As Congress considers new tax legislation, item one on its agenda should be to eliminate the harm to U.S. manufacturing jobs contained in the Tax Jobs and Cuts Act (TJCA).
Many were surprised by General Motors recent announcement that it would trim production in the U.S. by closing plants in Ohio and Michigan and laying off 14,000 workers. But anyone paying close attention to TJCA should recognize that it encourages U.S. companies to move their factories overseas.
Congress hurriedly adopted TJCA last December in a process many criticized as too rushed to permit full analysis of its impact.
In a victory lap after the its adoption, however, House Speaker Paul Ryan (R-Wis.) wrote that TJCA “prevents American jobs … from moving overseas by eliminating incentives that now reward companies for shifting jobs … and manufacturing plants abroad.”
In fact, a close examination of TJCA shows the opposite. TJCA contains three provisions that encourage U.S. companies to pull factories out of the U.S.
The first is the disparate tax rates on income earned in the U.S. versus income earned abroad. TJCA slashed corporate tax rates, from a maximum marginal rate of 35 percent to a flat rate of 21 percent, purportedly to discourage U.S. companies from moving abroad.
The problem is that while TCJA reduced the corporate tax rate for income earned in the U.S. to a flat 21 percent, it reduced the maximum tax rate to only 10.5 percent for the operating income earned by a U.S. corporation's foreign subsidiary outside the U.S.
This rate differential alone creates a significant incentive for U.S. companies to shift income-producing assets overseas into foreign subsidiaries, but this is just the first problem.
The second problem is that TJCA allows the foreign income of a U.S. corporation’s foreign subsidiary to be tax-free to the extent the foreign subsidiary’s income does not exceed 10 percent of the subsidiary’s assets.
For example, if a U.S. parent corporation transfers $10 million in assets to fund its foreign subsidiary, the first $1 million earned each year by the foreign subsidiary is tax-free so long as the U.S. parent ensures that its foreign subsidiary maintains assets with a tax basis of $10 million.
This creates an incentive for U.S. companies to transfer more assets into foreign subsidiaries. The more assets held by foreign subsidiaries, the more they can earn with no U.S. tax.
For example, if the U.S. corporation above transferred $50 million of property to its foreign subsidiary instead of $10 million, then the first $5 million of income would be tax-free each year instead of only the first $1 million.
This provision, the global intangible low-tax income, has an appropriate acronym — GILTI. These firms are guilty of shipping jobs overseas.
These two provisions are bad, but Congress — attempting to ameliorate GILTI — added another that worsened the situation.
The new provision, called the foreign derived intangible income (FDII), reduces the 21-percent tax on the foreign income of U.S. corporations to 13.125 percent to the extent that their profits on all their sales (domestic and foreign) exceed 10 percent of their domestic tangible assets.
Congress hoped this would counteract the incentive in GILTI to remove assets from the U.S., but it does the opposite. FDII creates yet another incentive for U.S. corporations to pull factories out of the U.S.
This occurs because U.S. corporations obtain the benefit of the lower 13.125-percent tax rate on their foreign income when they have fewer tangible assets in the U.S.
For example, a U.S. company that has $100 million of assets in the U.S. needs to earn over $10 million before its tax rate is reduced from 21 percent to 13.125 percent on its foreign income.
In contrast, a company with only $10 million of tangible property in the U.S. needs only to earn $1 million before the low tax rate applies to its foreign income.
These complex rules create strong incentives for U.S. companies to move their manufacturing facilities abroad to foreign subsidiaries. What should Congress do?
First, Congress should eliminate the tax-free treatment and low maximum 10.5-percent tax rate applied to foreign income earned by our foreign subsidiaries. All income earned by foreign subsidiaries should be taxed at the same 21-percent rate and in the same manner that applies to U.S. corporations.
Second, Congress should eliminate the tax breaks for shifting income-producing factories overseas by repealing GILTI and FDII.
America’s workers deserve a tax system that creates a level playing field for manufacturing in the U.S. These actions will remove the incentive for U.S. companies to ship factories overseas because their U.S. tax liability will be the same regardless of where the factories are located.
James R. Repetti is professor of law at Boston College Law School. He's an expert in tax policy and an author of several books on taxation, including "Introduction to United States International Taxation," 6th Edition.