July 26,2017

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Tax Talk: The $2+ Trillion Lockout

With congressional efforts to overhaul the nation's broken tax code moving forward in earnest, creating a tax system that ensures American businesses, both large and small, can successfully compete in today’s international markets remains a top goal.

As part of this discussion, thought leaders, tax experts, and stakeholders often talk about the need to put an end to the “lock-out effect.”

So, what is it and why does it matter?

The Lock-Out Effect
Under the United States’ current worldwide tax system, income earned by a U.S. multinational in America is generally taxed right away. Income earned abroad is taxed in a foreign jurisdiction, and then again in the United States. However, companies can delay paying U.S. taxes on overseas earnings until the funds are repatriated. This is known as “deferral.”  

Combined, the option to defer U.S. taxes and the punitively high U.S. corporate tax rate creates incentives for U.S. businesses to park profits offshore, often for long periods. That way, firms can avoid paying the high U.S. rate. In effect, those profits are subject to U.S. taxation, but are locked out of the taxable U.S. corporate income base – this is known as the lock-out effect.

Rather than returning profits from subsidiaries overseas to the U.S. parent corporations where they would be subjected to the high U.S. corporate rate, those resources are often used to make investments, grow economies, and create jobs overseas, rather than in America. 

As Senate Finance Committee Chairman Orrin Hatch (R-Utah) puts it:

           “This isn’t a dodge or a tax hustle on the part of these companies – they’re simply doing what the tax code tells them to do. The tax code essentially tells U.S. companies: You can have $100 in Ireland, say, or you can have $65 in the U.S. Well – no surprise here – companies generally opt to have $100 in Ireland."

Money Trapped Abroad
Because of the United States’ antiquated and anti-competitive tax code, a massive amount of capital –  likely exceeding $2.6 trillion – is locked outside the country and unavailable for investment in America.

This means fewer financial resources for American jobs, American wages, and American job creators here at home.

It also means more resources for foreign countries. The profits earned abroad can be used to grow foreign economies, boost foreign tax collections, and, ultimately, put America at a competitive disadvantage.

As the Senate Finance Committee’s bipartisan Tax Reform Working Group on International Taxes explained in a report:

           “As a result of our worldwide system of international taxation—combined with the high U.S. corporate tax rate and the option to defer those earnings overseas—U.S. multinational companies have a powerful incentive to make foreign, rather than domestic investments. The ability to defer payment of residual U.S. tax liability on the returns to the foreign investments may make those foreign investments more attractive on an after-tax basis, even if they yield the same pre-tax return as a domestic investment. Publicly traded firms have the additional incentive to declare in filings to the S.E.C. that they are reinvesting foreign earnings overseas rather than repatriate them to the United States.”

Ending the Lock-out Effect
Shifting to a territorial tax system – a policy supported by members from both sides of the aisle and the current administration – will put an end to the lock-out effect, provide incentives for American companies to bring overseas earnings back to invest in their domestic operations, and, because the earnings aren’t hit by the U.S. tax, eliminate the current incentive to keep those monies abroad.

While this change in policy will provide a long-term solution to the lock-out problem, lawmakers are also examining ways, including a deemed repatriation tax, to bring back the $2.6-plus trillion that is currently trapped overseas. Any efforts to address this would be considered in the context of comprehensive tax reform.

Bottom line: Putting an end to the lock-out effect will increase America’s international competitiveness and ensure that American companies can invest more resources here at home. This means stronger economic growth, better jobs, and bigger paychecks for more Americans.