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As Congress considers a massive $3.5 trillion spending package largely focused on social spending, members are looking for “pay-fors,” and one the House is considering is a reduction in the rate of the foreign-derived intangible income (FDII) deduction. FDII is equal to foreign-derived profits in excess of the “normal” returns to qualified investment.
The current FDII deduction rate is the same as the minimum rate on Global Intangible Low Tax Income (GILTI), which was established as a minimum tax on foreign earnings. But the House draft would increase the FDII rate from its current 13.125 percent to 20.7 percent, while increasing GLTI from 13.125 percent to 17.2 percent. This would lead to less intellectual property being developed and held in the United States, hurting the economy and jobs.
One of the key rationales for President Biden’s Build Back Better initiative and House Democrats’ proposed $3.5 trillion spending package is to boost U.S. competitiveness. President Biden this week said:
These bills are not about left versus right, or moderate versus progressive, or anything that pits Americans against one another. These bills are about competitiveness versus complacency. They're about opportunity versus decay. They’re about leading the world, or continuing to let the world pass us by, which is literally happening.
National Economic Council chair Brian Deese agrees:
There is a through-line to everything that we are advancing, from investments in education, to winning the clean energy economy of the future to restoring fairness in the tax code, that connects to how we make ourselves globally competitive in this next quarter of the 21st century.
Much of this invoking the term “competitiveness” may simply be an attempt to gain support for what is largely a social-spending package and to wrap it around a jobs and economic growth mantle. Or these may be sincerely held views.
Regardless, it is clear that paying for this increased spending by raising U.S. corporate taxes will, at least at the margin, make companies in the United States less globally competitive. How could it not, since it raises their taxes relative to those their competitors pay. This is obviously particularly problematic for firms in globally traded sectors, such as manufacturing, content, software, and other information. Raising taxes on firms that sell only domestically might lead to reduced investment, but it will have little effect on U.S. economic competitiveness vis-à-vis other nations. In contrast, raising taxes on traded-sector firms will directly limit their ability to compete, and that will have a negative impact on U.S. jobs, per-capita income growth and national security.
The increase in the FDII rate is in this category since it reduces a tax incentive only on companies that compete in global markets—and moreover, on the most important traded-sector industries: advanced, knowledge-based companies and industries that pay higher wages on average.
It is ironic and troubling that neither political party appears to be able to “walk and chew gum at the same time” when it comes to competitiveness policy. While President Trump and Republicans sought to make the U.S. corporate tax code more globally competitive, they also wanted to cut or hold the line on key public investments to make America more competitive, such as in science and engineering funding and public-private R&D partnerships. Democrats thankfully support increased government investment in areas to boost competitiveness, but they want to raise corporate taxes. The reality is that if America is to successfully compete in global markets it will need a competitive tax code and more public investment. One is not enough.
The Tax Cuts and Jobs Act made a number of changes to U.S. corporate tax law that were designed to make the U.S. system competitive with the other tax regimes. One key goal of reform was to reduce profit shifting to other nations with lower taxes (GILTI) while at the same time providing incentives for holding IP in the United States (FDII). The ultimate goal of both policies is to encourage firms to source income as domestic and discourage firms from sourcing income as foreign. Indeed, Congress wanted U.S. companies to hold IP in the United States, both for tax and innovation reasons. This was especially important given the rise of so-called “innovation boxes” that at least 19 countries had implemented by 2019. For example, the Netherlands introduced its innovation box where income from IP is taxed at just 9 percent in 2021. According to one academic study, these incentives not only led to income shifting to the innovation box countries, but also to increased investment and jobs in these countries. As such, the 13.125 percent effective FDII rate on IP profits was to help the United States compete with these innovation boxes, and keep IP at home.
While one can have legitimate discussions about whether GILTI and FDII are optimally designed—for example, whether Congress should instead have created an “innovation box,” as ITIF has proposed, or whether the concept of qualified business asset investment (QBAI) works as intended—but one key principle from the legislation is that the GILTI and FDII rates should be the same. The problem with expanding the effective tax on foreign IP income, especially if the rate is higher than GILTI, is that it creates an incentive to move IP offshore. If the proposal raises the tax rate on domestic income more than on foreign income, then companies have an incentive at the margin to profit shift.
Moreover, it makes little sense for Congress to make major changes to the U.S. international corporate tax system when it appears that most countries will soon sign onto a global corporate minimum tax of 15 percent. If this is implemented, as it should be, then it would make GILTI unnecessary.
Finally, some, including the Biden administration want to eliminate FDII and instead provide direct incentives for R&D through an expanded R&D credit. There are three problems with this approach. First, a key goal is not just to support more R&D per se, but also to make U.S. knowledge-based companies more competitive in global markets. FDII does exactly that, just as foreign innovation boxes do in other nations. In addition, U.S. knowledge-based companies generate exportable IP in multiple ways, with R&D being only one. Limiting their support only to the R&D credit would mean other forms of innovation and knowledge production would not be supported.
Second, the U.S. R&D credit is already very weak compared to other nations. The United States ranks 24th out of 34 comparable nations in R&D tax generosity. As international R&D tax experts John Lester and Jacek Warda wrote for ITIF:
The international comparison, coupled with a benefit-cost analysis, suggests U.S. tax support for R&D is too low. The analysis in this paper confirms that substantial increases in U.S. tax support for R&D would improve overall economic performance, including innovation, productivity, and international competitiveness. A fiscally responsible target would be to increase the overall subsidy rate to 15.5 percent from 9.5 percent. This could be done by eliminating the 2017 repeal of the expensing of R&D costs, while slightly more than doubling the effective rates for the ASC and the RC through some combination of higher statutory rates and design changes. In addition, there is an advantage in using more than one instrument to achieve the target support level. As a result, the favorable tax treatment of foreign-derived intangible income (FDII), which indirectly supports R&D by reducing the tax rate on income from commercialized R&D products that are exported, should be expanded to cover income derived from commercialized R&D products sold domestically. Such a change would raise the R&D subsidy rate by about 2 percentage points while encouraging the retention in America of commercialization activity and the associated taxable income.
In other words, multiple instruments are needed, including an expanded, not contracted FDII.
Third, while the administration may actually intend to expand the R&D tax credit to the same extent it limits FDII, the political reality is that is highly unlikely to happen. The tax increase (reduced or eliminated FDII deduction) is easy to implement, but given the budget deficit and massive competition for new spending, including tax expenditures, the odds that the R&D credit would be expanded by an equivalent amount are quite low. And the result would be further decline in U.S. tax generosity for R&D and further loss of innovation jobs to other nations.
To be sure, the federal government does not raise enough revenues, particularly as spending is expected to increase. But the focus should be on raising taxes in ways that limit U.S. competitiveness harm and economic growth. Despite what many free-market advocates might claim, raising taxes on individuals, especially wealthy individuals, will likely have no negative effect on the economy. This is particularly true with raising taxes on dividends. At the same time, instituting a carbon tax could raise hundreds of billions while also driving clean energy innovation and adoption. But raising taxes on companies that compete in global markets, particularly in knowledge-intensive, high-value-added industries, is a recipe for a larger trade deficit, fewer good jobs, and a weaker national defense industrial base.