Statement of Ernest S. Christian, Chief Counsel,
Center for Strategic Tax Reform
Testimony Before the Subcommittee on Select Revenue
of the House Committee on Ways and Means
Hearing on the Extraterritorial Income Regime
May 9, 2002
Mr. Chairman and Members of the Committee. I am honored to
appear before you today to talk about WTO-legal ways of making American
companies and their employees more competitive in world trade.
Some people think that the answer may be provided by the
so-called subtraction-method value added tax. In reality, however, the
subtraction method VAT is largely a mirage that exists primarily in the
imaginations of some academics. The tax they so describe is, in substance,
identical to a slightly amended version of our present corporate income tax that
takes into account the existence of the employer payroll tax (the FICA tax as it
is often called).
Therefore, let us set aside the VAT syndrome and the political
baggage that goes with it. We can then concentrate on the few changes in
the current corporate income tax that are necessary for it to qualify as an “indirect
tax” under WTO rules.
Once we have qualified our corporate tax as an “indirect tax”,
we can then exclude export income from U.S. tax. Once we have excluded
export income from tax, we can then adopt a truly territorial tax system that
will allow U.S. companies to invest and compete directly in foreign
markets. Devices such as FSC and ETI are unnecessary.
There is no need to resort to some new and radical tax system.
Indirect tax status is imminently obtainable within the framework of
current law and within the framework of American tax traditions.
An “indirect tax” under WTO rules has a base equal to value
added. To most people, the most familiar form is the European-style VAT
structured to resemble a sales tax, but there are other forms of taxes on value
added that bear no resemblance whatsoever to a sales tax and have nothing
whatsoever to do with taxing consumers.
Value added is a concept similar to net income -- as explained
in the Appendix to my testimony.
Only two amendments are necessary to convert our existing
corporate tax on net income into a tax on value added. Each such amendment
is meritorious on its own and neither is shocking.
The first amendment is to make the interest that a corporation
pays to its debtholders nondeductible in the same way that the dividends it pays
to its equity shareholders are presently nondeductible. As a result, all
the income from both debt and equity capital would be included in the
corporation’s tax base.
After having included in the tax base the income from capital,
the other step necessary to complete the value added base would be to include
the income from labor. The measure of this income is the amount of wages
paid to the corporation’s employees -- just as the amount of income from
capital is the amount of interest and dividends paid by the corporation.
Under the present corporate income tax, wages are, in form,
deductible and, therefore, in form, are not included in the corporation’s
tax base, but, in reality, under current law, the corporation must pay a 7.65
percent FICA payroll tax on the first $84,900 of each employee’s wages.
Thus, under current law, wages up to $84,900 are already included in the
corporate tax base -- except at a 7.65 percent tax rate instead of the 35
percent tax rate that applies to the rest of the corporate tax base.
The obvious solution is to broaden the corporate income tax base
by allowing no deductions for interest, dividends or wages – and, with that
broad tax base, lower the corporate tax rate to the range of 8 to 12 percent on
a revenue-neutral basis. In order not to double tax the wage component of
the new tax base, corporations would be allowed a credit for the employer
payroll tax or corporations would be allowed to deduct wages up to $84,900 per
employee with only the excess for highly paid employees being
There are various ways of “integrating” the existing
corporate income and payroll taxes in order to have a base equal to value added
and, therefore, to have the same base as an indirect tax under WTO rules.
None of these increases the tax burden on the labor component of GDP except in
the case of the highest paid employees and, even in their case, not by very
This is not pie-in-the-sky stuff. Its pedigree is
impeccable. The starting point is the Comprehensive Business Income Tax (CBIT)
proposal made in 1992 by the Treasury Department after years of study.1 The study was primarily authored
by the Honorable R. Glenn Hubbard, presently Chairman of the President’s
Council of Economic Advisors, and Professor Michael J. Graetz of Yale
University, both of whom were Deputy Assistant Secretaries of the Treasury at
the time. The 1992 Treasury study suggested that (1) interest be made
nondeductible like dividends and (2) that all businesses, whether or not
incorporated, be subject to a uniform business tax which involved a half dozen
or so amendments to the then current corporate income tax. The Treasury
made this recommendation after concluding that allowing a deduction for
interest, but not dividends, and taxing incorporated businesses differently from
unincorporated businesses, had a significant negative effect on GDP
Other amendments that would normally be included in converting
the corporate income tax into a more comprehensive tax with a base equal to
value added are (1) cash accounting for inventory and (2) full first-year
expensing of capital equipment, but neither of these are necessary.2
Only the two simple amendments already described are necessary
to achieve “indirect tax” status and the ability to solve the FSC/ETI
problems and much more.
This Committee and this Congress have before them a huge
bipartisan opportunity to serve the national interest. You can enact a few
simple amendments that will then open the door to all kinds of opportunities for
enhanced world trade, more and better paying manufacturing jobs in America, and
overall higher standards of living for Americans.
Instead of penalizing exports and, therefore, driving offshore
American companies that would rather stay home, we can exclude exports from tax
and make the United States of America a prime location for manufacturing and
selling to markets around the world. The U.S. would be an especially
desirable location if we also amended the code to allow full first-year
expensing such as proposed by Congressman Philip English and Congressman Richard
Neal in their recent High Productivity Investment Act (H.R. 2485).
Instead of making it hard for American companies to directly
compete in foreign markets that cannot be fully served by exports at the outset,
we could adopt a territorial system that would give them an even chance.
Moreover, when U.S. companies do succeed in a foreign market, we could stop
penalizing them if they bring their money home for reinvestment in the American
economy. (Present law gives them a tax break if they keep the money abroad
invested in someone else’s economy.) We could also stop favoring large
companies (who can afford to keep the money abroad) over small companies who
need to bring the cash home and, who, therefore, must pay the tax penalty
imposed by current law.
The need to cure these and many other fundamental defects in
America’s international tax rules is a long-standing bipartisan point of
view. Moreover, it is in the joint and mutual interest of all companies
and all employees for America to be the location of choice for companies
-- foreign and domestic – engaged in world trade.
In the past, the barrier to action was the mistaken belief that
in order to do so, America would have to take some drastic step such as
repealing the income tax and replacing it with some kind of sales tax.
Today, we know better. Only a few straightforward
amendments to the income tax are necessary.
The time for bipartisan action is now. The need is
great. The opportunity is here.
Appendix to Testimony
A Step-By-Step Guide: How To Convert The Corporate Income
Tax Into An Indirect Tax under WTO and Thereby Solve the FSC/ETI
Dilemma and Much More
Preamble: Why Do It
FSC/ETI and/or an outright exclusion of export income would be legal under
WTO rules if the existing corporate income tax (or an amended version thereof)
were classified as an “indirect” tax. So-called “inversions” and
other devices by which U.S. companies flee to foreign locations would also be
eliminated. Indeed, the United States of America would become the location
of choice for both U.S.-owned and foreign-owned companies engaged in world
What Is An Indirect Tax
A tax with a base equal to value added is classified as an indirect
tax. The most familiar form is the European-style VAT which is structured
to resemble a sales tax, but there are other forms of taxes on value added that
bear no resemblance whatsoever to a sales tax. Indeed, as will be seen
later, when the existing corporate income tax and the existing employer payroll
tax are considered together, their consolidated tax base is almost exactly equal
to value added.
Thus, it is not only the VAT-type sales tax that can have a value added base
and, thereby, can gain the advantages that accrue under the WTO to taxes
classified as “indirect”.
A modified version of the existing corporate income tax can also gain those
advantages for the United States.
The Concepts of Value Added and Income Are Similar
Like the corporate income tax, a tax on value added is imposed on businesses,
not on individuals. Compared to the corporate income tax, the essential
difference is in the tax base. In its most simple form (before adjustment
for exports and imports), a business’s value added tax base is equal to its
Example: During the year, Black Corp. has gross income of $100X from
the production and sale of widgets. Its value added tax base is $100X.
This simple form of gross receipts tax would work just fine if all goods and
services were produced and sold by one gigantic company, but, in reality, the
total value of goods and services in the economy is added in bits
and pieces by a large number of companies.
Note: The fundamental flaw with any gross receipts tax is the
obvious pyramiding of tax that occurs when more than one company is involved in
producing a particular product or service. For example, if, in order to
produce and sell $100X of widgets, Black Corp. had bought widget parts and
components from White Corp. for $30X, the combined tax base of the two companies
would be $130X even though only $100X of final product had been produced and
Therefore, in order to void pyramiding, taxes on value added as well as taxes
on net income typically allow a business to deduct from its tax base the cost of
the inputs (such as parts and components) that it purchases from some other
Example: Black Corp. paid (1) $30X for widget components, (2) $10X
for a widget assembly machine, (3) $1X for interest on debt to finance that
machine and (4) $50X for employees to produce and sell the $100X of widgets it
sold during the taxable year. Black Corp. also paid a $9X dividend to
(1) Value Added Calculation: Black Corp.’s value added tax
base for the year is $60X, computed as follows:
|Gross Income . . . .
. . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . .
Costs Paid to Another Business for Components and
Included in Payee’s Tax Base under Value Added System.
. . . . . . . . . . . . .
|Deductible Costs Paid
to Another Business for a Machine
and Included in Payee’s Tax Base under Value Added
System. . . . . . . .
Nondeductible Costs Not Included in Payee’s
Tax Base under a Value Added System:
| $1X of Interest
$9X of Dividends
$50X Salaries to Employees
Note: In value-added parlance,
Black Corp. has been allowed to deduct the amounts paid
to other businesses because those amounts are included
in the other business’s value added tax base.
Salaries paid to employees are not deducted because
the employee’s wages are not taxable under the value-added
tax. Only businesses are subject to the tax on
value added. In income tax parlance, it would
be said that Black Corp. has been able to deduct inventory
costs in the year paid (instead of using inventory accounting
which over time tends to defer deductions beyond the
year of payment). In income tax parlance, it would
also be said that Black Corp. has been able to expense
capital equipment (instead of depreciating its cost
over a period of years), but has not been able to deduct
wages paid to employees or interest paid to debtholders
or dividends paid to shareholders.
(2) Net Income Calculation: Black Corp.’s
net income tax base for the year is approximately $24X,
computed as follows:
Gross Income . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . .
. . . $100X
Less: Approximate Amount of Deductions Allowed under
Inventory Accounting Rules
for the $30X Paid for Components that was included in
the Payees Tax Base a/ . . . . . . $(20X)
First-Year Depreciation Deduction Allowed for the $10X
Paid for the Machine that was included in the Payees
Gross Income b/. . . . . . . . . ($4.4X)
Cost of Salaries Paid to Employees . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . ($50X)
Interest Cost . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . ($1X)
a/ Although in our overly simplified example where all
purchases and sales are made in the same year, the full
$30X would be deductible, in the typical real-life case,
the business would have some costs that would be perpetually
deferred under inventory accounting rules.
b/ The depreciation calculation assumes 30% bonus depreciation
and MACRS depreciation on 5-year property.
Comparison of Value Added and Net Income Calculations
The differences between the two systems are easily
discernible (and, as shown later, easily reconcilable).
- Cash vs. Inventory Accounting. In the
example, the value added system uses cash accounting
whereas the net income calculation uses inventory
accounting, but this is not an inherent difference:
an amended corporate income tax whose base was equal
to value added could continue to use inventory accounting.
A cash system is simpler and generally better, but
that reform is not necessary in order to convert the
corporate income tax into an “indirect tax”.
- Expensing vs. Depreciation. In the
example, the value added system expenses capital equipment
purchases, whereas the net income calculation uses
depreciation, but, again, this difference is not immutable.
Expensing is a superior rule, but the corporate income
tax can be converted into an “indirect tax” without
making that change. The corporate tax could
qualify even though it continued to use the depreciation
rules of current law.
The two remaining differences relate to the deductions
allowed under the current corporate income tax for interest
paid to debtholders and compensation paid to employees.
Because a value added base (the key to “indirect tax”
status) includes the output of all capital (as
well as the output of labor), no deductions for interest
or compensation are allowed. Therefore, in this
case, the familiar income tax deductions must give way
to the value added rule but, as shown below, the deduction
for interest is not an inherent characteristic of a
corporate income tax and, insofar as concerns wages,
the absence of any income tax deduction for compensation
paid employees is not the radical change that might
be thought. In fact, when the existing payroll
tax is taken into account, a large portion of wages
paid are, in effect, already nondeductible under present
- No Deduction for Interest Paid. A deduction
for interest paid is not an inherent or necessary
characteristic of a corporate income tax. Indeed,
allowing a deduction for interest (the cost of debt
capital) but not for dividends (the cost of equity
capital) is a major distortion under present law that
impedes GDP growth according to a Treasury study a
few years ago.3
That study recommended replacing the current corporate
income tax with a Comprehensive Business Income Tax
(CBIT) that allowed no deduction for interest.
(Dividends are not deductible under present law.)
(As will be seen later, had the CBIT proposal raised
its horizons only slightly higher and taken into account
the payroll tax that existed then (and now) in another
portion of the Internal Revenue Code, the Comprehensive
Business Income Tax would have had a base equal to
- No Deduction for Wages. The idea that
wages paid are fully deductible under present
law is largely a mirage arising from the fact that
the corporate income tax (where wages are deductible
and are not part of the tax base) is in one part of
the tax code and the employer payroll tax (where wages
are not deductible and are in the tax base) is in
another part of the tax code. When, however,
these two taxes are viewed together, it is easily
seen that in substance most wages are
already nondeductible. In form, under present
law when a business pays wages it is entitled to deduct
them from its corporate base, but when the business
turns to another page of its tax return, it must add
back those wages to the base of its employer payroll
tax and pay tax on them. The difference is,
of course, that the corporate rate is presently 35
percent whereas the payroll tax rate is presently
7.65 percent, but under the reformed corporate tax,
the tax rate would be much lower -- about the same
as the 7.65 percent employer payroll. In that
case, the amended “indirect” corporate income tax
could continue to allow a deduction for wages up the
the $84,900 cutoff point of the payroll tax or could
disallow a deduction for all wages, but allow a credit
for the payroll tax. In either case, the total
tax attributable to wages -- whether called a corporate
tax or payroll tax would not be greatly different
from present law.
Thus, like so much else about the comparison between
a value added base and a net income tax, the differences
are much less than thought.
Obvious Conclusion: The Existing Corporate Income Tax
Can Readily Be Converted into an Indirect Tax
The bottom line point is glaringly simple: Forget about
VATs (subtraction-method or otherwise) and all other
exotic tax reforms. Instead, convert the existing
corporate income tax into an indirect tax by the simple
expedient of disallowing the deduction for interest
(treat same as dividends) and integrating the corporate
income tax with the existing payroll tax by various
cross credits or offset formulas that results in a combined
labor and capital base equal to value added.
Once indirect status is achieved, export income can
be excluded from tax. Once export income is excluded,
a correct and fair territorial system could be adopted.
With indirect status, imports could also be brought
into the U.S. tax base. That is, however, an option,
not a requirement.
of the Treasury, Integration of the Individual and
Corporate Tax Systems – Tax Business Income Once (Washington,
DC: GPO, 1992). Because the CBIT proposal would
have maintained a higher rate of tax -- about 31 percent
on corporations -- it recommended that the nondeductibility
of interest be phased in over a period of time.
CBIT would also have excluded interest and dividends
at the personal level.
2 Some kind
of border tax adjustment for imports could also be added
-- such as if a company sought to move a plant abroad
and sell back into the United States -- but that is
not a necessary component and is outside the scope of
the present inquiry.
at n. 1