The Heritage Foundation

WebMemo #509 on Taxes

May 24, 2004

May 24, 2004 | WebMemo on Taxes

FSC/ETI: A Missed Opportunity?

The World Trade Organization (WTO) repeatedly has ruled that provisions of U.S. tax law provide an impermissible "export subsidy." The WTO also ruled that the European Union could impose more than $4 billion of taxes on U.S. exports unless and until these provisions, known as Foreign Sales Corporation and Extraterritorial Income Exclusion (FSC/ETI), are repealed. These taxes began to take effect earlier this year.

 

While lawmakers understandably are upset that the WTO is interfering with U.S. tax law, it was thought that this dark cloud contained a silver lining. The FSC/ETI provisions are not good tax policy and the revenue generated by repealing those provisions can be used to finance much-needed changes in tax law.

 

Special interests come first

Unfortunately, it appears that lawmakers are squandering this opportunity. The lion's share of the money from FSC/ETI repeal (as well as some revenues from other sources) is being used to create a special tax break for certain manufacturers. In addition, politicians have inserted an inordinate amount of narrow tax breaks on behalf of certain companies and industries.

 

To be sure, there is some pro-growth reform in the legislation-particularly the version approved by the House Ways & Means Committee. It also is possible that a conference committee (which will occur after the full House of Representatives approves a bill) will produce a final product that is better than what was produced by either the House or Senate.

 

But even the most optimistic scenario of what might happen now is rather dismal compared to what might have happened. This is particularly troubling because lawmakers had so many positive options-pro-growth tax policies that could have been implemented with the money gained by repealing FSC/ETI. For instance, they could have:

  • Lowered the corporate tax rate: At 40 percent (including the average of state corporate tax rates), the United States now has the second high corporate tax rate in the world, second only to Japan. America's corporate tax rate is higher than the rate in every European nation-even socialist welfare states like France and Sweden. This creates a significant competitive disadvantage for U.S.-based companies. But international competitiveness is just one argument for lowering the corporate tax rate. The corporate tax also reduces the after-tax income generated by investing, and this disincentive is particularly acute since corporate income is double-taxed (though, thanks to the 2003 tax bill, the rate of double-taxation on dividends and capital gains has been reduced to 15 percent).

    The Congressional Budget Office (CBO) recently acknowledged that "Marginal tax rates (the tax rate on additional increments of income) are the rates critical to influencing growth and efficiency." And in an analysis of how best to use the FSC/ETI money, CBO chose corporate rate reduction over a manufacturing tax preference, writing that, "In terms of economic efficiency, the proposed across-the-board 2 percentage- point rate cut is superior… It would not have the distortions associated with favoring exports, domestic production, or manufacturing. In addition, it would lessen all of the distortions associated with the corporate income tax."
       
  • Shifted to a territorial tax system: The United States is among the small minority of nations that tax business income earned outside national borders. This policy of "worldwide taxation" is inconsistent with fundamental tax reform and imposes a heavy compliance burden on U.S.-based corporations. Most important, this policy undermines U.S. competitiveness, which is why territorial taxation would be preferable. Territorial taxation-the common-sense notion of taxing only income earned inside national borders-would enable U.S. companies in foreign markets to compete on a level playing field.

    Worldwide taxation subjects U.S. companies to higher tax rates than those paid by companies based in other nations. For example, an American-based company competing 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 American 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. But this still means that the U.S. firm pays nearly three times as much in taxes as companies based in other nations, most of which have territorial tax systems.
       
  • Extended "bonus" depreciation: In 2002 and 2003, legislation was approved and signed reducing the tax burden on new investment. Under current law, companies are not allowed to deduct the full cost of new investments when calculating their net income (an approach that is know as "expensing"). Instead, they must "depreciate" these costs by pretending they occur over a period of time. For all intents and purposes, this means a portion of the money spent on new investment is treated like profit and subject to high tax rates. The 2002 and 2003 tax bills reduced this perverse tax by giving companies greater ability to recognize-and immediately deduct-certain investment expenses. This move toward expensing has been a big success, boosting investment in software and equipment.

    That is the good news. The bad news is that these provisions are temporary. They expire at the end of 2004, and there will be a significant tax increase on new investment if they are not made permanent-or at least extended.

 

Conclusion

There are persuasive arguments for all three options listed above, and there are many other problems in the tax code that could have been mitigated if lawmakers used the FSC/ETI money to implement good tax reform and boost the economy. But there was almost no serious discussion of good tax policy on Capitol Hill, and the Administration compounded the problem by failing to exercise any leadership.

 

Defenders of the status quo argued that there was not enough money for a significant reduction in the corporate tax rate-especially since the revenue estimators at the Joint Committee on Taxation cling to antiquated static scoring methods. But even a 2-percentage point reduction in the rate would have been an important step. They argued that there was not enough money to shift from worldwide taxation to territorial taxation. But they could have taken a big step in the right direction-as Ways & Means Chairman Bill Thomas originally proposed. They did not need to make an argument against the extension of bonus depreciation, unfortunately, because there was no serious effort to pursue that approach, even though it would have disproportionately benefited manufacturing industries.

 

Politicians rejected pro-growth options and instead chose to craft special interest legislation. This is tragic because it symbolizes the growing tendency to use the tax code as a tool of social engineering. But it is even more discouraging because it means a missed opportunity to make America more prosperous and competitive.

 

Daniel J. Mitchell is McKenna Senior Fellow in Political Economy at The Heritage Foundation.

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy

Related Issues: Taxes