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483 January 27, 1986 THE HOUSE TAX BILL PENALIZING U.S. COMPET ITIVENESS Bruce Bartlett John M. Olin Fellow INTRODUCTION d bi At a time when the U.S. economy is being. batter tough foreign competition, the tax reform-bill passed by the House of Representatives in December almost seems designed to make matters worse. In the name of reform, the House bill weakens e,xisting tax measures that encourage capital investment, foreign trade, and research and development precisely those factors that would enable the U.S. to compete more successfully with foreign businesses.
The House bill, therefore, penalizes The House bill cuts back on the foreign earned income exclusion for Americans working overseas, cuts back on the research and development tax credit, restricts use of the foreign tax credit raises the cost of capital f.or American firms, and raises the capital gains tax.
The U.S. economy is now very international. Imports and exports amount to 15 percent of Gross National Product-roughly double that in the early 1970s. The flow of foreign capital into the U.S.! moreover is close to $100 billion per year: this has important implications for interest rates and exchange rates affects the investment climate in the U.S. or the ability.of U.S. firms to compete internationally can have consequences far greater than the dollar val u e of the taxes involved. weigh heavily in any overall assessment of the House tax bill Any tax change, therefore, which These consequences must TAXATION OF AMERICANS ABROAD The United States is the only major industrialized country that taxes its citizens without regard to their residence or source of income. When an Englishman moves permanently to the U.S. or some other country and earns income in thatcountry, for example, he is no longer subject to British taxation. An American working abroad however, mu st pay not only foreign taxes but U.S. taxes as well.
For many years the only relief granted was an exclusion of 20,000 on foreign earned income and a credit for foreign taxes paid against one's U.S. tax liability on income above $20,0
00. Even so most Americans had to pay far higher taxes on foreign earned income than citizens of almost every other country.
By 1980 it was widely agreed-that heavy taxation of Americans working abroad had a negative effect on the ability of U.S. firms to operate internatio nally. Among Jimy Carter's points, in a message to Congress on September 9, 1980, were 1) U.S. companies were replacing many of their American personnel with foreign personnel 2) When American companies engaged in engineering or construction work abroad h i red Americans because of their skills and reliability these companies risked 1,osing contracts for overseas projects because of the higher labor cost lost. The result was that U.S. exports were 3) When these companies hired non-Americans, they may have wo n the contracts, but lost a good share of the valuable follow-up exports because foreign nationals favored foreign suppliers who were more familiar to them 4) Foreign operations by American companies tended to create a need for exports from the U.S. and to generate substantial earnings that benefited the U.S. balance of payments. Some companies felt that they could conduct such operations more successfully if they were free to use American rather than foreign employees developed valuable technology lost in t he case of American employees, who were less apt to move to foreign-owned companies when they changed employment 6) The detriment to competitiveness had a snowballing effect as foreign companies gained strength at U.S. expense 5) American companies operat i ng abroad sometimes picked up or This technology was less likely to be I I 27) The special deductions allowed for foreign living costs and hardship conditions were insuff-iciently generous and too complicated had to be paid significantly more than foreign workers to give them the same after-tax income.
American firms to compete internationally. They could not open foreign sales offices and staff them with American personnel, bid on foreign contracts, or properly service the products they-sold overseas. Cha se estimated that U.S. exports decline 10 percent for every 10 percent reduction in the number of U.S. workers overseas.
The reduction in U.S. exports, in turn, raises U.S. unemployment and reduces federal revenue. The study concluded that "the tax on U.S workers overseas costs the U.S. Treasury and the country many times more than it yields in revenue I2 The Chase findings are confirmed and the Treasury Department A 1980 study by Chase Econometrics found that Americans overseas This was severely hamperin g the ability of generally by other studies cfnducted by the General Accounting Office As a result of such analyses, Congress significantly changed the law in 1981 to allow Americans working abroad to exclude up to $75,000 of foreign earned income from U.S . tax. This exclusion is scheduled to rise to $95,000 in 19
90. The House tax bill, however, freezes the foreign earned income exclusion at $75,0
00. The House Ways and Means Committee's only rationalization for this is that Itit is appropriate to reduce the maximum potential preference for Americans earning active income abroad The amount of tax revenue to be gained by this is only $22 million in 19
86. At a time of grave concern about the trade deficit and U.S. export competitiveness, it makes no sense to penalize 1. "United States Export Promotion Policies Public PaDers of the Presidents of the United States: Jimmv Carter. 1980-8L 3 books (Washin gton, D.C.: U.S. Government Printing Office, 1982), Book 11, pp. 1692-1693 2. Testimony of Robert D. Shriner, Director of Washington Operations, Chase Econometric Associates, in U.S. Congress, House, Committee on Ways and Means, Advisabilitv of a Tax Redu c tion in 1980 Effective for 1981, 3 parts, 96th Congress, 2d Session (Washington D.C.: U.S. Government Printing Office, 1980), Part 3, pp. 1935-1937 3. John Mutti, The American Presence Abroad and U.S. ExDorts (Washington, D.C Department of the Treasury, O f fice of Tax Analysis Paper 33, October 1978); Comptroller General of the United States Laws (Washington, D.C U.S. General Accounting Office, IDi81-29, February 27, 1981 4. Tax Reform Act of 1985, House Report 99-426, 99th Congress, 1st Session, December 7 1985, p. 430 3Americans working abroad. Indeed, to the extent it has any impact on the number of Americans working abroad, it will be a negative impact on the trade balance and federal. revenues.
Ronald Reagan, by contrast, in his tax reform proposal, allowed the exclusion to rise to 95,000 annually for Americans earning income abroad will support the President's approach to this matter.
Policy makers truly concerned about American competitiveness RESEARCH AND DEVELOPMENT Most economists agree that resear ch and development (R&D expenditures play a key role in competitiveness and productivity growth As Table 1 indicates, the U.S. has been running a large trade surplus in RhD-intensive products and a deficit in non-R&D-intensive products. It is essential fo r the U.S..to maintain technological leadership, especially when there is concern over the trade deficit.
Table 1 Manufactured Product Groups, 1970-80 in billions of dollars U. S Trade Balance in RtD-Intensive and Non-RhD-Intensive Year R&D-Intensive Non-R hD-Intensive 1980. 52.4 39.3 1978 29.6 1977 1976 29.0 1975 29.3 1970 11.7 Source: National Science Board 33.5 34.8 -35.4 23.5 16.5 9.5 -8.3 I1 i I I I I I I 5. See the literature cited in Rolf Piekarz, Eleanor Thomas, and Donna Jennings International Comp a risons of Research and Development Expenditures in John W. Kendrick ed International ComDarisons of Product ivitv and Causes of the Slowdown (Cambridge Massachusetts: Ballinger, 1984 pp. 235-240. In the late 1970s, when it became apparent that the U.S tec h nological lead was slipping, it was widely blamed on a slowdown in U.S. R&D expenditures, coupled with a major increase in R&D spending by America's international competitors. Between 1964 and 1978, for example U.S. R&D expenditures as a share of GNP fell by 25 percent while R&D expendituresaincreased in Japan by 32 percent and in West Germany by 47 percent.
Congress responded in 1981 by wisely instituting a 25 percent tax credit for boosts in R&D spending. The credit applies only to the extent that a comp any's qualified research and development expenditures in a given year exceed the average for the previous three years percent and restricts its use No reason is given for the change.
Reagan's tax reform proposal would retain the R&D tax credit at the 25 p ercent rate and extend it for another three years, subject to some redefinition of qualified research credit. existed only three years. Because the credit is incremental in nature, the major benefits are to be expected in the future, not immediately that t he R&D tax credit did increase RtD expenditures The House tax reform bill, however, reduces the credit to 30 There is, to be sure, debate on the merits of the R&D tax One problem in resolving the debate is that the credit has Nevertheless, the available e mpirical evidence indicates The best reform would be to make the R&D tax credit permanent.
Explains the Congressional Budget Office: "It is generally recognized that research benefits the nation more than it benefits any individual company, and that privat e firms tend to devote less resources to research and development than the public interest would warrant: this is particularly true for the high-technology industries I9 Moreover 6. National Science Board, Science Indicators 1982 (Washington, D.C.: U.S. G o vernment Printing Office, 1983), p. 197 7. Tax Reform Act. OD. cit, p. 177 8. U.S. Congress, Joint Economic Committee, The R&D Tax Credit: An Evaluation of Evidence on Its Effectiveness Joint Committee Print, 99th Congress, 1st Session (Washington D.C.: U . S. Government Printing Office, 1985); Kenneth M. Brown, ed The R&D Tax Credit Issues in Tax Policv and Industrial Innovation (Washington, D.C.: American Enterprise Institute, 1984); Eileen L. Collins, An Earlv Assessment of Three R&D Tax Incentives Provid e d bv the Economic Recoverv Tax Act of 1981 (Washington, D.C.: National Science Foundation, 1983 9. Federal Financial Sumort for Hiah-Technoloav Industries (Washington, D.C Congressional Budget Office, 19851, p. xi 5-as long as firms believe the tax credit is temporary they are unlikely to respond fully to it.
The amount of revenue that the House bill would raise by trimming the R&D credit is relatively small 474 million in 19
86. For that amount the House is seriously risking further erosion in the U.S technology lead.
FOREIGN TAX CREDIT The foreign tax credit exists to prevent companies from being taxed twice on the same income-once by a foreign country and again by the U.S. A credit is allowed for foreign taxes paid on income derived from direct operati ons or investments in a foreign country. Companies may not use this credit to reduce their U.S. tax on U.S. income. This limit is calculated on the basis of the company's overall worldwide income. In effect, foreign taxes are averaged together.
The House, generally following Reagan's proposal, calls for limiting the foreign tax credit using the aggregate of all foreign taxes paid by a U.S. firm to calculate the firmls tax credit, the proposed change sets per country limits. The result is that a U.S. firm c an offset only its earnings from a specific country with a tax paid to that country: high t'axes paid to one country cannot be used to offset the U.S. firm's earnings from another country. The Administration argues that this change is necessary because th e current systemlodistorts firms' decisions whether to invest in one country or another In contrast to the current method of There are several problems with the per country limit. First, it is a complex.method that mocks tax simplification. Corporations ar e seldom organized on a strict country-by-country basis. Explains Richard Rahn of the U.S. Chamber of Coverce A German manufacturing subsidiary of a U.S. company may well develop technology that it licenses to a Dutch or Japanese enterprise and will sell i ts products throughout Europe, Africa, and perhaps elsewhere and may do so though branches or subsidiaries The current averaging method is consistent with the approach normally taken by U.S. business to overseas investment.
Second, averaging mitigates some of the difficulties caused by rules in different countries for determining the tax base and the 10. The President's Tax ProDosa 1s to t he Conpress for Fairness. Growth. and Simolicitv Washington, D.C U.S. Government Print i ng Office, 1985 pp. 387-388 11. Statement before the House Ways and Means Committee, June 26, 1985, p. 41 6-timing of income and deductions. For this reason, virtually every other industrialized country uses the averaging method, exempts direct investment 12income, or uses a per country limit that permits a form of averaging.
The per country limit would increase sharply the tax burden on companies with foreign operations. Losses in individual countries for instance, could not be applied to reduce overall foreign income.
Instead, companies would be required to carry losses forward against future income in the same country in which the loss was incurred.
This would lead almost certainly to a sharp cutback in new foreign investment, especially long-term investments that might not yield profits for many years to countries where companies already have profitable operations.
Future investment probably would be limited One of the few bright spots in the U.S. trade picture is the foreign operations of U.S. compani es. A recent study of total worLdwide sales by U.S. companies, including foreign subsidiaries indicates that the U.S. is.far more compc#itive in international markets than the trade deficit suggests. Income from' foreign investments, moreover, contributes substantially to the current account balance.
The problems presented by the foreign tax credit could be solved if Congress were to renounce its claim on the foreign income of U.S taxpayers altogether. There is no justification for imposing U.S. tax on inc ome legititately earned in a foreign country true tax reform tax credit, as the House bill provides, on the other hand, would reduce foreign investment, increase the current account deficit, and unfairly penalize long-term investments and those in low-tax countries This would be Adoption of the per country limit on the foreign COST OF CAPITAL The cost of capital-capital being the plant, equipment structures, and financing needed to create goods and services--is a 12. Ibid, Appendix 13. Robert E. Lipsey and Irving B. Kravis The Competitive Position of U.S. Manufacturing Firms," Banca Nazionale del Lavoro Ouarterlv Review, June 1985, pp. 127-154, also published as National Bureau of Economic Research Working Paper 1557, February 1985 14. See J. D. Foster, The Taxation of Foreign Source Income: Tax Rerorm and Confusion Washington, D.C.: Institute for Research on the Economics of Taxation, Economic Report No. 36, 1985 7key element in international competitiveness is higher in the U.S. than in other countries, th e U.S. has a harder time competing in capital-intensive products. Capital also is critical to productivity growth their workers with newer, more efficient plant and equipment in the long run, will enjoy higher productivity and will be better able to compet e internationally As Table 2 indicates, there is a close relationship between capital investment and productivity growth If the cost of capital Nations that are able to provide Table 2 Comparison of Capital Formation in Six Countries, 1971-1980 percent Cou n try Japan France Germany Italy U.K U.S Source Gross Investment as Growth Rate of Output per Percent of GDP hour in Manufacturing 34.0 7.4 24.2 4.8 23.7 22.4 19.2 4.9 4.9 2.9 19.1 2.5 Organization for Economic Cooperation and Development Lagging U.S. capit a l formation and productivity were key reasons why, in 1981, Congress sharply cut the tax burden on fixed capital by allowing accelerated depreciation. By all accounts, this 1981 strategy worked. Investment spending during the current economic expansion ha s been signifigantly higher than the average for postwar recoveries and expansions I 15. See Michael J. Boskin Fixed Investment (Washington, D.C.: National Chamber Foundation, 1985); Stephen A. Meyer Tax Policy Effects on Investment: The 1981 and 1982 Tax Acts Federal Reserve Bank of Philadelphia Business Review, November/December 1984, pp. 3-14; Leonard Sahling and M.
A. Akhtar What Is Behind the Capital Spending Boom?" Federal Reserve Bank of New York Ouarterlv Review, Winter 1984-85, pp. 19-27; Allen Sin ai, Andrew Lin, and Russell Robins Taxes, Saving, and Investment: Some Empirical Evidence National Tax Journal 36, September 1983, pp. 321-345; Virgil Ketterling, "Capital Investment in the U.S.
Economy: Current Recovery Compared to Previous Recoveries in U.S. Industrial Outlook Washington, D.C.: U.S. Department of Commerce, 1985), pp. 17-28 aThe 1981 tax cut shortened depreciation schedules. Depreciation is the wearing out of plant and equipment. Firms are allowed to deduct from their gross income a perc e ntage of this depreciation annually to allow them to build a reserve for replacing their plant and equipment when it wears out the reserve accumulates. In theory, depreciation rates should correspond to the actual rate at which plant and equipment wear ou t.
Some critics argue that the 1981 depreciation schedules are shorter than real economic depreciation rates. Thus, it is said, firms have had their capital investment subsidized by the tax code The shorter the schedule, the faster It is true that some cap ital investment is subsidized, especially when depreciation allowances are combined with the investment tax credit ITC which gives firms a 10 percent credit against taxes owed for investments in machinery and equipment. But from the standpoint of internat ional competitiveness, what matters is that U.S depreciation rates must compete with thobe of other nations.
Depreciation schedules are an important factor used by multinational companies to calculate the after-tax rate of return on their potential investment. If the U.S. after-tax rate of return is lower than elsewhere, the U.S. risks losing that investment.
In a'recent survey, the international accounting firm of Arthur Andersen Co. found that the present value of U.S. depreciation rates is not particularly generous by world standards. Table 3 summarizes the Arthur Andersen study.
The present value rates mean that, adjusted for the interest and the inflation rates firms are able ultimately to deduct more or less than the full cost of a piece of equipment A theoretically ideal capital cost recovery system would allow firms to deduct exactly 100 percent of the present value of equipment; no more, no less. Yet,,as Table 3 indicates, only under the extremely optimistic assumption of zero inflation does the c u rrent depreciation system lead to a.U.S rate of at least 100 percent. Under both the Administration's depreciatiog proposals and the House bill, firms ultimately would deduct less than the full present value of their investment. This means they would have less capital to replace or modernize their aging plant-and equipment. This translates directly into lower productivity and fewer jobs Both Reagan and the House would eliminate the investment tax credit, first introduced in 1962 by John F. Kennedy, lengthe n depreciation rates, and cut corporate tax rates. These changes, it is claimed, will encourage firms to invest without regard to tax considerations. The different tax treatment of various forms of c I 9Table 3 Comparison by Country of Present Value of Cos t Recovery Allowances Country Ranking 0% Inflation 5% Inflation 8% Inflation Luxembourg 1 147 0 136.2 130.5 Spain 2 Belgium 3 124 2 116 2 111.1 105.8 104.6 100.3 Canada 4 104 8 96.3 91.8 u.s 5 105 3 92.9 86.6 France 6 92.8 85.1 81.1 81.2 I Hong Kong 7 Denm a rk 8 u.s 9 Sweden 10 Italy 11 U.K 12 Germany 13 92.5 85.0 87.7 84.0 81.9 87.1 83.4 81.4 75.6 90.5 80.7 90.1 79.8 79.4 74.6 89.1 74.7 72.3 i 88.8 77.7 u.s 14 Switzerland 15 South Korea 16 u.s 17 88.6 88.0 86.7 75.1 77.0 71.1 76.8 74.9 71.4 I 69.2 I 70.9 72 . 4 I Japan 18 82.3 69.0 62.8 Taiwan 19 82.3 69.0 62.8 Current Law Reagan Proposal (May 1985 Current law without Investment Tax Credit Treasury Propnsal (November 1984 Source: Tax Notes, June 24, 1985, p. 1508 10 I investment is thought.to induce considerab le distortion in inveskment decisions, costing the nation billions of dollars in-efficiency.
But while-evening-out tax rates on different forms of investment and between different industries is laudable, this should not be accomplished at the expense of an overall increase in taxation on capital. The U.S. already double-taxes saving and investment. This disincentive to invest would be made worse under both the House bill and the Reagan proposal.
The House tax bill eliminates the ITC and makes the depreciation schedules longer than the Reagan proposal. This boosts effective tax rates on capital sharply. Amherst College economist Yolanda Henderson has calculated effective tax rates based on the Hou se bill and finds that tax rates will rise steeply in almost every category summarizes her findings.
Table 4 Table 4 Corporate Sector Tax Rates in percentages Category Equipment Structures Public Utilities Inventories Land Current Law Reagan Proposal 18.3 37.9 24.5 36.3 29.5 29.7 41.6 38.8 49.9 41.9 Overall Corp. Rate 31.1 34.4 Source: Tax Notes, December 9, 1985, p. 1061 House Bill 41.2 40.9 43.5 39.8 43.0 41.5 16. For some recent estimates, see Charles L. Ballard, John B. Shoven, and John Whalley The Tot al Welfare Cost of the United States Tax System: A General Equilibrium Approach,"
National Tax Journal 38, June 1985, pp. 124-140; idem, "General Equilibrium Computations of the Marginal Welfare Costs of Taxes in the United States," American Economic Revie w 75, March 1985, pp. 128-138 11 The U.S. taxes capital more heavily than most industrialized countries, p7nd far more than Japan, its most successful competitor still further. Some economic forecasting firms are predicting a sharp slowdown in economic gr o wth and a rise in unemployment if the House bill passes. The culprit, warn these forecasters,will be the increased cost of capital It makes little sense to increase taxation on capital CAPITAL GAINS Many analysts have argued that the economic stagnation o f the 1970s was linked to the 1969 increase in capital gains taxes, since this tax hits most heavily the most dynamic, innovative sector of the economy. In 1978 Congress slashed the capital gains tax from a maximum of 49 percent to 28 percent. The result: a massive outpouring of venture capital, risk taking, and innovation that, among other things, sped the development of Silicon Valley and the computer revolutionia At the same time, revenues from the capital gains tax increased.
The reduction in the top ma rginal individual tax rate in 1981 from 70 percent to 50 percent brought the effective maximum tax rate on long-term capital gains down to 20 percent. The House tax bill would increase the maximum capital gains tax on individuals to 22 percent. The maximu m tax on corporate capital gains would jump from 28 percent to 36 percent that previous cuts in the capital gains tax had an enormously positive impact on the economy and on federal revenues. Curiously, defying the historical record, the House Wdys and Mea n s Committee asserts that a hike in the tax actually would increase revenue The House bill ignores all the evidence A rise in the capital gains tax would impair U.S competitiveness. The higher tax would hit high technology, the area 17. For a comparison of the U.S. and Japanese tax systems, see David Brazell, Aldona Robbins, Gary Robbins, and Paul Craig Roberts, The Cost of CorDorate Caoital in the United St ates and JaDan (Washington, D.C Institute for Political Economy, 1985); George Hatsopoulos, High Cos t of Cab ital: Handicao of American Tndustrv (Washington, D.C American Business Conference, 1983 and U.S. Congress, Joint Economic Committee JaDanese Tax Policv, 98th Congress, 2nd Session (Washington, D.C.: U.S. Government Printing Office, 1985 18. On the impact of the capital gains tax, see ReDort to Conpress on the Ca~ital Gains Tax Reductions of 1978 (Washington, D.C.: Department of the Treasury, Office of Tax Analysis, September 1985 12 - most stimulated by previous capital gains tax cuts and the area in which the U.S. is most competitive.
Congress should compare U.S. treatment of capital gains with that of this nation's toughest international, competitors. This would reveal that even the-current 20 percent capital gains tax'in the U.S is high by intern ational standards, as Table 5 illustrates Table 5 Comparison of Individual Taxation of Capital Gains on Portfolio Stock Investments, Industrialized and Pacific Basin Countries in percent Country Maximum Short-Term Rate Maximum Long-Term Rate U.S. 50 20 no n e Australia 61 none Belgium none Canada France Germany Italy Japan The Netherlands Sweden U.K Hong Kong Malaysia Taiwan Singapore 17 16 56 none none none 50 30 none none none none 17 16 none none none none 2 0 30 none none none none Source: Arthur Anderse n Co. and Securities Industry Association 13 CONCLUSION The House tax bill manifests a remarkable misunderstanding of the realities of international competition. It appears almost to be designed to penalize and reduce U.S. competitiveness. When the Senate s tarts taking its long, hard look at the House bill, it should take into account the measurels impact on international economic competitiveness. If the serious flaws of the House bill are not corrected, this tax "reformt1 could hamper seriously the U.S. ab ility to counter the brutal global economic competition that it faces 14 -