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11 Tax Reform: Prescriptions and Prospects THOMAS A. BARTHOLDl Joint Committee on Taxation, U.S. Congress The chapters by Glenn Hubbard and Peter Merrill very ably describe how fundamental tax reform might affect businesses that engage in cross-border sales, production, and research. My comments are confined to three areas. First, what does economic analysis tell us about the policy question of whether and to what extent the research and development expenditures of these businesses should be subsidized? Second, what is the tax treatment of R&D under current tax reform proposals? Third, what are the prospects for fundamental tax reform? There are two strands of academic research that investigate the research ac- tivities and investment decisions of multinational enterprises. The first strand comes from scholars in the field of industrial organization and is typified by the work of Caves (1982~. This strand analyzes the multinational firm as possessing substantial holdings of intangible capital, brand names, patents, know-how, and the like. The research emphasizes that to exploit its intangible capital more fully the firm may have to locate overseas as well as in the United States. Because physical capital is complementary to intangible capital, exploitation of intangible assets may motivate investment abroad by U.S.-based multinationals. Likewise, with a physical presence overseas, the multinational may find it profitable to develop additional intangible assets overseas by undertaking R&D. This strand of research generally ignores tax policy as a factor in the overseas location of intangible and physical capital. It emphasizes that there are economically valid reasons to invest abroad and to engage in R&D abroad. Peter Nugent's observa- tions about the market's dictating Merck's overseas presence is a concrete illus- tration of this strand of academic research. iThese comments are the author's alone and should not be construed to reflect the views of any member of the United States Congress or of the staff of the Joint Committee on Taxation. 143

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44 BORDERLINE CASE The second body of research comes from scholars in the field of public fi- nance. The work of Hines (1993) and his chapter in this volume typify this analysis of the research activities and investment decisions of multinational en- terprises. Here the emphasis is squarely on the extent to which taxes matter to the decision to invest abroad or undertake research abroad relative to undertaking the same activities in the United States. With apologies to Hines's more sophisti- cated econometrics, one can think of the empirical work of the public finance economists as estimating an equation of the following sort. R= or+ ~ (1 - t), (1) where R is research expenditures and (1 - t) is the classic public finance charac- terization of the "tax price" of an activity. Hines finds statistically significant and quantitatively large bs. That is, the tax price matters to the research decisions of multinational enterprises. Unfortunately, there has been no synthesis of these two strands of literature. The industrial organization economist pays scant attention to taxes as a factor in the multinational's decisions. Similarly, public finance economists pay scant attention to factors beyond taxes. In terms of equation (1), above, the work of industrial organization economists is about explaining the a term, whereas the work of public finance economists is about explaining the b term. Lack of a synthesis makes it difficult to answer the overriding policy ques- tion: Does society in general and do U.S.-based multinationals in particular un- dertake the "right" amount of R&D? Because of spillover effects (positive exter- nalities) from the creation of knowledge, a case can be made for subsidizing R&D and for worrying where the spillover occurs.2 However, economists have not identified what the "right" amount of R&D is. Equation (1) can help us think about this policy question. It says that some R&D activities are going to occur despite the use of policy tools; that is, some R&D activities are inframarginal. The a term can be thought of as the inframarginal component. Equation (1) also states that R&D responds at the margin to tax policy changes. If the inframar- ginal component is large, and large in comparison to the marginal component, there may be less concern about the effect of the tax price than if the inframar- ginal component is small. Without a synthesis of the academic research it is difficult to assess whether or to what extent R&D should be subsidized and the efficacy of tax policy as a tool to be used to increase social welfare. My second comment amplifies the contributions of Hubbard and Merrill with respect to how consumption-based tax reform proposals treat R&D expendi- tures and more generally all expenditures that create intangible assets com- pared to the treatment of these expenditures under the current income tax. The key point is that a consumption tax puts investment in physical capital on a par 2The literature does not adequately address a second policy question: If R&D is subsidized to account for the positive externalities of knowledge creation, does it matter whether the R&D occurs in the United States or abroad?

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TAX REFORM 145 with investment in intangible capital all such investments are expensed. Under the income tax system, investments in intangible capital generally are expensed whereas investments in physical capital generally are depreciated. In addition, certain R&D expenditures qualify for a further credit. Replacement of the in- come tax with a consumption tax is unquestionably good for investment in physi- cal capital. The effect on intangible capital is ambiguous. Investment in physi- cal capital is advantaged relative to investment in intangible capital. Because of complementanties between physical and intangible investment, if aggregate in- vestment increases, intangible capital may benefit. Also, as the Joint Committee on Taxation (JCT) staff described in a recent report (JCT, 1996), a consumption tax may encourage the location of intangible capital in the United States rather than abroad. The big policy question remains unanswered. Is the amount of R&D that would be undertaken under a consumption tax the socially optimal amount; that is, does it account for the positive externalities? Many people ask, "Is fundamental tax reform on the table?" I think it is fair to say that fundamental tax reform is not on the table, but perhaps it is in the kitchen. There is strong interest in fundamental reform in Congress. One need only examine the names of people associated with the topic to conclude that tax reform if not "on the table" is "in the kitchen": Bill Archer, Chairman of the House Ways and Means Committee; Dick Armey, Majonty Leader of the House of Representatives; Pete Domenici, Chairman of the Senate Budget Committee; and in the past Bill Roth, Chairman of the Finance Committee, have all expressed interest in fundamental reform. That said, in the short run, further piecemeal reform affecting the income taxation of U.S.-based multinationals is more likely. As an example, the last Congress passed a repeal of Internal Revenue Code section 956A. The President has proposed, and Congress recently enacted, reform of the foreign sales corpora- tion rules relating to software sales abroad. Two bills in the 104th Congress, S. 2086 introduced by then-Senator Larry Pressler and H.R. 1690 introduced by Representative Amo Houghton, included provisions for treating all operations in any European Union country as being from one country and eliminating overlap- ping taxation under rules relating to passive foreign investment companies and rules relating to controlled foreign corporations. This latter provision was in- cluded in the recently enacted Taxpayer Relief Act of 1997. I would expect interest in smaller-scale reform of this sort within the current income tax to con- tinue in the 105th Congress. REFERENCES Caves, Richard E. 1982. Multinational Enterprises and Economic Analysis. Cambridge, Mass.: Cam- bridge University Press. Hines, James R., Jr. 1993. "On the sensitivity of R&D to delicate tax changes: The behavior of U.S. multinationals in the 1980s." In Studies in International Taxation, A. Giovannini, R.G. Hubbard, and J.B. Slemrod, eds. Chicago, Ill.: University of Chicago Press. Joint Committee on Taxation. 1996. Impact on International Competitiveness of Replacing the Fed- eral Income Tax (JCS-5-96). Washington, D.C.

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