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December 11, 2006
A Challenge to Conventional International Tax Wisdom
by Martin A. Sullivan

Full Text Published by Tax Analysts®

Article originally published in
Tax Notes and Tax Notes International
on December 11, 2006.


International tax policy is not written in black or white but rather in shades of gray. The grayness results because there is no clear answer to the question, should the foreign income of U.S. multinationals be taxed at the U.S. rate or the foreign rate? Economists want a level playing field, but for international tax policy, they don't know which level to choose. The usual guiding principles of economics provide little guidance.

As a result, U.S. international tax policy is a jumble of rules with a variety of political and economic justifications. It is often described as a "compromise" that strikes a "balance." We lean toward tightening foreign tax rules and putting foreign income on equal footing with U.S. income when we think foreign investment hurts the U.S. economy. Then we lean toward relaxing the rules and giving foreign income favorable treatment if we believe foreign investment promotes U.S. interests.

When does foreign investment promote U.S. interests? The answer to that question -- and therefore the answer to the question of where to strike the right balance in international taxation -- does not depend on economic principles but rather on economic facts.1 In this article, the facts come from U.S. Commerce Department data on affiliates of U.S.-based multinational corporations. Tables 1 and 2 below summarize the data for 1983 and 2004.

       Table 1. Facts About Affiliates of U.S. Multinational
                        Corporations, 1983
         (Dollar amounts in millions. Employees in thousands.)

                                  Gross       Net Property,      Employees
                                 Receipts      Plant, and
                                                Equipment

 All countries                   $719,245         $159,137        4,853.6

 Group A. Countries with effective rates more than 20 percentage
 points below U.S. rate

 Netherlands Antilles               7,446              342            2.7
 Bermuda                           18,462              136            3.3
 Switzerland                       32,696            1,049           38.4
 Ireland                            4,965            1,399           33.2
 Singapore                         12,510            1,297           47.4
 Hong Kong                          8,119            1,577           39.9
 Other "20 percent countries"      23,975            5,321            216

 Group B. Countries with effective rates between 15 percentage
 points and 20 percentage points below U.S. rate

 Netherlands                       26,588            4,058           98.6
 Malaysia                           4,885            1,813           60.6
 Other "15 percent countries"       1,992              252             15

 Group C. Countries with effective rates less than 15 percentage
 points below U.S. rate

 United Kingdom                   107,674           28,052          678.4
 Canada                           121,805           33,018          824.2
 Indonesia                         11,270            4,519           44.7
 Norway                             8,802            5,619           15.9
 Germany                           67,242           11,592          490.5
 Libya                              3,765              561            3.9
 United Arab Emirates               3,787              977            5.6
 Nigeria                            3,934            1,038            7.6
 Japan                             25,387            2,845           85.1
 Australia                         25,975            6,698          183.5
 France                            41,109            4,937          278.1
 Italy                             24,872            2,576          168.6
 Brazil                            20,681            7,425          326.2
 Belgium                           19,922            2,444          118.8
 South Africa                       7,945            1,164           80.8
 Saudi Arabia                       9,775              663           89.1
 All other countries               73,662           27,765            898

                           [Table continued]

                               Before-Tax    Effective Tax      Return on
                                 Profits         Rate             Sales

 All countries                    $56,904            52.9%            8%

 Group A. Countries with effective rates more than 20 percentage
 points below U.S. rate

 Netherlands Antilles               1,437            15.4            19
 Bermuda                            1,196             3.0             6
 Switzerland                        1,135            20.5             3
 Ireland                              950             3.3            19
 Singapore                            726            15.0             6
 Hong Kong                            653            11.2             8
 Other "20 percent countries"       1,898            17.1             8

 Group B. Countries with effective rates between 15 percentage
 points and 20 percentage points below U.S. rate

 Netherlands                        1,484            32.7             6
 Malaysia                             630            33.8            13
 Other "15 percent countries"         109            33.9             5

 Group C. Countries with effective rates less than 15 percentage
 points below U.S. rate

 United Kingdom                     9,533            60.8             9
 Canada                             8,556            43.2             7
 Indonesia                          4,164            57.2            37
 Norway                             3,000            73.2            34
 Germany                            2,816            46.7             4
 Libya                              2,097            93.4            56
 United Arab Emirates               1,910            84.7            50
 Nigeria                            1,777            80.0            45
 Japan                              1,479            51.7             6
 Australia                          1,473            67.1             6
 France                             1,332            55.3             3
 Italy                              1,169            41.7             5
 Brazil                               982            75.4             5
 Belgium                              680            39.0             3
 South Africa                         650            41.8             8
 Saudi Arabia                         544            84.7             6
 All other countries                4,524            71.8             6

 Source: U.S. Department of Commerce. See Appendix for details.

       Table 2. Facts About Affiliates of U.S. Multinational
                        Corporations, 2004
         (Dollar amounts in millions. Employees in thousands.)

                                 Gross        Net Property,     Employees
                                Receipts       Plant, and
                                                Equipment

 All countries                $3,493,764          $768,231        8,617.2

 Group A. Countries with effective rates more than 20 percentage
 points below U.S. rate

 Ireland                         135,752           13,333            82.8
 Bermuda                          66,775            4,526             2.3
 Switzerland                     148,504            6,595            67.3
 Singapore                       129,055           10,161           110.7
 Belgium                          78,206           12,226           120.0
 China                            64,563           12,455           407.9
 Hong Kong                        67,740            5,447           117.8
 Cayman Islands                   32,075            3,276             8.3

 Other "20 percent countries"    107,838           30,297             350

 Group B. Countries with effective rates between 15 percentage
 points and 20 percentage points below U.S. rate

 Australia                        93,789           34,505           271.9
 Sweden                           57,261           17,943           101.2
 Malaysia                         35,312            5,856            97.5
 Spain                            73,252           13,081           197.2
 Other "15 percent countries"     61,282           25,897             200

 Group C. Countries with effective rates less than 15 percentage
 points below U.S. rate

 Canada                          437,649          123,440         1,065.1
 United Kingdom                  461,918          122,432         1,166.3
 Japan                           186,985           24,155           227.6
 Netherlands                     177,233           20,537           175.1
 France                          171,415           32,669           562.8
 Norway                           27,895           17,217            33.4
 Mexico                          117,183           25,682           785.2
 Other Africa                     21,786           19,547            68.1
 Germany                         264,635           49,420           601.7
 Indonesia                        12,098           11,103            59.7
 Italy                           101,081           17,238           238.5
 Brazil                           73,787           20,586           345.8
 Nigeria                           8,554            8,267             7.3
 Thailand                         28,453            7,075           114.4
 All other countries             251,688           73,265           1,031

                           [Table continued]

                              Before-Tax    Effective Tax       Return on
                                Profits         Rate              Sales

 All Countries                  $253,265            28.2%            7.2%

 Group A. Countries with effective rates more than 20 percentage
 points below U.S. rate

 Ireland                          20,087             8.3            14.8
 Bermuda                           9,957             5.8            14.9
 Switzerland                       9,161            12.2             6.2
 Singapore                         6,269            11.1             4.9
 Belgium                           6,080            14.3             7.8
 China                             5,735            15.0             8.9
 Hong Kong                         4,593            15.1             6.8
 Cayman Islands                    3,648             0.8            11.4
 Other "20 percent c              10,290            14.4             9.5

 Group B. Countries with effective rates between 15 percentage
 points and 20 percentage points below U.S. rate

 Australia                         8,054            20.4             8.6
 Sweden                            3,357            23.8             5.9
 Malaysia                          3,252            20.2             9.2
 Spain                             3,171            23.4             4.3
 Other "15 percent c               7,353            23.8            12.0

 Group C. Countries with effective rates less than 15 percentage
 points below U.S. rate

 Canada                           26,219            31.5             6.0
 United Kingdom                   21,900            32.7             4.7
 Japan                            16,440            37.4             8.8
 Netherlands                       8,644            30.9             4.9
 France                            8,381            28.4             4.9
 Norway                            7,663            69.8            27.5
 Mexico                            6,904            33.9             5.9
 Other Africa                      6,599            39.3            30.3
 Germany                           5,559            41.1             2.1
 Indonesia                         4,372            43.6            36.1
 Italy                             4,180            53.3             4.1
 Brazil                            4,149            34.0             5.6
 Nigeria                           3,953            77.9            46.2
 Thailand                          3,016            25.7            10.6
 All other countries              24,279            38.5             9.6

 Source: U.S. Department of Commerce. See Appendix for details.

The Situation in 1962

Congress devised the basic structure of U.S. antideferral rules in 1962. It was a "practical legislative solution"2 to address particular facts and circumstances that prevailed at the time. Figure 1 below provides a simplified view of the world in 1962. It highlights three features. First, U.S. multinationals did not face a lot of competition from other multinationals.3 Second, there was little U.S. foreign direct investment in low-tax countries.4 Third, there was rapid growth in the use of earnings stripping transactions in which multinationals artificially shifted income from high-tax affiliates to tax havens.5

Figure 1. U.S. International Tax: 1962 View



The Commerce Department provides data only back to 1983, but those early figures show that -- even two decades after the enactment of subpart F -- direct investment in low-tax countries accounted for only a small amount of foreign direct investment in tangible assets by U.S.-based multinationals. Figure 2 below shows the percentage of physical capital held by U.S. multinational corporations in low-tax countries in 1983 and 2004. In 2004 the amount of property, plant, and equipment in countries with effective tax rates more than 20 percentage points below the U.S. statutory rate was 12.8 percent. In 1983 that figure was 7.8 percent. It does not seem unreasonable to infer that the percentage was even lower in 1962.6

Figure 2. Percentage of Physical Capital Held by
U.S.Multinational Corporations in Low-Tax Countries



Source:This chart is a distillation of the data presented in tables 1 and 2.

The Kennedy administration wanted a general antideferral regime. It proposed repealing deferral, except in developing nations (which at the time included countries like Ireland and Singapore). Congress, however, did not agree to blanket repeal. Eventually a compromise was struck in which deferral was limited only for passive income and income from earnings-stripping transactions. Active business income from low-tax countries could still be deferred.7

As a result of the complex compromise that brought subpart F into law, two generations of tax lawyers grew up with the mindset that active income from bricks-and-mortar investment was good and should enjoy deferral, and mobile income deflected from high-tax countries to tax havens in abusive "mere paper" transactions was bad and should be denied deferral. But was this new gospel based on an enduring principle, or was it based on the situation as it existed in 1962?

From an economic perspective, there is nothing intrinsically meritorious about active investment in low-tax countries that suggests it should be given preferential treatment under U.S. tax law. Is it too far-fetched to believe that preferential treatment was tolerated because it was not a major issue under the existing circumstances when the subpart F rules were developed? First, for nontax reasons, at that time there was simply a lot less direct investment in low-tax economies than there is now. Second, it was the Kennedy administration's intention, as a matter of foreign policy, to allow the deferral of income from affiliates in developing countries, many of whom would have had low tax rates. At that time, the looming economic concern of international tax policy was that high-tax industrialized countries would siphon U.S. investment when they were effectively transformed into low-tax countries through the use of earnings stripping transactions.


The Situation Now

As we all know, the facts and circumstances have changed since 1962. Figure 3 below provides a simplified view of the major developments.

Figure 3. U.S. International Tax: 2006 View



First, we now have the phenomenon of "runaway headquarters." It was inconceivable in 1962 that U.S. corporations would move their operation centers to foreign jurisdictions to reduce taxes. That is no longer the case. Corporations headquartered in the United States can and do relocate to other industrialized countries.

This migration can manifest itself in a variety of ways. For example, when a U.S. company merges with a foreign company, the new entity may locate its headquarters abroad because of restrictive U.S. international tax rules. Or, if U.S. tax rules are tough, start-up companies are more likely to establish their headquarters offshore. Perhaps most worrisome are the less visible and more subtle possibilities. Foreign-based multinationals may be able to gobble up more of the world's productive capacity than U.S. corporations burdened with U.S. international tax rules. In that case, the corporate headquarters don't move, but, in effect, the subsidiaries underneath them do. The potentially detrimental effect is the same: fewer headquarters jobs for U.S. residents.

The second major change since 1962 is that interaffiliate cross- border transactions with real business purposes are much more common. As the world gets smaller and communications and transportation costs drop, it is routine for sales and services affiliates to be centralized along multinational -- rather than national -- lines to achieve economies of scale.8 Income from those transactions can easily get caught in the web of subpart F base company rules.

Those developments provide justification to shift the balance of U.S. international tax policy toward more favorable treatment of foreign investment. Conservative think tanks cite those changes as a justification for moving toward a territorial tax system in which most foreign-source income would be exempt from U.S. tax.9 Multinational corporations cite those changes as a justification for relaxing U.S. international tax rules (but not necessarily for switching to a territorial system).10

On top of the changes in the nontax characteristics of multinational business, a major (and largely unintended) shift in the balance of international tax policy occurred in the late 1990s when the Treasury Department announced the check-the-box entity classification rules. The rules allowed U.S. corporations to engage in earnings stripping transactions and circumvent U.S. antideferral rules.

The final development I will highlight here has to do with foreign direct investment in low-tax countries. There is more of it now than in 1962. And, as suggested by the arrow in Figure 2, there could be more of it in the future.11


The Problems With Low-Tax Investment

Should the U.S. be concerned about the rise in foreign direct investment in low-tax countries?

To answer that question, I will draw the oft-made distinction between two categories of foreign direct investment. The first type establishes "export platforms" that provide market access for goods and services from the United States. This type of investment is more likely to help create jobs in the United States. Economists say this type of foreign investment complements domestic investment. The second type of foreign investment builds production facilities that provide goods to the U.S. economy and compete with U.S. exports in foreign markets. Economists say this type of investment substitutes for domestic investment.

It is interesting to note that the first type -- investment for market access -- does not give a multinational much flexibility regarding location. For example, an investment in marketing and distribution to help sell products in France must, for the most part, be made in France. In contrast, investment for production is mobile. With low tariffs and transportation costs, corporations have considerable leeway in choosing the location of their production facilities.

The differences in the degree of mobility of those two types of investment provide a clue of how they might be taxed. We know from economic theory and casual observation that countries reduce tax rates to attract mobile production. However, there is less need to engage in tax competition by host countries when foreign investment relates to access to domestic markets. If that is true, foreign investment that tends to help the United States would generally be found in high-tax countries, and investment that tends to hurt the United States would be found in low-tax countries.

Is there any evidence to support this theory? Table 3 below provides some. It shows the latest available data on U.S. trade with foreign affiliates of U.S. multinationals. On the top half of the table are the countries that account for the most net imports from foreign affiliates into the United States. On the bottom half are the countries that account for the most net exports from the United States. The countries at the top, those with which the United States has a negative trade balance with foreign affiliates, tend to have lower effective corporate tax rates than those at the bottom. Specifically, the countries where affiliates tend to import more goods into the United States have an average effective tax rate of 21 percent. (If Canada and Mexico -- where proximity, rather than tax competition, accounts for imports into the United States -- are excluded, the average rate declines to 12 percent.) The countries where foreign affiliates are receiving more exports from the United States have an average effective tax rate of 28 percent.

    Table 3. Balance of Trade in Goods of the United States With
           Foreign Affiliates of U.S. Corporations, 2004
                     (Dollar amounts in billions)

                                   Exports of Goods     Imports of Goods
                                  From United States       Shipped by
                                     to Foreign          Affiliates to
                                     Affiliates          United States

 All countries                         $184.1                 $231.5

 Top 10 importing into United           105.4                  174.8
 States

 Top importers, minus Canada             17.1                   49.1
 and Mexico

 Top 10 exporting from United            51.4                   25.5
 States

 Countries with most net imports from affiliates to the United States

  1   Canada                             58.9                   84.5
  2   Ireland                             2.2                   15.5
  3   Mexico                             29.5                   41.2
  4   Malaysia                            1.5                    8.5
  5   Hong Kong                           2.4                    6.5
  6   Sweden                              1.4                    5.3
  7   Singapore                           7.9                    9.9
  8   Thailand                            0.9                    1.7
  9   Cayman Islands                      0.2                    0.7
 10   Costa Rica                          0.4                    0.9

 Countries with most net exports from the United States to affiliates

  1   Japan                               9.4                    2.6
  2   Netherlands                         7.8                    2.6
  3   Belgium                             5.1                    2.0
  4   Australia                           4.4                    1.7
  5   United Kingdom                     11.9                    9.8
  6   Taiwan                              3.1                    1.2
  7   South Korea                         1.9                    0.3
  8   Switzerland                         3.4                    2.5
  9   Brazil                              3.1                    2.3
 10   Philippines                         1.3                    0.6

                           [Table continued]

                                  U.S. Trade Balance     Effective Tax Rate
                                     With Foreign
                                      Affiliates

 All countries                         -$47.4                    28%

 Top 10 importing into United           -69.4                    21
 States

 Top importers, minus Canada            -32.0                    12
 and Mexico

 Top 10 exporting from United            25.9                    28
 States

 Countries with most net imports from affiliates to the United States

  1   Canada                            -25.6                    32
  2   Ireland                           -13.3                     8
  3   Mexico                            -11.7                    34
  4   Malaysia                           -7.0                    20
  5   Hong Kong                          -4.1                    15
  6   Sweden                             -3.9                    24
  7   Singapore                          -1.9                    11
  8   Thailand                           -0.8                    26
  9   Cayman Islands                     -0.5                     1
 10   Costa Rica                         -0.5                    11

 Countries with most net exports from the United States to affiliates

  1   Japan                               6.8                    37
  2   Netherlands                         5.2                    31
  3   Belgium                             3.1                    14
  4   Australia                           2.8                    20
  5   United Kingdom                      2.1                    33
  6   Taiwan                              1.9                    25
  7   South Korea                         1.6                    27
  8   Switzerland                         0.9                    12
  9   Brazil                              0.9                    34
 10   Philippines                         0.7                    34

 Source: U.S. Department of Commerce. See Appendix for details.

Ireland is the most prominent example of the link between low tax rates and high imports into the United States. As shown in Table 3, the average effective tax rate on profits in Ireland was 8 percent in 2004. In the same year, Irish affiliates of U.S. multinational corporations received $2.2 billion of exports from the United States while importing $15.5 billion of goods into the United States -- a negative $13.3 billion trade balance for the United States with Irish affiliates of U.S. corporations.

Overall, these data suggest that investment in low-tax countries (which tends to increase imports into the United States) is less beneficial to U.S. competitiveness than investment in high-tax countries (which tends to facilitate exports from the United States).

That basic argument grows stronger when one takes transfer pricing into account. As Lee Sheppard has written: "Transfer pricing is not a detail." (See Tax Notes, Nov. 21, 2005, p. 1002, Doc 2005-23402 [PDF], or 2005 TNT 224-4 .) Aggressive transfer pricing can turbocharge the incentive effects of low rates. For example, suppose a corporation can shift profits from a country with a 35 percent tax rate to a country with a 15 percent tax rate, so that before-tax profits in the low-tax country double. In that case, the corporation pays 15 cents for each dollar of real profit in the low-tax country. And, by virtue of profit shifting, it reduces tax in the high-tax country by 20 cents. The combination of those two effects results in an effective tax rate of negative 5 percent.

Is there any evidence that aggressive transfer pricing inappropriately shifts profits to tax havens? Figure 4 below shows that 30 percent of the before-tax profits of foreign affiliates were located in countries with average effective tax rates 20 percentage points below the U.S. rate. However, only 13 percent of the physical capital, 24 percent of the sales, and 15 percent of the employees of foreign affiliates were located in those countries. These data are not conclusive evidence, but they do suggest that the level of profit in low-tax countries is not commensurate with real economic activity. Ireland, again, provides a striking example. Its low statutory rate of 12.5 percent seems to be a magnet for profits, as evidenced by the fact that the ratio of profits to sales there is twice the worldwide average.


Figure 4. Affiliates of U.S. Companies in Low-Tax Countries,
Share of Worldwide Totals, 2004



Source: Data from Table 2.

Time to Reorder Priorities?

Since 1998 the check-the-box rules and the wave of earnings stripping transactions they have enabled have transformed U.S. international taxation. Understandably, because of the sheer magnitude and rapidity of the change they have caused, the check-the- box rules have captured the attention of international tax practitioners.

Whether the ensuing reduction in the tax burden on foreign investment is a positive or negative policy development is often framed as an issue of neutrality. Some say earnings stripping is good because it makes U.S. multinationals more competitive.12 Some say it is bad because it provides tax incentives to shift investment out of the United States.13

In their June testimonies before the House Ways and Means Committee, Paul Oosterhuis and Michael Graetz deepened the debate with additional insights. Oosterhuis argued that U.S. tax rules should be reasonably in line with the rules of other countries that serve as homes to major multinational competitors, and that the type of earnings stripping enabled by the check-the-box rules is "substantially more difficult to accomplish" under the rules in most of those countries than under U.S. rules.14 Graetz expressed concern that when the United States unilaterally allows earnings stripping by its multinationals, it is inviting foreign countries to enact rules that will allow their companies to strip earnings from the United States.

Without taking away anything from those arguments, I suggest that problems with direct foreign investment in low-tax countries are as large as, if not larger than, the problems arising from earnings stripping from high-tax countries. There are two reasons. First, as already noted, investment in high-tax countries tends to be the type that helps create U.S. jobs, and investment in low-tax countries tends to be the type that reduces U.S. employment.

Second, even if there are no differences in the character (that is, export versus import enhancing) of investment in high- and low- tax countries, there are differences in the magnitude of economic distortions due to the differences in the effective rate of foreign tax on each type of investment. The tax differential between the U.S. rate and the rate in high-tax countries (after earnings stripping) is probably smaller than the differential between the U.S. rate and the rate in low-tax countries (particularly after transfer pricing). There is less economic inefficiency in the first case than in the second.

For example, suppose an earnings stripping transaction cut the effective rate of tax in Germany in half -- say, to 20 percent -- while direct investment in a low-tax country like Ireland -- turbocharged with aggressive transfer pricing -- reduced the effective tax rate to zero. With a combined state and federal rate in the United States close to 40 percent, this would result in a 20 percent differential for investment in Germany and a 40 percent differential for investment in Ireland. If those numbers are in the ballpark, the tax benefits for investing in Ireland should cause greater concern than the tax benefits for investing in Germany.15

Therefore, as we think about where to strike the right balance in international tax policy, consideration should be given to the potential inefficiencies resulting from direct active investment in low-tax countries. This is the "challenge to conventional international tax wisdom" in the title to this article.


Policy Implications

What do these concerns about foreign investment in low-tax countries suggest for policy?

First, they are another reason for the United States to lower its statutory corporate tax rates. Among its many benefits, a rate cut will reduce the incentive for corporations to shift profits and investment to low-tax jurisdictions. Although there is no political impetus for cutting corporate taxes now, international development will probably necessitate a U.S. rate cut sooner than most politicians realize.16

Second, the United States should beef up transfer pricing rules to prevent increasing the incentive effect of already favorable tax rates in production tax havens. Lax transfer pricing rules are an inefficient means of promoting multinational competitiveness.

Third, the United States should consider -- in part as a backstop to the transfer pricing rules, and in part to trim the most potent incentives for investment in foreign production -- a modest tightening of U.S. tax rules for active income generated in low-tax countries. One possibility would require U.S. companies operating in low-tax countries to pay an additional U.S. tax on current foreign earnings equal to the difference between a minimum rate of, for example, 20 percent or 25 percent, and the effective foreign rate. U.S. companies would still have incentive to invest offshore, but the largest and most harmful incentives to shift income and investment out of the United States would be eliminated. (This type of targeting by tax rate is sometimes called a "low-tax kick-in.")

A final word about context: Politicians trying to strike a populist chord may be tempted to associate the perceived problems of the offshoring of jobs and the decline in U.S. manufacturing jobs to the favorable tax treatment foreign investment receives relative to domestic investment. But that would be like blaming an assistant coach for a team's bad season.

In 2004 foreign affiliates of U.S. multinational corporations employed 8.62 million people. Of that total, 1.27 million were in countries with tax rates 20 percent below the U.S. rate (as can be seen in Table 3). Most of those jobs would be in foreign jurisdictions regardless of the tax rules. Nontax factors (like low labor costs and proximity to raw materials and inexpensive energy) dominate most investment location decisions. And whatever jobs are lost as a result of the tax benefits of foreign investment in production facilities may be indirectly offset, at least in part, by increases in jobs for the provision of headquarters services.

I do not know the number of jobs lost because of the favorable tax treatment of foreign investment. It may be 0, 10,000, or 100,000. But in any case, I know that it is a minute part of the national employment picture. Figure 5 below shows, for example, that any effect of international tax rules on domestic employment is small compared with the 2.8 million manufacturing jobs lost between 2001 and 2005.


Figure 5. Decline in U.S. Manufacturing Employment, 2001-2005,
Compared With U.S. Multinational Employment in Low-Tax Countries



Source: Data from Table 2 and U.S. Bureau of Labor Statistics, data series 30000000, "Manufacturing, All Employees (in thousands) Seasonally Adjusted," available at ftp://ftp.bls.gov/pub/suppl/empsit.compaes.txt.

In summary, given the potent tax advantages sometimes available to investment in foreign production, we should be concerned about the potential for tax policy contributing to the phenomenon of "runaway plants." But the magnitude of the problem is relatively small, and concerns about it should be balanced against concerns about runaway headquarters. Given the current facts and circumstances, when policymakers are choosing how to strike the balance of international tax policy, if they are going to curtail foreign tax benefits at all, they may want to give priority to the foreign tax rules that have the most potential to hurt U.S. employment.


Appendix: Notes on the Data

Most data in this article are from the Bureau of Economic Analysis (BEA) of the Commerce Department, International Economic Accounts, U.S. Direct Investment Abroad: Financial and Operating Data, Additional Data for U.S. Parent Companies and Foreign Affiliates, Revised 1983 Estimates and Preliminary 2004 Estimates (available online at http://www.bea.gov/bea/ai/iidguide.htm#link12b). All data presented here are for majority-owned, nonbank foreign affiliates of nonbank U.S. parents.

In tables 1 and 2, pretax income is constructed by adding net income and foreign income taxes and then subtracting income from equity investments. The effective tax rate is foreign income taxes divided by pretax income. Gross receipts is labeled "Total Income" in the BEA tables.

In tables 1 and 2, the data are sorted into three categories: countries with average corporate tax rates more than 20 percent below the U.S. rate; countries with average tax rates between 20 percent and 15 percent below the U.S. rate; and countries with average tax rates less than 15 percent below the U.S. rate.

The U.S. rate is the combined federal and average effective state corporate tax rates. For 1983 it is assumed to be 49.7 percent, which equals the top federal statutory rate of 46 percent plus an average effective rate of 3.7 percent (equal to 1.0 minus 0.46, multiplied by a pre-federal-tax average state tax rate of 6.9 percent). The combined federal and average effective state corporate tax rate for 2004 is assumed to be 39.5 percent, which equals the top federal statutory rate of 46 percent plus an average effective rate of 4.9 percent (equal to 1.0 minus 0.35, multiplied by a pre-federal- tax average state tax rate of 6.9 percent). See the data appendix of Sullivan (2006) for more details.

For 1983 Group A countries have effective tax rates below 29.7 percent. Group B countries have effective tax rates between 29.7 and 34.7 percent. Group C countries have rates above 34.7 percent. Only countries for which total pretax profit of U.S. affiliates exceeds $500 million are reported separately in Table 1. Countries with effective tax rates below 29.7 percent not listed separately in Table 1 are Argentina, Bahamas, Cayman Islands, Denmark, Jamaica, Liberia, Panama, South Korea, and Taiwan.

For 2004 Group A countries have effective tax rates below 19.5 percent. Group B countries have effective tax rates between 19.5 percent and 24.5 percent. Group C countries have rates above 24.5 percent. Only countries for which total pretax profit of U.S. affiliates exceeds $500 million are reported separately in Table 2. Countries with effective tax rates below 19.5 percent not listed separately in Table 2 are Barbados, Chile, Costa Rica, the Dominican Republic, Israel, Luxembourg, Poland, Portugal, and Venezuela.

Data for Table 1 are from BEA Table 24, "Net Property, Plant, and Equipment of Affiliates, Country by Industry"; BEA Table 28, "Income Statement of Affiliates, Industry by Account"; and BEA Table 46, "Employment of Affiliates, Country by Industry."

Data for Table 2 are from BEA Table III.E 1, "Income Statement of Affiliates, Country by Account"; BEA Table III.B 7, "Net Property, Plant, and Equipment of Affiliates, Country by Industry"; and BEA Table III.H 1, "Employment and Compensation of Employees of Affiliates, Country by Type."

Data for Table 3 are directly from tables 1 and 2 with the addition of imports ("Total imports of goods shipped by affiliates") and exports ("Total exports of goods shipped to affiliates") from BEA 2004 Table III.I 1, "U.S. Trade in Goods With Affiliates, by Country of Affiliate."


References

Rosanne Altshuler and Harry Grubert, "Governments and Multinational Corporations in the Race to the Bottom," Tax Notes, Feb. 27, 2006, p. 979, Doc 2006-754 [PDF], or 2006 TNT 39-40 .

Craig R. Barrett, Testimony Before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means, June 22, 2006.

Michael J. Graetz, Testimony Before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means, June 22, 2006.

James R. Hines Jr., Testimony Before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means, June 22, 2006.

R. Glenn Hubbard, Testimony Before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means, June 22, 2006.

Daniel J. Mitchell, "Making American Companies More Competitive," Heritage Foundation Backgrounder #1691, Sept. 25, 2003.

National Foreign Trade Council, The NFTC Foreign Income Project: International Tax Policy for the 21st Century (Fred F.Murray, editor in chief) Washington, D.C., Dec. 15, 2001(http://www.nftc.org/default.asp?Mode=DirectoryDisplay&id=162).

Office of Tax Policy, Department of the Treasury, The Deferral of Income Earned Through U.S. Controlled Foreign Corporations: A Policy Study, Dec. 2000 (http://www.ustreas.gov/offices/tax- policy/library/subpartf.pdf).

Paul W. Oosterhuis, Testimony Before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means, June 22, 2006[a].

Paul W. Oosterhuis, "The Evolution of U.S. International Tax Policy: What Would Larry Say?" 2006 Laurence Neal Woodworth Memorial Lecture in Federal Tax Law and Policy, Tax Notes, July 3, 2006[b], p. 87, Doc 2006-11895 [PDF], or 2006 TNT 128-19 .

Judy Scarabello, "NFTC Refutes Benefits of Territorial Tax System," National Foreign Trade Council press release, May 5, 2004.

Stephen E. Shay, Testimony Before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means, June 22, 2006.

Martin A. Sullivan, "On Corporate Tax Reform, Europe Surpasses the U.S.," Tax Notes, May 29, 2006, p. 992, Doc 2006-10099 [PDF], or 2006 TNT 103-5 .


FOOTNOTES

1 Glen Hubbard (2006) makes a similar point:

    One implication of the accumulation of research is that there is no simple general abstract principle that applies to all international tax policy issues. The best policy in each case depends on the facts of the matter and how the system really works.

2 Paul Oosterhuis (2006b). In his tribute to Larry Woodworth, former chief of staff of the Joint Committee on Taxation, Oosterhuis highlighted the "practical wisdom" of the subpart F rules, which Woodworth played a major role in devising.

3 According to the Council of Economic Advisers' Economic Report of the President, 2003: "In 1960, 18 of the world's 20 largest companies (ranked by sales) were located in the United States, but by the mid-1990s that number had fallen to 8."

4 Oosterhuis (2006b) wrote that, at the time, lowering a U.S. corporation's effective tax rate below the U.S. rate "required locating profitable manufacturing facilities in low-taxed jurisdictions, which for non-tax reasons was often more difficult to do" (emphasis added). Treasury (2000, p. 21): "This legislative history indicates that Congress (and the Administration) assumed that U.S.-owned foreign corporations were conducting active businesses only in countries in which the tax rate was equivalent to that of the United States."

5 In 1960 according to the 2000 Treasury Department report, "use of tax haven corporations to obtain a tax advantage for income otherwise earned in a high-tax foreign country was a new and rapidly growing phenomenon."

6 And whatever little there was, it was not a major concern because the Kennedy administration wanted to encourage U.S. investment in developing countries as a form of foreign aid. Many developing countries no doubt were low-tax countries. In the 2006 Woodworth lecture, Oosterhuis (2006b) said that when the rules favoring developing economies were formulated (in force from 1962 through 1976), "only 21 countries outside the former communist bloc were excluded from being defined as less developed countries. Singapore and Ireland, for example, were both eligible for less- developed country designation."

7 Treasury (2000, pp. 18-19). The Treasury Department was concerned about two situations:


    The first situation arose when taxpayers were conducting business operations in a foreign jurisdiction with tax rates that were lower than those in the United States. The second situation arose when taxpayers were conducting business operations in a foreign jurisdiction with tax rates that were comparable to or greater than those in the United States but were able to lower their foreign tax burden artificially through an arrangement involving a tax haven corporation. Subpart F was designed to address the second situation. The Kennedy Administration did not consider the first situation to be a concern because, in 1962, tax rates in most developed countries that were not used for tax haven operations were substantially comparable to the U.S. tax rate, and the Kennedy Administration specifically intended to encourage investment in lesser developed countries that were not used for tax haven operations.

8 Oosterhuis (2006a), in his June 22 Ways and Means testimony, described the situation this way:

    As business models have adapted to the globalized economy and manufacturing and marketing of products is conducted across multiple national boundaries for legitimate business reasons, the mechanical nature of the rules results in many transactions creating subpart F income even though they involve very real and substantial business operations.

9 For example, Daniel Mitchell (2003) of the Heritage Foundation favors a territorial system:

    Ideally, lawmakers should engage in wholesale change, junking America's "worldwide" tax system (whereby companies are taxed on income earned in other nations) and replacing it with a "territorial" tax system (the common-sense practice of taxing only income earned inside national borders). This reform would allow U.S.-based companies to compete on a level playing field with foreign competitors.

10 For example, Judy Scarabello (2004) of the National Foreign Trade Council stated that:

    moving to a territorial tax system alone would not cure the problems inherent in the U.S. international tax system and would put U.S. companies at a significant disadvantage in the global market. The United States should instead concentrate legislative efforts on improving current international tax rules.

11 Craig Barrett (2006), chairman of the board, Intel Corp.:

    Many countries compete intensely to attract Intel's facilities, although this has also changed in recent years. More nations very intent on attracting high-tech state-of-the-art factories, such as Intel's, now also have the requisite infrastructure and well-trained workforce they lacked in years past. Many countries offer very significant incentive packages and have highly favorable tax systems." (Emphasis added.)

12 The National Foreign Trade Council report (2001, p. 27) takes this position: "Capital export neutrality is not a persuasive justification for rules that penalize the use of centralized sales and services companies or inter-affiliate debt financing."

13 Graetz (2006) characterizes this view as follows:


    Analysts who are predominantly concerned with the potential for tax-induced capital flight abroad -- those who urge policy based on capital export neutrality -- will argue that the U.S. should act unilaterally to shore up the ability of foreign governments to prevent such tax reductions, for example, by tightening our Subpart F rules.

14 Oosterhuis (2006a) specifically mentions Canada, France, Germany, Japan, and the United Kingdom. Except in the case of Canada, he suggests that "the kinds of earnings stripping transactions that check-the-box planning and newly enacted related party look-through rules permit are substantially more difficult to accomplish."

15 Those concerns are heightened if one takes into account the economic principle that the inefficiency of uneven taxes varies with the square of the differential. Therefore, in this example, the tax differential between Ireland and the United States, which is twice as large as the tax differential between Germany and the United States, is four times as inefficient.

16 See Sullivan (2006).

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