Will U.S. Investment Go Abroad in a Territorial Tax: A Critique of the President's Advisory Panel on Tax Reform

Abstract

This article critiques the Report of the President's Advisory Panel on Federal Tax Reform (the Report). The Report recommends the U.S. adopt a territorial tax system that would exclude income earned by U.S. taxpayers actively conducting foreign businesses. The Report anticipates that its proposal might generate concern about whether a territorial system would cause U.S. businesses to allocate more jobs and assets overseas to low-tax countries. Referring to an article by Altshuler and Grubert, the Report says:

Researchers found no definitive evidence that location incentives would be significantly changed, which suggests that the territorial system the panel has proposed would not drive U.S. jobs and capital abroad relative to the current system.

The Report incorrectly uses the absence of evidence of an adverse effect to assert that there will be no adverse effect. Theory predicts that a territorial tax will increase the incentive for U.S. multinationals and firms with no prior foreign investment to increase capital transfers to foreign subsidiaries in low-tax countries. A careful reading of the Altshuler-Grubert study reveals that Altshuler and Grubert view their empirical results as inconclusive. Moreover, there are additional factors not considered by Altshuler and Grubert that create further uncertainty about their empirical results, as detailed in this article.

The Report justifies its recommendation for a territorial tax by asserting that the tax will eliminate the tax impediment to repatriating earnings and will make U.S. multinationals more competitive. A complete analysis of the welfare effects of a territorial tax, however, requires that such benefits be considered in the context of other welfare costs that a territorial tax may impose on domestic investment. Since a territorial tax represents a significant variance from the U.S. tax norm that all income should be taxed, the U.S. should enact a territorial system only if it can be shown that the benefits outweigh the costs. This article explains that the Report does not consider potential costs of a territorial tax that make it impossible to determine the net welfare impact of a territorial tax. As a result, this article concludes that the Report fails to make a persuasive case for such a tax.

Keywords: Tax reform, territorial tax system, multinational corporations, investment, taxation

JEL Classification: H25, G31