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Introduction JAMES POTERBA Massachusetts Institute of Technology The global business environment is changing. Even as recently as 10 years ago, international joint ventures were relatively uncommon, and large U.S.-based multinational corporations could be considered "American firms." Yet the grow- ing integration of world markets for capital and many products, coupled with the rise of electronic communication media such as e-mail and video teleconferenc- ing, has made it more difficult to assign corporations to particular countries. The emergence of "virtual corporations," which raise capital in one country, carry out research in another, manufacture in a third, and finally sell their products in a fourth country, is an important reality of the 1990s. Large U.S.-based "virtual firms" in many industries now compete with similar virtual firms based in other nations. The identification of firms as "American," "Dutch," or "Japanese" may now reflect little more than an accident of birth. Current indications suggest that the trend toward global firms will continue and, if anything, accelerate in the future. One of the few features of the business environment that does depend on where a firm is nominally headquartered is its tax treatment. The U.S. corpora- tion income tax is a "residence-based" tax, which means that U.S. firms are taxed on their worldwide income. Since U.S.-based firms often pay taxes to foreign governments on profits earned abroad, the U.S. tax code includes a foreign tax credit provision that allows U.S.-based firms to reduce their U.S. tax liability by the amount of foreign tax payments, subject to a variety of limitations. Firms that are constrained by these limits and pay more foreign taxes than they can credit against U.S. tax liability become excess foreign tax credit firms, a condition that can affect their incentives for domestic as well as foreign investment and R&D expenditure. A further complication arises because U.S.-based firms are taxed on 1
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2 BORDERLINE CASE the earnings of their foreign subsidiaries only when these earnings are repatriated to the U.S. parent firm. U.S. taxes can therefore be deferred when profits are earned in a low-tax foreign country, retained within the subsidiary, and rein- vested. The core of the tax code as it relates to international operations of U.S.-based firms is a set of provisions that defines taxable income and the tax burdens on domestic and foreign business. Two principal sets of rules concern the deferral of tax on income earned abroad and the allocation of joint costs, such as headquar- ters staff or R&D expenses, across operations in different countries. The first set of provisions, known as "anti-deferral rules," arises because the U.S. tax system does not generally tax multinational firms on their income from foreign opera- tions until the earnings from these operations are repatriated to the United States. By retaining earnings in a foreign subsidiary, a U.S.-based firm can therefore defer U.S. tax on these earnings. A variety of tax rules, many of which have been enacted in the last decade, limit the extent of income tax deferral on foreign earnings. These rules require U.S.-based firms to include part of their foreign profits in their current taxable income and consequently can raise the effective tax bud en on foreign operations. These rules can, in some cases, also raise the effective tax burdens on the domestic source income of foreign members of U.S.- based multinationals. The anti-deferral rules in the United States stand in marked contrast to the tax rules in many other developed nations, a number of which do not tax the foreign-source earnings of their domestic multinationals at all. The second set of core international tax provisions, known as "allocation rules," governs the extent to which U.S. group expenses are allocated to and deducted against reported foreign-source taxable earnings. These rules are par- ticularly important with respect to R&D outlays and other spending on intangible assets, because they reduce the foreign tax credits that may be claimed as an offset against the U.S. taxes imposed on reported taxable income of U.S.-based multinationals. The R&D allocation rules generally increase the after-tax cost of carrying out research and development in the United States, and they can place U.S.-based firms at a disadvantage relative to firms based in other nations. Anti- deferral rules and allocation provisions substantially complicate administration of the U.S. corporate income tax and can also affect the incentives for plant, equipment, and R&D investment by U.S.-based multinational firms. The complexity of various international tax rules and the relatively small number of firms affected by them have limited the attention that they have re- ceived in discussions of national policy toward science, technology, and capital formation. To remedy this situation, the National Research Council's Board on Science, Technology, and Economic Policy (STEP) organized a conference to consider the impact of these provisions. The meeting, held at the National Acad- emy of Sciences in Washington on February 14, 1997, brought together industry experts from large multinational firms, academic researchers who have explored the quantitative impact of tax provisions on corporate R&D spending, and tax
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INTRODUCTION 3 policy experts able to place the international tax rules in a broader context of options for tax reform. This volume, containing the papers and prepared com- ments presented at the conference, provides background material on the structure of international tax rules and the provisions of the tax code affecting corporate R&D performed in the United States, as well as downstream investment in plant and equipment. My attempt in this introduction to summarize the papers and discussion does not purport to represent the views of the STEP Board or the consensus conclu- sions and recommendations of the National Research Council. Rather, this mate- rial will be one of several elements to be considered by the STEP Board early next year in its formal report of a study of the changes in industrial R&D and innovation and their bearing on industries' performance. That study and these conference proceedings have been supported by the National Aeronautics and Space Administration and the National Science Foundation. Taken together, the presentations to the conference suggest that these tax rules significantly affect the business environment for R&D spending and invest- ment in physical capital, and they raise a number of issues that warrant further attention from tax policymakers. International tax rules primarily affect firms that carry out business in several nations. Although such firms represent a minor- ity of corporations, they account for more than three-quarters of corporate R&D spending in the United States. Changes in these tax provisions therefore have the potential to exert first-order influence on the level, location, and composition of research and development spending. Industry experts from large, it&D-intensive, multinational firms argued that international tax rules can and do affect the effective tax burden on research and innovation expenditure and on the follow-on physical investment that embodies the outcomes of this R&D. They affect the incentives for firms to carry out research and to invest in physical capital in other nations, because foreign opera- tions can have immediate consequences for the firm's corporation tax liability in the United States. International tax rules can also affect the tax burdens that multinational firms face on purely domestic projects. For some firms, these rules raise the cost of carrying out research and development projects in the United States. The effects of international tax rules on aggregate R&D spending in the United States are difficult to quantify. Industry experts acknowledge that the location of many corporate R&D facilities is driven by the availability of skilled researchers rather than tax policy considerations. They also indicate, however, that when other factors are equal, tax disparities can affect the size and location of R&D facilities. In analyzing tax incentives for plant and equipment investment or R&D out- lays, it is important to consider the tax burdens on U.S.-based firms relative to those of their competitors. Where multinational firms based in other nations face lower tax burdens on operations in the United States or elsewhere, U.S.-based firms may choose not to invest in projects that other multinationals find attractive
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4 BORDERLINE CASE to undertake. In some cases this occurs because the international tax provisions of the U.S. tax code raise the effective tax rates on U.S.-based firms. The precise effect of international tax rules on the incentives facing a firm depends on the nature of the corporation's multinational operations, the particular countries in which the firm has operations, and a range of other firm-specific characteristics. Several conference participants observed that it is essential to rec- ognize firm heterogeneity with respect to these rules. Changes in the tax rules that reduce the cost of R&D projects for some firms may increase the cost of similar projects for others. The discussion of how international tax rules affect individual firm decision making provides an important warrant for studying these public policy questions, but it does not lead naturally to quantitative evidence on how these tax rules and other tax incentives affect total private R&D outlays and private investment spending. To address these issues, the STEP Board commissioned summary pa- pers from several leading academic researchers who have studied the influence of taxation on corporate R&D and plant and equipment investment. Although inter- national tax rules were largely ignored in academic discussions of tax policy until the early 1980s, in the last decade and a half there has been a substantial volume of research on these issues, and this work provides further evidence of the impor- tance of these rules in affecting firm behavior. The existing scholarly literature makes two important observations about the impact of international tax provisions. First, because the location of some R&D facilities and some types of manufacturing facilities may be largely independent of other business considerations, such decisions can be very sensitive to tax rate differences or other factors that create cost differentials between different loca- tions. An example of such facilities might be late-stage pharmaceutical manufac- turing plants, which do not depend on access to a highly skilled work force. Firms considering the construction of such facilities are likely to be very attuned to the impact of taxation on the net cost of operations. For footloose facilities, one would expect a priori to find a high "supply elasticity" with respect to tax incentives, and there is a presumption that tax differentials either between firms or across countries would have notable consequences for the location of such activities. Second, the empirical literature on international tax rules and the level and location of business activity yields substantial evidence that tax rules have impor- tant effects. Expenditures on R&D by multinational firms respond to tax rate differentials, with many estimates suggesting that a 1 percentage point increase in the cost of an R&D project reduces expenditures on that type of project by more than 1 percent. The question of whether private R&D spending is highly sensi- tive to its after-tax cost is an important consideration with regard to the desirabil- ity of special tax subsidies. If the percentage increase in R&D spending exceeds the percentage reduction in the cost per unit of R&D, then a tax credit that costs $100 million will increase private R&D spending by more than this amount. Empirical evidence on tax incentives and R&D suggests that the variation in the
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INTRODUCTION s cost of R&D induced by international tax rules could have important effects on the aggregate volume of R&D spending. This evidence also suggests that well- designed R&D tax incentives, which reduce the effective cost of carrying out corporate R&D, have substantial power to increase private R&D outlays. Evidence on whether and how international tax rules affect the pattern of foreign direct investment (FDI) and the location of manufacturing facilities is less robust than is the evidence with regard to R&D. This may reflect the fact that much FDI is motivated by strategic business considerations that override tax- related international differences in R&D costs. One striking piece of evidence on how taxation affects business location comes from the location decisions of in- bound FDI, that is, investment in U.S. facilities by foreign multinationals. The pattern of state-level corporate income taxes in the United States appears to affect the location patterns of such inbound FDI. Given the small differentials among these tax rates, it seems likely that the larger cross-national variations in corpo- rate income tax also affect investment location decisions. Another important finding that confirms the impact of international tax rules on firm behavior con- cerns interest allocation rules. Firms that face higher after-tax costs of borrowing in the United States borrow less and are more likely to configure their financial structure in alternative ways that preserve interest-tax deductions An important open issue with respect to tax rates, R&D outlays, and physical investment concerns the degree to which changes in the location of R&D facili- ties affect the location of follow-on manufacturing facilities. There appears to be substantial variation across industries, and even across manufacturing processes, in the links among basic research, development, and subsequent manufacturing operations. Although one industry expert cited an example of a pharmaceutical firm whose manufacturing plant location was determined largely by the previous location of R&D facilities, other types of manufacturing processes appear to be more easily separated from earlier development facilities. It is difficult to discuss detailed tax provisions, such as those in the interna- tional tax arena without discussing potential tax reform. Tax reform raises two distinct issues. The first concerns the impact of fundamental tax reform for example replacing U.S. corporate and personal income taxes with a value-added tax on the incentives for R&D and plant and equipment investment by U.S.-based multinational firms. The second concerns potential changes in the current in- come tax code, short of replacing the corporate income tax, that might stimulate R&D spending and capital formation generally. Fundamental tax reform would have many different effects on the tax treat- ment of physical and technological investment by U.S.-based firms. Such reform would remove some tax provisions that currently favor R&D spending relative to other types of investment, notably the immediate expensing of R&D and the in- cremental research and experimentation tax credit. Fundamental tax reform would also affect the tax treatment of royalty income received by U.S. multina- tionals that license technology abroad and would eliminate the R&D expense
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6 BORDERLINE CASE allocation rules that are necessitated by the current income tax. The net effect of these multiple reforms is highly dependent on firm circumstances. At least for some firms that are currently able to take full advantage of tax incentives for R&D activity, fundamental tax reform could reduce the attractiveness of R&D spending. Effects on physical investment incentives are also complicated, but because most plant and equipment investment is not eligible for expensing at the present time, moving toward a consumption tax would be more likely to increase investment incentives. The chances of fundamental tax reform are always quite low, and most dis- cussions of tax reform therefore focus on incremental changes that might be made in the federal corporation income tax. Several reform proposals were outlined and evaluated at the meeting. Industry participants emphasized the need for more stability in the tax code. A very common complaint about the latest incremental research and experimentation credit, which expired on May 31,1997, but has been extended retroactively, is that its short-term character reduces its impact on R&D spending. R&D programs, particularly those that focus on basic research, inherently represent long-term commitments of corporate resources. Executives considering such expenditure programs are understandably reluctant to increase R&D budgets in response to a credit that has a legislated life far shorter than their R&D program and could fail to be extended. Stable, long-term rules for the tax treatment of R&D expenditures thus command widespread support in the busi- ness community as a policy reform that would encourage corporate spending on research and development. A second incremental tax reform proposal concerns the statutory corporation tax rate in the United States. A number of tax practitioners at the conference suggested that the current statutory rate of 35 percent is high relative to rates in other major industrial countries and that this tax rate places U.S.-based firms at a competitive disadvantage relative to other global firms. Recent history may be helpful in evaluating this claim. When the Tax Reform Act of 1986 was adopted, the federal statutory corporate income tax rate fell from 46 to 34 percent. This reduction transformed the United States into a relatively "low-tax" developed country and made it attractive for many firms to report earned income in the United States rather than other, higher-taxed jurisdictions. In the decade since the watershed tax reform of 1986, however, other developed nations have modi- fied their tax codes, and as a result, U.S.-based firms no longer enjoy a statutory tax rate well below that of other countries. The statutory tax rate in the United States also depends on the combined federal and state income tax rates. Firms based in most other nations face only a single, national level of taxation. One of the crucial lessons from the economic theory of investment behavior is that the statutory corporate tax rate is not a sufficient measure of the tax burden facing corporate outlays on plant, equipment, or R&D. Rather, the effective tax burden depends on the statutory tax rate as well as the provisions for depreciating physical capital goods, the tax treatment of interest and dividend payments, and a
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INTRODUCTION 7 host of more specialized provisions such as the corporate alternative minimum tax and the treatment of foreign-source income. Although comparisons of statu- tory corporate tax rates in different nations are simple, they provide an imperfect measure of the tax burdens on both tangible and intangible investments across countries. Nevertheless, the shifting pattern of relative statutory tax rates in the United States and other nations during the last decade warrants attention from policymakers. A third set of proposed tax changes involves incremental reforms to the for- eign-source income rules in the current corporation income tax. There is general agreement that the current system of tax rules in the United States is more com- plex than that in most other nations. The compliance costs of these rules are substantial. The current tax code provisions that discourage the development of joint ventures between U.S.-based firms and foreign partners and the many anti- deferral provisions that raise the tax burdens on U.S. firms relative to foreign firms undertaking the same projects are considered prime candidates for reform. The corporate tax experts and tax policy scholars who participated in the STEP conference generally agreed on the importance of international tax policy as a factor in corporate decisions with respect to basic research outlays, expendi- tures on product and process development, and the level of plant and equipment investment. Although the international tax rules are intricate and are not easily explained to those who are not familiar with both the current dynamics of interna- tional business and the details of the tax code, they can substantially affect the after-tax return on various investments. These tax rules represent an important part of the tax and regulatory environment in which firms make decisions about the level and composition of R&D spending programs, and they warrant close scrutiny by all policymakers concerned with the level of private-sector spending on technology and capital formation.
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Representative terms from entire chapter: