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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.
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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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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.
Representative terms from entire chapter:
foreign tax
