October 31, 2001

October 31, 2001 | Backgrounder on Trade, Economic Freedom

How to Improve U.S.-EU Trade Relations

The Bush Administration has inherited a large number of unresolved trade disputes with the European Union (EU), whose members generally stand shoulder to shoulder with America on other fronts, including the war on terrorism. While economies around the globe flounder, disputes between the two largest economic blocs over agriculture policies, investment laws, taxes, and regulatory regimes are stifling the most lucrative trading relationship in the world. Both blocs are at fault, even using the dispute settlement mechanism established by the World Trade Organization (WTO) to score political points against each other, rather than to help resolve disputes and liberalize trade.

This spiraling tit-for-tat dynamism--in which both blocs have initiated trade complaints as bargaining chips in unrelated disputes or as retaliatory measures to even the score for an adverse WTO ruling--cannot continue. It is harming economies, undermining efforts to expand free trade, and souring relations between the United States and the EU at a time when relations should be strong. If it is not abandoned quickly, the contest could imperil the success of the new global free trade round to take place in Qatar next month.

The Administration could change this unsavory dynamic by pulling some disputes off the table. The battle over the U.S. tax treatment of Foreign Sales Corporations (FSC) is one example. The WTO recently sided with the EU that such treatment violates its rules against preferential treatment for exports. The United States, which has a relatively high corporate income tax, created this tax provision to help U.S. exporters compete globally; they receive a lower tax on FSC profits from export sales than similar domestic sales. In this way, the United States tries to compensate exporters whose worldwide income is subject to both U.S. and foreign taxes.1 (Other countries generally tax their exporters on income earned at home.) Moreover, the United States taxes the profits of U.S. companies twice: first at the corporate level and again as personal income when distributed to shareholders.

Abolishing the entire corporate income tax is the ideal response. Such an action would clearly benefit American businesses. If that is not possible in the near future, however, the Administration should consider interim measures, such as combining FSC repeal with a shift to a territorial system that only taxes income earned within U.S. borders. Such a system would satisfy WTO concerns while removing a competitive disadvantage for U.S.-based businesses. In addition, it would break the tit-for-tat dynamic hampering relations with the EU. In this way, the United States could encourage the EU to take the next step and reduce or eliminate its protectionist agricultural subsidies that greatly inhibit trade and aggravate relations. By setting a standard of "free trade by any means," the United States would begin to change the unhealthy dynamic underlying trade negotiations at the WTO, enabling free trade to be treated as economic opportunity rather than political concession.

Trade Disputes
Recent news reports have highlighted the importance that the United States and the European Union place on international trade in order to strengthen weak economies and combat terrorism.2 But beneath the rhetoric lie contentious issues between the world's two most successful trading blocs. The United States wants the EU to liberalize its agriculture sector, while the Europeans want the United States to liberalize its tax regimes. The EU further contends that agriculture trade liberalization cannot be separated from environmental concerns. In case after case, the two blocs have brought their escalating complaints to the World Trade Organization. But rather than use its dispute settlement mechanism to reach agreements that open markets and liberalize trade, they use it to score political points against one another, while failing to heed WTO pleas to open their domestic markets.

The EU Complaint.
The U.S. government established the FSC in the tax code to benefit multinational American businesses and level the economic playing field. It sought to offset perceived advantages in the European tax codes for transnational European businesses. Under the U.S. tax code, the relatively high corporate income tax paid by U.S. businesses on total domestic and foreign sales, combined with taxes they pay other countries on their foreign sales and the additional double taxation of that income when it is paid to shareholders puts these businesses at a competitive disadvantage. But trying to fix poor tax policy by creating a special tax entitlement is not the answer.

The EU brought its complaint that America's FSC system was an unlawful subsidy of U.S. exports before the WTO in September 1998. During the WTO adjudication process, the United States argued that the European Union had reached an understanding with the U.S. government in 1981 that it would not object to FSCs as a counterbalance to European advantages. But such a claim makes little sense, since eliminating the FSC will help U.S. companies compete with European businesses.

After the United States lost the case but failed to adequately adjust the FSC provision to satisfy the WTO concerns, the WTO decided to allow the EU to levy up to $4 billion in punitive tariffs on U.S. products. The judgment--greater than 10 times the punishment levied against the EU in the combined beef and bananas cases--was described by U.S. Trade Representative (USTR) Robert Zoellick as "the nuclear weapon of free trade" because it could initiate a broader trade war.3 The United States has decided to appeal the verdict, but there is little chance that this will affect the WTO's decision. Moreover, U.S. failure to accept the judgment could poison other aspects of the U.S.-EU trading relationship.

Washington's counterproductive response to the ruling merely intensifies the tit-for-tat syndrome afflicting U.S.-EU relations at the WTO. According to an editorial in The Financial Times, "The [FSC] case was initiated mainly to hit back at US harassment over the EU's disregard for WTO rulings against its beef ban and banana import regimes."4 Others posit that the EU lodged the FSC complaint so as to use WTO-approved punitive tariffs as bargaining chips if the United States ever elected to bring a case against the EU for its subsidies of Airbus.5 EU member states believed they would quite likely lose such a case. Neither explanation shows the EU in a very good light, and the tit-for-tat dynamic palpably sets back the cause of trade liberalization. The use of the WTO dispute resolution mechanism as a public relations tool or part of a bargaining strategy to safeguard protected markets, rather than as a way to liberalize global free trade, puts the long-term survival of the WTO in jeopardy.

Predictably, some in Washington have suggested that if the EU goes ahead and levies the punitive tariffs, the United States should bring WTO cases against EU members for their tax laws and for Airbus subsidies.6 This, in addition to problems in dealing with the EU's Common Agricultural Policy (CAP), makes the possibility of a full-blown trade war increasingly plausible. But as the world collectively slides into recession, this is the last thing the global economy needs.

The U.S. Complaint.
One of the largest trade irritants between the two blocs has to do with the EU's subsidies for its farmers under the Common Agricultural Policy. The CAP, the single largest sectoral impediment to free trade in the world, consumes half of the EU's budget each year and accounts for 85 percent of total global agricultural subsidies.7

Agricultural liberalization remains a contentious issue worldwide, and entrenched interests limit efforts at reform at every level. Thus, while average global tariffs on manufactured goods have decreased from 40 percent to 4 percent over the past 50 years, average agricultural tariffs remain at over 40 percent.8 Promises to eradicate this bastion of global protectionism are not infrequent. At the end of the Uruguay Round of free trade liberalization in 1994, for example, the United States and the EU promised that agricultural liberalization would form the basis for the next multilateral effort to reduce trade barriers. Clearly, there was a sense in the international community then that it was time for CAP reform.

Nevertheless, the EU is stalling, attempting to link talks on liberalizing agriculture policy to environmental and food safety issues. It wants the WTO to recognize its "precautionary principle" as a basis for limiting agricultural imports into Europe. Under this principle, the EU claims the right to ban the import of products if there is an uncertainty or the possibility of a health or environmental hazard, even in the absence of scientific evidence to substantiate such claims. Current WTO policy allows countries to block the import of products only when science supports such claims.

Worldwide reaction to the EU's demand is clear. The precautionary principle is seen as a way for the EU to maintain an inefficient and overly subsidized farming sector. Likewise the EU's efforts to link agricultural liberalization to environmental issues is seen as a strategy to keep imported agricultural products out of Europe--hence, another form of protectionism.

The Cairns Group, a forum of agricultural exporting nations such as Australia and Argentina, have argued in the run-up to the Qatar round that agriculture should be treated just like any other traded good. They reject the EU's efforts to link farming reform with environmental concerns. The United States supports the Cairns Group's position.

For many developing countries, reforming agricultural policies is the most important goal of this new trade round. Nevertheless, the EU has adopted an increasingly confrontational tone as the prospect of a global coalition around genuine agricultural reform has evolved. Pascal Lamy, the EU commissioner responsible for trade, has stated that if the Qatar mandate suggests agriculture negotiations be governed only by trade concerns, "there will be no agreement."9

For the EU, talks on the environment are a quid pro quo for ambitious negotiations on agriculture liberalization. The EU wants negotiations over agriculture policy to take account of environmental, food safety, and animal welfare concerns. The Cairns Group and many in the U.S. policy community think this agenda is another EU strategy to justify continuing its CAP subsidies to EU farmers.

It does not appear that either the EU or the Cairns Group (with support from the United States and most developing nations) will back down. Peter Carl, the head of the EU's trade directorate in Brussels, recently said, "Trade and the environment, or the omission of it, is indeed a deal-breaker."10 Upon hearing this, one developing country's trade official replied, "If the EU says it's a deal-breaker so be it. There are just too many people against it."11 Thus, the United States once again faces the prospect of implacable EU opposition to genuine agricultural liberalization at the next trade round.

The Way Forward
In order to weather the current U.S.-EU trade storm and change the unproductive tit-for-tat dynamic that characterizes their relations, the Bush Administration should adopt creative and proactive trade policies that move away from the Clinton Administration's penchant to make trade liberalization some sort of political concession. Specifically, the Bush Administration should

  • Accept the WTO ruling regarding the FSC and abolish the current corporate income tax system. The United States should avoid abusing the WTO dispute resolution mechanism by continuing to elect to pay the fines the WTO allows in punitive tariffs on specific goods, rather than liberalizing its markets, as was intended. The current approach does nothing to advance the cause of global free trade. Acquiescing in the WTO's judgment regarding the FSC and abolishing the corporate income tax is the ideal approach. It would benefit Americans in several ways:

    First, abolishing the corporate income tax would be fair, because it would help eliminate double taxation of income, in which profits taxed first at the corporate level are then again taxed as personal income distributed to shareholders.

    Second, abolishing the corporate income tax would not result in a net loss of income. Corporate taxation accounts for around 13 percent of on-budget federal revenue. Some studies estimate that enforcing and collecting the tax costs at least as much as it gathers in revenue.12

    Third, it would provide an immediate economic stimulus--something the American economy, heading into a recession, desperately needs. With an effective tax rate on corporate profits of more than 50 percent, abolishing the tax would free up a windfall of capital that companies could reinvest to generate healthy long-term growth.

    Fourth, abolishing the tax will enhance American competitiveness. One need only look at Ireland, which accounts for 1 percent of the euro-zone and is the destination of around 40 percent of all North American foreign direct investment (FDI) to Europe, to see the economic advantages of a low rate of corporate taxation.

    Fifth, such a policy would break the tit-for-tat cycle and change the whole political dynamic in trade negotiations between the United States and the EU, refuting the notion that economic liberalization through the guise of adverse WTO rulings is economically disadvantageous.

If abolishing the FSC is not immediately feasible, then the Administration should consider an interim step of combining FSC repeal with moving toward a territorial tax system. A territorial tax would make U.S. companies immediately more competitive, reduce the hefty compliance costs under the current tax system, and bring U.S. policy in line with current WTO policies. Most of America's trading partners already have territorial tax systems.

  • Ally with the Cairns Group and other countries that oppose the EU's efforts to dilute global agricultural liberalization with other considerations. As John Van Oudenaren, chief of the European division at the Library of Congress, suggests, it often seems that the EU hides behind "such high-sounding principles as precaution (food safety), multifunctionality (agriculture), and diversity (culture)."13 The EU appears ready to discuss anything but agricultural liberalization.

    The Administration should view the EU's unilateral call for a quid pro quo regarding agricultural liberalization talks and environmental, health, and cultural factors as a negotiating tactic designed to protect its inefficient farmers. History shows that the adoption of demanding environmental standards gathers pace as incomes rise, and that such regulations are largely dependent on the increase in prosperity that follows free trade. U.S. negotiators should take every opportunity to hammer home these lessons to their European counterparts.

  • Pursue a policy of free trade by any means if a new global free trade round does not occur. 14 Unlike the Clinton Administration, whose zeal for free trade flagged following the WTO non-agreement in Seattle in November-December 1999, the Bush Administration should adopt a policy of free trade by any means if the Europeans refuse to compromise on their agricultural negotiating position at Doha. Such a policy would enable the United States to continue expanding economic opportunities around the world while making it clear that the EU will not be allowed to become an obstacle to free trade. Protectionist policies will merely restrict European economic opportunities. In this effort, the Administration should:

    First, lobby Congress to grant trade promotion authority (TPA) for the President, which on a practical level will be necessary to pursue a multifaceted trade policy.

    Second, finalize bilateral free trade agreements with countries such as Chile, Singapore, and Australia.

    Third, pursue regional free trade initiatives in the Western Hemisphere by making the Free Trade Agreement of the Americas (FTAA) a more substantial part of overall U.S. foreign policy.

    Fourth, work toward establishing a global free trade association (GFTA)15 of countries genuinely committed to free trade (such as the United Kingdom, Estonia, Ireland, Australia, and New Zealand), who agree to further liberalize their comparatively free-market economies for mutual benefit.

Such an all-encompassing trade strategy would force the EU to rethink any reticence about market liberalization. And it would conclusively change the global free trade dynamic by making free trade an economic reward, rather than a political concession.

Conclusion
Historically, times of recession are accompanied by waning enthusiasm for global free trade. The Bush Administration has responded bravely, creatively, and positively to the shattering events of September 11. It is critical for the prosperity of the world today that the White House more aggressively hew to a free trade line in the months ahead. By abolishing the corporate income tax, holding firm in the face of EU recalcitrance regarding agricultural liberalization, and pursuing a policy of free trade by any means, the Administration can underpin the security of the global economy--a vital factor in winning the war against terrorism and in ensuring that economic opportunity continues to expand opportunities in America and throughout the rest of the world.

John C. Hulsman, Ph.D., is Research Fellow for European Affairs in the Kathryn and Shelby Cullom Davis Institute for International Studies at The Heritage Foundation.


1. U.S. exporters generally must pay U.S. taxes on their total income earned at home and overseas, as well as foreign taxes on the portion of that income earned abroad, putting them at a competitive disadvantage.

2. "The U.S. and Europe are counting on international trade as their longest-range weapon in the war against terrorism. The theory behind this strategy goes like this: Expanded trade wraps the world more tightly in a web of commerce, lifting living standards in impoverished regions and eliminating an important cause of war and terror." From Bob Davis, "Trade Craft Is Employed on War's Economic Front," The Wall Street Journal, October 29, 2001, p. A1.

3. Editorial, "The WTO's Bombshell," The Wall Street Journal, September 22, 2001, p. A16.

4. Editorial, "The FSC Bomb," Financial Times, June 28, 2001.

5. Boeing, an American company, sees an opportunity to lodge a trade complaint as Airbus, another aviation and defense company, accepts $4 billion in loans with below market rates from France, Germany, Britain, and Spain in order to develop the A380 jumbo jet under a $12 billion program. Many analysts believe that the EU states would lose such a case if it were brought before the WTO.

6. "The FSC Bomb."

7. Adam Entous, "Labor Groups Challenge WTO on Trade Round," Reuters, November 29, 1999.

8. The Economist, "Playing Games with Prosperity," July 28, 2001, p. 26.

9. Ibid.

10. Frances Williams, "EU Warning on Agriculture in Trade Round," Financial Times, October 4, 2001, p. 8.

11. Frances Williams, "EU Stance Threatens New Trade Round," Financial Times, October 5, 2001, p. 7.

12. "The WTO's Bombshell."

13. John Van Oudenaren, "E Pluribus Confusio," The National Interest, No. 65 (Fall 2001), p. 29.

14. See John Hulsman, Gerald P. O'Driscoll, Jr., and Denise Froning, "The Sole Guiding Principle Must Be Free Trade by Any Route," in 2001 Index of Economic Freedom, ed. Gerald P. O'Driscoll, Jr., Kim R. Holmes, and Melanie Kirkpatrick (Washington, D.C.: The Heritage Foundation and Dow Jones & Company, Inc, 2001), Chapter 3.

15. See John Hulsman and Aaron Schavey, "The Global Free Trade Association: A New Trade Agenda," Heritage Foundation Backgrounder No. 1441, May 16, 2001; John Hulsman, "The World Turned Rightside Up: A New Trading Agenda for the Age of Globalization," Heritage Foundation Lecture No. 653, January 24, 2000; and O'Driscoll et al., 2001 Index of Economic Freedom, Chapter 3.

About the Author

John Hulsman Senior Research Fellow

Related Issues: Trade, Economic Freedom