Key Points
When foreign tax rates rise, the impact on U.S. tax revenues from multinational firms and capital allocation varies depending on whether the foreign affiliates are in low- or high-tax jurisdiction. In high-tax jurisdictions, a 1 percent increase in foreign tax rates leads to a 3.2 percent rise in foreign tax payments, no change in U.S. tax liabilities, and a greater capital reallocation toward U.S. domestic production, reducing foreign affiliate capital by 2.2 percent. In low-tax jurisdictions, a 1 percent increase in foreign tax rates results in an 8.2 percent increase in foreign tax payments, a nearly 90 percent reduction in U.S. tax liabilities, and only a modest shift of capital toward U.S. domestic production, with foreign affiliate capital decreasing by 0.3 percent.
When the U.S. government reduces the tax exemption on foreign-earned income, the impact differs depending on whether the foreign affiliate is located in a low- or high-tax jurisdiction. For affiliates in high-tax jurisdictions, a 1 percentage point decrease in U.S. tax exemptions leaves both U.S. tax liabilities and capital allocation unchanged. However, for affiliates in low-tax jurisdictions, the same reduction in exemptions increases U.S. tax liabilities by 0.9 percent.
Taxing Foreign Affiliates of U.S.-Domiciled Firms
Foreign affiliates of U.S.-domiciled firms are subject to taxation by the foreign jurisdictions in which they operate and by the U.S. government. Policies like Pillar II influence the tax rates imposed by foreign governments on foreign affiliates and the domestic tax revenues generated from these firms, both of which shape investors' incentives to invest in foreign operations. Domestic proposals that alter the taxation of foreign-derived tangible income can change the effective U.S. tax rates on foreign earnings, potentially influencing the allocation of capital between domestic and foreign uses.
This brief outlines the international component of the Penn Wharton Budget Model’s (PWBM) dynamic Overlapping Generation (OLG) model, which is used to analyze the macroeconomic and budget impact of changes in the taxation of foreign affiliates of U.S.-domiciled firms. We evaluate how changes in foreign tax rates and domestic tax exemptions affect the taxes paid by foreign affiliates as well as the distribution of U.S.-domiciled capital between foreign and domestic firms. To preview this capability, PWBM runs two illustrative experiments.
In the first illustrative experiment, the foreign tax rate is increased. Foreign affiliates of U.S.-domiciled firms tend to shift capital toward domestic uses when they’re located in high-tax jurisdictions, but do not when they are in low-tax jurisdictions. This is because domestic taxes revenues do not offset the increase in foreign tax revenues in high-tax jurisdictions, but they do when the affiliates pay a lower level of foreign taxes.
In the second illustrative experiment, the amount of foreign income excluded from domestic taxation is increased. Both foreign and domestic taxes for foreign affiliates of U.S.-domiciled firms in high-tax jurisdictions do not change, so there is little change in these affiliates’ economic behaviors. For affiliates located in low-tax jurisdictions, domestic taxes decline as the exemption increases, but the change in taxes is very small and does not lead to large changes in capital invested abroad.
The international component of the PWBM dynamic OLG model keeps track of both capital inflows—investments that foreign investors make in the United States—as well as capital outflows—investments that U.S. investors make in foreign affiliates operating abroad. Additionally, the model accommodates two distinct tax schedules: one for income U.S. firms generate from domestic operations and another for income earned through foreign affiliates.
Investors seek the highest returns, and changes to either tax schedule affect returns across businesses, leading investors to reallocate capital to maximize profits. Consequently, changes to one tax schedule can have dynamic effects on U.S. households’ decisions about how much to work and save and foreign investors’ choices on where to allocate their investments. These decisions, in turn, affect the level of domestic capital, labor supply, aggregate output, and income and ultimately impact government deficits and debt. In this brief, however, we focus on the effects of domestic and foreign taxes paid by firms.
We model international gross capital positions, which include foreign investors’ holdings in the U.S. economy and U.S. investors’ holdings abroad. By modeling both gross positions rather than just the net international capital position, PWBM can analyze changes to tax rates and schedules that apply to U.S. investors’ foreign assets holdings.
The supply of assets from domestic and foreign sources must equal the demand for capital:
The left side represents assets that can be used to buy government debt or private, productive capital domestically and abroad. Some of these resources come from U.S. household savings (
), and the rest are foreign-owned U.S. assets (
), which are domestic assets in the U.S. that foreign investors own. Total assets, (), change in response to changes in interest rates and policy. How total assets are split between domestic and foreign investments depends on interest rates and policy differences between domestic and foreign countries. Relative changes in interest rates or policy may result in changes in the allocation of capital between foreign affiliates and domestic production.
Assets are split among several types of uses. The first is government debt (
), which is broken into foreign-owned government debt (
) and domestically owned government debt (
). When the U.S. government issues or retires debt, a fixed fraction of that change is apportioned to foreigners’ holdings.
The remaining assets are allocated between capital used in domestic production () and capital used by foreign affiliates (
). The capital used in domestic production is divided into three components: foreign investments in C-corporations (
), domestic investment in C-corporations (
), and domestic investment in pass-through entities (
). Foreign investors are not allowed to own U.S. pass-through entities. However, foreign-owned capital can still finance foreign affiliates. For example, foreign investors from Kuwait may invest in a U.S. company like Amazon, which then uses that capital to fund a distribution facility in Germany.
Capital allocated to domestic firms is determined so that the return on capital from domestic corporate production equals the return from foreign affiliates, adjusted for a small home bias. If returns from foreign affiliates exceed those from domestic corporations, capital will shift from low-return domestic production to higher-return foreign investments. By influencing the return on capital, tax policy determines the allocation of capital between the U.S. domestic production sector and foreign affiliates, thereby impacting overall output in the U.S. economy.
Foreign affiliates of U.S.-domiciled firms produce goods and services abroad, remitting dividends back to the United States. While domestic firms in the model may vary by production sector and operate either as C-corporations or pass-through entities, the international sector is represented by a single firm organized as a C-corporation, which produces a single good for consumption or investment, using a Cobb-Douglas production function. Although U.S. investors supply capital to the foreign affiliate, the firm hires local labor in its host country.
Two key production parameters for the foreign affiliate are the labor share (the amount of income that goes to wages in each sector) and economic depreciation (the rate at which productive capital wears out and becomes unproductive). The default labor share is 0.55 and the capital depreciates at a rate of 5.6 percent. In the initial steady state, PWBM sets the amount of labor used by foreign affiliates such that the total compensation paid by foreign affiliates is about 7.1 percent of the total compensation paid by domestic firms. Like domestic firms, foreign affiliates use labor and capital to produce output. They then sell that output and pay taxes to the U.S. and foreign governments. After that, they distribute their net profits as dividends to their owners.
The tax system for foreign affiliates is based on a description of international taxation published by the Joint Committee on Taxation. Foreign affiliates are subject to two business taxes, one paid to the U.S. government and one to the foreign government.
Where 
represents the total tax paid by the foreign affiliate in year 
, 
is the average foreign tax rate on the foreign affiliate's gross operating surplus (the value of the output minus the wage bill) 
, and 
is the amount that the foreign affiliate pays to the U.S. government. PWBM does not model the foreign tax code in detail; instead, is an effective rate that accounts for various features of the foreign tax system, including deductions, credits, expensing, and other provisions.
The tax that the foreign affiliate pays to the U.S. government () in year is based on foreign income subject to U.S. taxation (
), the standard U.S. corporate tax rate (
, currently set at 21 percent), and the foreign tax credit (
) which offsets the taxes already paid to foreign governments:
The foreign affiliate’s taxable income () is the sum of the Global Intangible Low Tax Income or GILTI (
) and other included income, which is a fraction of the foreign affiliate’s overall income ().
The GILTI tax base is calculated as:
This equation represents the foreign affiliates’ income (), adjusted for exclusions (
) such as income already subject to high foreign taxes, dividends, and other exclusions (collectively referred to as net tested income). That amount is then reduced by a “routine” return on tangible assets, , known as Deemed Tangible Income Return (DTIR). In that expression,
is the allowed return on tangible assets (10 percent under current law), and represents Qualified Business Asset Income (QBAI).
is the foreign affiliate’s capital to which the exemption applies.
After calculating the GILTI tax base, a Section 250 deduction (
), which is currently 50 percent, is applied. This deduction reduces the portion of the GILTI base that is subject to business taxation ():
Finally, the foreign tax credit () is calculated as the lesser of two components:
The first component represents the foreign tax applicable to the GILTI base under Section 960 (Deemed Paid Credit for Subpart F Inclusions). It is calculated by multiplying the foreign tax rate by the Section 960 deduction rate 
and the GILTI base 
. The second component represents the U.S. statutory corporate tax rate , applied to the GILTI base after adjusting for allocatable expenses, represented by 
. The foreign tax credit is the minimum of these two components, ensuring that the taxpayer doesn’t claim a credit that exceeds the U.S. tax liability on the GILTI income.
In the first year of the baseline, capital inflows are set such that the return foreigners earn on their U.S. investments equals a fixed rate of 3.1 percent. Foreign investors seek competitive returns, meaning the returns from U.S. investment must align with opportunities available in the rest of the world. If returns on their U.S. investments in the United States fall below those offered elsewhere, capital will flow out of the U.S., raising domestic returns as a result. Conversely, if U.S. returns exceed those available abroad, foreign investors will increase their investments in the U.S. economy, driving returns closer to the global rate.
In all policy experiments, foreign labor remains fixed at its baseline level and foreign capital invested in the U.S. is assumed to be constant. However, those assumptions are primarily for presentational purposes. When foreign investment in the U.S. is allowed to adjust in response to policy changes, the results are quantitatively like those observed when foreign capital investment is held constant.
Tax policies, both domestic and international, can significantly impact the taxes that foreign affiliates of U.S.-domiciled firms pay to the U.S. government. Policies such as Pillar II, the global minimum tax, influence the effective tax rates foreign affiliates pay foreign governments and the amount of money those affiliates pay to the U.S. government. Similarly, changes in U.S. tax policy—such as modifications to foreign income exemptions, can alter the tax burden faced by U.S. foreign affiliates domestically.
In the first experiment, we analyze how changes in foreign tax rates impact the taxes paid by foreign affiliates of U.S.-domiciled firms to foreign and U.S. governments. We examine two scenarios, focusing on affiliates operating in low-tax (12 percent) and high-tax (about 24 percent) jurisdictions. As we show below, this experiment demonstrates that for firms facing high foreign effective tax rates, further increases in the foreign rate have large real impacts on the firm and negligible fiscal effects for the U.S. In contrast, firms facing relatively low foreign effective tax rates see only small real impacts from marginal increases in the foreign rate, with larger fiscal effects for the U.S.
In the second experiment, we assess how increasing exemptions by decreasing the DTIR affects these same affiliates in low- and high-tax jurisdictions. In contrast to the first experiment, firms facing high foreign effective tax rates are unaffected by this policy reform with no corresponding U.S. fiscal effect. Firms facing low foreign effective tax rates, on the other hand, face a significant change in U.S. tax liability.
For each scenario, we report semi-elasticities that capture how domestic and foreign tax revenues respond to long-run changes in foreign tax rates and domestic tax exemptions for U.S. foreign affiliates. The reported semi-elasticities represent the percent change in an indicator resulting from a one-percentage-point change in either the foreign tax rate or DTIR exemption.
| Foreign Affilate Foreign Effective Tax Rate | ||
|---|---|---|
| Low Tax (12 percent) | High Tax (23.6 percent) | |
| U.S.-Owned Foreign Affiliates | ||
| Productive Capital | -0.3% | -2.2% |
| U.S. Business Taxes | -88.9% | 0.0% |
| Foreign Business Taxes | 8.2% | 3.2% |
| GILTI | 0.0% | -0.1% |
| Foreign Tax Credit | 8.4% | -0.1% |
In Table 1, we present the key effects on foreign affiliates of U.S.-domiciled firms for a change in foreign tax rates, showing scenarios where foreign affiliates are subject to low tax rates abroad (12 percent) and high tax rates abroad (about 24 percent).
When foreign affiliates are located in high-tax jurisdictions with an average effective foreign tax rate of about 24 percent, a 1 percent increase in the foreign tax rate results in a 3.2 percent increase in taxes paid by these affiliates. Due to the high tax environment, these firms generate enough foreign tax credits to offset their U.S. tax burden on GILTI and other included foreign income fully. Since their U.S. tax liabilities are already zero, the increase in the foreign tax rate generates excess foreign tax credits that cannot be used and, therefore, has no effect on U.S. tax payments. However, the rise in foreign taxes leads to lower returns on capital, causing foreign affiliate capital to decline by 2.2 percent.
Overall, increasing tax rates in already high-tax jurisdictions result in increased foreign tax payments, unchanged domestic tax liabilities, and increased capital allocation towards U.S. domestic production.
Foreign affiliates respond differently when situated in low-tax jurisdictions. In such cases, a foreign tax increase results in an 8.2 percent increase in foreign business taxes. Since these affiliates operate in a low-tax jurisdiction, the foreign tax credit is fully utilized, and the U.S. collects some tax on foreign income. Consequently, increasing the foreign tax rate generates additional foreign tax credits that reduce tax liability owed to the U.S. government. Specifically, the foreign tax credit increases by 8.4 percent as the affiliates pay more foreign taxes, reducing their U.S. tax liability on foreign earnings by almost 89 percent in response to this policy change. This large elasticity comes from the fact that as the firm’s foreign effective rate increases from 12 percent to 13 percent, it approaches GILTI’s minimum tax rate of 13.125 percent under current law, above which the U.S. collects zero tax on foreign earnings.
In contrast to high-tax jurisdictions, where foreign taxes increase but domestic taxes remain unchanged, the reduction in U.S. taxes for foreign affiliates in low-tax jurisdictions largely offsets the impact of higher foreign taxes. In other words, U.S. firms facing a low foreign effective tax rate will primarily react to increases in foreign tax rates by reallocating tax liability from the U.S. to foreign governments. Consequently, the real overall effect on taxes and capital investments for affiliates in low-tax regions is relatively small, and these firms relocate less capital toward U.S. domestic production compared to firms in high-tax jurisdictions.
| Foreign Affilate Foreign Effective Tax Rate | ||
|---|---|---|
| Low Tax (12-percent) | High Tax (23.6 percent) | |
| U.S.-Owned Foreign Affiliates | ||
| Productive Capital | 0.0% | 0.0% |
| U.S. Business Taxes | -0.9% | 0.0% |
| Foreign Business Taxes | 0.0% | 0.0% |
| GILTI | -0.9% | -0.7% |
| Foreign Tax Credit | -0.9% | -0.7% |
Changes to the DTIR are a key policy lever the U.S. government can adjust to affect the taxation of U.S.-domiciled foreign affiliates. Lowering the DTIR increases taxes on foreign-earned income for some businesses, as a lower DTIR excludes less income from U.S. taxation. This leads to a higher overall tax bill for affected firms.
Table 2 highlights the key effects of a change in DTIR on foreign affiliates of U.S.-domiciled firms, comparing cases where affiliates face low foreign tax rates (12 percent) and high foreign tax rates (about 24 percent).
As previously discussed, in high-tax jurisdictions, foreign affiliates typically generate enough foreign tax credits to fully offset U.S. tax liability on foreign earnings classified as GILTI. A 1 percentage point decrease in the DTIR results in a 0.7 percent increase in GILTI, as less of the affiliate’s foreign income becomes exempt from U.S. taxation. The foreign tax credit also increases by 0.7 percent. Overall, the policy reform does not impact U.S. tax liability, given that the firm is in an excess credit position. As a result, there is no meaningful change to the affiliate’s return to capital, and productive capital does not shift location.
In contrast, for affiliates located in low-tax jurisdictions, a decrease in the DTIR tends to increase U.S. tax liability. In this case, a 1 percentage point decrease in the DTIR increases GILTI by 0.9 percent and the foreign tax credit by 0.9 percent. Overall, U.S. tax liability on foreign earnings increases by 0.9 percent.
This analysis was produced by Lysle Boller, Jon Huntley, and Felipe Ruiz Mazin under the direction of Felix Reichling and the faculty director, Kent Smetters. Mariko Paulson prepared the brief for the website.