The Merits of a Territorial Tax System

October 26, 2012

The United States' corporate tax rate is one of the highest in the world at 35 percent. The average corporate tax rate of many industrialized countries sits at 23 percent. As a result, many corporations are incentivized to shift operations overseas as it becomes costlier to do business in the United States, say Diana Furchtgott-Roth, a senior fellow, and Yevgeniy Feyman, a research assistant, with the Manhattan Institute.

The current system that the United States operates under is known as the worldwide tax system.  Essentially, this means that any income made overseas is subject to U.S. taxes.  Critics have correctly pointed out that this system discourages companies from repatriating any income to the United States. For example, American companies have about $1.7 trillion in earnings that haven't been brought into the United States for fear of being taxed.

In contrast to this is what is known as the territorial tax system. This system is used by an overwhelming majority of Organization for Economic Cooperation and Development (OECD) countries. With it, companies are not subject to domestic taxes on any income that is earned abroad. Rather, companies are only responsible for paying taxes at the rate in whichever country the income is earned.

This system has proven itself to meet the demands of globalized businesses. In an effort to become more competitive, both presidential candidates offer proposals to change the current tax system to make it friendlier to businesses.

  • Romney and Obama want to bring down the corporate tax rate to 25 percent and 28 percent, respectively.
  • Obama has proposed reducing the deductibility of ordinary interest; ending tax preferences for oil and gas; ending deductions for moving overseas; and imposing a minimum tax on foreign income held abroad.
  • However, his plan would drive more companies offshore to evade the minimum tax on foreign income and the increase in tax for oil and gas.
  • Romney, on the other hand, proposes a pivot to the territorial tax system with a minimum repatriation tax and ending some tax preferences.

Critics of the territorial system argue that many jobs would be created overseas rather than in the United States. However, studies on the territorial system have not looked at the combined effect of a territorial system and a lower tax rate that would attract more companies and jobs to the United States.

Source: Diana Furchtgott-Roth and Yevgeniy Feyman, "The Merits Of A Territorial Tax System," Manhattan Institute, October 2012.

 

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