The
World Trade Organization (WTO) has repeatedly sided with the
European Union (EU) and ruled that provisions of U.S. tax law
provide impermissible "subsidies" because business income from
exports is sometimes not taxed at the same rate as other forms of
corporate income. More specifically, the WTO twice ruled that the
Foreign Sales Corporation (FSC) portion of the tax code violated
trade rules, leading U.S. lawmakers to replace FSC with the
Extraterritorial Income Act (ETI). But the EU argued that the new
law also was an impermissible subsidy, and the WTO subsequently
ruled two more times against the United States.
The
WTO decisions put the United States in a difficult position. If
FSC/ETI is not repealed, the EU has the right to impose more than
$4 billion of "compensatory" tariffs every year on American
products. These taxes on U.S. exports, which could be as high as
100 percent, would fall on over 1,800 different products including
agriculture, jewelry, steel, machinery and mechanical appliances,
wool and cotton textiles, and toys. Yet repealing the law means
higher corporate income taxes--also about $4 billion annually--for
companies that benefit from the law. This seems like a no-win
situation--either higher taxes on corporate income or higher taxes
on exports.
While not desirable, the WTO decisions
could be a blessing in disguise if they spurred much-needed tax
reform. The tax code has numerous features that significantly
undermine the competitiveness of U.S.-based companies. The bad news
is that fixing these problems would "cost" money (according to
static revenue-estimating models). The good news, in a manner of
speaking, is that repealing ETI would generate about $49.4 billion
in tax revenue over the next 10 years--money that can be used to
ameliorate the anti-competitive provisions of the tax code.
Ideally, lawmakers should engage in wholesale
change, junking America's "worldwide" tax system (whereby companies
are taxed on income earned in other nations) and replacing it with
a "territorial" tax system (the common-sense practice of taxing
only income earned inside national borders). This reform would
allow U.S.-based companies to compete on a level playing field with
foreign competitors, particularly if it is accompanied by a
significant reduction in the corporate tax rate.
Even
incremental reform could significantly improve U.S. competitiveness
and boost economic performance. In particular, lawmakers could:
- Make interest
expense allocation less onerous. Companies should not be
required to pretend some of their interest costs are incurred
overseas, a policy that results in higher tax burdens.
- Reduce foreign
tax credit baskets. Companies should not be required to
engage in complicated calculations that limit their ability to
avoid being double-taxed on foreign-source income.
- Allow deferral
of foreign base company sales and services income.
Com-panies should not be required to pay U.S. tax when a subsidiary
in one foreign country sells to a subsidiary in another foreign
country, so any delay in the U.S. tax liability is a positive
step.
- Protect against
ex-piring foreign tax credits. Companies should be allowed
to benefit fully from their foreign tax credits to minimize the
adverse impact of worldwide taxation on competitiveness.
- Permit
repatriation of overseas income. Companies should be
allowed to bring profits back to the U.S. at a much lower tax rate,
a policy that will boost domestic investment and move the tax
system closer to territoriality.
These reforms, discussed in greater detail
below, are incorporated into legislation being considered on
Capitol Hill. Such proposals would help U.S. companies compete in
global markets.
Current Tax Law Treatment of U.S.-Based
Companies
The
aggregate tax burden in America is too high, but most other
industrialized nations have a tax burden that is far more onerous.
This would suggest that U.S.-based companies have a competitive
advantage in the global economy, but this is not the case. The U.S.
corporate tax rate is among the highest in the world, and companies
are forced to pay that tax on income that is earned--and subject to
tax--in other nations. The combination of these features brings to
mind Clint Eastwood's "spaghetti Western" The Good, the Bad, and
the Ugly.
The Good: A
Lower Total Tax Burden. As indicated in Chart 1, federal,
state, and local taxes consume about 30 percent of national
economic output in the United States. This is far too high, but the
burden of government is much heavier in most European nations. In
the EU, taxes consume about 42 percent of gross domestic
product.
Not surprisingly, America's lower tax burden
translates into superior economic performance. Per capita economic
output in the U.S. is nearly 50 percent higher than in the EU.
America also enjoys much more job creation, resulting in
significantly less unemployment.
Aggregate tax figures are important, but
they do not necessarily reveal the tax burden on different types of
economic activity. One reason the United States has a big overall
advantage, for instance, is the absence of a national sales tax.
Countries in the EU, by contrast, are required to levy a
value-added tax of at least 15 percent. This consumption-based levy
is at least partially responsible for the bloated welfare states in
most EU nations.
America also tends to have lower payroll
and personal income tax rates. Significant changes in tax rates
since 2001--lowering personal income and capital gains tax rates,
slashing the dividend tax rates, and a move toward expensing of
investment--have further improved the competitiveness of the U.S.
tax code.
The Bad: A High Corporate
Tax Rate. The overall tax burden in the United States may
be low compared to Europe, but this does not mean that America has
an advantage in all areas. The United States, for instance, has one
of the highest corporate income tax rates in the industrialized
world. The federal government imposes a corporate income tax rate
of 35 percent, and state corporate tax burdens increase the
effective tax rate to 40 percent. According to Organisation for
Economic Co-operation and Development (OECD) and KPMG data, this is
the second-highest corporate tax burden of any developed
nation.
America has fallen behind because many
other nations--particularly in Europe--have dramatically lowered
their corporate tax rates in the past 15 years. This vigorous tax
competition has led to better tax policy. Ireland is perhaps the
most spectacular example, lowering its corporate rate from 50
percent to just 12.5 percent.
Many other nations have also reduced corporate
rates to help their companies compete in the global economy.
Iceland and Hungary have 18 percent tax rates on business income,
and even socialist nations like France and Sweden have lower
corporate tax rates than America. The average corporate tax rate in
Europe has fallen by about 7 percentage points just since 1996.
The Ugly:
Worldwide Taxation. American-based companies are taxed on
their worldwide income. This policy is very
anti-competitive, subjecting U.S. companies to higher tax rates
than those paid by companies based in other nations.
For
example, an American-based company operating in Ireland is at a
disadvantage since its profits are subject to the 35 percent U.S.
corporate income tax in addition to Ireland's 12.5 percent
corporate tax. The U.S. company generally can claim a credit for
the taxes paid to Ireland, so the overall tax rate on Irish-source
income should not exceed 35 percent. As Table 1 indicates, however,
this still means the U.S. firm pays nearly three times as much tax
as an Irish company. It also means that the U.S. firm pays nearly
three times as much tax as a Dutch firm competing in Ireland, since
Holland has a territorial tax system. Furthermore, these foreign
tax credits are not always available because they can expire or be
limited by other factors.
Making matters worse, the tax code contains a
plethora of rules that make it even harder for companies to
compete. Tax rules for using foreign tax credits, for instance, are
so onerous that companies sometimes are double-taxed on
foreign-source income. Companies also are forced to misallocate
certain expenses in order to increase taxable income. Even features
designed to mitigate the anti-competitive nature of worldwide
taxation--such as deferral--are subject to a multiplicity of
restrictions.
Worldwide taxation means that U.S.-based companies
are not allowed to compete on a level playing field. Most nations
do not tax companies on their worldwide income. This means that
companies based in those nations can take full advantage of the low
corporate tax rates that now exist in so many countries. Adding
insult to injury, compliance costs for foreign-source income are
extraordinarily high, forcing internationally active American
companies to spend huge amounts of money and to divert a
substantial amount of time and energy just to fill out tax
forms.
Making American-Based Companies More
Competitive
Fundamental
Reform. Policymakers should junk America's worldwide tax
on corporate income and shift to territorial taxation. Such a step
would be poetic justice. The EU filed the WTO cases against America
in hopes of forcing lawmakers to increase the tax burden on U.S.
companies. If lawmakers instead use the WTO rulings as an impetus
to improve the tax code, American companies will become more
effective competitors in the world economy, and the EU will regret
its attack on U.S. fiscal sovereignty.
However, getting revenge on the EU is the
last reason to fix the tax code. The main reason to shift to
territorial taxation is that it is good, pro-growth tax policy.
Specifically, territorial taxation promotes:
- A level playing
field. American companies would be allowed to operate
under the same rules as companies from other nations. Income earned
in a foreign country would be taxed by the foreign country, and all
corporations--whether from that country or anyplace else in the
world--would be treated the same.
- Competitiveness. American companies
would not face a second layer of tax when competing in a low-tax
jurisdiction. Paying the local tax rate (instead of the local tax
rate and a tax to the IRS) would enable American companies to get
more business (which is very important in low-tax economies since,
not surprisingly, they tend to grow faster and attract more
economic activity).
- Simplicity. American companies no longer
would need to include foreign revenues and expenses in their U.S.
tax return, which requires immense amounts of paperwork and complex
calculations of foreign tax credits and the resulting U.S. tax. A survey of
Fortune 500 companies found that international tax rules accounted
for nearly 44 percent of compliance costs, a disproportionately
high number since companies generally have a much smaller share of
their employment, sales, and assets outside of the U.S. economy. Under a
territorial system, companies would merely need to track revenues
and expenses in each country in which they operate.
- Tax
reform. Territorial taxation is part of every serious tax
reform plan. The flat tax eliminates worldwide taxation. The
national retail sales tax eliminates worldwide taxation. The
inflow-outflow tax (sometimes known as the USA tax) eliminates
worldwide taxation. Shifting from worldwide
taxation to territorial taxation is both necessary and desirable
for a fair, simple, pro-growth tax system.
- Respect for
sovereignty. Territorial taxation is the fiscal equivalent
of a "good neighbor policy." Each nation taxes activity inside its
own borders but respects the right of other nations to determine
the tax treatment of income earned inside their borders. This is in
stark contrast to worldwide taxation, which necessarily requires
governments to impose laws on an extraterritorial basis.
- Fiscal
competition. Worldwide tax systems mean that companies
always pay the highest possible tax--either the tax of their home
country or the tax of the country in which they are operating. With
territorial tax systems, by contrast, companies can benefit from
lower tax rates in fiscally responsible jurisdictions. This
enhances the flow of jobs and capital to lower-tax jurisdictions
and promotes tax competition as a liberalizing force in the world
economy.
As the Joint Committee on Taxation acknowledges, "Without the
constraint of some residence-based taxation of foreign-source
income, a major barrier to tax competition would be removed."
- More
exports. Territorial taxation means that U.S.-based
companies will earn a larger share of global business. This is good
for exports and domestic employment since successful international
companies often buy raw materials and intermediate goods from their
home country. The OECD estimates that every dollar of direct
investment overseas by a nation's companies yields $2 of additional
exports for that country. Foreign production also
generates exports. A survey of the empirical literature reveals
that one dollar of overseas production by U.S. affiliates generates
an average of $0.16 in exports from the United States.
- No more
inversions. To improve their competitiveness and protect
the interests of workers and shareholders, some companies have
rechartered (a process sometimes known as "inversion") in
jurisdictions with better tax law. Companies that charter in
Bermuda and Cayman still keep their headquarters and factories in
the United States, and they still pay tax to the IRS on their
U.S.-source income, but they escape worldwide taxation. Inversions
protect American economic interests, but they are a second-best
option. Shifting to a territorial tax system is the best
approach.
- Fewer foreign
takeovers. Glenn Hubbard, former Chairman of the Council
of Economic Advisers, has noted that "from an income tax
perspective, the United States has become one of the least
attractive industrial countries in which to locate the headquarters
of a multinational corporation." If U.S. companies become
subsidiaries of foreign firms, however, their market value will
rise because they escape worldwide taxation. This is why
foreign-based companies "take over" U.S.-based companies
three-fourths of the time when there is a cross-border merger. There is
nothing wrong with cross-border mergers, and there is nothing wrong
with foreign-based companies acquiring U.S.-based companies, but
bad U.S. tax law should not be the cause. Territorial taxation will
put U.S.-based companies on a level playing field.
- WTO-compliant
policy. Territorial taxation is fully consistent with
international treaty obligations. Most nations use this approach,
and the WTO has already ruled that territorial taxation does not
violate trade rules.
Worldwide taxation is bad tax policy and should be
repealed. Nations are sometimes guilty of enacting laws--including
tax laws--to give their companies a special advantage. The United
States is guilty of this practice, but in the perverse sense that
American tax laws put U.S.-based companies at a competitive
disadvantage.
Good
tax policy should neither subsidize nor penalize any company,
regardless of whether it is foreign or domestic. This is why
territorial taxation is ideal policy. If the U.S. had a territorial
system, every company operating in the United States, regardless of
where it is chartered, would pay tax to the IRS on its U.S.-source
income.
This, of course, happens now. What would
change, though, is that the foreign-source income of U.S. companies
would be taxed only by foreign governments, thereby allowing
American firms to compete on a level playing field with companies
from other countries.
Incremental
Reform. To the extent that fundamental reform is not
immediately feasible, lawmakers should fix at least some of the
worst features of the current tax system. Repealing the ETI
provision will generate about $49.4 billion over 10 years, but this
is not nearly enough money to finance a complete shift to a
territorial system, especially since Congress continues to rely on
inaccurate "static scoring" methodology to estimate the revenue
impact of major tax legislation. Congress could increase the amount
of available money by extending some trade-related fees (and this
is widely expected), but it is unlikely that the total pool of
money will exceed $100 billion over 10 years.
It
is therefore essential for lawmakers to choose reforms that will
generate the most "bang for the buck," and two lawmakers have
undertaken this much-needed task. Important incremental reforms are
included in H.R. 2896, sponsored by Representative Bill Thomas
(R-CA), chairman of the House Ways and Means Committee, and S.
1475, sponsored by Senator Orrin Hatch (R-UT), a senior member of
the Senate Finance Committee.
The
following proposals certainly would help to improve the
competitiveness of U.S.-based companies and are critical
incremental steps toward a territorial tax system because they
reduce and delay taxation of foreign-source income.
- Make interest
expense allocation less onerous. Internationally active
U.S. companies are required to pretend that some of their domestic
interest costs are incurred overseas. This artificially reduces
foreign-source income, which causes additional double taxation
since it simultaneously reduces the amount of foreign tax credits
that can be claimed--notwithstanding the amount of foreign taxes
that have actually been paid. The rules boost effective
tax rates for U.S. companies, most notably for investments
overseas, but also on their U.S. investments. Yet this rule generally
does not apply to foreign companies operating in the United
States.
One way to ameliorate
this unfair practice is to take into account a company's
international interest costs--the "worldwide fungibility"
approach. Chairman Thomas and Senator
Hatch propose to give companies greater ability to use this method,
which "would significantly expand the ability of many U.S.-based
multinational enterprises to claim foreign tax credits."
- Reduce foreign
tax credit baskets. U.S. companies are forced to segregate
their foreign-source income into nine separate "baskets," and
foreign taxes paid on income in one basket cannot be credited
against U.S. taxes on foreign-source income in another basket. Each
basket corresponds to a type of income such as "withholding tax
interest" or "financial services income." This policy "creates
unnecessary complexity and distorts business decision making." And since
it makes it harder for U.S. companies to get credit for taxes paid
overseas, this policy means the effective tax rate on
foreign-source income can be higher than the statutory tax rate in
either the United States or the country where the income is
earned.
Chairman Thomas and
Senator Hatch would reduce the number of baskets from nine to two,
a step that would reduce double taxation, lower compliance costs,
and promote tax competition.
- Allow deferral
of foreign base company sales and services income. To
reduce the burden of worldwide taxation, companies are supposed to
be able to "defer" U.S. taxes on some forms of foreign-source
income. But another part of the tax code--Subpart F--is supposed to
limit the applicability of deferral to "active" income (as opposed
to investment income such as the interest companies earn in bank
accounts). Even by this misguided standard, however, some types of
foreign-source income are not treated properly, including income a
U.S. subsidiary (the base company) in one foreign country earns by
selling to another U.S. subsidiary in a different country.
Chairman Thomas and
Senator Hatch would extend deferral so that this income is
protected from immediate taxation. This would lower compliance
costs and allow U.S.-based multinationals to improve the efficiency
of their overseas operations by centralizing sales and services
functions for a number of different foreign markets within a single
foreign entity.
This reform also is
a major step toward a territorial tax system. As noted by the U.S.
Treasury in a report published in 2000, "The deferral achieved by
operating abroad through a foreign subsidiary...can neutralize the
effect of worldwide taxation.... Moreover, in certain
circumstances, deferral can effectively make what is nominally a
worldwide system into a territorial system."
- Protect against
expiring foreign tax credits. The tax code allows an
American company to claim a credit for taxes paid to foreign
countries, but these foreign tax credits expire after five years,
and many companies lose their credits or must engage in
complicated, inefficient transactions to use them. Any time a
foreign tax credit expires, the U.S. company is subject to a form
of double taxation that can increase effective tax rates above the
tax rate either in the United States or in the country where the
income is earned.
To ameliorate this
risk, the Thomas bill extends the life of foreign tax credits to 10
years, and the Hatch bill extends it to 20 years.
- Permit
repatriation of overseas income. Deferral allows a company
to postpone tax on foreign-source income, but the tax saving exists
only if the company does not "repatriate" the money. Of course,
discouraging the flow of capital to America is foolish.
Chairman Thomas and
Senator Hatch propose to give companies a period during which they
can bring money back to the United States without having to pay the
35 percent tax rate on corporate income. Instead, the tax would be
only 5.25 percent. This proposal could attract $300 billion to the
American economy, money that could fund new
investments, increase dividends, and help pay down debt to improve
balance sheets. Best of all, "pressure might then arise to 'extend'
the provision, thus rendering an ostensibly temporary stimulus
provision a further step toward the adoption of a territorial-type
tax system."
The
international provisions of the tax code desperately need reform,
and Representative Thomas and Senator Hatch have identified some
high-priority targets for incremental reform. But many "domestic"
tax policy changes could help U.S. companies become more
competitive. Lowering the corporate income tax rate clearly would
help, as would a shift from depreciation to expensing.
The
Thomas bill takes some big steps toward these goals by lowering the
corporate tax rate for all businesses with less than $10 million in
taxable income, extending a temporary provision that reduces the
tax bias against new investment through 2005, and further reducing
the burden of depreciation for manufacturing equipment. The Hatch
bill, meanwhile, allows 100 percent expensing for investments
through 2006.
These are important steps to fundamental
tax reform. Shifting to a flat tax, needless to say, would solve
all of the problems in the tax code, both domestic and
international.
Conclusion
In
1960, America was home to 18 of the world's 20 largest
corporations. By 1996, however, only eight of the world's 20
largest companies were based in America. Tax policy surely was not
the only factor in this shift, but worldwide taxation is
unquestionably hindering the competitiveness of U.S.-based
companies. American companies that compete in global markets face
significantly higher effective tax rates than their foreign
counterparts.
There are many other signs that worldwide
taxation imposes unacceptably high costs, including corporate
inversions. Most companies that have rechartered in jurisdictions
with better tax law presumably would have remained U.S. companies
if America had a territorial tax system, but they were not willing
to sacrifice the interests of their workers and shareholders just
for the "privilege" of enduring worldwide taxation.
Cross-border mergers are another warning
sign. In general, there is no reason for concern if a foreign-based
company becomes the "parent" following a merger with a U.S.-based
company. However, if foreign-based companies are taking over
U.S.-based companies because worldwide taxation reduces the
competitiveness and lowers the value of American companies--a
factor that has been cited in some high-profile acquisitions of
U.S. companies, such as Daimler's merger with Chrysler--worldwide
taxation should be repealed.
Territorial taxation is good tax policy.
It is simple, it is pro-tax reform, and it will help the U.S.
economy. Territorial taxation means more jobs, better jobs, and
improved competitiveness of U.S. companies.
By
dragging America to the WTO, the European Union has unwittingly
given policymakers a golden opportunity to improve the tax
treatment of internationally active U.S. companies. If Congress
lacks the political will to engage in fundamental reform, it should
at least go as far toward a territorial tax system as possible.
Daniel J.
Mitchell, Ph.D., is McKenna Senior Research Fellow in the
Thomas A. Roe Institute for Economic Policy Studies at The Heritage
Foundation.