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10
Directions for International Tax Reform
GARY HUFBAUER
Institute for International Economics
This chapter examines the "here and now" of international taxation and pre-
scriptions for the international component of basic tax reform. Between "what
is" and what some experts believe "should be," we consider whether counter-
vailing forces will check the pattern in recent years of a stepwise evolution of the
international tax system.
"HERE AND NOW" OF INTERNATIONAL TAXATION
In the 1950s, 1960s, and even the 1970s, the United States entertained a
"grand vision" of the international tax system. This vision was built around sev-
eral foundation facts and assumptions (Hufbauer, 1992~:
Countries that were important players in the international economy generally op-
erated "classical" tax systems, consisting of separate corporate and individual
income taxes. It was thought that these systems could be satisfactorily meshed,
on a bilateral basis, through a series of tax treaties.
.
.
Sales, excise, value-added, and kindred consumption taxes were put in a
separate conceptual box. Their international aspects namely, the extent
that they could be adjusted at the border were addressed in the General
Agreement on Tariffs and Trade (GATT), which has now become the
World Trade Organization (WTO).
Most business and personal income was tightly "linked" to one nation or
another and not easily shifted as a way of avoiding taxes. Most interna
iThe views in this chapter are the opinions of the author and do not necessarily reflect the opinions
of the institute, its board of trustees, or its advisory board.
133
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34
BORDERLINE CASE
.
tional firms were structured in a hierarchical parent-subsidiary relation-
ship relationship, with capital flowing from the parent to the subsidiary
and income flowing in the other direction. Most individuals who earned
income abroad did so in the form of wages and salaries.
The network of purchases and sales of goods and services between related
corporate taxpayers was not dense. Most of these transactions could be
compared with similar transactions between unrelated parties to deter-
mine a fair "arm' s-length" price so that income and expense could not be
shifted between jurisdictions for the purpose of tax avoidance.
In this world, the key tasks of international tax officials, acting as revenue
collectors, were to determine the "source" of income and the "residence" of the
taxpayer. "Source rules" evolved naturally from the links between geography
and income. "Residence rules" were built on the place of business organization or
the place where the individual spent most of his working time.
Once source and residence rules were agreed between countries, it was a
matter of dickering to establish which country, the source country or the resi-
dence country, had the primary right to tax the income in question and which had
the secondary right. Most of the dickering was done in bilateral tax treaties. The
source country was generally assigned primary taxation rights to the particular
stream of income. This primary right was recognized by the residence country
when it exempted the income from its own tax net or when it allowed a credit
against its own taxes for foreign taxes paid on the income (the foreign tax credit).
Within the treaty framework, however, source countries usually agreed to cap
particular taxes (e.g., a 10 percent limit on withholding taxes imposed on royalty
income).
Up to this point, the conceptual framework had little economic rationale,
except to avoid "double taxation." Double taxation was regarded as a vice, based
on the argument that it would discourage international trade and investment.
The United States contributed two economic doctrines to the system. The
most important was "capital export neutrality." The principle, inconsistently ap-
plied, was that U.S. firms and residents should not have a tax incentive to operate
outside the United States. Latent tax inducements would be offset by the U.S.
system of taxing worldwide income; any U.S. firm or resident would eventually
pay the same overall rate of tax, no matter where in the world it operated. This
would be achieved by taxing the worldwide income of U.S. firms and residents
and allowing a credit for foreign taxes imposed on foreign-source income. As the
principal home country for multinational corporations and a country with rela-
tively high corporate tax rates in the 1950s and 1960s, the United States provided
an "umbrella" that invited other countries to raise their corporate rates to the U.S.
level.
The second economic doctrine was that foreign countries should not practice
tax discrimination against U.S. firms. Taken together, nondistortion and nondis
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DIRECTIONS FOR INTERNATIONAL TAX REFORM
135
crimination constituted the original "level playing field": U.S. firms should, in
the long run, not pay less tax when operating abroad than when operating at home
and foreign governments should not tax U.S. firms more heavily than they taxed
their own or third-country firms. Like all level playing field concepts, this was
laden with inconsistencies that became more apparent over time.
By the 1980s, many events had converged to erode these foundation facts
and assumptions about the workings of the international economy and the proper
role of the international tax system. For one thing, many industrial countries
abandoned their "classical" systems of income taxation for "integrated" systems
that gave recognition at the personal level for taxes paid at the corporate level.
The proper way to "mesh" classical and integrated systems across international
boundaries is not at all obvious.
Second, many industrial countries placed more emphasis on the role of sales,
excise, value-added, and other consumption taxes in their fiscal structures. These
taxes have important consequences that are unevenly addressed by the rules of
GATT and the WTO (Hufbauer, 1996~. Moreover, the doctrine of capital export
neutrality cannot be implemented satisfactorily without taking these other taxes
and production subsidies into account.
New forms of international income and expense exploded-technology in-
come of various types from movie royalties to patent licensing fees; plain vanilla-
and-chocolate sundae portfolio income (interest and dividends and gains and
losses from dealing in foreign exchange and derivatives); electronic commerce
(both telecommunications transmission services and various sorts of remote
value-added services); business, artistic, and professional services (Bechtel to
Michael Jackson to Arthur Andersen); and huge intracorporate sales of goods and
services. Source and residence rules are not obvious for many of these new forms
of income and types of expenses. In many cases, comparable transactions be-
tween unrelated taxpayers do not exist or are highly idiosyncratic, so there are
few ready benchmarks for applying the arm' s-length pricing standard.
The combination of global integration, new forms of income and expense,
and increasing sophistication among corporate taxpayers loosened the old links
between geography and income. Increasingly, firms learned to "game" the tax
systems of the world, not only to alter source and residence on paper but also to
change the location of plants, R&D facilities, and headquarters operations.
Between the 1960s and 1980s, the United States relative to other industrial
nations exchanged its position as the country with high personal and corporate
marginal tax rates for a new position as a low income tax country. Since the mid-
1980s, however, the United States has once again drifted up into the high corpo-
rate tax ranks, as established industrial countries and emerging industrial powers
have cut their own corporate rates. At the same time, multinational corporations
based in Europe, Asia, and Latin America have come to play a much larger role in
the world economy. These developments meant that U.S. leverage as a discipli-
narian of tax distortions and tax discrimination diminished and Treasury Depart
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BORDERLINE CASE
ment revenues from U.S. firms' operations abroad shrank relative to revenues
from foreign firms doing business in the United States.
What has been the U.S. response to the altered landscape of the global
economy? Senator Russell Long (D-LA) said it all in his famous aphorism,
"Don't tax you, don't tax me, tax the fellow behind the tree!" U.S. and foreign
multinationals are the quintessential "fellow behind the tree" big, rich, and cava-
lier in the eyes of tax populists.
The Tax Reform Act of 1986 marked the turning point. The conceptual
foundations of U.S. international tax policy, already eroded by global forces,
were all but ignored in the search for revenue. In this search, the guiding light
had been created years earlier by Stanley S. Surrey, a distinguished professor at
the Harvard Law School and Assistant Secretary for Tax Policy during the
Kennedy and Johnson administrations. Surrey's searchlight was his list of "tax
expenditures," a schedule of revenue lost by departures from an "ideal" tax sys-
tem. Surrey's ideal basically amounted to a flat-rate, broad-base, classical tax
system.
This ideal is too simplistic for the realities of international taxation. It ig-
nores the fact that whereas the U.S. Congress can, if it wishes, establish uniform
taxation across all states and sectors of the U.S. economy, it has no such power
for the rest of the world. In a global economy where the United States is one
among several important players, the realities of competition must be taken into
account. The tax expenditure concept ignores this fundamental fact.
Despite this basic flaw, Surrey's ideal tax system has long been used to gen-
erate the Treasury Department's tax expenditure estimates. These numbers were
picked up by congressional tax staff, were suitably polished, and became objects
of desire in the 1986 tax reform debate. Basically, revenue goals were pushed
wherever there was a soft spot in the collective armory of multinational firms,
and wherever foreign retaliation would not be too severe. The result is a great
deal more complexity and somewhat more revenue (Hufbauer, 1992~.
Much the same process has continued to dominate international tax legisla-
tion since the Tax Reform Act of 1986. Indeed, as McClure and Ossi (1997)
point out, despite widespread recognition that U.S. taxation of international in-
come has become mindlessly complex, and despite many proposals for simplify-
ing the system and giving it direction, only one small reform has been enacted
since 1986 the repeal of Internal Revenue Code section 956A.
The year 1997 saw a modest revival of tax populism of the 1986 vintage.
The difference between 1997 and 1986 is that the term "tax expenditures" is too
dry and technical for present needs; it has been replaced by the more emotive
term "corporate welfare." Missing from both the 1986 drive to reduce tax expen-
ditures and the current drive to curtail corporate welfare is any coherent articula-
tion of the purposes of the tax system in shaping the U.S. role in the international
economy.
Instead, the tax writers simply turn to the tax expenditures schedule and
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DIRECTIONS FOR INTERNATIONAL TAX REFORM
TABLE 10.1 Office of Management and Budget 1996 Estimates of Potential
Revenue from Eliminating Selected Tax Expenditures (billions of dollars)
137
1 997 1 997-2001
Exclusion of income of foreign sales corporations
Inventory property sales source rule expections (the export source rule)
Interest allocation rules exception for certain financial operations
Deferral of income from controlled foreign corporations
1.6
1.5
0.1
2.0
9.0
8.5
0.4
12.1
search for opportunities to raise revenue. What was on the list? The fiscal year
1997 budget listed the corporate tax expenditure items shown in Table 10.1, with
figures for both 1997 and the five years 1997-2001.
In 1997, there was an assault on the export source rule and modest attempts
to curb deferral. Some members of Congress pushed to replace the arm' s-length
pricing standard by a formula approach. None of these proposed changes made
any headway. Abroad, some countries would like to tax payments for electronic
commerce (e.g., payments for seismic analysis done in the United States for drill-
ing operations conducted in the South China Sea). However, new "source" taxes
on electronic commerce were strongly resisted by the U.S. Department of the
Treasury (1996~.
COUNTERVAILING FORCES
What countervailing forces could alter the evolution of the international tax
system, which is now decisively shaped by revenue considerations? In my judg-
ment, four forces are working in a more positive direction. To a certain extent,
they were evident in the 1997 debate.
First, many countries have come to see multinational corporations as an ally,
not an enemy. The degree of affection differs from country to country and sector
to sector. In situations where local, especially state-owned, enterprises have a
major presence and in situations such as natural resources and basic telecommu-
nications where economic rents are abundant, the welcome mat may not be fully
extended. However, over the past 20 years, more countries have come to see the
advantages of an active presence of foreign corporations in more sectors of the
domestic economy (Graham, 1996a). This trend is almost sure to continue. As it
proceeds, more countries will adapt their tax systems to attract firms, especially
high-technology firms, corporate headquarters, and R&D facilities.
Among countries of the Organization for Economic Cooperation and Devel-
opment (OECD), for example, Spain, Canada, and Australia have the most attrac-
tive R&D packages for large firms, whereas Germany, Italy, and New Zealand
have the least generous packages (OECD, 1996~. In the next decade, countries
such as Brazil, Argentina, Chile, Singapore, China, and India are likely to be
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come important competitors for high-tech firms and R&D facilities. Currently,
the United States is "king of the mountain" among industrial countries in terms of
R&D effort, corporate vitality, and economic growth. To keep this position, the
United States will have to adapt its tax system to remain at least as hospitable as
its major competitors.
The second countervailing force is growing recognition of the economic gains
associated with larger exports of goods and services. Export growth has contrib-
uted about 28 percent of real U.S. gross domestic product (GDP) expansion in the
past four years, even though exports in 1992 accounted for only 10 percent of the
U.S. economy. More important, studies by Richardson and Rindal (1996) and the
U.S. Department of Commerce (1996) demonstrate that export jobs pay a wage
and salary premium of about 15 percent more than comparable jobs in other sec-
tors of the economy. These facts, energetically advertised by the Clinton admin-
istration (Magaziner, 1996), are gaining acceptance among the American public.
Within a few years, tax measures that harm U.S. export capabilities may be re-
garded with the same disapproval that would be visited on tax measures that
discourage education or R&D.
The third countervailing force is the demonstrably strong connection, at least
for the United States, between foreign direct investment (FDI) and U.S. exports.
Research to which I contributed a few years ago shows that U.S. exports to a
given country rise by about 2.5 percent for every 10 percent increase in U.S.
direct investment in that country (Hufbauer et al., 1994~. Graham (1996b) also
finds a strong positive correlation between U.S. foreign direct investment and
U.S. exports after allowing for the normal "gravity model" variables income
per capita, population, and distance.
Increasingly, foreign direct investment is an essential component of corpo-
rate export efforts. This is especially true for high-technology customized goods
and services that require hands-on interaction between seller and buyer and ex-
tensive after-sale maintenance. One reason the United States exports so little to
Japan, Korea, and China is that local policies in these countries have long kept
U.S. multinationals at bay. These policies are being transformed for reasons
already discussed. To expand its export position in Asia and elsewhere, the United
States will have to do its part by maintaining a competitive tax climate for U.S.
firms that invest abroad.
The fourth countervailing force is the responsiveness of production location
decisions to corporate tax rates, documented in a recent report for the Export
Source Coalition (Hufbauer and DeRosa, 1997~. Although "older" studies (dat-
ing from 1981) surveyed by Hines (1996a) cannot be summarized by a single
number, a rough characterization of their results is that a 1 percentage point in-
crease in the effective business tax rate induces a 1 percent decrease in the stock
of plant and equipment in other words an elasticity coefficient of 1.0.
However, recent scholarship has detected significantly larger effects. Grubert
and Multi (1996) estimated an elasticity coefficient of 3.0 for U.S. foreign direct
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DIRECTIONS FOR INTERNATIONAL TAX REFORM
139
investment placed in various locations. In another paper, Hines (1996b) esti-
mated that a 1 percentage point increase in a state's corporate tax rate (e.g., from
6 to 7 percent) would reduce inward foreign investment in the state by about 10
percent. Finally, in a paper studying the effect of taxation and corruption on
direct investment flows from 14 "home" countries to 34 "host" countries, Wei
(1997) estimated an elasticity coefficient of 5.0 for the impact of the host country's
tax rate.
Recent scholarship uses more sophisticated econometric techniques than the
earlier work surveyed by Hines, but there is more to the story than an improved
ability to detect production response rates. With the integration of the world
economy and the sharp decline of major political risks communism, socialism,
expropriation, and protectionism firms have in all liklihood become more re-
sponsive to differental tax rates. The consequences of high response rates can be
dramatic. Hufbauer and DeRosa (1997) calculate, for example, that repealing the
export source rule, a leading target on the administration's 1997 tax agenda, could
ultimately reduce U.S. exports by about $33.5 billion (in the year 2000) as firms
relocate production abroad and knock about $1.9 billion off the wage and salary
premiums associated with high-paying export jobs for a revenue gain of only
$1.6 billion. Similar adverse consequences might result from eliminating the
foreign sales corporation or repealing the deferral provisions of U.S. tax law.
To summarize, it seems likely that a chain of competitive consequences-
running from friendly tax climates abroad, to wage and salary premiums in U.S.
export industries, to the link between U.S. foreign direct investment and U.S.
exports, to the production response of export activities to tax differentials are
beginning to shift the current focus on revenue collection as the touchstone of
U.S. tax policy, making a sensible international component of basic tax reform
easier to implement.
INTERNATIONAL COMPONENT OF BASIC TAX REFORM
The fundamental goals of basic tax reform, along the lines of the flat tax or
the Nunn-Domenici USA (unlimited savings allowance) tax, are to promote sav-
ings and investment and to simplify the tax system. There is little reason to
endorse the upheaval and agony of basic tax reform unless you believe three
things: (1) savings and investment will rise significantly in response to a con-
sumption-oriented tax system (Hubbard and Skinner 1996~; (2) higher savings
and investment will augment the long-term rate of U.S. GDP growth from, say,
2.5 to 3.5 percent; and (3) tax simplification is very desirable, even if some people
pay more taxes. In the overall scheme of things, the international aspects of basic
tax reform are secondary to these fundamental goals.
That said, the international consequences would be significant. The design
of basic tax reform proposals is essentially "territorial." Corporate income earned
within the United States would be subject to U.S. tax; corporate income earned
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BORDERLINE CASE
abroad would not. This basic change would ensure that U.S. firms operating
abroad could compete on the same tax terms as foreign firms. On balance, this
feature would not cost revenue because foreign subsidiaries operating in the
United States could no longer deduct interest payments to their overseas parent
corporations. The additional revenue collected on the U.S. operations of foreign
subsidiaries would make up for any tax revenue lost on the overseas operations of
U.S. subsidiaries.
Once the territorial aspect of the reformed tax system is understood and ac-
cepted, it leaves an important international question: What is the proper tax treat-
ment of exports and imports of goods and services? I have analyzed the eco-
nomic and legal aspects of this question elsewhere (Hufbauer, 1996~. Here, I
sketch the central issues that are likely to arise when the debate is joined. For
brevity, they are stated as political and economic propositions.
The first political proposition is that imported goods and services should be
taxed the same as domestically produced goods and services. This will guard
against an apparent tax incentive to produce abroad and sell the goods and ser-
vices back into the U.S. market. Exceptions to symmetrical tax treatment be-
tween imports and domestic production should be negotiated country by country
or with regional groups such as the European Union on a reciprocal basis.
The second political proposition is that business profits earned on U.S. ex-
port sales should be treated the same as business profits earned on production
abroad. In other words, these profits should be excluded from the U.S. tax net.
Otherwise there will be an apparent incentive to locate abroad rather than pro-
duce in the United States for the export market.
In addition to these political propositions about basic tax reform, some less
evident economic proportions should be taken into account. There are two basic
principles for making adjustments at the border for domestic taxation-the destina-
tion principle and the origin principle. Under the destination principle, domestic
taxes are imposed on imports of goods and services but not on exports. Under the
origin principle, the reverse happens: domestic taxes are not imposed on imports,
but they are on exports.
In theory, exchange rate changes can offset border tax adjustments, both in
terms of the overall U.S. trade balance position and in terms of the relative attrac-
tiveness of the United States as a place to invest. However, the impact of ex-
change rate changes will almost certainly differ, sector by sector, from the impact
of border tax adjustments. Moreover, not one person in 10 understands the mac-
roeconomic equivalence between exchange rate changes and border tax adjust-
ments. These are two powerful reasons for endorsing the destination principle.
The impact of basic tax reform on the domestic savings-investment balance
will be the primary determinant of the trade balance consequences of tax reform.
The presence or absence of border tax adjustments and changes in the U.S. sys-
tem of taxing foreign income are secondary considerations. If basic tax reform
increases U.S. savings more than it increases U.S. investment, the U.S. trade
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DIRECTIONS FOR INTERNATIONAL TAX REFORM
141
balance will "improve." If tax reform increases U.S. investment more than sav-
ings, the trade balance will "worsen." That said, the success of basic tax reform
will be judged far more by its investment consequences than by its trade balance
consequences. The destination principle is more friendly to investment than the
origin principle since it automatically creates tax parity between domestic pro-
duction both in competition with imports and in export markets. Destination
principle adjustments require more administrative machinery, however, and cre-
ate a new form of tax on international transactions. This is particularly trouble-
some for rapidly growing electronic commerce. Destination principle adjust-
ments would require, for example, U.S. taxation of data analysis in Singapore
performed for a U.S. bank or payments by U.S. firms to France Telecom for the
transmission of voice, data, or video signals.
From these political and economic considerations, I draw a few major con-
clusions about the international aspects of basic tax reform. First, destination
principle border adjustments should be part of basic tax reform legislation. The
President should be authorized, however, to negotiate origin principle taxation on
a reciprocal basis, sector by sector, country by country. A system of origin prin-
ciple taxation might be negotiated with Canada and Mexico, and globally for
electronic commerce, before European and other countries attach value-added
taxes to electronic purchases.
Presumably, origin principle taxation would be negotiated only with coun-
tries and in sectors that implement business tax systems similar to the reformed
U.S. system. Origin principle taxation would apply equally to value-added, sales
and corporate income taxes; otherwise, U.S. firms would still be paying value
added taxes on their exports to Europe and elsewhere. Also, the origin principle
would be negotiated only in contexts where the United States is reasonably as-
sured that it would not lead to tax avoidance, for example, transshipment of French
goods through Canada and then to the United States to avoid U.S. border tax
adjustments on direct imports from France. The similarity of tax systems, com-
prehensive character of the origin principle where negotiated, and the antiabuse
provisions would guard against tax incentives for production relocation.
Under the origin principle, the United States would not collect revenue on
imports of goods and services but would collect revenue on exports of goods and
services. Because bilateral trade would seldom be balanced, one country or the
other would collect more revenue from application of the origin principle rather
than the destination principle. In some contexts, supplementary provisions might
be negotiated between the partners to achieve some degree of revenue equaliza-
tion. As a normal matter, however, adoption of the origin principle would amount
to acceptance of the implied division of revenue.
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Graham, E.M. 1996b. "The relationships between trade and foreign direct investment in the manufac-
turing sector: Empirical results for the United States and Japan." In Does Ownership Matter:
Japanese Multinationals in East Asia, D. Encarnation, ed. London: Oxford University Press.
Grubert, H., and J. Multi. 1996. "Do taxes influence where U.S. corporations invest?" Paper pre-
pared for the Conference on Trans-Atlantic Public Economics Seminar, Amsterdam, May 29-31
(revised August 1996; available from Grubert at the U.S Treasury Department).
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5589. National Bureau of Economic Research, Cambridge, Mass., May.
Hines, J.R. 1996b. "Altered states: Taxes and the location of foreign direct investment in America."
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Hubbard, R.G., and J.S. Skinner. 1996. "Assessing the effectiveness of savings incentives." Journal
of Economic Perspectives 10(4).
Hufbauer, G.C., assisted by J. van Rooij. 1992. U.S. Taxation of International Income, Washington
D.C.: Institute for International Economics.
Hufbauer, G.C., assisted by C. Gabyzon. 1996. Fundamental Tax Reform and Border Tax Adjust-
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Hufbauer, G.C. and D.A. DeRosa. 1997. "Costs and Benefits of the Export Source Rule." Tax Notes
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Hufbauer, G.C., D. Lakdawalla, and A. Malani. 1994. "Determinants of direct foreign investment and
its connection to trade." UNCTAD Review.
Magaziner, I. 1996. "An interview with Ira Magaziner." The International Economy X(6).
McClure, W.P., and G.J. Ossi. 1997. "Legislative proposals to reform and simplify the U.S. taxation
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and Innovation. Directorate for Science, Technology and Industry. Paris: OECD.
Richardson, J.D., and K. Rindal. 1996. Why Exports Matter: More! Washington, D.C.: Institute for
International Economics and the Manufacturing Institute.
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Wei, S. 1997. How Taxing Is Corruption on International Behavior? Kennedy School of Govern-
ment. Cambridge Mass.: Harvard University
Representative terms from entire chapter:
basic tax
