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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

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110 BORDERLINE CASE law. In addition, I analyze empirical evidence on investment and financing in- centives created by U.S. international tax rules and consider possible reforms.3 Finally, I describe how recent proposals for fundamental tax reform could affect multinational firms. TAX REFORM OBJECTIVES To frame a discussion of international tax reform or any broad tax reform it is necessary to articulate the objectives clearly. This chapter considers three objec- tives economic efficiency, competitiveness, and simplicity. Much of the debate over reform of international tax rules in the U.S. tax system stems from conflicts among these objectives. Economic Efficiency The federal government in the United States must raise substantial revenue each year. Absent reliance on lump-sum taxes, policymakers must choose among tax instruments and definitions of the tax base that distort decisions about saving or investment or work, thereby contributing to a loss in economic efficiency. The framework for analyzing international tax rules should focus on how to structure a system with the least severe distortions, subject to raising revenue and other policy concerns. Economists' exploration of "optimal taxation" has not always produced simple rules to guide the policy debate, but at least one clear statement has emerged since the pioneering work of Diamond and Mirrlees (1971~. The tax system should attempt to preserve "production efficiency" even if it introduces other distortions.4 This means that all firms should face the same prices for in- puts, including for our purposes the cost of capital, and for output. The reason to encourage production efficiency can be understood by considering the conse- quences of its absence; production could be reallocated to achieve a greater out- put for a given level of input. In the domestic context, broad-based income or consumption taxes are con- sistent with production efficiency. The term "broad-based income tax" is used here to denote one with a Haig-Simons definition of income and one in which there is full integration of the individual and the corporate income tax systems (U.S. Department of the Treasury, 1992a). Under such a regime, there is a wedge 3I do not address explicitly the question of whether incremental outbound foreign direct investment is "good" or "bad" for U.S. output or jobs. Economists have generally not taken seriously arguments that outbound foreign direct investment "destroys American jobs" (see, for example, Graham and Krugman, 1991; Feldstein, 1995; Lipsey, 1995). 4Conditions required to justify this result include, among other things, the availability of a variety of tax instruments and the ability to tax away pure profits.

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U.S. TAX POLICY AND MULTINATIONAL CORPORATIONS 111 between the cost of capital to businesses and the net rate of return received by individual savers, but because the wedge does not vary across firms, production efficiency is maintained. A "broad-based consumption tax" goes a step further. Not only is the cost of capital equivalent across firms, but also it equals the net rate of return to individual savers. To think of production efficiency in a global economy in which capital is mobile across national boundaries, we should focus on worldwide production efficiency, wherever investments require the same risk-adjusted pretax rate of return, irrespective of the investment's location or the nationality of the owner or investor. This concept of production efficiency implies that worldwide output will be maximized for any given level of inputs; it is similar to arguments used to bolster the case for "free trade." One way to achieve production efficiency in the international context is for all countries to adopt identical broad-based income or consumption taxes of the type described above. This adoption is not realistic, of course, nor is it necessary to achieve production efficiency. With full integration of corporate and indi- vidual income taxes, a pure residence-based tax system, in which a country's residents are taxed on all capital income they receive, would suffice. What would such a system look like? It would embody accrual taxation of the world- wide income of residents, offset with an unlimited credit for foreign taxes paid. In the real world, the temptation to tax capital owned by foreigners, together with the administration and monitoring problems associated with accrual taxa- tion, explains the absence of such a prototype from the set of tax systems we see in practice. Could a pure source-based or territorial tax system in which each country placed a uniform tax on all capital income generated domestically, irrespective of the owners of the capital (i.e., a flat-rate business tax with full integration of individual and corporate taxes), achieve production efficiency? Production effi- ciency could be achieved only in the unlikely event that all countries choose the identical effective tax rate on capital income. In addition, as elaborated later, a territorial system places significant pressure on rules governing the allocation of income and expenses, rules at the heart of many of the current debates over inter- national tax reform. Competitiveness Competitiveness is simply the ability of U.S.-headquartered firms to com- pete successfully with similarly situated foreign firms in international and do- mestic markets. This means that whatever else they do, U.S. international tax rules should not place a U.S. business at a competitive disadvantage in a foreign market, nor should they favor or penalize foreign or domestic businesses operat- ing in the U.S. market. If effective tax rates on capital income were identical across countries, objectives of efficiency and competitiveness would always be

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2 BORDERLINE CASE compatible, but in practice the two objectives may be in conflict. For example, U.S. firms operating in low-tax countries abroad may be required to pay a "re- sidual" tax in the United States in the name of efficiency, a tax that may place them at a disadvantage in competing with foreign multinationals in the low-tax 1- - Junsa~ct~on. Recently, some analysts have suggested that the focus of U.S. tax policy on production efficiency is misplaced when applied to multinational corporations (Frisch, 1990; Hufbauer, 1992~. In this argument, if portfolio capital is perfectly mobile internationally, multinational firms do not play a crucial role as allocators of capital. That is, if foreign subsidies raise funds at the margin from selling debt and equity to owners of portfolio capital rather than from parent-provided equity, concerns about efficiency should focus on portfolio investment.5 Moreover, if multinational enterprises exist to provide and coordinate "headquarters" services such as research and development or general management for related groups of firms and the location of these services generates spillovers in the home country, then concerns about the "competitiveness" of these firms in world markets should be discussed in tax policy debates.6 In practice, these arguments are associated with proposals to exempt active foreign-source income from U.S. taxation. Simplicity All else being equal, simple tax rules reduce compliance costs, facilitate tax administration, and limit the possibility of varying tax treatments of similarly situated firms. As such, a policy focus on "principled simplification" is likely to enhance both economic efficiency and competitiveness. The costs of compliance with international tax rules may pose serious efficiency and competitiveness con- cerns, and both business leaders and policymakers have voiced concern that the complexity of U.S. international rules increased after the passage of the Tax Re- form Act of 1986.7 5The substitutability of direct and portfolio capital is an empirical question. Portfolio and direct investment involve an important nontax difference since direct investment offers both ownership and control, as opposed to only ownership in the case of portfolio investment. The empirical investigation of Gordon and Jun (1993) does not find tax factors to be the most prominent determinant of the mix between direct and portfolio investment. More empirical study is needed to assess the relative roles of multinational firms' investment and portfolio investment in allocating capital for business invest- ment. 6The arguments that high value-added "headquarters" investments such as R&D generate externali- ties for the headquarters country is notper se a justification for a territorial tax system to avoid placing a residual tax on multinational firms' investment income. To the extent that headquarters activities generate externalities, they should be subsidized directly and generally. If, for example, the present subsidy to R&D in the United States is "too low," it could be increased across the board. It is unlikely that changing the tax rate on multinational firms headquartered in the United States is the most effi- cient means of achieving the appropriate subsidy. 7Proposals for simplification have been offered in U.S. Department of the Treasury (1993).

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U.S. TAX POLICY AND MULTINATIONAL CORPORATIONS Conflicts Among Objectives 113 Conflicts between policy objectives of efficiency and competitiveness typi- cally arise in debates over the appropriate norms for international tax policy. Derived from models of international trade and capital income taxation, two prin- ciples are conventionally suggested as guides to the taxation of international in- vestment: 1. Capital-Export Neutrality: Investors should pay equivalent taxes on caps tat income, regardless of the county in which that income is earned. . 2. Capital-Import Neutrality: All investments within a country should face the same tax burden, regardless of the nationality of the investor. As noted earlier, satisfying both principles at the same time is possible only if effective tax rates on capital income are identical across countries.8 The U.S. Treasury Department has generally favored the norm of capital- export neutrality,9 with a system that taxes the worldwide income of resident multinational firms and provides a tax credit for taxes on foreign-source income paid abroad.~ However, concern over preservation of the U.S. tax base has led to complex rules, reducing the likelihood of achieving efficiency, competitiveness, and simplicity objectives. U.S. INTERNATIONAL TAX RULES: THE INCENTIVES Incentives in U.S. international tax rules are considered here in three parts: (1) basic rules for determining U.S. tax treatment of foreign-source income, (2) complications of those basic rules arising from provisions of the alternative mini ~Economic analysis of the relative merits of norms of capital-export neutrality (CEN) and capital- import neutrality (CIN) has traditionally compared distortions in the level of saving within an economy and in the allocation of that saving among alternative investments at home and abroad. Implementing CIN by exempting active foreign-source income from taxation can promote worldwide economic efficiency if domestic savings are inefficiently low, although other capital tax instruments may also be used to achieve this objective. By contrast, CEN promotes worldwide efficiency in the allocation of savings. As such, CEN may be a better guiding principle when efficiency costs in the allocation of savings are large relative to costs of tax-induced distortions in the level of savings (see, for example, Horst, 1980; Giovannini, 1989). Indeed, empirical evidence generally supports the proportion that the responsiveness of domestic saving to a change in the net return is less then the responsiveness of the allocation of investment to tax policy. Nevertheless, some compromise between CEN and CIN is both inevitable and unobjectionable given the presence of tax-induced distortions of both investment and saving decisions and the complexity of the modern multinational firm. 9See, for example, the discussion in Hufbauer (1992). iIn practice, the U.S. system departs significantly from CEN, in part because of the absence of accrual taxation of foreign-source income and limitations on the foreign tax credit. Thor example, multinational enterprises often complain that policymakers' pursuit of CEN is at the expense of U.S. firms' competitiveness since, in some cases, U.S. firms may face a higher total tax burden on foreign-source income than foreign competitors.

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4 BORDERLINE CASE mum tax, and (3) rules relating to the allocation of expenses related to interest and to research and development. Taxation of Foreign-Source Income: The Basics The United States claims tax authority over all residents, meaning that U.S. individuals and corporations must pay tax to the U.S. government on all their income, whether earned in the United States or abroad.~3 As noted earlier, "resi- dence" is not the only possible basis for tax authority; some countries tax their residents on a "territorial" basis, so that only income earned within the country's borders is subject to tax. In addition to potential U.S. tax liabilities, U.S. multinationals usually owe taxes to foreign governments on profits earned within their borders. To avoid double taxation of foreign-source income, U.S. tax law provides a foreign tax credit for income and related taxes paid to foreign governments. For example, in the simplest possible situation, a U.S. corporation earning $100 in a foreign coun- try with a 10 percent tax rate (a foreign tax obligation of $10) pays only $25 to the U.S. government since its U.S. corporate tax obligation of $35 (35 percent of $100) is reduced to $25 by the foreign tax credit of $10. The foreign tax credit is, however, limited to the equivalent U.S. tax liability on that income. If the foreign tax rate is 50 percent instead, the firm pays $50 to the foreign government, but its U.S. foreign tax credit is limited to $35. Hence, a U.S. firm receives full tax credits for foreign tax payments paid only when it is in an "excess limit" position, that is, when its average foreign tax rate is less than the average tax imposed by the United States on foreign-source income. A firm has "excess credits" if its available foreign tax credits are greater than its U.S. tax liability on its foreign- source income. U.S. firms are required to calculate their foreign tax credits on a worldwide basis, so that all foreign income and foreign taxes paid are added together in computation of the foreign tax credit limit. Income is also decom- posed into different functional "baskets" in the calculation of applicable credits and limits. Deferral of U.S. taxation of certain foreign earnings is another important feature of the U.S. system for taxing overseas income. This deferral is of two types. The first is simply that unrealized capital gains are usually not taxed, a general feature of most income tax systems. Second, earnings of foreign subsid- iaries of U.S. corporations are not subject to U.S. taxation until repatriated to their parent corporations. This type of deferral is available only to foreign opera- tions that are incorporated separately in foreign countries ("subsidiaries" of the i2This is, of course, not an exhaustive list, which could include an analysis of transfer pricing regulations, sales source rules, foreign sales corporation rules, and other provisions. i3For more detailed descriptions of systems for taxing income from foreign direct investments, see Ault and Bradford (1990); Frisch (1990); Hines and Hubbard (1990); U.S. Congress, Joint Committee on Taxation (1990, 1991); and U.S. Department of the Treasury (1993).

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U.S. TAX POLICY AND MULTINATIONAL CORPORATIONS 115 parent) and not to consolidated ("branch") operations. Multinational companies generally are able to choose the organizational form of overseas operations and thereby influence their tax obligations. On the one hand, U.S. parent firms are generally taxed on their subsidiaries' foreign income only when it is repatriated and receive "indirect' foreign tax credits ("deemed-paid credits") for subsidiary foreign income taxes paid on income subsequently received as dividends. On the other hand, the U.S. government taxes branch profits as they are earned, just as it would profits earned within the United States. Organizing as a branch neverthe- less offers the chance to deduct foreign branch losses from U.S. income and may involve more lenient foreign regulations. It is possible for deferral to encourage firms facing low foreign tax rates to delay the repatriation of dividends.~4 i5 This incentive is enhanced when firms expect that future years offer a more favorable tax climate for repatriation, for example, in anticipation of a reduction in the domestic corporate income tax rate on excess foreign tax credits to use in offsetting U.S. tax liability on repatriations. Available empirical evidence suggests that firms choose patterns of dividend re- patriations to minimize tax liability (see Hines and Hubbard, 1990; Altshuler et al., 1995~. Dividends to the parent company are not the only possible form of repatria- tion. is Interest paid to the parent to service debt capital contributions is generally deductible in the host country. In some cases, transfer pricing can be used by a subsidiary to shift income to the parent or to other subsidiaries of the parent having more favorable tax treatment. Royalty payments to the parent can serve a similar function. Foreign governments often impose withholding taxes, credit- able against foreign tax liability of the parent, on dividend, interest, rent, and royalty payments from foreign subsidiaries to U.S. parents. Alternative Minimum Tax Complications As it does in the domestic context, the alternative minimum tax (AMT) em- bodies incentives affecting investment and financial policy decisions of multina i4Deferral per se may not encourage firms to delay paying dividends from foreign subsidiaries, since the tax to the U.S. government must at some point be paid (see Hartman, 1985; Altshuler and Fulghieri, 1994; Cummins and Hubbard, 1995). i5Congress enacted the subpart F provisions in 1962 in an attempt to prevent indefinite deferral of U.S. tax liability on foreign-source income. These provisions apply to "controlled foreign corpor- ations" at least 50 percent owned by U.S. persons holding stakes of at least 10 percent each. Subpart F provisions treat passive income as if it had been distributed to the U.S. parent company, thereby subjecting it to current taxation. Controlled foreign corporations that reinvest their earnings in active foreign businesses sidestep subpart F rules and may continue to defer U.S. tax liability on those earnings. Subpart F coverage was expanded in the Tax Reform Act of 1986 (see discussion in U.S. Department of the Treasury, 1993). i6For a comparison of the tax treatment of alternative forms of repatriation, see Hines and Hubbard (1990).

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116 BORDERLINE CASE tional firms. i7 First, foreign tax credit calculations differ between the regular tax and the AMT.~8 Second, relative investment incentives for regular tax and AMT firms differ from those in the domestic setting. The tax code often penalizes new domestic investment undertaken by an AMT firm relative to investment under- taken by a firm subject to the regular tax (see, for example, Lyon, 1990; Prakken, 1994~. A multinational firm, however, claims the same deductions for deprecia- tion of foreign-use property under the AMT as under the regular tax.~9 Therefore the AMT may create a relative incentive to locate investment overseas. Incen- tives for domestic investment are reduced by the AMT, whereas incentives for equity-financed foreign investment are unchanged or even improved under the AMT20 (see Lyon and Silverstein, 1995~. The AMT may also offer parent firms the opportunity to receive dividends from subsidiaries at a cost lower than that possible under the regular tax (see, again, Lyon and Silverstein, 1995~. Allocation of Interest and R&D Expenses Interest Allocation Rules In the domestic context, interest expense is deductible against taxable in- come; corporations can carry back net operating losses for three years and, to avail themselves of deductibility, carry them forward for 15 years. Determining interest deductions for multinational corporations is more complicated. The spirit of U.S. rules for the allocation of interest deductions is to allow the deductibility of interest against taxable income in the United States only for interest expense generating income subject to taxation in the United States. Such an approach is inherently difficult to implement because of the fungibility of funds within a multinational firm. The regulatory distinction between "domestic" and "foreign" interest expense is not merely academic and can affect firms' costs of finance. When interest i7It is probably important to analyze the interaction of AMT and foreign tax rules. In 1990, 53 percent of the assets and 56 percent of the foreign-source income of corporations filing Form 1118 could be attributed to firms paying AMT. i8The concepts of "worldwide income," "foreign income," and "U.S. tax liability" are calculated using AMT rules rather than regular tax rules. In addition, the combined use of AMT foreign tax credits and net operating loss deductions may not decrease tentative minimum tax by more then 90 percent. Such credits denied are treated like other excess foreign tax credits and may be carried back for two years and forward for five years to offset tentative minimum tax. i9Foreign investment receives slower depreciation allowances absolutely than domestic investment under both the regular tax and the AMT systems. Firms subject to the AMT may nonetheless face a relative incentive to invest overseas. 20With debt finance, incentives for foreign and domestic investment may be curtailed by the AMT. This is because the after-tax cost of $1.00 of interest expense increases from $0.65 under the regular tax to $0.80 under the AMT. Nonetheless, although the cost of all debt-financed investment is raised under the AMT, the cost of foreign investment relative to domestic investment is still lower for the AMT firm than for the regular tax firm (see Lyon and Silverstein, 1995).

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U.S. TAX POLICY AND MULTINATIONAL CORPORATIONS 117 expense is determined to be foreign, it reduces foreign taxable income but only for the purposes of U.S. taxation, since foreign governments do not as a rule allow U.S. firms to lower foreign taxable income because of interest expenses in the United States. As a result, a U.S. firm benefits from interest deductions deter- mined to be "foreign" only if that firm is in an excess limit position for foreign tax credit purposes. This occurs because, for such firms, a portion of the foreign- source income is subject to residual tax; incremental interest expense allocated to foreign-source income simply reduces U.S. taxable income for the firm one for one. For firms with excess credits, the interest allocation rules can lead, in effect, to a partial disallowance of interest deductions. The Tax Reform Act of 1986 adopted a "one-taxpayer rule" in which the characteristics of all members of a controlled group determined interest alloca- tion. Prior to 1986, interest expenses were arrived at for each company individu- ally within a controlled group. The assumption underlying the new rule is that fungibility of funds implies that borrowing should be evaluated at the level of a controlled group. In practice, firms are obligated to allocate interest expense on the basis of the book values of domestic and foreign assets. As a consequence, firms with substantial foreign assets relative to total assets and with excess for- eign tax credits were unable to deduct a portion of their interest expense after 1986. Whether this denial raises firms' cost of capital depends on the cost at which firms can substitute equity for debt finance. R&D Allocation Rules Given the role often attributed to R&D intangible capital in explaining eco- nomic performance, it is not surprising that business, academic, and public policy attention has also focused on the tax treatment of R&D. In the domestic context, corporate R&D expenses are treated favorably for tax purposes.21 As with inter- est expenses, U.S. multinationals generally are not allowed to deduct their entire U.S. expenses on R&D against domestic taxable income; such expenses are allo- cated between domestic- and foreign-source income. The rules' intent is to pre- serve the favorable treatment of R&D only for expenditures related to production for domestic markets. As with interest expenses, the allocation of R&D expenses between domestic and foreign incomes can affect the value of the deduction. R&D expenses allo- cated against foreign-source income are valued by a U.S. firm only if it is in an excess limit position for foreign tax credit purposes. The Treasury Department 21 Such expenses are deductible for tax purposes, receiving favorable tax treatment given that accu- mulated R&D is usually thought of as a capital good. Since 1981, the United States has also had a research and experimentation (R&E) tax credit. The Tax Reform Act of 1986 reduced the generosity of this tax credit to 20 percent for eligible incremental R&D expenses above a base equal to the average of the firm's prior three years' worth of spending on R&D. After 1986, the credit survived through a series of temporary extensions.

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118 BORDERLINE CASE formalized rules for R&D expense allocation (section 1.861-8) in 1977. Over the course of the 1980s and 1990s, these rules have been changed many times.22 EFFECTS OF TAX INCENTIVES ON COST OF CAPITAL AND INVESTMENT Having identified some key investment and financing incentives present in U.S. international tax rules, let us turn now to empirical evidence on the effects of thee incentives on the cost of capital faced by U.S. multinational firms. Existing empirical studies of determinants of foreign direct investment (FDI) reflect researchers' interest in either industrial organization or taxation. Indus- trial organization inquiries have generally ignored tax considerations and ana- lyzed FDI as being governed by firms' desire to exploit the value of ownership- specific assets (e.g., intangible capital) or location-specific advantages related to sourcing or marketing.23 Empirical research has analyzed the roles played by ownership-specific and location-specific variables in determining FDI. Public finance inquiries have focused on the role of differential tax treatment in determining the source and location of FDI, holding nontax determinants constant. In this vein, a significant body of empirical research has examined the effects of taxation on the cost of capital for FDI into the United States, primarily the simple relationship between capital flows and measures of after-tax rates of return or effective tax rates on capital income. Following work by Hartman (1984, 1985), several studies have used annual aggregate data for inbound FDI financed by subsidiary earnings and parent com- pany transfers of funds. Hartman's approach assumes that subsidiaries' dividend payouts are a residual in firm decisions. Payout ratios do not affect firms' re- quired rate of return on equity invested, and permanent changes in home country tax rates do not affect dividend payouts or the cost of capital. In the context of FDI, these implications permit Hartman and others to ignore effects of perma- nent changes in home country tax parameters on FDI in "mature" subsidiaries paying dividends to their parent firms.24 Hartman estimates the effects on U.S. inbound FDI of changes in the after- tax rates of return received by foreign investors in U.S. inbound FDI and by 22Significant modifications were made in the Economic Recovery Tax Act of 1981, Tax Reform Act of 1986, Technical and Miscellaneous Revenue Act of 1988, Omnibus Budget Reconciliation Act of 1984, and subsequent legislative and administrative extensions. See Hines (1993) for a detailed . . discussion. 23See, for example, the reviews of studies in Caves (1982). 24This approach is more suitably applied to firm-level data. The underlying model suggests that a mature subsidiary's investment financed by retained earnings is unaffected by the home country tax rate. This suggestion is not equivalent to a claim that aggregate investment out of retained earnings will not be affected by the home country tax rate.

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U.S. TAX POLICY AND MULTINATIONAL CORPORATIONS 119 investors in U.S. capital generally, with the intent of measuring impacts of shifts in returns to new FDI. He finds that the ratio of FDI to GNP (gross national product) increases as after-tax rates of return rise and decreases as the relative tax rate on foreigners rises. These results suggested that taxes are an important deter- minant of FDI, and Hartman's study prompted many subsequent rounds of repli- cation and refinement (see, for example, Boskin and Gale, 1987; Newton, 1987; Slemrod, 1990~. These studies advance our understanding of the effects of taxation on FDI but raise a number of concerns. An obvious concern relates to problems of infer- ence about tax effects on firms' decisions using such highly aggregated data. A second concern is that nontax determinants of FDI are not modeled. Third, the FDI data supplied by the Bureau of Economic Analysis suffer two drawbacks: (1) they measure financial flows rather than new capital investment per se, and (2) they are based on periodic benchmark surveys, raising the possibility that FDI flows are more mismeasured the further the observation is from a benchmark year. In a world of ideal data, assessing the impact of taxation on firms' cost of capital for FDI would be straightforward. Consider a U.S. parent firm deciding how much to invest in a particular country. Intuitively, neoclassical models of investment predict that the firm will invest until the value of an additional dollar of capital equals the cost of investing.25 Unfortunately, this benchmark approach is not particularly useful as a practical guide to estimating the effects of taxation on the levels of firms' FDI. First, it is difficult to develop a proxy for the incre- mental value of investing from available data on financial market valuation even under the best of circumstances. For FDI, a further complication arises because location-specific effects on the value of incremental investment in the subsidiary cannot be captured by using available financial data at the parent-firm level, and subsidiary-specific financial market data are, of course, not observable. To reduce these practical problems, Cummins and Hubbard (1995) employ an empirical approach developed to estimate effects of after-tax returns to invest- ing with fewer informational requirements than conventional models. It allows one to ask the question: Given a change in a tax parameter, how does a sub- sidiary's return to investing change, and how does FDI change? Tax considerations can affect subsidiaries' new capital investment decisions through two channels.26 First, host country corporate income tax rates, invest- ment incentives, and depreciation rules affect the cost of capital for foreign inves- tors. This channel has been the focus of empirical analysis of the effects of tax policy on domestic investment. A second channel through which tax policy af- fects FDI from countries with worldwide tax systems such as the United States is 25See, for example, Alworth (1988). 26In general, investment through acquisitions is governed by a different set of tax determinants. See, for example, the discussion in Auerbach and Hassett (1993).

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22 BORDERLINE CASE tiveness. If U.S. firms are subject to a residual U.S. tax on investments in low-tax foreign countries, will they not be at a disadvantage in competing with multina- tionals headquartered in other countries?32 The answer is perhaps. Although it is true that the present system imposes a tax penalty on U.S. multinationals whose overseas operations are largely in low- tax countries, empirical studies of subsidiaries' dividend repatriations have shown that at least prior to the Tax Reform Act of 1986, significant "cross-crediting" of high-tax and low-tax income occurred (see Hines and Hubbard, 1990; Altshuler and Newton, 1993; Altshuler et al., 1995~. Firms with low-tax subsidiaries could blend repatriations from such subsidiaries with repatriations from high-tax sub- sidiaries. The Tax Reform Act of 1986 restricted the use of cross-crediting by increasing the number of separate limitation baskets. As a result, it is possible that the cost of capital faced by U.S. firms' subsidiaries operating in relatively low-tax jurisdictions rose after 1986.33 Because the new limitation baskets apply to only about one-fourth of all foreign-source income (U.S. Department of the Treasury, 1993), it is worth asking whether much revenue is, in fact, being pro- tected at the cost of the more complex rules. Unfortunately, at least to my knowl- edge, there has been no comprehensive analysis of repatriation decisions using data after 1986. Such an inquiry would require an examination of corporate tax return data on the post-1986 period by the Joint Committee on Taxation or the Office of Tax Analysis. In a separate exercise, Grubert and Multi (1994), using tax return data for 1990, have estimated that the average effective U.S. tax rate on active foreign income is approximately zero, although some individual firms, of course, pay residual U.S. tax.34 This estimate reflects the ability of firms operating in both low-tax and high-tax jurisdictions to adopt repatriation strategies to minimize the residual tax.35 In addition, Grubert and Multi note that in some cases, subsidiar- ies of U.S. firms repatriate low-taxed royalty and interest income along with more highly taxed dividend income. If the United States had a territorial (exemption) 32Calculations by the Organization for Economic Cooperation and Development (1991) and Jun (1995) suggest that for equity-financed investments, U.S. firms often face a higher cost of capital for overseas investment than non-U.S. firms. 33Since passage of the Tax Reform Act of 1986, section 904(d) of the Internal Revenue Code specifies separate foreign tax credit limitation for eight types of income. Other types of income are subject to a common "general limitation." 34The usual caution against interpreting the Grubert-Mutti calculation as a "revenue estimate" is in order. They assume no significant behavioral response by firms if the United States were to switch from a worldwide to a territorial tax system. This presumes, among other things, that firms would be unable to reclassify "royalties" as "dividends." 35The Grubert-Mutti calculations do not incorporate effects of the AMT. As noted earlier, the im- pact of the AMT is difficult to gauge. On the one hand, if the firm has domestic losses and significant foreign income, it may be subject to the 90 percent limitation on the foreign tax credit. On the other hand, if the firm is subject to the AMT because of domestic considerations, the residual tax rate is only 20 percent.

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U.S. TAX POLICY AND MULTINATIONAL CORPORATIONS 123 tax system, dividend income would be exempt in their estimate whereas world- wide taxation with a foreign tax credit would still apply to royalty income. The U.S. Treasury Department's interim study of U.S. international tax rules identified "simplicity" as an important goal for reform. This emphasis does not seem misplaced. The Office of Tax Policy Research at the University of Michi- gan has been compiling information on the overall costs of tax compliance for large corporations. Blumenthal and Slemrod (1994) analyzed compliance costs for 365 firms, with an emphasis on studying costs associated with taxing foreign- source income. They report that 39 percent of the total compliance cost of federal taxes can be traced to foreign-source income. Since the average fractions of as- sets abroad (19.2 percent), sales abroad (21.3 percent), or employment abroad (16.6 percent) are less then 39 percent, compliance costs associated with foreign- source income are about 8.5 percent of net U.S. revenue raised. The Blumenthal- Slemrod survey identifies foreign tax credit rules, expense allocation rules, and transfer pricing rules as being most burdensome. Compliance burdens for U.S. multinational firms occur within the U.S. sys- tem of worldwide taxation. The Grubert-Mutti estimate suggests that the United States raises very little revenue from this system. Should we infer, then, that the United States should switch from a worldwide to a territorial tax system? Again, the answer is only perhaps. Although either system provides relief from double taxation and a territorial system may in some ways be less expensive to adminis- ter, a move to a territorial system would significantly increase pressure on trans- fer pricing and allocation rules to address potential income shifting.36 In addi- tion, a territorial system might lead to an expansion of tax-haven activity and erosion of the tax base.37 To shed light on this concern, researchers and the Treasury Department should examine the experience of France and the Nether- lands with territorial systems. Complications from the Alternative Minimum Tax Empirical evidence on incentive effects of the AMT is not abundant, though the significant stock of outstanding corporate AMT credits indicates the potential importance of these effects (see Gerardi et al., 1994~. The incentive effects of AMT-related international tax rules on domestic investment are ambiguous. On the one hand, recall that the AMT can in some cases create a relative incentive to investment abroad rather than domestically for firms subject to the AMT. Calcu- lations reported in Lyon and Silverstein (1995) document this relative incentive 36For empirical evidence on the significant potential for income shifting, see Harris et al. (1993); and Hines and Rice (1994). 37Indeed, the territorial system ("modified exemption") prototype discussed in U.S. Department of the Treasury (1993) would exempt high-tax active foreign-source income. The study noted the pres- sure that such a system would place on source and expense allocation rules because classifying an expense as relating to exempt income would be tantamount to denying a deduction for the expense.

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24 BORDERLINE CASE in the case of equity-financed investment.38 On the other hand, AMT provisions may offer a window of opportunity for repatriating overseas earnings at a lower cost than that under the regular tax. To the extent that repatriated earnings are retained by U.S. parent firms, these incentives offer an ambiguous effect on over- all domestic investment. Additional empirical analysis is needed to understand the incentive effects of the AMT. Allocation of Interest and R&D Expenses As noted earlier, features of the current rules for allocating expenses for in- terest and R&D can in some cases lead to a partial disallowance of deductions, frustrating the law's intention of deductibility and leading to overtaxation of eco- nomic income. The available empirical evidence on these effects is summarized below. In the case of interest allocation rules, it is possible that firms in an excess credit position with significant foreign assets do not receive the complete benefit of the interest deduction. As a result, the introduction of allocation rules would raise the cost of capital for such firms to the extent that they could not easily substitute equity for debt finance.39 A simple test would be to compare invest- ment before and after 1986 for firms in excess limit and excess credit positions, holding other determinants of investment constant. Using Compustat data on 203 firms, Froot and Hines (1994) control for industry effects and the importance of foreign assets. They find that from 1986 to 1991, firms that could not fully deduct their U.S. interest expenses on average both borrowed 4.2 percent less as a frac- tion of firm assets and invested 3.5 percent less in property, plant, and equipment than firms whose deductions were not affected by the interest allocation rules. In a careful analysis of 13 large U.S. nonfinancial multinational firms, Altshuler and Mintz (1995) found that the interest allocation rules raised the cost of debt fi- nance significantly for domestic and foreign investment by U.S. firms with ex- cess foreign tax credits. Allocation rules for R&D expenses raise similar concerns for firms with ex- cess foreign tax credits. Hines (1993), analyzing longitudinal data on 116 U.S. multinational firms in the Compustat data, argues that the elasticity of domestic 38Lyon and Silverstein calculated the magnitude of the change in the price of foreign investment relative to domestic investment between AMT and regular tax firms under a set of assumptions. Consider the case of equity-financed investments by firms in excess limit status for foreign tax credit purposes. Firms expecting to be subject to the AMT for 10 years face roughly equivalent effective tax rates for domestic and foreign-use equipment, whereas regular tax firms face significantly higher effective tax rates for foreign investment than for domestic investment. In the cases Lyon and Silverstein considered, foreign investment is treated less favorably than domestic investment for firms facing a given tax system. Nonetheless, the AMT creates a relative incentive to locate investment abroad rather than in the United States. 39For example, such firms could replace debt with preferred stock (Collins and Shackleford, 1992).

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U.S. TAX POLICY AND MULTINATIONAL CORPORATIONS 125 R&D spending with respect to the after-tax price of R&D is in the range of -1.2 to -1.6. Although these very high estimates of responsiveness of R&D to tax policy are controversial,40 it is worth noting that Hines' estimates imply a large increase in R&D performed in the United States should R&D expense be 100 percent deductible against U.S. taxes. Evaluation of such reforms depends, of course, on the revenue cost and the availability of other means of stimulating R&D investment. INCREMENTAL REFORMS Tax-induced differences in costs of funds across firms for similar investment projects are not the hallmark of an efficient tax system. Similarly, to the extent that our international tax rules do not permit full deductibility of expenses, U.S. firms are placed at a competitive disadvantage vis-a-vis firms headquartered else- where. Finally, even this cursory discussion of rules associated with expense allo- cation and the AMT makes it clear that sacrifices in economic efficiency and competitiveness in our current rules are not purchasing "simplicity." What incremental reforms are suggested by these concerns? Let us put aside the question of the AMT, which is questionable tax policy warranting a more general discussion even in a strictly domestic context. With respect to interest allocation rules, the Tax Reform Act of 1986 applied a "water' e-edge fungibility" approach.41 In principle, "worldwide fungibility" could be implemented by com- bining domestic and foreign affiliates' interest expense and apportioning this com- bined amount to the income of the group by assets of domestic and foreign group members. In practice, this strategy is difficult to implement because of deferral. Alternatively, the United States could employ a simple "netting rule": interest would be allocated if the debt-asset ratio of the parent firm exceeded the debt- asset ratio of foreign subsidiaries or, possibly, the debt-asset ratio of the parent firm and foreign affiliates on a consolidated basis.42 In this case, a U.S. parent firm would be permitted full deductibility of interest expense if its debt-asset ratio is no greater than that of its foreign subsidiaries. The usefulness of such a rule in mitigating problems under current law depends on the ease with which multinationals can lever assets in source countries. Another alternative would be a simple requirement that the U.S. parent have a specified minimum amount of equity relative to assets;43 if more debt is used, a fraction of the interest expense would not be permitted. 40See the discussion in Hall (1993). 4iUnder a water's-edge approach, the debt of a U.S. parent is treated as if it supported foreign subsidiary investment to the same extent as domestic investment. Under a worldwide fungibility approach, a U.S. parent is allowed to take into account foreign subsidiaries' interest expense in appor- tioning its own interest expense. 42Some netting rules are discussed in Hufbauer (1992). 43Altshuler and Mintz (1995) refer to such a concept as a "fat capitalization" rule.

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26 BORDERLINE CASE It is also possible to apply a worldwide fungibility approach to the allocation of expenses for R&D. As with borrowing, under such an approach, R&D ex- penses of foreign subsidiaries would be considered in the determination of whether to allocate some portion of U.S.-incurred R&D expense to foreign-source income. The case for such a policy change would be bolstered by empirical evi- dence supporting the notion that R&D within a multinational firm is done pre- dominantly in locations in which related products are sold. ISSUES FOR GENERAL REFORM The financing and investment incentives created by U.S. international tax rules are complex and in some cases difficult to measure. Against such a back- drop, it is not likely that simple general reforms will address the concerns of policymakers and the business community regarding efficiency, competitiveness, and simplicity. It is productive to examine reforms in two steps: first, incremental changes to reduce significant problems or anomalies under current law, and sec- ond, to consider "international tax reform" in the context of reform of capital taxation.44 As a first step it is possible to reduce violations of efficiency and competi tiveness goals by modifying interest allocation rules and R&D allocation rules. Moreover, substantial simplification of foreign tax credit rules may be possible even in the context of the current worldwide tax system with deferral (see, for example, U.S. Department of the Treasury, 1993~. Finally, simplification gener- ally may be facilitated by international coordination, since many rules are de- signed to limit shifting of expenses or income for the purpose of tax avoidance. The form of this coordination should reflect the relative responsiveness to varia- tion in tax rates of real investment and reported income. To the extent that the responsiveness of reported income is greater than that of real investment, policy- makers may wish to focus on harmonizing statutory corporate tax rates while allowing investment incentives to vary across countries. The broader issue of whether the United States should move closer to a pure worldwide tax system, for example, by eliminating deferral, or to a territorial (exemption) system should be considered in the context of broader tax policy decisions. For example, to the extent that corporate income taxation is viewed as a backstop against income shifting (as in Gordon and MacKie-Mason, 1995), a move to a territorial tax system may lead to an erosion of the U.S. domestic tax base and require offsets from other distorting taxes. . 44Unfortunately, policymakers have not generally considered international tax reform in the context of general tax reform. For example, the Tax Reform Act of 1986 arguably used international tax rule changes to raise revenue rather than to advance the general goals of reform. The Clinton admin- istration's initial 1993 budget package likewise focused on revenue enhancement in the international tax area.

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U.S. TAX POLICY AND MULTINATIONAL CORPORATIONS 127 Nonetheless, the broader tax reforms currently under current discussion sug- gest that a move to a territorial tax system should be taken seriously. Many re- forms of business taxation, ranging from corporate tax integration to the adoption of consumption taxes, would be consistent with a territorial approach to the taxa- tion of foreign-source income. As an illustration, the Treasury Department's pro- posal in 1992 for corporate tax integration incorporated a dividend exclusion prototype in which investors would not pay taxes on dividends received (see U.S. Department of the Treasury, 1992a, 1992b). The proposal might encourage ex- amination of a modified exemption system under which U.S. parent firms would exclude from taxable income dividends received from overseas subsidiaries. The Treasury Department also described a Comprehensive Business Income Tax (CBIT) in which neither interest nor dividends would be deductible and in which investors would not pay taxes on interest and dividends received (U.S. Depart- ment of the Treasury, 1992a). In another example, the substitution of a uniform flat-rate consumption tax for domestic capital income taxes would remove distortions in both the location and the magnitude of corporate investment. For example, the "Saving-Exempt Income Tax" proposal of former Senator Sam Nunn and Senator Pete V. Domenici (see the discussion in Seidman, 1997) or the Flat Tax proposal of Robert Hall and Alvin Rabushka (1983,1995) would replace existing business income taxes with a tax on sales less the cost of purchases from other businesses; in short, domestic investment would be expensed.45 46 Because these proposals' intended tax base is consumption, not accrued income as in the current system, they are broadly consistent with a territorial tax system whose design should be considered. Fundamental tax reform also raises the issue of the effects of required rates of return on debt and equity in capital markets. Replacing the current tax system with the Comprehensive Business Income Tax or the Hall-Rabushka Flat Tax could significantly affect debt and equity returns and international flows of debt and equity capital (see Gentry and Hubbard, 1998~.47 45See descriptions in American Business Conference (1993) and Congressional Budget Office (1994). Such a tax is akin to a business transfer tax or substraction-method value-added tax. See for example, former Treasury Secretary Nicholas Brady's (1992) proposal for a business transfer tax. 46Alternatively, in the case of a corporate cash flow tax, investment would be expensed and interest deductions would no longer be permitted. In both the saving-exempt income tax and the cash flow tax prototypes, the elimination of interest deductions eliminates the need for interest allocation rules. 47The conventional explanation of the effect on interest rates of switching from the current tax system to a broad-based consumption tax such as the Flat Tax is that the pretax interest rate should fall. Consider, for example, the switch from the current tax system to CBIT. Two features of CBIT reform would directly affect corporate interest rates. First, taxes on interest income would be elimi- nated. Second, interest deductibility would be eliminated. In the simplest story, all interest income is taxed and all interest expenses are deducted. In a closed economy, if there is no heterogeneity in effective tax rates, the introduction of CBIT maintains the existing after-tax interest rate; that is, the pretax interest rate falls by the amount of the tax. In reality, there is heterogeneity in the effective tax rates facing suppliers and demanders of credit. Tax reform could cause downsize capital to flow from currently tax-favored sectors (e.g., housing) to the domestic business sector.

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128 BORDERLINE CASE REFERENCES Altshuler, R., and P. Fulghieri. 1994. "Incentive effects of foreign tax credits on multinationals." National Tax Journal 47:349-361. Altshuler, R., and J.M. Mintz. 1995. "U.S. interest allocation rules: Effects and policy." International Taxation and Public Finance 2:7-35. Altshuler, R., and T.S. Newton. 1993. "The effects of U.S. tax policy on the income and repatriation patterns of U.S. multinational corporations." In Studies in International Taxation, A. Giovannini, R.G. Hubbard, and J.B. Slemrod, eds. Chicago, Ill.: University of Chicago Press. Altshuler, R., T.S. Newton, and W.C. Randolph. 1995. "Tax effects on income repatriation by U.S. multinationals: Evidence from panel data." In The Effects of Taxation on Multinational Corpo- rations, M. Feldstein, J.R. Hines, and R.G. Hubbard, eds. Chicago, Ill.: University of Chicago Press. Alworth, J.S. 1988. The Finance, Investment and Taxation Decisions of Multinationals. Oxford: Basil Blackwell. American Business Conference. 1993. The Nunn/Domenici Proposal for a Saving-Exempt Income Tax: Overview and Summary. Conference Pamphlet. Washington, D.C. Auerbach, A.J., and K.A. Hassett. 1993. "Taxation and foreign direct investment in the United States: A reconstruction of the evidence." In Studies in International Taxation, A. Giovannini, R.G. Hubbard, and J.B. Slemrod, eds. Chicago, Ill.: University of Chicago Press. Ault, H.J., and D.F. Bradford. 1990. "Taxing international income: An analysis of the U.S. system and its economic premises." In Taxation in the Global Economy, A. Razin and J.B. Slemrod, eds. Chicago, Ill.: University of Chicago Press. Blumenthal, M., and J.B. Slemrod. 1994. "The compliance cost of taxing foreign-source income: Its magnitude, determinants, and policy implications." Mimeograph. University of Michigan. Boskin, M.J., and W.G. Gale. 1987. "New results on the effects of tax policy on the international location of investment." In The Effects of Taxation on Capital Accumulation, M. Feldsten, ed. Chicago, Ill.: University of Chicago Press. Brady, N.F. 1992. Speech to the Graduate School of Business of Columbia University. December 10. Caves, R.E. 1982. Multinational Enterprises and Economic Analysis. Cambridge, Mass.: Cam- bridge University Press. Collins, J., and D. Shackleford. 1992. "Foreign tax credit limitations and preferred stock issuances." Journal of Accounting Research 30. Congressional Budget Office. 1994. "Estimates for a prototype saving-exempt income tax." CBO memorandum. Washington, D.C., March. Cummins, J.G., and R.G. Hubbard. 1995. "The tax sensitivity of foreign direct investment: Evidence from firm-level panel data." In The Taxation of Multinational Corporations, M. Feldstein, J.R. Hines, and R.G. Hubbard, eds. Chicago, Ill.: University of Chicago Press. Cummins, J.G., K.A. Hassett, and R.G. Hubbard. 1994. "A reconsideration of investment behavior using tax reforms as natural experiments." Brookings Papers on Economic Activity 2: 181-249. In a small open economy, integration increases desired international lending. The effect on interest rates of the shift from CBIT to the Flat Tax depends on the interest sensitivity of the supply of funds to the domestic business sector. If the domestic business sector is a "small open economy," introduc tion of the Flat Tax leaves interest rates at their CBIT levels. If the supply of funds is not perfectly elastic, the higher demand for funds leads to a decline in the pretax interest rate from its pre-tax reform level by less than the tax wedge. Fundamental tax reform in the form of the CBIT or Flat Tax would increase the after-tax return on U.S. equities. As a result, fundamental tax reform would likely lead to inflows of equity capital. Such inflows would be attenuated to the extent that domestic capital flows into the domestic business sector as a result of tax reform.

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U.S. TAX POLICY AND MULTINATIONAL CORPORATIONS 129 Cummins, J.G., T.S. Harris, and K.A. Hassett. 1995. "Accounting standards, information flow, and firm investment behavior." In The Taxation of Multinational Corporations, M. Feldstein, J.R. Hines, and R.G. Hubbard, eds., Chicago, Ill.: University of Chicago Press. Cummins, J.G., K.A. Hassett, and R.G. Hubbard. 1996. "Tax reforms and investment: A cross- country comparison." Journal of Public Economics 62:237-273. Diamond, P., and J.S. Mirrlees. 1971. "Optimal taxation and public production. I: Production efficiency." American Economic Review61(March):8-27. Feldstein, M. 1995. "The effects of outbound foreign direct investment on the domestic-capital stock." In The Taxation of Multinational Corporations, M. Feldstein, J.R. Hines, and R.G. Hubbard, eds. Chicago, Ill.: University of Chicago Press. Feldstein, M., J.R. Hines, and R.G. Hubbard, eds. 1995. The Taxation of Multinational Corpora- tions. Chicago, Ill.: University of Chicago Press. French, K.R., and J.M Poterba. 1991. "Investor diversification and international equity markets." American Economic Review 81(May):222-226. Frisch, D.J. 1990. "The economics of international tax policy: Same old and new approaches." Tax Notes (April 30). Froot, K.A., and J.R. Hines, Jr. 1994. "Losing interest: Interest allocation rules and the cost of debt finance." Mimeograph. Harvard University. Gentry, W.M., and R.G. Hubbard. 1998. "Fundamental tax reform and corporate financial policy." In Tax Policy and the Economy, Vol. 12, J. M. Poterba, ed. Cambridge, Mass.: MIT Press. Gerardi, G., H. Milner, and G. Silverstein. 1994. "The effects of the corporate alternative minimum tax: Additional results from panel data for 1987-1991." National Tax Association-Tax Institute of America, Proceedings of the 86th Annual Conference, Giovannini, A. 1989. "Capital taxation: National tax systems versus the European capital market." Economic Policy 4(0ctober). Giovannini, A., R.G. Hubbard, and J.B. Slemrod, eds. 1993. Studies in International Taxation. Chi- cago, Ill.: University of Chicago Press. Gordon, R.H., and J. Jun. 1993. "Taxes and the form of ownership of foreign corporate equity." In Studies in International Taxation, A. Giovannini, R.G. Hubbard, and J.B. Slemrod, eds. Chi- cago, Ill: University of Chicago Press. Gordon, R.H., and J.K. MacKie-Mason. 1995. "Why is there corporate taxation in an open economy? The role of transfer pricing and income shifting." In The Taxation of Multinational Corpora- tions, M. Feldstein, J.R. Hines, and R.G. Hubbard, eds. Chicago, Ill.: University of Chicago Press. Graham, E., and P. Krugman. 1991. Foreign Direct Investment in the United States. Washington, D.C.: Institute for International Economics. Grubert, H., and J. Multi. 1994. "Taxing multinationals in a world with portfolio flows and R&D: is capital-export neutrality obsolete?" Mimeograph. U.S. Department of the Treasury. Washing- ton, D.C., April. Hall, B.H. 1993. "The sensitivity of R&D to delicate tax changes: The behavior of U.S. multination- als in the 1980s." Commentary in Studies in International Taxation, A. Giovannini, R.G. Hl~hh~r~l ~nr1 TR Rl~.mrorl ~.~1.~ ~hio.~o T11 IJniv~.r`~itv of ~hio.~o Pr~.c~c~ -7 ~ -7 --- ' ~ --D-7 ~ J -- ~ --D- Hall, R.E., and A. Rabushka. 1983. Low Tax, Simple Tax, Flat Tax. New York: McGraw-Hill. Hall, R.E., and A. Rabushka. 1995. The Flat Tax, 2nd ed. Stanford, Calif.: Hoover Institution Press. Harris, D., R. Morck, J.B. Slemrod, and B. Yeung. 1993. "Income shifting in U.S. multinational corporations." In Studies in International Taxation, A. Giovannini, R.G. Hubbard, and J.B. Slemrod, eds. Chicago, Ill.: University of Chicago Press. Hartman, D.G. 1984. "Tax policy and foreign direct investment in the United States." National Tax Journal 37(December):475-487. Hartman, D.G. 1985. "Tax policy and fireign direct investment." Journal of Public Economics 107- 121.

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130 BORDERLINE CASE Hines, J.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. Hines, J.R., Jr., and R.G. Hubbard. 1990. "Coming home to America: Dividend repatriation deci- sions of U.S. multinationals." In Taxation in the Global Economy, A. Razin and J.B. Slemrod, eds. Chicago, Ill.: University of Chicago Press. Hines, J.R., Jr., and E.M. Rice. 1994. "Fiscal paradise: Foreign tax havens and American business. Quarterly Journal of Economics 109(February):149-182. Horst, T. 1980. "A note on the optimal taxation of international investment income." Quarterly Journal of Economics 94(June):793-839. Hufbauer, G.C., assisted by Joanna M. Van Rooij. 1992. U.S. Taxation of International Income: Blueprint for Reform. Washington, D.C.: Institute for International Economics. Hufbauer, G.C., and J.M. Van Rooij. 1994. "U.S. taxation of multinationals: Scoring the Clinton proposals." In Tax Policy of Economic Growth in the 1990s. Washington, D.C.: American Council for Capital Formation Center for Policy Research. Jun. J. 1995. "The impact of international tax rules on the cost of capital." In The Effects of the Taxation of Multinational Corporations, M. Feldstein, J.R. Hines, and R.G. Hubbard, eds. hio.~r, D1 ~ tJniv~r`~itv of ~hi~.~r, pack ~-D-7 ~ ~ -- ~ --D- Jun. J. 1990. "U.S. tax policy and direct investment abroad." In Taxation in the Global Economy, A. Razin and J. B. Slemrod, eds. Chicago, Ill.: University of Chicago Press. Lipsey, R.E. 1995. "Outward direct investment and the U.S. economy." In The Taxation of Multina- tional Corporations, M. Feldstein, J.R. Hines, and R.G. Hubbard, eds. Chicago, Ill.: University of Chicago Press. Lyon, A.B. 1990. "Investment incentives under the alternative minimum tax." National Tax Journal 43:451-465. Lyon, A.B., and G. Silverstein. 1995. "The alternative minimum tax and the behavior of multina- tional corporations." In The Effects of the Taxation of Multinational Corporations, M. Feldstein, J.R. Hines, and R.G. Hubbard, eds. Chicago, Ill.: University of Chicago Press. Newton, T.S. 1987. "Tax policy and the multinational firm's financial policy and investment deci- sions." Unpublished doctoral dissertation. Princeton University. Organization for Economic Cooperation and Development. 1991. Taxing Profits in a Global Economy. Paris: OECD. Prakken, J.L. 1994. "Investment, economic growth, and the corporate alternative minimum tax." In Tax Policy for Economic Growth in the 1990s. Washington, D.C.: American Council for Capi- tal Formation Center for Policy Research. Razin, A., and J.B. Slemrod, eds. 1990 Taxation in a Global Economy. Chicago, Ill.: University of Chicago Press. Seidman, L.S. 1997. The USA Tax: A Progressive Consumption Tax. Cambridge, Mass.: MIT Press. Slemrod, J.B. 1990. "Tax effects on foreign direct investment in the United States: Evidence from a cross-country comparison." In Taxation in a Global Economy, A. Razin and J.B. Slemrod, eds. Chicago, Ill.: University of Chicago Press. U.S. Congress. 1990. Background and Issues Relating to the Taxation of Foreign Investment in the United States. Washington, D.C.: Joint Committee on Taxation. U.S. Congress. 1991. Factors Affecting the International Competitiveness of the United States. Washington, D.C.: Joint Committee on Taxation. U.S. Department of the Treasury. 1992a. Integration of the Individual and Corporate Tax Systems. Washington, D.C.: U.S. Government Printing Office. U.S. Department of the Treasury. 1992b. A Recommendation for Integration of the Individual and Corporate Tax Systems. Washington, D.C.: U.S. Department of the Treasury.

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737 U.S. Deponent of me Treasury. 1993. ~fe~~fio~' ~ R-~; 4~ If I. Ounce of Tax Po11cy. Wasbington, D.C.: U.S. Deponent of me Tossup. U.S. Deponent of me Treasury. 1997. B/~r B~r ~ Ago. Wasbing~n, D.C.: U.S. movement PdnUng O~c~

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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