Penn Wharton Budget Model finds federal reforms would increase tax rates for multinationals

A report by the Penn Wharton Budget Model found recently proposed federal tax reforms would increase tax rates on the income of multinationals.

A new proposal by the House of Representatives Ways and Means Committee seeks to increase the rate at which corporations are taxed if they don't meet the minimum tax. The Tuesday report found that if reforms proposed by the House Ways and Means Committee went into effect, it would more than triple the United States effective tax rate on multinationals' foreign income from around 2.1 percent to 7.4 percent, averaged by foreign income industries. This rate is higher than a proposal by the Organization for Economic Co-operation and Development, an international organization that creates economic policy, which would require U.S. multinationals to pay a residual tax rate of 6.1 percent.

The report conducted its analysis by examining the effect of tax rates on U.S. multinationals' foreign income under proposed changes by the House Ways and Means Committee and the Organization for Economic Co-operation and Development.

The 2017 Tax Cuts and Jobs Act changed how multinational corporations are taxed by allowing multinational corporations to only pay taxes in the territory the revenue was generated from, according to Penn Wharton Budget Model Associate Director of Policy Analysis Alex Arnon.

According to Arnon, if implemented by itself, "the territorial system" which stems from this policy can cause some issues.

“[The territorial system] creates its own set of bad incentives, because now, ideally what you want to do if you’re a U.S. corporation is get all of your income to be technically earned in some foreign country with a very low tax rate,” Arnon said. “So, all you really have to do is pay the very low tax rate to a foreign country — that might be Bermuda, or, say, the Cayman Islands — not a country where you’re actually really earning the money, but you can make it show up there through various financial mechanisms.” 

To avoid these tax avoidance issues, Arnon explained, the United States also implemented a minimum tax system, in which there is a minimum tax a company must pay abroad in order for taxes to be waived. If that minimum tax is not met, the U.S. will tax the income at below the statutory rate. This led to an effective tax rate on foreign income of about 2.1%.

"This created a mixed system where, if you earn income and you pay a lot of foreign taxes on it, you don’t have to pay U.S. taxes on it. But, if you earn foreign income and don’t pay foreign taxes on it, the U.S. is going to tell you that you have to pay something," Arnon said.

This is not the first time that the PWBM has covered the issue of taxation on foreign income. In July 2021, PWBM wrote an article regarding the effect of the OECD’s plan on profit shifting. According to the report, the future competitiveness of U.S. multinational firms is dependent on whether other OECD countries also increased their tax rates. 

To make these predictions about taxation, PWBM imagines themselves in the shoes of multinational corporations, according to Arnon.

“We’re trying to look at — given what we know about where multinationals are earning their incomes and what we know about the tax systems that they face right now — how would these changes affect them?” Arnon said.