Retirement and Social Security Reform
Springing Tax Reform From a Bad WTO Case
April 17, 2000
By Gary Hufbauer, Ernest Christian and Harold Adrion
Gary Hufbauer is the Reginald Jones Senior Fellow at the
Institute for International Economics and a former Treasury
tax official. Ernest Christian is a retired tax attorney and
former Treasury tax official. Harold Adrion is a partner with
the Ruchelman Law Firm.
In its recent Foreign Sales Corporation decision, the Appellate
Body of the World Trade Organization trashed legal history.
Deciding for the European Union and against the United States,
the Appellate Body ignored a settlement negotiated 20 years
ago.(1) Yet this bad decision
gives Congress a springboard to historic tax reform.
European countries (and many others) routinely exempt their
exports from value added tax. This saves European exporters
about $100 billion a year of tax payments on export sales.
European firms routinely sell these same exports through tax-haven
sales subsidiaries located in exotic places like Bermuda and
Hong Kong. This saves European exporters another $10 billion
a year of corporate income tax. By comparison, the Foreign
Sales Corporation saves U.S. exporters about $3.5 billion
a year. Most of the 6,000 firms that use the FSC are small
and medium-sized exporters with little or no production abroad.
Parallel tax savings are not available to U.S. exporters.
The main reason is that the WTO honors an archaic tax distinction
that has no economic basis. WTO rules allow corporate taxes
measured by value added (Europe) to be excused on exports
and imposed on imports. But WTO rules forbid similar adjustments
for corporate taxes measured by income (United States) --
even though the distinction between the two tax bases is more
form than substance.
In response to the WTO ruling, Congress will not simply repeal
the FSC and leave U.S. exporters at an even greater tax disadvantage.
The practical question is whether Congress will redress the
bad WTO decision by endorsing a small fix, or by attacking
the root through tax reform. A small fix is better than nothing.
But we urge Congress to use the WTO decision as a springboard
for historic tax reform.
Unlike the United States, most other countries have adopted
territorial systems of taxation: they do not tax overseas
investment. For example, if a French company makes and sells
products in the United States (pharmaceuticals, banking, or
telecommunications, it doesn't matter), France doesn't tax
The United States, by contrast, has an impractical general
rule: it taxes worldwide income. If a U.S. company makes and
sells products in France, the U.S. taxes the income. The rule
is justified by emotion, not logic: "Every U.S. corporation
should pay U.S. tax, whether it operates in Indiana or India,
New Mexico or old Mexico." Carried to its extreme, the
general rule would render U.S. firms totally noncompetitive
in a global economy, both as exporters and producers.
Successive Congresses, in their wisdom, have modified the
general rule with practical exceptions, ranging from the foreign
tax credit, to deferral, to the FSC. But the tensions between
the impractical general rule and the practical exceptions
have created an extraordinarily complex U.S. tax code -- a
dream for tax lawyers and a nightmare for everyone else.
Meanwhile, old and new problems fester in the world of international
taxation. An old problem is the "runaway plant,"
rechristened by Ross Perot as "the great sucking sound."
Will U.S. firms pull up stakes and move to developing countries,
and then sell back into the United States -- free of U.S.
corporate tax? A new problem is e-commerce. Will U.S. firms
be taxed on their Internet sales to customers abroad?
Congress could, in a single historical stroke, level the
field of export taxation, end anxiety about runaway plants,
resolve the looming debate over e-commerce, and discard the
hideously complex corporate income tax. It could achieve all
these goals by replacing the corporate income with the model
USA tax, jointly sponsored by former Senator Sam Nunn, D-Ga.,
Sen. Pete Domenici, R-N.M., and Rep. Phil English, R-Pa.
Under the USA business tax, taxable income would be determined
by subtracting permitted deductions from taxable receipts.
Taxable receipts cover revenue from sales in the United States,
but not exports or production abroad. Permitted deductions
cover all costs of business purchases from taxpaying U.S.
firms. Payments for imports are either taxed directly or disallowed
as a permitted deduction. By excluding exports from taxable
receipts, and by taxing imports directly or excluding them
from deductible expenses, the USA business tax provides a
"border tax adjustment" -- just as in Europe.
The USA business tax would level the field of export taxation,
eliminate the tax motive for runaway plants, resolve the looming
e- commerce debate, and radically simplify the U.S. income
tax code. How so?
- The steep tilt in export tax practices is leveled because
U.S. companies, like their European counterparts, would
pay no tax on exports.
- The runaway plant motive would disappear because any firm
that produces abroad and sells in the U.S. market effectively
pays the same tax as a competitor located in the United
- The looming debate over e-commerce is resolved because
sales to foreign buyers are not taxable receipts and purchases
from foreign sellers are taxed directly or not allowed as
a deductible expenses.
Congress can neither slice bread nor build the Internet.
But it can launch a tax triumph from an awful WTO decision.
1. For a critique of the WTO decision, see Gary Hufbauer,
"A Critical Assessment," Institute for International
Economics, Mar. 11, 2000, http://www.iie.com