Jane G. Gravelle Senior Specialist in Economic Policy
striking feature of the modern U.S. economy is its growing openness—its
increased integration with the rest of the world. The attention of tax
policymakers has recently been focused on the growing participation of
U.S. firms in the international economy and the increased pressure that engagement
places on the U.S. system for taxing overseas business. Is the current U.S. tax
system for taxing U.S. international business the appropriate one for the
modern era of globalized business operations, or should its basic
structure be reformed?
The current U.S. system for taxing international business is a hybrid. In part
the system is based on a residence principle, applying U.S. taxes on a
worldwide basis to U.S. firms while granting foreign tax credits to
alleviate double taxation. The system, however, also permits U.S. firms to defer
foreign-source income indefinitely—a feature that approaches a territorial tax
jurisdiction. In keeping with its mixed structure, the system produces a
patchwork of economic effects that depend on the location of foreign
investment and the circumstances of the firm. Broadly, the system poses a
tax incentive to invest in countries with low-tax rates of their own and a disincentive
to invest in high-tax countries. In theory, U.S. investment should be skewed
towards low-tax countries and away from high-tax locations.
Evaluations of the current tax system vary, and so do prescriptions for reform.
According to traditional economic analysis, world economic welfare is
maximized by a system that applies the same tax burden to prospective
(marginal) foreign and domestic investment so that taxes do not distort
investment decisions. Such a system possesses “capital export neutrality,” and
could be accomplished by worldwide taxation applied to all foreign
operations along with an unlimited foreign tax credit. In contrast, a
system that maximizes national welfare—a system possessing “national
neutrality”—would impose a higher tax burden on foreign investment, thus
permitting an overall disincentive for foreign investment. Such a system
would impose worldwide taxation, but would permit only a deduction, and
not a credit, for foreign taxes.
A tax system based on territorial taxation would exempt overseas business
investment from U.S. tax. In recent years, several proponents of
territorial taxation have argued that changes in the world economy have
rendered traditional prescriptions for international taxation obsolete, and instead
prescribe territorial taxation as a means of maximizing both world and national
economic welfare. For such a system to be neutral, however, capital would
have to be completely immobile across locations. A case might be made that
such a system is superior to the current hybrid system, but it is not
clear that it is superior to other reforms, including not only a movement toward
worldwide taxation by ending deferral, but also restricting deductions for
costs associated with deferred income or restricting deferral and foreign
tax credits for tax havens.
Date of Report: December 27, 2012
Number of Pages: 25 Order Number: RL34115 Price: $29.95
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