FORTUNE – The debate over Pfizer’s bid to buy U.K. drugmaker AstraZeneca is intensifying. Last week, AstraZeneca rejected Pfizer’s offer of $106 billion, even though it was about 7% higher than its previous bid.
As negotiations escalate, it’s worth taking a close look at Pfizer’s proposed merger into AstraZeneca (AZN) — with its tremendous implications for U.S. tax collections and tax policies. Pfizer’s (PFE) determination underscores how driven U.S. multinational corporations are to shift their domicile outside the U.S. Why? Unless they keep foreign profits abroad, the U.S. subjects them to a corporate tax of 35%.
As a result, more than $2 trillion in foreign profits held by multinationals are “locked out” of the U.S. These funds could otherwise be spent making critical investments in the U.S. economy, such as building manufacturing facilities, buying U.S. companies, or even paying dividends to shareholders. For instance, Apple (AAPL) recently borrowed $17 billion to pay dividends, despite holding more than $130 billion abroad.
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Thus, the current tax rules reduce investments in the American economy and distort business decisions of American executives. Moreover, although the U.S. corporate tax rate is almost the highest in the world, the U.S. Treasury receives relatively little revenue from taxes on foreign profits from multinationals.
Some U.S. business executives have pushed for a tax holiday — similar to the one in 2004 when foreign profits could be repatriated at a tax rate below 6%. But repeated tax holidays undermine any effort to reform problems with the existing system.
Other U.S. business executives have lobbied Congress to adopt a territorial system — foreign profits of multinationals would be taxed only in the jurisdiction where they were “located.” The problem with that idea, however, is that lawyers have become magicians in moving foreign corporate profits to no-tax or low-tax jurisdictions.
Others on the left want the U.S. to stop tax deferral and impose a 35% tax, but that approach risks putting U.S. companies at a tremendous competitive disadvantage in doing international business.
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So what would be a sensible fix to these problems? The U.S. should stop the current system of high rates and permanent tax deferral, and instead adopt a 17% tax on foreign profits of U.S. multinationals, with a U.S. credit for taxes already paid on such profits to foreign countries.
Here’s how the new system could work and the advantages it would provide.
If a multinational paid over 17% in U.K. taxes on its U.K. income, the company would be free to reinvest those profits wherever it wanted. So the company would pay the same tax rate on foreign profits as its competitors in most of the industrialized world. And then the company could repatriate those foreign profits to the U.S. without paying any additional U.S. tax.
And if the company shifted the bulk of its foreign profits to an offshore jurisdiction with a 2% tax rate, it would immediately have to pay the U.S. 15% of such profits (that is, the minimum U.S. tax of 17% on foreign profits minus the 2% paid in foreign taxes). So the new system would strongly discourage multinationals from finding clever ways to move foreign profits to tax havens. Regardless of the low rate in the tax haven, multinationals would pay total taxes of 17% (2% to the tax haven and 15% to the U.S.).
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The sticky wicket would be multinationals with active businesses in places like Ireland with a 12% corporate tax rate. They would have to pay a 5% tax to the U.S., which their foreign competitors would not be absorbing. But many American executives would be willing to pay a 5% transit fee in order to have the freedom to move their foreign profits back and forth to the U.S. as they please.
In short, the proposed 17% minimum tax on foreign profits would be far superior to the current system in three ways: It would allow U.S. executives to exercise their business judgment in deciding which country to put their manufacturing and research facilities. It would also encourage multinationals to invest more foreign profits into the U.S. economy. And it would raise revenues for the U.S. Treasury by stopping tax deferral and imposing a 17% minimum tax on foreign profits moved to tax havens.
More from Robert Pozen:
Robert Pozen is a nonresident senior fellow in Economic Studies at the Brookings Institution and a senior lecturer at Harvard Business School.
