Corporate Tax Expenditures: Evaluations of Tax Deferrals and Graduated Tax Rates

Congress and the administration are reexamining tax expenditures used by corporations as part of corporate tax reform. These tax expenditures-- special exemptions and exclusions, credits, deductions, deferrals, and preferential tax rates--support federal policy goals, but result in revenue forgone by the federal government.

GAO was asked to examine issues related to certain tax expenditures. This report uses GAO's tax expenditures evaluation guide to determine what is known about: (1) the deferral of income for controlled foreign corporations; (2) deferred taxes for certain financial firms on income earned overseas; and (3) the graduated corporate income tax rate. GAO combined the two deferral provisions for evaluation purposes.

GAO's guide suggests using five questions to evaluate a tax expenditure: (1) what is its purpose and is the purpose being achieved; (2) does it meet the criteria for good tax policy; (3) how is it related to other federal programs; (4) what are its consequences for the federal budget; and (5) how is its evaluation being managed? To address these questions, GAO reviewed the legislative history and relevant academic and government studies, analyzed 2010 Internal Revenue Service (IRS) data, and interviewed agency officials and tax experts.

Deferral : Both deferral tax expenditures confer the benefit of effectively reducing taxes by delaying the taxation of certain income of foreign subsidiaries of U.S. corporations until it is repatriated to the U.S. parent as dividends.

1. While views on the purpose of deferral have changed over time, currently, it is often viewed by experts as promoting the competitiveness of U.S. multinational corporations. Some experts argue that this view is too narrow. For example, this definition of competitiveness ignores the effect on other corporations that cannot use deferral, such as those that are purely domestic or export without foreign subsidiaries. Further, it ignores impacts on the wider economy.

2. Good tax policy has several dimensions. By delaying the tax on foreign source income, deferral could distort corporate investment and location decisions in a way that lower taxes, but favor less productive activities over more productive ones. Informed judgments about deferral's effect on the fairness of the tax system cannot be made because who benefits from deferral, after accounting for such factors as changes in prices and wages, has not been determined. However, there is widespread agreement among experts and the Internal Revenue Service (IRS) that deferral adds complexity to the tax code.

3. GAO did not identify other federal spending programs that provide similar support to U.S. multinational corporations.

4. Joint Committee on Taxation (JCT) 2011 estimates show relatively modest consequences for the federal budget.

5. No federal agency has been tasked with evaluating deferral.

Graduated corporate income tax rate schedule : The graduated tax rates lower tax rates for corporations with less than $10 million in taxable income.

1. The purpose of the graduated corporate income tax rate schedule is viewed by the sources GAO reviewed as supporting small businesses. However, evidence is mixed on whether it achieves this purpose. The tax rates may not be well targeted toward supporting small businesses because corporations that are large in terms of assets and gross receipts may have taxable income that is small enough to qualify for the rates.

2. The economic efficiency of the graduated rates depends on whether they correct for a market failure. This includes too few small businesses forming, given their potential for profit and innovation, which offsets the possible distortions from its advantaging one type of business organization over others. GAO did not identify any studies of the efficiency effects or those that specifically estimate the distribution of the benefits from the graduated rates. According to IRS staff, while the graduated rates present little complexity, some evidence of tax planning to avoid higher rates has been found.

3. The graduated rates may be related to a number of federal spending programs also targeted to small businesses.

4. JCT 2011 estimates also show modest consequences for the federal budget.

5. No federal agency has been tasked with evaluating the graduated rates.

GAO made no recommendations. Treasury, IRS, the Joint Committee on Taxation, and external experts provided technical comments that were incorporated, as appropriate.

In the past few years, both Congress and the administration have  proposed reforming the corporate income tax system. A key component  of discussions about reform is determining how the income of U.S.  multinational corporations should be taxed—in particular, whether the  federal government should continue or modify the current deferral of  taxes on certain income until it is repatriated back to the United States.  Currently, there are two provisions that relate to the deferral of U.S.  taxation of foreign-source income: a general provision that applies to all  controlled foreign corporations and a special provision applicable to active  financial-services income. Another key component of reform discussions  is the appropriate corporate income tax rate and structure. The current  structure includes a set of graduated tax rates. The Department of the  Treasury (Treasury) identifies both deferral provisions and the graduated  rates as corporate tax expenditures because they are reductions in the  federal corporate income tax liability that result from special provisions of  the tax code. As our prior work pointed out, these tax expenditures are  among the largest utilized only by corporate taxpayers. According to  Treasury’s estimates, the amount of corporate tax revenue forgone from  these three tax expenditures totaled almost $49 billion in fiscal year  2012. Modifying or eliminating these tax expenditures as part of  corporate tax reform will likely involve tradeoffs between various  objectives pursued by the federal government, such as tax revenue and  corporate investment.

Because of your ongoing interest in whether and how well these tax  expenditures are achieving their purposes, you requested that we apply  the guide that we recently developed for evaluating the performance of  tax expenditures to certain corporate ones. determine what is known about the following three tax expenditures: (1)  the deferral of income for controlled foreign corporations; (2) deferred  taxes for certain financial firms on income earned overseas; and (3) the  graduated corporate income tax rate.

This report uses our guide to  Because the two deferral provisions are so similar, we combine them for  evaluation purposes, and then evaluate the graduated rates separately.

Our tax expenditure evaluation guide outlines a series of questions and  criteria that can be used to evaluate tax expenditures. The five primary  questions outlined in the guide are:  1.  What is the tax expenditure’s purpose and is it being achieved?  2.  Even if its purpose is achieved, is the tax expenditure good policy?  a. Does it generate net economic benefits for society?  b. Is it fair?  c. Is it simple, transparent, and administrable?

GAO, Tax Expenditures: Background and Evaluation Criteria and Questions,  GAO-13-167SP (Washington, D.C.: Nov. 29, 2012). The graduated corporation income  tax rate is the terminology used in Treasury’s tax expenditure estimates, but we refer to it  as the graduated corporate income tax rate schedule or graduated rates for this report.

3.  How does the tax expenditure relate to other federal programs?  4.  What are the consequences for the federal budget of the tax  expenditure?  5.  How should evaluation of the tax expenditure be managed?

The guide’s questions cover a number of different policy objectives, which  sometimes compete with one another. This report provides information in  response to the questions, but does not attempt to balance the different  objectives or make recommendations. Rather, policymakers are in the  best position to judge how competing policy objectives should be  weighed.

As we note in our tax expenditure evaluation guide, the guide is not a  “one size fits all” framework for evaluating tax expenditures. We used  reasonable judgment in applying the guide’s questions and concepts to  evaluate the three tax expenditures. In some instances, we focused our  discussion on certain questions in the guide because they were more  relevant to the tax expenditures we were evaluating. At the same time, we  devoted less discussion to other questions that were more technical in  nature. See appendix I for the guide’s full list of questions.

To determine what is known with respect to the deferral tax expenditures  and the graduated corporate income tax rate schedule, we reviewed a  variety of sources. These sources included studies by GAO, the  Congressional Research Service (CRS), the Congressional Budget Office  (CBO), the Joint Committee on Taxation (JCT), and other federal  agencies; legislation, statutes, and regulations related to each of the tax  expenditures; and academic research. We also interviewed officials at  Treasury, the Internal Revenue Service (IRS), and three external experts,  one from CRS and two from universities, who have researched and  written extensively on the U.S. corporate income tax system. The results  from these interviews are not generalizable. When no consensus existed  among our sources for the answer to a question, we summarized the  debate and provided citations for the various views. We analyzed  Treasury’s tax expenditure estimates from 1998 to 2012, and 2011  estimates by JCT on the revenue effects of changing tax expenditures.  We also analyzed 2010 data from the IRS Statistics of Income (SOI), the  most recent year available at the time of our work, and data from the  Bureau of Economic Analysis (BEA) that covered 1987 to 2012. To  assess the reliability of the data and estimates, we reviewed agency  documentation, interviewed agency officials, and reviewed our prior  reports that have used them. We determined that the Treasury, BEA,  JCT, and IRS data and estimates were sufficiently reliable for our  purposes.

We conducted our work from April to September 2013 in accordance with  all sections of GAO’s Quality Assurance Framework that are relevant to  our objectives. The framework requires that we plan and perform the  engagement to obtain sufficient and appropriate evidence to meet our  stated objectives, and to discuss any limitations in our work. We believe  that the information and data obtained, and the analysis conducted,  provide a reasonable basis for any findings and conclusions in this  product.

The United States taxes domestic corporations on their worldwide  income, regardless of where it is earned, and provides credits for foreign  income taxes paid. A U.S. parent corporation may directly or indirectly  own multiple corporations, including both domestic and foreign  subsidiaries. The U.S. taxes the worldwide income of U.S. corporations,  whether earned domestically or abroad. However, the active business  income earned by foreign subsidiaries is generally eligible for deferral  from U.S. tax until it is distributed, usually in the form of dividends, to the   When income is  U.S. parent corporation or other U.S. shareholders.repatriated in this way, it may have already been taxed in the foreign  country where it was earned. To avoid taxing foreign source income  twice, the federal tax code allows U.S. parent corporations a foreign tax  credit (FTC) for taxes paid to other countries. A U.S. corporation would  pay U.S. tax on foreign-source income only to the extent that the U.S. tax  on that income exceeds the FTC. Figure 1 shows how deferral affects  how a dividend payment from a foreign subsidiary to its U.S. parent  corporation is generally taxed under the U.S. worldwide tax approach.

Passive income, such as dividends, interest, rental income, and royalties  received by controlled foreign corporations, and certain types of easily  manipulated active income, is not subject to deferral.for deferral is defined under Subpart F of the Internal Revenue Code  (IRC).

Unlike the United States, most developed countries do not tax  corporations on their worldwide income. Instead, these countries use a  territorial tax system that taxes only the income earned within a country’s  physical borders, and exempts from tax dividends received from foreign  subsidiaries on their foreign earnings as well as gains realized on the sale  of foreign subsidiaries. There has been a trend of developed countries  moving towards territorial tax systems. As of 2012, 28 of the 34 current  member countries of the Organisation for Economic Co-operation and  Development have adopted some form of a territorial tax system.  However, most countries generally do not use a pure form of either the  worldwide (also known as a full-inclusion system) or territorial tax system.  Rather, countries tend to use a hybrid system that contains some features  of both systems. For example, the deferral provisions in the U.S.  worldwide system delay the taxation of foreign source income, whereas a  purer form of the worldwide system would tax this income as it is earned.  As we have previously found, countries using the territorial approach do  not exempt all foreign source income from taxation, but have exceptions  for certain types of passive income.

The income of controlled foreign corporations that is generated through  the primary business activities related to financial-services is excepted  from Subpart F’s anti-deferral regime. Interest income, for example, which  would typically fall under the Subpart F definition, and thus would be  taxed currently whether or not it is repatriated to a U.S. parent  corporation, is permitted to be deferred under this active financial- services income provision. This tax expenditure is an exception to  Subpart F because it treats what would otherwise be considered passive  income as active business income that can be deferred since it was  earned through the primary business activities of financial-services  companies. The effect of the exception is to include financial-services  companies among the U.S. corporations that can defer taxation on their  business income earned abroad.

The United States taxes all foreign and domestic corporate income using  a graduated corporate income tax rate structure. Corporations with less  than $10 million in net taxable corporate income are subject to different  tax rates, depending on the amount of income earned. As seen in table 1,  income is taxed at graduated rates of 15, 25, 39, and 34 percent for  various income levels up to $10 million, and 35 and 38 percent for income  up to $18,333,333. The 38- and 39-percent rates reduce the benefits  provided by the lower graduated rates. Finally, for corporations with  taxable income higher than $18,333,333, a flat rate of 35 percent applies  to all taxable income.

Treasury and JCT designate the two deferral provisions and the  graduated corporate income tax rate schedule as tax expenditures  because they are special tax provisions that are exceptions to the normal  structure of the corporate income tax system. The deferral provisions  are designated as tax expenditures because they deviate from the  baseline case of a pure worldwide tax system in which U.S. corporations  would be taxed on their worldwide income whether or not the income is  repatriated to the United States. The graduated rate provision is  designated a tax expenditure because it is an exception to the normal  structure of a flat corporate income tax rate. All three tax expenditures  reduce revenue received by the federal government below what it would  be under the normal structure established by Treasury and JCT.

Treasury and JCT each compile an annual list of tax expenditures by  budget function with estimates of the corporate and individual income tax  revenue losses, also known as tax expenditure estimates. separately calculate the estimated revenue losses for each tax  expenditure under the assumptions that all other tax expenditures remain  in the tax code, and taxpayer behavior remains constant.expenditure estimates do not represent the amount of revenue that would  be gained if a particular tax expenditure was repealed, since repeal would  probably change taxpayer behavior in some way that would affect  revenue.

Office of Management and Budget (OMB), Analytical Perspectives, Budget of the United  States Government, Fiscal Year 2014 (Washington, D.C.: 2013); and JCT, Estimates of  Federal Tax Expenditures for Fiscal Years 2012-2017, JCS-1-13 (Washington, D.C.: Feb.  1, 2013).

Deferral Is Viewed by Many as Promoting Competitiveness

Deferral has long been a part of the tax code, and views of its purpose  have changed over time. Currently, it is often viewed by tax experts and  in the research that we reviewed as promoting competitiveness.  However, deferral’s effect on competitiveness depends on how  competitiveness is defined. If competitiveness refers to the ability of U.S.  multinational corporations to operate successfully in foreign markets  through their subsidiaries, then deferral, which increases after tax returns  by delaying tax payments, provides a benefit that may enhance  competitiveness.that, operating under a territorial tax system in their own countries, pay   In foreign markets, U.S. corporations face competitors  tax only in the foreign country. U.S. corporations under the worldwide  system must pay the foreign tax plus any U.S. tax on the same income.  By delaying this U.S. tax, deferral is said to move U.S. corporations closer  to having a “level playing field” with their foreign competitors.

Whether the tax benefit provided by deferral results in net positive  economic effects for the United States is the subject of debate. Some  research has found that investments U.S. multinationals make abroad,  due in part to the incentives provided by deferral, lead to positive  economic effects for employment and wages in the United States, while  others have questioned the magnitude of these effects. Treasury  officials noted that in some instances U.S. foreign direct investment may  be associated with increased investment in the United States. In other  instances, it may be associated with decreased U.S. investment, meaning  that the effect on employment and wages in the United States would be  uncertain.

However, whether this definition of competitiveness that focuses on  multinationals is appropriate has been a subject of debate among  experts. corporations to operate successfully in domestic markets, and to export  products into foreign markets. Deferral provides no benefit to these purely  domestic or exporting U.S corporations. Rather than leveling the playing  field, deferral benefits U.S. multinationals over other types of U.S.  corporations.

Competitiveness has also been defined as the ability of U.S.

See Nicola Satori and Reuven S. Avi-Yonah, “Symposium on International Taxation and  Competitiveness: Foreword,” Tax Law Review, vol. 65 (Spring 2012). This paper  summarizes a variety of viewpoints on competitiveness. of U.S. international corporate taxation allow U.S. multinational  corporations to pay a much smaller U.S. effective tax rate on foreign  source income than domestic income. If these multinationals earn  income in countries that, on average, have lower corporate tax rates than  the United States, they have an advantage over purely domestic U.S.  corporations because the average effective tax rate on the multinationals’  worldwide income may be lower than the rate paid by the purely domestic  corporations on their U.S. income. However, there is some research that  has found that multinationals and domestic-only firms face similar  effective tax rates.

Other tax experts argue that the appropriate definition of competitiveness  should focus on broader industry or national purposes rather than  corporations. For example, a U.S. industry is said to be more  competitive by attracting more investment and resources than foreign  industries. For others, competitiveness is a more general concept,  referring to the set of institutions, policies, and human and natural  endowments that make a country productive. A tax policy that promotes  competitiveness under this definition would try to assure that the tax  system does not prevent a country’s resources from being put to their  most productive uses. Countries that meet this standard can engage  most effectively in international trade that can be mutually beneficial. Tax  benefits for only certain corporations or industries may not meet this  criterion. Finally, some experts note that the concept of competitiveness  is the wrong concept to focus on when formulating tax policy and that  efficiency, which we discuss in the following section, is the appropriate  concept. They argue that simply using the wrong concept in this way  leads to bad policy outcomes.

Numerous Business Decisions Are Affected by Deferral and Each Has Consequences for Efficiency

Tax differences between countries can affect decisions made by  multinational corporations, including where to invest in operations, where  to locate their corporate residences, when to repatriate income from  foreign subsidiaries, and whether to acquire foreign or domestic  corporations. Their decisions are said to be distorted when the  corporations respond to tax differences by putting resources into less  productive activities because these activities are taxed less heavily than  more productive uses. As we stated in our guide, when this happens, the  economy is not as productive as it could be, and society does not achieve  as high a standard of living as it would if the distortion did not exist.

As mentioned above, the United States uses a hybrid form of the  worldwide tax system where deferral delays but does not eliminate the  U.S. tax on foreign source income. In this way, the U.S. worldwide system  has some features less like a pure worldwide system and more like a  territorial system. Moving in either direction would affect deferral. On one  hand, the United States could eliminate deferral if it moved towards a  more pure worldwide system by adopting a full inclusion system where  foreign source income is taxed by the United States as it is earned rather  than when it is repatriated. On the other hand, the United States could  move towards a more territorial system by exempting foreign source  income from U.S. taxation, or, in effect, making deferral permanent.effect on corporations’ decision making and ultimately on efficiency will  depend on which way of ending deferral is adopted. The following  discusses some of the decisions that have been identified in the literature  where deferral could increase or decrease distortions.

Some tax experts argue that deferral may distort decisions about where  U.S. corporations invest, compared to a full-inclusion system, if the U.S.  tax rate is higher than foreign tax rates, as is often the case. This  difference in tax rates, combined with the ability to defer paying the higher  U.S. tax until income is repatriated, could mean that a U.S. corporation  earns more after taxes from a less productive investment abroad than  from a more productive investment at home. The efficiency loss is the  loss of income (or product) that results when the corporation chooses the  less productive foreign investment because it produces a higher after-tax  return. Some research has shown that differences in tax burden do affect  corporations’ real investment decisions, which could lead to these  efficiency losses. this distortion affecting the allocation of investment domestically or abroad  could potentially be reduced because the tax incentive to invest abroad  would be eliminated, since corporations would pay the same U.S. tax on  their worldwide income, whether it comes from foreign or domestic  investments. Under a territorial system, these investment location  distortions may increase relative to the current system because the tax  incentive to invest in low-tax countries may be enhanced when the  differences in tax rates are made permanent. However, the  responsiveness of investment decisions to tax rate differences indicates  that U.S. corporations could be at a disadvantage under a full inclusion  system as they could be competing against foreign companies which  would likely be taxed under a territorial tax system and at a lower tax rate.  This disadvantage would be removed under a territorial system where  U.S. corporations would face the same tax rate as foreign competitors  also operating in those countries.

Organisation for Economic Co-operation and Development, Tax Effects on Foreign  Direct Investment: Recent Evidence and Policy Analysis: Tax Policy Study No. 17 (2007).

Some experts and research that we reviewed argue that deferral may  reduce distortions, compared to a full inclusion system, about where  businesses decide to incorporate, and whether U.S. corporations choose  to change their country of incorporation to a foreign country (so-called  corporate inversions). By choosing not to have its corporate residence in  the U.S., a corporation could permanently avoid U.S. tax on income  earned abroad, and whatever income it is able to shift out of the U.S.  Deferral may somewhat reduce this distortion by allowing corporations to  defer from tax income earned abroad. Some research has indicated that  taxing income, once it is repatriated, affects decisions of where to  incorporate, or to change incorporation from one country to another.  Some research has also shown that most inversions that occur for tax  reasons are to avoid U.S. tax on income earned in the U.S. by increasing  the scope for income shifting rather than to avoid U.S. tax on foreign- source income. However, recent research has found mixed results on  trends in the number of inversions. Some have found that only a small  number of U.S. corporations that conduct initial public offerings have  reincorporated in low-tax countries, while others have recently highlighted  an increase in inversions. In 2004, legislation was passed to limit the  ability of U.S. corporations to change their country of incorporation to a  foreign country. This corporate residence distortion could be increased  by full inclusion, which would raise the effective U.S. tax on income  earned abroad, and encourage companies to avoid this tax by moving  their residence abroad. A territorial system would eliminate this incentive  by removing the U.S. tax on foreign source income.

It is also argued that deferral, compared to a full inclusion system,  improves economic efficiency by removing distortions that affect  decisions about which subsidiaries and other assets corporations own.  Some corporate groups may be able to use foreign subsidiaries and  assets more productively because of synergies that result from ownership  within the corporate group, while another corporate group that acquired  these subsidiaries and assets would not have these synergies and  therefore would not be able to use them as productively. For this reason,  tax differences could lead to productivity loss when a corporation without  those synergies, but with more favorable tax treatment is able to outbid  for ownership of those assets a corporation with those synergies. In this  case, the use of deferral or a territorial system makes inefficiency less  likely and the move to full inclusion makes it more likely. However, others  argue that ownership synergies do not have significant effects on  productivity because there are numerous ways for corporations to use  assets as productively without owning them, such as leasing, contract  manufacturing, or licensing of trademarks or technology.deferral or a move to a territorial system would not produce significant  efficiency gains.

Some research has also shown that deferral can distort decision making  by affecting the timing of repatriations, referred to as the “lockout” effect.  The distortion would happen if deferral incentivizes corporations to keep  income abroad rather than repatriating it to the higher tax country. This  income may be more productive if repatriated and reinvested at home  rather than retained (or “locked out”) abroad for tax reasons. Although  estimates have varied over time, they consistently show that the lockout  effect does have efficiency costs. Estimates from 2001 of the efficiency  cost of U.S. multinational corporations from the lockout effect put the size   However, the  of the loss at about 1 percent of foreign pretax income.large repatriations under the 2004 tax holiday have suggested to some  researchers that these earlier estimates may be too small. More recent  estimates have shown that the efficiency loss increases with the amount  of earnings accumulated abroad, and could be as high as 7 percent of  foreign pretax income by 2015.systems eliminate the lockout effect. The territorial system makes foreign  earnings tax free whether or not they are repatriated, and the full inclusion  system makes foreign earnings taxable without repatriation.

Both the territorial and full inclusion  The extensive literature on deferral disagrees on its overall impact on  efficiency, or whether a movement toward a full inclusion or territorial  system would improve efficiency. Deferral’s effect on the decisions just  discussed, where to invest, where to locate headquarters, whether to  make an acquisition, and when to repatriate income can depend on  factors such as the location of the market (domestic or foreign) and the  source of investment capital (again, domestic or foreign). In addition,  there may be empirical disagreement about the size of an effect. Without  agreement on the separate effects on efficiency, there is no agreement  about how to add them up to get an overall effect.

Informed Judgments about Deferral’s Equity Require Information about Ultimate Beneficiaries

We were unable to find any studies that specifically estimate the  distribution of the benefits from the two deferral tax expenditures.  Treasury, CBO, and the Tax Policy Center have developed estimates of  the distribution of the corporate tax burden as a whole. However, these  studies may not indicate who ultimately benefits from deferral and,  further, whether deferral is fair and equitable.

The distribution of ultimate beneficiaries, referred to as the economic  incidence of the tax benefit, depends on the extent that the tax provision  leads to changes in the prices of goods or services. For example, the tax  benefit for corporations from deferral may be passed on to consumers  through lower prices, to employees through higher wages, or to investors  through higher returns. Economic incidence is difficult to determine due to  the complexity of the interactions that produce these price and income  changes. Studies of the distribution of burdens and benefits usually base  their estimates of economic incidence on empirical studies of how prices  in relevant markets, including markets for goods and services or labor  and capital markets, respond to changes in certain tax provisions. The  studies of the corporate tax burden that we identified did not estimate the  effect of deferral and their methods may require adjustments before such  an estimate can be made. Without these estimates, informed judgments  about deferral’s fairness will be hard to draw because such judgments  depend on knowing who receives the benefit of the tax expenditure.  Equally, the distributional effects of the territorial and full inclusion  alternatives to deferral are also unknown, and informed judgments about  the fairness of the alternatives cannot be made.

Although the ultimate beneficiaries are unknown, there is some evidence  that certain industries benefit more from deferral than others. An IRS  study found that during the one-time U.S. repatriation tax holiday in 2004,  certain industries, such as companies involved in pharmaceutical  manufacturing and computer and electronic equipment manufacturing,  benefited disproportionately, as they repatriated significantly more income  in the form of dividends relative to the size of the tax filers.

Deferral Adds Complexity to the Tax Code

There is widespread agreement among tax experts that the U.S. system  for taxing foreign source income is complex and adds burden for IRS and  taxpayers. Deferral contributes to this complex system by enhancing the  incentive for corporations to shift income abroad to be taxed at lower  rates. Deferral further adds complexity by interacting with a number of tax  provisions designed to limit income shifting. One of those provisions,  Subpart F of the IRC, creates an exception to the general rule of deferral  by defining certain types of passive income, such as interest and  royalties, as well as certain other easily manipulated income, as ineligible  for deferral. These types of income are viewed as subject to greater  manipulation to reduce taxes because they can be artificially shifted  between related parties.F. As noted previously, interest income that is generated through the  primary business activities of financial-services companies of controlled  foreign corporations is eligible for deferral. These various provisions add  complexity as taxpayers must determine which income can be deferred.

Moreover, there are also exceptions to Subpart  Deferral also affects complexity by interacting with the foreign tax credit  and transfer pricing. Our prior work has highlighted these areas as major  sources of compliance risk and burden. Deferral allows corporations to  time their repatriations of foreign source income for periods when they  have excess foreign tax credits, which can be used to lower the amount  of U.S. tax they pay. In these cases, complex rules for determining the  source of income are required to ensure that the foreign tax credits are  applied only against the portion of the corporation’s worldwide taxable  income attributable to foreign sources.limit income shifting by requiring that related corporations charge prices  for the goods and services they sell to each other that are comparable to  market prices. Identifying and evaluating these transfer prices can be  difficult for IRS and taxpayers when, as often is the case with intangible  property, limited information exists on comparable market prices.

Deferral Does Not Overlap Directly with Other Federal Programs

Our prior work on corporate tax expenditures identified no related federal  activities sharing the same reported purpose as the two deferral tax  expenditures.as an area of potential duplication and overlap, these programs are  focused primarily on small companies rather than U.S. multinational   Although we have highlighted export promotion programs  corporations.multinational corporations, and interacts with a number of other tax  provisions, such as Subpart F. When considering reform to this system,  changes to deferral would need to be coordinated with changes to other  tax provisions.

Deferral May Have Relatively Modest Consequences for the Federal Budget but Estimates Vary

According to JCT estimates produced in 2011 and reported by CBO,  ending deferral by moving to a full inclusion worldwide system, where  foreign source income is taxed whether or not repatriated, would increase  federal revenues by $4.7 billion in 2012. According to the same  estimates, exempting active foreign dividends from U.S. tax, similar to  that of a territorial tax system, and changing the tax treatment of  overhead expenses would increase revenues by $3.3 billion in 2012.  These estimates are based on specific proposals to change the tax code,  and include behavioral responses by taxpayers to the tax change. The  revenue estimate for exempting active foreign dividends shows an  increase in revenue chiefly because the expense allocation rules under  this option reduced the expenses that can be deducted from U.S. income  relative to the current system’s expense allocation rules.

The effect on U.S. tax revenue of full inclusion and territoriality depends  on the incentives the alternatives provide to shift income out of the United  States and its taxing authority and the specifics of the alternatives’  design. The incentive to locate income in low-tax countries may be less  under full inclusion and higher under the territorial system, thereby  eroding the U.S. corporate tax base. However, territorial systems in practice include design features, such as a minimum tax on foreign  source income, that are intended to limit these losses.

JCT and Treasury also make tax expenditure estimates on a regular  basis that do not account for how taxpayer behavior may change when a  tax expenditure is altered. Although these estimates do not represent the  amount of revenue that would be gained if deferral were eliminated, they  can indicate how revenue losses may be changing over time. The tax  expenditure estimates show that revenue losses from the general deferral  tax expenditure have increased significantly. These estimates of  increasing tax revenue losses are consistent with changes in the location  of earnings of U.S. corporations. During this period, U.S. corporations  were earning an increasing share of their profits from foreign sources,  likely increasing the amount of income deferred abroad. As seen in figure  2, U.S. corporate profits earned abroad, compared to total U.S. corporate  profits, have increased moderately since 1997.

In addition, a number of legislative changes may have affected the  revenue losses from deferral by making it easier to shift or keep income  abroad. These include the look-through rule exception from Subpart F.  This rule provides that dividends, interest, rents, and royalties received or  accrued by one controlled foreign corporation from a related controlled  foreign corporation are not treated as Subpart F income, and are eligible  for deferral. Finally, some have suggested that in light of the U.S. tax  repatriation holiday in 2004, which allowed U.S. corporations to exempt  most dividends from tax on a one-time basis, U.S. multinational  corporations may have accumulated foreign earnings abroad in  anticipation of another repatriation holiday.

No Consensus Exists on Which Agency Should Evaluate Deferral

No federal agency has been tasked to evaluate deferral. Since 1994, we  have recommended greater scrutiny of tax expenditures, as periodic  reviews could help determine how well specific tax expenditures work to  achieve their goals, and how their benefits and costs compare to those of  programs with similar goals. However, as we reported in June 2013, the  Office of Management and Budget (OMB) has not developed a framework  for reviewing tax expenditure performance. We made a number of  recommendations to OMB, including that it provide guidance to agencies  to identify tax expenditures that contribute to each appropriate agency  goal. In July 2013, OMB released guidance that directs agencies to  identify tax expenditures that contribute to their goals.

Evaluation of Graduated Corporate Income Tax Rate Schedule

The Graduated Corporate Income Tax Rate Schedule’s Purpose Is Viewed as Supporting Small Businesses, but It May Not Be Well Targeted to That Purpose

The purpose of the graduated corporate income tax rate schedule has  generally been described in the academic literature and by tax experts as  supporting small businesses by reducing their tax burden. The tax  expenditure benefits businesses that organize under Subchapter C of the  IRC, “C corporations,” by taxing their income at reduced tax rates when  the income falls beneath certain limits. To the extent that small  corporations have income beneath these limits, they could benefit from  the reduced rates.

Some rationales for providing this tax benefit to smaller businesses  include encouraging entrepreneurship, innovation, and small business  growth and employment. It has been argued in some academic literature  that the greater after-tax income may make the small businesses more  attractive to investors, and may alleviate a lack of access to capital that  small businesses experience due to limited information on their business  model or profit potential. Similar justifications have been made for  providing benefits through other federal programs, such as federal small  business loan programs. CRS’ tax expenditure compendium details how  the graduated corporate income tax rate schedule has developed and  changed legislatively over time.

Evidence is mixed on whether the lower corporate tax rates provided by  the graduated rate schedule increases business formation. research shows that, although only a small number of start-up companies  initially form as C corporations, when and if these businesses generate  profits, they have an incentive to incorporate so that these profits are  taxed at lower corporate tax rates. However, other research has also  indicated that incentives can produce the opposite effect. Businesses are  less likely to incorporate if corporate tax rates are high, compared to  individual tax rates, and instead may choose another form of business  entity that is taxed under the individual tax rates. In contrast, businesses  with losses will typically prefer not to incorporate so that these losses can  be deducted from other higher taxed personal income. Research has also  shown that in 2007 a majority of unincorporated small businesses faced a  marginal tax rate of 10 to 25 percent, making the rates they paid  comparable to those of the graduated corporate income tax rates. IRS  data have also shown that the number of businesses that organize  themselves as C corporations has declined, while those organizing as S  corporations and partnerships have been rising in the past decade. See  figure 3.

See Simeon Djankov, Tim Ganser, Caralee McLiesh, Rita Ramalho, and Andrei Shleifer,  “The Effect of Corporate Taxes on Investment and Entrepreneurship,” American Economic  Journal: Macroeconomics, vol. 2 (July 2010); and Julie Berry Cullen and Roger H.  Gordon, “Taxes and entrepreneurial risk-taking: Theory and evidence for the U.S,” Journal  of Public Economics, vol. 91 (2007).

Efficiency Effects of the Graduated Rates Are Disputed

Some academic literature has suggested that the graduated rates can  cause inefficiency by providing relief to some corporations and not others  depending on their taxable income. The economy is less efficient if the  rates divert resources from one type of corporation to another based on  tax considerations, rather than how productively the corporations use the  resources. Other sources of potential inefficiency include the incentive  provided by the graduated rates for small businesses to form as C  corporations to take advantage of lower corporate rates, compared to  those of individual tax rates. A Treasury study found that higher  differentials between corporate and non-corporate tax rates increased the  likelihood that a firm will convert from C to S corporation status after the  Tax Reform Act of 1986. In this case, small businesses may choose an  organizational form that they would not have selected without the tax  incentive, suggesting that this may not be the most productive way for  them to organize their operations.

The graduated rates could be justified on efficiency grounds if, from  society’s point of view, without the incentive too few small businesses are  formed given their potential for profit and innovation. It has been argued  by some research that small businesses need support because they  provide a disproportionate share of innovation and net job creation.  However, more recent research has shown that a small number of new  businesses may generate most of the innovation and net job creation. If  this is the case, targeted federal support for certain small businesses may  be more effective than graduated rates that apply to all corporations with  less than a certain amount taxable income.

The magnitude of the efficiency effects of the graduated rates has not  been estimated, but experts agree that the effect of reducing or  eliminating the rates will depend on how the change is implemented. For  example, reducing or eliminating the rates without making similar  changes to individual tax rates may motivate companies to change  organizational form—from C corporations to “pass-through” entities like S  corporations and partnerships—to take advantage of the differences  between corporate and individual income tax rates.

Informed Judgments about the Graduated Rates’ Equity Require Information about Ultimate Beneficiaries

As with the deferral tax expenditures, studies that specifically estimate the  distribution of the benefits from the graduated corporate income tax rate  schedule are unavailable. Without these estimates, conclusions about the  fairness of the tax expenditures will be hard to draw because such  judgments depend on who bears the burden of the tax or receives the  benefit of the tax expenditure. The ultimate beneficiaries depend on the  extent that the tax provision leads people to make decisions that change  the prices of goods or services. Just as in the case of the deferral tax  benefit, the benefit of graduated rates may be passed on to consumers  through lower prices, employees through higher wages, or to investors  through higher returns.

The Graduated Rates Likely Add Little Complexity to Determing Tax Liability But Some Evidence of Tax Planning Has Been Found

Although we did not find any estimates that isolate the compliance and  administrative costs associated with the graduated rates, both costs are  likely to be relatively low. IRS officials could not highlight any  administrative or compliance issues involved with administering the  graduated corporate income tax rate schedule. They said that applying  the graduated corporate income rate schedule for a particular taxpayer is  primarily a computational issue, and does not present much uncertainty to  taxpayers in determining their tax liabilities. However, IRS research has  found some evidence that corporations’ taxable income tends to cluster  below rate changes introduced by the tax rate brackets. The research  found that if the tax net income of corporations in their sample of  Schedule M-3 filers (generally those with assets of at least $10 million)  from tax years 2004 through 2008 rose 5 percent, a substantial number of  corporations would face higher marginal tax rates. This clustering of  filers around certain tax rates may be the result of tax planning that  increases compliance costs.

The compliance and administrative costs of the graduated rates have not  been estimated separately from the costs of complying with and  administering all the provisions of the corporate income tax. However,  estimates of the total compliance burden of small businesses may give  some context to the compliance costs associated with graduated rates. A  2007 study of businesses with assets of less than $10 million in 2002  found that small businesses initially face significant fixed compliance  costs, which increase at a decreasing rate as the business grows.However, the specific administrative and compliance costs of the  graduated rates may not be a large part of these costs compared with  other, more complicated provisions of the tax code.

Graduated Rates Are Related to a Number of Spending Programs but the Relative Effectiveness of the Tax Expenditure Has Not Been Assessed

Our prior work on corporate tax expenditures found no related federal  spending program sharing the same reported purpose as the graduated  rates of supporting small businesses that adopt the corporate form of  legal organization. However, there are federal spending programs that  share, at least in part, the similar purpose of supporting entrepreneurs  and small businesses. In prior work, we identified 52 programs at the U.S.  Departments of Agriculture, Commerce, and Housing and Urban  Development, and the Small Business Administration, which all overlap  with at least one other program in terms of the type of assistance they are  authorized to offer, and the type of entrepreneur they are authorized to  serve.

Changes in the graduated rates are generally part of proposals to reduce  the overall corporate tax rate which are discussed in the context of tax  reform. The issue of whether the tax expenditure could be better  designed to target small business or spending or non-tax policies that  support small businesses may be preferable but has not been part of the  discussion.

Moving to a Flat Corporate Income Tax Rate of 35 Percent Would Have Relatively Modest Consequences for the Federal Budget

According to JCT estimates produced in 2011 and reported by CBO,  moving to a single corporate rate of 35 percent would have raised $1.5   This estimate is based on a specific proposal to change  billion in 2012.the tax code, and includes behavioral responses by taxpayers to the tax  change. JCT and Treasury also annually calculate tax expenditure  estimates that do not account for how taxpayer behavior may change  when a tax expenditure is altered. Because they do not account for these  behavioral changes or interactions with other tax provisions, the tax  expenditure estimates available for the graduated rates do not represent  the amount of revenue that would be gained if these rates were repealed.  However, as mentioned above in the case of deferral, these estimates  can indicate how revenue losses may be changing over time. As shown in  figure 4, estimated tax revenue losses from the graduated corporate  income tax rate schedule have decreased in the past decade. From 1998  through 2012, estimated tax revenue losses fell from $7.3 billion to $4.3  billion in constant 2012 dollars. The estimated fiscal year 2012 loss was 3  percent of all estimated revenue losses from corporate tax expenditures  ($147 billion). The estimate was equal to 1.8 percent of corporate tax  revenue in 2012.

The decrease in figure 4 may be due, in part, to less companies  incorporating as C corporations, which we highlighted above.

No Consensus Exists on Which Agency Should Evaluate the Graduated Corporate Tax Rate Schedule

As in the case of the deferral tax expenditures, no agency has been  tasked with evaluating the graduated corporate income tax rate schedule.  In June 2013, we made a number of recommendations to OMB, including  that it should provide guidance to agencies to identify tax expenditures  that contribute to each appropriate agency goal. In July 2013, OMB  released guidance that directs agencies to identify tax expenditures that  contribute to their goals.

Agency and Third Party Comments and Our Evaluation

We provided a draft of this report to the Secretary of the Treasury and the  Commissioner of Internal Revenue for comment. We also asked the Joint  Committee on Taxation (JCT) and all external experts we interviewed to  review a draft of this report. Treasury, IRS, JCT, and external experts  provided technical comments that were incorporated, as appropriate.

We sent copies of this report to the Secretary of the Treasury, to the  Commissioner of Internal Revenue, and other interested parties. This  report will also be available at no charge on GAO’s website at  http://www.gao.gov.

If you have any questions on this report, please contact me at (202) 512- 9110 or whitej@gao.gov. Contact points for our offices of Congressional  Relations and Public Affairs may be found on the last page of this report.  Key contributors to this are listed in appendix IV.

Appendix I: Objectives, Scope, and Methodology

This report uses our tax expenditures evaluation guide to determine what  is known about following three tax expenditures: (1) the deferral of  income for controlled foreign corporations; (2) deferred taxes for certain  financial firms on income earned overseas; and (3) the graduated  corporate income tax rate. Because deferred taxes for certain financial  firms on income earned overseas is a special case of the treatment of  foreign source income of all controlled foreign corporations, our first  section of the report focuses our discussion on the more general case of  all controlled foreign corporations using deferral. Our second section of  the report covers the graduated corporate income tax rate schedule. For  both sections of the report, we cover the five questions outlined in our  guide and listed below to determine what is known about each tax  expenditure. We highlight what questions we are answering for each tax  expenditure at the beginning of each section of the report.

To evaluate the three tax expenditures above, we applied our tax  expenditure evaluation guide, which was issued in November 2012.guide outlines a series of questions and sub-questions that can be used  to evaluate tax expenditures. The five primary questions and sub- questions outlined in the guide are:  1.  What is the tax expenditure’s purpose and is being achieved?

What is the tax expenditure’s intended purpose?

Have performance measures been established to monitor success  in achieving the tax expenditure’s intended purpose?

Does the tax expenditure succeed in achieving its intended  purpose? 2.  Even if its purpose is achieved, is the tax expenditure good policy?

Does the tax expenditure generate net economic benefits for  society?

Is the tax expenditure simple, transparent, and administrable? 3.  How does the tax expenditure relate to other federal programs?

Does the tax expenditure contribute to a designated cross-agency  priority goal?

Does the tax expenditure duplicate or overlap with another federal  effort?

Is the tax expenditure being coordinated with other federal  activities?

Would an alternative to the tax expenditure more effectively  achieve its intended purpose? 4.  What are the consequences for the federal budget of the tax  expenditure?

Are there budget effects not captured by Treasury’s or the Joint  Committee on Taxation’s tax expenditure estimates?

Are there options for limiting the tax expenditure’s revenue loss?  5.  How should evaluation of the tax expenditure be managed?

What agency or agencies should evaluate the tax expenditure?

When should the tax expenditure be evaluated?

What data are needed to evaluate the tax expenditure?

The guide’s questions cover a number of different policy objectives.  Sometimes, these objectives compete. This report provides information  responsive to the questions, but does not attempt to balance the different  objectives or make recommendations. Rather, policymakers are better  positioned to judge how competing policy objectives should be weighed.  As we note in our tax expenditure evaluation guide, it is not a “one size  fits all” framework for evaluating tax expenditures. We used reasonable  judgment in applying the guide’s questions and concepts to evaluate the  three tax expenditures. In some instances, we focused our discussion on  certain questions in the guide because they were more relevant to the tax  expenditures we were evaluating, while devoting less discussion to others  that were more technical in nature.

Question 1 above covers the tax expenditure’s intended purpose and  if it is being achieved. Since the purpose of the deferral tax  expenditures is unclear, we did not address the sub-questions related  to whether the deferral tax expenditures achieve their intended  purpose, and if performance measures have been established.

For question 2 above, our discussion of the deferral tax expenditures  and criteria for good policy also includes question 3 above which  covers alternatives to the tax expenditures, as there is a natural  relation to alternative proposals and how they may affect the criteria  outlined in question 2.

To the extent that we use our tax expenditure evaluation guide in the  future on other tax expenditures, the structure and focus of future reports  may differ from how it is presented in this report. To determine what is  known about the deferral tax expenditures and the graduated corporate  income tax rate schedule by answering the five questions listed above,  we reviewed the following sources:

Our previous work on tax expenditures, tax reform, tax policy and  administration, duplication, overlap, and fragmentation, and results- oriented government and program evaluation.

Previous work by the Congressional Research Service (CRS), the  Congressional Budget Office (CBO), the Joint Committee on Taxation  (JCT), the Department of the Treasury (Treasury), and the Internal  Revenue Service (IRS).

Academic and scholarly research on the tax expenditures and  corporate taxation. To identify academic literature, we searched terms  and certain authors in a number of academic literature databases,  such as ProQuest, Econlit, and Social SciSearch. We reviewed and  identified academic literature cited in CRS’ tax expenditure  compendium, and a comprehensive study by JCT on foreign direct  investment. We reviewed articles published in the National Tax  Journal and asked Treasury, IRS, and the external experts we  interviewed for recommendations on articles to review. We also  interviewed Treasury and IRS officials, and external experts affiliated  with CRS and two universities, who specialize in the U.S. corporate  income tax system. The results from these interviews are not  generalizable.

Treasury tax expenditure estimates for fiscal years 1998 through  2012, and estimates by JCT on the revenue effects of making  changes to the tax expenditures in our scope. To identify how the  deferral and graduated corporate income tax rate schedule tax  expenditures have changed in terms of their aggregate estimated  revenue losses, we analyzed tax expenditure estimates developed by  the Treasury and reported by the Office of Management and Budget  in the Federal Budget’s Analytical Perspectives for fiscal years 1998  through 2012. We converted all tax expenditure estimates for each  fiscal year into 2012 constant dollars to adjust for inflation. We did so  by using the chain price indexes reported in the fiscal year 2014  federal budget. While sufficiently reliable as a gauge of general  magnitude, summing tax expenditure estimates do not take into  account any interactions between tax expenditures. In addition, tax  expenditure estimates do not incorporate any behavioral responses.  Thus, they do not represent the revenue amount that would be gained  if a specific tax expenditure was repealed. To identify JCT estimates  of the revenue effects of making changes to the tax expenditures in  our scope, we reviewed CBO’s latest report that outlines spending  and revenue options. These options outline a number of changes to  the tax expenditures in our scope with accompanying estimates from  JCT. Its revenue-effect estimates take into account a number of  behavioral changes, unlike the tax expenditure estimates that  Treasury and JCT complete. These include possible behavioral  changes in: (1) corporate dividends and retained earnings; (2) the  corporate capital structure; (3) corporate equity valuations; (4)  repatriations of deferred foreign income; and (5) business entity  choice.

Data estimates from IRS Statistics of Income (SOI) Corporate Tax  File, 2010, the most recent year available at the time of our work, and  Bureau of Economic Analysis (BEA) data on corporate profits from  1987 through 2012. We requested estimates from the IRS SOI 2010  Corporate Tax File on the number of C corporations by their corporate  income tax bracket, and a measurement of their size—in this case— business receipts. Data compiled by IRS SOI are based on a stratified  random sample of 63,630 corporate income tax returns for 2010 from  corporations that end their corporate year from July 1, 2010, through  June 30, 2011. These estimates are subject to sampling errors. The  margin of error is based on a 95-percent confidence interval. For our  report, IRS SOI provided data on C corporations, which include active  corporations filing tax forms 1120, 1120-F, 1120-L, and 1120-PC.  Data are not included for “pass-through” entities, which file on forms  1120S, 1120-REIT, and 1120-RIC. We used business receipts as our  measurement of size and used IRS’ breakout for the different sizes of  business receipts. We also obtained data from IRS on the number of  different types of business form entities (C corporations, S  corporations, and partnerships) from 1986 to 2008. We also analyzed  data from BEA on corporate profits by industry from 1987 to 2012. To  determine how the composition of U.S. corporate profits have  changed over time, we took a ratio of the amount of profit earned by  U.S. corporations abroad compared to the total amount of profits  earned by U.S. corporations. This analysis was based on a similar  analysis used in academic literature.

To assess the reliability of the data and estimates, we reviewed agency  documentation, interviewed agency officials, and reviewed our prior  reports that have used the data and estimates. We determined that  Treasury, JCT, BEA, and IRS data and estimates were sufficiently reliable  for our purposes. However, the IRS SOI corporate sample may not  provide a precise estimate of the number of taxpayers claiming a tax  expenditure when the number of taxpayers is very small. We conducted  our work from April to September 2013 in accordance with all sections of  GAO’s Quality Assurance Framework that are relevant to our objectives.  The framework requires that we plan and perform the engagement to  obtain sufficient and appropriate evidence to meet our stated objectives,  and to discuss any limitations in our work. We believe that the information  and data obtained and the analysis conducted provide a reasonable basis  for any findings and conclusions in this product.

Appendix II: Comparison of Territorial and Worldwide Corporate Income Tax Systems

Many proposals for changing the way the current U.S. system taxes  foreign source income are detailed and complex. In general, however,  they involve redesigning the current system to more resemble a pure  worldwide or a pure territorial system. The basic designs of the three  systems being considered as alternatives are the following:

The current worldwide system with deferral. Foreign active business  income is taxed when repatriated as dividends to the U.S. This  system has a foreign tax credit limited to the U.S. tax liability on  foreign source income, and certain anti-deferral provisions like  Subpart F.

A territorial system that uses a dividend exemption. The dividends  derived from foreign active business income can be repatriated  without U.S. tax. This system would continue to tax Subpart F income  as do most countries with territorial systems.

A worldwide system with full inclusion. The current worldwide system  is retained, but deferral of foreign active business income is  eliminated.

The current system serves as a benchmark against which to compare the  alternatives. When applying the criteria of a good tax system, the  territorial and worldwide systems with full inclusion are examined for their  effect on efficiency, equity, and complexity, and their relativity to the  effects of the current system. Figure 5 illustrates how the basic design of  the full inclusion worldwide system and the territorial system affects the  taxes that corporations pay.

As shown in figure 5, Country A has a worldwide tax system that taxes  income of its domestic corporations, and that of foreign corporations  earned within its borders at the same 35-percent rate. The domestic  corporation and the subsidiary of the foreign corporation each pay $35 in  taxes to Country A. Additionally, Country A taxes the income of the  foreign subsidiaries of its corporations at the same 35-percent rate.  However, in this case, it provides a credit for taxes paid to the country in  which the subsidiary operates. The subsidiary gets a $15 credit for the tax  it pays to Country B, and subtracts this amount from the $35 tax liability  that it owes its home Country A. The total tax paid by the subsidiary is  $15 to Country B plus the $20 net tax that it pays at home for an overall  tax of $35. For the worldwide system, taxes paid are the same for  corporations operating within Country A, and for its corporations operating  abroad.

In a territorial system, income is taxed only by the country in which it is  earned. In figure 5, Country B has a territorial system that imposes a 15- percent tax on corporations that operate within its borders. The domestic  corporation and the subsidiary of the foreign corporation remit the same  tax payment of $15 to Country B on $100 of income earned there. Unlike  the worldwide system, the territorial system imposes no tax on the income  of the foreign subsidiaries of its own corporations. For the territorial  system, taxes paid are equal for corporations operating within Country B,  but differ for corporations operating across borders.

As discussed above, the experts we interviewed agreed and economic  theory suggests that any corporate tax system’s overall effect on  efficiency depends on its relative effect on different types of investment  decisions. The full inclusion system is likely to increase investment  location efficiency relative to the current and territorial systems. Under the  current system, investment abroad has a lower tax cost when repatriation  of the foreign source income is deferred. Full inclusion would eliminate  this tax advantage, and would be more consistent with efficient location  decisions. When the foreign tax rate is lower than the U.S. tax rate,  domestic corporations under full inclusion pay taxes on income earned at  home and abroad at the same rate—the U.S. tax rate. The system does  not provide incentives either to invest abroad or at home (i.e. it is neutral   The territorial system, on the  with respect to the location of investment).other hand, may increase investment location inefficiencies by making the  location incentives that arise when countries adopt different tax rates  permanent.

However, as previously noted in this report, these inefficiencies may be  offset to some extent by improved ownership efficiencies and reduced  incentives to move corporate residences abroad. Corporations operating  under a territorial system pay the same tax rate on income from their  operations in each country. This would eliminate any tax advantage that  would allow a less efficient owner in that country to acquire the more  productive corporation. While the full inclusion system may not distort  location decisions, it may distort decisions about who owns the foreign  subsidiaries. Some advocates of the territorial system argue that  efficiency gains from eliminating this ownership distortion can offset any  efficiency losses from distorted location decisions.

The experts whom we interviewed and the research that we reviewed  agreed that both the territorial and full inclusion systems eliminate  efficiency cost from the lockout effect that exists under the current  system. Full inclusion eliminates the lockout effect by making foreign- earned income taxable without repatriation. The territorial system  eliminates the lockout effect by making foreign-earned income tax free,  whether or not they are repatriated. The effect of the lockout’s elimination  could be significant because of possibly large efficiency costs due to  growing accumulations of income abroad.

Some research has suggested that income-shifting incentives should be  significantly reduced under full inclusion, but may be increased under the  territorial system. Researchers have found evidence of extensive income  shifting under the current system. Full inclusion nearly eliminates  incentives for income shifting because corporations pay the same rate  under full inclusion, regardless of where the income is located and the  timing of its repatriation.likely increase the incentive to shift income to lower-tax countries  because income earned abroad would be exempt from being taxed, even  when repatriated.

The territorial system, on the other hand, would  The relative effects of the alternatives on compliance and administrative  burden depend on the specifics of their design. As described above, the  current system is complex, and imposes compliance and administrative  burden by requiring extensive calculations and adjustments involving  foreign tax credits, sourcing rules for income and expenses, and transfer- pricing rules to limit income shifting. Some research has shown that, while  a full inclusion system would reduce the benefits and scope for income  shifting, it would also retain some of the current system’s burden, such as  the foreign tax credit and sourcing rules for income and expenses. The  territorial system, by increasing income-shifting incentives, may require  provisions to protect the tax base that can add considerable complexity to  the tax code. The degree of complexity relative to the current system will  depend in part on how much of the current rules are maintained or  expanded in the new system. However, because both the territorial and  full inclusion systems remove any incentive to delay repatriation, they  would eliminate compliance and administrative burden due to the  repatriation tax planning that occurs under the current system.

Based on the research and revenue estimates we reviewed, the revenue  raised by each system depends on the specifics of its design. How much  of the potential worldwide tax revenue a country gets depends on its tax  system’s incentives to relocate income to a lower tax rate country. Some  research has noted that under full inclusion, the corporation has no  incentive to relocate income to a lower tax country unless it has excess  foreign tax credits. However, under a territorial tax system, the  corporation has an incentive to move income to a lower tax rate foreign  country. Based on these incentives, it would appear that revenue for the  home country is likely to decrease when a country moves from a  worldwide to a territorial system. However, the relative effects on revenue  ultimately depend on the details of the design. For example, some  features of a territorial system’s design are implemented specifically to  limit revenue losses. Under its territorial system, Japan imposes a per- country minimum tax, which means that corporations will lack incentives   Other  to locate income in a country with a tax rate below the minimum.features of a tax system that affect revenues include changes in income  and expense allocation rules that would increase foreign source income  attributed to the home country under a territorial system.

Appendix III: IRS Statistics of Income Data on the Number of C Corporations by Taxable Income and Size of Business Receipts, 2010

Appendix III: IRS Statistics of Income Data on  the Number of C Corporations by Taxable  Income and Size of Business Receipts, 2010 (25 percent) $75,000 -  $100,000   (34 percent) (39 percent) $335,000 -  $10,000,000  (34 percent) $15,000,000   (35 percent) $18,333,333   (38 percent)

Over  $18,333,333  (35 percent) ** Data have been combined with data in a lower size class to avoid disclosure for specific  corporations.   $75,000 -  $100,000   25 percent) (34 percent) (39 percent) $335,000 -  $10,000,000  (34 percent) $10,000,000- $15,000,000  (35 percent) $15,000,000- $18,333,333  (38 percent)

Over  $18,333,333  (35 percent)  — The sample has no observations in this cell. The population may have corporations in this cell.  However, we do not have sufficient information to calculate an appropriate margin of error.

Appendix IV: GAO Contact and Staff Acknowledgments

James R. White, (202) 512-9110 or whitej@gao.gov.

In addition to the contact name above, Kevin Daly (Assistant Director),  Jason Vassilicos (Analyst-in-Charge), Elwood D. White, JoAnna Berry,  Robert Gebhart, Eric Gorman, Lois Hanshaw, Benjamin Licht, Ed  Nannenhorn, Karen O’Conor, Kathleen Padulchick, Robert Robinson,  Stewart W. Small, Anne Stevens, and Jim Wozny all made contributions  to this report.

Question: What are the current views on deferral?

Answer: While views on the purpose of deferral have changed over time, currently, it is often viewed by experts as promoting the competitiveness of U.S. multinational corporations.

Question: Why do some experts disagree with this view?

Answer: Some experts argue that this view is too narrow. For example, this definition of competitiveness ignores the effect on other corporations that cannot use deferral, such as those that are purely domestic or export without foreign subsidiaries. Further, it ignores impacts on the wider economy.

Deferral Is Viewed by Many as Promoting Competitiveness

Appendix I: Objectives, Scope, and Methodology

Question: What might be the consequences of tax delay for foreign source income?

Answer: By delaying the tax on foreign source income, deferral could distort corporate investment and location decisions in a way that lower taxes, but favor less productive activities over more productive ones.

Question: To what extent is it possible to determine deferral's effect on the fairness of the tax system?

Answer: Good tax policy has several dimensions. Informed judgments about deferral's effect on the fairness of the tax system cannot be made because who benefits from deferral, after accounting for such factors as changes in prices and wages, has not been determined.

Question: What is the expert stance on deferral?

Answer: However, there is widespread agreement among experts and the Internal Revenue Service (IRS) that deferral adds complexity to the tax code.

Numerous Business Decisions Are Affected by Deferral and Each Has Consequences for Efficiency

Informed Judgments about Deferral’s Equity Require Information about Ultimate Beneficiaries

Deferral Adds Complexity to the Tax Code

Question: What is the purpose of the graduated corporate income tax rate schedule?

Answer: The purpose of the graduated corporate income tax rate schedule is viewed by the sources GAO reviewed as supporting small businesses.

Question: Does evidence support this?

Answer: However, evidence is mixed on whether it achieves this purpose.

Question: Why might the schedule not acheive this purpose?

Answer: The tax rates may not be well targeted toward supporting small businesses because corporations that are large in terms of assets and gross receipts may have taxable income that is small enough to qualify for the rates.

Evaluation of Graduated Corporate Income Tax Rate Schedule

The Graduated Corporate Income Tax Rate Schedule’s Purpose Is Viewed as Supporting Small Businesses, but It May Not Be Well Targeted to That Purpose

Efficiency Effects of the Graduated Rates Are Disputed

Question: On what does the economic efficiency of graduated rates depend?

Answer: The economic efficiency of the graduated rates depends on whether they correct for a market failure.

Question: What situations does this correction include?

Answer: This includes too few small businesses forming, given their potential for profit and innovation, which offsets the possible distortions from its advantaging one type of business organization over others.

Question: What did IRS staff disclose about rates?

Answer: According to IRS staff, while the graduated rates present little complexity, some evidence of tax planning to avoid higher rates has been found.

Question: To what extent did GAO identify other studies of graduated rates?

Answer: GAO did not identify any studies of the efficiency effects or those that specifically estimate the distribution of the benefits from the graduated rates.

The Graduated Rates Likely Add Little Complexity to Determing Tax Liability But Some Evidence of Tax Planning Has Been Found

Question: What was GAO asked to examine?

Answer: GAO was asked to examine issues related to certain tax expenditures.

Question: What does the report contain?

Answer: This report uses GAO's tax expenditures evaluation guide to determine what is known about: (1) the deferral of income for controlled foreign corporations; (2) deferred taxes for certain financial firms on income earned overseas; and (3) the graduated corporate income tax rate. GAO combined the two deferral provisions for evaluation purposes.