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Search Terms: tax w/5 foreign w/5 income, House or Senate or Joint

Document 50 of 113.

JUNE 30, 1999, WEDNESDAY

SECTION: IN THE NEWS

LENGTH: 4059 words

HEADLINE: PREPARED TESTIMONY OF
R. GLENN HUBBARD
ON BEHALF OF THE INTERNATIONAL TAX POLICY FORUM
BEFORE THE HOUSE COMMITTEE ON WAYS AND MEANS
SUBJECT - THE IMPACT OF U.S. TAX RULES
ON INTERNATIONAL COMPETITIVENESS

BODY:

I. Introduction
I am R. Glenn Hubbard, Russell L. Carson Professor of Economics and Finance, Graduate School of Business, Columbia University. I am testifying today on behalf of the International Tax Policy Forum, of which I am the research director. Founded in 1992, the International Tax Policy Forum is a diverse group of U.S.-based multinationals, including manufacturing, service, energy, financial service, and technology companies. The Forum sponsors research and education regarding the U.S. taxation of income from cross-border investments. As a matter of policy, the Forum refrains from taking positions on legislative proposals. John M. Samuels, Vice President and Senior Counsel for Tax Policy and Planning of General Electric, is chairman of the Forum. PricewaterhouseCoopers LLP acts as consultant to the Forum. A list of member companies is attached as Appendix A of this testimony. The Forum welcomes the opportunity to testify today on the effect of U.S. tax rules on the international competitiveness of U.S. companies. Increasingly, the markets for our companies have become global, and our competitors are foreign-based companies operating under tax rules that are often much more favorable than our own.
The existing U.S. tax law governing the activities of multinational companies has been developed in a patchwork fashion over many years. In many instances, current law creates barriers that harm the competitiveness of U.S. companies. These rules also are horribly complex both for U.S. multinational companies to comply with and for the Internal Revenue Service to administer. That is why the Forum believes it is important for this Committee to review the current U.S. international tax rules with a view to reducing complexity and removing impediments to U.S. international competitiveness.
II. The Role of U.S. Multinational Corporations in the U.S. Economy
The primary motivation for U.S. multinationals to operate abroad is to compete better in foreign markets, not domestic markets. 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. More than one-half of all foreign affiliates of U.S. multinationals are in the service sector, including distribution, marketing, and servicing U.S. exports.1 Foreign investment allows U.S. multinationals to compete more effectively around the world, ultimately increasing employment and wages of U.S. workers.
A. Exports
Much research has shown that U.S. operations abroad produce a net trade surplus for the United States. Foreign affiliates of U.S. companies rely heavily on exports from the United States. Foreign affiliates of U.S. multinationals purchased just under $200 billion of merchandise exports from the United States in 1996. Additional exports by U.S. multinationals to unaffiliated foreign customers accounted for an additional $213 billion in merchandise exports. Altogether, exports by U.S. multinationals were $407 billion in 1996 or 65 percent of all U.S. merchandise exports.2
A recent study by the Organization for Economic Cooperation and Development complements other academic research in finding that each dollar of outward foreign direct investment is associated with $2.00 of additional exports and an increase in the bilateral trade surplus of $1.70.3
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. The strategy used by U.S multinationals of using foreign affiliates in coordination with domestic operations to produce goods allows U.S. multinationals to compete effectively around the world while still generating significant U.S. exports. These U.S. exports result in additional employment of U.S. workers at higher than average wage rates.4
A number of studies find 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:
The fundamental empirical result is that the labor demand of U.S. multinationals is linked internationally at the firm level, presumably through trade in intermediate and final goods, and this link results in complementarity rather than competition between employers in industrialized and developing countries.5
This relationship between foreign operations and domestic employment was also noted by the Council of Economic Advisers in the 1991 Economic Report of the President:
In most cases, if U.S. multinationals did not establish affiliates abroad to produce for the local market, they would be too distant to have an effective presence in that market. In addition, companies from other countries would either establish such facilities or increase exports to that market. In effect, it is not really possible to sustain exports to such markets in the long run. On a net basis, it is highly doubtful that U.S. direct investment abroad reduces U.S. exports or displaces U.S. jobs. Indeed, U.S. direct investment abroad stimulates U.S. companies to be more competitive internationally, which can generate U.S. exports and jobs. Equally important, U.S. direct investment abroad allows U.S. firms to allocate their resources more efficiently, thus creating healthier domestic operations, which, in turn, tend to create jobs.6
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.? Among U.S. multinationals, total research and development in 1996 mounted to $113 billion, of which $99 billion (88 percent) was performed in the United States.s 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.

U.S.
multinationals provide significant contributions to the U.S. economy through:
- A strong reliance on U.S.-provided goods in both domestic and foreign operations;
- Additional domestic employment of employees at above average wages; and
- Critical domestic investments in equipment, technology, and research and development.
As a result, the United States has a significant interest in insuring that its tax rules do not hinder the competitiveness of U.S. multinationals.
III. Tax Policy and U.S. International Competitiveness
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. As an example of this heightened worldwide competition, between 1960 and 1996 the number of the world's 20 largest corporations headquartered in the United States declined from 18 to just 8.
A. Why Tax Policy Matters
With the increasing globalization of the world economies, it has become critical for U.S. businesses to compete internationally if they wish to remain competitive at home. If U.S. businesses are to succeed in the global economy, they will need a U.S. tax system that permits them to compete effectively against foreign-based companies. This requires that U.S. international tax rules not place U.S.- headquartered multinationals at a competitive disadvantage in foreign markets.
From an income tax perspective, the United States has become one of the least attractive industrial countries in which to locate the headquarters of a multinational corporation. This is because there are several major respects in which U.S. tax law differs from that of most of our trading partners.
First, about half of the OECD countries have a territorial tax system (either by statute or treaty), under which a parent company is not subject to tax on the active income earned by a foreign subsidiary.x By contrast, the United States taxes income earned through a foreign corporation when it is repatriated or deemed to be repatriated under various "anti-deferral" rules in the tax code.
Second, even among countries that tax income on a worldwide basis, the active business income of a foreign subsidiary is generally not subject to tax before it is remitted to the parent.10 This differs from the U.S treatment of foreign base company sales and service income, and certain other types of active business income, which are subject to current U.S. tax even if such income is reinvested abroad.11
Third, other countries with worldwide tax systems have fewer restrictions on the use of foreign tax credits than does the United States. The United States, on the other hand, has a variety of rules that limit the crediting of foreign taxes. Such rules include: the use of multiple "baskets," restrictions imposed by the alternative minimum tax, the apportionment of interest and certain other deductions against foreign source income, and the attribution to a foreign subsidiary of a larger measure of income for U.S. purposes ("earnings and profits") than is used by other countries.12 These rules can result in the incomplete crediting of foreign taxes and, as a result, the double taxation of foreign source income earned by U.S. multinational corporations.
Fourth, among the OECD countries, the United States, the Netherlands, and Switzerland are the only countries that fail to provide some form of integration of the corporate and individual income tax systems? This integration is provided by the major trading partners of the United States in order to reduce or eliminate the extent to which corporate income is double taxed by recognizing that dividends are paid to shareholders from income previously taxed at the corporate level.
The net effect of these tax differences is that a U.S. multinational operating through a foreign subsidiary frequently pays a greater share of its income in foreign and U.S. tax than does a similar foreign subsidiary owned by a competing multinational company headquartered outside of the United States.14 This makes it more expensive for U.S. companies to operate abroad than their foreign-based competitors. In such circumstances, U.S. companies can only successfully compete against foreign-based multinationals if they are sufficiently more efficient than the competition to overcome this artificially imposed tax disadvantage.
B. Capital Export Neutrality While concerns for competitiveness require a U.S. multinational operating in a foreign country to pay the same tax as a foreign-based multinational operating in that country, another efficiency concern is frequently proffered to support taxing a U.S. investor equally whether the investment is made at home or abroad. This latter notion is referred to as "capital export neutrality." Capital export neutrality seeks to ensure that a resident of a given country pays the same rate of tax whether the investment is made at home or abroad. In general terms, capital export neutrality is thought to not bias the location of investment from the investor's perspective. Capital export neutrality requires that all foreign source income be taxed on a current basis by the home country and that the home country provides an unlimited foreign tax credit for all taxes paid.
The principles of competitiveness and capital export neutrality necessarily conflict whenever effective tax rates differ across countries. U.S. international tax policy has frequently wrestled with the tradeoffs between these two principles. In a recent speech, Treasury Assistant Secretary of Tax Policy, Donald Lubick, noted the tradeoff between these principles.
The Internal Revenue Service issuance last year of Notice 98-11, in which the IRS announced that Treasury would issue regulations to prevent the use of certain "hybrid branch" arrangements deemed contrary to the policies and rules of Subpart F, demonstrated the Treasury's concern for capital export neutrality.16 The hybrid branch arrangements targeted by this Notice reduced foreign taxes, not U.S. taxes. Indeed, the use of these arrangements can only serve to increase total U.S. tax paid by U.S. multinationals since aggregate foreign tax credits would be reduced. The debate regarding the principles of competitiveness and capital export neutrality dates back at least to 1961, when President Kennedy proposed the current taxation of all foreign source income earned by foreign subsidiaries of U.S. companies (except in developing countries). The legislation ultimately enacted in 1962, however, put traditional concerns of competitiveness ahead of the Kennedy Administration's concerns for capital export neutrality.17
C. Does Capital Export Neutrality Promote Efficiency?
The theoretical model in which capital export neutrality results in worldwide efficiency in the allocation of capital resources is a fairly simple model. In its simplest form, savings in every country is in fixed supply and is not responsive to market opportunities. As a result, each dollar of foreign direct investment by a domestic resident results in one less dollar of domestic investment. The model makes a number of simplifications, but, even so, capital export neutrality leads to worldwide efficiency only if all countries follow a tax system imposing capital export neutrality. As noted earlier, in practice a substantial number of the major trading partners of the United States--half of the OECD---exempt active foreign source income from taxation. In such a case, an attempt by the United States to maintain capital export neutrality does not necessarily improve either worldwide efficiency or U.S. well-being. A well-known economic theorem shows that when there is more than one departure from economic efficiency, correcting only one of them may not be an improvement. 18 Unilateral imposition of capital export neutrality by the United States may fail to advance both worldwide efficiency and U.S. national well-being.
The simple model supporting capital export neutrality fails to consider a number of real-world features that significantly affect the tax policy conclusions one should draw regarding the tax principles that promote worldwide efficiency and U.S. well-being. For example, the model fails to consider that competition among multinational corporations takes place in a strategic environment where companies can increase their income by achieving economies of scale.

In work co-authored with Michael Devereux, we show that, when these assumptions are relaxed, deferral of home-country taxation on foreign source income can increase the well-being of domestic residents relative to a system of current inclusion of foreign earnings?
The simple model supporting capital export neutrality also fails to consider the possibility that foreign direct investment is complementary to domestic investment--rather than a substitute for domestic investment. As discussed earlier, a number of economic studies find that, at the firm level, foreign direct investment results in an increase in exports from the home country to foreign subsidiaries.
Another important example of the simple model's failings is that it ignores the possibility that domestic residents can transfer their savings abroad through portfolio investment as an alternative to foreign direct investment. As recently as 1980, portfolio investment abroad by U.S. investors was only about one-sixth the size of U.S. direct investment abroad. By 1997, however, portfolio investment abroad was 40 percent larger than U.S. direct investment abroad.2x If U.S. tax law disadvantages U.S. multinationals, U.S. investors today have the opportunity to direct their savings to portfolio investment in foreign multinationals, the foreign investments of which are not subject to U.S. corporate income tax.
For these masons, contemporary economic analysis offers little reason to believe that unilateral adoption of the principle of capital export neutrality can improve either worldwide efficiency or U.S. well-being.
D. Implications for U.S. Multinationals
As noted earlier, from a tax perspective the United States is one of the least favorable industrial countries in which a multinational corporation can locate. Over time, these U.S. tax rules could lead to a reduction in the share of multinational income earned by companies headquartered in the United States. This decline in the importance of U.S. multinationals should be a concern for the very. real loss in economic opportunities such a decline would bring about for American workers and their families.
Professor Laura Tyson, former Chair of the Council of Economic Advisers and former Director of the National Economic Council, points out a number of political, strategic, and economic reasons why maintaining a high share of U.S. control over global assets remains in the national interest.21 These include:
- U.S. multinationals locate over 70 percent of their assets and employment in the United States;
- U.S. multinationals invest more per employee and pay more per employee at home than abroad in both developed and developing countries; and
- U.S. multinationals perform the overwhelming majority of their research and development at home.
If the United States wishes to attract and retain high-end jobs, the U.S. tax system must not discourage multinationals from establishing their headquarters here.
In several recent high-profile mergers among U.S. and European multinational corporations (including AEGON-Transamerica, BP-Amoco, Daimler-Chrysler, Deutsche Bank-Bankers Trust, and Vodafone-AirTouch) the merged entity has chosen to be a foreign-headquartered company. In recent testimony before the Senate Finance Committee, DaimlerChrysler's vice president and chief tax counsel specifically implicated the overly burdensome U.S. international tax regime as a key factor in the merged firm's decision to be a German-headquartered company? Future investments made by these companies outside of the United States are unlikely to be made through the U.S. subsidiary since tax on these operations can be permanently removed from the U.S. corporate income tax system by instead making them through the foreign parent.
As I pointed out earlier, portfolio investment offers still another, perhaps less visible, route by which foreign-owned multinationals can expand at the expense of U.S. multinationals. If U.S. multinationals cannot profitably expand abroad due to unfavorable U.S. tax rules, foreign-owned multinationals will attract the investment dollars of U.S. investors. Individuals purchasing shares of foreign companies-- either through mutual funds or directly through shares listed on U.S. and foreign exchanges---can generally ensure that their investments escape the U.S. corporate income tax on foreign subsidiary earnings.
While some have suggested that reductions in the U.S. tax on foreign source income could lead to a movement of manufacturing operations out of the United States ("runaway plants"), a far more likely scenario is that a noncompetitive U.S. tax system will lead to "runaway headquarters"---a migration of multinational headquarters outside the United States and an increase in the foreign control of corporate assets.
The decline in the market share of multinationals headquartered in the United States has important implications for the well-being of the U.S. economy. High-paying manufacturing jobs and high-paying executive jobs are lost with the movement of these headquarters. Research and development may be shifted abroad, in addition to jobs in high-paying service industries, such as finance, associated with headquarters' activities. Further, foreign-based multinationals operating in the United States rely significantly more on inputs and supplies produced offshore than do U.S.-owned companies. At the same time, the channeling of new investment outside of the United States through foreign subsidiaries owned by the foreign parent results in the generation of income completely outside of the U.S. tax system. A desire to tax foreign source income at rates higher than those of our competitors may ultimately insure that that there is little income left to tax.
IV. Conclusions
In summary, U.S. tax rules can have a significant impact on the ability of U.S. multinationals to compete successfully around the world and, ultimately, at home. On behalf of the International Tax Policy Forum, I urge that this Committee carefully review the U.S. international tax system with a view to removing impediments that limit the ability of U.S. multinationals to compete globally on the same terms as foreign-based multinationals. Such reforms would enhance the well-being of American families and allow the United States to retain its world economic leadership position into the 21st century.
FOOTNOTES:
1 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).
2 National Foreign Trade Council, The NFTC Foreign Income Project. International Tax Policy for the 21st Century, chapter 6 (1999).
3 OECD, Open Markets Matter: The Benefits of Trade and Investment Liberalization, p. 50 (1998).
4 Mark Doms and Bradford Jensen, Comparing Wages, Skills, and Productivity between Domestic and Foreign-Owned Manufacturing Establishments in the United States, mimeo. (October 1996).
5 David Riker and Lael Brainard, U.S. Multinationals and Competition from Low Wage Countries, National Bureau of Economic Research Working Paper no. 5959 (1997).
6 Council of Economic Advisers, Economic Report of the President, p. 259 (1991).
7 Robert Lipsey, "Outward Direct Investment and the U.S. Economy," in The Effects of Taxation on Multinational Corporations, p. 30 (1995).
8 U.S. Department of Commerce, Survey of Current Business (September 1998). 9 Organization for Economic Cooperation and Development, Taxing Profits in a Global Economy (1991). l0 Organization for Economic Cooperation and Development, Controlled Foreign Company Legislation (1996). 11Foreign source income relating to active financing income was taxed on a current basis until the 1997 Act. Such income presently is exempted from current taxation, although this exemption is slated to expire on December 31, 1999. 12 Price Waterhouse LLP, Taxation of U.S. Corporations Doing Business Abroad: U.S. Rules and Competitiveness
Issues, Financial Executives Research Foundation (1996).
13 Sijbren Cnossen, Reform and Harmonization of Company Tax Systems in the European Union, mimeo., Erasmus
University (1996). 14 Organization for Economic Cooperation and Development, Taxing Profits in a Global Economy (1991).
15 Donald C. Lubick, Treasury Assistant Secretary of Tax Policy, Speech before the George Washington University/IRS Institute (December 11, 1998).
16 Regulations that would have created subpart F income with respect to such transactions were proposed in March 1998, but their withdrawal was subsequently announced by Notice 98-35. Notice 98-35 expresses the intention to re-issue similar rules.
17 See National Foreign Trade Council, The NFTC Foreign Income Project: International Tax Policy for the 21st Century, chapter 2 (1999). 18 R.G. Lipsey and K. Lancaster, "The General Theory of the Second Best," Review of Economic Studies, pp. 11-32 (1956-57).
19 Michael P. Devereux and R. Glenn Hubbard, "Taxing Multinationals," mimeo. (January 1999).
20 U.S. Department of Commerce, Survey of Current Business (July 1998).
21 Laura D'Andrea Tyson, "They Are Not Us: Why American Ownership Still Matters," American Prospect (Winter 1991).
22 John L. Loftredo, "Testimony before the Senate Finance Committee" (March 11, 1999). END

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Document 50 of 113.


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