Corporate tax reform has emerged as an area of potential bipartisan action in the United States Congress over the next few months. But fundamental questions about the right approach remain.

There is widespread agreement that the US corporate tax system is deeply flawed. The rate is too high; the base is too narrow; it is costly to administer; and it is riddled with credits, deductions, and special preferences that distort decisions, harming the economy.

Despite the high rate, corporate tax revenues comprise a relatively small share of government revenue, partly because a rising share of total business receipts – currently more than 30% – flows through so-called “pass-through” business organizations, which are not subject to corporate tax. Indeed, most corporate tax revenues are paid by a small number of large multinational companies that earn more than half of their income from their foreign operations.

These companies compete in global markets with firms headquartered in countries that use business-friendly tax policies to attract the investments, income, and associated externalities of multinational companies. The problem for the US is that developed and emerging economies have been slashing their rates, leaving the US – which had one of the developed world’s lowest corporate tax rates after the 1986 tax reform – at a serious disadvantage.

Most recently, the United Kingdom reduced its rate to 20%, half of the combined US federal and average state rates. And, since 2013, the UK has applied a special tax rate on income from patents, which will fall gradually to 10% by 2017. Twelve European Union countries currently have or are implementing similar special tax regimes, or “patent boxes,” for income from intellectual property, which is taxed at rates of 5-15%.

The US statutory corporate tax rate, at 39% in total, is more than 14 percentage points above the OECD average – making it the highest in the developed world. These differences affect corporate decisions about how much to invest, how to finance investment, and where to do business.

The pro-growth rationale for a sizable reduction in the US rate has garnered bipartisan support – a rarity in today’s Congress. Obama has proposed a rate of 28%, with a preferential rate of 25% for manufacturing, and additional special provisions to promote investment in research and development and clean energy.

There is also bipartisan agreement that the foregone revenues from a rate reduction should be covered mainly by broadening the tax base – the same approach adopted in the 1986 tax reform. Broadening the base would also reduce the tax system’s complexity and enhance its efficiency. But there remain deep fissures over which preferences should be eliminated and which activities currently outside the corporate tax base should be brought into it.

Another area of controversy is how to reform the taxation of American multinationals’ foreign earnings. Every other G-7 country, and 28 of the other 33 OECD members, have “territorial” tax systems, which allow globally engaged companies to repatriate most of their active foreign earnings without paying a significant additional domestic tax. By contrast, the US adheres to a “worldwide” model, which subjects American companies’ foreign earnings to US corporate tax, with a credit for taxes paid in foreign jurisdictions.

America’s high corporate rate and worldwide approach to taxing the foreign earnings of its multinationals undermine their competitiveness in global markets and in cross-border acquisitions. Current US law attempts to blunt these competitive disadvantages through deferral, allowing US multinationals to delay tax payments on their foreign subsidiaries’ earnings until they are repatriated to the US.

But deferral has costs. Deferred earnings are “locked out” of the US economy, meaning that the government receives no tax revenues from them and they are not directly available for domestic use by the US parent companies. And these companies incur a cost of about 7% of their incremental deferred foreign income as a result of suboptimal use.

The Obama administration proposes ending deferral, requiring instead that US companies either pay an effective tax of at least 22.4% on their earnings in every foreign jurisdiction where they operate, or pay an additional tax to the US on this income at the time it is earned. A key goal is to moderate the incentives for US multinationals to “shift their profits to tax havens.”

But most of the earnings subject to the minimum tax would not be the result of profit-shifting to tax havens; they would be generated by real economic activity to serve foreign markets. The affected earnings would include, for example, a significant share of foreign income earned by US multinationals in the EU, which accounted for about 45% of US multinationals’ total foreign income in 2012. Sixteen of the 28 EU countries have statutory tax rates below 22.4%, and effective tax rates are likely to be even lower.

Furthermore, while non-US companies can take advantage of the generous patent boxes in 12 EU countries, US companies would be subject to the much higher minimum rate, undermining their ability both to compete in these markets and to acquire foreign companies with desirable intellectual property. They would instead become more attractive targets for foreign acquirers and would have even stronger incentives to move their headquarters, R&D, and future intellectual property to lower-tax jurisdictions with territorial systems.

In a world of mobile capital – especially profitable intangible capital with R&D externalities – the US should adopt a “hybrid” territorial system that includes base-protection measures consistent with those successfully used by other developed countries. And it should promote multilateral measures to combat profit-shifting to tax havens.

As the US embarks on corporate tax reform, policymakers should bear in mind that other countries are using carrots, not sticks, to compete for the activities and income of global companies. America should do likewise.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

To keep up with the Agenda subscribe to our weekly newsletter.

Author: Laura Tyson is a former chair of the US President’s Council of Economic Advisers.

Image: A U.S. Flag is displayed in front of the U.S. Capitol. CREDIT: REUTERS/MOLLY RILEY