Quick Study: The International Components of Tax Reform
IPI Center for Tax Analysis
February 12, 2002
By Ernest S. Christian
Through a combination of historical accidents,
serious policy mistakes, internal political constraints, and
some fairly smart maneuvering by other nations, the U.S. administers
an international tax policy that runs contrary to both logic
and national self-interest. And because this policy is clearly
out of step with the tax practices of most other countries,
the U.S. must change its basic rules so it can join the rest
of the world in subsidizing exports in a treaty-legal way.
For years the U.S. has been struggling to extricate itself
from the clutches of its archaic worldwide taxing system and
to alleviate the tax bias against its own exports. But because
of the continuing political influence of those who view foreign
trade with suspicion, the effort has been schizophrenic and
largely ineffectual. Instead of changing the basic rules that
comprise the source of the problem, the U.S. has created an
extraordinary hodgepodge of international tax rules and exceptions
that often operate at cross-purposes.
For example, U.S. owned companies that do business abroad
can defer U.S. tax on their foreign-source profits
only if they reinvest the profits abroad. If they bring the
money home for reinvestment in the U.S. economy, they will
have to pay a full and immediate U.S. tax. In order to enjoy
the benefits of deferral, companies must also forego opportunities
to minimize the amount of taxes they pay to foreign governments
which, in most cases, means that the company will pay more
foreign tax than is necessary. Although the price is often
high, the value of deferral is usually worth it
to the large companies whose cash flow capacities permit them
to keep all foreign-source profits abroad. But to the many
smaller companies that need the cash and that must repatriate
earnings, deferral is not an option. They must immediately
pay U.S. tax on their worldwide income.
Even among large companies the current code causes incongruous
results. A company with the financial capacity to perpetuate
deferral can build a plant abroad and sell its products in
foreign markets without paying U.S. tax. But if that same
company were to build a plant here and export Americanmade
goods to the same foreign market, it would have to pay a full
and immediate U.S. tax. Not only does the current tax code
favor large companies over small ones, it also favors foreign-
made products over American-made ones.
The Elements of Tax Reform
From an international perspective, tax reform consists ideally
of two inter-dependent components. The first is a territorial
rule that excludes from tax the income that U.S. companies
derive from activities conducted outside the U.S. An American
company pays only the tax of the host country and is therefore
on an equal footing with its local competitors. The second
component is a set of complementary border tax adjustments.
One adjustment imposes tax when companies outside the U.S.
export into the U.S. market. The other excuses tax when companies
inside the U.S. export to foreign markets.
Such a system provides an even-handed choice to U.S.- and
foreign-owned companies that sell to the U.S. market. If either
manufactures the goods in the U.S., it pays U.S. income tax
on both manufacturing and sales activities. Or they may manufacture
the goods abroad but sell them in the U.S., in which case
they incur U.S. income tax on sales in this country and the
U.S. collects an import tax. As far as U.S. law is concerned,
the total tax cost associated with selling the goods in the
U.S. market is essentially the same, regardless of whether
a company manufactures the goods at home or abroad.
Because the U.S. tax is the same either way, neither foreignowned
nor American companies would gain a distinct U.S. tax advantage.
A company may locate its plant in the U.S. and export abroad,
in which case the border tax adjustment on outbound transactions
would exclude the companys export income from U.S. tax.
Or, a U.S. company may locate its plant in a foreign country
in which the territorial rule excuses the company from U.S.
tax on its foreign-source income.
Given the choice of staying home and still being able to
make tax-free exports to foreign markets, most U.S. companies
would probably manufacture in the U.S. And given the same
choice, most foreign-owned companies would see the wisdom
of locating a plant in the U.S. and using it as a base for
taxfree export sales to markets all around the world.
Such tax adjustments are not new. All countries that maintain
value-added tax (VAT) systems already exempt their own exports
from tax, and impose import taxes when other countries export
to them. Replacing Americas current worldwide taxing
system (which taxes the income of U.S. companies from their
activities outside as well as inside the country) with a territorial
system that taxes only their income from activities inside
the U.S. is fully consistent with international standards.
How U.S. Companies Participate in Foreign Markets
U.S. companies compete in global markets in two ways. First,
they produce products in the U.S. and sell them abroad. These
exports may be tangible (automobile), intangible (patent),
or service (an architect designs a building for Berlin). These
are export transactions that produce U.S.-source income because
the activity occurs within the U.S.
American companies also compete in global markets by conducting
business activities abroad. A U.S. company sells its American-made
product to its foreign subsidiary, which distributes the product
in the foreign market. Because the distribution (and sometimes
the production) occurs outside the U.S., this is foreign-source
When capital investment and labor are in the U.S. and the
customers are abroad, the benefits of export trade are obvious.
New customers abroad permit sales to exceed the domestic demand
for consumption and investment goods. As the amount of GDP
increases, so do aggregate wages and returns to capital, thereby
increasing U.S.-source income. When U.S. businesses produce
and/or distribute goods abroad, they make foreign direct investment
or FDI. If foreign operations are limited to distribution,
FDI is small. But if production and distribution are overseas,
FDI is large.
When U.S. companies conduct operations abroad, both the foreign
nation and the U.S. economy benefit. Customer base expands
and foreign-source income rises. Moreover, direct investments
and operations by U.S. companies in foreign markets lead to
increased exports of American-made goods and to more (not
less) jobs in the high-paying sectors of the U.S. economy.
This symbiotic relationship between exports to a foreign country
and business operations in that country highlights the importance
of having a neutral tax system that allows U.S. companies
to choose the combination that will maximize sales in foreign
markets to the ultimate benefit of U.S. labor and capital.
While foreign operations in the U.S. are conducted the same
way, the impact of taxes is quite different. Generally, the
income foreign companies derive from producing and distributing
within the U.S. is partially or wholly exempt from homecountry
income taxes and is not subject to value-added taxes. In addition,
their domestic-source income from home-country activities
is exempt from a major portion of their home countrys
tax burden and is never taxed in the U.S. In contrast, when
U.S. companies produce goods and services for export, their
domestic-source income from activities in the U.S. is fully
taxed by the U.S. Moreover, when those products enter the
foreign country, they are taxed again by the country of destination.
How Taxes Distort Choices, Reduce Returns, and Misallocate
Under current U.S. law, consumed income is taxed less that
saved income. This encourages Americans to consume as much
as possible. Also under current law, imports are exempt from
the taxes that are imposed on the manufacturers of American-made
products for sale in the U.S. or for export. This combination
of encouraged consumption and subsidized imports guarantees
to produce some degree of trade imbalance. Once started, such
distortions tend to perpetuate and enlarge themselves.
When taxes intervene, they usually reduce the return to labor
and capital. If a $10 tax is imposed on a company, it must
either reduce wages or dividends by $10 (which penalizes workers
or investors) or raise prices by $10. Yet every $10 increase
the company receives has already been taken away by the tax
and nothing remains for employees or shareholders.
Taxes can also reduce the amount of goods produced by labor
and capital. Higher tax rates can reduce the value of employee
efforts, making them less inclined to produce. The same is
true of capital investment. Low after-tax returns can make
entrepreneurial investment no longer worth the risk. And because
taxes can have uneven impacts (taxing some income sources
more heavily than others), they can have a deleterious impact
on economic output.
The U.S. practice of taxing an American-owned company on
its worldwide income can be highly disadvantageous to American
interests. U.S. companies already compete against foreign
companies who operate under territorial systems of taxation
that permit them to exclude from their home-country tax large
portions of the income they earn in the global marketplace.
Moreover, when taking into account the taxes the other countries
impose on U.S. companies when they export into foreign markets,
the failure of the U.S. to border-adjust for imports works
against U.S. interests and becomes much harder to defend as
Even under existing treaty obligations and interpretations
dating back to the 1960s and 1970s, the U.S. can make its
tax system border adjustable without having to enact a European
VAT or any form of sales or transactions tax. Instead, it
need only make its corporate income tax neutral as between
labor and capital in order to be able to exclude its export
sales from tax, as the Europeans and others already do.
A Practical Example
A tax system designed to address the international components
of reform is H.R. 134, a comprehensive proposal that includes
a reformed personal tax too. H.R. 134 recognizes the benefit
to the U.S. economy when U.S. companies compete and win in
the global marketplace. It then equips them with the kind
of tax system that will be most conducive to that success.
First, it says that foreign-source income of U.S. persons
should not be taxed. Second, in the case of an export sale,
both the manufacturing and the sales profits should be treated
as foreign-source incomeas if the product had been manufactured
and sold abroad. Third, when a U.S. company succeeds in a
foreign market, it should be encouraged to bring its profits
home, without penalty, for reinvestment in the U.S. Moreover,
the U.S. tax burden should no longer be concentrated solely
on U.S. labor and capital as it is today. Instead, foreign
companies that participate in the U.S. market should be brought
into the U.S. tax base and be required to share in the U.S.
H.R. 134 adopts a territorial system whereby all foreignsource
income of U.S. citizens and companies is excluded from U.S.
tax. American companies could make foreign direct investment
and operate in overseas markets (either through a branch,
a U.S. subsidiary, or a controlled foreign corporation) without
incurring U.S. tax on profits and without regard to whether
those profits are reinvested abroad or repatriated to the
U.S. All foreign-source interest, dividends, and royalties
would be excluded from U.S. tax as well.
Under the fully territorial regime contained in this model,
U.S. companies would be subject only to the taxes of the host
country where they compete in foreign markets and would be,
for the first time in history, on equal tax footing with their
competitors. Because U.S. companies would pay no U.S. tax
on their foreign-source income, the foreign tax credit would
An import tax is the other critical function of H.R. 134.
Like the export exclusion, the first function of the import
tax is to permit the territorial system to be enacted and
to function without creating a tax haven. If a U.S. company
moved a plant offshore and sold back to the U.S., it would
pay an import tax equal to the U.S. business tax rate but
without any deductions. Therefore, there would be no U.S.
tax incentive for the company to move abroad.
The other function of the import tax involves trade. Because
import taxes have been associated with VATs, import adjustments
have been considered tariffs designed to make foreign goods
more expensive. Rather than keeping foreign-made goods out
or causing U.S. purchasers to pay more for them, the primary
function of the proposed import adjustment is to expand the
U.S. tax base to include the foreign-based companies that
sell into the U.S. market. In effect, they end up bearing
part of the U.S. tax burden.
Territorial versus Worldwide Taxation
All countries do not have the same tax systems. If they did,
the result would be exactly the same to every national treasury
and to all businesses regardless of a territorial or a worldwide
system. Absolute uniformity of taxation across national boundaries
would make taxes a neutral competitive factor not only within
a market but across markets as well.
In the imperfect world of reality where tax systems vary
greatly, territoriality may not achieve uniformity of taxation
across all markets but it will produce uniformity of taxation
within the same market. In contrast, the worldwide tax system
does not achieve neutrality of taxation within a foreign market
and, in fact, is not intended to do so. Todays foreign
tax credit is so limited that the U.S. worldwide tax is a
non-neutral factor to the disadvantage of U.S. companies.
Without question, territoriality gives the U.S. government
the least opportunity to interfere with the way U.S.-owned
companies compete in foreign markets. Both the foreign tax
credit and deferral are creatures of the worldwide tax system
and both have forced U.S. companies to conduct their business
abroad in ways that have made them less competitive.
Territoriality facilitates foreign direct investment, and
anytime U.S.-owned companies gain wealth by means of exploiting
a foreign market, the nation is wealthier and everyone is
better off. But what happens to U.S. output and jobs when
a U.S. company manufactures and sells products in a foreign
Basically, foreign direct investment by U.S. firms also enhances
their U.S. operations and domestic job-creating capacities.
Foreign operations can use U.S.-made components. When penetrating
a foreign market with direct investment, export sales to that
market usually increase as well. Foreign direct investment
by U.S. companies is complementary to, not a substitute for,
U.S. production and jobs.
Importing a Tax Base and Cutting Taxes for Americans
Tax reform can mean a massive tax cut for U.S. labor and
capital. Currently labor and capital bear the entire burden
of the U.S. income tax, and labor alone carries the weight
of payroll taxes. If part of that tax was replaced by an import
tax primarily borne by foreign labor and capital, the U.S.
would have gained an additional tax base of wages, interest,
and dividends received by foreigners who produce (outside
the U.S.) the goods and services that they export into the
Lets assume that the U.S. replaces the current corporate
and personal incomes taxes with a business and personal tax
similar to the model of H.R. 134. Now assume the bill imposes
a 10% import tax, a good portion of which would be borne by
foreign labor and capital. The model tax would raise the same
annual amount for the treasury as the current income tax,
and yet reduce the tax burden on Americans by at least $100
billion a year.
There are many reasons for tax reform, but the most powerful
politically may be the may be the tax cut inherent in tax