Statement of Michael J. Graetz, Justus S. Hotchkiss Professor of Law, Yale Law School, New Haven, Connecticut

Testimony Before the Subcommittee on Select Revenue Measures
of the House Committee on Ways and Means

June 22, 2006

Mr. Chairman and Members of the Committee─

Thank you for inviting me to testify today on the subject of international tax reform.  I want to begin my testimony with three basic observations. 

First, it is no longer possible─given the integration of the world economy─to regard domestic tax reform and international tax reform as if they are two different subjects.  When Congress last enacted fundamental tax reform--in 1986--the stock of cross boarder investment was less than 10% of the world’s output.  Today it equals about one quarter of the world’s output.  The U.S. corporate tax affects U.S. companies doing business domestically, U.S.-headquartered firms doing business abroad and foreign-headquartered firms doing business here.  It, therefore, affects the competitiveness of U.S. companies and the attractiveness of the United States as a place for investment of domestic and foreign capital. 

When John Castellani, President of the Business Roundtable, testified here last month on the topic of tax reform generally, he said that the priority for U.S. corporations is to lower significantly the U.S. corporate tax rate.  I agree that the U.S. corporate rate is a crucial issue for our nation’s economy.  After the 1986 tax reform, our corporate tax rate was one of the lowest in the world; today it is one of the highest.  [See Figures 1 and 2.[1]]  In my view, the most important corporate tax change Congress could enact--both to stimulate our domestic economy and to increase the competitiveness of U.S. companies

throughout the world--would be to lower our corporate tax rate substantially.  Although a 25% rate would put us in line with most OECD nations, it is worth trying to get that rate down to 15% --the rate now applicable to dividends and capital gains—or to no more than 20%.  Such a rate reduction would be very good for the U.S. economy. It also would allow much simplification of our rules for taxing international business income; for example, a 15% rate would greatly diminish the payoff from both corporate tax shelters – which frequently have international aspects – and intercompany transfer pricing that shifts U.S. income abroad while consuming great resources of the IRS and taxpayers alike.   

But given the current financial condition of the federal government--with deficits as far as the eye can see -- and the inevitable future demands for spending on retirement income, health care, and long-term care for an aging population, it is not possible to achieve this kind of corporate rate reduction without a major restructuring of our domestic tax system.  Corporate tax receipts were $279 billion in FY2005, $303 billion in FY 2006, about 2.3% of our GDP. While some corporate base broadening is surely feasible, base broadening alone will not produce enough revenue to pay for the kind of rate reduction I am urging here. My first point, therefore, is simple but challenging:  Lowering the corporate tax rate significantly─the priority for international competitiveness of the U.S. economy and for international tax reform--cannot happen without domestic tax reform.

In my view, the goal of such a tax reform should be to reduce our nation’s reliance on the income tax and increase our reliance on consumption taxation.  I have detailed elsewhere how enacting a value added tax (or a similar tax on goods and services) at a 10-14% rate would allow us to eliminate 150 million Americans from the income tax altogether by enacting an exemption of $100,000 (for married couples) and to lower the income tax rate for income above that level to 20-25%.[2]  It would also permit the kind of corporate rate reduction, I am advocating here.

Compared to other OECD countries, the United States is a low tax country. As a percentage of GDP, our taxes are as low as Japan’s and much lower than most European nations.  [See Figure 3]  But we are not a low income tax country.  Our income taxes as a share of GDP are not lower than the average elsewhere.  [See Figure 4.]  The critical difference is that we rely much less than other OECD nations on consumption taxes. [See Figure 5.] The tax reform proposal I am advocating would shift that balance dramatically, making our consumption taxes comparable to those elsewhere and our income taxes much lower.  [See Figures 5 and 6.] This would enhance our nation’s economic growth and dramatically simplify our tax system while maintaining roughly the same distribution of tax burdens as current law.

Second, any major domestic tax reform must fit well with international tax practices.  For example, while I found much to admire in the Report of the President’s Panel on Tax Reform issued last November, a crucial weakness of its proposal for a consumption tax alternative to the income tax─its so-called “Growth and Investment Tax”─ is that it does not mesh well with longstanding international practices.  Indeed, adopting that proposal would require not only the votes of the Congress and the signature of the President, but also would require the U.S. to renegotiate all 86 of our bilateral Income Tax Treaties as well as the General Agreement on Trade and Tariffs (GATT).  If the proposal had no other major shortcomings (which it does), it is so out of sync with our international tax and trade arrangements that it is unrealistic as a practical matter.  The panel, in my view, also failed to take into account the potential responses of other nations to the kind of major tax reform it was suggesting. 

I do not mean to suggest that incremental improvements in our system for taxing international income cannot occur in the absence of fundamental tax reform.  Some international tax reforms─such as moving to a territorial system--can be done independently of domestic tax reform on a revenue neutral basis.  But in my view, the benefits for the American people of such changes will be quite small relative to the potential benefits achievable through a fundamental restructuring of our nation’s domestic and international tax system.

Third, in evaluating either domestic or international tax reforms it is important to have the same goal in mind:  improving the wellbeing of American citizens and residents.  For too long, international tax reform has occurred in the context of a debate between two normative ideas─capital export neutrality and capital import neutrality─that both fail to ask the fundamental question:  What will be the effects of the changes on the wellbeing of Americans? 

Unfortunately and importantly, many policymakers longstanding understanding of the normative underpinnings of international tax policy is thoroughly unsatisfactory.  I have made this point in detail elsewhere.[3]  The essential problem is that at least since 1962, when Subpart F was enacted, the Treasury Department, the Joint Committee on Taxation, and most other policymakers have looked to capital export neutrality (CEN) and capital import neutrality (CIN or “competitiveness”) as their guide to U.S. international tax policy.  It is now well known that we cannot have both CEN and CIN simultaneously when there are differences in the tax base or tax rates between two countries.  If our policy guideline is to compromise somewhere between CEN and CIN, that is no guideline at all.  Such compromises make setting international tax policy free play; you can compromise anywhere.  The fundamental questions we should be asking are “What policy is in the U.S.’s national interest?”  What rules will best serve the long-term interests of the American people?  These are the questions we normally ask about domestic tax policies and about other non-tax international policies, and these are the basic questions for international tax policy as well.  There is no reason to depart here, as so many analysts do, by substituting worldwide economic efficiency norms.

The great difficulty, of course, is knowing what to do to improve the wellbeing of our citizens and residents.  The essential problem is empirical uncertainty.  As is so often the case with tax policies, it is very difficult to know with certainty the consequences of alternative policy decisions.  Contested facts inevitably will play an important role.  For example, does foreign expansion by U.S. multinationals reduce or expand American jobs?  Although there is much concern about outsourcing U.S. jobs, the best evidence at the moment seems to be that foreign expansion by U.S. multinationals usually increases U.S. jobs.  Nor do we know with certainty the extent to which capital used abroad replaces capital that would otherwise be deployed in the U.S. or, instead, is complementary to capital used in the U.S.  Again, the best evidence seems to be that foreign investment is most often complementary to domestic investment.  Nevertheless, we need to seek better information about these kinds of questions in order to make firm judgments about the effects of alternative policies on the welfare of the American people. 

I should emphasize that seeking to advance the wellbeing of the American people does not, mean abandoning this nation’s leading role in multinational organizations such as the OECD and WTO.  Nor does it mean that we should always adopt policies advancing the competitiveness of U.S. multinationals.  Advancing the competitive position of U.S. multinationals may or may not be the best course depending on the particular issue and circumstances. 

In sum, my three basic points are these: (1) International tax reform and domestic tax reform are now inextricably linked, and the best way to improve the international competiveness of the U.S. economy is through a fundamental restructuring of our nation’s tax system.  (2) It would be a serious mistake to undertake a domestic tax reform that ignores international tax and trade arrangements.  (3) The test for both domestic and international tax reforms should be whether they will improve the wellbeing of the American people.  Let me know turn to discuss a few specific issues relating to the international taxation of business income. 

Taxing International Business Income 

Currently, the big debate in international tax policy is whether we should substitute for our foreign tax credit system─often referred to as a worldwide system─a system that exempts active business income earned abroad.  More than half of OECD countries now exempt dividends paid from foreign subsidiaries.  The origins of U.S. international tax policy demonstrate that our foreign tax credit was not put into the tax code to promote capital export neutrality.  It was enacted in 1918 for mercantilist reasons.  The policy of the U.S. then was to encourage U.S. companies to go abroad and trade.  The limitation on the foreign tax credit, which was put into the law a few years later in 1921, was intended to protect U.S. taxation of U.S. source income.[4]  An unlimited foreign tax credit would allow taxpayers to escape U.S. tax on U.S source income. 

The key difficulty in international tax policy is that we have two national governments with legitimate claims to tax the same income:  The country where the capital originates (the residence country) and the country where the income is earned (the source country).  They must decide how to split the tax dollars between the two nations.  The goal of multinational corporations, of course, is to pay taxes to neither. 

It has long been the tax policy of the U.S. and of other industrialized nations to treat the prime claim between the two nations as the claim of the country where the income is earned─the source country─when the taxation of active business income is at issue.  The primacy of source-based claims to income taxes on active business income has been a feature not only of the U.S. system, but of all OECD tax systems since the 1920’s.  The fundamental goal has been to avoid double taxation.  If the source country taxes the business income, the residence country should not tax it again. 

It is more difficult, however, to know how much to worry about low or even zero taxation by the source country.  Should the United States, for example, be concerned if U.S. multinationals are avoiding taxes by stripping income out of source countries in Europe and elsewhere?  This, of course, is the basic goal of much recent international tax planning involving the use of hybrid entities and the so-called check-the-box rules and the foreseeable effect of the new CFC look-through rules.  Analysts who are predominately 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 or even by eliminating the ability of U.S. multinationals to defer foreign-source income reinvested abroad.

My approach to this issue would take a different tack.  My concern is that if U.S. policy encourages or readily facilitates the ability of U.S. companies to strip earnings without paying taxes to the country where the income is earned, foreign countries will respond by enacting rules that will allow their companies to strip earnings from the U.S. without paying tax.  Our own experience with transfer pricing and our recent experience with efforts to restrict such earnings strippings demonstrates the difficulty of effective unilateral action by the source country.  European nations will have even greater difficulties in protecting their corporate tax bases due to limitations imposed by the European treaties as interpreted by the European Court of Justice.  The potential for an ongoing “race to the bottom” as each nation assesses the international “competitiveness” of its own multinationals and aids their avoidance of taxes abroad suggests great caution in enacting rules that facilitate tax avoidance abroad by U.S. multinationals.

However, given our system for taxing active business income, which concedes the primacy of source-based taxation, an exemption system and our foreign tax credit system with deferral generally available for active business income, are not terribly far apart.   The two methods are very close, although they differ in certain important respects.[5]  In my view, the major difference is that with an exemption system there would be little or no cost to U.S. multinationals in bringing earnings back to the United States.  Under our foreign tax credit system, much tax planning occurs to avoid incremental U.S. income tax when money is brought back into the United States. 

Thus, the crucial advantage of an exemption system is to eliminate the burden on the repatriation of foreign earnings to the United States and remove the tax barrier to investing here.  As experience with the Homeland Investment Act has well demonstrated, there are substantial earnings of U.S. companies that have been trapped abroad which will return to the United States for either a small U.S. income tax or none at all.  The key reason to move to an exemption system is to remove the tax barrier to repatriation, not simplification or international competitiveness.  Removing this tax barrier would lower the cost of capital for U.S. companies and could do so without any substantial revenue loss.  In my view, this would be a worthwhile improvement in U.S. tax policy, although, I have said, the key issue for the competitiveness of the U.S. economy both domestically and for U.S. multinationals operating throughout the world is a significantly lower corporate tax rate.

There are a number of important questions, however, that must be answered before moving to an exemption system.  As is typically the case in tax policy, the devil is in the details.  For example, there is the question to what extent expenses should be allocated between taxable U.S. income and non-taxable foreign income.  A worldwide allocation of interest as under the 2004 legislation seems appropriate as the President’s Panel suggested.  The Joint Committee on Taxation has suggested that research and development expenses should also be allocated between domestic and foreign income.  The President’s Panel disagreed.  I would support the President’s Panel in this regard.  Royalties will be taxed when paid to a U.S. parent under a dividend exemption system, and this should make the allocation of R & D to foreign income unnecessary.  The Joint Committee on Taxation and the President’s Panel also diverged on the treatment of general and administrative expenses. Again, I am inclined to think that the President’s Panel came closer to the best answer.  One option used abroad, which should be considered here, is not to allocate such expenses but to allow an exemption of only 90 or 95 percent of dividends.

There is also a question about how to treat exports.  Should the current sales source rules for domestically manufactured products be retained?  In my view, shifting from our current system to an exemption system does not itself demand revision of this rule, although such a shift would provide a good occasion to reassess its effectiveness.   

Third, it is important to note that interest, rents, royalties, and other payments deductible abroad are not usually excluded in an exemption system.  Exempting them from taxation here would mean that such payments are subject to tax nowhere, which clearly seems the wrong answer.  On the other hand, under current law, foreign tax credit planning most often makes royalty income from abroad nontaxable.  Many multinationals will no doubt push for continued exemption of royalty income. If we were to take that path, it would re-open the question whether to allocate research and development expenses. With both of these issues in play, assessing the impact of alternative rules on the level and types of research and development activities in the United States seems essential before reaching a final conclusion. 

Fourth, with exemption, we would clearly have to maintain an equivalent to our current Subpart F for passive income. This means that there will be at least two categories of income: exempt income and income currently taxable subject to foreign tax credits. Congress should resist creating a third category of income that can be deferred and allowed foreign tax credits. With income either exempt or taxed currently subject to foreign tax credits, the question will inevitably occur regarding the proper scope of Subpart F, particularly with respect to “base company” income and other types of active business income, such as the income of financial services businesses. 

Thus, moving to an exemption system for active business income does not allow the complete elimination of foreign tax credits.  We will, for example, still have to maintain a foreign tax credit for taxes withheld abroad on payments of royalties and other income.  An exemption system, however, should allow a single foreign tax credit limitation. 

Finally, the question will arise whether dividend exemption should apply to pre-effective date income.  Since the main reason for adopting an exemption system is to permit repatriations of income without imposing a U.S. tax burden, I am inclined to believe that the best answer to this question is yes, the exemption should apply to income earned before the date when the law changes.  If Congress concludes otherwise, however, it would be much simpler to limit the exclusion to a specified percentage of dividends rather than attempt to determine whether dividends were from pre-or post-enactment earnings. 

Before I conclude, I would like to illustrate once again the linkage between the level of corporate tax rates and fundamental issues of international taxation. In a recent paper, Harry Grubert of the Treasury Department and Rosanne Altshuler, who served as the staff economist for the President’s Tax Reform Panel, have estimated that repealing deferral of all CFC business income would allow the corporate tax rate to be reduced to 28% on a revenue neutral basis.  Personally, I do not think─given the rates of corporate tax around the world─that a 28% rate is low enough to permit the repeal of deferral without harming both the competitiveness of U.S. companies and the U.S. economy.  But, if the corporate tax rate were lowered to 15%, as I have suggested should be our goal, repealing deferral would look very different. Current U.S. taxation of all foreign source business income at a 15% rate, offset by appropriately limited credits for foreign taxes, would become a reasonable alternative worthy of careful consideration. And, as the Grubert-Altshuler paper suggests, repealing deferral might be one element to help finance the rate reduction..  Current taxation of all income earned abroad, with a foreign tax credit up to the new U.S. 15% rate, would allow great simplification of our international income tax system in a context providing the economic advantages from restructuring our domestic tax system that I described earlier.   

As I indicated at the beginning of this testimony, I do not believe that such a substantial rate reduction can be accomplished in the absence of a major restructuring of the U.S. tax system.  Therefore, this option will no doubt have to wait until the Congress undertakes the broader task.  Given the ongoing expansion of the individual AMT and the coming expiration in 2010 of the tax reductions enacted in the past several years, however, serious Congressional consideration of a major restructuring of our nation’s tax system in the years ahead does not seem unrealistic. 

Thank you for allowing me to make these observations here today.  I will be happy to answer any questions. 

[1] Figure 2 illustrates only statutory corporate rates; other measures generally show similar patterns.

[2] See Michael J. Graetz, “100 Million Unnecessary Returns: A Fresh Start for the U.S. Tax System,” Yale Law Journal, Vol. 112 pp. 261-310; Michael J. Graetz “A Fair and Balanced Tax Reform for the Twenty-first Century.  Toward Fundamental Tax Reform (edited by Alan J. Auerbach and Kevin A. Hassett) (AEI Press, 2005). Low- and middle-income workers would be protected a tax increase by payroll tax offsets.

[3] Michael J. Graetz, “Taxing International Income: Inadequate Principles, Outdated Concepts, and Unsatisfactory Policy,” Tax Law Review, Vol. 54, pp. 261-336 (2001).

[4] See Michael J. Graetz and Michal O’Hear, “The ‘Original Intent’ of U.S. International Income Taxation”, Duke Law Journal, Vol. 46, pp 1022-1109, (1997).

[5] See Michael J. Graetz & Paul W. Oosterhuis, “Structuring an Exemption System for Foreign Income of U.S. Corporations,” National Tax Journal, Vol. 44, pp 771-786 (2001).