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Taxes and International Trade

Taxes and International Trade-1

July 27, 2004

In recent months the issue of taxation of multinational corporations (MNCs) has become quite prominent, because the US government is under international pressure to reform its tax laws. In one of these cases, the measure was the Byrd Amendment^1.1, which refunded sanctions revenues against foreign producers to the companies that filed anti-dumping complaints. In the more recent case, the DISC/FSC dispute has come to the forefront. The USA taxes corporate income based on international income for the corporation; EU members tax corporate income based on domestic income.

Globalization 101: Since the early 1960s, the United States has taxed world-wide income of U.S. corporations—that is, income on revenue of foreign subsidiaries as well as of U.S.-based operations. European countries, however, have applied only a territorial tax—that is, a tax on revenue derived only from European-based operations. The United States, therefore, created the Domestic International Sales Corporation (DISC) provision in its tax code in the early 1970s, which deferred tax collection on U.S. corporations’ foreign operations, to lighten what it felt was an unfair burden on those corporations compared to their European competitors.
European governments considered the DISC a form of export subsidy because, they said, it encouraged companies to sell abroad through foreign subsidiaries to take advantage of the tax deferral, and so they challenged it in the GATT dispute resolution process (a precursor to the WTO). The case was resolved [...] in the early 1980s [...] allowing the United States to create a modified tax break, called the Foreign Sales Corporation (FSC) [...] to grant tax relief to exporting companies, in exchange for dropping a challenge to the legitimacy of Europe’s value-added tax (VAT) system. This system provided that goods that are sold within a European country are subject to a tax, but not those sold to someone outside the country—effectively a tax exemption for exports and, thus, an export subsidy.

I emphasised the last sentence: it means that a EU-based subsidiary of an American corporation must pay taxes to the US Treasury as would the same firm on sales in the USA; but if it sells to countries that are neither EU member states nor the USA, then those sales are tax free. This tended to arouse ire in the USA on the part of labor groups, since it effectively subsidized capital exports from the USA. Virtually any measure that increases exports of goods and services will stimulate exports of capital (AKA "shipping American jobs overseas"). But, like many trade agreements, it also bribed the Europeans—successfully—to cooperate with an American system to subsidize exports to the 3rd world.

The problem with bribes is that once you start, you can no longer appeal to the rules:

This agreement held until 1998. The EU, exasperated by the United States’ successful WTO suits against the EU’s banana import program, which benefited exporters in former European colonies in the Mediterranean at the expense of Central American nations, and against the EU’s ban on beef from cattle fed with growth hormones, challenged the FSC in the WTO. Since the FSC did, technically, violate the WTO’s Agreement on Subsidies and Countervailing Measures (SCM), the WTO ruled against the United States both at the first and appeals level[...]. The United States, however, could not challenge the VAT system as an export subsidy because of a well-established distinction between direct taxes on revenue, such as an income tax, and indirect taxes on revenue, such as the transaction-based VAT.

The advantage was that the EU member states had already thrashed out a standard system of applying industrial policy that their immediate neighbors and competitors could accept. The USA had avoided such a step because doing so is politically painful—abolishing the unitary corporate income tax system would sharply reduce revenues, favor large corporations over small ones, and antagonize liberal interests. A value-added tax (VAT) could be introduced to offset the lost revenue, but it would be regressive, and there are other problems as well. The USA had, between 1861 and 1945, totally relied on tariffs to offset industrial policy of its competitors; after 1945, this was of diminishing importance, and we took up targeted loopholes. The EU is far better at that sort of thing.

After the 1998 banana clash, in which EU member states rejected the bribe^1.2, joined up with Japan and other nations, and demanded that the USG obey the rules.

To comply with the WTO ruling, the United States repealed the FSC provision but enacted a new provision called the Extraterritorial Income (ETI) provision. The ETI changed the FSC in two ways. First, while the FSC only applied to exports of U.S.-made items, ETI benefits applied to property manufactured both in and outside of the United Sates (though foreign-made property has to meet a series of standards to be eligible for the tax exemption). Second, non-U.S. corporations were also entitled to claim benefits under the ETI regime if they elected to be treated as domestic corporations for other tax purposes.
The creation of the ETI did not end the dispute, however. The EU brought a new WTO challenge because the United States had created a transition period for implementation of the ETI during which the FSC was still to remain effective, more companies would actually benefit under the ETI changes, and ETI would still function as an export subsidy because the benefit was contingent on exporting. To the disappointment of the United States, the WTO ruled again in favor of the EU in February 2002
The U.S. Treasury and Congress have now proposed 20 changes to the U.S. tax code that eliminate the export benefits of the FSC/ETI entirely, but attempt to benefit U.S. corporations by simplifying provisions of the code governing treatment of foreign income.

The EU continues to file these measures, presumably because the trade commission is the one significant entity in the EU; and it is determined to get unconditional surrender from the US on this matter. So far, the US Congress has refused to make a clean capitulation, instead revising the codes and twisting arms so member states are less interested in prosecuting the US to the fullest extent of the law. The Congress doesn't want to want to be exposed to the rebuke that it doesn't understand international laws (it had to ratify the WTO), and its members have a professional stake in honoring commitments to US exporters...even if those commitments have been really expensive.

(Part 2) NOTE: 1.1 "Continued Dumping and Subsidy Offset Act of 2000," also known as the "The Byrd Amendment," is an addendum to the Trade Act of 1930 ("Smoot-Hawley Tariff"). Oddly enough, the extremely notorious Smoot-Hawley Tariff remains in force today, although nearly all countries in the world receive "most favored nation" (MFN) status, exempting them from the most onerous provisions. Rather than abolish the SHT and replace it with something reflecting the new global trade regime, it has been modified with several hundred amendments.

1.2 The bribe—that is to say, the US Congress "paid" the European Commission to ignore the FSC's violation of GATT by re-writing our tax laws to not favor exports to the EU.

Taxes and International Trade-2

July 30, 2004

(Part 1)

This series of posts was stimulated in part by Discourse's George Mundstock, who has a series on taxation of MNC's non-US income (1, 2, 3, 4, 5, 6, 7, 8). This starts out with a hypothetical heart surgeon named Sue:

Sue is a leading heart surgeon. She went to college and med school on federally-guaranteed loans at schools that received considerable state and federal support. Her clinical work, internship, and residencies were at hospitals that received much government aid. After establishing herself at THE private clinic in New York, she decided to operate only in countries with “reasonable” malpractice laws.
In 2004, Sue received $1 million for surgeries performed in countries with no income tax.^2.1 $2 million was earned for surgeries in Europe, which was taxed by the countries where the surgeries were performed at 50%. Her only other income was on investments held in an account in London. She is a US citizen and resides in Manhattan. If the US were to tax her, she would happily move to Geneva [...] (Remember, this is a hypothetical. Currently, the US would tax her, but little tax would be owed, because of the way that the US foreign tax credit works, which will be discussed in later posts)
How should the US tax her on her $3 million of 2004 surgery income? The pro-business, anti-tax right would say not at all, as taxation would drive her to Europe.

The entries that follow are short and easy to follow. Mr. Mundstck doesn't address the matter of corporate taxation, but it's rather interesting to notice the logic: we could argue that the nicest course of action—that most pleasing to non-US governments—is to give them a monopoly on the right to tax Sue's income earned abroad. This would plausibly warm the hearts of other countries since they are empowered to chose optimal tax curves.

(Think of it this way: national governments lose revenue if their labor force is taxed at too high a rate, since the aggregate demand curve shifts to the left. On the other hand, if they don't tax their labor force at all, there's no tax revenue. Somewhere in between the extremes is the optimal level of taxation; this is the idea the Laffer Curve was supposed to illustrate. But, if other countries are taxing their citizens as well, then the constrained optimum is lower, and the coutnry gets substantially less revenue. If the country is Switzerland or Australia, where a huge share of the labor force is expat, this is an important consideration of the tax code. So if all nations agree to not tax income their citizens earn abroad, then they can all move to the Laffer optimum)

While Mr. Mundstock does go into considerable detail analyzing the taxation of foreign personal income (see here, especially), I'm interested in the fact that, in terms of corporate tax law, such "altruism" has aroused not gratitude but a welter of EU sanctions against the US. In entries 6 and 7, he discusses them. Oddly, he doesn't go into the matter of the DISC/FSC/ETI squabble. (Incidentally, WTO rulings against the USA on this quarrel have been $4 billion in fines; it happens that the EU has—as usual—escaped any potential retaliation even though it encourages exports through VAT discrimination, because the VAT is excluded from WTO regulation. This, Dear Readers, is why Americans believe our diplomats are idiots.)

In fact, I think this is a fundamental problem of nations attempting to regulate or tax a world economy. There's no way that counties can please each other and there's reason to believe that the EU has a strong interest in filing suit after suit against the US tax code, since no matter what it is, it can be construed as discriminatory. The interest is, of course, to get the US government to concede on some other issue. In the meantime, tax policies aren't going to influence export flows to other OECD countries. The USA runs mostly trade deficits with OECD countres; it runs most trade surpluses with non-OECD/non-OPEC countries (the big exceptions are Mexico, China, and India). The USA conducts the bulk of its trade with the OECD, OPEC, China and Mexico. These massive flows aren't going to be influenced by taxes. They are going to be influenced by industrial policy.

ADDENDUM: Actually, the USA has had an industrial policy for nearly a century; around the 1980's we essentially blew that to hell. The Reagan Administration attempted to stimulate high-tech investment through DARPA and some consortiums, but of course these were merely corporate welfare. The end of US industrial policy was heralded by the violent shift of the nation's IS curve to the right (that's IS as in ISLM; see my explanation of this here). We at HC aren't partisan hacks; we aren't proposing that the Reagan WH was to blame for this, since the political machinery did select for them. However, my point is that we've actually have a program in place for a quarter century to maximize consumption of imports—chiefly petrol, actually—whilst hollowing out the manufacturing base. Taxes can be used to alter this behavior and it's becoming plain that I need to explain how that could be done efficaciouly. NOTE: 2.1 Countries with no tax on income include the Bahamas, Bermuda, Cayman Islands, Haiti, and Turks & Caicos Islands; countries with extremely low rates are British Virgin Islands (BVI), Hong Kong, Macau, and Switzerland.