a global marketplace and create American jobs at home.

TechAmerica provides an informative pamphlet (opens .pdf) explaining the harm the proposal could inflict on the U.S. technology industry. Some if its 1,500 members, who also overlap with many of those in the Business Software Alliance, include Google, Verizon, Motorola and Xerox. It notes:

U.S. multinational high-tech manufacturers generated 54 percent of sales through their affiliates overseas. For many tech companies the numbers are even higher. Intel, for example, employs 45,000 people in the United States and manufactures 75 percent of its products here; yet the world's biggest chipmaker generates 80 percent of revenues abroad.

It's not just the high-tech titans that rely on foreign markets. Some small- and medium-sized technology companies earn as much as 97 percent of their revenues overseas --- helping to achieve the scale necessary to produce highly specialized and sophisticated products by selling to consumers around the world.

There are some pretty prominent critics of the proposal in the business community, so I don't think that even this tax proposal, attempting to be sold as merely closing corporate tax loopholes, will be a slam dunk. Technology, in particular, is an industry very important to many in Congress and the Obama administration. I don't think it will be very easy to ignore its growing chorus opposing the measure. The proposal is one to keep an eye on in the months to come though, because it should be an interesting fight. It's failure might also make healthcare reform more difficult, as Washington would never see the much-needed tax revenue it would have generated.