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