“Made in America” Tax Reform?
President Biden has been credited with making proposals that can save the international system of taxing corporate profits. That would be a pretty significant achievement for any President, let alone one that has been in office for barely a hundred days. How valid are these claims? Are we on the point of a new, stable, and harmonious, international tax system, thanks to Biden?
To begin to answer this, let’s first look at what has happened to the US position.
One characterisation of the aim of US international tax policy for the last couple of decades is that it has sought to create a competitive advantage for US-based multinationals, by making it easier for them to reduce their tax liabilities on foreign activities and foreign profit. The combination of the check-the-box rules and deferral of US tax on foreign income saw trillions of dollars pile up in tax havens, largely untaxed. The OECD BEPS initiative, and many unilateral measures by other countries, were largely taken to address these perceived problems.
A major change came from the 2017 US tax reform, which, among other things, introduced the GILTI provision, under which half of foreign income in excess of 10 percent of foreign tangible assets are included in US taxable income, with a credit for 80 percent of foreign taxes paid. But Biden wants to go further by: (a) raising the minimum tax rate on foreign income to 21%; (b) getting rid of the exemption for 10 percent of tangible assets; and (c) applying the minimum tax on a country-by-country basis instead of a worldwide basis. These measures would significantly increase the pressure on the offshore low-tax income of US MNEs.
There is a logic in these proposals. The Biden administration would like to raise far more revenue from corporation tax and proposes to raise the rate of tax on domestic profit back up to 28%. However, the plan would be vulnerable to offshoring if there continued to be a relatively low effective tax rate on foreign income, as US companies would be incentivised to undertake their productive activity elsewhere, moving “American” jobs abroad: hence the “Made in America” tax plan targets just this possibility.
As an aside, this concern doesn’t seem very consistent with the argument, also made by the US administration, that the rise to 28% would not harm the level of investment in the US, on the grounds that there is no evidence that the tax rate cut from 35% to 21% in the 2017 reform stimulated investment. For the record, the consensus from academic research is that the location of investment is sensitive to differences in the level of taxation.
Under the Biden Plan, the concern with offshoring is to be addressed by raising the tax rate on profit earned by US multinationals abroad. This is the goal of the 21% minimum tax. This explains the extensions to the GILTI provision, including the abolition of the exemption for the return to tangible investment: it seems clear that the concern here is not about profit shifting, it is about moving jobs.
But the proposed minimum tax rate potentially creates another problem, which returns us to the earlier policy: perhaps this would create a competitive disadvantage to US-based multinationals relative to their non-US competitors who may not face such a high tax rate. To deal with that problem, the solution is clearly to try to persuade the rest of the world to do likewise and therefore have all states introduce minimum tax rates.
The logic explains why the US has now become an avid supporter of Pillar 2. It now seems less enthusiastic about Pillar 1; it appears willing to accept what would appear to be a reduced- in-scope version of Pillar 1 (which would apply only to a handful of companies), but only as a negotiating tactic as part of a reform package that dramatically strengthens Pillar 2 and delivers its adoption globally.
So that appears to be the strategy. The key question is whether it will deliver the desired aims for the US. And that depends on whether a sufficient part of the rest of the world can be persuaded to go along with the Biden proposal to strengthen Pillar 2 by removing the substance carve-out and raising the threshold rate of tax.
The history of the last few decades does not offer much encouragement. There have been proposals for a harmonised minimum tax rate before, but they have never been agreed. That is because the calculation of at least some countries is that they would be better off undercutting other countries to attract more inward investment. This has been a pretty good policy for Ireland over the years. And in the absence of a consensus minimum rate, the result has been a steady fall in tax rates.
What is different now? Perhaps the fact of the strong US leadership of this proposal may make the difference. Perhaps other countries will now see more benefit from potentially higher revenues than from competing for inward investment. The pandemic has certainly increased the need for tax revenue – but it has also increased the need for investment.
What may also be different now is the threat of punishment. The undertaxed payments rule of Pillar 2, and the SHIELD provision of the Made in America tax plan, both propose that there should be restrictions on allowing costs to be deducted from tax, where those costs involve payments to related parties in countries that are not part of the minimum tax system. Of course, refusing a deduction also creates a disincentive to investment, so is not cost-free for the country implementing such a policy.
A second difference would arise if parent companies could be prevented from moving to countries not implementing Pillar 2 by the countries in which they are currently tax resident. In that event, the benefits to potential host countries would be much reduced. That brings us to the other element of the SHIELD provision, essentially designed to prevent such inversions (and proposing a residence rule based on 50% ownership). Legal arguments as to the extent to which this would be permitted in the EU may be important.
The jury is still out on whether these factors may induce the Inclusive Framework to agree to a Pillar 1 and 2 package this summer along the lines of the Biden proposal. But even if it does so, this framework may not offer a long-term stable solution. At some point, future governments are likely to reconsider the trade-off between revenue and investment, and some may be tempted to withdraw from any agreement. Just as with the current system, and as with all cartels that aim to keep prices high, there will always be some incentive for some countries to undercut their rivals.
The Biden administration has missed an opportunity to propose a system that could raise substantial revenue without this fundamental problem of incentives: a move in the other direction, towards taxing profit in the relatively immobile location of the customer. That still seems like a better longer-term approach.
Relevant research from the Centre for Business Taxation:
- Taxing Profit in a Global Economy, Michael P. Devereux, Alan J. Auerbach, Michael Keen, Paul Oosterhuis, Wolfgang Schön and John Vella, Oxford University Press, 2021.
- Michael P. Devereux, François Bares, Sarah Clifford, Judith Freedman, İrem Güçeri, Martin McCarthy, Martin Simmler and John Vella The OECD Global Anti-Base Erosion Proposal, Oxford University Centre for Business Taxation Report, 2020.