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10 Directions for International Tax Reform GARY HUFBAUER Institute for International Economics This chapter examines the "here and now" of international taxation and pre- scriptions for the international component of basic tax reform. Between "what is" and what some experts believe "should be," we consider whether counter- vailing forces will check the pattern in recent years of a stepwise evolution of the international tax system. "HERE AND NOW" OF INTERNATIONAL TAXATION In the 1950s, 1960s, and even the 1970s, the United States entertained a "grand vision" of the international tax system. This vision was built around sev- eral foundation facts and assumptions (Hufbauer, 1992~: Countries that were important players in the international economy generally op- erated "classical" tax systems, consisting of separate corporate and individual income taxes. It was thought that these systems could be satisfactorily meshed, on a bilateral basis, through a series of tax treaties. . . Sales, excise, value-added, and kindred consumption taxes were put in a separate conceptual box. Their international aspects namely, the extent that they could be adjusted at the border were addressed in the General Agreement on Tariffs and Trade (GATT), which has now become the World Trade Organization (WTO). Most business and personal income was tightly "linked" to one nation or another and not easily shifted as a way of avoiding taxes. Most interna iThe views in this chapter are the opinions of the author and do not necessarily reflect the opinions of the institute, its board of trustees, or its advisory board. 133
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34 BORDERLINE CASE . tional firms were structured in a hierarchical parent-subsidiary relation- ship relationship, with capital flowing from the parent to the subsidiary and income flowing in the other direction. Most individuals who earned income abroad did so in the form of wages and salaries. The network of purchases and sales of goods and services between related corporate taxpayers was not dense. Most of these transactions could be compared with similar transactions between unrelated parties to deter- mine a fair "arm' s-length" price so that income and expense could not be shifted between jurisdictions for the purpose of tax avoidance. In this world, the key tasks of international tax officials, acting as revenue collectors, were to determine the "source" of income and the "residence" of the taxpayer. "Source rules" evolved naturally from the links between geography and income. "Residence rules" were built on the place of business organization or the place where the individual spent most of his working time. Once source and residence rules were agreed between countries, it was a matter of dickering to establish which country, the source country or the resi- dence country, had the primary right to tax the income in question and which had the secondary right. Most of the dickering was done in bilateral tax treaties. The source country was generally assigned primary taxation rights to the particular stream of income. This primary right was recognized by the residence country when it exempted the income from its own tax net or when it allowed a credit against its own taxes for foreign taxes paid on the income (the foreign tax credit). Within the treaty framework, however, source countries usually agreed to cap particular taxes (e.g., a 10 percent limit on withholding taxes imposed on royalty income). Up to this point, the conceptual framework had little economic rationale, except to avoid "double taxation." Double taxation was regarded as a vice, based on the argument that it would discourage international trade and investment. The United States contributed two economic doctrines to the system. The most important was "capital export neutrality." The principle, inconsistently ap- plied, was that U.S. firms and residents should not have a tax incentive to operate outside the United States. Latent tax inducements would be offset by the U.S. system of taxing worldwide income; any U.S. firm or resident would eventually pay the same overall rate of tax, no matter where in the world it operated. This would be achieved by taxing the worldwide income of U.S. firms and residents and allowing a credit for foreign taxes imposed on foreign-source income. As the principal home country for multinational corporations and a country with rela- tively high corporate tax rates in the 1950s and 1960s, the United States provided an "umbrella" that invited other countries to raise their corporate rates to the U.S. level. The second economic doctrine was that foreign countries should not practice tax discrimination against U.S. firms. Taken together, nondistortion and nondis
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DIRECTIONS FOR INTERNATIONAL TAX REFORM 135 crimination constituted the original "level playing field": U.S. firms should, in the long run, not pay less tax when operating abroad than when operating at home and foreign governments should not tax U.S. firms more heavily than they taxed their own or third-country firms. Like all level playing field concepts, this was laden with inconsistencies that became more apparent over time. By the 1980s, many events had converged to erode these foundation facts and assumptions about the workings of the international economy and the proper role of the international tax system. For one thing, many industrial countries abandoned their "classical" systems of income taxation for "integrated" systems that gave recognition at the personal level for taxes paid at the corporate level. The proper way to "mesh" classical and integrated systems across international boundaries is not at all obvious. Second, many industrial countries placed more emphasis on the role of sales, excise, value-added, and other consumption taxes in their fiscal structures. These taxes have important consequences that are unevenly addressed by the rules of GATT and the WTO (Hufbauer, 1996~. Moreover, the doctrine of capital export neutrality cannot be implemented satisfactorily without taking these other taxes and production subsidies into account. New forms of international income and expense exploded-technology in- come of various types from movie royalties to patent licensing fees; plain vanilla- and-chocolate sundae portfolio income (interest and dividends and gains and losses from dealing in foreign exchange and derivatives); electronic commerce (both telecommunications transmission services and various sorts of remote value-added services); business, artistic, and professional services (Bechtel to Michael Jackson to Arthur Andersen); and huge intracorporate sales of goods and services. Source and residence rules are not obvious for many of these new forms of income and types of expenses. In many cases, comparable transactions be- tween unrelated taxpayers do not exist or are highly idiosyncratic, so there are few ready benchmarks for applying the arm' s-length pricing standard. The combination of global integration, new forms of income and expense, and increasing sophistication among corporate taxpayers loosened the old links between geography and income. Increasingly, firms learned to "game" the tax systems of the world, not only to alter source and residence on paper but also to change the location of plants, R&D facilities, and headquarters operations. Between the 1960s and 1980s, the United States relative to other industrial nations exchanged its position as the country with high personal and corporate marginal tax rates for a new position as a low income tax country. Since the mid- 1980s, however, the United States has once again drifted up into the high corpo- rate tax ranks, as established industrial countries and emerging industrial powers have cut their own corporate rates. At the same time, multinational corporations based in Europe, Asia, and Latin America have come to play a much larger role in the world economy. These developments meant that U.S. leverage as a discipli- narian of tax distortions and tax discrimination diminished and Treasury Depart
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136 BORDERLINE CASE ment revenues from U.S. firms' operations abroad shrank relative to revenues from foreign firms doing business in the United States. What has been the U.S. response to the altered landscape of the global economy? Senator Russell Long (D-LA) said it all in his famous aphorism, "Don't tax you, don't tax me, tax the fellow behind the tree!" U.S. and foreign multinationals are the quintessential "fellow behind the tree" big, rich, and cava- lier in the eyes of tax populists. The Tax Reform Act of 1986 marked the turning point. The conceptual foundations of U.S. international tax policy, already eroded by global forces, were all but ignored in the search for revenue. In this search, the guiding light had been created years earlier by Stanley S. Surrey, a distinguished professor at the Harvard Law School and Assistant Secretary for Tax Policy during the Kennedy and Johnson administrations. Surrey's searchlight was his list of "tax expenditures," a schedule of revenue lost by departures from an "ideal" tax sys- tem. Surrey's ideal basically amounted to a flat-rate, broad-base, classical tax system. This ideal is too simplistic for the realities of international taxation. It ig- nores the fact that whereas the U.S. Congress can, if it wishes, establish uniform taxation across all states and sectors of the U.S. economy, it has no such power for the rest of the world. In a global economy where the United States is one among several important players, the realities of competition must be taken into account. The tax expenditure concept ignores this fundamental fact. Despite this basic flaw, Surrey's ideal tax system has long been used to gen- erate the Treasury Department's tax expenditure estimates. These numbers were picked up by congressional tax staff, were suitably polished, and became objects of desire in the 1986 tax reform debate. Basically, revenue goals were pushed wherever there was a soft spot in the collective armory of multinational firms, and wherever foreign retaliation would not be too severe. The result is a great deal more complexity and somewhat more revenue (Hufbauer, 1992~. Much the same process has continued to dominate international tax legisla- tion since the Tax Reform Act of 1986. Indeed, as McClure and Ossi (1997) point out, despite widespread recognition that U.S. taxation of international in- come has become mindlessly complex, and despite many proposals for simplify- ing the system and giving it direction, only one small reform has been enacted since 1986 the repeal of Internal Revenue Code section 956A. The year 1997 saw a modest revival of tax populism of the 1986 vintage. The difference between 1997 and 1986 is that the term "tax expenditures" is too dry and technical for present needs; it has been replaced by the more emotive term "corporate welfare." Missing from both the 1986 drive to reduce tax expen- ditures and the current drive to curtail corporate welfare is any coherent articula- tion of the purposes of the tax system in shaping the U.S. role in the international economy. Instead, the tax writers simply turn to the tax expenditures schedule and
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DIRECTIONS FOR INTERNATIONAL TAX REFORM TABLE 10.1 Office of Management and Budget 1996 Estimates of Potential Revenue from Eliminating Selected Tax Expenditures (billions of dollars) 137 1 997 1 997-2001 Exclusion of income of foreign sales corporations Inventory property sales source rule expections (the export source rule) Interest allocation rules exception for certain financial operations Deferral of income from controlled foreign corporations 1.6 1.5 0.1 2.0 9.0 8.5 0.4 12.1 search for opportunities to raise revenue. What was on the list? The fiscal year 1997 budget listed the corporate tax expenditure items shown in Table 10.1, with figures for both 1997 and the five years 1997-2001. In 1997, there was an assault on the export source rule and modest attempts to curb deferral. Some members of Congress pushed to replace the arm' s-length pricing standard by a formula approach. None of these proposed changes made any headway. Abroad, some countries would like to tax payments for electronic commerce (e.g., payments for seismic analysis done in the United States for drill- ing operations conducted in the South China Sea). However, new "source" taxes on electronic commerce were strongly resisted by the U.S. Department of the Treasury (1996~. COUNTERVAILING FORCES What countervailing forces could alter the evolution of the international tax system, which is now decisively shaped by revenue considerations? In my judg- ment, four forces are working in a more positive direction. To a certain extent, they were evident in the 1997 debate. First, many countries have come to see multinational corporations as an ally, not an enemy. The degree of affection differs from country to country and sector to sector. In situations where local, especially state-owned, enterprises have a major presence and in situations such as natural resources and basic telecommu- nications where economic rents are abundant, the welcome mat may not be fully extended. However, over the past 20 years, more countries have come to see the advantages of an active presence of foreign corporations in more sectors of the domestic economy (Graham, 1996a). This trend is almost sure to continue. As it proceeds, more countries will adapt their tax systems to attract firms, especially high-technology firms, corporate headquarters, and R&D facilities. Among countries of the Organization for Economic Cooperation and Devel- opment (OECD), for example, Spain, Canada, and Australia have the most attrac- tive R&D packages for large firms, whereas Germany, Italy, and New Zealand have the least generous packages (OECD, 1996~. In the next decade, countries such as Brazil, Argentina, Chile, Singapore, China, and India are likely to be
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138 BORDERLINE CASE come important competitors for high-tech firms and R&D facilities. Currently, the United States is "king of the mountain" among industrial countries in terms of R&D effort, corporate vitality, and economic growth. To keep this position, the United States will have to adapt its tax system to remain at least as hospitable as its major competitors. The second countervailing force is growing recognition of the economic gains associated with larger exports of goods and services. Export growth has contrib- uted about 28 percent of real U.S. gross domestic product (GDP) expansion in the past four years, even though exports in 1992 accounted for only 10 percent of the U.S. economy. More important, studies by Richardson and Rindal (1996) and the U.S. Department of Commerce (1996) demonstrate that export jobs pay a wage and salary premium of about 15 percent more than comparable jobs in other sec- tors of the economy. These facts, energetically advertised by the Clinton admin- istration (Magaziner, 1996), are gaining acceptance among the American public. Within a few years, tax measures that harm U.S. export capabilities may be re- garded with the same disapproval that would be visited on tax measures that discourage education or R&D. The third countervailing force is the demonstrably strong connection, at least for the United States, between foreign direct investment (FDI) and U.S. exports. Research to which I contributed a few years ago shows that U.S. exports to a given country rise by about 2.5 percent for every 10 percent increase in U.S. direct investment in that country (Hufbauer et al., 1994~. Graham (1996b) also finds a strong positive correlation between U.S. foreign direct investment and U.S. exports after allowing for the normal "gravity model" variables income per capita, population, and distance. Increasingly, foreign direct investment is an essential component of corpo- rate export efforts. This is especially true for high-technology customized goods and services that require hands-on interaction between seller and buyer and ex- tensive after-sale maintenance. One reason the United States exports so little to Japan, Korea, and China is that local policies in these countries have long kept U.S. multinationals at bay. These policies are being transformed for reasons already discussed. To expand its export position in Asia and elsewhere, the United States will have to do its part by maintaining a competitive tax climate for U.S. firms that invest abroad. The fourth countervailing force is the responsiveness of production location decisions to corporate tax rates, documented in a recent report for the Export Source Coalition (Hufbauer and DeRosa, 1997~. Although "older" studies (dat- ing from 1981) surveyed by Hines (1996a) cannot be summarized by a single number, a rough characterization of their results is that a 1 percentage point in- crease in the effective business tax rate induces a 1 percent decrease in the stock of plant and equipment in other words an elasticity coefficient of 1.0. However, recent scholarship has detected significantly larger effects. Grubert and Multi (1996) estimated an elasticity coefficient of 3.0 for U.S. foreign direct
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DIRECTIONS FOR INTERNATIONAL TAX REFORM 139 investment placed in various locations. In another paper, Hines (1996b) esti- mated that a 1 percentage point increase in a state's corporate tax rate (e.g., from 6 to 7 percent) would reduce inward foreign investment in the state by about 10 percent. Finally, in a paper studying the effect of taxation and corruption on direct investment flows from 14 "home" countries to 34 "host" countries, Wei (1997) estimated an elasticity coefficient of 5.0 for the impact of the host country's tax rate. Recent scholarship uses more sophisticated econometric techniques than the earlier work surveyed by Hines, but there is more to the story than an improved ability to detect production response rates. With the integration of the world economy and the sharp decline of major political risks communism, socialism, expropriation, and protectionism firms have in all liklihood become more re- sponsive to differental tax rates. The consequences of high response rates can be dramatic. Hufbauer and DeRosa (1997) calculate, for example, that repealing the export source rule, a leading target on the administration's 1997 tax agenda, could ultimately reduce U.S. exports by about $33.5 billion (in the year 2000) as firms relocate production abroad and knock about $1.9 billion off the wage and salary premiums associated with high-paying export jobs for a revenue gain of only $1.6 billion. Similar adverse consequences might result from eliminating the foreign sales corporation or repealing the deferral provisions of U.S. tax law. To summarize, it seems likely that a chain of competitive consequences- running from friendly tax climates abroad, to wage and salary premiums in U.S. export industries, to the link between U.S. foreign direct investment and U.S. exports, to the production response of export activities to tax differentials are beginning to shift the current focus on revenue collection as the touchstone of U.S. tax policy, making a sensible international component of basic tax reform easier to implement. INTERNATIONAL COMPONENT OF BASIC TAX REFORM The fundamental goals of basic tax reform, along the lines of the flat tax or the Nunn-Domenici USA (unlimited savings allowance) tax, are to promote sav- ings and investment and to simplify the tax system. There is little reason to endorse the upheaval and agony of basic tax reform unless you believe three things: (1) savings and investment will rise significantly in response to a con- sumption-oriented tax system (Hubbard and Skinner 1996~; (2) higher savings and investment will augment the long-term rate of U.S. GDP growth from, say, 2.5 to 3.5 percent; and (3) tax simplification is very desirable, even if some people pay more taxes. In the overall scheme of things, the international aspects of basic tax reform are secondary to these fundamental goals. That said, the international consequences would be significant. The design of basic tax reform proposals is essentially "territorial." Corporate income earned within the United States would be subject to U.S. tax; corporate income earned
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140 BORDERLINE CASE abroad would not. This basic change would ensure that U.S. firms operating abroad could compete on the same tax terms as foreign firms. On balance, this feature would not cost revenue because foreign subsidiaries operating in the United States could no longer deduct interest payments to their overseas parent corporations. The additional revenue collected on the U.S. operations of foreign subsidiaries would make up for any tax revenue lost on the overseas operations of U.S. subsidiaries. Once the territorial aspect of the reformed tax system is understood and ac- cepted, it leaves an important international question: What is the proper tax treat- ment of exports and imports of goods and services? I have analyzed the eco- nomic and legal aspects of this question elsewhere (Hufbauer, 1996~. Here, I sketch the central issues that are likely to arise when the debate is joined. For brevity, they are stated as political and economic propositions. The first political proposition is that imported goods and services should be taxed the same as domestically produced goods and services. This will guard against an apparent tax incentive to produce abroad and sell the goods and ser- vices back into the U.S. market. Exceptions to symmetrical tax treatment be- tween imports and domestic production should be negotiated country by country or with regional groups such as the European Union on a reciprocal basis. The second political proposition is that business profits earned on U.S. ex- port sales should be treated the same as business profits earned on production abroad. In other words, these profits should be excluded from the U.S. tax net. Otherwise there will be an apparent incentive to locate abroad rather than pro- duce in the United States for the export market. In addition to these political propositions about basic tax reform, some less evident economic proportions should be taken into account. There are two basic principles for making adjustments at the border for domestic taxation-the destina- tion principle and the origin principle. Under the destination principle, domestic taxes are imposed on imports of goods and services but not on exports. Under the origin principle, the reverse happens: domestic taxes are not imposed on imports, but they are on exports. In theory, exchange rate changes can offset border tax adjustments, both in terms of the overall U.S. trade balance position and in terms of the relative attrac- tiveness of the United States as a place to invest. However, the impact of ex- change rate changes will almost certainly differ, sector by sector, from the impact of border tax adjustments. Moreover, not one person in 10 understands the mac- roeconomic equivalence between exchange rate changes and border tax adjust- ments. These are two powerful reasons for endorsing the destination principle. The impact of basic tax reform on the domestic savings-investment balance will be the primary determinant of the trade balance consequences of tax reform. The presence or absence of border tax adjustments and changes in the U.S. sys- tem of taxing foreign income are secondary considerations. If basic tax reform increases U.S. savings more than it increases U.S. investment, the U.S. trade
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DIRECTIONS FOR INTERNATIONAL TAX REFORM 141 balance will "improve." If tax reform increases U.S. investment more than sav- ings, the trade balance will "worsen." That said, the success of basic tax reform will be judged far more by its investment consequences than by its trade balance consequences. The destination principle is more friendly to investment than the origin principle since it automatically creates tax parity between domestic pro- duction both in competition with imports and in export markets. Destination principle adjustments require more administrative machinery, however, and cre- ate a new form of tax on international transactions. This is particularly trouble- some for rapidly growing electronic commerce. Destination principle adjust- ments would require, for example, U.S. taxation of data analysis in Singapore performed for a U.S. bank or payments by U.S. firms to France Telecom for the transmission of voice, data, or video signals. From these political and economic considerations, I draw a few major con- clusions about the international aspects of basic tax reform. First, destination principle border adjustments should be part of basic tax reform legislation. The President should be authorized, however, to negotiate origin principle taxation on a reciprocal basis, sector by sector, country by country. A system of origin prin- ciple taxation might be negotiated with Canada and Mexico, and globally for electronic commerce, before European and other countries attach value-added taxes to electronic purchases. Presumably, origin principle taxation would be negotiated only with coun- tries and in sectors that implement business tax systems similar to the reformed U.S. system. Origin principle taxation would apply equally to value-added, sales and corporate income taxes; otherwise, U.S. firms would still be paying value added taxes on their exports to Europe and elsewhere. Also, the origin principle would be negotiated only in contexts where the United States is reasonably as- sured that it would not lead to tax avoidance, for example, transshipment of French goods through Canada and then to the United States to avoid U.S. border tax adjustments on direct imports from France. The similarity of tax systems, com- prehensive character of the origin principle where negotiated, and the antiabuse provisions would guard against tax incentives for production relocation. Under the origin principle, the United States would not collect revenue on imports of goods and services but would collect revenue on exports of goods and services. Because bilateral trade would seldom be balanced, one country or the other would collect more revenue from application of the origin principle rather than the destination principle. In some contexts, supplementary provisions might be negotiated between the partners to achieve some degree of revenue equaliza- tion. As a normal matter, however, adoption of the origin principle would amount to acceptance of the implied division of revenue. REFERENCES Graham, E.M. 1996a. Global Corporations and National Governments. Washington, D.C. Institute for International Economics.
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142 BORDERLINE CASE Graham, E.M. 1996b. "The relationships between trade and foreign direct investment in the manufac- turing sector: Empirical results for the United States and Japan." In Does Ownership Matter: Japanese Multinationals in East Asia, D. Encarnation, ed. London: Oxford University Press. Grubert, H., and J. Multi. 1996. "Do taxes influence where U.S. corporations invest?" Paper pre- pared for the Conference on Trans-Atlantic Public Economics Seminar, Amsterdam, May 29-31 (revised August 1996; available from Grubert at the U.S Treasury Department). Hines, J.R. 1996a. "Tax Policy and the Activities of Multinational Corporations." Working Paper 5589. National Bureau of Economic Research, Cambridge, Mass., May. Hines, J.R. 1996b. "Altered states: Taxes and the location of foreign direct investment in America." American Economic Review 85(5). Hubbard, R.G., and J.S. Skinner. 1996. "Assessing the effectiveness of savings incentives." Journal of Economic Perspectives 10(4). Hufbauer, G.C., assisted by J. van Rooij. 1992. U.S. Taxation of International Income, Washington D.C.: Institute for International Economics. Hufbauer, G.C., assisted by C. Gabyzon. 1996. Fundamental Tax Reform and Border Tax Adjust- ments. Washington D.C.: Institute for International Economics. Hufbauer, G.C. and D.A. DeRosa. 1997. "Costs and Benefits of the Export Source Rule." Tax Notes International 14(20). Hufbauer, G.C., D. Lakdawalla, and A. Malani. 1994. "Determinants of direct foreign investment and its connection to trade." UNCTAD Review. Magaziner, I. 1996. "An interview with Ira Magaziner." The International Economy X(6). McClure, W.P., and G.J. Ossi. 1997. "Legislative proposals to reform and simplify the U.S. taxation of foreign income." Tax Notes International 14(5). Office of Management and Budget. 1996. Budget of the United States Government. Analytical Per- spectives. Fiscal Year 1997. Washington D.C.: Office of Management and Budget. Organization for Economic Cooperation and Development. 1996. Fiscal Measures to Promote R&D and Innovation. Directorate for Science, Technology and Industry. Paris: OECD. Richardson, J.D., and K. Rindal. 1996. Why Exports Matter: More! Washington, D.C.: Institute for International Economics and the Manufacturing Institute. U.S. Department of Commerce. 1996. U.S. Jobs Supported by Exports of Goods and Services. Wash- ington D.C.: Economics and Statistics Administration. U.S. Department of the Treasury. 1996. Selected Tax Policy Implications of Global Electronic Com- merce. Washington, D.C.: Office of Tax Policy. Wei, S. 1997. How Taxing Is Corruption on International Behavior? Kennedy School of Govern- ment. Cambridge Mass.: Harvard University
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