Statement of Peter R. Merrill, Principal and Director,
National Economic Consulting Group, PricewaterhouseCoopers LLP,
and Consultant, International Tax Policy Forum

Testimony Before the House Committee on Ways and Means

Hearing on the WTO's Extraterritorial Income Decision

February 27, 2002

U.S. TAX POLICY AND INTERNATIONAL COMPETITIVENESS

I.          Introduction

I am Peter Merrill, a Principal and Director of the National Economic Consulting group at PricewaterhouseCoopers LLP.  I am also a consultant to the International Tax Policy Forum, a group of U.S.-based multinational companies from a broad range of industries, and co-author of a recent book published by the National Foreign Trade Council on International Tax Policy for the 21^st Century.  For the record, I am testifying today on my own behalf and not as a representative of any organization.

The focus of my testimony is the relationship between U.S. tax policy and international competitiveness.  In many instances, current rules regarding the taxation of both domestic and foreign income create barriers that harm the competitiveness of U.S. companies.  These rules also are horribly complex both for taxpayers to comply with and for the Internal Revenue Service to administer.

The existing extraterritorial income (ETI) tax regime serves in part to offset some of the anti-competitive features of U.S. tax policy.  Thus, the WTO’s adverse decision in the ETI case raises the question how Congress can strengthen the competitive position of the U.S. tax system.  Regardless of how the ETI dispute is resolved, I believe it is important for this Committee to review the current U.S tax rules with a view to reducing complexity and removing impediments to U.S. competitiveness.

II.        TAX POLICY AND INTERNATIONAL COMPETITIVENESS

While there are a variety of ways to define competitiveness, in this testimony I focus on the standard of living of U.S. residents as the measure of economic performance.  Achieving a high standard of living ultimately rests on the productivity of U.S. investments.  Growing productivity in turn requires investment—in plant and equipment and in the development and dissemination of knowledge through research and education.

The challenge for tax policy is to design a tax system that raises revenue with the least damage to the growth of productivity and national income.  A poorly designed tax system can impose unnecessarily high costs to the economy—so-called dead-weight loss—by discouraging savings and investment, by causing investment to be allocated inefficiently, or by requiring excessive resources to be devoted to complying with and administering the tax rules.

III.       U.S. MULTINATIONALS AND INTERNATIONAL COMPETITIVENESS

In a global market, the competitiveness of a country depends on the ability of its enterprises to produce goods and services that are successful both at home and in foreign markets.  Today, almost 80 percent of world income and purchasing power lies outside of U.S. borders.  Opportunities for U.S. companies to grow their businesses increasingly lie overseas.   From 1986 to 1997, foreign sales of S&P 500 companies grew 10 percent a year, compared to domestic sales growth of just 3 percent annually.[1]

A.        U.S. Investment Abroad and Exports

It is a common perception that investment abroad by U.S. multinationals comes at the expense of the domestic economy.  This is an incorrect view.  The primary motivation for U.S. multinationals to operate abroad is to compete better in foreign markets, not domestic markets.  According to the Commerce Department, less than 11 percent of sales by U.S.-controlled foreign corporations were made to U.S. customers.[2]

Investment abroad is required to provide services that cannot be exported, to obtain access to natural resources, and to provide goods that are costly to export due to transportation costs, tariffs, and local content requirements.  Foreign investment allows U.S. multinationals to compete more effectively around the world, ultimately increasing employment and wages of U.S. workers.

While about one-fourth of U.S. multinational parent companies are in the services sector, 56 percent of all foreign affiliates are this sector, which includes distribution, marketing, and product support services.[3]  Without these sales and services subsidiaries, it would be impossible to sustain current export volumes.

According to the U.S. Commerce Department, in 1998, U.S. multinationals were directly responsible, through their domestic and foreign affiliates, for $438 billion of U.S. merchandise exports—almost two-thirds of all merchandise exports.[4]

A recent study by the Organization for Economic Cooperation and Development (OECD) found that each dollar of outward foreign direct investment is associated with $2.00 of additional exports.[5]

B.        U.S. Employment

Foreign investment by U.S. multinationals generates sales in foreign markets that generally could not be achieved by producing goods entirely at home and exporting them.

A number of studies find U.S. investment abroad generates additional employment at home through an increase in the domestic operations of U.S. multinationals.  As noted by Professors David Riker and Lael Brainard:

“Specialization in complementary stages of production implies that affiliate employees in industrialized countries need not fear the multinationals’ search for ever-cheaper assembly sites; rather, they benefit from an increase in employment in developing country affiliates.”[6]

Moreover, workers at domestic plants owned by U.S. multinational companies earn higher wages than workers at domestic plants owned by companies without foreign operations, controlling for industry, size of company, and state where the plant is located.[7] 

C.              U.S. Research and Development

 Foreign direct investment allows U.S. companies to take advantage of their scientific expertise, increasing their return on firm-specific assets, including patents, skills, and technologies.  Professor Robert Lipsey notes that the ability to make use of these firm-specific assets through foreign direct investment provides an incentive to increase investment in activities that generate this know-how, such as research and development.[8]

 Among U.S. multinationals, total research and development in 1996 amounted to $113 billion, of which $99 billion (88 percent) was performed in the United States.[9]  Such research and development allows the United States to maintain its competitive advantage in business and be unrivaled as the world leader in scientific and technological know-how.

D.              Summary

U.S. multinationals provide significant contributions to the U.S. economy through:

• Sales of U.S. goods and services abroad;

• Domestic employment at above average wages; and

• Critical domestic investments in equipment, technology, and research and development.

As a result, the United States has an important interest in insuring that its tax rules do not hinder the competitiveness of U.S. multinationals.

IV.       DOMESTIC TAX COMPETITIVENESS

A.        Corporate Income Tax Rate

With the reduction in the U.S. corporate income tax rate from 46 to 34 percent, as a result of the Tax Reform Act of 1986, it is commonly thought that the United States is a low-tax jurisdiction for corporations.   While true immediately after the 1986 Act, it is no longer true today.  The United States increased the corporate income tax rate to 35 percent in 1991.  Meanwhile, the average central government corporate tax rate in OECD member states has fallen since 1986 to 30.5 percent in 2001—4.5 percentage points less than the U.S. rate (see Exhibit 1).  This disparity in corporate tax rates would be even larger if corporate income taxes imposed by subnational levels of government were taken into account.

B.        Double Taxation of Corporate Dividends

In addition to a relatively high corporate income tax rate, the United States is one of only three OECD member countries that does not provide some form of relief from the double taxation of corporate dividends (see Exhibit 2).  Most OECD countries relieve double taxation of corporate dividends at the shareholder level through some form of credit, exemption, or special tax rate for dividend income.  For a shareholder in the top individual income tax bracket (38.6 percent[10]), the combination of corporate and individual income tax is over 60 percent of distributed corporate income (see Exhibit 3).  The combined income tax rate on distributed corporate income is even higher if state and local tax on corporate and individual income are taken into account.

C.        Reliance on Income and Profit Taxation

While the total tax burden as a percent of Gross Domestic Product (GDP) is relatively light in the United States compared to other OECD countries, reliance on income taxes to fund spending at all levels of government is unusually high.  In 1999, the United States relied on income and profits taxes for almost half of all revenues (49.1 percent) while the average OECD country raised slightly over one-third of revenues (35.3 percent) from this source (see Exhibit 4).  The U.S. data include sales taxes imposed by state and local governments; the federal government is even more heavily reliant on income and profits taxes as there is no broad-base consumption tax at the federal level.  Indeed, the United States is the only one of the 30 OECD member countries that does not have a national value-added tax.

D.        Conclusion

When compared to other OECD and EU member countries, the United States relies relatively heavily on income taxes to fund government operations, has a comparatively high corporate income tax rate, and is unusual in not providing a mechanism for relieving the double taxation of corporate income.

From a trade standpoint, heavy reliance on income taxes relative to consumption taxes may be viewed as disadvantageous because the WTO Agreement on Subsidies and Countervailing Measures permits border tax adjustments for indirect taxes such as consumption taxes, but prohibits such adjustments for income and profits taxes.  However, from the standpoint of U.S. economic growth, the main reason to avoid over-reliance on income and profit taxes is that they discourage savings and investment, which are closely linked to growth in national income.

V.        INTERNATIONAL TAX COMPETITIVENESS

A.        Rising Level of International Competition

In 1962, when the controlled foreign corporation rules in Subpart F were adopted, the U.S. multinationals overwhelmingly dominated global markets.  In this environment, the consequences of adopting tax rules that were out-of-step with other countries were of less concern to many policymakers.

Today, the increasing integration of the world economies has magnified the impact of U.S. tax rules on the international competitiveness of U.S. multinationals.  Foreign markets represent an increasing fraction of the growth opportunities for U.S. businesses.  At the same time, competition from multinationals headquartered outside of the United States is becoming greater.[11]

• Of the world’s 20 largest corporations, the number headquartered in the United States has declined from 18 in 1960 to just 8 in 1996.
• U.S. multinational companies’ share of global cross-border investment has declined from 50 percent in 1967 to 25 percent in 1996.
• The 21,000 foreign affiliates of U.S. multinationals compete with about 260,000 foreign affiliates of foreign multinationals.

If U.S. rules for taxing foreign source income are more burdensome than those of other countries, U.S. multinationals will be less successful in global markets, with adverse consequences for exports and employment at home.

B.        International Comparison of U.S. Rules for Taxing Multinational Companies

A study published by the European Commission last year found that, on average, U.S. multinational companies bear a higher effective tax rate when investing into the European Union than do EU multinationals.  The additional tax burden borne by U.S. multinationals ranges from 3 to 5 percentage points depending on the type of finance used (see Exhibit 5).

In addition to the relatively high U.S. corporate income tax rate, there are a number of other reasons why United States has become a relatively unattractive jurisdiction in which to locate the headquarters of a multinational corporation. 

First, about half of the OECD countries have a dividend exemption (“territorial”) tax system under which a parent company generally is not subject to tax on the active income earned by a foreign subsidiary (see Exhibit 6).  By contrast, the United States taxes income earned through a foreign corporation when repatriated (or when earned if subject to U.S. anti-deferral rules).

Second, the U.S. foreign tax credit, which is intended to prevent double taxation of foreign source income, has a number of deficiencies that increase complexity and prevent full double tax relief, including:[12]

• Over allocation of U.S. interest expense against foreign source income due to failure to take into account foreign debt.  This reduces the foreign tax credit limitation and can cause income that has been subject to foreign tax at a rate of 35 percent or more to be subject to additional U.S. tax;
• Asymmetric loss recapture rules that have the effect of restoring U.S. but not foreign income, thereby reducing the foreign tax credit limitation;
• The limitation on foreign tax credits to 90 percent of alternative minimum tax liability;
• The limited carryover period for foreign tax credits (two years back and five years forward); and
• The complexity associated with the numerous separate foreign tax credit limitations and the “high-tax kick out” rules that move certain income out of the passive basket.

A third difference from the multinational tax rules of other countries is the unusually broad scope the U.S. anti-deferral rules under subpart F.  While most countries tax passive income earned by controlled foreign subsidiaries, the United States is unusual in taxing a wide range of unrepatriated active income as a deemed dividend to the U.S. parent, including:[13]

• Foreign base company sales income;
• Foreign base company services income; and
• Active financial services income (an exclusion of this income from Subpart F expired last year).

The net effect of these tax differences is that a U.S. multinational frequently pays a greater share of its income in foreign and U.S. tax than does a competing multinational company headquartered outside of the United States.

Complexity.  The U.S. rules for taxing foreign source income are among the most complex in the Internal Revenue Code.  A survey of Fortune 500 companies found that 43.7 percent of U.S. income tax compliance costs were attributable to foreign source income even though foreign operations represented only 26-30 percent of worldwide employment, assets and sales.[14]  These data show that U.S. tax compliance costs related to foreign source income are grossly disproportionate.  These high compliance costs are a hidden form of taxation that discourages small U.S. companies from operating abroad and makes it more difficult for larger companies to compete successfully with foreign multinationals.

The international tax recommendations in the Joint Committee on Taxation’s simplification study are a good start to begin addressing the high compliance burden imposed by U.S. international tax rules.[15]  It should also be noted that the Treasury Department’s tax simplification project, described in the Administrations FY 2003 Budget, identifies the international tax rules as an area singled out by taxpayers as one of the biggest sources of compliance burden.[16]

D.        Conclusion

Short of adopting a territorial tax system, there are significant opportunities to increase the competitiveness and reduce the complexity of the U.S. tax rules applicable to foreign source income.  Indeed, there are a number of reasons to think very carefully before adopting a territorial income tax system.

First, foreign experience suggests that adopting a territorial income tax system does not guarantee a simple tax regime.   OECD Countries with territorial income tax systems also have parallel foreign tax credit rules for foreign income that is not exempt.  Moreover, many OECD countries with territorial income tax systems also have anti-deferral rules that tax certain income earned by foreign subsidiaries on a current basis.

Second, depending on how a territorial tax system is designed, it could cause a substantial tax increase for companies that currently repatriate dividends from high-tax jurisdictions.  Present law allows excess foreign tax credits on high-taxed foreign income to be used to reduce U.S. tax on low-taxed foreign income within the same limitation category.  Under a dividend exemption system, cross crediting between dividends and other types of foreign income generally is not possible.

Third, allocation of U.S. interest and other domestic expenses against foreign source income causes these expenses to be nondeductible under a territorial income tax system.  Double taxation will result unless foreign governments allow a deduction for these allocated expenses.

One opportunity for international tax reform is worth special mention within the context of these hearings, i.e., the foreign base company sales rules adopted by Congress in 1962 as part of Subpart F of the Internal Revenue Code.  Absent these rules, U.S. companies would be able to set up sales companies in low-tax jurisdictions and reinvest their active foreign earnings without current U.S. tax.  In fact, part of the benefits of the FSC regime were attributable to the fact that it created an exception to the foreign base company sales rules.[17]  Repeal of the foreign base company sales rules would put U.S. companies in a more comparable position to their foreign competitors who generally can use these structures with being subject to home country tax.  Moreover, the original policy rationale for these rules was thrown into doubt by the Treasury Department’s policy study on Subpart F, released in December 2000, which concluded that the economic efficiency effects of the base company rules were “ambiguous.”[18]

VI.       SUMMARY

U.S. rules for taxing both domestic and foreign source income are out of step with other major industrial countries in a number of ways.  Regardless of the ultimate resolution of the ETI case, Congress should consider changes to the U.S. system that promote economic growth and reduce costs of complying, with and administering the tax system.

If the United States is an unattractive location—from a tax standpoint—to headquarter a multinational corporation, then U.S. multinationals will lose global market share.  This can happen in a variety of ways.

First, U.S. individual and institutional investors can choose to invest in foreign rather than U.S. headquartered companies.  Indeed, as of 1999, almost two-thirds (66 percent) of all U.S. private investment abroad was in the form of portfolio rather than foreign direct investment.  This allows U.S. investors to invest in multinational companies whose foreign operations generally are outside the scope of U.S. tax rules.

Second, in a cross-border merger, the transaction may be structured as a foreign acquisition of a U.S. company rather than the reverse.  Measured by deal value, over the 1998-2000 period, between 73 and 86 percent of large cross-border transactions involving U.S. companies have been structured so that the merged company is headquartered abroad.[19]  Clearly taxes are only one of many considerations in the structuring of these transactions, but it is notable that in one large transaction, taxes were specifically identified as a significant factor.[20]  By choosing to be headquartered abroad, the merged entity can invest outside the United States without being subject to the complex and onerous U.S. rules that apply to the foreign source income of U.S.-headquartered companies.[21]

Third, and most starkly, a growing number of U.S. companies have structured transactions in which their U.S. parents are acquired by their own foreign subsidiaries.  Such “inversion” transactions, like foreign acquisitions of U.S. companies, allow new foreign investments to be structured as subsidiaries of a foreign parent corporation and thus not subject to U.S. rules relating to the taxation of foreign source income.

Fourth, an increasing number of new ventures are being incorporated at inception as foreign corporations.

While some have suggested that reducing the U.S. tax burden on foreign source income could lead to a movement of manufacturing operations out of the United States (“runaway plants”), an alternative scenario is that a noncompetitive U.S. tax system will lead to a migration of multinational headquarters outside the United States.

A decline in the market share of U.S. multinationals may affect the well being of the U.S. economy because, as noted above, U.S. multinationals play an important role in promoting U.S. exports and creating high-wage jobs.

Exhibit 1—Central Government Corporate Income Tax Rates, 1986-2001

¹Midpoint tax rate used for countries with multiple rates.

Sources:  Jeffrey Owens, Tax Reform for the 21st Century, Tax Notes International. 2001 data from American Council for Capital Formation, “The Role of Federal Tax Policy and Regulatory Reform in Promoting Economic Recovery and Long-Term Growth,” November 28, 2001.

Exhibit 2—Taxation of Corporate Dividends in OECD Countries, 1999

¹   Germany recently has adopted a 50 percent dividend exclusion.
²   Deduction for dividends paid may offset fully the corporate and personal income tax for dividends up to 15 percent of capital value.  Dividends in excess of this limit are fully taxed at both levels.
³   Ireland eliminated its imputation credit effective April 6, 1999.
⁴   Luxembourg has a 50 percent dividend exclusion.
⁵   Information as of 1996 based on S. Cnossen.

Sources:
PricewaterhouseCoopers, Individual Taxes 1999-2000: Worldwide Summaries (John Wiley & Sons, 1999) and Sijbren Cnossen, Reform and Harmonization of Company Tax Systems in the European Union, Research Memorandum 9604, Erasmus University, Rotterdam (1996).

Exhibit 3—Combined U.S. Individual and Corporate Statutory Tax Rate in 2002:

Corporate Income Distributed as a Dividend to Individual Shareholder in Top Bracket

Exhibit 5—Effective Average Tax Rate for Investment into EU

Source:  Commission of the European Communities, “Towards an Internal Market without Obstacles,” Com(2001)582, Brussels, October 23, 2001.

Exhibit 6—Taxation of Foreign Subsidiary Dividends in OECD Countries, 1999

¹  Although Ireland nominally has a worldwide tax system, under the Finance Act of 1988, foreign subsidiary dividends generally are exempt if re-invested in employment-generating activities within Ireland.
²  Information as of 1990 based on OECD.
³   Some treaties provide for the exemption method.

Sources:

(1)   PricewaterhouseCoopers, Individual Taxes 1999-2000: Worldwide Summaries (John Wiley & Sons, 1999).
(2)   OECD, Taxing Profits in a Global Economy: Domestic and International Issues (1991).

Exhibit 7

[1] Wall Street Journal, “U.S. Firms Global Progress is Two-Edged,” August 17, 1998.

[2] U.S. Department of Commerce, Survey of Current Business (July 2000).  Note that 40 percent of the sales back to the United States were from Canadian subsidiaries.

[3] Matthew Slaughter, Global Investments, American Returns.  Mainstay III: A Report on the Domestic Contributions of American Companies with Global Operations, Emergency Committee for American Trade (1998).

[4] National Foreign Trade Council, The NFTC Foreign Income Project: International Tax Policy for the 21st Century, chapter 6 (1999).

[5] OECD, Open Markets Matter: The Benefits of Trade and Investment Liberalization, p. 50 (1998).

[6] David Riker and Lael Brainard, U.S. Multinationals and Competition from Low Wage Countries, National Bureau of Economic Research Working Paper no. 5959 (1997) p. 19.

[7] Mark Doms and Bradford Jensen, Comparing Wages, Skills, and Productivity between Domestic and Foreign-Owned Manufacturing Establishments in the United States, mimeo. (October 1996).

[8] Robert Lipsey, “Outward Direct Investment and the U.S. Economy,” in The Effects of Taxation on Multinational Corporations, p. 30 (1995).

[9] U.S. Department of Commerce, Survey of Current Business (September 1998).

[10] Under the Economic Growth and Tax Relief Reconciliation Act of 2001, the top individual income tax rate is scheduled to be reduced to 35 percent in 2006.

[11] See, National Foreign Trade Council, International Tax Policy for the 21^st Century, vol. 1, 2001, pp 95-96.

[12] See, National Foreign Trade Council, U.S. International Tax Policy for the 21^st Century, vol. 1, Part II, 2001

[13] Ibid., vol. 1, Part I.

[14] Marsha Blumenthal and Joel Slemrod, “The Compliance Costs of Taxing Foreign-Source Income:  Its Magnitude, Determinants, and Policy Implications, International Tax and Public Finance, vol. 2, no. 1, 37-54 (1995).

[15] Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986, JCS-3-01 (April 2001).

[16] Office of Management and Budget, Budget of the United States Government, Fiscal Year 2002, Analytical Perspectives, p. 79

[17] This exception was one of the reasons that the FSC regime was determined by the WTO to violate the Agreement on Subsidies and Countervailing Measures under the “but for” test.]

[18] U.S. Department of the Treasury, Office of Tax Policy, The Deferral of Income Earned through U.S. Controlled Corporations:  A Policy Study (December 2000) p. 47.  The report reached similar conclusions regarding the other foreign-to-foreign related party rules of Subpart F such as the foreign base company services income rules.

[19] Recent examples include:  AEGON-Transamerica, BP-Amoco, Daimler-Chrysler, Deutsche Bank-Bankers Trust, and Vodafone-AirTouch.

[20] See, John L. Loffredo, “Testimony before the Senate Finance Committee” (March 11, 1999) regarding the Daimler-Chrysler transaction.

[21] Where business reasons dictate the form of a transaction, there generally is no cause for concern.  The concern we are raising is that non-competitive U.S. tax rules may be influencing the form of transactions.