Obama's Incredibly Bad Idea

One of the proposals Obama has put forth that has received scant attention is the idea that US companies would have to pay taxes on their global income and not just on their US income.  Given how bad an idea this is, it is surprising that it hasn't received more attention.

Obama's corporate tax proposal has five key elements:

• It lowers the corporate tax rate to 28%
• It caps the corporate tax rate for manufacturers at 25%
• It imposes a 20% AMT on foreign profits irrespective of whether companies bring those profits back (although it does allow the deduction of foreign taxes paid)
• It introduces a 20% tax credit for moving operations to the US and disallows deduction of expenses related to moving operations abroad
• It eliminates a host of deductions to simplify the tax code, making these changes somewhat revenue neutral 

The aforesaid changes introduces a significant change in how multinationals are taxed.

Currently, not only does the US have one of the highest corporate tax rates in the world, but the US is one of the few countries that does not use a territorial tax treatment, i.e. unlike other countries which tax income earned within their borders, the US taxes global income and not just US income.  However, there is a pretty big loophole.  Multinationals are only taxed on the  foreign profits they bring back to the US.  So, they can effectively indefinitely defer paying taxes in the US by not bringing the profits back to the US.

To fix the loophole, Obama has proposed a 20% alternate minimum tax on foreign income.  

To understand why it is bad, consider a thought experiment.  Imagine that India decides to encourage the car industry and reduces corporate income tax rates for car companies to zero. Car companies from around the world would suddenly find the Indian market more attractive.  However, under Obama's tax rule, US car companies would still need to pay the 20% rate in the US.  That means US companies operating internationally would suddenly be at a huge disadvantage, earning upto 20% lower returns than companies incorporated elsewhere.

The counter argument is that US companies would not be tempted to park money abroad as there would be no advantage to parking the money abroad.  However, the same could be said if the US moved to a territorial tax system.  If companies no longer had to worry about getting taxed on foreign profits they bring back to the US, they would have more incentives to bring the money back.  Not having a territorial tax system actually deters companies from repatriating foreign profits.  Moreover, taxing income in foreign countries seriously affects the competitiveness of US companies.

The only saving grace is that even if Obama wins, its highly unlikely that this proposal will make it past the GOP dominated House.