US should respond to OECD tax project with an ‘innovation box’

While the U.S. is plagued by inertia when it comes to tax policy, the rest of the world hasn’t been standing still. The biggest change of late has been the completion of the Organization for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting Project, or BEPS, a multiyear endeavor with the express goal of deterring multinational corporations from shifting their profits across countries to exploit tax rate differentials.

{mosads}The extent to which this effort will be judged successful is to be determined, but one outcome that’s already known is that the final version of the project essentially codified the use of “innovation boxes” in member countries. The most productive response for the U.S. to the BEPS project — in terms of spurring domestic investment and job creation — would be for Congress to create an innovation box tax regime as well.

With both tax-writing committees holding hearings on BEPS this week and the recently announced Pfizer-Allergan merger fomenting vitriol about corporations “deserting” America, the political environment may be propitious to consider a less-than-comprehensive tax reform that addresses the the conflicting incentives the code provides U.S. multinationals.

More than a fad

An innovation box taxes the profits that accrue to patents, unique production processes, copyrights and similar productive intellectual property at a lower rate than other profits. The idea is that since these happen to be relatively easy items to move to another country, taxing them at a lower rate should keep them from migrating elsewhere.

What’s more, in many industries there are significant cost advantages to doing research and development and production nearby, so an innovation box can protect manufacturing jobs, as well as white-collar tech jobs, from leaving a country.

A large number of OECD countries (along with China) have already implemented some version of an innovation box, both to protect their own industries as well as to attract jobs from businesses located elsewhere. When the BEPS project began, some harbored a hope that it would severely constrain the scope of innovation boxes, but the participating members refused to allow anything to seriously constrain their use. As a result, several countries that went into BEPS without an innovation box (most notably Ireland) are creating their own version of one.

Some tax policy professionals complain that an innovation box is merely a gimmick and no substitute for the sort of wholesale roots-and-branches reform of the tax code that the U.S. desperately needs. While a wholesale reform may be ideal, such a change is not occurring anytime soon. President Obama has made it clear that he will not countenance any change in the top tax rate affecting small businesses and pass-through entities, a constraint that scuttles any reform of the personal code. And while a sharply lower corporate tax rate might be preferable to a targeted tax change like an innovation box, the fact that any rate reduction has to be paid for by finding tax savings elsewhere means that there’s little room to cut the overall tax rate.

The obvious path for the U.S. to take toward an innovation box — and one that the House Ways and Means Committee has already considered — involves moving from our current worldwide-plus-deferral tax system to a territorial regime, whereby profits are taxed only in the jurisdiction in which they are earned. Doing so would also lessen the incentive in the tax code for U.S.-based multinationals to invest foreign-sourced profits overseas, as well. It would also obviate the tax incentives for corporate inversions, whereby a foreign entity takes over a U.S.-based business so that its foreign-sourced profits are no longer subject to U.S. taxes when brought into the U.S.

Such a change could generate substantial new tax revenue by assessing a one-time tax on the $2.1 trillion of profits currently parked abroad. Former Ways and Means Chairmen Dave Camp (R-Mich.) and Paul Ryan (R-Wis.) considered a tax rate in the vicinity of 10 percent, which would be enough revenue to move to an innovation box with a rate of roughly 10 to 15 percent, close to the global norm.

Global tax policy changes behoove an innovation box

A comprehensive tax reform is vastly preferable to a piecemeal reform of the code that begins with the relatively unsexy chore of fixing how we tax U.S. multinationals, but wholesale changes to the tax code are not in the immediate offing. In the meantime, our trading competitors continue to lower their corporate rate and use tools like innovation boxes to attract and retain both high-skilled and manufacturing jobs in their country.

An innovation box can be a relatively inexpensive and focused way for the U.S. to attract and retain research and experimentation in this country as well as the jobs that go along with it. What’s more, implementing an innovation box won’t preclude comprehensive tax reform in the future; in fact, it’s hard to envision a feasible tax reform in the future where an innovation box wouldn’t make sense for the U.S.

Regardless of how tax policy proceeds, it’s important that it takes into account the global environment in which our U.S. multinationals operate. While many people treat them as the bane of society, the fact is that they employ tens of millions of Americans and account for the bulk of U.S. economic activity. A tax reform that reduces the incentives currently in place for them to move operations and jobs abroad would be a change most Americans should welcome.

Brannon is president of Capital Policy Analytics, a consulting firm in Washington.