Commentaries

Tax Reform

Savings, Retirement and Social Security Reform

Contributing Members Commentaries

The International Components of Tax Reform: Tax Policy that Serves the National Interest (Part1)

Journal of International Taxation
July 2003, pp. 48-59
By Ernest S. Christian

ERNEST S. CHRISTIAN is an attorney and tax policy consultant in Washington, DC. He was former Deputy Assistant Secretary (for Tax Policy) and Tax Legislative Counsel of the Treasury Department, and served on President Reagan's Tax Transition Team. Mr. Christian is author of numerous books and articles on taxes and tax reform, and a longtime advocate of a simpler tax system that is not biased against saving and international competitiveness. He serves as Chief Counsel of a privately funded nonprofit corporation, the Center for Strategic Tax Reform that was established in 1991 to develop a series of options for fundamental tax restructuring that serve the strategic interests of the U.S. in a world economy. A shorter version of this article appeared in Quick Study, Institute for Policy Innovation (IPI), February 12, 2002.

Tax reform remedies thus far have been a hodgepodge of international tax rules that often operate at cross-purposes, create perverse incentives, and incur the ire of international trade organizations.

From an international perspective (and as used in this article), "tax reform" should consist of two interdependent components. The first is a territorial rule that excludes from tax the income that U.S. companies derive from activities conducted outside the U.S. Under a territorial rule, a U.S. company could conduct business operations in a foreign market, pay only the tax of the host country and, therefore, be on an equal tax footing with the local companies with which it must compete. The second international component is a set of complementary border tax adjustments. One border adjustment imposes tax when companies located outside the U.S. export into the U.S. market. The other border adjustment excuses tax when companies located inside the U.S. export to foreign markets.
This is the first of a two-part article on how the current tax system puts U.S. companies at a disadvantage in their efforts to compete internationally. Part 2 will appear in a forthcoming issue.

Evenhanded Choice of Market

The reformed tax system should provide an evenhanded choice to U.S.- and foreign-owned companies that want to sell manufactured products in the U.S. market.

U.S. market. They could choose to manufacture the goods in the U.S., in which case they would pay U.S. income tax on both their manufacturing activities and their sales activities in the U.S. Alternatively, they could choose to manufacture the goods abroad but sell them in the U.S. In this situation, in addition to the U.S. income tax on the sales activities in the U.S., the U.S. would collect an import tax, the economic burden of which would fall back on the capital and foreign labor used to manufacture the goods abroad. Therefore, insofar as U.S. tax law is concerned, the total tax cost associated with selling the goods in the U.S. market would be essentially the same, without regard to whether the company chose to manufacture the goods in the U.S. or abroad. Because the U.S. tax would be the same either way under tax reform, many foreign-owned companies would decide to manufacture in the U.S. the products that they sell in the U.S. Similarly, because U.S.-owned companies could gain no U.S. tax advantage by moving their plants abroad (perhaps to some "tax haven") and selling their products back into the U.S. market, they, too, would tend to manufacture in the U.S. the products that they sell in the U.S.(1)

Foreign market. When the desire is to sell manufactured products in a foreign market instead of the U.S. market, tax reform also provides both U.S.-owned and foreign-owned companies an evenhanded choice. The company could choose to locate its plant in the U.S. and export to the foreign market, in which case tax reform's border tax adjustment on outbound transactions would exclude the company's export income from U.S. tax. Alternatively, if the foreign market could not be fully and effectively served solely by exports from the U.S., the company could choose to locate a plant in the foreign country where the market is. In that situation, under tax reform's territoriality rule, the company would be excused from U.S. tax on its foreign-source income. Therefore, without regard to whether the company chose to manufacture in the U.S. or abroad, the company's income from selling products to customers located outside the U.S. would be free of U.S. tax.

Given the choice of staying home (with all the related nontax benefits) and still being able to make tax-free exports to foreign markets, most U.S. companies would tend to manufacture in the U.S. In addition, given the choice-which tax reform definitely provides-many foreign-owned companies would see the wisdom of locating a plant in the U.S. and using it as a base for making tax-free export sales to markets all around the world.

Tax adjustments for cross-border transactions are not some radical departure from the international norm. All countries that maintain value-added tax (VAT) systems already exempt their own exports from tax and impose import taxes when other countries (including the U.S.) export to them. The only thing extraordinary about the U.S. making border tax adjustments is that it would do so in a way that is consistent with its own tradition of taxing income, without resorting to any of the sales-tax-type arrangements that are the hallmark of the VATs.

Replacing the current U.S. worldwide taxation system (which taxes the income of U.S. companies from their activities outside as well as inside the U.S.) with a territorial system (which taxes only their income from activities inside the U.S.) is fully consistent with international standards. Many other countries already have territorial-type systems that exempt all or part of the income that their companies derive from business activities conducted outside the country.

The U.S. has been struggling for years to extricate itself from the clutches of its archaic worldwide taxation system-and to alleviate the tax bias against U.S. exports that is one of the defining characteristics of the current Code. But because of the continuing political influence of those who view foreign trade with suspicion, the effort has been schizophrenic and largely ineffectual. Instead of forthrightly changing the basic rules that are the source of the problem, the U.S. has resorted to a series of complex and ill-conceived exceptions variously known as "deferral," "DISC," and "FSC."

The result of these struggles with worldwide taxation has been an extraordinary hodgepodge of international tax rules and exceptions that often operate at cross-purposes. (2) For example, U.S.-owned companies that do business abroad can "defer" U.S. tax on their foreign-source profits only if they reinvest the profits abroad. If they bring the money home for reinvestment in the U.S. economy, they will have to pay a full and immediate U.S. tax. To enjoy the benefits of deferral, companies must also forgo opportunities to minimize the taxes that they pay to foreign governments--in most instances, this means that the company will pay more foreign tax than is necessary. Although the price is often high, the value of "deferral" is usually worth it to the large companies whose cash-flow capacities permit them to keep all foreign-source profits abroad. But to the many smaller companies that need the cash and must repatriate earnings, deferral is not an option. They must immediately pay U.S. tax on their worldwide income.

Even among large companies, the current Code causes incongruous results. For example, as already noted, a large company with the financial capacity to perpetuate deferral can build a plant abroad and sell its products in foreign markets without paying U.S. tax, but-and here is the incongruity-if that same large company were to build a plant in the U.S. and export American-made goods to those same foreign markets, it would have to pay a full and immediate U.S. tax (or a slightly reduced U.S. tax under the FSC exception). Thus, not only does the current Code favor large companies over small companies, but it favors foreign-made products over American-made products.

Basic Concepts and Quantities

U.S. companies compete in global markets in two ways. One is to produce a product in the U.S. and sell it to a customer outside the U.S. The product that is exported may be a manufactured item such as an automobile, an intangible such as a patent, or a service (for example, when an architect in Chicago creates the design and specifications for a building to be erected in Berlin). Generally, these are export transactions that produce U.S.-source income because the activity that produces the income (e.g., the manufacture of the automobile) occurred within U.S. territory.

U.S. companies also compete in global markets by conducting business activities abroad. The typical example is when a U.S. company sells its American-made product to its foreign subsidiary, which then distributes the product in the foreign market. Because the business activities of the typical distribution subsidiary occur outside U.S. territory, its income is foreign source. Thus, a typical export transaction may result in some U.S.-source income (the manufacturing profit of the U.S. parent company) and some foreign-source income (the distribution profit of the foreign subsidiary).

Another way for U.S. companies and their subsidiaries to compete around the world is by producing a product in the foreign market where it is to be sold or by some combination of foreign-country production and exports from the U.S. Sometimes, the best way for a U.S. company to compete in a foreign market is to go there and conduct a full range of business activities-all the way from manufacturing the product to distributing it to customers and servicing it after they buy it. Other times, the local production may be an assembly operation using U.S.-made components. Local production may also be only the first step in the process of developing the U.S. company's share of the foreign market. For example, once the company gains acceptance for its locally made products, it may build on that success by adding to its product line additional items brought in from its factories in the U.S. In other situations, however, local production is the only way to do business in a foreign market. (3)

Quantitative measures. Quantitative measures help to illustrate the two methods by which U.S. companies sell goods and services to foreign customers and use the proceeds to pay wages and returns on investment to the employees, shareholders, and debt holders whose labor and capital produced the goods and services. As shown in Exhibit 1, the dollar volume of U.S. exports is large and growing.

Because the capital investment and the jobs are in the U.S. and the customers are abroad, the benefits of export trade are obvious. New customers abroad permit sales to exceed the domestic demand for consumption and investment goods. As the amount of GDP increases, so do aggregate wages and returns to capital, thereby producing an increase in U.S.-source income. Manufacturing jobs in the export sector are particularly high-paying. Not all service jobs are necessarily high-paying (many are not), but those associated with exports are typically high-value-added positions that pay premium compensation.
When U.S. businesses go beyond the export trade and start producing or distributing goods and services abroad, they make what is called "foreign direct investment" (FDI). If a U.S. company undertakes to build a plant and to manufacture goods abroad, the level of FDI is likely to be large. On the other hand, if its foreign operations are limited to sales administration and distribution, the FDI is likely to be small. As shown by Exhibit 2, U.S. FDI has been increasing steadily since 1960.

The amount of foreign-source income derived by U.S. companies is another way to measure the extent to which U.S. companies are participating in the economies of other countries. Exhibit 3 shows foreign-source income for U.S. companies in selected years.

When U.S. companies conduct business operations abroad, one beneficiary is the foreign country where those investment and job-creating activities occur. The other beneficiary is the U.S. economy, which is made wealthier because the customer base of U.S. companies has been expanded and their foreign-source income has been increased. A U.S.-based headquarters also provides many high-paying service jobs and facilitates U.S.-based R&D. Like all income, the foreign-source income that U.S. companies derive from conducting business operations abroad will have been produced by a combination of labor and capital. Because the foreign-based portion of the work force will in most instances be composed predominantly of foreigners, the U.S. economy will not get all of the return to labor, but the U.S. economy will get the return to capital, including the risk premium-which, for some foreign-source income, is quite high.

Direct investment and exports correlation. The U.S. economy benefits in a second and often more important way when U.S. companies make direct investments in foreign countries. A landmark analysis by Edward Graham shows a very high statistical correlation between (1) a greater amount of direct investment by U.S. companies in a country and (2) the export of a greater amount of American-made products to that country. (4)

The Graham study provides strong support for what has long been foretold by logic and borne out by experience: direct investments and operations by U.S. companies in foreign markets lead to increased exports of American-made goods and to more (not less) jobs in the high-paying sectors of the U.S. economy. This symbiotic relationship between exports to a foreign country and business operations in that country highlights the importance of having a neutral tax system that allows U.S. companies to choose the combination that will maximize sales in foreign markets to the ultimate benefit of U.S. labor and capital.

Foreign companies do business in the U.S. economy by the same combination of exports and direct investment that U.S. companies use to participate in the global market. The impact of taxes on them, however, is quite different. The income that foreign companies derive from distribution or manufacturing operations in the U.S. is, generally, wholly or partially exempt from home-country income taxes and is not subject to VAT. In addition, when foreign companies produce goods and services for export to the U.S., their domestic-source income from home-country activities is generally exempt from a major portion of their home country's tax burden and is never taxed in the U.S. In contrast, when U.S. companies produce goods and services for export, their domestic-source income from activities in the U.S. is fully taxed by the U.S. and when those products enter the foreign country, the output of U.S. labor and capital is taxed again by the country of destination.

Foreign countries compete in the U.S. market primarily by exports. Their exports to the U.S. exceed U.S. exports to them by such a wide margin that the resulting U.S. trade deficit is the dominant fact of world trade today. Exhibit 4 shows by category and in total the dollars that Americans spent in 1980 and 1999 on goods and services imported from the rest of the world. Exhibit 5 shows for the period 1990-1999 the dollars spent on imports and obtained from exports, and the net trade deficit (excess of imports over exports).

Taxes and the U.S. trade deficit. Normally, the U.S. could not perpetually buy more from the rest of the world than the rest of the world buys from it. This is because the people who in the aggregate comprise the U.S. economy cannot as a group (absent some exogenous source of dollars) spend more to buy goods and services than the wages, interest, and dividends that they are paid for producing goods and services.

Example. In a closed economy (hypothetical) where there is no trade with other nations, the people of the U.S. would themselves buy all of the goods and services that they produced with the money that they were paid for producing those goods and services. For example, hypothesizing from 1999 data ($billions), they would be paid $9,553.2 for producing $9,553.2 of goods and services that they would purchase. In this example, the books balance: income equals expenses.

In a balanced trade situation, also hypothetical and extrapolated from 1999 data ($billions), the people of the U.S. would be paid $9,553.2 for producing $9,553.2 of goods and services. Of the total output, they would purchase $8,563.0 and sell (export) $990.2 to foreigners for which they would receive $990.2 that they would use to buy (import) $990.2 of goods and services from foreigners. In that situation, the books would also balance. The American people acquired enough dollars from foreigners to pay for what they bought from foreigners.

In the reality of a trade deficit situation using 1999 data ($billions), the people of the U.S. were paid $9,299.2 for producing $9,299.2 of goods and services. They purchased $8,309.0 and sold (exported) $990.2 to foreigners, but they bought (imported) $1,244.2 from foreigners. The books did not balance. The Americans had only $9,299.2 to spend (the amount that they produced), but they bought $9,553.2-thereby leaving themselves short of dollars. The amount of that shortage, $254.0, is exactly equal to the amount by which imports ($1,244.2) exceeded exports ($990.2).

The U.S. has been able to sustain an enormous trade deficit only because the countries of the rest of the world have sent back to the U.S. a portion of the dollars that the U.S. paid them for their exports. They have done so by purchasing U.S. assets and debt. Consequently, the deficit in the U.S. trade account resulting from a net outflow of dollars for goods and services has been offset by a surplus in the U.S. capital account resulting from a net inflow of dollars for investment. In this respect, the U.S. is exactly like a family that must either borrow or deplete savings to spend more than its current income.

When foreigners invest in the ownership of U.S. assets, the inflow of dollars appears as an adjustment in the capital account but, in substance, the transaction is an export. Normally, an export is reflected in the trade account. That kind of export occurs when Americans sell the fruits from their tree, but keep the tree. On the other hand, when Americans start selling off land, factories, businesses, etc., to finance their trade deficit, they are selling the tree itself, so the transaction appears in the capital account.

Direct investment in the U.S. by foreigners is relatively small, although it has begun to increase. (5) Exhibits 6 and 7 show, respectively, the dollar amounts of direct investment in the U.S., income derived by foreign companies from activities in the U.S., and U.S. income tax paid by foreign companies on that income.

Although FDI in the U.S. is increasing, foreigners have financed the U.S. trade deficit primarily by buying U.S. government debt. U.S. debt held by foreigners has steadily increased from less than one-quarter in the 1980s to over one-third today, pretty much in proportion to the size of the U.S. trade deficit. In the last three years, foreigners have begun to shift some of their investments into private debt and equity instruments as well. See Exhibit 8.

When foreigners make these loans to the U.S., they are accomplishing two things. First, they are making credit sales to their customers. (Just as the U.S. could not buy more from foreigners than they buy from the U.S., absent the capital account adjustment, the foreigners could not sell more to the U.S. than the U.S. sells to them). The credit sales that foreigners make to the U.S. enable them to maintain their net surplus in the trade balance with the U.S., so it should be no surprise that the foreigners who hold the largest amount of U.S. debt are the ones who export the most to the U.S. For example, $60 billion (24%) of U.S. net imports come from Japan and Japan holds $320 billion of U.S. debt (26% of the U.S. debt held by foreigners). Another 16% is held by European Union (EU) countries, which account for 10% of U.S. net imports. In addition to lending Americans a portion of their savings (to make up for the low level of personal savings in the U.S.), when foreigners buy U.S. debt they are also acquiring a claim on a portion of U.S. national income (the interest charged on the loan) and a mortgage on a portion of America's assets. The sheer size of the U.S. trade deficit and the degree of dependence on foreigners to finance it is a frequently voiced concern-and rightfully so. The implied long-term decline in U.S.-headquartered manufacturing facilities has serious economic, and even military, implications.
But the trade deficit is not necessarily all bad and all parts of the deficit are not necessarily the same. Some portion of the deficit may represent the most efficient use of labor and capital between the U.S. and its trading partners. For example, it may be to everyone's benefit (including America's most specifically) for the U.S. to borrow money from foreigners, put it to a use that pays a return far greater than the interest cost, and use the profit to buy a large volume of relatively cheap goods from the lenders.

Taxes distort choices, reduce returns to labor and capital, and misallocate resources.

Some (perhaps a very large) portion of the U.S. trade deficit is due to government interventions that have distorted choices and worked to the disadvantage of the U.S. Among those distortions are two provisions of U.S. tax laws. First, because consumed income is, under current law, taxed less heavily than saved income, Americans are encouraged to consume as much as possible. (6) Second, under current law, imports are exempt from the taxes that are imposed on the manufacturers of American-made products for sale in the U.S. or for export. The combination of a tax incentive for consumption combined with a tax subsidy for imports is almost guaranteed to produce some degree of trade imbalance. Once started, an imbalance attributable to those kinds of tax distortions tends to perpetuate and enlarge itself. For example, when Americans are encouraged to consume ever larger amounts of tax-subsidized imports, the less likely they are to save, and the more likely they are to borrow from foreigners, who can afford to lend to Americans only by continuing to sell to Americans more than they buy from Americans.

When taxes intervene in situations where the producer is in one country and the customer is in another, the fundamentals of tax intervention are the same as when the producer and customer are all located in the same country and are all citizens of the host country. So, generally, are the consequences. The first thing any tax will do is reduce returns to labor (wages and salaries) and to capital (dividends and interest).

Example. Consider the current corporate income tax or any other tax that ostensibly is imposed on businesses. When an additional $10 tax is imposed on a company, it must either reduce wages and dividends by a total of $10, or it can raise prices by $10 if the government inflates the money supply sufficiently to permit that to occur. When overall price levels are inflated, everything that the company's employees and shareholders buy will cost a greater number of cheaper dollars, but their wages and dividends will remain the same. Even though the company increased prices, each $10 that it received from doing so was taken away by the tax increase and is unavailable for salary increases, etc. Thus, under either scenario--(1) constant price levels and lower wages, or (2) constant wages and higher price levels-the real burden of the $10 tax is borne by labor and capital.

In addition to these unavoidable impacts on the returns to labor and capital, a tax may also drastically reduce the amount of goods and services produced by labor and capital. For example, high marginal tax rates on wage income reduce the after-tax "price" that employees receive for their labor, and the lower the price that they receive, the less inclined they are to sell. The same is true of capital investment. Low after-tax returns can quickly make entrepreneurial investment and innovation no longer worth the risk.
Even if tax rates are sufficiently low to permit relatively high levels of investment and work effort, a tax may still have an unnecessarily deleterious impact on output in the economy. For example, a tax (like the current federal income tax) may have a very uneven impact, taxing some sources and uses of income more heavily or lightly than others, and making distinctions between otherwise seemingly identical business transactions. As it does so, it not only reduces the rate of return (as would any tax) but it also alters the relative rates of returns among different investment choices and ways of doing business, often influencing the relative proportions of labor and capital inputs in many transactions and in the economy as a whole-both domestic and foreign.

The main differences between the one-country and multi-country situations are threefold:

1. Destructive total tax. In the multi-country situation, there is a high possibility that more than one country will tax the same transaction, thereby making the total tax destructively high. (The need to avoid double taxation is the cardinal principle of many international agreements, but that principle is often violated.)
   
   
2. Distortion. When companies of different national " citizenship" are competing in the same market, it is highly likely that one of them will be taxed more heavily than another. The presence of multiple tax jurisdictions with greatly different ways of taxing labor and capital (both foreign and domestic) makes it much more likely that taxes will distort not only the competitive balance between companies, but also the way that they use the labor and capital resources at their command.
   
   
3. Tax competition. There is the matter of "tax competition" in a direct and overt way. The winning country may deliberately use a combination of tax penalties on foreign companies and tax exemptions for its own companies as a way of gaining an advantage in international trade. Further, there is a certain amount of what might be called "comparative" tax disadvantage--the losing country may tax its nationals in a way that is perfectly reasonable when viewed in isolation, but that is highly destructive to its own interest compared to the way that other countries tax their companies in similar situations of international commerce.

The U.S. practice of taxing an American-owned company on its worldwide income is not altogether unreasonable, in and of itself, but it becomes highly disadvantageous to American interests when American-owned companies must compete against foreign companies that operate under territorial systems of taxation that permit them to exclude from their home-country tax large portions of the income that they earn in the global marketplace. Similarly, it is not on its face unreasonable for the U.S. not to claim any tax revenue from the profits earned by foreign labor and capital when they export into the U.S. market, but when one takes into account the taxes that foreign countries impose on U.S. companies when they export into foreign markets, the failure of the U.S. to border-adjust for imports works against U.S. and interests and, thus, becomes much harder to defend.

History and Perspective on International Components of Reform

The worldwide reach of the U.S. tax combined with a highly restricted credit for foreign income taxes paid on foreign-source income is clearly out of step with the tax practices of most other countries. So is the insistence on taxing export income-which, under current law, results in taxable U.S.-source income insofar as the U.S. manufacturing portion of the profit on export sales is concerned. The U.S. has gotten itself into this position, and remained there, through a combination of historical accidents, serious policy mistakes, internal political constraints that have prevented their correction, and lastly, some fairly smart maneuverings by other countries-primarily European-in taking advantage of misconceptions in the U.S. about VATs, border tax adjustments, and the GATT (now WTO) rules.

European countries (and many others) routinely exempt their exporters from VAT and have territorial-type systems that allow their export firms to sell their products through subsidiaries located in low- or zero-tax countries. For example, if a French company manufactures widgets in France, it does not pay VAT when it exports them to its sales subsidiary in an offshore tax-haven country. Further, it does not pay income tax to France on its sales and distribution profit when the subsidiary reroutes the widgets to a customer in the U.S. that, in turn, imposes neither an import tax nor an income tax on the French company or its subsidiary. If the situation were reversed, a U.S. manufacturer of widgets would pay income tax on the export sale to its subsidiary, pay income tax on the resale by the subsidiary to the customer in France, and pay an import tax to France when the widgets were delivered.

Some European countries have integrated corporate tax systems whereby corporate tax payments function as prepaid taxes for shareholders who are allowed a credit against their tax liability on dividends. In many instances, the result is no VAT on exports, no income tax on foreign-source income, and a shareholder credit for any corporate income tax prepaid on their behalf. In the U.S., not only are shareholders not allowed a credit for corporate income taxes, but corporations frequently are not even allowed a full credit for the tax that they pay to foreign countries on top of the tax they pay to the U.S.
It is not as if the U.S. has been unaware all these years that taxing exports and foreign-source income runs contrary to both logic and national self-interest. As far back as 1918, the U.S. tried to ameliorate the adverse impact with the China Trade Act provision. Although constricted and schizophrenic, the exception under the current Code that allows deferral of tax on the foreign-source income is, itself, an attempt to blunt some of the worst aspects of worldwide taxation. Since the 1970s, when the U.S. allowed the Europeans to maneuver it into agreeing to their border-adjustable VATs, the U.S. has sought to achieve a relatively minuscule subsidy for some of its own exports while continuing generally to tax exports and foreign-source income on a worldwide basis.

DISCs and FSCs. The first artifice was the domestic international sales corporation (DISC), which was enacted in 1971. After protracted GATT litigation centered on the archaic distinction between "indirect" and " direct" taxes, DISCs were repealed in 1982 and replaced by the foreign sales corporation (FSC). Over the ensuing years, the list of exports eligible under the FSC rules expanded and by the time that the FSC was invalidated in 1999 by a WTO panel report (affirmed on appeal), it had become a major element in U.S. export trade, heavily relied on in the software and aircraft sectors and by a broad array of manufacturing firms, both large and small. In late 2000, after much anguishing in the Congress and the business community over the loss of the relatively minuscule benefits provided by FSC, Congress enacted the FSC Repeal and Extraterritorial Income Exclusion Act of 2000, wherein it replaced FSC with a similar provision (often referred to as FSC-II) that has also been challenged in the WTO. A final and probably negative WTO decision on FSC-II is expected in early 2002. (7)

The WTO challenges on FSC and FSC-II have been criticized as disregarding an understanding reached in the Uruguay and Tokyo Rounds, but, leaving that aside, the WTO decisions are a powerful indictment of the approach that has characterized both DISCs and FSC. In holding that the FSC is an invalid subsidy to exports, the report of the WTO panel said that the U.S. could have either a territorial rule or a worldwide rule, but not a partial territorial rule that applies only to FSC exports. (8) In addition, the report went on to say "[The U.S.] is not free ... [to] provide an exemption … specifically related to exports because it [the exemption] is necessary to eliminate a disadvantage to exporters created by the U.S. tax system itself." In effect, the report called on the U.S. to make changes in its basic rules sufficient to permit it to join the rest of the world in subsidizing exports in a treaty-legal way, or, barring that, to reconcile itself to suffering the consequences of self-inflicted wounds, but, in all events, to stop trying by means of artifice to escape from the trap set and sprung in 1970.

VAT-direct or indirect tax? In 1970, the U.S. made the mistake of acceding to the Europeans' argument that their emerging VAT systems were indirect taxes on products, as distinguished from direct taxes on firms (such as the U.S. corporate income tax), and that, therefore, they (the Europeans) should be permitted to rebate the VAT to exporters. Conversely, any rebate or remission of the U.S. corporate income tax to exporters would be a prohibited subsidy.

Having accepted not only the false premise that the European VATs are multi-stage sales taxes borne by the purchasers of products, and having also accepted the corollary false premise that any import tax on inbound transfers is by definition also a sales tax borne by consumers of products in the country of destination, the U.S. has since then been in a box from which it has, so far, been unable to extricate itself. The U.S. allowed itself to be maneuvered into a position where-seemingly-it could subsidize its exports the way that Europeans subsidize their exports only by replacing its current income tax system with a sales tax, or some other form of transactions tax that is, at the federal level, inimical to the U.S. political ethic and culture and that, therefore, would stand no realistic chance of enactment. Meanwhile, the Europeans and many others around the world were going merrily about adopting and increasing "indirect" border-adjustable VAT while relying less and less on income taxes.

Seemingly, the 1960s and early 1970s were a dark age when the principles of neoclassical economics nearly disappeared but, fortunately, those principles have now reemerged and most economists now recognize that all taxes, by whatever name called and however collected, are paid out of income (returns to labor and capital) and are borne proportionately by the labor and capital factors of production. Thus, correctly understood, the "indirect" taxes-such as a VAT or sales tax-that the WTO allows to be border adjusted are not taxes on goods, but are, in fact, taxes on the income of the people who provided the labor and capital to produce those goods.

The long-standing distinction in the WTO rules between a direct and indirect tax lacks any substance and should be abolished. It is the elimination of these kinds of fundamental artificialities that should be included in any new round of trade negotiations, not equally artificial distinctions between FSC, FSC-II, and similar arrangements.

In the meantime, even without any changes in underlying WTO rules, it is gradually becoming widely understood that under existing treaty obligations and interpretations dating back to the 1970s and before, the U.S. can make its tax system border-adjustable without having to enact a European VAT or any form of sales or transactions tax. Instead, it need only make its corporate income tax neutral as between labor and capital- an example is the business cash-flow tax described in Part 2 of this article--to be able to exclude its export sales from tax, as the Europeans and others already exclude theirs. Not everyone agrees with that analysis (most particularly, probably not the Europeans), but the analysis is well documented and powerful. (9)

Conclusion

Part 2 of this article, in an upcoming issue, will cover the structure and policy of the international components of Reform, and importing a tax base and how tax reform could produce a result that is in effect a massive tax cut for U.S. labor and capital.

Exhibit 1: Growth in U.S. Exports, 1980 to 1999 ($Billions)

Source: U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business, Washington DC, August through November 2000, "Selected National Income and Product Accounts (NIPA) Tables," Table 4.1.

Exhibit 2: Direct Foreign Investment by U.S. ($Millions)

Source: U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business, Washington DC, October 2000, Table 10, pp. 112-117.

Exhibit 3: U.S. Income Receipts From Abroad ($Millions)

Exhibit 4: Growth in U.S. Imports, 1980 to 1999 ($Billions)

Source: U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business, Washington DC, August through November 2000, "Selected NIPA Tables," Table 4.1.

Exhibit 5: U.S. Exports and Imports, 1990 to 1999 ($Billions)

Source: U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business, Washington DC, August through November 2000, "Selected NIPA Tables," Table 1.1.

Exhibit 6: Direct Foreign Investment and Payments in U.S. ($Millions)

Source: U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business, Washington DC, October 2000, Table 10, pp. 112-117.

Exhibit 7: Foreign-Controlled Domestic Corporations, 1997, Selected Items by Selected Countries
(All figures are estimates based on samples-money amounts are in thousands of dollars)

Source: Internal Revenue Service, "Foreign-Controlled Domestic Corporations, 1997," Statistics of Income Bulletin, Summer 2000, pp. 122-179.

Exhibit 8: Major Foreign Holders Of Treasury Securities ($Billions)

Notes

1. International tax reform of the type described is a clear and unassailable move toward making taxes a neutral factor, and neutrality is the universally accepted first principle of sound tax policy, but this is also a case where "doing the right thing" redounds heavily to the benefit of the U.S.

2. The general rule is worldwide taxation, expanded to include not only the worldwide income of U.S. corporations but also the worldwide income of foreign corporations controlled by U.S. persons. Thus, U.S. companies must pay U.S. tax on their domestic-source income and, if they directly or indirectly participate in foreign markets, they must pay U.S. tax on their foreign-source income as well.

3. U.S. brand soft drinks (and other similar products where the ratio of weight to price is high) are marketed all around the world, but they are normally produced locally using a formula and technologies that are of U.S. origin. Construction firms and mining companies also, by definition, compete on site in the foreign country where they are working-although often much of the equipment and materials that they use is of U.S. origin.

4. Wada and Graham, Appendix B, "Is Foreign Direct Investment a Complement to Trade?," Fighting the Wrong Enemy, Graham (Washington, D.C.: Institute for International Economics, September 2000). See also "Foreign Direct Investment Outflows and Manufacturing Trade: A Comparison of Japan and the United States" in Encarnation, ed., Japanese Multinationals in Asia: The Regional Operations of Japanese Multinationals (Oxford and London: Oxford University Press, 1997) and "U.S. Direct Investment Abroad and U.S. Exports in the Manufacturing Sector: Some Empirical Results Based on Cross Sectional Analysis," in Buckley and Mucchielli, eds., Multinational Firms and International Relocation (Cheltenham, England: Edward Elgar, 1997).

5. One alarming aspect of foreign investment in the U.S. is the extent to which U.S. companies are being merged into foreign companies and are reemerging as controlled subsidiaries of foreign parent corporations whose headquarters and dominant stock ownership is outside the U.S.

6. Americans are encouraged to consume as much of their income as possible as fast as possible because income that is consumed immediately is taxed less heavily than income that is saved and consumed later.

7. See Larkins, "FSC-ETI Dispute: EU 5, U.S. Zero-Game Over?," 13 JOIT 10 (December 2002) 1207; Larkins, "WTO Appellate Body Denounces ETI Exclusion: Anatomy of an Export Subsidy," 13 JOIT 10 (May 2002) 0502; Larkins, "Extraterritorial Exclusion Replaces FSC Regime: Mirror Rules, Broader Spectrum," 12 JOIT 22 (May 2001) 0511

8. The language of the WTO decision on FSCs and the subsequent debate in Congress has perhaps led to blurring in the minds of some of the otherwise clear distinction between the manufacturing profit on an export sale, which is U.S.-source income, and the distribution profit, which is foreign-source income.
A business-level tax that includes both the labor factor and the capital factor generally would qualify under international agreements. See Hufbauer and Gabyzon, "Fundamental Tax Reform and Border Tax Adjustments" (Washington, D.C.: Institute for International Economics, 1996).