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4 International Tax Policy, Investment, and Technology HARRY GRUB ERT U. S. Department of the Treasury MEASUREMENT OF NET INCOME Although allocation rules may seem arbitrary and a nuisance, they arise out of the necessity, under an income tax, to measure net foreign income. Countries such as the United States that allow a credit for foreign income tax limit the credit to what the home country tax would be on the income. Otherwise, there would be an incentive for foreign governments to raise their taxes and effectively collect revenue on domestic U.S. income. Net foreign income, therefore, has to be mea- sured. The problem is even more acute under an exemption or territorial system in which (active) foreign income is exempt from home-country tax. Any in- creased allocation of expenses to foreign income directly increases home-country tax liability. The problem of allocating overhead expenses is familiar to us all as personal taxpayers and is motivated by considerations similar to those that give rise to expense allocations to foreign income. Many members of the academic commu- nity are probably acquainted with the "home office" deduction in which housing expenses have to be allocated between business and nonbusiness uses. Invest- ment in tax-exempt state and local bonds is an example in which interest ex- penses have to be divided between taxable and non-taxable income. If an indi- vidual borrows and invests in state and local bonds, the Internal Revenue Code may limit the amount of deductible interest expense. This is analogous to a com- pany that borrows at home and invests abroad where the income might be de- ferred indefinitely or, in any case, be out of the home-country tax base because it is shielded by foreign tax credits. iNothing in these remarks should be construed as reflecting the view of the U.S. Treasury Depart- ment. 65
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66 BORDERLINE CASE 1995 REGULATIONS FOR R&D ALLOCATIONS Jim Hines describes in his chapter the R&D allocation regulations, issued in 1995, that supersede the substantially more onerous regulations originally pro- mulgated in 1977. I would like to add a few observations to put them in perspec- tive. Consider a U.S. company that performs domestic R&D and, using the re- sults of its ongoing R&D program, has foreign sales just equal to its domestic sales. Then, if it can take full advantage of the "optional gross income method" in the regulations, which is apparently very common, the company will allocate 12.5 percent of its R&D expenses to foreign income.2 In other words, the alloca- tion to domestic income is seven times the allocation to foreign income even though foreign and domestic sales are equal. Furthermore, because of the royalty rule that Hines mentions, the U.S. tax regime for high-technology companies is much more favorable than the regime faced by comparable foreign companies based in an exemption country. For example, Germany exempts the active foreign income of its companies by treaty, but this territorial exemption does not generally extend to royalties, which are fully taxable. In contrast, a U.S.-based multinational corporation (MNC) in an excess foreign tax credit position would earn royalties that are both deductible from foreign tax and free from U.S. tax while losing only a relatively small part of its R&D deductions through allocations to foreign income. HOW MUCH U.S. R&D IS ALLOCATED TO FOREIGN INCOME? U.S. companies now report their R&D allocations on the tax form on which they calculate their foreign tax credit. In addition to the optional gross income method mentioned earlier, there are several reasons why allocations seem to be smaller than a straightforward application of the sales method would suggest. Companies can exclude "legally mandated R&D" that cannot be expected to have value abroad. Testing required by the Food and Drug Administration is cited in the regulations as an example. Foreign sales are to be taken into account only if the foreign affiliate "can reasonably be expected to benefit directly or indirectly from the taxpayer' s research expense connected with the product category." Also, foreign sales do not attract an allocation if the foreign affiliate has entered into a "bona fide" cost-sharing arrangement with the parent U.S. company. The evi- dence on actual allocations suggests that companies allocate only about one-half 2Under the sales method, companies first allocate 50 percent of R&D exclusively to domestic income and the remainder to foreign and domestic income based on sales. The sales method would, therefore, allocate 25 percent (0.5 x 0.5) to foreign income. Under the optional gross income method, the allocation to foreign income can be reduced to the greater of half of the sales allocation or the pure gross income allocation. Foreign gross income tends to be low relative to domestic gross income because it is made up largely of (repatriated) net income items such as dividends and royalties and does not include depreciation, interest, and other overhead expenses that are in do- mestic gross income.
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INTERNATIONAL TAX POLICY, INVESTMENT, AND TECHNOLOGY 67 of the U.S. R&D to foreign income that Jim Hines estimates in his studies. He may, therefore, be substantially overstating the impact of the allocation rules. RESIDUAL U.S. TAX RATE ON FOREIGN BUSINESS INCOME To assess the significance of the international tax rules, it is useful to look at the residual U.S. tax rate on foreign business income and how it has changed since the Tax Reform Act of 1986. In 1984, the residual U.S. tax rate on the foreign income earned by U.S. manufacturing companies in the "general" or ac- tive basket was 8 percent. By 1992, primarily as a result of the large drop in the statutory corporate tax rate in the Tax Reform Act (TRA) of 1986, the residual U.S. tax on active foreign income had fallen to about 4 percent. Even if we adjust for other provisions of the TRA, including the financial services income basket, the baskets of "10 to 50 percent owned" companies, and the expansion of the passive basket, the residual rate still seems to be substantially lower than it was in 1984. Accordingly, the complaints, perhaps justified, by the business community about changes in the international tax system brought about by the TRA must reflect the greater complexity of the new rules and their effect on domestic busi- ness decisions, not any increase in tax burdens. Furthermore, these estimates of residual U.S. tax are based on foreign-source income and expense as defined in the tax code, which may not give a true picture of income and tax burdens on actual foreign operations. For example, the foreign income base does not include income earned by foreign affiliates that is not cur- rently repatriated. Also, some of the income identified as foreign source actually arises from domestic operations. For example, 50 percent of export sales income can be classified as foreign source and absorb excess foreign tax credits gener- ated by operations abroad. To that extent, the international tax system provides a bonus for foreign operations. If a company has excess foreign tax credits, not only is there no residual U.S. tax but some of the foreign tax credits can offset the U.S. tax on domestic operations. On the other hand, in some cases, foreign in- come can be understated, for example, because allocations of interest expenses may be higher than they would be under the more conceptually correct "world- wide fungibility." Grubert and Mutti (1995) make various adjustments for un- derstatements and overstatements and conclude that the residual U.S. tax rate on operating income abroad is very small and, indeed, might even be negative. RESPONSIVENESS OF INVESTMENT LOCATION TO LOCAL TAX RATES Joel Slemrod has mentioned my recent paper with Jack Mutti on taxes and the location of investment (Grubert and Mutti, 1996), giving me the opportunity to elaborate on it further. Our paper used the 1992 Treasury Department tax files to study the investment choices of more than 500 large U.S. manufacturing com
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68 BORDERLINE CASE panics in 60 potential foreign locations. The choice of investment location abroad seems very responsive to the local effective tax rate. After combining both the decision to locate in a foreign country and the decision about how much to invest there, we concluded that the overall elasticity of capital with respect to the change in 1 - t (i.e., one minus the tax rate; or the change in the after-tax rate of return given the pretax return) is about three. Another way of evaluating the importance of local tax rates is to use the results to estimate the extent to which the distribution of real capital among the 60 foreign locations would be altered if taxes did not play a role. We concluded that about 15 percent of the U.S. manufacturing capital abroad would be in a different foreign location but for the effect of taxes.. We were surprised by the influence attributed to taxes, but the specific pattern of the results tended to strengthen our confidence. For example, investments by electronics and computer companies seem much more sensitive to taxes than those of companies in foods and pharma- ceuticals, in which local market and regulatory considerations are more likely to be dominant. Also, production for sale to other foreign affiliates appears to be especially sensitive to local tax rates, which seems plausible. Still, Jack Mutti and I continue to worry that we have overestimated the impor- tance of taxes. It was, therefore, interesting to hear from the business participants at this conference that their operations have become very mobile. The growth of the "virtual corporation," "flexible" work forces, and the importance of new attractive locations with low tax rates suggest that perhaps we were not far off the mark. Yet we should be clear that no inferences can be drawn from our results about the role of taxes in the choice between the United States and potential foreign locations. The distribution of U.S. capital among foreign locations was the subject. The only evidence we presented on the U.S.-versus-foreign choice was that there seemed to be no relationship between the tax sensitivity of an industry and the share of its capital that was abroad. Finally, my colleagues and I are planning to link the 1984,1992, and perhaps 1994 files to study the changes in location over the period. This, we believe, has several advantages. It covers the period of the Tax Reform Act of 1986, which altered the incentive to invest in various locations. The response of location to changes in tax rates also makes it possible to control for fixed geographical ef- fects that are difficult to identify in a single cross section. Another advantage is that the TRA changed the effective tax rates on investment in the United States by varying amounts in different industries, so it may be possible to identify the role of taxes in the choice between U.S. and foreign locations. REFERENCES Grubert, H., and J. Mutti. 1995. "Taxing multinationals in a world with portfolio flows and R&D: Is capital export neutrality absolute?" International Tax and Public Finance 2:439-457. Grubert, H., and J. Mutti. 1996. "Do Taxes Influence Where U.S. Corporations Invest?," prepared for presentation at the Conference of the Trans-Atlantic Public Economics Seminar, Amsterdam.