Cato Tax Bootcamp: An International Tax Primer

Adam N. Michel

The final installment in our tax bootcamp series covers the international tax system. It starts by describing what multinational tax systems attempt to do, covers the three theoretical types of international tax systems, discusses how real-world rules fit the theory, and reviews the magnitude of profit shifting—the boogieman that drives aggressive international rulemaking. The last section briefly overviews the Organisation for Economic Co-operation and Development’s (OECD) two-pillar framework. 

This is the last in a four-part series covering everything you need to know about the US tax code ahead of the 2025 congressional tax debate. Or at least everything that could fit into six hours of lecture and discussion. Part one is on Tax Code 101, part two is on the Tax Cuts and Jobs Act, and part three is on the history of radical tax reforms. This fourth installment draws heavily from my more comprehensive report on the same topic.

What is an International Tax System For?

Corporate income taxes must collect revenue from sprawling multinational business networks that span dozens of countries. The core challenge is to determine which multinational profits are subject to tax, in which country, and at what tax rate.

In apportioning multinational income, international tax systems usually try to achieve four competing goals: 1) raise revenue, 2) attract global investment and jobs, 3) increase the competitiveness of home-grown firms doing business abroad, and 4) reduce complexity.

Policymakers must balance these four goals, which are often in tension. For example, the corporate tax can collect more revenue from domestic firms by applying increasingly costly rules to include more foreign income in the domestic tax base. However, more revenue may come at the expense of higher compliance costs and difficulties for domestic businesses competing abroad.

Paper profit shifting, whereby firms manipulate the rules to reduce taxes, often takes two forms: aggressive pricing agreements between subsidiaries and financial techniques, such as strategically allocating debt. However, determining the legitimate transactions from the rest can be difficult.

About two-thirds of profit shifting occurs through the transfer pricing system—a complex set of rules governing the transfers of assets and services between related parties in different taxing jurisdictions. For example, patents and their connected royalties can be moved to lower-tax countries. For a time, Starbucks famously held its roasting recipe in the Netherlands, accruing profits at a preferential tax rate. The second primary method of shifting profits involves borrowing in high-tax jurisdictions, where interest payments are often deductible, and lending from low-tax jurisdictions, where interest income is more lightly taxed.

The difficulty of policing these transactions is one reason many economists favor eliminating the corporate income tax. It is also among the most economically distortionary forms of raising revenue. The easiest way to cut the Gordian knot of international tax is to simply repeal the corporate income tax and rely on more stable, less destructive sources of revenue.

Three Theories of the International Tax Base

In principle, cross-border tax systems can levy taxes based on the taxpayer’s residence, the source of the profits, or the destination of the end consumer. Most corporate income taxes begin with the principle that profits should be taxed where the income is generated but then piece together a hodgepodge of other rules that incorporate other principles. The following subsections describe each tax base and its use in the US context.

Residence-based taxes

Residence-based or “worldwide” tax systems tax the income of resident entities irrespective of where the income is earned. This is often also called “capital export neutrality.” Under a worldwide system, a US-headquartered firm would pay the same corporate tax on income earned in the United States and income earned overseas.

If implemented fully without deferrals or other carveouts, a worldwide tax system can limit domestic firms’ profit-shifting incentives by applying the same tax rate no matter where profits are located. However, if domestic tax rates are higher than in other countries, such systems will disadvantage home-grown and domestically headquartered firms investing or otherwise competing abroad. 

The United States had a worldwide tax system before 2018, leading to more than 60 “inversions” of domestically headquartered firms moving their headquarters to lower tax countries without worldwide systems. These US-based firms competing abroad had to pay the US’s 39 percent federal and state combined corporate tax rate. In comparison, their competitors faced average tax rates 14 percentage points lower in the typical OECD country, with average combined tax rates of about 25 percent that same year. This system led to about $2.6 trillion in profits held overseas by US-based firms that could defer their domestic tax bill on some foreign profits.

Source-based taxes

Source-based or “territorial” tax systems only tax profits earned within the borders of the taxing jurisdiction. Often called “capital import neutrality,” territorial systems ensure that two investments in the same location face the same tax rate, regardless of where the investor is located.

Territorial systems are implemented through a “participation exemption” for all or a portion of foreign-earned capital gains and dividend income. Most OECD countries have complete territorial systems that exempt 100 percent of both types of income. In 2018, the United States switched to a territorial system with an exemption for foreign dividends received (but not for capital gains). Only Chile, Colombia, and Mexico still have worldwide tax systems as of 2024.

While territorial systems can be simpler because they disregard activity outside the territory, they can also create arbitrage opportunities. Thus, most territorial tax systems employ anti-abuse rules to protect the domestic tax base, such as controlled foreign corporation (CFC) rules and limits on intraparty payments.

The 2017 Tax Cuts and Jobs Act paired a federal corporate income tax rate reduction from 35 percent to 21 percent and the partial participation exemption with four new anti-abuse rules. The first two apply a carrot-and-stick approach to high-return intangible income, creating a minimum tax on foreign income and an offsetting subsidy for locating the income domestically. The second two place limits on intraparty payments. 

• Global Intangible Low-Taxed Income (GILTI): a minimum tax between 10.5 percent and 13.125 percent (increasing in 2026 to 13.125 percent and 16.406 percent) on income that exceeds a 10 percent return. The GILTI rate is a range due to an 80 percent limit on foreign tax credits (FTC). GILTI is a new CFC income category layered on top of the existing “Subpart F” and expense allocation rules.
• Foreign-Derived Intangible Income (FDII): a deduction for foreign export income connected to intangible assets held in the United States, creating a lower effective tax rate of 13.125 percent on eligible income (16.406 percent in 2026).
• Base Erosion and Anti-Abuse Tax (BEAT): a minimum tax of 10 percent (12.5 percent in 2026) on income of affiliated foreign entities with gross receipts of $500 million or more. The tax applies if qualifying “base-erosion payments”—interest, rents, royalties, services, depreciation, and amortization—exceed 3 percent of total corporate deductions.
• Interest Limitation: limits interest expense deductions to 30 percent of earnings before interest and taxes (EBIT). From 2018–2021, the limit was 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA).

Destination-based taxes

Destination-based tax systems tax profits based on where the customers or end users are located instead of the location of production or headquarters. The destination principle is most commonly used in value-added taxes (VATs) on consumption, but also underlies digital services taxes (DSTs) and some features of anti-abuse rules, such as the BEAT in the United States and diverted profits taxes in the UK and Australia.

Instead of the US territorial system implemented in the Tax Cuts and Jobs Act, there was an original proposal for a novel destination-based corporate tax system. This would have been implemented through a “border adjustment” that would allow exporting firms a deduction for the cost of exports and would tax the value of imports at the corporate tax rate. This proposal was abandoned due to political concerns and uncertainty over some of the strong assumptions necessary to keep the tax from acting like an across-the-board tariff.

For more on the economics of destination-based income taxes, see “Reviewing the Case Against a Border-Adjusted Corporate Income Tax.”

Is Profit Shifting a Problem?

Implicit in the layers of complex and costly anti-abuse rules is that profit shifting—the problem the rules are intended to fix—is a big and growing problem, undermining the ability to raise sufficient revenue through the corporate income tax. However, the available data show that profit shifting to low-tax countries or “tax havens” is small and declining.

Measured correctly, corporate profits in tax havens amount to about 8 percent of total US corporate profits (or as much as 11 percent). Figure 1 from a longer Cato report shows two different measures of tax haven profits of US multinationals. The chart shows that the share of total US corporate income reported in tax havens grew modestly over time, and following the 2017 corporate tax cut, it fell to its lowest level in a decade. The data suggest a lower corporate tax rate is one of the most effective reforms to reduce profit shifting. The share of US corporate profits in tax havens declined 30 percent after the 2017 corporate tax cut. 

A significant share of corporate profits in low-tax countries (shown in Figure 1) are not shifted there artificially but are associated with real investments. However, even the artificially shifted profits are still associated with real economic benefits, like jobs and investment, in both tax havens and non-haven jurisdictions.

The OECD Two-Pillar Tax Cartel

In October 2020, the OECD outlined a “Two-Pillar” approach to remake the international tax system in close consultation with the Biden administration. The proposal is the latest in the OECD’s efforts to stop profit shifting. It is intended to raise multinational businesses’ effective tax rates and reallocate taxing rights away from countries like the United States to others.

President Trump distanced the US from the OECD agreement in one of his first Executive Orders. Pressure from the Trump administration will likely stall the deal’s progress. The most effective way to end the OECD’s global tax deal is for Congress to withdraw from the organization and cut its US funding.

Pillar One would reallocate an estimated $205 billion of large multinational corporate profits to countries where customers are located and away from where the firms have a physical and productive presence.[1] This would be done using a complicated formula based on a company’s sales, marketing, and distribution in each jurisdiction. The new tax is intended to replace a patchwork of DSTs that some countries currently charge large technology firms based on revenue and users in their country.

Like DSTs, Pillar One intentionally targets America’s most profitable firms. By one estimate, US companies account for 58 percent of profits redistributed under the new tax system. By redistributing the US tax base, the Joint Committee on Taxation (JCT) estimates Pillar One could reduce US revenue by between $1.4 billion and $100 billion annually. The pact would require a multilateral treaty and significant changes to domestic tax laws.

Pillar Two is a 15 percent global minimum tax on large multinationals. Like Pillar One, the Pillar Two rules primarily target American firms, which are estimated to earn nearly 40 percent of all in-scope multinational income, about the same amount as the next 10 countries’ shares combined. The JCT estimates Pillar Two could reduce US domestic tax revenues over 10 years by between $57 billion and $122 billion. Other estimates predict the tax will reduce US domestic investment by $22 billion annually.

Pillar Two includes a novel extraterritorial feature called the Undertaxed Profits Rule (UTPR), which allows countries to increase taxes on a business’s domestic subsidiary if a related entity in another jurisdiction pays a tax rate below 15 percent. Columbia University legal scholar David Schizer likens the UTPR to California being able to tax a resident of Virginia on income earned in Virginia simply because his daughter lives in California.

UTPR’s tax base shifts the global competition for international business investments from reducing economically beneficial tax rates to economically costly government subsidies. It does this by treating direct state subsidies more favorably than non-refundable tax credits and other tax benefits. The new OECD-built tax system favors China’s preferred model of economic competition and incentivizes a global shift to its less efficient and more corruption-prone system of governmental favoritism.

The system also includes two new domestic taxes—the Qualified Domestic Minimum Top-Up Tax (QDMTT) and the Income Inclusion Rule (IIR)—to enforce the 15 percent tax on domestic income and firms. Countries have already begun to implement these domestic components of Pillar Two but have not yet begun enforcing the UTPR.