Copyright 1999 Federal Document Clearing House, Inc.
Federal Document Clearing House Congressional Testimony
March 11, 1999, Thursday
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 2759 words
HEADLINE:
TESTIMONY March 11, 1999 JOHN MUTTI PROFESSOR GRINNELL COLLEGE
SENATE FINANCE WORLD ECONOMY AND INTERNATIONAL TAXES
BODY:
STATEMENT OF JOHN MUTTI March 11, 1999
Chairman Roth and distinguished committee members. I am pleased to have the
opportunity to testify today. I admire the ambitious agenda that you have set
for these hearings. I particularly appreciate the fact that you do not plan to
look at each item of concern to a particular firm or industry in isolation, but
instead you intend to examine the overall rationale behind the U.S. taxation of
international income. Globalization indeed does mean that more U.S. firms face
competition from more firms internationally than was previously the case. That
observation aptly characterizes sales in foreign markets, but it also applies to
sales domestically, too. Electronic commerce makes it easier for foreigners to
market directly to U.S. buyers, just as U.S. producers can access foreign
markets more easily. Fewer sectors of our economy represent nontraded goods and
services protected from foreign competition. Designing policy to take into
account the new realities of international competition requires that we look
both outward and inward. My comments today fall in the category of "big picture"
issues that are relevant in assessing possible directions for international tax
reform. I comment on three issues, each of which involves a question of policy
and also a question of the appropriate analytical framework to apply. The three
issues are: - (1) the taxation of worldwide income; - (2) the integration of
U.S. individual and corporate income taxes; and - (3) the
exemption of foreign-source income from U.S.
taxation. With respect to the taxation of worldwide income, globalization has
meant that producers are more aware than ever of the way U.S. taxation affects
their competitive position. As important as U.S. exports or U.S.-controlled
production abroad are, however, we should not ignore the way the competitive
positions of other U.S. producers are affected by changes in the way business is
done internationally or by proposed tax policy changes. Special provisions to
promote one type of activity may well appear to encourage U.S. growth and
efficiency, but we should keep in mind an additional question: would the same
loss in tax revenue that arises from addressing one concern, such as the
enhanced competitiveness of U.S.-controlled production abroad, be just as
effective in promoting U.S. growth and efficiency if it were devoted to a
measure that reduced the cost of capital for all domestic producers?
Alternatively stated, if there is a government budget constraint that must be
met, when a loss in revenue occurs as a result of tax measures adopted in one
area, what is the effect of increased taxes paid elsewhere in the economy?
(Joint Tax Committee, 1991). For example, some claim that to promote
cutting-edge, R&D- intensive U.S. industries that produce worldwide it would
be desirable to move away from the standard of taxing the worldwide income of a
country's firms or individual residents. From a world perspective that
traditional standard, together with the granting of credit for foreign taxes
paid, has been favored because it results in capital export neutrality;
investment is allocated to the location where its before-tax productivity is
greatest. Admittedly, this standard does not automatically confer a benefit upon
the United States as a whole if real returns are higher in other countries, who
attract investment from the United States and gain the opportunity to tax first
the income earned in their country. That asymmetric result of capital primarily
flowing out of the United States appears less relevant now than was true
previously. For example, in 1980 the stock of outward foreign direct investment
as a share of U.S. GDP was 8.1 percent and the stock of inward foreign direct
investment as a share of U.S. GDP was 2.7 percent; in 1995 these two figures had
become 9.8 percent and 7.7 percent, respectively. Inflows of foreign direct
investment have grown faster than outflows (United Nations, World Investment
Report 1997). An alternative standard is capital import neutrality, which would
result when the final tax on income would be levied in the country where it is
earned. Proponents of this standard note that it would allow U.S. corporations
that invest abroad to avoid a residual tax in the United States. U.S.
multinational corporations could thereby compete more effectively with firms in
that country or with firms whose home from countries exempt foreign-source
income from taxation. Furthermore, if that improved profitability allowed U.S.
firms to expand and carry out more research and development, then their domestic
production also would become more competitive; domestic and foreign production
would be complementary because of this common dependence on R&D (Hufbauer
1992, Frisch 1990). Such a line of reasoning is quite plausible. At the same
time, however, we should examine whether providing more favorable tax treatment
to production abroad is more effective than providing more favorable treatment
to production at home (Grubert and Mutti 1995). If U.S. attempts to sell in
foreign markets are characterized by more intense competition and greater
availability of substitutes than when U.S. producers serve the home market, then
a given tax advantage may result in a larger percentage expansion of foreign
sales. Given the nature of international commerce today, though, the assumption
of a protected home market and less competition the closer to home one is
geographically seems less justified than might have been true in the past.
Beyond this ambiguity, we further need to examine how the incentive to carry out
additional R&D affects domestic versus foreign sales. Some economists report
that greater profitability in foreign markets appears to be less of an
inducement to additional U.S. R&D,because R&D has its greatest pay off
in the domestic market (Bailey and Lawrence 1992). Only with a lag is it
transferred to foreign markets. Thus, the type of tax treatment most likely to
promote R&D activity at home is not at all obvious. Treating foreign income
or royalties from abroad more favorably than domestic income does not
necessarily have a greater effect. From the accepted position that there is
under investment in R&D, because those who generate new ideas cannot
appropriate enough of the benefits, the desired domestic policy would be an
R&D tax credit. Its effect would be to improve the competitive position of
those who compete with foreigners at home as well as abroad. This approach could
be pursued quite independently from any change in the principle of worldwide
taxation. The second issue I would like to address is the integration of the
corporate and individual income tax systems. I was pleased to see that Chairman
Roth raised this issue in his recent speech to the International Finance
Association. Given that the United States is one of the few countries to retain
a classical system that taxes capital income at both the corporate and the
individual level, economists have long recognized that this creates a bias
toward using debt rather than equity as a source of funds and a bias against
operating as a corporation. Integration will result in a gain in efficiency for
the economy as a whole. Nevertheless, how should we predict such a change will
affect the competitiveness of U.S. producers or judge whether the policy is
successful? In a global setting our intuition can be misleading if we do not
apply the appropriate framework to project such consequences. In a closed
economy setting, economists predict that integration will make equity more
attractive to investors, reduce the cost of capital to U.S. producers in the
corporate sector, and result in lower prices of their output. In an open
economy, that would seem to result in greater exports and fewer imports. Yet,
that projection is incomplete if we ignore the effect on investment income and
the value of the dollar internationally, or if we fail to consider the different
effects on flows of debt and equity. Also, we need to specify carefully how
inward and outward investment are to be treated in any integration plan (see
Grubert and Mutti 1994). Suppose the United States were to follow the pattern of
European integration schemes and to deny the benefits of integration to foreign
owners of U.S. stock. In that case, integration would likely result in
foreigners buying less U.S. equity. U.S. stockholders would be willing to pay a
higher price for U.S. stock because they could claim a credit against their
individual income tax liability for the corporate income tax
paid; foreign owners would not be able to use this credit and
would not benefit from paying less tax at the individual level. Yet, if we just
focus on equity holdings, we may too pessimistically predict a large outflow of
capital from the United States. As U.S. investors shift from debt to equity,
interest rates will rise and foreigners will have an incentive to buy U.S. debt.
Thus, there is not likely to a big inflow or outflow of capital internationally.
Nevertheless, U.S. investment income is likely to rise, because U.S. investors
now have portfolios more heavily weighted to equity than debt. That greater
investment incomes results in a stronger dollar, fewer exports and greater
imports. The U.S. economy benefits from greater output, income and saving, but
the effects are distributed differently across industries than we might have
first expected; output in sectors that compete most directly with imports in the
U.S. market or with exports in foreign markets are adversely affected by the
dollar appreciation and instead nontraded industries expand. We should not
conclude the policy has failed, however, because the competitiveness of export
industries has not risen. Even with a worsening of the trade balance, which is
offset by greater net foreign investment earnings, the economy is operating more
efficiently. The choice to deny integration benefits to foreigners often has
been motivated by the belief that foreign investors will receive little of this
benefit if they owe a residual tax to their home government. Under those
circumstances, granting benefits to foreign investors simply benefits foreign
treasuries without making investment in the host country more attractive. More
recently, there has been less concern over that situation and more attention
paid to the role of portfolio investment as an increasingly important source of
finance internationally. If portfolio investment has risen substantially from
countries where no residual tax is levied, then granting benefits of integration
to foreigners may be an important step in ensuring that the cost of capital to
domestic producers falls. In the extreme case of a small country that is
dependent on portfolio capital as a marginal source of investment funds, denying
benefits to foreigners simply means that no change in the cost of capital
occurs, as foreigners drastically reduce their holdings of equity and domestic
stockholders receive a windfall gain from integration (Boadway and Bruce 1992).
Because the United States is not a small country, and foreign investors are not
the sole marginal source of funds for new investment, the effect of denying
benefits to foreigners would not be so drastic. European countries have reached
a variety of different answers in determining how much of a benefit to pass on
to foreigners in bilateral tax treaty negotiations; from a unilateral
perspective a country implicitly balances the gains from shifting part of its
tax burden to foreigners against the benefits from a larger capital inflow when
it reduces that tax. The preceding two issues arise within a residence-based
income tax system that taxes the worldwide income of the country's firms and
residents. In contrast, the third issue I would like to address, potential
exemption of active foreign-source income from
U.S. tax, points in a different direction. As suggested above,
a tax system could be source based, where only income earned in the source
country or territory is taxed. In fact, most countries have elements of both
principles included in their tax systems. The competitive disadvantage faced by
U.S. MNCs when they are subject to residual U.S. taxation is partially offset by
their ability to claim a foreign tax credit,limited by the amount of U.S. tax
that would be due on that income, and by their ability to defer U.S. taxation
until the income is repatriated. How large, then, is this residual U.S. tax
effect? In terms of a residual tax collected by the U.S. government on active
non- financial income earned abroad (the general basket), the numbers are not
large. In 1990, for example, the U.S. Treasury collected $2.0 billion from
repatriated active foreign income of $73.4 billion. The ratio of these two
figures suggests that the United States is close to an exemption system already
with respect to active income. In fact, most European countries that have
exemption systems do not exempt all foreign source income. Rather, they exempt
active operating income. They tax interest income, in part because a bank
deposit abroad is a very close substitute for a bank deposit at home, and a
country could lose its tax base very quickly if one were exempt and the other
not. Also, if an income tax system is designed to tax all income once, then
interest, headquarters' charges, and royalties that are deductible expenses
abroad are to be taxed by the home country. If the United States were to exempt
active foreign source income, what implications would that have for other
measures of the tax code? Currently, U.S. parent corporations that have excess
foreign tax credits can receive royalties from abroad or a portion of export
earnings free of any residual U.S. tax. Is there a strong rationale to extend
that same treatment to all firms, regardless of their foreign tax credit status,
or should the usual treatment of royalties and interest under an exemption
system be applied? What expenses should be allocated against exempt income?
Would tax simplification result? Grubert and I are currently examining those
questions. To summarize my comments today, which admittedly touch on just some
of the relevant reform issues before the committee, I reiterate that the
analytical questions they raise apply beyond the specific policies discussed.
First, heightened international competition occurs both in foreign markets and
the domestic market, and therefore tax policy changes need to address both
situations. Often, maintaining a broad tax base with a low tax rate is the most
effective policy to ensure that the competitiveness of producers in both
situations is encouraged. Second, effects of tax changes on capital flows and
investment income, and not just on the cost of capital, are important parts of
predicting how tax policy changes affect competitiveness. Policies that have the
desirable effect of increasing U.S. efficiency and growth do not necessarily
improve the U.S. trade balance. Third, even if the U.S. system of taxing
foreign-source income approximates an exemption system, would there be major
consequences from establishing that as a matter of policy? Fundamental questions
of what income is to be taxed, or whether different regimes are appropriate for
different types of income, must be answered. I regard these perspectives as
important in considering reforms of the international tax system. Work Cited
Bailey, Martin and Robert Lawrence, "Appropriate Allocation Rules for the 861-8
Regulation," Council on Research and Technology, (1992) Boadway, Robin and Neil
Bruce, "Problems with Integrating Corporate and Personal Income taxes in an Open
Economy, Journal of Public Economics, (June 1992): 39-66. Frisch, Daniel, "The
Economics of International Tax Policy: Some Old and New Approaches," Tax Notes
(April 30, 1990): 581-591. Grubert, Harry and John Mutti, "Taxing Multinational
Corporations in a World with Portfolio Flows and R&D: Is Capital Export
Neutrality Obsolete?" International Tax and Public Finance, (1995): 439-457.
Grubert, Harry and John Mutti, "International Aspects of Corporate Tax
Integration: the Contrasting Role of Debt and Equity," National Tax Journal
(1994): 111-133. Hufbauer, Gary, U.S. Taxation of International Income,
Blueprints for Reform, Washington, DC: Institute for International Economics
(1992). Joint Committee on Taxation, Committee on Ways and Means, Factors
Affecting the Competitiveness of the United States (May 30, 1991).
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