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The International Components of Tax Reform:
Tax Policy that Serves the National Interest (Part 2)
Journal of International Taxation
February 2004
By Ernest Christian*
Before border tax adjustments can be contemplated seriously
as part of tax reform, they must first be disassociated from
the VAT and the popular misconceptions that surround that
particular form of European tax.
This is the second and concluding installment on how the current
tax system puts U.S. companies at a disadvantage in their
efforts to compete internationally. Part 1 covered even-handed
choice of market, basic concepts and quantities, and history
and perspective on international components of reform.(1)
Discussed below are the structure and policy of the international
components of reform, territorial vs. worldwide taxation,
border tax adjustments, breaking out of the VAT syndrome,
cross-border adjustments for inbound transactions, and importing
a tax base and cutting tax for Americans.
Structure and Policy of the International Components of
Reform
As an example of a tax system designed to address the international
components of reform, consider the business cash-flow tax
in H.R. 134, which was introduced in the 106th Congress as
the "Simplified USA Tax Act." H.R. 134 is a comprehensive
proposal that includes a reformed personal tax as well as
a reformed business tax but, for present purposes, the focus
will be solely on the business tax and its two international
ingredients.(2)
The business cash-flow tax in H.R. 134 recognizes the benefit
to the U.S. economy that arises when U.S. companies compete
and win in the global marketplace. It then sets out to equip
them with the kind of tax system that will be most conducive
to that success.
First, it says that the foreign-source income of U.S. persons
should not be taxed. Second, it says that in an export sale,
both the manufacturing profit and the sales profit should
be treated as foreign-source income, the same as if the product
had been manufactured and sold abroad. Third, it says that
when a U.S. company succeeds in a foreign market, it should
be allowed-indeed, encouraged-to bring its profits home, without
penalty, for reinvestment in the U.S.
The business cash-flow tax also says that the U.S. tax burden
should no longer be concentrated solely on U.S. labor and
U.S. capital as it is today. Instead, foreign companies that
participate in the U.S. market should be brought into the
U.S. tax base and required to share in the U.S. tax burden
in a WTO-consistent way.
Territorial system
The business cash-flow tax adopts a territorial system whereby
all foreign-source income of U.S. citizens and their corporate
alter egos is excluded from U.S. tax (thus, the deferral exception
and the FSC-II/ETI provision would be repealed as superfluous).
U.S. companies would be able to make direct foreign investment
and operate in foreign markets, either through a branch, U.S.
subsidiary, or controlled foreign corporation, without incurring
U.S. tax on the profits from these investments and operations-and
without regard to whether the profits are reinvested abroad
or repatriated to the U.S. All foreign-source interest, dividends,
and royalties would be excluded from U.S. tax as well. Under
the fully territorial regime in the business cash-flow tax,
U.S. companies would be subject only to the taxes of the host
country where they compete in foreign markets. For the first
time in history, they would be on equal tax footing with their
competitors abroad. U.S. companies would pay no U.S. tax on
their foreign-source income, so the foreign tax credit would
be repealed.
Export income excluded
Because the business cash-flow tax classifies export income
as foreign source, the model tax excludes export income from
tax and, therefore, the model makes U.S. tax treatment a neutral
factor in a U.S. company's decision to service a foreign market
from a U.S.-sited plant or from a foreign-sited plant. Therefore,
the business cash-flow tax cuts the logic out from under the
traditional argument that a territorial tax system would cause
U.S. companies to locate their plants abroad to take advantage
of a zero U.S. tax rate on foreign-source income.
To the extent that existing U.S. taxes may be embedded in
the price of some particular exports under current law, the
exclusion of export income from tax will tend to alter the
terms of trade in favor of those products, but that is not
the primary function of the export exclusion. In most instances,
the trade effect probably would be minor. Even if it were
wiped out completely and quickly by adjustments in exchange
rates, the export exclusion under the business cash-flow tax
would still be a vital part of the international component
of tax reform because it enables territoriality to be enacted
and to function without any concern about "runaway"
plants.
Import tax
An import tax is the other part of the border tax adjustment
procedure under the business cash-flow tax and it, too, performs
multiple functions. Like the export exclusion, the first function
of the import tax is to permit the territorial system to be
enacted and to function without running afoul of a version
of the "runway plant" argument that is concerned
not with plants moving abroad to serve foreign markets (the
problem addressed by the export exclusion), but rather with
U.S. plants moving abroad and then selling back into the U.S.
market from some assumed "tax haven" foreign manufacturing
facility. Under the business cash-flow tax, if a U.S. company
were to move its plant offshore and sell back into the U.S.,
it would have to pay an import tax exactly equal to the U.S.
business tax rate but without any deductions. Therefore, there
would be no U.S. tax incentive for the company to move aboard.
The other function of the import tax has to do with the terms
of trade but not in the way that most of us have been accustomed
to thinking. Traditionally, because import taxes have been
associated with VATs, import adjustments have been thought
of as some kind of tariff designed to make foreign goods more
expensive-but that imaginary process is not actually the trade-related
function of the import tax under the business cash-flow tax
regime. Rather than keeping foreign-made goods out (or causing
U.S. purchasers to have to pay more for them), the primary
function of the import adjustment under the model tax is to
expand the U.S. tax base to include the foreign-based companies
that sell into the U.S. market. Except for unique products
for which there is no competition among foreign sellers into
the U.S. market and little or no potential for competition
from domestic-source products, the foreign companies who sell
into the U.S. market will need to absorb all or part of the
import tax and will, therefore, end up bearing part of the
U.S. tax burden.(3) (The analysis by which the import tax
can result in an expansion of the U.S. tax base and an implicit
tax cut for U.S. labor and capital is discussed below).
Territorial Vs. Worldwide Taxation
The distinction between territorial and extraterritorial worldwide
taxation is, of course, exactly the distinction that exists
under the current Code between domestic- and foreign-source
income. The geographical location of the activity that produces
the income is what counts, not the location of the customer.
Thus, under current law, income from the production of goods
and services in the U.S. is domestic-source even though the
customer is a foreigner who pays from a foreign-sited bank.
Conversely, income from the production of goods outside the
territory of the U.S. or from services performed outside the
U.S. is foreign-source income.
Taxing U.S. citizens on both domestic- and foreign-source
income (worldwide) or only on domestic-source income (territoriality)
produces different results simply because all countries do
not have the same tax system (e.g., same rates, base). If
they did, the end result to all national treasuries and to
all businesses would be exactly the same under either a territorial
system or a worldwide system.
Example
A U.S. company earns $100 in Germany that is taxable in both
the U.S. and in Germany at the same rate under a worldwide
system. If the U.S. immediately and fully allowed the company
a credit for the tax paid to Germany, the result to all parties
would be the same as if only Germany (not the U.S.) had taxed
the $100 of income derived from the U.S. company's operations
in Germany.
Absolute uniformity of taxation across national boundaries
would make taxes a neutral competitive factor-not only within
a market but across or among all markets as well-and economists
would say that such a condition would maximize economic efficiency,
productivity, and the world's wealth. In the imperfect real
world where tax rates and systems around the world vary greatly,
territoriality will not achieve uniformity of taxation across
all markets, but it will tend to produce uniformity of taxation
within the same market. For example, if the U.S. shifted to
a territorial system, a U.S. company operating in France would
pay exactly the same tax as the French companies alongside
of which it competes in that market. While less than perfect,
economists would say that achieving tax neutrality within
markets by shifting to territoriality would greatly increase
efficiency, productivity, and wealth.
In contrast, the worldwide tax system does not achieve neutrality
of taxation within a foreign market and, in fact, is not intended
to do so. There is an inherent assumption in the worldwide
approach that the U.S. tax rate will be higher than the tax
rate of the foreign country where U.S. companies are doing
business and, therefore, that U.S. companies will pay a higher
tax rate than their local competitors. For most of the post-WWII
era, U.S. tax rates generally were higher than in most other
countries. For example, if in 1975, a U.S. company earned
$100 in Country X and paid a $20 tax, it would have been required
to pay a $48 tax in the U.S. minus a credit for the $20 Country
X tax, resulting in a $28 competitive disadvantage for the
U.S. company.
Today, a U.S. company that operates abroad may, in some instances,
encounter a foreign tax rate that is lower than the U.S. tax
rate and, in others, a foreign tax rate that is higher than
the U.S. tax rate. In theory, of course, if the foreign rate
were higher than the U.S. rate, and if the U.S. allowed a
full and immediate credit for the foreign tax, the U.S. company
would- after credit-bear only the foreign tax (the same as
under a territorial system) and taxes would be a neutral factor.
However, as a practical matter, the foreign tax credit is
so limited today that the U.S. worldwide tax is a non-neutral
factor to the disadvantage of U.S. companies without regard
as to whether the foreign tax rate is lower or higher than
the U.S. tax rate.
Theoretical case for territoriality
Proceeding from the correct neoclassical view that all taxes-by
whatever name called and by whatever means collected-are borne
by the labor and capital that produces the income with which
the taxes are paid, a strong theoretical case can be made
that it is only the country where the labor and capital are
employed that should tax the output that it produces. This
argument in support of territoriality is strongest when applied
to returns to labor. Indeed, it is generally only the country
of location that taxes the returns to labor at all. (For example,
payroll taxes, as such, are imposed only on a payroll within
the jurisdiction. Further, even under the U.S.'s expansive
worldwide income tax, a partial exemption is made for earnings
from employment outside U.S. territory.)
Without question, territoriality is the simplest system and
permits the U.S. government the least opportunity to interfere
with the way that U.S.-owned companies can compete in foreign
markets. (Both the foreign tax credit and deferral are creatures
of the worldwide tax system and both have forced U.S. companies
to conduct their business abroad in ways that have made them
less competitive.)
Territoriality in practice
Territoriality facilitates foreign direct investment (FDI)(4)
and anytime U.S.-owned companies gain wealth by means of exploiting
a foreign market, the nation is wealthier and everyone is
better off. But that salutary effect, important though it
is, is too indirect to satisfy some people. Their question
is very specific: What does it do for U.S. output and U.S.
jobs when a U.S. company manufactures and sells widgets in
a foreign market?
There is plenty of anecdotal evidence to support the proposition
that FDI by U.S. firms also enhances their U.S. operations
and domestic job-creating capacities. Many companies have
testified before the Congress to that effect. Some of their
foreign operations use U.S.-made components. Others point
out that once they have penetrated a foreign market by direct
investment, their export sales to that market usually increase
as well. There is also important statistical evidence that
FDI by U.S. companies is complementary to U.S. production
and jobs, not substitutional.(5)
Border Tax Adjustments, Tax Incidence, Related Matters
Border tax adjustments for imports and exports are essential
to a properly functioning territorial system, and provide
other important advantages as well. But before they can be
contemplated seriously as part of tax reform, they must first
be understood and before they can be understood, they must
be disassociated from the VAT and the popular misconceptions
that surround that particular form of European tax.
Breaking Out of the VAT Syndrome
The principal barriers to enactment of a border adjustable
tax system in the U.S. have been 1) the mistaken belief that
only a VAT can be border adjusted, and 2) the corollary misperception
that any tax that is border adjusted must be a VAT even though
it is not. These two propositions stem from the peculiar idea
that the VAT is some kind of cascading tax where business
A pays a tax that it passes on in price to business B, which
also pays a tax and then passes on the cumulative tax to consumer
C, who reimburses business B by paying the higher "plus
tax" price that is inherent in the popular concept of
"VAT." The resulting picture of a multi-stage sales
tax, where businesses pass on their tax costs to one another
and finally to the consumer, is so thoroughly ingrained that
one need only mention "VAT" and economists and others
who should know better immediately suspend logic by assuming-in
the above example-that business B gladly will pay business
A's taxes and that consumer C readily will pay the higher
tax-inclusive price, all without curtailing demand, as if
the demand for all products and all substitutes were price
inelastic.
Any tax that is border adjusted is automatically classified
as a regressive, consumer-borne sales tax, even though taxes
without border tax adjustments are correctly understood to
be borne by factor incomes, i.e., wages, gains, interest,
and dividends.(6) This logical legerdemain-engaged in as often
by misguided proponents of reform as by ill-intentioned opponents-is
most often accomplished by renaming border adjustable business
cash-flow taxes as "subtraction-method VATs."
Reality is quite different
A cash-flow tax is collected from a business in direct proportion
to its payments of wages (returns to labor) and dividends
and interest (returns to capital). In effect, it is a tax
on gross profit before payments to employees, shareholders,
and debt holders. A business cash-flow tax bears no resemblance
whatsoever to a sales tax-VAT or otherwise. Indeed, because
it applies equally to returns to labor (wages) and returns
to capital (dividends and interest), a business cash-flow
tax is nearly identical to the combination of the current
corporate income tax (which applies only to returns to equity
capital but not wages) and the current FICA payroll tax (which
applies only to returns to labor but not to returns to capital).
A modified form of border tax adjustment can be included in
a business cash-flow tax, but that does not mean it is a sales
tax-VAT-type or otherwise. In fact, but for its ability to
qualify for a modified form of border tax adjustment, it would
never occur to any proponent or opponent of tax reform to
think of a business cash-flow tax as a sales tax.
Any tax that is neutral as between labor and capital-by whatever
name called and however collected-can, under applicable treaties,
be adjusted at the border for imports and exports. The reason
that a sales tax (including the European VAT-type) can be
border adjusted is because the final sales price of goods
to which the tax applies includes the output of labor and
the output of capital. Similarly, the cash-flow tax qualifies
because it, too, includes the output of both labor and capital,
but at the other end of the economic process where the goods
and services are produced. The tax is measured not by the
amount for which the goods and services are sold but, instead,
by the amount of the wages paid to employees who produce the
goods and services and the amount of dividends and interest
paid to owners of the capital that the employees used in the
production process.
The existing corporate income tax does not qualify for border
tax adjustment because it applies only to the equity capital
portion of the production process. Therefore, unlike the business
cash-flow tax and the sales tax, which-while at opposite ends
of the economic spectrum are neutral as between labor and
capital-the current corporate income tax applies only to some
capital income and not at all to labor income and is, therefore,
non-neutral.
When the drafters of the GATT allowed "direct" taxes
to be forgiven on exports, they had the European VAT-type
tax in mind as the primary then-existing example. Further,
consistent with the highly mechanistic approach to taxes that
tended to prevail at that time (especially in Europe), they
probably also viewed the VAT as being in economic substance
exactly what its statutory structure implies: a retail sales
tax collected at the final consumption end of the economy
with an aggregate base equal to the total value of goods and
services produced and sold. None of this means, however, that
some other tax that has exactly the same base (although measured
at the opposite end of the economy where goods and services
are produced and expressed as the total amount paid to labor
and capital for that production) cannot also be forgiven on
export. Nor does it mean that everyone-most especially the
Congress and President-must accede to some archaic, highly
mechanistic approach to economic incidence and characterize
business cash-flow taxes and all other border adjustable taxes
as regressive levies borne by consumers in proportion to retail
purchases when in fact, according to the most basic principles
of economics, common sense, and the modern view of tax incidence,
all such taxes (including the VAT itself) are ultimately borne
by labor and capital income.
Tax incidence
The question of tax incidence (who actually bears the economic
burden) is quite simple. A tax many be collected at any of
three points in the economy:
1. When goods and services are produced and sold by businesses.
2. When employees and capital owners receive the wages,
dividends, and interest paid to them by businesses for their
labor and the use of their capital in producing the goods
and services.
3. When consumers purchase the goods and services for their
own use and benefit.
Properly calculated, the tax base is the same in each case,
i.e., the dollar amount of goods and services produced and
sold is equal to the dollar amount of goods and services purchased,
and both are equal to the dollar amount of the returns to
labor (wages) and returns to capital (interest and dividends)
for producing them.
Extended Reach of Cross-Border Adjustments for Inbound
Transactions
When a country imposes a tax on inbound transfers of goods
and services (an import tax), it extends its jurisdiction
to apply to the income of noncitizens and foreign corporations
from activities outside its own borders. This fact seems to
have escaped the attention of most U.S. commentators, but
it is known to the Europeans and others who--by means of border
taxes-have been taxing the U.S.-source income of U.S. citizens
and companies for many years.
Under the false rubric that their import taxes are taxes on
the purchasers of imported products, the Europeans and others
have been able to maintain the fiction that when they impose
tax on imports, they are doing no more than taxing their own
citizens in a way of their own choosing. In fact, however,
when the Europeans, for example, tax imports of goods manufactured
in the U.S., they are not just taxing their own citizens and
companies who purchase those U.S.-origin products. Instead,
for the most part, the economic burden of the import tax will
fall on the U.S. labor and capital that produced the imported
product. Thus, when Europeans impose import taxes on American-made
products, they are, in reality, taxing the income of Americans
as well.
Viewed from the standpoint of a U.S. company engaged in export
trade with Europeans, the overall situation is as follows:
Its U.S.-source income must bear the burden of both the U.S.
income tax and the European import tax for which it will get
no credit for U.S. purposes. Once understood, this extraterritorial
reach of border taxes gives new and realistic meaning to the
"destination" principle that confused lawyers and
economists are so fond of in trying to explain the artificial
distinction between direct and indirect taxes. By, in effect,
taxing the U.S. producers of goods and services destined for
Europe and using the revenues to pay for welfare programs
in their own countries or to hold down the level of their
internal budget deficits while not increasing taxes on their
own citizens and companies, EU member countries have managed
to shift a large portion of their tax burden off their own
citizens.
Conclusion--Importing a Tax Base, Cutting Taxes
In addition to the many other benefits to be derived therefrom,
tax reform could produce a result that is-in effect-a massive
tax cut for U.S. labor and capital. At present, with only
immaterial exceptions, U.S. labor and capital together bear
the entire burden of the current U.S. income tax, and U.S.
labor alone bears the economic burden of U.S. payroll taxes.
But if part of that tax were to be replaced by an import tax
that is borne primarily by foreign labor and capital, the
U.S. would, in effect, have imported an additional tax base
consisting of the wages, interest, and dividends received
by foreigners who produce (outside the U.S.) the goods and
services that they export into the U.S. market to the tune
of $1,244.2 billion each year.(7)
Example
The U.S. replaces the current income tax, corporate and personal,
with business and personal taxes similar to those in H.R.
134 that, among other things, imposed a 10% import tax. The
H.R. 134 tax would raise the same $1,086.6 billion of annual
revenue for the Treasury as the current income tax but, under
the H.R. 134 tax, $124.4 billion would come from an import
tax (10% x $1,244.2 imports) and a good portion of that import
tax would be borne not by Americans, but, instead, by foreign
labor and capital. If, to be generous, it is assumed that
Americans would bear as much as 20% of the import tax, that
would still leave $100 billion (80%) to be borne by foreigners.
The result is to reduce the tax burden on Americans by at
least $100 billion per year.
There are many other reasons for tax reform, and perhaps many
better ones. But the most politically powerful may be the
"tax cut" that is inherent in tax reform.
Footnotes
1. Christian, "The International Components of Tax Reform:
Tax Policy That Serves the National Interest (Part 1),"
11 JOIT 48 (July 2003).
2. Under H.R. 134, an 8% or 10% cash-flow tax was imposed
on incorporated and unincorporated businesses. The tax was
territorial. Export income was excluded from tax. A tax was
imposed on imports at the same rate as the business cash-flow
tax.
3. The usual (and generally incorrect) way of looking at an
import tax is the same as the usual (and generally incorrect)
way of looking at a retail sales tax. The false premise is
that is if the import tax is 10%, U.S. purchasers of imported
products will pay 10% more for all imports.
4. See Christian, Part 1, supra note 1.
5. See Wada and Graham, Appendix B, "Is Foreign Direct
Investment a Complement to Trade?," in Graham, Fighting
the Wrong Enemy (Washington, D.C.: Institute for International
Economics, September 2000). See also Graham, "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 University Press, 1997); and
Graham, "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 Publishing, 1997).
6. "Factor income" is defined on the website of
the United Nations Statistics Division as "[c]ompensation
of employees by, and operating surplus of, producers. The
net domestic product is often valued at factor incomes."
See http://unstats.un.org/unsd/cdb/cdb_dict_xrxx.asp?def_code=256.
7. For the statistics, see Christian, Part 1, supra note 1.
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.
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