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OCR for page 85
8
International Tax and Competitiveness
Aspects of Fundamental Tax Reformi
PETER R. MERRILL
Price Waterhouse LLP
INTRODUCTION
Continued growth of the U.S. economy into the twenty-first century is more
dependent than ever on trade and investment ties with the world economy. Ex-
ports represent more than 11 percent of all the goods and services produced in the
United States, and overseas investment accounts for more than 19 percent of
corporate profits. In 1994, approximately 2,600 U.S. corporations operated more
than 21,000 affiliates abroad.
As foreign economies have grown over the last three decades, their busi-
nesses have expanded overseas and now rival U.S. corporations in their interna-
tional scope. Whereas 18 of the world's 100 largest companies were headquar-
tered in the United States in the 1960s, only 8 of them are today. The United
States is still the world's largest economy, but it now produces 25 percent of the
world's output, compared to 40 percent in the 1960s.
The U.S. tax system and its interaction with foreign tax systems affects the
cost of financing overseas investment and also the amount of such investment
(Hubbard, 1995~. Fundamental changes in U.S. tax policy have the potential to
affect domestic as well as cross-border investment. Changes in U.S. tax policy
also may have collateral effects on the U.S. tax treaty network depending on how
foreign governments react. Thus, the international implications of fundamental
tax reform cannot be ignored.
iThe views expressed in this chapter are those of the author and should not be attributed to Price
Waterhouse LLP.
87
OCR for page 86
88
BORDERLINE CASE
COMPARISON OF U.S. AND FOREIGN TAXATION OF
INCOME FROM INTERNATIONAL OPERATIONS
A number of objectives have been advanced for the U.S. international in-
come tax regime. In addition to the goal of raising sufficient tax revenues, these
objectives include (U.S. Congress, 1992~:
.
.
Efficient international capital allocation. Taxes (other than taxes in the
nature of user fees) should not distort firms' investment location deci-
sions; in other words, private investment should flow to the locations that
offer the highest pretax rates of return.
· International tax competitiveness. U.S.-owned investments should not
be subject to higher taxes than foreign-owned investments in the same
location.
Simplicity. Compliance and administrative costs should be as low as
possible.
· Harmonization. The United States should not depart unnecessarily from
widely accepted international income tax norms.
As discussed below, the current U.S. income tax system does not fully
achieve any of these objectives.
Efficient International Capital Allocation
The efficiency objective can be achieved by taxing worldwide income on a
uniform and current basis with an unlimited credit for foreign taxes (other than
taxes in the nature of user fees).
The present U.S. tax system deviates from this efficient tax system in a num-
ber of respects. For example, (1) different depreciation rules apply to domestic
and foreign investment; (2) losses of a foreign corporation cannot be consolidated
with its U.S. parent; (3) the foreign tax credit is subject to numerous limitations;
and (4) income earned through a foreign corporation generally is not taxed until
repatriated.
Some have argued that the taxation of foreign direct investment may no
longer be relevant for locational efficiency because international portfolio invest-
ment has become far more significant (Hufbauer, 1992; Frisch, 1992~. Under this
view, the marginal source of finance for international investment is international
portfolio capital.
International Tax Competitiveness
The competitiveness objective could be achieved by exempting foreign-
source active business income from domestic taxation (i.e., territorial taxation),
so that the only applicable income tax would be that imposed by the host coun-
try. The present U.S. income tax system differs from this internationally com
OCR for page 87
8
International Tax and Competitiveness
Aspects of Fundamental Tax Reformi
PETER R. MERRILL
Price Waterhouse LLP
INTRODUCTION
Continued growth of the U.S. economy into the twenty-first century is more
dependent than ever on trade and investment ties with the world economy. Ex-
ports represent more than 11 percent of all the goods and services produced in the
United States, and overseas investment accounts for more than 19 percent of
corporate profits. In 1994, approximately 2,600 U.S. corporations operated more
than 21,000 affiliates abroad.
As foreign economies have grown over the last three decades, their busi-
nesses have expanded overseas and now rival U.S. corporations in their interna-
tional scope. Whereas 18 of the world's 100 largest companies were headquar-
tered in the United States in the 1960s, only 8 of them are today. The United
States is still the world's largest economy, but it now produces 25 percent of the
world's output, compared to 40 percent in the 1960s.
The U.S. tax system and its interaction with foreign tax systems affects the
cost of financing overseas investment and also the amount of such investment
(Hubbard, 1995~. Fundamental changes in U.S. tax policy have the potential to
affect domestic as well as cross-border investment. Changes in U.S. tax policy
also may have collateral effects on the U.S. tax treaty network depending on how
foreign governments react. Thus, the international implications of fundamental
tax reform cannot be ignored.
iThe views expressed in this chapter are those of the author and should not be attributed to Price
Waterhouse LLP.
87
OCR for page 88
88
BORDERLINE CASE
COMPARISON OF U.S. AND FOREIGN TAXATION OF
INCOME FROM INTERNATIONAL OPERATIONS
A number of objectives have been advanced for the U.S. international in-
come tax regime. In addition to the goal of raising sufficient tax revenues, these
objectives include (U.S. Congress, 1992~:
.
.
Efficient international capital allocation. Taxes (other than taxes in the
nature of user fees) should not distort firms' investment location deci-
sions; in other words, private investment should flow to the locations that
offer the highest pretax rates of return.
· International tax competitiveness. U.S.-owned investments should not
be subject to higher taxes than foreign-owned investments in the same
location.
Simplicity. Compliance and administrative costs should be as low as
possible.
· Harmonization. The United States should not depart unnecessarily from
widely accepted international income tax norms.
As discussed below, the current U.S. income tax system does not fully
achieve any of these objectives.
Efficient International Capital Allocation
The efficiency objective can be achieved by taxing worldwide income on a
uniform and current basis with an unlimited credit for foreign taxes (other than
taxes in the nature of user fees).
The present U.S. tax system deviates from this efficient tax system in a num-
ber of respects. For example, (1) different depreciation rules apply to domestic
and foreign investment; (2) losses of a foreign corporation cannot be consolidated
with its U.S. parent; (3) the foreign tax credit is subject to numerous limitations;
and (4) income earned through a foreign corporation generally is not taxed until
repatriated.
Some have argued that the taxation of foreign direct investment may no
longer be relevant for locational efficiency because international portfolio invest-
ment has become far more significant (Hufbauer, 1992; Frisch, 1992~. Under this
view, the marginal source of finance for international investment is international
portfolio capital.
International Tax Competitiveness
The competitiveness objective could be achieved by exempting foreign-
source active business income from domestic taxation (i.e., territorial taxation),
so that the only applicable income tax would be that imposed by the host coun-
try. The present U.S. income tax system differs from this internationally com
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ASPECTS OF FUNDAMENTAL TAX REFORM
89
petitive tax system because the foreign investments of U.S. taxpayers can result
in additional U.S. tax liability. This can occur because the taxpayer repatriates
income from relatively low-tax foreign countries or because the foreign tax credit
is limited artificially by the overallocation of U.S. expenses against foreign-
source income.
Under one view of multinational investment, home-country taxes do not di-
rectly affect the investment decisions of "mature" subsidiaries that finance for-
eign investment from retained earnings (Hartman, 1985~. Under this model, the
imposition of U.S. tax on income earned in low-tax countries does not cause a
competitiveness problem for mature foreign subsidiaries. A competitiveness is-
sue arises, however, in the case of investments made out of parent equity rather
than retained earnings of the foreign subsidiary.
Another view is that imposition of an "efficient" worldwide income tax sys-
tem is consistent with international competitiveness because the burden of capital
income taxation is borne fully by domestic savers. In this model the imposition
of U.S. taxes on foreign investment does not put U.S. multinationals at a competi-
tive disadvantage because U.S. investors are prepared to accept a lower net of tax
return on this investment than investors who reside in countries that impose lower
income taxes (Gravelle, 1996~. With rising international capital mobility, how-
ever, one may question the assumption that a nation's capital income taxes are
borne fully by resident savers.
Harmonization
U.S. international tax rules frequently are more burdensome than those
of other major industrialized countries such as France, Germany, and Japan
(Granwell et al., 1996~. As a result of these differences, the United States is
generally considered an unattractive location, from the standpoint of corporate
income taxes, for the establishment of corporate headquarters.
· The United States taxes the worldwide income of U.S. businesses and
U.S. citizens. Many other countries exempt foreign-source business in-
come either by statute (e.g., France) or by treaty (e.g., Germany).
The U.S. foreign tax credit system requires complex calculations of sepa-
rate limitations for different categories of income. The foreign tax credit
systems of other countries generally are simpler.
· Virtually alone among the major industrial countries, the United States
refuses to accept tax sparing provisions in its bilateral income tax treaties.
Under a tax sparing agreement, the home country agrees to treat income
that benefits from tax incentives in the host country as having been sub-
ject to tax at the normal rates. Developing countries often insist on tax
sparing agreements as condition for entering into bilateral income tax trea-
ties with capital exporting countries. Consequently, the U.S. treaty net-
work is less extensive than that of most other major industrial countries.
.
OCR for page 90
9o
BORDERLINE CASE
.
.
.
· Most countries' anti-deferral regimes do not tax active business income
but instead are limited to passive types of income. In contrast, the United
States imposes current U.S. tax on several types of active business income
as well as passive income.
· Unlike other major industrial countries, the United States treats a loan
from a foreign subsidiary to its domestic parent as a deemed dividend,
potentially triggering current U.S. tax on foreign income.
The United States has more detailed and complex rules for allocating and
apportioning expenses between domestic- and foreign-source income than
does any other major industrialized country. These rules often conflict
with source rules adopted by other countries, giving rise to the risk of
double taxation.
Unlike other countries, the United States imposes an alternative minimum
tax that limits utilization of otherwise allowable foreign tax credits. This
can result in U.S. tax being imposed on foreign income that has borne
foreign income tax in excess of the U.S. rate.
Unlike most other major industrial countries, the United States has a "clas-
sical" income tax system that imposes tax on corporate income at both the
corporate and the shareholder levels.
Simplification
The U.S. rules for taxing foreign-source income are among the most compli-
cated in the world. The cost of complying with these rules represents a hidden tax
on U.S.-based multinational companies. Recent research has confirmed that the
international provisions of the U.S. tax code impose disproportionately high com-
pliance burdens both relative to U.S. tax rules for domestic income and relative
to foreign countries' taxation of international income. For example, one survey
of firms in the Internal Revenue Service's (IRS) large-case audit program found
that nearly 40 percent of total federal income tax compliance costs are attribut-
able to foreign-source income. This is disproportionately large compared to the
average fraction of assets (21.1 percent), sales (24.1 percent), and employment
(17.7 percent) abroad. By contrast, a survey of 965 European firms found no
evidence that compliance costs were higher for foreign-source income than for
domestic-source income (Blumenthal and Slemrod, 1994~.
Summary
The U.S. international tax system is a hybrid, with elements of residence-
and source-based taxation. It does not adhere consistently to the principles of
locational neutrality or international competitiveness; instead, present law may
be viewed as a complex mixture of these principles. It is also fair to say that the
effects of income tax rules on the behavior of multinational corporations are com
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ASPECTS OF FUNDAMENTAL TAX REFORM
91
plex and not fully understood by economists. Consequently, the evaluation of
international tax reform proposals depends, in part, on the model of multinational
behavior that is assumed.
Since the changes in the international tax rules made by the 1986 Tax Re-
form Act, a number of bills have been introduced in Congress to make incremen-
tal reforms in the present international income tax rules.2 In the 104th session of
Congress, more fundamental tax reform proposals were introduced that would
have replaced the income tax system with a consumption-based tax system. These
fundamental tax reform proposals are discussed in the following section and in
the last section of this chapter.
FUNDAMENTAL TAX REFORM:
KEY INTERNATIONAL ISSUES
Among the fundamental tax reform proposals introduced in the 104th Con-
gress are S. 722, the Unlimited Savings Allowance (USA) Tax, sponsored by
Senators Sam Nunn (D-GA) and Pete V. Domenici (R-NM); H.R. 2060, the Flat
Tax, sponsored by House Majority Leader Dick Armey (R-TX); and H.R. 3039,
the National Retail Sales Tax, sponsored by Representatives Dan Schaefer
(R-CO) and Billy Tauzin (R-LA).
All of these proposals would eliminate the federal income tax and replace it
with a new consumption-based tax system. Each of the three proposals would tax
only U.S. operations. These bills would repeal most U.S. withholding taxes on
income paid to foreign investors. U.S. businesses operating abroad would not be
taxed on their foreign-source income, nor would dividends paid by foreign sub-
sidiaries back to their U.S. parents be subject to U.S. tax. Because these systems
generally exclude foreign operations from the U.S. tax base, they would elimi-
nate the foreign tax credit rules and the complex rules taxing certain unrepatriated
income of U.S.-controlled foreign corporations (subpart F of the tax code).
The fundamental tax reform proposals also raise certain new issues in the
international context that have not yet been fully explored.
Reactions of Other Countries
It is not clear how foreign governments would react to a decision by the
United States to repeal its income tax system and replace it with a consumption-
based tax. They might respond negatively by adopting new antiabuse rules or
terminating existing tax treaties with the United States. Alternatively, they might
opt to leave their treaties with the United States in place and perhaps lower their
own taxes to retain U.S. investment.
2For example, the Rostenkowski-Gradison 1991 bill (H.R. 5270), the Houghton-Levin 1995 bill
(H.R. 1690), and the Pressler-Baucus 1996 bill (S. 2086). Some of the provisions contained in these
bills were enacted in the Taxpayer Relief Act of 1997.
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92
BORDERLINE CASE
One of the features of the U.S. consumption tax proposals that may concern
our trading partners is their proposed elimination of taxes on virtually all invest-
ment, including income from the portfolio investments of foreign residents. In-
deed, eliminating the income tax system and replacing it with a system that ex-
empts portfolio income could well turn the United States into a tax haven from
the perspective of other countries (Avi-Yonah, 1995~.
Although the consumption tax proposals would alleviate U.S. concerns re-
garding transfer pricing practices and earnings stripping, they likely would exac-
erbate foreign concerns about these same issues (Grubert and Newton, 1995; Avi-
Yonah, 1996)
In response to these concerns, foreign governments might either pursue an
approach similar to that of the United States that is, lower their taxes on invest-
ment as well or attempt to capture the revenue forgone by the United States.
This latter option could involve taxing their resident multinationals on worldwide
profits, including U.S.-source profits.3 In addition, foreign governments could
impose new antiabuse rules; for example, they might enact earnings stripping
rules that limit the deduction of interest paid to U.S. affiliates. Foreign govern-
ments might also deny a foreign tax credit for U.S. taxes. Foreign governments
also might consider nontax measures, including capital controls, to stem the po-
tential flow of capital into the United States.
Risks to the U.S. Tax Treaty Network
If the United States adopted one of the leading consumption-based tax re-
form proposals, it is not clear how the U.S. tax treaty network would be affected.
The United States now has bilateral income tax treaties with nearly 50 countries.
The treaties provide numerous benefits to investors, including reduced withhold-
ing tax rates on income flows between the United States and the treaty partner.
Under the USA Tax, the Flat Tax, and the National Retail Sales Tax, U.S.
withholding taxes on the income of foreign corporate investors generally would
be repealed. Therefore, the reduced withholding tax rates under the treaties no
longer would confer a special benefit to foreign treaty partners. As a result, U.S.
tax treaty partners all of whom have some form of income tax system may
view themselves as providing benefits to U.S. investors while their own investors
receive few benefits from the United States under these income tax treaties. Ac-
cordingly, treaty partners may believe they have little to gain by continuing their
existing tax treaty relationships with the United States, or by reducing cross-
border withholding tax rates in future treaty negotiations.
On the other hand, many treaty partners may wish to maintain their treaties
with the United States to preserve certain other benefits provided under the agree-
ments. In addition to lowering withholding rates, tax treaties also include guid
3See Avi-Yonah (1996, p. 262).
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ASPECTS OF FUNDAMENTAL TAX REFORM
93
ance on a number of important issues, such as rules for determining each country's
jurisdiction to tax multinational business income, as well as on numerous indus-
try-specific questions. In addition, treaty partners might decide to maintain a
treaty relationship with the United States because imposing the higher statutory
withholding rates on U.S. investors would make foreign jurisdictions less attrac-
tive as locations for U.S. investment.
Trade, Transfer Pricing, and the "Origin" and "Destination" Principles
The leading tax restructuring proposals differ in their treatment of exports
and imports. Both the National Retail Sales Tax proposal and the USA Business
Tax are "destination-based" taxes. Under the destination principle, imports are
taxed and exports are exempt, and the tax base generally would be consumption
of goods and services within the United States. By contrast, the Flat Tax is an
"origin-based" tax. Under the origin principle, exports are taxed and imports are
not. Under the Flat Tax, the tax base generally would be consumption plus net
exports.4
Some observers believe that destination-based taxes promote exports and
discourage imports. Despite the intuitive appeal of this idea, economists gener-
ally believe that destination-based taxes offer no long-term export incentives
(Grubert and Newton, 1995, p. 628. See also Grossman, 1980; Dixit, 1985; and
Feldstein and Krugman, 1990.) In any event, destination-based taxes do offer
other advantages over origin-based taxes. Foremost among these advantages is
greater administrability particularly in the area of transfer pricing.
Under a destination-based tax, transfer prices generally would not be rel-
evant to determining U.S. tax liability. Because export sales and presumably
also royalty receipts from abroad would be exempt, and imports including
royalty payments to foreign parties would be nondeductible, the prices set for
such transactions would not affect the U.S. tax base. Accordingly, there would be
little opportunity to use transfer prices to reduce U.S. taxes. Rather, multination-
als would have an incentive to shift profits out of other countries that impose
income taxes and into the United States (by inflating interest and royalty pay-
ments to the United States); (Avi-Yonah, 1995, p. 917~; (Grubert and Newton,
1995, p. 637).
By contrast, under an origin-based tax, such as the Flat Tax, transfer pricing
would continue to be a concern from a U.S. perspective because export sales
would be taxable and imports would be deductible.
It is important to note that all of the major consumption-based tax alterna-
tives would eliminate certain export incentives provided under our current in-
come tax system. Repeal of current foreign sales corporation and export source
4Disregarding the individual standard deduction and personal exemption that reduce the potential
tax base.
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94
BORDERLINE CASE
rules could shift the composition of exports away from manufacturing and
toward services.5
Legality Under International Trade Rules
Another issue is whether a move to a consumption-based tax system with
"border tax adjustments" would pass muster under international trade rules. This
question already has been raised with respect to at least one fundamental tax
reform proposal the USA Business Tax. International trade rules generally per-
mit border adjustments for indirect taxes, such as value-added taxes, but they bar
these adjustments under direct taxes, such as income taxes.
Although the USA Business Tax is similar to a value-added tax, it is drafted
as a direct tax and therefore might be challenged under trade rules. Another
feature of the USA Tax that might cause concerns is the credit it provides for
payroll taxes a feature not present in foreign value-added tax (VAT) systems. It
is possible that a payroll tax credit could be viewed as inconsistent with GATT
requirements (Summers, 1996~.
Foreign Direct Investment
By itself, adoption of a consumption tax would have little effect on the loca-
tion of investment because imposition of a consumption tax does not alter the rate
of return on the marginal investment (whether in the United States or abroad).
Repeal of the U.S. income tax system, however, would likely have important
effects on the magnitude and composition of both inbound and outbound foreign
direct investment.
Absent reaction by foreign governments, inbound investment would be at-
tracted to the United States, particularly from countries with territorial tax sys-
tems. Unless U.S. interest rates fall substantially, the elimination of interest de-
ductibility would cause equity financing to become relatively more attractive
compared to debt financing for foreign investors in the United States.
In the case of outbound investment, U.S. investors would likely shift invest-
ment away from high-tax foreign jurisdictions and into the United States and
low-tax foreign jurisdictions. Absent a decline in U.S. interest rates, U.S. multi-
nationals would be expected to reduce debt financing in the United States and to
increase debt abroad.
R&D AND TECHNOLOGY ISSUES
The leading proposals to restructure the U.S. tax system could have a significant
impact on decisions relating to the development and use of technology. All three
leading tax reform proposals the USA Tax, the Flat Tax, and the National Retail
5The Taxpayer Relief Act of 1997 extended the tax benefit of foreign sales corporations to software
exports.
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ASPECTS OF FUNDAMENTAL TAX REFORM
95
Sales Tax would represent a major break from the current-law treatment of R&D.
None of the three proposals would retain the research and experimentation (R&E)
tax credit and none would provide any incentive for performing R&D activities.
As discussed below, these and other effects of the various proposals on R&D
expenditures should be weighed carefully to ensure that one of the main goals of
tax restructuring advocates increasing the national rate of economic growth is
not undermined by inadvertently causing a decline in R&D spending in the United
States (National Commission on Economic Growth and Tax Reform, 19966~.
Tax Treatment of R&D Under Present Law
Since 1981, the U.S. income tax has provided an explicit incentive to boost
the level of R&D above the level that otherwise would occur in the marketplace.
The regular R&E tax credit under section 41 provides a 20 percent credit for the
amount by which a taxpayer's qualified research expenditures generally com-
prised of wages and supplies for a taxable year exceed a base amount.7 The
base amount generally is calculated as the product of the taxpayer's "fixed base
percentage" and the average annual gross receipts of the taxpayer for the four
preceding taxable years. The "fixed base percentage" generally is equal to the
percentage that aggregate qualified research expenditures for the five fiscal years
1984-1988 is of aggregate gross receipts over the period.
In 1996, Congress added an alternative incremental tax credit (AIRC) with
rates of 1.65, 2.20, and 2.75 percent for research in excess of 1.0, 1.5, and 2.0
percent, respectively, of average annual gross receipts during the four preceding
years. Once the AIRC is elected, it can be revoked only with the consent of the
Secretary of the Treasury. The purpose of the AIRC is to provide an incremental
incentive for companies to increase research expenditures in situations where
changes in business conditions since the 1984-1988 base period have caused the
fixed base percentage to become out of date.
A tax system's impact on R&D is not limited to its treatment of costs relat-
ing to the development of new technologies. The tax treatment of the utilization
of these technologies also plays a role in taxpayer decisions relating to R&D
activities. For many high-technology companies, a key issue is how U.S. inter-
national tax rules treat income derived from exploiting the use of an intangible
asset overseas.
Royalties received for the use of intangible assets outside the United States
generally are considered territorially to be foreign-source income for purposes of
the foreign tax credit. Under the so-called look-through rules, foreign royalties
6According to the report of the National Commission on Economic Growth and Tax Reform, "at-
tention must be given to the proper tax treatment of foreign-source license fees, royalties, and other
intangibles so as not to discourage research and development in the United States."
7Deductions allowed under section 174 are reduced by an amount equal to 100 percent of the
taxpayer research credit. In lieu of reducing section 174 deductions, taxpayers may elect to claim a
reduced credit.
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98
BORDERLINE CASE
$100 million in total research expenses, $52 million is wages and salaries; $6.24
million, employee benefits; $3.98 million, payroll tax; $15 million, depreciation;
and $22.78 million, other expenses (U.S. Congress, 1995~.~°
In 1994, the research tax credit amounted to 4.4 percent of qualified research
expenses, so the hypothetical taxpayer in this example is assumed to be able to
claim a research credit of $1.85 million (4.4 percent of $42 million of qualified
research expense).ll
The taxpayer's R&D activities result in patents and other valuable intan-
gible assets that produce U.S. income and foreign income. For purposes of this
example, it is assumed that half of the income from the intangible assets is earned
in the United States and the other half is attributable to foreign royalties. The
taxpayer's foreign royalties are subject to an average withholding tax rate of
5 percent.l2 U.S. multinationals are required to allocate domestic research ex-
pense between U.S. and foreign sources for purposes of computing the foreign
tax credit. In this example, the taxpayer allocates 25 percent of U.S. research
expense to foreign sources.l3 For simplicity, the example includes only items of
income and expense directly related to R&D, and the taxpayer is assumed not to
be subject to the alternative minimum tax.
Under present law, if the expired R&E tax credit were extended, the hypo-
thetical taxpayer would have to earn $90.7 million to break even on $100 million
of R&D if the taxpayer was in an excess foreign tax credit position and $98.2
million if in a deficit foreign tax credit position. The break-even return is less
than the $100 million cost of R&D due to the research credit ($1.85 million) and,
in the case of the excess foreign tax credit taxpayer, the utilization of foreign tax
credits (in excess of the 5 percent withholding tax on the royalty).
The impact of the USA Business Tax and the Flat Tax on the cost of per-
forming R&D in the United States can be measured by calculating the change in
return required to break even on $100 million of R&D for the taxpayer in the
preceding example. The 11 percent USA Tax is intended to be revenue neutral.
By contrast, the 17 percent Flat Tax introduced by Representative Armey would
raise less revenue than current law. For the sake of comparability, the Flat Tax
also is analyzed at a 21 percent rate, which has been determined by the Treasury
teethe Office of Technology Assessment estimates that 62 percent of research expense is allocable
to compensation. The employer's share of payroll taxes is calculated at the statutory 7.65 percent rate,
and employee benefits (excluding payroll taxes) are assumed to be 12 percent of wages.
iiData provided by the IRS Statistics of Income Division based on Forms 6765 filed for tax years
ending July 1, 1993, through June 30, 1994.
i2The United States seeks to obtain a zero withholding tax rate on royalties in its bilateral income
tax treaties, but many treaties provide for a 5 percent or higher rate such as the U.S. treaties with
Australia, Canada, China, France, India, Italy, Japan, and Spain. (See Price Waterhouse LLP, 1996.)
i3Under regulations, taxpayers that use the gross sales method generally may allocate 50 percent of
U.S. research expense to U.S. source income and then apportion the remaining 50 percent on the basis
of U.S. and foreign sales.
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ASPECTS OF FUNDAMENTAL TAX REFORM
TABLE 8.1 Percentage Increase in Break-even Rate of Return on Domestic
R&D Over Present Law Static Effects
99
Taxpayer With Excess Taxpayer Without Excess
Tax Regime Foreign Tax Credits (%) Foreign Tax Credits (%)
USA Tax 09.9 1.5
Armey Flat Tax (17%) 15.6 6.8
Revenue-neutral Flat Tax (21%) 16.4 7.6
SOURCE: Price Waterhouse LLP calculations (see Appendix).
Department as necessary to achieve revenue neutrality (U.S. Department of the
Treasury, 1996~.
Under the USA Business Tax, the break-even return on $100 million of R&D
would be $99.6 million under the facts of the example. Thus, for the taxpayer in
this example, the USA Tax would increase the after-tax cost of R&D by about 2-
10 percent, depending on whether or not the taxpayer currently is in an excess
foreign tax credit position. The potential rise in the after-tax cost of R&D prima-
rily is attributable to the loss of the research and foreign tax credits and the inabil-
ity to deduct compensation and payroll taxes.
As shown in Table 8.1, under the Armey Flat Tax, the break-even return on
$100 million of R&D would be $104.9 million at a 17 percent rate and $105.6
million at a 21 percent rate. Thus, for the taxpayer in this example, the 21-percent
Flat Tax would increase the after-tax cost of R&D by about 8-16 percent com-
pared to present law, depending on whether or not the taxpayer is in an excess
foreign tax credit position. The rise in the after-tax cost of R&D primarily is
attributable to the loss of the R&E credit, the taxation of foreign royalties with no
credit or deduction for foreign withholding taxes, and the inability to deduct pay-
roll taxes and employee benefits.
Dynamic Effects
Under conventional incidence assumptions, taxes imposed on compensation
costs are ultimately borne by workers. In addition, it commonly is assumed that
a single-rate broad-based sales tax or value-added tax will cause a corresponding
increase in the price level, as a result of accommodating monetary policy.
Example
Under the above assumption, the break-even return on $100 million of R&D
under the USA Business Tax or the Flat Tax is $100 million plus foreign with-
holding taxes grossed up by the applicable marginal tax rate. Consequently, the
break-even return on $100 million of R&D would be $102.6 million under the
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100
BORDERLINE CASE
TABLE X.2 Percent Increase in Break-Even Rate of Return on Domestic
R&D over Present Law Dynamic Effects
Taxpayer With Excess Taxpayer Without Excess
Tax Regime Foreign Tax Credits (%) Foreign Tax Credits (%)
USA Tax 13.1 4.5
Armey Flat Tax (17%) 13.7 5.0
Revenue-neutral Flat Tax (21%) 13.9 5.2
NOTE: Business taxes imposed on compensation costs are assumed to be borne by workers; USA
Business Tax is fully passed forward in prices.
SOURCE: Price Waterhouse LLP calculations (see Appendix).
USA Business Tax, $103.1 million under the 17 percent Flat Tax, and $103.3
million under the 21 percent Flat Tax. This represents about a 5-14 percent in-
crease in the after-tax cost of R&D, compared to present law, under both the Flat
Tax and the USA Business Tax (see Table 8.2~.
INCREMENTAL REFORM OF THE INCOME TAX SYSTEM
As an alternative to fundamental tax reform, incremental changes to the ex-
isting income tax system could be adopted. Reforms to the current system could
help address numerous areas of complexity in the international provisions of the
tax code.
Foreign Tax Credit
The United States taxes its citizens, residents, and domestic corporations on
a worldwide basis and seeks to alleviate international double taxation through the
foreign tax credit. The foreign tax credit, however, is subject to significant limi-
tations. Although foreign rules determine the amount of foreign tax imposed
(subject to U.S. currency translation rules), foreign-source income must be rede-
termined under U.S. rules for purposes of the foreign tax credit. The differences
between the U.S. and foreign definitions of taxable income particularly the rules
on the sourcing of income and the allocation of deductions create complexity
and increase the risk of double taxation. Other countries with foreign tax credit
systems frequently seek to promote harmony, minimize complexity, and avoid
double taxation by using the foreign jurisdiction's definition of taxable income
for foreign tax credit proposes.
Of particular note is the method by which U.S. interest expense is allocated
between domestic and foreign sources. Under present law, U.S. interest expense
is allocated between domestic- and foreign-source income according to a mea
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ASPECTS OF FUNDAMENTAL TAX REFORM
101
sure of domestic and foreign assets. Foreign interest expense, however, is allo-
cated entirely to foreign-source income. The use of a "water' e-edge" fungibility
principle, rather than a "global" fungibility principle, to allocate interest expense
systematically understates foreign-source income and overstates domestic-source
income for purposes of the foreign tax credit.
In addition, U.S. rules impose numerous limitations on the availability of
foreign tax credits, which bring their own complexities and further erode the
effectiveness of the foreign tax credit mechanism in reducing double taxation.
For example, separate limitations apply to eight special categories (or "baskets")
of income. In addition, U.S. taxpayers that own interests of between 10 and 50
percent in foreign companies must compute a separate foreign tax credit limita-
tion for each such company.~4 Moreover, these separate limitations impose sub-
stantial administrative complexity on U.S. firms attempting to calculate the
amount of foreign tax credit to which they are entitled. Measures to simplify and
streamline the foreign tax credit rules could greatly reduce the compliance bur-
dens faced by U.S. businesses competing abroad.
It has become increasingly clear that the foreign tax credit system, since it
was modified in 1986, imposes unacceptable compliance and enforcement bur-
dens on taxpayers and tax authorities alike. Large companies must devote sub-
stantial resources each year to obtain and process from sources all over the world
the information that is needed for the foreign tax credit computation. It has be-
come impossible for U.S. multinationals to perform the actual computations with-
out the aid of sophisticated computer software, and it is impossible for the IRS to
audit these computations without relying on such software. These tasks certainly
would be simplified by proposals to reduce the number of foreign tax credit bas-
kets required by current law. Thus it is time to consider replacing the basket
approach entirely with some simpler foreign tax credit system or even with a
territorial income tax system (described below).
Anti-deferral Rules
The United States generally does not tax U.S. shareholders on foreign-source
income earned through a foreign corporation until such income is repatriated to
the United States, just as it does not tax individual U.S. taxpayers on the earnings
of corporations in which they own stock until dividends are declared and paid.
This deferral is intended to permit U.S. taxpayers to compete internationally by
reinvesting their foreign earnings without subjecting such earnings to current U.S.
income taxation.
The United States, however, has adopted significant anti-deferral regimes
that generally tax U.S. shareholders currently on certain types of undistributed
i4The Taxpayer Relief Act of 1997 eliminates the separate foreign tax credit calculation for taxable
years beginning after 2002.
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BORDERLINE CASE
foreign income as if such income were repatriated. Although other developed
countries also limit the extent to which their taxpayers may defer tax on certain
income earned by affiliated foreign corporations, U.S. rules are considerably more
far-reaching and complex.
For example, the anti-deferral regimes of other developed countries gener-
ally eliminate deferral only for passive income. In contrast, U.S. anti-deferral
regimes also eliminate deferral for many types of active trade or business income,
including financial services income, international shipping and aircraft income,
and certain other types of income.
Unlike other developed countries, which generally have only one anti-defer-
ral regime, the United States has six. These regimes, enacted piecemeal over the
last half-century, reflect a series of responses to perceived shortcomings in the
deferral rules existing at the time of enactment. The aggregate result is a "patch-
work" system that requires current taxation of certain types of income by refer-
ence to different factors and criteria (or imposes an interest charge on certain
actual or deemed dispositions). The multiplicity and complexity of these anti-
deferral regimes impose significant compliance costs on U.S. taxpayers and rep-
resent heavy administrative burdens for U.S. tax administrators.
Policymakers should give serious thought to consolidating the existing re-
gimes and modifying their scope to achieve greater consistency with the anti-
deferral rules imposed by our major trading partners.~5 Many other countries
apply a much simpler effective foreign tax rate test or impose current tax only on
active business income from specified low-tax countries. Such alternatives may
not ultimately prove preferable to the basic U.S. approach, but they should be
given serious consideration in any fundamental reform process (U.S. Department
of the Treasury, 1993~.
Alternative Minimum Tax
The stated purpose of the alternative minimum tax (AMT) is "to ensure that
no taxpayer with substantial economic income can avoid significant tax liability
by using exclusions, deductions and credits." This purpose is accomplished by
imposing an AMT to the extent that AMT liability exceeds regular tax liability.
Under regular income tax rules, a U.S. taxpayer may claim a foreign tax
credit for foreign taxes paid up to 100 percent of its U.S. tax liability on foreign
source income. This system seeks to prevent double taxation of foreign source
income. For taxpayers subject to the AMT, however, the foreign tax credit may
offset no more than 90 percent of a taxpayer's AMT liability. Not only does this
limitation on the foreign tax credit lack any clear economic rationale, it also ap-
pears inconsistent with certain U.S. treaty obligations.
i5The Taxpayer Relief Act of 1997 provides that U.S.-controlled foreign corporations will not be
subject to the passive foreign investment company (PFIC) rules after 1997.
i6S. Rep. No. 99-313, 99th Congress, 2d Sess. 518-519 (1986).
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ASPECTS OF FUNDAMENTAL TAX REFORM
TERRITORIAL INCOME TAXATION
103
Another option would be to retain an income tax system but move from
worldwide taxation to a territorial tax system for taxing foreign income. A "ter-
ritorial" or "exemption" tax system is used in some form, either by statute or by
treaty, by more than a dozen major industrialized countries, including the Nether-
lands, France, Germany, and Canada. Rather than merely deferring tax until
foreign-source income is repatriated, countries with territorial income tax sys-
tems exempt the active business income earned abroad by their multinationals.
Multinationals based in such countries, therefore, pay only the local tax imposed
in countries in which they do business.
A move to a territorial income tax system could promote the competitiveness
of U.S. multinationals by exempting foreign-source dividends and branch income.
This could help ensure that foreign subsidiaries do not pay more tax in the aggre-
gate on corporate income than do their foreign-based competitors in foreign mar-
kets. It is not clear, however, that a move to a territorial income tax system would
greatly simplify current law for all taxpayers. Because passive investment in-
come presumably would be taxed currently, look-through, anti-deferral, and for-
eign tax credit rules generally would remain necessary for passive foreign in-
come. Transfer pricing issues would be at least as important under a territorial
income tax system as they are today. Finally, it is important to note that a territo-
rial income tax could actually increase U.S. tax on foreign-source royalties and
export income compared to current U.S. law. Under a territorial system, excess
foreign tax credits on high-tax dividends no longer would be available to reduce
U.S. tax on foreign-source royalties and export income.l7
CONCLUSION
Although the international tax impact of various fundamental tax reform pro-
posals thus far has not received the same attention as the domestic aspects of
these proposals, they could have profound effects on the ability of U.S. compa-
nies and U.S. workers to compete in the global marketplace. Lawmakers must be
careful to give full consideration to these international issues as they weigh re-
placement tax alternatives.
A switch to a consumption-based tax system could provoke undesirable re-
actions from our trading partners. A unilateral move to a consumption tax system
could prompt trading partners to impose antiabuse rules and other measures aimed
at capturing the taxes forgone by the United States. Our trading partners may feel
compelled to take these steps to prevent taxpayers from shifting profits into the
United States and, thereby, eroding their tax bases. In addition, our tax treaty
i7The President's fiscal year 1998 Budget proposes to repeal the current export sales source rule
and replace it with an "activities-based" method of sourcing income from the export of inventory
property.
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104
BORDERLINE CASE
partners may consider terminating tax treaties because these agreements no longer
would confer significant benefits from the United States. This could result in
serious hardships for U.S. firms, which in the absence of the treaties would be-
come subject to higher foreign withholding tax rates. Both of these possibili-
ties the expansion of foreign taxing jurisdiction and the abrogation of tax trea-
ties should cause policymakers to think carefully before undertaking any radical
overhaul of the current tax system. In addition, each of the leading fundamental
tax reform proposals could increase tax burdens on U.S. technology and U.S.
exports, with potentially harmful effects on the economy.
Incremental reforms also may offer a possible alternative to the venous fun-
damental tax reform proposals. Such incremental reforms could go a long way
toward addressing provisions of U.S. tax law that are overly complex or discnm~-
nate against investment abroad.
A territorial income tax system is another alternative worthy of serious con-
sideration if a consumption-based tax system is not adopted. However, it is not
yet clear whether a move to such a system would be an improvement. Although
a territorial income tax system would, in theory, help multinational businesses, it
may not be a panacea. In practice, this approach could result in stiffer taxes on
foreign-source royalties and exports without eliminating the need for transfer pnc-
ing rules or an anti-deferral regime for passive income.
REFERENCES
Avi-Yonah, R.S. 1995. "The international implications of tax reform." Tax Notes (November):913,
922.
Avi-Yonah, R.S. 1996. "Comment on Grubert and Newton." National Tax Journal 49(2):259, 262.
Blumenthal, M., and J.B. Slemrod. 1994. "The compliance cost of taxing foreign-source income: Its
magnitude, determinants, and policy implications." In National Tax Policy in an International
Economy: Summary of Conference Papers. Washington, D.C.: International Tax Policy Fo
rum.
Dixit, A. 1985. "Tax policy in open economies." In Handbook of Public Economics, A. Auerbach
and M. Feldstein, eds. Amsterdam: North-Holland.
Feldstein, M., and P. Krugman. 1990. "International effects of value-added taxation." Pp. 263-278
in Taxation in the Global Economy, A. Razin and J. Slemrod, eds. Chicago: University of
Chicago Press.
Frisch, D. 1992. "The economics of international tax policy: Some old and new approaches." Tax
Notes (April):581-591.
Granwell, A., P. Merrill, and C. Dubert. 1996. Taxation of U.S. Corporations Doing Business Abroad:
U.S. Rules and Competitiveness Issues, Chapter 9. Morristown, New Jersey: Financial Execu-
tives Research Foundation.
Gravelle, J.G. 1996. Foreign Tax Provisions of the American Jobs Act of 1996. Washington, D.C.:
Congressional Research Service.
Grossman, G.M. 1980. "Border tax adjustments: Do they distort trade?" Journal of International
Economics 10 (February): 117- 128.
Grubert, H., and T.S. Newton. 1995. "The international implications of consumption tax proposals."
National Tax Journal 48(4):619.
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ASPECTS OF FUNDAMENTAL TAX REFORM
105
Hartman, D. 1985. "Tax policy and foreign direct investment." Journal of Public Economics
26(1): 107-121.
Hubbard, R.G. 1995. "U.S. tax policy and foreign direct investment: Incentives, problems, and
reforms." Tax Policy and Economic Growth. Washington, D.C.: American Council for Capital
Formation.
Hufbauer, G. 1992. U.S.Taxation of International Income: BlueprintforReform. Washington, D.C.:
Institute for International Economics.
National Commission on Economic Growth and Tax Reform. 1996. Unleashing America's Poten-
tial: A Pro-Growth, Pro-Family Tax System for the 21st Century. Washington, D.C.: National
Commission on Economic Growth and Tax Reform.
Price Waterhouse LLP. 1996. Corporate Taxes: A Worldwide Survey (1996 Edition). New York,
New York.
Summers, V. 1996. "The border adjustability of consumption taxes, existing and proposed." Tax
Notes International 1793, 1800.
U.S. Congress, House of Representatives. 1992. Statement of Fred T. Goldberg, Jr., Assistant Sec-
retary (Tax Policy), U.S. Department of the Treasury, before the Committee on Ways and Means.
Serial no. 102-176.
U.S. Congress, Office of Technology Assessment. 1995. Pp. 19-20 in The Effectiveness of Research
and Experimentation Tax Credits. Washington, D.C.: U.S. Government Printing Office.
U.S. Department of the Treasury. 1993. International Tax Reform: An Interim Report. Washington,
D.C.
U.S. Department of the Treasury. 1996. "New Armey-Shelby flat tax would still lose money, Trea-
sury finds." Office of Tax Analysis. Reprinted in Tax Notes (January):451-61.
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APPENDIX
Static Effect of Tax Restructuring Proposals on
the Tax Treatment of R&D: Example
ASSUMPTIONS
Foreign share of return 50 percent
Foreign withholding tax 5 percent
Total Qualified Nonqualified
R&D expenses (section. 174) 100.00 42.00 58.00
Wages and salaries 52.00 22.00 30.00
Employer share of payroll tax 3.98 NA 3.98
Employee benefits 6.24 NA 6.24
Fixed cost (depreciation) 15.00 NA 15.00
Other 22.78 20.00 2.78
U.S. R&D allocated to U.S. source 75%
Present Law Flat Tax USA Tax
ExcessDeficit Armey- Revenue Nunn
ItemFTCFTCShelbyneutralDomenici
Tax status
Tax rate35%35%17%21%11%
Effective rate of R&D credit 4.4% 4.4% NA NA NA
Foreign tax credit position Excess Deficit NA NA NA
AMT no no NA NA NA
Gross income 90.68 98.15 104.87 105.56 99.63
U.S. source 45.34 49.08 52.44 52.78 49.82
Foreign royalty, gross of withholding tax 45.34 49.08 52.44 52.78 49.82
Withholding tax 2.27 2.45 2.62 2.64 2.49
Research expense (section 174) 100.00 100.00 100.00 100.00 100.00
U.S. source 75.00 75.00 100.00 100.00 100.00
Foreign source 25.00 25.00 0.00 0.00 0.00
Components of research expense
Wages 52.00 52.00 52.00 52.00 52.00
Payroll tax 3.98 3.98 3.98 3.98 3.98
Benefits 6.24 6.24 6.24 6.24 6.24
Capital cost recoverya 15.00 15.00 16.86 16.86 16.86
Otherb 22.78 22.78 22.78 22.78 22.78
Qualified research expense 42.00 42.00 NA NA NA
Taxable income -7.47 0.00 13.23 13.92 10.17
U.S. tax before credits -2.62 0.00 2.25 2.92 1.12
Credits 8.97 4.30 0.00 0.00 3.98
Research credit 1.85 1.85 NA NA NA
Foreign tax credit 7.12 2.45 NA NA NA
Payroll tax credit NA NA NA NA 3.98
U.S. tax after credits -11.58 -4.30 2.25 2.92 -2.86
U.S. and foreign tax -9.32 -1.85 4.87 5.56 -0.37
Research expense after U.S. and foreign tax 90.68 98.15 104.87 105.56 99.63
NOTE: FTC = foreign tax credit
aR&D capital costs generally are five-year property under present law but would be expenses under
a consumption tax. With 7% annual growth, steady-state ratio of depreciation to investment is 89%.
bAmount deductible assumed not to change under USA and Flat Taxes.
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ASPECTS OF FUNDAMENTAL TAX REFORM
APPENDIX Continued
Dynamic Effect of Tax Restructuring Proposals on
the Tax Treatment of R&D: Examples
107
ASSUMPTIONS
Foreign share of return 50 percent
Foreign withholding tax 5 percent
Total Qualified Nonqualified
R&D expenses (section 174) 100.00 42.00 58.00
Wages and salaries 52.00 22.00 30.00
Employer share of payroll tax 3.98 NA 3.98
Employee benefits 6.24 NA 6.24
Fixed cost (depreciation) 15.00 NA 15.00
Other 22.78 20.00 2.78
U.S. R&D allocated to U.S. source 75%
Present Law
Flat Tax USA Taxa
Excess Deficit Armey- Revenue Nunn
Item FTC FTCShelbyneutralDomenici
Tax status
Tax rate 35% 35%17%21%11%
Effective rate of R&D credit 4.4% 4.4% NA NA NA
Foreign tax credit position Excess Deficit NA NA NA
AMT no no NA NA NA
Gross income 90.68 98.15 103.11 103.27 102.56
U.S. source 45.34 49.08 51.56 51.64 51.28
Foreign royalty, gross of withholding tax 45.34 49.08 51.56 51.64 51.28
Withholding tax 2.27 2.45 2.58 2.58 2.56
Research expense (sec. 174) 100.00 100.00 100.00 100.00 100.00
U.S. source 75.00 75.00 100.00 100.00 100.00
Foreign source 25.00 25.00 0.00 0.00 0.00
Components of research expense
Wages 52.00 52.00 52.00 52.00 52.00
Payroll tax 3.98 3.98 3.98 3.98 3.98
Benefits 6.24 6.24 6.24 6.24 6.24
Capital cost recoveryb 15.00 15.00 16.86 16.86 16.86
OtherC 22.78 22.78 22.78 22.78 22.78
Qualified research expense 42.00 42.00 NA NA NA
Taxable income -7.47 0.00 3.11 3.27 -48.72
U.S. tax before credits -2.62 0.00 0.53 0.69 0.00
Credits 8.97 4.30 0.00 0.00 0.00
Research credit 1.85 1.85 NA NA NA
Foreign tax credit 7.12 2.45 NA NA NA
Payroll tax credit NA NA NA NA 0.00
U.S. tax after credits -11.58 -4.30 0.53 0.69 0.00
U.S. and foreign tax -9.32 -1.85 3.11 3.27 2.56
Research expense after U.S. and foreign tax 90.68 98.15 103.11 103.27 102.56
aUSA Business Tax is assumed to be passed forward in prices. Prices are shown net of USA Tax.
bR&D capital costs generally are five-year property under present law but would be expenses under
a consumption tax. With 7% annual growth, steady-state ratio of depreciation to investment is 89%.
CAmount deductible assumed not to change under USA and Flat Taxes.
i8Taxes imposed on compensation costs are assumed to be borne 100 percent by workers.
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9
U.S. Tax Policy and Mullinational
Corporations: Incentives, Problems,
and Directions for Reform
R. GLENN Hug BARD
Columbia University and the National Bureau of Economic Research
INTRODUCTION
As multinational corporations play a larger role in the business activities of
the global economy, interest in international aspects of capital income taxation
has been stimulated. In the United States, debate has centered on the competitive
position of U.S. firms in international product and capital markets. This concern
is accompanied by complaints that U.S. international tax rules have become more
complex and more distorting in the past several years, particularly since the pas-
sage of the Tax Reform Act of 1986. Discussions in Congress and the adminis-
tration over the past several years indicate a willingness to consider significant
reforms. In Europe, increased liberalization of capital markets prompted Euro-
pean Commission discussions on harmonization of corporate taxation. These
policy developments around the world raise a deeper question of whether the
current system of taxing international income is viable in a world of significant
capital market integration and global commercial competition.
Academic researchers have shown renewed interest in the determinants of
capital formation and allocation, patterns of finance in multinational companies,
international competition, and opportunities for income shifting and tax avoid-
ance. This research brings together approaches used by specialists in public fi-
nance and international economics.2 In this chapter, I describe the objectives that
guide the study of international tax rules and provide an introduction to U.S. tax
iThe author is grateful to Thomas Barthold, Dale Jorgenson, Peter Merrill, and James Poterba for
helpful comments and suggestions, and to the American Enterprise Institute for financial support.
2See, for example, the paper in Razin and Slemrod (1990); see also Giovannini et al. (1993); and
Feldstein et al. (1995).
109
Representative terms from entire chapter:
tax credit
