Retirement and Social Security Reform
The WTO as Tax Nanny
CSTR's Tax Policy Wire
April 25, 2006
By Gary Clyde Hufbauer (Reginald Jones Senior Fellow, Institute
for International Economics)
In a recent paper published by the WTO, but
issued solely under the author's name, Michael Daly (2005)
examined "The WTO and Direct Taxation". The paper
makes interesting reading, both for its summary of the WTO's
role as creeping regulator of direct taxation and for its
discussion of the anachronistic distinction between direct
and indirect taxation.
The GATT's original (1947) role in tax matters was essentially
limited to Article III, National Treatment on Internal
Taxation and Regulation. Article XVI, Subsidies,
permitted the rebate or exemption of indirect taxes, but had
no teeth with respect to direct taxes until the Tokyo Round
Subsidies Code was adopted in 1979 (Hufbauer and Erb, 1984).
Beginning with the Tokyo Round code and continuing with the
Uruguay Round Agreements on subsidies, investment and agriculture,
member countries have expanded the WTO's mandate.
National Treatment. Article III(1) proscribes, in
general terms, the use of internal taxes and other charges
as a means of protecting domestic production. Article III(2)
prohibits the application of internal taxes and other charges
on imported products in excess of the amounts levied on "like
domestic products". Article III(4) requires that imported
products be accorded no less favorable treatment than domestic
products with respect to laws, regulations and requirements
affecting their internal sale, transportation, distribution
Until the second FSC Appellate Body decision (January 2002),
it was widely thought that the proscriptions and requirements
of Article III applied to product specific taxes - i.e., indirect
taxes -- and had little if any application to direct taxes.
There were two reasons for this assumption. First, since the
main concern of the GATT-1947 was tariffs, and since internal
taxes and other charges and regulations applied to specific
products could be easily substituted for a tariff unless disciplined,
Article III was seen as a backstop to whatever tariff commitments
the contracting parties might make. Second, the language of
Article III is replete with references to "products"
and "like products", terminology that conjures up
The FSC Panel Report issued in January 2002 and largely affirmed
by the Appellate Body gave a more expansive reading the Article
III, especially Article III(4). Finding no explicit exclusion
of income tax measures, the Panel reasoned that they were
subject to the same national treatment regulation as indirect
taxes. While this holding was a minor feature in the FSC case,
it represented a major judicial leap. All national tax systems,
as well as other national regulatory systems (e.g., labeling
requirements, food and drug standards), are now subject to
scrutiny when they discriminate against imported products.
It may be a long time before WTO cases are brought against
the tax practices of Papua New Guinea or Paraguay, but discrimination
by the United States or the European Union is sure to attract
Uruguay Round. The Uruguay Round of Multilateral Trade
Negotiations, concluded in 1994, greatly enlarged the scope
of the GATT-1947 by adding new subjects, such as TRIPs (Trade
Related Intellectual Property Rights) and TRIMs (Trade Related
Investment Measures), by amplifying the Agreement on Subsidies
and Countervailing Measures (SCM), by adding an Agreement
on Agriculture (AoA), and by extending the core principles
of the GATT to a new agreement on services, GATS (General
Agreement on Trade in Services).
GATS. Article XVII of the GATS extends to services
the national treatment principles of Article III(4) of the
GATT. However, Article XVII only applies to those services
and modes of delivery individually scheduled by GATS Members
- and so far the schedules have more holes than a Swiss cheese.
In principle, the same "equality of income taxation"
that the FSC Panel pronounced for imported and domestic goods
could be invoked by a future WTO Panel to benefit imported
services and foreign-owned service providers, but until more
services and modes of delivery are scheduled, that prospect
remains an aspiration.
TRIMs. The TRIMs Agreement has more immediate impact
on direct taxation - but only for investment in the production
of goods (not services) by developed countries. The Agreement
applies the obligations of GATT Article III to investment,
and specifically prohibits developed countries from applying
four kinds of investment measures: (a) benefits conditioned
on local content requirements; (b) measures that condition
a firm's ability to import on the volume or value of its exports;
(c) foreign exchange balancing requirements; (d) domestic
sales requirements that involve restrictions on exports. Noteworthy,
however, is that the TRIMs Agreement does not preclude the
attachment of export performance requirements to tax relief
(though such measures might run afoul of the SCM Agreement),
nor does it prevent developed countries from insisting on
local equity participation or up-to-date technology imports.
Moreover, developing country Members of the WTO are free to
deviate "temporarily" from the strictures of the
TRIMs Agreement. At the Hong Kong Ministerial meeting, in
December 2005, it was agreed that the temporary deviation
can last another 10 years. The long and short of the TRIMs
Agreement is that developed countries can offer all the investment
incentives they please, by tax relief or other means, provided
they avoid local content requirements. Developing countries
can offer all the investment incentives they please, full
Subsidies Agreement. The SCM Agreement negotiated
in the Uruguay Round carries over the anachronistic distinction
between direct and indirect taxes on goods, inherited from
the Tokyo Round Subsidies Code and prior agreements and reports
stretching back to the 19th century. Indirect taxes can be
imposed on imported goods and rebated (or exempted) on exported
goods, but direct taxes cannot be adjusted at the border.
The SCM Illustrative List (drawn almost word-for-word from
the Tokyo Round Code) spells out the direct vs. indirect tax
distinction. The bottom line is that the rebate or exemption
of direct taxes on exports amounts to a prohibited export
subsidy. This is true whether or not direct tax relief has
any impact on product prices (the famous bi-level pricing
test articulated in GATT Article XVI, and very hard to satisfy
in practice). Kindred provisions do not apply to taxes on
services, since GATS Article XV on Subsidies calls
for negotiations, which have yet to occur.
Footnote 59 of the SCM Agreement (drawn from the Tokyo Round
Code) attempted to separate the WTO from the domain of foreign
source income and double-tax treaties by stipulating that
the Illustrative List does not prevent Members from taking
measures to avoid double-taxation of foreign source income.
Footnote 59, however, proved no obstacle to the second FSC
Panel (2002), the one that found fault with the Extraterritorial
Income Act (ETI). The ETI was designed as an exemption from
double taxation of foreign source export income, with a pattern
of benefits similar to those provided by the FSC. The Panel
Report, affirmed by the Appellate Body, found that the ETI
provision was considerably broader than, and at odds with,
customary territorial or foreign tax credit provisions found
in statutory schemes and income tax treaties. Hence, like
the FSC before it, the ETI amounted to a prohibited export
The ETI decision takes the WTO deeply into the domain of
foreign-source income and double-tax treaties. Depending on
future cases, WTO Panel Reports could challenge other tax
practices, such as the US export source rule, or anomalies
in the territorial systems practiced by European countries.
Agriculture Agreement. The AoA defines government
"outlays" to include revenue foregone, and thereby
encompasses not only subsidies but also tax measures that
affect farming and forestry. With the expiration of the so-called
"peace clause" in January 2005, WTO Members are
free to bring cases against agricultural subsidies (including
tax relief) that either amount to export subsidies or cause
trade injury to other Members. So far, the decided WTO cases
(cotton and sugar) deal with subsidies, not tax measures.
While WTO Members have broadly committed to reduce their agricultural
subsidies during the Doha Development Round, it is worth noting
that subsidies and tax relief measures that do not increase
production or depress prices (so-called "green box"
measures) need not be reduced, and are presumptively insulated
from criticism in dispute proceedings.
Trade Policy Reviews. The Uruguay Round Agreements
instituted the Trade Policy Review Mechanism (TPRM), under
which the WTO Secretariat issues periodic reports on the trade
practices of Member countries. While the TPRs are not meant
to provide a legal guidepost to WTO violations, they are meant
to call out questionable practices. Observing this distinction,
the reports are drafted in circumspect language.
Nonetheless, several TPRs have identified questionable direct
tax practices. For example, in the European Union and Malaysia,
annuities and pensions purchased from locally owned companies
qualify for personal tax relief, but not when purchased from
foreign-owned companies. (Since these services are not scheduled
under the GATS, there is no violation of WTO rules.) Several
developing country Members provide corporate tax relief as
a means of export assistance (e.g., Bangladesh, China, India,
Malaysia, Papua New Guinea). Article 27.4 of the SCM provided
an 8-year grace period for developing Members, but that has
now expired. However, no cases have been brought and the practices
Many countries provide corporate tax relief for new investment
at home but not abroad, purchases of machinery and equipment
made domestically, and shipping income earned by domestic
flag carriers. Some countries - notably in East Asia - attract
foreign investment with preferential corporate rates not available
to local firms. China taxes foreign investors at 15 percent,
rather than the standard 33 percent, and provides extended
reductions even from the 15 percent rate. Some TPRs have questioned
"tax sparing" provisions, common in OECD tax treaties
with developing countries, inasmuch as these provisions amount
to corporate relief for taxes not paid, and the tax incentives
offered by developing countries are often targeted at production
for export markets.
WTO Tax Cases. Some 34 tax disputes have been brought
to the WTO since its inception in 1995; 24 of the cases deal
with indirect taxes and 10 involve direct taxes. By and large,
the indirect tax cases raise the issue of differential and
unfavorable treatment of imported products (periodicals, spirits,
beer, cigarettes, autos, integrated circuits), and are decided
under Article III. The WTO decisions have articulated in considerable
detail the definition of "like products" and the
requisite elements of discrimination.
The granddaddy direct tax cases were, of course, the FSC/ETI
Panel Reports and Appellate Body decisions.1
Other cases have involved, for example, Turkey's taxation
of royalties earned by foreign films, Canada's exemption of
the Export Development Corporation (a crown corporation),
US federal and state tax relief for the production of large
civil aircraft, and European tax measures relating to income
earned through exporting or foreign production. Apart from
the FSC/ETI cases, and the Canadian exemption, the other cases
were either settled or are subject to on-going consultations.
The last two sections of Daly's paper (prior to his conclusion)
examine the history and justification of the distinction between
direct and indirect taxes articulated in the SCM Agreement.
Incidence Assumptions. When the distinction between
direct and indirect taxes arose in the 19th century, the common
indirect taxes were tariffs and excise taxes on luxury and
sin goods, such as whisky and tobacco, and the common direct
taxes were property taxes and estate duties. European countries
were just beginning to experiment with corporate income taxes,
while personal income taxes, social security taxes, and value
added taxes were all unknown. In that bygone world, it was
easy to assume that indirect taxes were passed forward into
the price of products, and direct taxes were borne by property
owners. Accordingly, it was natural to write rules in bilateral
trade treaties that permitted the exemption of indirect taxes
on exported merchandise, and the imposition of such taxes
on imported merchandise. Otherwise producers of high-taxed
goods would be at a great disadvantage when they exported,
or when they faced competition from imported products that
did not bear the same tax.
Even though the tax world after the Second World War bore
no resemblance to the 19th century, these historic assumptions
about tax incidence were implicitly adopted in GATT Article
XVI which expressly permitted the remission or exemption of
taxes "borne by the like product". While Article
XVI said nothing about direct taxes, the assumption that direct
taxes are not, in the main, reflected in product prices was
explicitly adopted by a GATT Working Party Report issued in
1970. The 1979 Tokyo Round Code on Subsidies classified taxes
into direct and indirect categories, based on legal analogy
not economic observation, and the distinctions were carried
verbatim into the 1994 Uruguay Round SCM Agreement.
By these agreements, adjustment at the border for any tax
classified as a direct tax became a prohibited export subsidy.
Any factual determination of the supposed depressing impact
of direct tax relief on the prices of exported products -
the famous bi-level pricing test enunciated in GATT Article
XVI - was dropped as a legal test.
Empirical Evidence. The incidence assumptions underlying
the GATT distinction between direct and indirect taxes have
long been questioned by economists. Today, it is fair to say
that the old incidence assumptions have scant theoretical
or empirical support. Depending on the peculiarities of the
market in question, and the openness of the economy, direct
taxes can be shifted forward into product prices and indirect
taxes can be shifted backwards into factor incomes.
Moreover, there is a further anomaly in the WTO rules. One
rationale for prohibiting an export subsidy is that such measures
reduce prices in the world market, thereby injuring foreign
producers. This was the rationale articulated in GATT Article
XVI. According to historic incidence assumptions, relief from
direct taxes only increases factor incomes; it does not reduce
product prices. Under this assumption, how can direct tax
relief in country A harm foreign producers in country B?
In sum, the WTO rules rest on a massive contradiction. To
the extent direct taxes are passed forward in product prices,
there is no rationale for disallowing the same border adjustments
permitted for indirect taxes. To the extent direct taxes are
passed backwards to factor incomes, there is no rationale
for characterizing tax relief as an export subsidy.
Michael Daly surveys the literature and reaches a conclusion
that is hardly startling, but one that breaks new ground for
a document published under the imprimatur of the WTO:
Clearly, the incidence of various taxes has a bearing on
existing WTO rules concerning tax adjustments at the border
in respect of exports. With recent empirical evidence suggesting
that the distinction between direct and indirect taxes on
businesses for purposes of such adjustment has become rather
blurred, a review of WTO rules in this regard might be warranted.
1. The reports are critically reviewed in Hufbauer (2002).
Daly, Michael. 2005. "The WTO and Direct Taxation."
Geneva: World Trade Organization. Discussion Paper No. 9.
Hufbauer, Gary Clyde and Joanna Shelton Erb. 1984. Subsidies
in International Trade. Washington: Institute for International
Hufbauer, Gary Clyde and Carol Gabyzon. 1996. Fundamental
Tax Reform and Border Tax Adjustments. Washington: Institute
for International Economics. Policy Analyses in International
Hufbauer, Gary Clyde. 2002. "The Foreign Sales Corporation
Drama: Reaching the Last Act?" Washington: Institute
for International Economics. Policy Brief Number PB02-10.
World Trade Organization. 1999. The Legal Texts: The Results
of the Uruguay Round of Multilateral Trade Negotiations.
Cambridge: Cambridge University Press.
World Trade Organization. 2002. United States - Tax Treatment
for "Foreign Sales Corporations": Recourse to Article
21.5 of the DSU by the European Communities. AB-2001-8.
Geneva: WT/DS108/AB/RW. 14 January 2002.