The Tax Treatment of Foreign Income: Issues and Options

William G. Gale

Mr. Chairman and Members of the Committee:

Thank you for giving me the opportunity to testify at this hearing. The tax treatment of foreign income has become increasingly important in light of the WTO’s decisions regarding U.S. export subsidies, and growing controversies regarding corporate sheltering and corporate inversions. These concerns have also increased interest in long-standing debates about whether the U.S. should switch to a territorial tax system, and whether and how the international competitiveness of U.S. firms can be enhanced.

My testimony contains two parts: a summary of principal conclusions, and supporting analysis.

Principal Conclusions

  • The bright line: The concepts of international taxation are sometimes murky and the practice of international taxation can be complex and situation-specific. Despite, or because, of these factors, Congress should keep one overarching principle in mind in redesigning the taxation of international income. That principle is that features of the tax code that affect the taxation of off-shore income should not be allowed to erode the taxation of domestically generated income. If this “bright line” is crossed on an enduring basis, the consequences could be very serious.
  • Export subsidies: I agree with the EU that U.S. tax incentives for exports should be considered prohibited subsidies. Even ignoring their legality, the export incentives are ineffective in improving the trade balance, and inefficient in that they pass subsidies on to foreigners and cause firms to choose projects with lower total returns over projects with higher total returns. In addition, some current export subsidies cross over the “bright line” noted above and let firms reduce taxes on their domestically generated income. Both national welfare and the public fisc would be improved if the subsidies were abolished. If Congress would like to recycle the revenue savings into the corporate tax system, the best use would be a reduction in the corporate tax rate or the AMT.
  • Corporate inversions: Inversions occur when firms move their legal headquarters out of the U.S. solely for tax purposes. Although they are not illegal and do make perfect sense from the firm’s perspective, inversions are particularly troubling from a policy viewpoint. Specifically, inversions allow firms not only to reduce or eliminate taxes on their foreign source income, but also to reduce or eliminate taxes on their domestic income. And they create these incentives without requiring any sort of change in “real” economic activity. Thus, they cross the “bright line” noted above. New laws should strive to eliminate the tax savings from inversions.
  • Territorial tax system: Although the best solutions would be to repeal export subsidies and outlaw inversions, it is also natural to consider more broad-based reforms to the tax system. Moving to a territorial tax system is not a useful substitute for export subsidies, for two reasons. First, a territorial tax system reduces the taxation of foreign investment by U.S. firms, which is quite different from reducing the cost of exporting goods. Second, the export subsidies are counterproductive in the first place and should not be replaced. Nor is moving to a territorial system a helpful way to deal with corporate inversions. Territorial systems generally make it more difficult to defend the domestic tax base from attack, since moving offshore results in a bigger tax savings under a territorial system than a world-wide system. That is, territorial systems enhance and legitimize methods of tax avoidance and evasion that should be curtailed under any sensible policy rule. Going to a territorial system as a response to corporate inversions is like choosing to reduce the crime rate by legalizing certain crimes. Thus, although there are reasons to consider territorial tax systems, substituting for export subsidies and stopping inversions are not among them.
  • Fundamental tax reform: Replacing the corporate income tax with a value-added tax raises many important issues, including the impact on economic growth, the distribution of tax burdens, tax complexity and so on. Fundamental tax reform obviates the need for export subsidies, but that does not mean the subsidies will disappear. Replacing the corporate tax with a VAT would likely worsen the trade balance, since it will increase investment more than saving. Likewise, a VAT would not relieve the demand for corporate inversions. Some businesses would see their tax liabilites skyrocket under a VAT and thus would have incentives to shift profits out of the U.S.