Understanding the President’s international tax proposal

Let’s look at three factories, each of which produces $100 of income.

  1. Your factory A is in the U.S. Your corporation pays a 35% U.S. corporate income tax rate ($35).
  2. Your factory B is in China. Your corporation pays a 15% Chinese corporate income tax rate ($15). You owe the U.S. government $35 in taxes, minus a credit for the $15 you paid to China. China gets $15, and the U.S. government gets $20.
  3. Your British competitor’s factory C is also in China. He pays a 15% Chinese tax rate ($15), and no taxes to his home government.

Factory B shows the effect of a worldwide tax system, in which the firm pays the same total tax wherever the income is earned. Taxes are based on the nationality of the payor, not the location at which the income is earned.

Factory C shows the effect of a territorial tax system. Income is taxed only where it is earned.

The U.S. actually has a hybrid. You can defer the taxes you owe from factory B until you bring that income back to the United States. This is an advantage relative to a pure worldwide system.

Left-leaning and other protectionist elected officials like to argue that a worldwide system “discourages U.S. firms from moving their factories overseas.” Senator Kerry argued this in the 2004 Presidential campaign. A worldwide system also raises more money for the home government to spend on other programs.

The territorial system creates a level playing field for American firms when they are competing overseas. Your factory B in China is at a severe disadvantage compared to the British factory C in China. You might consider moving your headquarters to London and turning your firm into a British corporation. As the global economy grows more interconnected this is increasingly easy to do.

The President’s new international tax proposal moves us toward a worldwide system. I think we should move in the opposite direction, toward a territorial system.

I think that lower taxes are good, and worldwide tax systems are a throwback to a time when the world economy was less global. Yes, in a territorial system companies can open factories overseas to avoid higher taxation in the U.S. But the more relevant comparison is whether Intel’s chip fabrication plant in China will be disadvantaged relative to the Malaysian, Brazilian, or French plant in China. If you are […]