Mr. Chairman, Congressman McNulty, and distinguished members of the Subcommittee, I appreciate the opportunity to appear at this hearing to discuss the future of the extraterritorial income tax regime.  Today, after exploring the current state of our country’s international tax regime, I would like to offer for your consideration four fundamental principles for international tax reform that I hope you will find useful during the course of the Committee’s work.

For the record, let me note that while I am currently serving as Senior Policy Advisor to PricewaterhouseCoopers, I am testifying today on my own behalf and not as the representative of any organization.

First, I am extremely pleased to have this chance to discuss with my former colleagues the critical issue of ensuring that U.S. international tax rules provide a level playing field for U.S. businesses to compete globally.  As President Bush stated early in his Administration, “Open trade fuels the engine of economic growth that creates new jobs and new income in the United States and around the world.”  We must have a tax system that frees American workers and businesses to participate fully and fairly in the benefits of an open global trading system.

Achieving this goal in a manner that honors our international trade commitments is a fundamental imperative for our country.  I am confident that the House Committee on Ways and Means will address this challenge by once again demonstrating its longstanding bipartisan commitment to putting first the interests of American workers and businesses.

The Subcommittee has been charged with the responsibility for exploring options that respond to the January 14^th World Trade Organization appellate ruling that the U.S. tax code is inconsistent with our obligations under the WTO.  This decision marks the fourth time the WTO has ruled this way, twice in the Foreign Sales Corporation (FSC) case and now twice in the extraterritorial income (ETI) case.

I believe that I share the disappointment of each of you that Congress once again must confront this issue. I had the distinct honor of chairing the House Committee on Ways and Means when we all worked together in a bipartisan manner to pass legislation in November 2000 that responded to an earlier WTO ruling by repealing the FSC and enacting the ETI provisions. 

Unfortunately, the most recent WTO rulings find that the current ETI, like the FSC provisions that preceded them, are inconsistent with our international trade commitments.  A WTO Arbitration Panel is expected to rule by April 29 on the amount of sanctions the European Union can impose against U.S. exports to EU countries. The amount and timing of any retaliation remains unclear.   What is clear are the serious risks posed by sanctions to our recovering U.S. economy and the orderly operation of a global trading system.

Chairman McCrery, in announcing this hearing, you stated that “it is critical that we make a prompt, yet thorough inquiry into possible changes to the ETI system which are both WTO-compliant and foster the competitiveness of American companies.”  You asked for help in exploring the possibility of leaving the ETI in place but making modifications to it that address the objections raised by the European Union.

I do not think it is possible to design a replacement that will replicate the same benefits to the same taxpayers and still satisfy the WTO rules. On this point, I concur with Chairman Thomas.  Thus, the Committee will need to recognize that there will be winners and losers with respect to any change to the existing rules.  However, I believe that it is important to balance the needs of various affected industries and implement any proposed legislation in a manner that avoids disruption of current business plans and activities.

Let me state emphatically that the Committee should not consider another interim response to the WTO ruling.  In my opinion, the ETI cannot be modified to preserve effectively its essential benefits and still be in compliance with the WTO.  I believe the Committee needs to consider fundamental reform of the ways that U.S.-based businesses are taxed.  As you all know, I have been a long-time advocate of fundamental tax reform.  While reform of our overall tax system remains an issue for another day, it is vital that the Congress begin to consider comprehensive overhaul of U.S. international tax rules.

The current ETI provisions, like the earlier FSC provisions, are integral parts of a larger system of international tax rules under which U.S.-based businesses must compete internationally.  The ETI and FSC provisions were designed to level the playing field at least partially for those U.S.-based businesses that are subject to those rules. 

In my view, we force U.S.-based businesses to enter the global trading arena with one hand tied behind their backs relative to the tax codes of the countries where corporations are competing against us. The existing ETI provisions serve only in part to offset some of the anti-competitive features of U.S. international tax rules.  It is important that we examine just how complex and burdensome those rules are.

First, current international tax rules are grossly outdated.  The basic Subpart F rules, for example, were enacted in 1962.  These rules reflect the economic climate of that time.  In 1962, the United States was a net exporter of capital and ran a trade surplus.  Imports and exports were only one-half of the percentage of GDP that they are today.  As we all know, the world has changed.  Our tax laws need to change too.

The impact of U.S. tax rules on the international competitiveness of U.S. multinationals is much more significant an issue than it was forty years ago. Today, foreign markets provide an increasing amount of the growth opportunities for U.S. businesses.  At the same time, competition from multinationals headquartered outside of the United States is becoming greater.  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.  Around the world, 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.-based businesses will be less successful in global markets, with negative consequences for exports and jobs at home.  I think a fair comparison of U.S. international tax rules and those of other nations shows that American businesses are increasingly put at a competitive disadvantage in the world marketplace.

First, about half of OECD countries have a territorial tax system under which a company generally is not subject to tax on the active income earned by a foreign subsidiary.  By contrast, the United States taxes income of a U.S.-controlled foreign corporation either when repatriated or when earned in cases where income is subject to U.S. anti-deferral rules.

Second, the scope of U.S. anti-deferral rules under subpart F is unusually broad compared to those of other countries.  While most countries tax passive income earned by controlled foreign subsidiaries, the United States stands out for taxing as a deemed dividend a wide range of active income under various subpart F provisions.

Third, 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.

Taken all together, you find that a U.S.-based business operating internationally 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. 

In addition to a comparatively higher effective tax rate, the U.S.-based business is burdened by tax rules that are among the most complex in the entire U.S. tax code. Economists who surveyed 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.  The complexity and high compliance costs associated with U.S. international tax rules represent essentially an additional hidden tax on American businesses that operate abroad.

One indication of the impact of an overly burdensome and complex tax regime on the U.S. economy is in the area of corporate mergers and reorganizations.  As this Committee knows from past hearings on international tax simplification, U.S. international tax rules can play a key role in determining the location of a corporate headquarter.  This was clearly the situation in the case of DaimlerChrysler.  In fact, recent studies have shown that between 73 and 86 percent of large cross-border transactions involving U.S. companies have resulted in the merged company being headquartered abroad.

How we tax foreign source income will influence what kind of economy we have in the long run - specifically, whether we have a strong and vibrant economy with competitive workers and companies, and whether we can create more export-related jobs which pay on average 17 percent more to the workers of this country.

In conclusion, let me say that we must consider the bigger picture when discussing the current U.S. international tax system.  Achieving a high standard of living for American workers and their families ultimately rests on the productivity of U.S. investments.  Growing productivity in turn requires investment in plant and equipment and in the further development of knowledge through research and education.

The challenge is to design a tax system that raises revenue with the least damage.  An overly complex and burdensome tax system can impose unnecessarily high costs to the economy 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.

With these larger issues in mind, I would like to offer four fundamental principles that I hope you would consider during your deliberations.  I believe that the following bedrock guidelines should be part of the core criteria by which any proposal is judged:

Four fundamental principles to guide WTO response

1. If and to the extent that the ETI regime is repealed, any scored positive revenues such action generates should be reserved for measures to improve the competitiveness of U.S. corporations operating in the world marketplace;
2. In designing international tax reform measures, the Committee should balance the needs of various affected industries;
3. The Committee should seize every opportunity presented during this process to fashion simplified international tax rules that U.S. businesses can understand and the government can administer; and
4. If the ETI regime is repealed or substantially changed, there should be an adequate transition period to avoid disruption of current plans and business activities.

A successful U.S. response to the WTO’s ruling against the ETI has the potential to address two key priorities for our country.  First, we must make the United States more competitive internationally, and, second, we must address the underlying problems with the U.S. international tax rules that are resulting in fewer and fewer global business headquarters being located in our country.

As Chairman Thomas noted to the full Committee at the February 27th hearing, the task before you is not an easy one.  It will require the collective effort of all Members from both parties to build a consensus on an approach that will meet U.S. international commitments while maintaining the competitiveness of American businesses and workers in the global marketplace.  I am confident that the Members of the House Committee on Ways and Means, with the active leadership of the Bush Administration and the collaboration of Senate colleagues, will rise to the occasion once again.

Finally, I would note Ambassador Zoellick’s efforts to have the European Union defer any retaliatory action while the United States works to comply with our WTO commitments.  There remains the likelihood that some action may be required this year. Because of the huge potential magnitude of this issue, it would be highly desirable for the Congress to work with the White House to put in place a joint bipartisan task force to make formal recommendations to the Congress on a solution.  That task force should include: (1) the Administration; (2) select Members of Congress from both parties; and (3) representatives of both business and organized labor.

For my part, I would like to offer my assistance, and the assistance of PricewaterhouseCoopers, as the committee considers any replacement of the ETI regime.

Thank you again for the opportunity to testify today.  I will be happy to answer any questions you may have.