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At 35 percent, the U.S. corporate income tax is technically among the highest in the world. In practice, corporations pay a small fraction of that, and some pay no taxes at all. Corporations will do everything under the law to reduce their tax bill, and often this involves going abroad.

There is near-unanimous understanding that the U.S. tax system is broken, yet there is very little agreement about how to fix it. One of the proposals gaining traction in Congress is a territorial tax system. Here’s what you need to know about how it works, and why progressives are mobilizing in opposition.

How Our Current System Works

On paper, the U.S. currently has a “worldwide tax system” where corporations are taxed the full 35 percent no matter where their profits come from, minus taxes paid to foreign governments. There is a catch, though: When Congress created the corporate tax in 1913, it only counted profits that are brought back home, or “repatriated.” As a result, corporations can and do defer their overseas profits indefinitely, stockpiling them in tax havens such as Bermuda or the Cayman Islands, where they accrue interest and remain untaxed.

Multinationals can transfer ownership of whatever assets the law allows, such as patents or intellectual property, to subsidiaries known as controlled foreign corporations in offshore tax havens. These subsidiaries then accumulate the profits from these assets and hold them indefinitely. U.S. multinationals are currently deferring taxes on $2.1 trillion in profits, some of it stored as cash but much of it in the form of bonds.

What a Territorial System Would Do

A territorial system is a two-tiered system in which domestic profits would get taxed at the full rate and profits from abroad would be U.S. tax-free. Business groups and their representatives support this for the obvious reasons that businesses would pay less in taxes on their offshore profit, as much of the profit would be “booked” in tax havens.

And while proponents of such a system point out that most countries don’t have worldwide systems, true territorial systems are very rare. Almost all countries have laws against offshoring domestic assets, and most of them have a minimum tax on foreign profits. As a result, European-based multinationals have a higher effective tax rate despite having half the actual tax rate.

Recently, Sens. Rob Portman (R-Ohio) and Chuck Schumer (D-N.Y.) proposed a more territorial tax scheme as part of the current negotiations to pay for highway funding over the next six years. The details are still unclear, but they intend to tax the existing $2.1 trillion in foreign profits at a low rate, the receipts of which they would dedicate to supplement the Highway Trust Fund. Then they would significantly lower future taxes on foreign profits, though by how much has not been clarified.

The Progressive Case Against Territorial Tax

A truly territorial tax system would worsen the already grotesque distortions spawned by our current system. Offshoring would become even more tantalizing as corporations would no longer have to defer repatriation; they could instantaneously turn offshored profits straight into dividends and stock buybacks. Indeed, its main effect would be to reward corporations that shift operations abroad, likely at the expense of U.S. jobs and wages.

This would also be true of two-tiered systems like the one President Obama has proposed, in which domestic profits would be taxed at 28 percent and foreign profits would be taxed at 19 percent (again, minus foreign taxes). These proposals would simply be rewarding the corporations that have deferred hundreds of billions in taxes over the years, at the expense of those corporations too small or too honest to set up a subsidiary in a tax haven.

A Better Idea

Because of indefinite deferral, our tax system is effectively territorial because it makes corporate taxes on profits earned offshore optional. What this amounts to is an enormous tax break for multinational corporations, a tax expenditure paid out of the public purse.

Instead of worsening the problem with a territorial tax system, we could fix the root of the problem by eliminating deferral. Without indefinite deferral, corporations could no longer escape U.S. taxes by funneling money into tax havens. This would add more than $600 billion per decade in revenue as the corporations pay their share of the price of maintaining our society. It would also mean a tax system that no longer punishes corporations that produce and operate in the U.S. for the benefit of those that offshore our assets and outsource our jobs.

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