Globalization is knitting separate nationaleconomies into a single world economy. That isoccurring as a result of rising trade and invest-ment flows, greater labor mobility, and rapidtransfers of technology.

As economic integration increases, individualsand businesses gain greater freedom to take advan-tage of foreign economic opportunities. That, inturn, increases the sensitivity of investment andlocation decisions to taxation. Countries feel pres-sure to reduce tax rates to avoid driving away theirtax bases. International “tax competition” isincreasing as capital and labor mobility rises.

Most industrial countries have pursued taxreforms to ensure that their economies remainattractive for investment. The average top per-sonal income tax rate in the major industrialcountries of the Organization for EconomicCooperation and Development has fallen 20 per-centage points since 1980. The average top cor-porate income tax rate has fallen 6 percentagepoints in just the past six years.

Rising tax competition has caused governmentsto also adopt defensive rules to prevent residentsand businesses from enjoying lower tax ratesabroad. In the United States, such tax rules are

hugely complex and affect the ability of U.S. com-panies to compete in world markets. Other defen-sive responses to tax competition include proposalsto harmonize taxes across countries and to restrictcountries from offering tax climates that are toohospitable to foreign investment inflows.

Those defensive responses to tax competitionare a dead end. They do nothing to promote eco-nomic growth or reform inefficient tax systems. Amore constructive response to tax competitionwould be to learn from foreign reforms and adoptpro-growth tax policies at home. The UnitedStates should be a leader but has fallen behind ontax reform. For example, the United States nowhas one of the highest corporate tax rates amongmajor nations. The chairman of the president’sCouncil of Economic Advisers, Glenn Hubbard,believes that “from an income tax perspective, theUnited States has become one of the least attrac-tive industrial countries in which to locate theheadquarters of a multinational corporation.”

As international capital and labor mobilityrises, the risks associated with not having an effi-cient federal tax structure increase. This countryshould respond to rising tax competition by mov-ing toward a low-rate consumption-based system.

International Tax CompetitionA 21st-Century Restraint on Government

by Chris Edwards and Veronique de Rugy

_____________________________________________________________________________________________________

Chris Edwards is director of fiscal policy studies and Veronique de Rugy is a policy analyst at the Cato Institute.

Executive Summary

No. 431 April 12, 2002

Introduction

In past decades, many governmentsshunned inflows of foreign investment andrestricted their citizens’ investments abroad.But a sea change in political attitudes towardforeign investment has occurred since the1970s. Most governments today activelyencourage inflows of foreign investmentbecause they recognize that it is a key factorin maximizing economic growth.

Foreign investment exploded with theremoval of capital controls and the deregula-tion of financial markets in major economiesin the 1970s and 1980s. Many developingcountries followed suit in the 1990s. Reformsincluded allowing foreign currency exchange,allowing the purchase of foreign securities,and allowing foreigners to buy domesticsecurities and acquire domestic firms. As hasbeen widely observed, advances in technolo-gy and communications have spurred capitaland labor flows, with the Internet and othertools opening up global investment andwork options for individuals and businesses.

High tax rates are more difficult to sus-tain in the new economic environment. Thatis particularly true for taxes on capital, whichinclude taxes on business profits and taxeson individual receipts of dividends, interest,and capital gains. Basic economic theory sug-gests that high taxes on capital create anincreasing drag on growth as capital mobili-ty increases. High taxation of capital causescapital flight, thus reducing domestic pro-ductivity, wages, and incomes. 1 MartinFeldstein, James Hines, and Glenn Hubbard,the chairman of president’s Council ofEconomic Advisers, have made that pointwith respect to the corporate income tax:

Many economists argue that it isinefficient to use corporate incometaxes to raise revenue in openeconomies. If capital is internation-ally mobile, the burden of corporatetaxes falls largely on other immobilefactors (such as labor), and the tax

system would be more efficient ifthese other factors were insteadtaxed directly.2

Two centuries ago Adam Smith similarlyrecognized that heavy taxes on mobile“stock,” or capital, would cause a loss toworkers and the economy:

Secondly, land is a subject whichcannot be removed, whereas stockeasily may. The proprietor of land isnecessarily a citizen of the particularcountry in which his estate lies. Theproprietor of stock is properly a citi-zen of the world, and is not necessar-ily attached to any particular coun-try. He would be apt to abandon thecountry in which he was exposed to avexatious inquisition, in order to beassessed to a burdensome tax, andwould remove his stock to someother country where he could eithercarry on his business, or enjoy hisfortune more at his ease. By remov-ing his stock he would put an end toall the industry which it had main-tained in the country which he left.Stock cultivates land; stock employslabour. A tax which tended to driveaway stock from any particular coun-try, would so far tend to dry up everysource of revenue, both to the sover-eign and to the society. Not only theprofits of stock, but the rent of landand the wages of labour, would nec-essarily be more or less diminishedby its removal.3

What is new since Smith’s time is the greaterability of corporations and individuals to movethemselves and their investments across bor-ders. In closed economies, high taxes on capitalincome and skilled workers stunt economicgrowth. As economies open up, such bad taxpolicy causes even larger economic losses due togreater impacts on investment and labor flows.4

As a result, tax competition is becoming moreimportant all the time.

2

High taxes oncapital create anincreasing drag

on growth as cap-ital mobility

increases.

Tax competition may be broadly defined toinclude the tax policy influence that countriesexert on each other. If neighboring countriesare prospering under low tax rates, citizensand policy experts may demand the samefrom their own government. Consider Ireland.In 2000 that small country of 3.8 million peo-ple attracted more foreign direct investment(FDI) than either Japan or Italy.5 The maindraw for foreign investors has been a 10 per-cent corporate tax rate on manufacturing,financial services, and other activities.6 As aresult, Ireland has boomed and now has one ofthe highest standards of living in the world.7 AUnited Nations report called Ireland “themost dynamic country in the developed worldin terms of recent growth and competitive per-formance” and hailed its change from “a back-ward low-productivity economy into a centerof technology-intensive manufacturing andsoftware activity.”8

But such tax cut success stories concernsome economists who view tax competitionas distortionary. It is thought that if differenttax rates cause capital and labor to migrateacross borders, those resources may not endup in their most productive uses. So Irelandis receiving “too much” investment becauseof its low tax rates, according to that view.But that loses sight of a larger issue: high taxrates shackle economic growth. Thus, to theextent that tax competition creates pressureto reduce tax rates globally, all countries gainfrom increased growth and higher incomes.

Opposition to international tax competi-tion is wrapped in the language of economicsbut seems to stem mainly from political con-cerns. In particular, some people worry thattax competition reduces governments’ abilityto redistribute income. When borders areopened, businesses and individuals that aretaxed heavily to pay for redistribution willrationally look to better locations for work-ing and investing. A high-profile 1998 reportfrom the Organization for EconomicCooperation and Development on “harmfultax competition” calls such tax avoidancebehavior “free riding” that “may hamper theapplication of progressive tax rates and the

achievement of redistributive goals.”9

Like many of the OECD report’s argu-ments, that one is internally contradictory.Redistribution involves taxing some peopleat high rates and others at low rates. The “freeriders” would seem to be the latter group,who pay a less than proportionate share oftheir income in taxes. In our view, interna-tional tax competition may indeed hamperincome redistribution, but that is a beneficialoutcome because redistribution has pro-gressed to a remarkably high degree in mostindustrial countries.10

In addition to OECD and other interna-tional efforts to dampen tax competition,governments are taking numerous defensivemeasures on their own. For example, they areimposing layers of complex tax rules on theforeign operations of corporations. In thisregard, the United States enacted its “subpartF” regime in 1962 and has beefed up thoserules a number of times since. Other coun-tries have followed suit with similar rulesdesigned to limit the benefits of investmentin foreign countries that have lower taxes.But the U.S. rules are usually considered themost complex, and they damage the ability ofU.S. companies to compete abroad. Suchrules are merely Band-Aids that cover theneed for more fundamental tax reforms.

This study examines the growth of globalcapital and labor mobility, the global fall intax rates since the 1980s, the basics of U.S.international tax rules, the responsiveness ofinvestment flows to taxation, tax competi-tion theory, and government responses to taxcompetition. It concludes by examining poli-cy options for the United States, includingreplacing the individual and corporateincome taxes with a low-rate consumption-based tax system.

Growing Capital and LaborMobility

Capital MobilityWorld economies have become more

tightly integrated in recent decades. Rapid

3

Opposition tointernational taxcompetition iswrapped in thelanguage of eco-nomics but seemsto stem mainlyfrom politicalconcerns.

growth in cross-border investment has been akey dimension of that integration. In pastdecades, many countries erected barriers toforeign investment, but today most countriesrealize that foreign investment means newjobs, new factories, and access to leading-edge technology. As a result, governmentshave removed the shackles they once placedon international investment flows.

Since the 1970s most countries have elimi-nated foreign exchange controls.11 With thewidespread adoption of floating currencyexchange rates, countries were able to opentheir borders to free flows of investment capi-tal, while still maintaining independent mon-etary policies. Other deregulatory actions havealso promoted investment flows. For example,hundreds of bilateral investment treaties havebeen signed to reduce investment barriers. AUnited Nations report found that 95 percentof government FDI rules in the 1990s were inthe direction of deregulation.12 Financial mar-

kets have been deregulated around the world,making them more attractive to foreigninvestors. Coincident with that trend, largeselloffs of state-owned companies increasedinvestment opportunities in many formerlyclosed economies.

Technology has also greatly boostedinvestment flows. Dramatic reductions incommunication and transportation costs,huge gains in computer power, and the riseof the Internet have facilitated rising capitalflows.13 Richard McKenzie and Dwight Leeexplored those trends in their 1991 book,Quicksilver Capital.14 More recently, Vito Tanzidescribed how globalization has combinedwith new technologies, such as electroniccommerce, to create “fiscal termites” thatoblige governments to reduce tax rates so asto retain their tax bases.15

Technology and deregulation have workedin a virtuous circle to spur international taxcompetition. For example, containerized ship-

4

Technology andderegulation haveworked in a virtu-ous circle to spurinternational tax

competition.

$204$158 $168

$208 $226

$331$385

$478

$693

$1,075

$1,271

$-

$200

$400

$600

$800

$1,000

$1,200

$1,400

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Figure 1World Foreign Direct Investment Flows

Sources: United Nations, World Investment Report 2001 (New York: United Nations Conference on Trade andDevelopment, 2001); and United Nations, World Investment Report 1996 (New York: United Nations Conferenceon Trade and Development, 1996).Note: Figures are foreign direct investment inflows.

ping has increased global transportation effi-ciencies. That has coincided with reductionsin international trade barriers. Together, thosetrends allow production in many industries tobe placed nearly anywhere in the world withgoods shipped cheaply to the final destina-tion. As a result, countries must work hard toprovide a competitive business climate forglobal corporations scouting for new factorylocations.

There have been dramatic increases in bothFDI and foreign portfolio investment. Directinvestment refers to investments by multina-tional corporations that result in a large own-ership stake (more than 10 percent) in a for-eign company, called an affiliate.16 Foreignaffiliates may be established by creating a newcompany or acquiring an existing company.Direct investments are usually made withlong-term investment goals in mind.

By contrast, foreign portfolio investmentrefers to financial investments that do notresult in large ownership stakes (no more

than 10 percent) in any one company.Portfolio investment is more volatile thandirect investment and is usually undertakenwith shorter-term investment goals in mind.

World direct investment flows soared to$1.3 trillion in 2000, up from just $204 bil-lion in 1990 (Figure 1). World portfolioinvestment flows increased to $1.4 trillion in2000, up from $219 billion in 1990 (Figure2). Foreign investment flows were down in2001 because of the global economic slow-down. In recent years, direct and portfolioinvestment, on net, has flowed out of Europeand Japan and into the United States andfast-growing developing countries.17 Figures3 and 4 show the growth in direct and port-folio investment flows to and from theUnited States.18

Direct investment flows allow multina-tional corporations to establish global pro-duction and sales networks. One-third of thesales of the 500 largest U.S. companies is nowfrom their foreign affiliates.19 Those affiliates

5

Countries mustwork hard to pro-vide a competi-tive business cli-mate for globalcorporationsscouting for newfactory locations.

$219

$396 $402

$642

$379

$517

$782$876

$1,016

$1,476 $1,433

$-

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Figure 2World Foreign Portfolio Investment Flows

Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2001 (Washington: IMF, 2001).Note: These are private flows of financial securities (stocks and bonds). Figures are the average of inflows andoutflows.

serve as conduits for the movement of U.S.exports into foreign markets.20 U.S. corpora-tions had about 24,000 foreign affiliates in1998, up 40 percent from a decade earlier.21

The bulk of those affiliates are in high-income industrial countries, not developingcountries or tax havens.22 Globally, there arenow about 60,000 multinational corpora-tions with 500,000 foreign affiliates.23

Portfolio investment flows have risen ascountries have expanded their stock markets,debt has become securitized, and financialwealth holdings have risen. The Internation-al Monetary Fund reports that global assetsmanaged by institutional investors topped$30 trillion by 1998, having doubled since1990.24 Market capitalization of foreignfirms on the New York Stock Exchange ismore than $3 trillion.25

Despite the large volumes of cross-borderinvestment flows, research has suggestedthat world capital markets are still far fromfully integrated. For example, investors havesubstantial “home-country bias” because

they do not have full information about for-eign markets.26 Therefore, it seems likely thatwe are at just the beginning of a long processof global integration and that economicforces and technology will continue to driveforeign investment flows even higher.

Taxation and Capital FlowsTo attract foreign investment, countries

must first get the economic fundamentalsright. They need to establish a stable curren-cy, have reliable legal rules to prevent expro-priation of assets, and have liquid and trans-parent financial markets. For example, anunstable currency caused by loose monetarypolicy gives a clear signal to potentialinvestors that a devaluation, which wouldthreaten to reduce the value of any profitsmade in that currency, is likely.

Dozens of formerly socialist countries inLatin America, Asia, and Eastern Europe havebegun to get the economic fundamentalsright in the past two decades. Many industrialcountries have also made substantial market

6

It seems likelythat we are at justthe beginning of

a long process of global

integration.

0

50

100

150

200

250

300

350

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Outflows

Inflows

Figure 3U.S. Foreign Direct Investment Flows

Source: U.S. Department of Commerce, Survey of Current Business, various issues, Tables F.2, G.1.

reforms. As a consequence, tax policy has risenin importance as a factor influencing globalinvestment flows. That is, as nontax factorsbecome more equalized between countries, taxcompetition becomes more intensive.

Consider business location decisions.Traditionally, an important reason to investabroad was to gain access to fixed resources,such as oil deposits. Today, more industries arefootloose and can be located just about any-where. Finance and services, for example, are thetwo fastest growing areas of U.S. direct invest-ment aboard.27 Also, an increasing share ofproduct value is in the form of intangibles suchas knowledge, trademarks, and patents. Theprofits from intangibles may be easily moved tolow-tax countries. As a result, corporations aremuch more sensitive to different countries’ taxrates today than they were previously.

Indeed, empirical research finds that FDIis becoming more sensitive to taxation. In anew compilation of studies on the issue, edi-tor James Hines of the University of

Michigan Business School concludes that“recent evidence indicates that taxation sig-nificantly influences the location of FDI, cor-porate borrowing, transfer pricing, dividendand royalty payments, and research anddevelopment performance.”28

A study by Rosanne Altshuler, HarryGrubert, and Scott Newlon found that U.S.multinationals became more sensitive totaxes on FDI between 1984 and 1992.29 For1992, their results suggest that countrieswith tax rates 10 percent higher than those ofother countries received 30 percent less U.S.FDI, controlling for other factors. Resultsfrom other studies have found lower but stillsubstantial behavioral responses. Theauthors note that “most recent studies indi-cate that taxes exert a strong influence onlocation decisions.”30

Similarly, a recent IMF study found “strongevidence” that direct investment flows are affect-ed by tax systems.31 The study’s results showedthat lower-tax countries had larger inflows of FDI

7

Empiricalresearch findsthat FDI isbecoming moresensitive to taxation.

0

50

100

150

200

250

300

350

400

450

500

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Inflows

Outflows

Figure 4U.S. Foreign Portfolio Investment Flows

Source: U.S. Department of Commerce, Survey of Current Business, various issues, Tables F.2, G.1.Note: These are private flows of financial securities (stocks and bonds).

than did the higher-tax countries examined. FourEuropean countries with favorable tax regimes—Ireland, the Netherlands, Luxembourg, andSwitzerland—accounted for 9 percent ofEuropean GDP but attracted 38 percent of U.S.FDI to Europe between 1996 and 2000.32

Evidence also indicates that taxes affect FDI flowsat the subnational level. One recent study foundthat U.S. states with higher taxes attract fewernew investments and plant expansions from for-eign corporations than do lower-tax states.33

Portfolio investment flows have alsobecome more responsive to taxes. A recentIMF report noted that “amid widespreadcapital account liberalization and increasedreliance on securities markets, theseinvestable funds became increasingly respon-sive to changing opportunities and risks in awidening set of regions and countries.”34

Portfolio flows can be shifted in and out offoreign investments quickly and are moresensitive to short-term returns than is FDI.Many countries have eliminated taxationaltogether on certain inflows of portfolioinvestment because of increased tax sensitivi-ty. For example, the United States eliminatedtaxation of portfolio interest earned by for-eigners in the early 1980s for that reason.

The effect of tax competition on portfolioinvestment flows is being felt intensely in theEuropean Union. High-tax countries such asGermany and Sweden have had substantialoutflows of savings, often not reported toauthorities, to lower-tax EU countries.35 A 10percent German withholding tax on domesticinterest payments was introduced in 1989 and“caused a massive movement of funds toLuxembourg.”36 The tax was abolished. Theadoption of the euro has intensified tax com-petition pressures because it eliminates cur-rency risk and narrows interest rate differen-tials across Europe. The introduction of theeuro adds to the pressure for tax competitioncreated by prior reforms, such as the removalof internal migration barriers in 1992, whichincreased pressure to reduce tax rates on labor.

Labor MobilityInternational tax competition is generat-

ed by mobile labor as well as mobile capital.While national borders impose large barriersto the free movement of persons, technologi-cal advances, regional trading zones, andgreater information about foreign opportu-nities are creating rising cross-border laborflows. That is particularly the case for highlyskilled labor in industries such as high-techand finance. Countries sharing a commonlanguage and culture, such as Canada andthe United States, may expect to feel thestrongest tax competition pressure.

Millions of people migrate each year fornonfinancial reasons, such as family reunifi-cation or to escape from oppressive politicalregimes. An analysis by the OECD foundthat, while family and political factorsremain important causes for migration, therehas been a rise in migration for economic rea-sons.37 One of those reasons is personal taxes,which vary substantially between countries,particularly for people with high incomes.Income taxes in most countries have margin-al rates that rise with income, so it is the mostskilled workers with the highest incomeswho are most responsive to tax competition.

Numerous factors have increased theimportance of taxes to international migra-tion. First, the Internet has increased infor-mation about foreign opportunities andallowed firms to broaden international jobsearches. Second, falling travel and commu-nication costs have made it easier for workersto take employment in foreign countries andmaintain close contact with relatives. Third,emigration restrictions in many formerlyrepressive regimes have been eliminated.

A fourth trend is the increased technologicalability to perform work in foreign countrieswhile residing elsewhere. The Internet allowssoftware writers and other professionals to earnwages anywhere in the world and remain con-nected to customers electronically, while livingin countries with attractive tax climates.

Fifth, regional trading pacts have allowedincreased worker mobility. The EU allowscomplete mobility for workers in membercountries. The North American Free TradeAgreement allows for some increased mobili-

8

International taxcompetition is

generated bymobile labor as

well as mobilecapital.

ty of skilled professionals. Labor mobilityoften increases as a side effect of trade agree-ments because trade and investment flowsare facilitated by the cross-border movementof technicians and managers.38

Sixth, a number of countries have raisedimmigration limits for highly skilled work-ers.39 In the United States, the H1-B annualwork visa limit for skilled professionals wassubstantially increased until 2003.40 Somecountries, notably Canada, have tilted theirimmigration systems toward people who arehighly skilled or have money to invest. Inaddition, many countries have signed bilater-al immigration and tax treaties, which easeimmigration and prevent double taxing oflabor income.41

The success of immigrants in the high-techsector illustrates the gains that accrue to theU.S. economy as a result of encouraging thosewith high skill levels to immigrate. One studyfound that Chinese and Indian immigrantswere running 24 percent of Silicon Valleyhigh-tech firms in 1998.42 Other studies havefound that some immigrant groups, includ-ing Koreans and Middle Easterners, havestrong propensities to start businesses.43 Themessage to policymakers is that building anattractive economic climate with low tax ratescan give the economy a substantial boost fromhighly skilled imported labor.

Taxation and Labor FlowsIn a world where the cost of and restrictions

on labor mobility are falling, citizens dissatis-fied with government benefits received com-pared to taxes paid can vote with their feet andmove to more favorable economic climates.Because nonfinancial factors play a large role inimmigration, we expect to see the largest effectsof tax competition when those other factors areequalized. A good example is the tax competi-tion pressure on Canada from its lower-taxneighbor, the United States.

The Canadian “brain drain” to the UnitedStates has been a top concern of Canadianpolicymakers. 44 NAFTA intensified labormobility with a new work visa for skilled pro-fessionals called “TN.” It is estimated that for

each skilled American who moves to Canadathere are six Canadians who migrate to theUnited States under this visa category.45

Canadian studies have identified the differ-ences in tax rates as an important factor caus-ing the brain drain.46

Anecdotal evidence of the brain drain hassubstantially affected Canadian tax debates.John Roth, when he was head of Canada’stop high-tech firm, Nortel, routinely warnedthe Canadian government that tax ratesneeded to be cut because his best engineersand managers were moving to the UnitedStates, often to work for Nortel’s U.S. opera-tions.47 Roth also noted that when top man-agers left, they often took some of their bestworkers with them.

Since the removal of internal migrationrestrictions in the EU in 1992, Europeans havealso become more sensitive to tax differencesbetween countries. Although there are stilllarge language and cultural barriers to migra-tion within Europe, there has been an influxof young, skilled workers to cities, such asLondon, with more opportunities and lowertaxes, particularly in fields such as technologyand finance. London’s workforce is about 23percent foreign, and many of those workersare from higher-tax France.48 About 500,000French citizens now live in Britain, and hun-dreds of high-growth entrepreneurial Frenchcompanies have moved to Britain in recentyears.49 A French government report notesthat a large share of the country’s engineeringgraduates leaves the country each year andthat 40,000 French high-tech workers have leftto work in Silicon Valley.50

Ireland is another interesting case study oftaxes and migration. For years, many youngIrish, who were English speaking and oftenwell educated, sought a better life in Englandor the United States. But corporate tax cuts,followed by individual tax cuts, reversed theIrish migration pattern. Ireland now hasrecord net immigration of more than 20,000annually, caused by a marked increase inimmigration and a fall in emigration duringthe past decade.51 The Irish brain drain wasplugged with tax cuts.

9

Corporate taxcuts, followed byindividual taxcuts, reversed theIrish migrationpattern.

International tax competition withrespect to labor is highly visible in the high-paid celebrity world of musicians, models,actors, and sports stars. In 1999 Frenchsupermodel Laetitia Casta was selected to bethe new Marianne, the country’s nationalsymbol of virtue and beauty. But soon after,Casta became notorious by moving toBritain to escape high French taxes. Castawas not alone. Many top French soccer andtennis players, artists, and models havemoved to Switzerland, Britain, the UnitedStates, and elsewhere. Tax avoidance has longbeen a popular game among celebrities inEurope. Luciano Pavarotti long claimed resi-dence in Monte Carlo but was chased downby the Italian government for $12 million inunpaid taxes.52 Tennis star Boris Becker, whoclaimed residence in Monaco and laterSwitzerland, has had trouble with theGerman tax authorities.53

Although the United States has generallybeen a beneficiary of skilled labor migration, itcannot rest on its laurels. As noted, othermajor economies have cut income tax rates inrecent years. If foreign skilled professionalsstay home because of tax cuts in their homecountries, the United States loses brainpower.And U.S. emigration for tax reasons may beincreasing, although accurate numbers arenot available. Somewhere between 1 and 6million Americans live abroad.54 Unfortu-nately for them, the United States is one ofjust a small handful of countries that tax theircitizens’ foreign earnings (above an exemptionamount) even when they live abroad.55 As aconsequence, some Americans living abroadhave renounced their U.S. citizenship to avoidU.S. taxes. The federal government respondedin 1996 with a law that taxes earnings of suchindividuals for 10 years after they have givenup their citizenship.56 Chasing afterAmericans living abroad seems an overlyaggressive and unfair tax policy that missesthe point that U.S. tax rates are too high andshould be reduced in accordance with foreigntrends. The United States should adopt taxrates that encourage workers and high-wealthindividuals to remain resident, rather than

give them incentives to take their skills andinvestment capital elsewhere.

Global Reduction in Tax Rates

The vast majority of industrial nationshave reduced their personal and corporateincome tax rates since the 1980s. The averagetop corporate tax rate for national govern-ments in the OECD fell from 41 percent in1986 to 32 percent in 2000 (Table 1). The U.S.federal rate is 35 percent. A new survey by theaccounting firm KPMG, which takes intoaccount both national and subnational taxes,found that the average 40 percent U.S. federaland state corporate rate combined is almost 9percentage points higher than the OECDaverage in 2002 of 31.4 percent (Table 2).

The average top national individualincome tax rate in OECD countries fell from55 percent in 1986 to 41 percent by 2000.57

That rate is comparable to the current top U.S.federal rate of 38.6 percent, which is scheduledto fall to 35 percent by 2006.58 The annualEconomic Freedom of the World report, whichincludes both national and subnational taxes,found that the average top individual tax ratein OECD countries fell from 67 percent in1980 to 47 percent by 2000 (Table 3).59

Capital gains taxes have also been cut innumerous countries. For example, Canadacut its capital gains income inclusion from75 percent to 50 percent in 2000, thus reduc-ing the effective gains rate to half of the ordi-nary marginal tax rate.60 In many countriessuch efforts have been spurred by the desireto emulate U.S. high-tech success, which wasfueled by investment sensitive to capitalgains taxes, including “angel” financing, ven-ture capital, and public stock offerings.61

Note that a number of countries, such as theNetherlands, New Zealand, Hong Kong, andTaiwan, generally do not tax capital gains.62

Corporate capital gains taxes are also animportant tax factor. The Netherlands, forexample, does not tax corporate capital gains,thus reducing taxes on corporate restructur-

10

The vast majorityof industrialnations have

reduced their per-sonal and corpo-

rate income taxrates since the

1980s.

ings. That and other tax factors make theNetherlands a good location for holding com-panies and multinational headquarters. 63

Germany’s recent corporate tax reforms abol-ished its 50 percent capital gains tax on salesof stakes in other companies because of com-petitiveness concerns. Those reforms prompt-ed the European Union to express concernthat this may constitute “unfair tax competi-tion” because it will attract foreign holdingcompanies to Germany.64

Tax competition has spurred other taxreforms. A group of Nordic countries has

installed dual income tax systems that fea-ture a low flat rate on capital income (inter-est, dividends, and capital gains) but retainprogressive rates on labor income. Denmark,Finland, Norway, and Sweden implementedsuch reforms a decade ago. The Netherlandsand Austria have recently enacted similarreforms, and other European countries havemoved in that direction.65 The OECD notesthat those “moves toward a lower and flat taxon capital income have often reflected theneed to remain competitive on the interna-tional capital markets.”66 Dual income tax

Table 1Top Corporate Income Tax Rates (percent), 1986–2000 (national-level taxes only)

ChangeCountry 1986 1991 1995 2000 1986–2000

Australia 49 39 33 34 -15Austria 30 30 34 34 4Belgium 45 39 39 39 -6Canada 36 29 29 28 -8Denmark 50 38 34 32 -20Finland 33 23 25 29 -4France 45 42 33 33 -12Germany 56 50 45 40 -16Greece 49 46 40 40 -9Iceland 51 45 33 30 -21Ireland 50 43 40 24 -26Italy 36 36 36 37 1Japan 43 38 38 27 -16Korea 30 34 32 28 -2Luxembourg 40 33 33 37 -3Mexico 34 34 34 35 1Netherlands 42 35 35 35 -7New Zealand 45 33 33 33 -12Norway 28 27 19 28 0Portugal 47 36 36 32 -15Spain 35 35 35 35 0Sweden 52 30 28 28 -24Switzerland 10 10 10 8 -2Turkey 46 49 25 33 -13United Kingdom 35 34 33 30 -5United States 46 34 35 35 -11

Average for 26OECD countries 41 35 33 32 -9

Source: OECD, “Tax Rates Are Falling,” OECD in Washington, March–April 2001.

11

A group ofNordic countrieshas installed dualincome tax sys-tems that featurea low flat rate oncapital income.

systems with lower tax rates on capitalincome are a constructive response to thewidespread tax avoidance and evasion thathave occurred under Europe’s high tax rates.

Another policy response to tax competi-tion has been the reduction and eliminationof special taxes on wealth in Europe. Capitalmobility has undermined the ability to col-

lect those redistributionist taxes. In the1990s Norway and Sweden reduced theirwealth taxes, and Denmark, the Netherlands,Austria, and Germany abolished them.67 Onesurvey of 19 countries found that the averagewealth tax has fallen 40 percent since themid-1980s. 68

Tax competition has also driven down with-

12

Tax competitionhas driven down

withholding taxeson payments to

foreigners ofinterest, divi-

dends, and otherinvestment

returns.

Table 2Top Corporate Income Tax Rates (percent), 1996–2002(national and state or provincial taxes)

ChangeCountry 1996 1997 1998 1999 2000 2001 2002 1996–2002

Australia 36.0 36.0 36.0 36.0 36.0 34.0 30.0 -6Austria 34.0 34.0 34.0 34.0 34.0 34.0 34.0 0Belgium 40.2 40.2 40.2 40.2 40.2 40.2 40.2 0Canada 44.6 44.6 44.6 44.6 44.6 42.1 38.6 -6Czech Republic 39.0 39.0 35.0 35.0 31.0 31.0 31.0 -8Denmark 34.0 34.0 34.0 32.0 32.0 30.0 30.0 -4Finland 28.0 28.0 28.0 28.0 29.0 29.0 29.0 1France 36.7 36.7 41.7 40.0 36.7 35.3 34.3 -2Germany 57.4 57.4 56.7 52.3 51.6 38.4 38.4 -19Greece 40.0 40.0 40.0 40.0 40.0 37.5 35.0 -5Hungary 33.3 18.0 18.0 18.0 18.0 18.0 18.0 -15Iceland 33.0 33.0 30.0 30.0 30.0 30.0 18.0 -15Ireland 38.0 36.0 32.0 28.0 24.0 20.0 16.0 -22Italy 53.2 53.2 41.3 41.3 41.3 40.3 40.3 -13Japan 51.6 51.6 51.6 48.0 42.0 42.0 42.0 -10Korea 33.0 30.8 30.8 30.8 30.8 30.8 29.7 -3Luxembourg 40.3 39.3 37.5 37.5 37.5 37.5 30.4 -10Mexico 34.0 34.0 34.0 35.0 35.0 35.0 35.0 1Netherlands 35.0 35.0 35.0 35.0 35.0 35.0 34.5 -1New Zealand 33.0 33.0 33.0 33.0 33.0 33.0 33.0 0Norway 28.0 28.0 28.0 28.0 28.0 28.0 28.0 0Poland 40.0 38.0 36.0 34.0 30.0 28.0 28.0 -12Portugal 39.6 39.6 37.4 37.4 35.2 35.2 33.0 -7Slovak Republic n/a n/a n/a n/a n/a 29.0 25.0 n/aSpain 35.0 35.0 35.0 35.0 35.0 35.0 35.0 0Sweden 28.0 28.0 28.0 28.0 28.0 28.0 28.0 0Switzerland 28.5 28.5 27.8 25.1 25.1 24.7 24.5 -4Turkey 44.0 44.0 44.0 33.0 33.0 33.0 33.0 -11United Kingdom 33.0 31.0 31.0 31.0 30.0 30.0 30.0 -3United States 40.0 40.0 40.0 40.0 40.0 40.0 40.0 0

Average for 30OECD countries 37.6 36.8 35.9 34.8 34.0 32.8 31.4 -6

Source: KPMG, “Corporate Tax Rate Survey,” January 2002, www.us.kpmg.com/microsite/Global_Tax/TaxFacts.

holding taxes on payments to foreigners of inter-est, dividends, and other investment returns.Withholding taxes create an investment disincen-tive by placing an “exit fee” on repatriated earn-ings. For example, businesses are dissuaded frombuilding factories in countries that place a hightax on repatriated dividends. One survey of 19major economies found that the withholding taxon bank interest has been more than cut in half inthe past decade.69

Britain and the United States jump-start-ed the worldwide move toward lower taxrates in the 1980s. Between 1982 and 1986Britain cut its corporate tax rate from 52 to

35 percent and the United States followed in1986 by cutting its rate from 46 to 34 per-cent. Substantial cuts followed in Australiain 1988, Canada between 1986 and 1988,France between 1986 and 1993, Germany in1990, and Japan between 1989 and 1991.70

Both the direct threat of a disappearingtax base and general intellectual trends led tothose reforms. Countries that have close eco-nomic ties will naturally respond morestrongly to each other’s tax reforms. After the1986 U.S. tax cut, Canadian policymakerswere very concerned that U.S. corporationswould shift profits from their high-tax

13

Britain and theUnited Statesjump-started theworldwide movetoward lower taxrates in the 1980s.

Table 3Top Personal Income Tax Rates (percent), 1980–2000(national and state or provincial taxes)

ChangeCountry 1980 1985 1990 1995 2000 1980–2000

Australia 62 60 49 47 47 -15Austria 62 62 50 50 50 -12Belgium 76 76 55 58 58 -18Canada 60 50 44 44 44 -16Denmark 66 73 68 64 59 -7Finland 65 64 63 55 52 -13France 60 65 53 51 54 -6Germany 65 65 65 66 59 -6Greece 60 63 50 45 43 -17Iceland 63 56 40 47 45 -18Ireland 60 65 58 48 42 -18Italy 72 81 66 67 51 -21Japan 75 70 65 65 50 -25Korea 89 65 60 48 44 -45Luxembourg 57 57 56 50 49 -8Mexico 55 55 40 35 40 -15Netherlands 72 72 72 60 52 -20New Zealand 62 66 33 33 39 -23Norway 75 64 54 42 48 -27Portugal 84 69 40 40 40 -44Spain 66 66 56 56 48 -18Sweden 87 80 72 58 51 -36Switzerland 31 33 33 35 31 0Turkey 75 63 50 55 45 -30United Kingdom 83 60 40 40 40 -43United States 70 50 33 42 42 -28

Average for 26OECD countries 67 63 53 50 47 -20

Source: James Gwartney and Robert Lawson, Economic Freedom of the World: Annual Report 2001 (Vancouver:Fraser Institute, 2001), chap. 5. Figures include the lowest state or provincial tax rate, as applicable.

Canadian subsidiaries back to their U.S. par-ent companies.71 They could do that fairlyeasily by increasing their debt financing intheir Canadian subsidiaries to shift taxableincome out of Canada. As a consequence,Canada moved quickly to cut its corporatetax rate to avoid losing its tax base.

Since the mid-1990s, another round ofmarginal rate cuts has occurred. Majoreconomies that have reduced top personal taxrates in recent years include Germany, theNetherlands, and the United States.Corporate tax rates have been recently cut inAustralia, Germany, Canada, and Denmark.72

For example, Canada is phasing in a cut of itsfederal corporate rate from 28 percent in 2000to 21 percent by 2004.73

Note that, with regard to the corporateincome tax, the statutory rate is just one fac-tor in the attractiveness of a business tax cli-mate. The overall, or effective, marginal taxrate is affected by depreciation deductions,investment credits, and other provisions.Effective corporate tax rates have fallen in theOECD countries in recent years, but not by asmuch as statutory rates.74 Nonetheless,statutory rates are the relevant tax factor toconsider in making many corporate deci-sions. For example, tax advantages gained byshifting corporate borrowing between coun-tries depend on statutory rates.75 As onestudy found, “Reported income of corpora-tions can be highly elastic with respect to thestatutory tax rate since income can be easilyshifted from one tax jurisdiction to anotherwithout moving real assets.”76

In addition to broad-based tax cuts, somegovernments offer special narrowly focusedtax breaks to firms scouting for new loca-tions.77 Those types of special deals are oftenmade by subnational governments to attracthighly valued investments such as computerchip plants.78 But targeted tax breaks are dis-couraged by economists, who favor broad-based tax reductions. Narrow tax incentivesadd complexity and unfairness and increaseopportunities for corruption. Also, specialincentives are often Band-Aids that covermore fundamental policy problems such as

excessive regulation. For example, Indonesiaand India frequently offer such tax incentivesto lure investment and yet rank 72nd and92nd, respectively, in the world in terms ofbasic economic freedoms. 79

In summary, tax competition has causedsubstantial cuts in individual and corporatestatutory income tax rates. Other reformshave included reductions in wealth taxes;withholding taxes; and taxes on individualinterest, dividends, and capital gains.Although those reductions in tax rates havebeen very beneficial, tax competition has notyet reduced overall tax levels in most coun-tries. Total taxes as a percentage of GDP rosefrom 32.1 percent in 1980 to 37.3 percent by1999, on average, in the OECD countries.80

Therefore, international tax competition hasnot yet caused Big Government to melt away.That is due in part to the numerous defensivemeasures governments have taken to protecttheir tax bases, including the enactment ofcomplex tax rules on income earned abroad.

U.S. International Tax Rulesand Their Effects

Theories of International TaxationWith regard to domestic taxation, econo-

mists support more neutral tax systems thatallow investment to flow to the highest-val-ued uses. Taxation can distort neutrality byfavoring some investments over others or byfavoring consumption over investment.However, neutrality can have a number ofdifferent meanings in an international con-text, thus making the choice of the most effi-cient tax rules tricky.81

Capital export neutrality (CEN) positsthat investors should face the same tax rateon a marginal investment both at home andabroad, taking into account taxes in both thehome country of the investor and the hostcountry where the investment is located.CEN suggests, for example, that “too much”investment would flow to the United States ifa German company faced, say, a 40 percenttax on a German investment but only a 35

14

Corporate taxrates have been

recently cut inAustralia,Germany,

Canada, andDenmark.

percent tax on a similar U.S. investment.CEN may be achieved by taxing residents ona worldwide basis and providing a credit forforeign taxes paid to prevent double taxation.Supporters of CEN believe that it wouldmaximize world economic efficiency byremoving tax considerations from locationdecisions on investments.

Capital import neutrality (CIN) positsthat investments in a particular countryshould face the same tax rate no matterwhere the investor resides. That standardwould be violated, for example, if a U.S. com-pany faced a 35 percent tax on a Britishinvestment, but a British company faced a 30percent tax on the same British investment.That situation occurs under current lawbecause a U.S. company would pay the U.S.government a residual 5 percent tax on theinvestment, in addition to the British tax.Supporters of CIN argue that the U.S. com-pany should face the same 30 percent Britishtax as the British company without any resid-ual U.S. claim. CIN may be achieved under a“territorial” tax system that would not placea U.S. tax on foreign investments ofAmericans.

The United States developed its complexand jerry-built international tax structurearound the CEN principle, although withmany exceptions.82 Since the early 1960s,Congress has used CEN as justification toexpand the taxation of U.S. firms doing busi-ness abroad. Meanwhile, the CEN view of taxneutrality has become less achievable andmore irrelevant in a global economy with largeportfolio capital flows and many countriesthat do not adhere to CEN.83 It often seemsthat the federal government claims allegianceto CEN simply to promote tax proposals thesole aim of which is to raise money from largecorporations, unseen by average citizens whoultimately bear the burden.

There is growing concern that the U.S.adherence to CEN creates excessive tax com-plexity and damages the ability of U.S. corpo-rations to compete in world markets.84 It alsocreates a disincentive to locate headquartersof multinational corporations in the United

States.85 For those reasons, we conclude thatthe United States should adopt a territorialapproach to international business taxation.

Background on U.S. International TaxRules

The United States taxes U.S. residents andcorporations on their worldwide income. Forexample, a U.S. resident who owns stock in aBritish corporation, or a U.S. corporation thathas a production facility in Germany, reportsthe income from his foreign activities on hisU.S. tax return. That worldwide approach totaxation follows from the CEN principle,which seeks to equalize tax on investments byU.S. residents and businesses regardless ofwhere the investments are located.

With regard to individuals, most, but notall, countries follow a more or less expansiveworldwide taxation approach.86 That is, mostcountries tax the foreign investment incomeof their residents to some extent. With regardto businesses, some countries follow theworldwide tax approach of the United States,but many do not. About half of OECD coun-tries, such as France and the Netherlands,have territorial systems of business taxation,which means that foreign-source income isnot taxed.87 However, most countries do notfollow either approach strictly.

Much of the focus of international tax com-petition is on the activities of multinational cor-porations. To understand some of the taxincentives and disincentives for corporateinvestment decisions, it is necessary to graspsome of the basic features of U.S. internationaltax rules under the corporate income tax.

U.S. foreign affiliates are generally struc-tured as either branches or subsidiaries.Branches are not separately incorporatedabroad, and their profits are immediatelysubject to the U.S. income tax. By contrast,subsidiaries are separately incorporatedabroad. Most are “controlled foreign corpo-rations” (CFCs), that is, subsidiaries that aremore than 50 percent owned by U.S. share-holders.88 U.S. tax is generally assessed onCFC profits only when they are repatriated,or sent home to the United States. Put anoth-

15

There is growingconcern that theU.S. adherence toCEN createsexcessive taxcomplexity anddamages the abil-ity of U.S. corpo-rations to com-pete in worldmarkets.

er way, U.S. tax is “deferred” until profits arerepatriated.

In addition to U.S. tax, U.S. foreign affili-ates face tax in the host countries whereinvestments are located. To avoid double tax-ation, the United States provides a tax creditfor foreign taxes paid on that income.However, the foreign tax credit is limited tothe 35 percent U.S. corporate tax rate. As aresult, U.S. affiliates in high-tax countriespay the higher foreign tax rate. For example,profits of a U.S. affiliate in Belgium that paysa 40 percent Belgium tax receive a 35 percenttax credit to offset the 35 percent U.S. tax onthat income. As a result, that foreign incomewill be taxed at an overall rate of 40 percent.

By contrast, U.S. affiliates in low-taxcountries must pay at least the U.S. tax rateon foreign income. For example, the profitsof a U.S. affiliate in the United Kingdom areassessed the 35 percent U.S. tax and the 30percent U.K. tax. A foreign tax credit can betaken up to the 30 percent level of the U.K.tax. On net, that income will end up facing a30 percent U.K. tax plus a residual 5 percenttax paid to the U.S. government.

Within limits, U.S. corporations can blendincome from their affiliates located in high-tax and low-tax countries to reduce the resid-ual U.S. tax on their foreign operations andtake maximum advantage of foreign tax cred-its. U.S. businesses that operate in high-taxforeign countries generate “excess foreign taxcredits” and cannot offset all their foreigntaxes with U.S. foreign tax credits. Firms inthis situation have a strong incentive to shoparound for investments in low-tax countries touse the excess credits.89 By contrast, U.S. busi-nesses that have most of their operations inlow-tax countries do not have excess foreigntax credits. As a result, they are less interestedin shopping around for other low-tax jurisdic-tions when making new investments abroad.

The effect of the foreign tax credit oninvestment incentives can be illustrated withreference to the Tax Reform Act of 1986(TRA86). TRA86 reduced the U.S. corporatetax rate from 46 to 34 percent, a rate below therates of many other major countries at the

time. As a result, many U.S. companies wereexpected to be pushed into an excess foreigntax credit position. That provided increasedincentives for U.S. firms to locate new invest-ments in low-tax countries; U.S. foreign invest-ment became more tax sensitive. As a conse-quence, many foreign governments reducedtheir own corporate tax rates after 1986 forfear of losing U.S. investment inflows.90

The Intolerable Complexity ofInternational Business Taxation

Although the federal government claimsthe right to tax the worldwide income of U.S.businesses, there have traditionally been limitsto that claim. As noted, business profitsearned abroad in CFCs are generally not taxedby the federal government until repatriated tothe United States. And firms may averageincome in high-tax and low-tax countries toreduce residual U.S. tax on foreign incomeand take full advantage of foreign tax credits.

However, in recent decades the federalgovernment has aggressively expanded thetaxation of foreign income of U.S. compa-nies. Legislation in 1962, 1986, and otheryears has added layers of new rules designedto deny U.S. taxpayers the benefits of invest-ing in low-tax foreign jurisdictions. In somecases, those rules end up double taxing theforeign income of U.S. businesses. Manyother countries have followed the U.S. lead bybeefing up their own tax rules on foreignincome. The flood of such anti-avoidanceand anti-deferral legislation has muted inter-national tax competition.

A key thrust of government efforts hasbeen to limit the ability of firms to defer tax onCFC earnings until repatriated. The primaryU.S. anti-deferral rules, called “subpart F,”were introduced in 1962 and have since beenexpanded a number of times.91 For example,rules under TRA86 expanded subpart F to enddeferral of the tax on income earned by finan-cial services subsidiaries.92

Subpart F aims to tax when earned aCFC’s passive investment income, such asdividends and interest. For example, if aU.S. subsidiary in Ireland earned profits

16

Many foreigngovernments

reduced their owncorporate tax

rates after 1986for fear of losingU.S. investment

inflows.

in its computer manufacturing plant thatit then invested in U.K. equities, the earn-ings of those financial investments wouldbe immediately taxed in the United States.The subpart F rules also aim to immedi-ately tax foreign “base company” sales andservices income, meaning sales into thirdcountries from certain U.S. foreign sub-sidiaries.93 For example, profits fromexport sales to Germany from a U.S.-owedSwiss affiliate may be immediately taxablein the United States.

The subpart F regime has been joined byother anti-deferral rules in the U.S. taxcode.94 In all there are six often-overlappinganti-deferral regimes that create a complexweb for Americans to navigate through wheninvesting abroad. The U.S. international taxrules are generally considered the most com-plex and aggressive among the industrialnations. In a 1999 report, the NationalForeign Trade Council concluded that “U.S.anti-deferral rules have been subject to con-stant legislative tinkering, which has createdboth instability and a forbiddingly arcaneweb of rules, exceptions, exceptions to excep-tions, interactions, cross references, andeffective dates, giving rise to a level of com-plexity that is intolerable.”95

In addition to the anti-deferral rules,numerous other provisions raise taxes onU.S. firms’ foreign income and add greatcomplexity. For example, the United Stateshas special rules to allocate interest andresearch and development (R&D) expensesbetween domestic and foreign income. Thoserules can result in firms being denied legiti-mate business deductions. The constantchanges to the R&D rules during the pastdecade have been a poster child for the insta-bility and complexity of the U.S. internation-al tax system.

Limits on foreign tax credits also greatlyincrease the complexity of the U.S. corporatetax system. The operation of the foreign taxcredit makes it advantageous for firms to bal-ance income earned in high-tax and low-taxcountries. But the ability to average high- andlow-tax foreign income is limited by the require-

ment that foreign income be placed in nine dif-ferent categories, or “baskets,” that cannot beblended. For example, financial servicesincome, shipping income, and passive invest-ment income are placed in separate basketsrequiring separate foreign tax credit calcula-tions. Other countries do not have such exces-sively complex foreign tax credit systems.96

All in all, U.S. rules raise the tax rate on for-eign investment higher than that on foreigninvestment by firms headquartered in othermajor countries.97 The complexity of tax ruleson U.S. foreign income is so great that oneestimate found that 46 percent of federal taxcompliance costs for Fortune 500 companiesstemmed from rules on foreign income.98 As aresult, U.S. companies are at a tax disadvan-tage in world markets. The chairman of theCouncil of Economic Advisers, GlennHubbard, noted that “in many instances, cur-rent law creates barriers that harm the com-petitiveness of U.S. companies. These rules arealso horribly complex both for U.S. multina-tionals to comply with and for the InternalRevenue Service to administer.”99

The anti-competitive U.S. business taxrules are due in part to policymakers whoview multinational corporations as “cashcows” able to absorb tax hikes, unseen by vot-ers.100 In addition, many policymakers seemto view foreign business activity with suspi-cion. Foreign operations are seen, incorrectly,as a loss to the U.S. economy. The evidenceshows the contrary.101 For example, abouttwo-thirds of U.S. export trade is facilitatedby U.S. multinational companies and theirforeign affiliates.102

Tax Rules for Foreign Investment in theUnited States

The complex tax rules on U.S. investmentabroad are paired with different tax rules forinvestment by foreigners in the UnitedStates.103 The corporate income tax rules forU.S.-incorporated businesses owned by for-eigners are similar to those for U.S.-ownedcorporations. There is a separate set of rulesfor taxing foreign-owned businesses operat-ing as branches in the United States.

17

Foreign opera-tions are seen,incorrectly, as aloss to the U.S.economy. Theevidence showsthe contrary.

When U.S.-source financial payments,such as dividends, interest, and royalties, aremade to foreigners, the United States with-holds taxes. Withholding taxes attempt toroughly duplicate the individual-level taxesthat would apply if a U.S. resident receivedthose forms of income. The basic flat rateU.S. withholding tax is 30 percent, but thatrate is generally reduced in bilateral taxtreaties to a range of from 0 to 15 percent. Asnoted, tax competition has caused U.S. andforeign withholding taxes to trend down-ward in recent years.

Important exceptions to U.S. withholdingtax rules are made for interest and capitalgains. Bank deposit interest paid to foreign-ers has long been exempt from U.S. taxa-tion.104 And since 1984 portfolio interestearned by foreigners on government and pri-vate securities is not taxed by the UnitedStates. These rules were implementedbecause of the realization that competitionfrom low-tax foreign jurisdictions for thefunds of international investors would makeany U.S. tax on those forms of interestuncompetitive.105 Similarly, capital gains,except for gains on real estate, earned by for-eigners in the United States are exempt fromU.S. taxation.

Those rules have attracted large flows offoreign investment to the United States.Today, there is more than $1.1 trillion of for-eign deposits in U.S. banks.106 That mobileinvestment capital helps fuel our economyand would end up elsewhere if not for favor-able tax policies. For example, Miami hasbecome an international banking center forLatin America because of the tax exemptionon interest, in combination with the fact thata number of Latin American countries haveterritorial tax systems with respect to theirresidents’ foreign income.107

Some experts have argued that the inter-est and capital gains tax exemptions ought tobe expanded to include dividends, so as tofurther attract foreign investment flows tothe United States.108 Even better, if theUnited States adopted a low-rate consump-tion-based tax system, it would become a tax

haven for all types of portfolio and directinvestment flows from abroad.

Three Business Responses toInternational Tax Competition

Complex tax rules on international invest-ment mean that investment decisions are mul-tifaceted and involve more than simply findingthe jurisdictions with the lowest statutory rates.Businesses may be repelled or attracted by taxrules in different countries. Multi-national cor-porations respond in three ways to different taxstructures. First, firms can move the physicallocation of their facilities, including corporateheadquarters, manufacturing plants, and R&Dfacilities. Different aspects of tax systems affectthe attractiveness of jurisdictions for each ofthose activities. For example:

• Rapid depreciation deductions, orimmediate write-off of capital purchas-es (expensing), attracts capital-inten-sive industries, such as manufacturing.

• Large R&D tax credits and the abilityto expense R&D investments attractR&D facilities.

• Territorial tax systems attract corpo-rate headquarters of multinationalfirms. Under a territorial system, affili-ates are able to compete in foreign mar-kets without an extra layer of taxationimposed in the headquarters country.

Some of the ways that tax rules affect loca-tion decisions are illustrated by TRA86,which reduced the U.S. corporate income taxrate from 46 to 34 percent, a rate lower thanthat of other major countries at the time.Increased investment flows into the UnitedStates were expected. But TRA86 also elimi-nated the investment tax credit and reduceddepreciation deductions, thus making theUnited States a less attractive location forinvestment. Joel Slemrod of the University ofMichigan Business School examined the off-setting effects of TRA86 and figured thatoverall effective tax rates on investment inthe United States rose slightly.109 At the sametime, the tax rate on foreign investment by

18

If the UnitedStates adopted a

low-rate con-sumption-based

tax system, itwould become atax haven for all

types of portfolioand direct invest-ment flows from

abroad.

U.S. businesses fell because repatriations offoreign profits faced the lower U.S. tax ratebut were not affected by the less generouscapital investment rules. So, on net, TRA86was expected to create a modest outflow ofdirect investment from the United States.

The second business response to differentcountries’ tax systems is to financially restruc-ture so as to pay the lowest overall global taxrate. There are many ways that firms can dothat:

• Firms may optimally time dividendrepatriations from high- and low-taxforeign affiliates in order to maximizeusage of foreign tax credits.

• Firms may repatriate money fromabroad in different forms, includingdividends, interest, rent, and royalties.Each type of payment may be subjectto different taxes, such as differentwithholding tax rates.

• Firms may change their debt/equitystructure and the allocation of debtand equity issuance between parentcompany and subsidiaries. For exam-ple, firms can maximize borrowing incountries with high tax rates to maxi-mize the benefit of interest deductions.

• Firms may move the profits attribut-able to intangible assets, such aspatents and copyrights, to low-taxcountries and shift the expense pay-ments for using those intangibles tohigh-tax countries.

• Firms may use different business struc-tures to operate abroad, includingbranches, subsidiaries, holding compa-nies, partnerships, and “hybrids.”(Hybrids are considered different busi-ness structures under foreign and U.S.laws.) For example, operations in low-tax countries can be set up as CFCs,not branches, in order to benefit fromdeferral of U.S. income tax.

The third response of companies to differ-ent tax systems is to use “transfer pricing” toshift profits to low-tax countries. That means

setting prices on purchases from and sales toforeign affiliates too high or too low in orderto effectively move taxable income betweencountries. For example, if a U.S. corporationoverbills its Belgium subsidiary for materialspurchased, it has shifted profits from high-tax Belgium to the lower-tax United States.

Evidence indicates that tax avoidancethrough transfer pricing is substantial, but itis unclear exactly how large the activity is. Infact, it is often very difficult to determine whatthe correct price or profit margin on particu-lar transactions should be. Although intra-company transactions are supposed to be car-ried out at arm’s-length or market prices,many transactions are unique and have nomarket comparison. Many intracompanytransactions, for example, involve the returnsto unique intangible assets. As a result, someexperts think that the transfer pricing rules are“economically illogical” and “inherently unad-ministerable.”110 Many countries, led by theUnited States, have implemented increasinglycomplex rules, including greater reportingand penalties, to thwart perceived abuses andprotect the tax base.

Empirical studies have confirmed theimportance of each of the three differenttypes of business response to internationaltax incentives. In summarizing recent stud-ies, the University of Michigan’s James Hinesfinds that “evidence indicates that taxationsignificantly influences the location of FDI,corporate borrowing, transfer pricing, divi-dend and royalty payments, and research anddevelopment performance.”111

Tax Competition Theory and Politics

Tiebout TheoryThe economics literature on tax competi-

tion traces its lineage to a 1956 study byCharles Tiebout examining the provision ofpublic goods by local governments.112

According to Tiebout’s analysis, competitionbetween local governments for mobile house-holds enhances society’s overall welfare. To

19

According toTiebout’s analy-sis, competitionbetween localgovernments formobile house-holds enhancessociety’s overallwelfare.

avoid losing residents, jurisdictions must tai-lor public spending and tax levels to suit localpreferences. Individuals choose the jurisdic-tions in which they live according to theirdemand for public goods relative to local taxlevels. If some households desire well-financedpublic schools, they may choose to pay higherproperty taxes. If not, they may move to juris-dictions with lower taxes and more efficient,or more limited, government services.

Competition between governments isakin to market competition for products.Market competition encourages productionefficiency and satisfaction of consumerdemands. Tax competition provides politi-cians with incentives to improve governmentefficiency and satisfy voter demands. Theresult of tax competition should be that thelevel of taxes reflects typical preferences with-in each jurisdiction. Tiebout’s theory focusedon local governments, but with growinginternational flows of labor and capital,national governments are becoming morelike local governments as they compete fortaxpayers across national borders.

Finding Inefficiencies in Tiebout’s TheorySince Tiebout’s study, many theorists

have constructed highly stylized models oftax competition to judge its effect on socialwelfare.113 As in other areas of academic eco-nomics, these mathematical models rely onunderlying assumptions that often end updriving the conclusions. Some theorists havetweaked the assumptions and concludedthat tax competition is efficient. Others havetweaked the assumptions and concludedthat tax competition is inefficient because itleads to a “race to the bottom” with tax levelsthat are too low.

The latter results have been used to arguethat tax competition between countries isinefficient. As investment flows to low-taxcountries, inefficiency is thought to occurbecause resources may not end up in thehighest-valued uses. The idea is that the taxsystem ought to be “neutral” and have noeffect on investment decisions. The EU usesthese arguments in its ongoing program to

get its low-tax member countries to raisetheir taxes. A European Parliament fact sheetsays that harmonization of business taxes“may be required to prevent distortions ofcompetition, particularly of investment deci-sions. Where tax systems are non-neutral . . .resources will be misallocated.”114

Similar concerns have led the OECD topursue a global program of curtailing “harm-ful tax competition.” In an important 1998report, Harmful Tax Competition: An EmergingGlobal Issue, the OECD concluded that“harmful” tax policies create “potential dis-tortions in the patterns of trade and invest-ment and reduce global welfare.”115 Reportsby the OECD, the EU, and other critics of taxcompetition are wrapped in seemingly neu-tral language such as “distortion,” “welfare,”“nonneutral,” and “misallocated.” But theeconomics of the critics is often contradicto-ry or based on questionable assumptions.Often, beneath the economic language, arepolitical goals, not economic theory.

Do Low Taxes Harm Global Welfare?What is the harm in “harmful” tax competi-

tion? The 1998 OECD report launched arobust international debate on the issue, so it isuseful to examine the report’s assumptions indetail. The report identifies six negative effectsof harmful low-tax regimes.116 Of the six, itappears that at least four harms—“distortingfinancial and, indirectly, real investment flows,”“undermining the integrity and fairness of taxstructures,” “discouraging compliance by alltaxpayers,” and “increasing the administrativecosts and compliance burdens on tax authori-ties and taxpayers”—are probably more true ofhigh-tax regimes. The fifth harm cited is hollowbureaucrat-speak: “re-shaping the desired leveland mix of taxes and public spending.” Thesixth harm—”causing undesired shifts of partof the tax burden to less mobile tax bases, suchas labour, property and consumption”—gets itbackwards. The last effect is a desired andexpected shift in a globalized economy.

From the report’s perspective, a key sourceof harm occurs when tax policy in one coun-try affects the tax base of other countries.

20

Tax competitionprovides politi-

cians with incen-tives to improve

government efficiency.

Those effects are called “spillover effects” or“externalities.” The 1998 OECD report saidthat harmful tax policies erode the tax basesof other countries by “bidding aggressively”for foreign investment flows.117 A follow-upOECD report in 2000 said that harmful taxpractices “unfairly erode the tax bases ofother countries and distort the location ofcapital and services.”118 At the same time, theOECD says it supports recent income taxrate reductions that have occurred in manycountries in response to globalization. Butthe reforms that the OECD supports alsoattract foreign investment inflows and“erode” other nations’ tax bases. That is a keyinconsistency in the OECD position.

The 1998 OECD report finds that “globali-sation has also been one of the driving forcesbehind tax reforms,” including rate cuts.119 A2001 OECD report on the issue finds that “themore open and competitive environment of thelast decades has . . . encouraged countries tomake their tax systems more attractive toinvestors. In addition to reducing overall taxrates, a competitive environment can promotegreater efficiency in government expenditureprograms.”120 To the OECD, cutting taxes toattract investors is sometimes good policy, butother times it “erodes” tax bases.

Public finance expert Wallace Oatesdescribes the harm of tax competition as “akind of fiscal externality in that local officialsdo not take into account the impact theirdecisions have on the tax bases of other juris-dictions. This typically leads to decisionsinvolving suboptimal tax rates.”121 AEuropean Parliament study similarlydescribed the supposed problem:

The second goal of tax harmoniza-tion is to avoid the negative external-ities that can follow an individual taxreform in one country. . . . Morespecifically, cutting taxes in onecountry raises the competitivenessand/or attractiveness of this countryrelative to others. The resulting flowsof goods, capital—and also, possibly,high-skilled labour—is detrimental

to partner countries in term of eco-nomic activity and in terms of taxrevenues.122

Such criticisms of tax competition purportto examine the effects on “global welfare.”Suppose the United States cut taxes to boostinvestment but did not take into account theeffect on Germany. That would be deemed aninefficiency or “externality” of tax competition.If countries do right by their own citizens withtax cuts, they supposedly harm other nations.That conclusion can clearly fly in the face ofnational sovereignty and therefore cannot be aguide for U.S. tax policy. U.S. policymakers seekfirst and foremost to design policies that bene-fit the American economy. It would not makesense to hold off on U.S. tax cuts because ofconcerns of foreign jurisdictions that havemore inefficient high-rate systems.

Tax Competition Is Not Zero-SumThe allegation of harmful “fiscal externali-

ties” assumes a false zero-sum view of tax pol-icy. In reality, the large economic gains madepossible by tax rate cuts mean that tax compe-tition is not a negative-sum game for theUnited States or the world as a whole. As anyone country adopts a more efficient tax sys-tem to maximize growth, other countries fol-low suit, with the result that global investmentand output rise. The round of income taxreductions following U.S. tax reforms in 1986is a good example. All countries end up betteroff as each country pursues its own interest.

The supposed “global welfare” cost of taxcompetition is based on how tax differencesalter the allocation of an assumed fixedamount of investment across countries. But farmore serious welfare costs occur within coun-tries that have high income tax rates, particu-larly on capital and skilled workers. High mar-ginal income tax rates create large “deadweightlosses.” Those losses, or inefficiency costs, risemore than proportionally as marginal tax ratesincrease, so even modest rate reductions lead tolarge economic gains.123 For example, MartinFeldstein, president of the National Bureau ofEconomic Research, estimated that President

21

The allegation ofharmful “fiscalexternalities”assumes a falsezero-sum view oftax policy.

Bush’s income tax cut plan of last year wouldreduce deadweight losses caused by the tax sys-tem by about $600 billion over 10 years.124 Taxcompetition creates downward pressure onincome taxes, particularly inefficient capitalincome taxes, and thus boosts investment andeconomic growth worldwide.

Public Interest vs. Public ChoiceMost policymakers would probably not dis-

agree that tax rate reductions enhance econom-ic growth. But the concern is that tax competi-tion ends up driving tax rates “too low.” Buthow low is too low? As University of Chicagoprofessor Julie Roin notes, “Advocates of taxharmonization appear to regard any departurefrom the level and distribution of the tax bur-den set in the non-competitive world as undulylow.”125 That is in large part because of theassumptions built into their models. The statusquo government is taken to be the optimal size,determined by efficient political decisionmak-ing. In a recent study, the European Parliamentexhibited the status quo mindset by criticizingtax competition on the basis that “each countryhas an incentive to lower corporate taxes belowthe level that would be consistent with its nat-ural position.”126 But what in the world is the“natural” position? Harmful tax competitiontheories implicitly assume the “public interest”theory of government. Government is assumedto be a benevolent maximizer of citizens’ wel-fare. Tax competition is seen as throwing awrench into the optimal fiscal balance achievedwhen governments have monopoly controlover capital and labor.

An alternative model of government, the“public choice” view, regards public officialsas engaged in self-interested behavior thatmay or may not maximize social welfare.Instead of steering fiscal policy towardachieving the general public good, policy-makers and bureaucrats “seek to maximizebudgets, and thereby to obtain greater power,larger salaries, and other perquisites. Budgetmaximization results in higher governmentspending overall, inefficient allocationamong government agencies, and inefficientproduction within them.”127

According to the public choice view, inter-national tax competition enhances welfarebecause it constrains government from grow-ing inefficiently large. Governments that donot face competition operate like privatemonopolists and have little incentive toreduce waste and increase quality. Just asglobalization limits the power of privatemonopolies in domestic markets, it also actsto limit the power of government monopo-lies. The “race to the bottom” propositionfocuses only on the outcome of mathemati-cally stylized competition and ignores thereal-world benefits of the competitive processitself. That process involves forcing toughchoices to be made, creating innovations, dis-carding bad ideas, and organizational learn-ing to produce better products at lower costs.Nobel prize–winning economist Gary Beckerobserved that “competition among nationstends to produce a race to the top rather thanto the bottom by limiting the ability of pow-erful and voracious groups and politicians ineach nation to impose their will at theexpense of the interests of the vast majorityof their populations.”128

Neutrality and DiversityAnother key idea behind concerns about

international tax competition is tax “neutral-ity.” Economists generally support tax sys-tems that do not distort economic decisions,for example, by favoring one industry overanother. No tax is completely neutral, butgovernments should collect revenue in amanner that minimizes distortions of thedomestic economy. But the good idea of taxneutrality within national borders is not eas-ily translated to cross-border economicissues. We noted that CEN and CIN both aimfor “neutrality” of international taxation, buteach results in different policy prescriptions.

The broader issue is that taxation is butone of many government policies that impactinternational trade and investment flows.Many policy decisions create what may beviewed as nonneutralities. Consider twocountries that have identical tax systems. Thegovernment in one country spends mainly

22

Governments thatdo not face com-petition operate

like privatemonopolists andhave little incen-

tive to reducewaste and

increase quality.

on efficiency-enhancing education andtransportation infrastructure. The other gov-ernment spends mainly to support decliningindustries and redistribution programs. Thedifference in government spending maycause investment to flow to the former coun-try, which practices “unfair infrastructurecompetition.” International agreementscould be drafted to require countries to haveminimum levels of inefficient redistributionspending and place maximum limits on effi-ciency-enhancing infrastructure spending.

In the real world, national governmentsdiffer substantially in their priorities.“Government competition” between coun-tries occurs in many dimensions, includingtaxation, spending, regulation, efficiency ofcourt systems, and other items. All those pol-icy differences may generate cross-borderinvestment and labor flows. For example,countries known for greater political stabilityand efficient legal systems will attract moreforeign investment than unstable and cor-rupt regimes. It is not clear why tax policiesrequire international harmonization whenhuge nonneutralities exist in many othergovernment attributes.

Tax harmonization would have countriesimpose similar taxes regardless of substantialmaterial or cultural differences, with theresult that some countries would have taxesthat were too high from their citizens’ per-spective.129 For example, research by RichardBaldwin and Paul Krugman finds that har-monizing tax rates across “core” and “periph-ery” regions within Europe would be ineffi-cient because those two areas have differenteconomic structures.130

Allowing diversity in fiscal systems issuperior to enforcing global harmonization.With diversity and competition, different taxpolicies may result in different levels of suc-cess. Citizens gain knowledge about policiesthat work in neighboring jurisdictions andwould demand the same from their own leg-islature. Recent global pro-growth trends,such as the privatization revolution andincome tax rate cuts, did not result from atop-down scheme imposed by an interna-

tional organization. Those policy reformsresulted from countries acting for their owndomestic benefit after learning from othercountries’ experiences. Attempts to placeglobal restrictions on tax systems throughinternational bodies will put a straightjacketon the beneficial evolution of independentnational fiscal systems.

Such a straightjacket would be particular-ly harmful for lower-income countries pursu-ing tax reduction strategies. Attraction of pri-vate foreign capital is crucial to the develop-ment of poorer countries, and tax cuts areone method of pursuing growth that shouldbe open to every country. As Julie Roin notes,residents of a wealthy area may not want anew automobile plant because of added con-gestion or pollution, but an area with highunemployment would be happy to forgosubstantial tax revenues to lure the plant.131

Regions and countries are very diverse inmany ways, so international policies that pre-vent poor countries from expressing theirpreference for more growth through less tax-ation are very unfair.

Defensive Responses to TaxCompetition

Layering New Tax Rules on Foreign IncomeCountries have responded to internation-

al tax competition in a variety of ways. Likethe United States, most major countries havecut statutory tax rates on individual and cor-porate income. Many countries have also fol-lowed the U.S. lead with the enactment ofdefensive measures that increase tax com-plexity and limit tax competition, includinganti-deferral rules and tougher transfer pric-ing rules.132 For example, after Britain abol-ished exchange controls in 1979, the tax basebecame more vulnerable. Britain respondedwith substantial corporate and individual taxcuts, but it also enacted anti-deferral legisla-tion for CFCs in 1984.133

Similarly, as Germany has opened its bor-ders under European economic integration,it has both cut tax rates and added new tax

23

It is not clear whytax policiesrequire interna-tional harmo-nization whenhuge nonneutral-ities exist inmany other governmentattributes.

rules on foreign income. Germany had a par-ticularly high corporate tax rate to defend,and German corporations have been aggres-sive in reducing their German taxableincome.134 German firms have found manylower-tax investments abroad, including U.S.real estate and Irish financial services. TheGerman government responded by cuttingthe corporate tax rate from about 60 percentin the early 1990s to 38 percent by 2002.135

The title of a 1994 tax cut law indicates thetax competition pressure Germany felt: “Lawto Secure the Competitiveness of Germany asa Location for Enterprises in a CommonMarket.”136 The government also respondedwith anti-deferral rules for CFCs to stem theoutflow of capital to lower-tax countries.

The OECD has been urging countries toadopt anti-deferral and anti-avoidance rules,and by the mid-1990s about half of OECDmember countries had done so.137 Othercountries have added rules since then, suchas Italy in 2000. The U.S. rules, however, arestill generally considered the most aggressiveand complex. The 1999 National ForeignTrade Council study found that, while othercountries have mimicked the U.S. rules, “invirtually every scenario considered, however,the U.S. imposed the severest regime.”138 Forexample, most countries limit deferral forjust passive investment income, but theUnited States also limits deferral for sometypes of active business income.139

Some countries have not followed the U.S.path of expanding the taxation of foreignincome. The Netherlands, as noted, has avery attractive environment for corporatelocation given its territorial tax system andabsence of capital gains taxation. TheNetherlands officially touts its lack of CFCrules as an important advantage for compa-nies considering investment locations, asdescribed on the Netherlands ForeignInvestment Agency website:

The Netherlands is one of the fewcountries in Europe that does not (yet)bear the burden of Controlled ForeignCompany (CFC) rules. CFC rules aim

to prohibit the use of low tax environ-ments and other tax planning ideas. Bytheir nature, these rules contain manyelements of overkill and prohibitestablishment of a tax efficient groupstructure. It is therefore very importantto choose a holding location that doesnot have CFC rules.140

The overkill the Dutch warn about isalready evident in U.S. tax rules. For example,U.S. efforts to increase the taxation of foreignshipping income have evidently caused theU.S.-owned “open registry” shipping fleet tonearly disappear. Oceangoing ships often flythe flags of open-registry countries such asPanama, while their owners reside elsewhere.The U.S.-owned share of the open-registryfleet plummeted from 26 percent in 1975 tojust 5 percent by 1996, apparently because ofthe aggressive expansion of U.S. taxation ofthat income source.141 Before 1975 foreignshipping income could be deferred until repa-triated to the United States. But U.S. anti-deferral legislation in 1975 and 1986 madeforeign shipping income immediately taxable.That raised the costs of U.S. ship ownershipand led to the transfer of U.S. ships to foreignownership. So that federal effort to raisemoney from corporations ended up losingmoney as the tax base disappeared.

Efforts to expand the taxation of foreignincome can backfire because corporationshave the option of migrating abroad. U.S.firms are reincorporating abroad withincreasing frequency.142 Certainly, govern-ments need to put efforts into reducing taxevasion. But those efforts have substantialcosts, including high complexity, reducedbusiness efficiency, and disappearance of thetax base. Some level of avoidance and evasionis normal for any tax system, so the knee-jerkresponse to every international tax issueshould not be a new layer of rules.

As noted, overall levels of taxation in mostOECD countries are still at record highs, sotax competition is not causing the tax base todisappear overnight. In the meantime, gov-ernments need to implement simpler, lower-

24

Efforts to expandthe taxation of

foreign incomecan backfire

because corpora-tions have the

option of migrat-ing abroad.

rate, consumption-based systems that areeasier to police and provide fewer incentivesfor taxpayers to avoid and evade.

Curbing Tax Competition throughInternational Cartels

Another government response to risingtax competition is the various efforts to coor-dinate tax systems across countries to limitcompetition in the manner of a cartel. TheEU has been a leader in this response to taxcompetition and has pushed its membercountries to harmonize their tax systems. Arecent European Parliament fact sheetexplains: “The objective of more recentmoves towards a general taxation policy hasbeen to prevent the harmful effects of taxcompetition, notably the migration ofnational tax bases as firms move betweenMember States in search of the mostfavourable tax regime.”143 Another fact sheetcalled for further harmonization of businesstaxation “to prevent the undermining of rev-enues through ‘tax competition.’”144

To date, the most far-reaching EU harmo-nization effort was the imposition in 1992 ofa minimum standard value-added tax (VAT)rate of 15 percent. The EU has also tried toget member countries to harmonize incometax rates. The 1992 Ruding Commission pro-posed creating a minimum corporate tax rateof 30 percent.145 Going back further, a 1975European Commission draft directive calledfor harmonizing corporate rates at between45 and 55 percent.146 Luckily for Europeancitizens, those plans were not enactedbecause they could have prevented the reduc-tions in corporate tax rates that haveoccurred in EU countries in recent years. Theaverage EU corporate tax rate fell from 38.2percent in 1996 to just 32.5 percent in2002.147 The drop in rates has improved theefficiency of European taxation, a benefitthat would not have occurred if harmoniza-tion had put a straightjacket on reform.

While EU documents admit that tax com-petition has some good aspects, there is astrong movement to squelch it.148 For example,the EU has pushed low-tax European countries

to impose withholding taxes on outflows ofcapital income to prevent citizens from benefit-ing from lower taxes on their savings in othercountries. The German chancellor recentlycalled for fully integrating European taxa-tion.149 The head of the European Central Bankrecently said that the euro would lead to greaterharmonization of all taxes in Europe.150

France’s prime minister has condemned taxcompetition as “fiscal dumping” and said that“the corporate tax system as a whole will have tobe harmonised” since it is unfair for corporateheadquarters to move to low-tax EU regions.151

Those developments are important forthe United States because the same argu-ments used to support tax harmonizationwithin Europe are being heard in globalforums. For example, a high-level UnitedNations panel has proposed creating aInternational Tax Organization that woulddevelop norms for tax policy, engage in sur-veillance of tax systems, and negotiate withcountries to “desist from harmful tax compe-tition.”152 The ITO would be akin to theWorld Trade Organization, which handlestrade disputes. But economists nearly univer-sally agree on the benchmark of free trade.153

There is no such agreement in the tax world:proponents of broad-based income taxes andproponents of consumption-based tax sys-tems would come to vastly different conclu-sions about what an ITO should enforce.

Another important reason to oppose anew international tax bureaucracy is the largebias it would have toward tax increases. TheUN report proposing an ITO makes thatclear. The report suggests creation of a “glob-al source of funds” from a “high yielding taxsource.”154 The report suggests future studyof a “Tobin tax” on foreign exchange markettransactions to finance “global publicgoods.” The report says that an ITO “couldtake a lead role in restraining the tax compe-tition designed to attract multinationals.”155

Another suggestion in the UN report, whichis very disturbing from a civil liberties pointof view, is for the proposed ITO to operate aglobal system of taxing emigrants becausebrain drains “expose source countries to the

25

The same argu-ments used tosupport tax har-monization with-in Europe arebeing heard inglobal forums.

risk of economic loss when many of theirmost able citizens emigrate.”156 The ideaseems to be that the proposed ITO wouldassess a tax on, say, new U.S. citizens ofChinese origin and send the money back tothe government of China.

Although the UN has not yet acted on itsproposals, the OECD has been at the fore-front of global efforts to stifle tax competi-tion.157 Its April 2000 report on the issuefound that “harmful tax competition is by itsvery nature a global phenomenon and there-fore its solution requires a global endorse-ment and global participation.”158 TheUnited States needs to decide where it standson this new international crusade.

“Global participation” so far includes pres-suring a list of tax haven countries to changevarious laws deemed harmful and requiringchanges to a long list of “harmful preferentialtax regimes” in major industrial countries,including one tax break in the UnitedStates.159 In tax havens, the OECD focus is onindirect methods of nullifying tax competi-tion, such as information sharing betweengovernments. The idea is to give tax collectorsin each country access to information aboutthe economic activities of its citizens abroad,in hopes that this will eliminate the attractive-ness of low-tax countries. Many countries taxindividual residents on some portion of theirincome on a worldwide basis, so gainingaccess to foreign information helps high-taxcountries sustain their high rates. Informationexchanges raise serious issues of financial pri-vacy and national sovereignty

What is really driving the efforts to sup-press tax competition is the politics of redis-tribution. The primary tax used for redistrib-utive purposes, the income tax, has the mostmobile of tax bases and thus is most affectedby international tax competition. The 1998OECD report concluded that internationaltax competition “may hamper the applica-tion of progressive tax rates and the achieve-ment of redistributive goals.” That occursbecause, when borders are opened, business-es and individuals that are taxed heavily topay for redistribution move their activities to

more hospitable locations. The OECD callssuch tax avoidance behavior “free riding.” Arecent European Parliament report echoedthat view, calling it “free loading.”160

That is an odd characterization. “Free rid-ing” better describes those on the receiving endof government redistribution, who face little orno taxation while others carry a heavy burden.IRS data show that the highest-income 5 per-cent of U.S. taxpayers paid 55 percent of all fed-eral income taxes in 1999.161 So, while interna-tional tax competition may indeed hamperincome redistribution, that seems to be a posi-tive outcome because redistribution hasreached severe proportions. Curtailment ofredistribution is an advantage, not a disadvan-tage, of international tax competition.

The redistribution issue also highlights theunderlying “income tax–centric” view of theworld that critics of tax competition hold. Acentral feature of “harmful tax competition” issaid to be no or low taxation of capital income.But many economists think that consump-tion-based taxes are superior to income-basedtaxes, which aim to heavily tax capital income.Treasury Secretary Paul O’Neill has suggestedthat the United States consider scrapping thecorporate income tax.162 Such reforms, aimedat reducing the tax burden on capital income,would be deemed harmful because they would“poach” flows of capital from high-tax coun-tries and cause “fiscal externalities.”

The OECD says that “countries shouldremain free to design their own tax systemsas long as they abide by internationallyaccepted standards in doing so.”163 TheUnited States should be very concerned thatthe OECD or other international bodies donot start creating international “standards”that lock in high-rate income tax systems andthus preclude pro-growth consumption-based tax reform.

Options for U.S. Tax Policy

Cut Tax RatesWhile the United States raised tax rates in

the 1990s, other major countries were cut-

26

The United Statesshould be veryconcerned that

the OECD orother internation-

al bodies do notstart creatinginternational

“standards” thatpreclude pro-

growth consump-tion-based tax

reform.

ting tax rates and pursuing other tax reforms.As noted in a recent European Parliamentreport, “Since the 1990s, a wind of taxreforms has been blowing through theEuropean Union . . . most reforms can beseen as supply-side oriented.”164 The presi-dent of the International Fiscal Associationnoted that tax cuts would likely continue andthat the average corporate rate in Europewould eventually fall to about 25 percent.165

That rate would be 10 percentage pointslower than the 35 percent U.S. federal corpo-rate tax rate. The combined U.S. federal andaverage state corporate tax rate of 40 percentis currently higher than the rates in all but 3of 30 OECD countries.166 Effective corporaterates have also been falling in Europe.167 TheUnited States should move to get back thebusiness tax advantage it gained in 1986 byimmediately reducing its corporate incometax rate to 20 percent.

Personal income tax rate cuts enacted in2001 were a step in the right direction for theU.S. tax system. But more must be done. As astep toward a low-rate consumption-basedtax system, Congress could consider theNordic approach of retaining the current taxrates on labor income but taxing capitalincome at a low, flat rate. That would help torectify the heavy taxation on dividendincome in the United States, which is taxed atthe corporate level and again at the individ-ual level. Two-thirds of OECD countriespartly or fully relieve the double taxation ondividend income.168 But the United Statesdoes not and as a result has the fourth high-est overall tax rate on dividends in theOECD.169 This heavy taxation has a negativeeffect on competitiveness because it raises thecost of capital for U.S. companies.170 Tobegin reducing capital income taxation, theUnited States could adopt a flat 10 percenttax rate for dividends, interest, and capitalgains at the individual level.

As noted, tax rate cuts would increase eco-nomic growth by reducing the distortions, ordeadweight losses, that the tax system impos-es on the economy. 171 Aside from the growthadvantages of tax rate cuts, lower rates would

greatly reduce the need for the complexdefensive measures that the federal govern-ment has taken in areas such as anti-deferralrules and transfer pricing. Lower marginaltax rates would reduce tax evasion and taxavoidance behavior by individuals and corpo-rations.172 Empirical studies have shown thatover time lower rates produce a larger taxbase due to reduced avoidance and evasionand increased economic activity.173

Oppose Efforts to Curtail Tax CompetitionThe release of the 1998 OECD report on

“harmful” tax competition created continu-ing controversy over the broad sweep andaggressive stance taken by the organization.The OECD followed up with a report in 2000that identified harmful tax practices bymember countries and listed 35 tax havensthat could face a variety of proposed sanc-tions. A further update report was issued in2001. As the largest OECD member country,the United States has a key role to play in thedebate. The following discussion provides abrief overview of where the debate stands.174

Since coming to office, the Bush adminis-tration has slowed down the ambitious plansof the OECD to build an international cartelto curb tax competition. Treasury SecretaryO’Neill expressed his reservations about theOECD project in congressional testimonylast year: “I felt that it was not in the interestof the United States to stifle tax competitionthat forces governments—like businesses—tocreate efficiencies.”175 For example, he dis-agreed with OECD efforts to prevent coun-tries from offering preferential tax treatmentto foreign investors (so-called ring fencing).

Much of the debate has focused on indi-rect efforts to curb tax competition. In par-ticular, the OECD is pressuring offshorefinancial centers, or tax havens, to agree toexchanges of tax information or face sanc-tions from OECD countries. There are alsodemands for more transparency in thosejurisdictions, which means eliminating spe-cial reduced tax rates and reducing banksecrecy. Offshore financial centers combinelow-tax climates with high levels of financial

27

The combinedU.S. federal andaverage state cor-porate tax rate of40 percent is cur-rently higherthan the rates inall but 3 of 30OECD countries.

privacy, so these demands strike at core fac-tors behind their economic success. Not sur-prisingly, targeted jurisdictions have resistedoutside demands to change their tax andfinancial policies. After all, attracting finan-cial services can be a successful developmentstrategy for poorer countries in theCaribbean and elsewhere that have few nat-ural resources on which to build an economy.

There has also been substantial opposi-tion in Congress, led by House MajorityLeader Dick Armey (R-Tex.), to U.S. involve-ment with the OECD initiative. Armey hasargued that the United States should notsupport “a global network of tax police” andthat it is unfair for large wealthy countries tobully small, often poorer nations to changesuccessful economic policies.176 In fact, tar-geted nations have argued that the OECDpressure and threatened sanctions arebreaches of international law and violationsof their sovereignty.177 They resent the unfair-ness of the whole process, including the factthat many OECD countries also have sup-posedly harmful tax rules that have not beenfixed.178 Nonetheless, more than a dozen tar-geted jurisdictions have made deals tochange some of their laws in order to call offthe OECD dogs.179

One part of the OECD initiative thatO’Neill supports is pushing foreign coun-tries to enter into taxpayer informationexchange agreements. The United Statesalready has agreements for such informationexchanges with about 60 countries. O’Neillsays those should be limited to particularinvestigations and not general “fishing expe-ditions.”180 But the United States needs to bevery careful with the idea of informationexchanges because the United States is itselfa large tax haven. An immediate threat is aproposed U.S. Treasury regulation thatwould require U.S. banks to report interestearned by foreigners to the IRS and thenshare that information with other coun-tries.181 As noted, the tax exemption for for-eigners on U.S. bank interest has helpedattract more than $1.1 trillion in bankdeposits to the United States. 182 As one

national banking organization noted, if thisregulation were finalized and the IRSbreached the financial privacy of thosedeposits, it “could trigger massive with-drawals of foreign deposits from U.S.banks.”183 The money would flee to moreattractive investment climates with stricterprivacy standards.

O’Neill also testified to Congress withrespect to the OECD initiative that theUnited States should “not interfere in theinternal tax policy decisions of other coun-tries.”184 But hunting for income tax evadersin countries that do not have tax systemssimilar to ours does indeed intrude on thetax policy of those countries. There is anunderlying OECD bias in favor of high-rate,broad-based income tax systems. Since manytax havens do not have income taxes, or havelow rates, their tax systems are eyed with sus-picion. Without an income tax, governmentsgenerally do not need to know personalfinancial investment information. A benefitof replacing the income tax with some ver-sion of a consumption-based tax in thiscountry would be added financial privacy.For example, under Armey’s flat tax therewould be no need for citizens to report sav-ings income (dividends, interest, and capitalgains) to the government as they currentlydo. Thus, it does not seem fair to tell othercountries to change their higher standards offinancial privacy for the benefit of OECDincome tax systems that many economistsagree should be replaced with consumption-based tax systems.

Since September 11, concerns about off-shore financial centers as tax havens havetaken a back seat to concerns about criminalactivity in those jurisdictions. The UnitedStates has stepped up its efforts againstmoney laundering and financing of terror-ism activities. Tax policy and financial priva-cy rules of offshore centers need not conflictwith these important criminal investigationpriorities. Many banking centers such asSwitzerland and the Cayman Islands havemutual legal assistance agreements with theUnited States to exchange information on

28

House MajorityLeader Dick

Armey has arguedthat the United

States should notsupport “a global

network of taxpolice.”

criminal matters.185 But the United Statesshould pressure jurisdictions that do refuseto cooperate on criminal matters to do so.

So far, it appears that offshore centershave not stood in the way of U.S. law enforce-ment. The September 11 terrorists apparent-ly did not rely on offshore or tax havenbanks; instead they relied on banking sys-tems in the United States, Europe, and theMiddle East, including the informal“hawala” system.186 A large share of criminalmoney is laundered in wealthy industrialnations, not tax havens. For example, it isestimated that about half of all launderedmoney goes through U.S. financial institu-tions.187 Smart criminals often avoid taxhavens because of the obvious red flag theiruse provides to authorities.

For those reasons, the United States shouldnot participate in international efforts to bullyforeign jurisdictions to weaken their owneconomies in order to prop up inefficient taxpolicies in some OECD countries.188 Armeybelieves that applying such pressure couldmake those countries less willing to aid us inthe more important mission of stemming ter-rorism and other criminal activity.189 Besides,as noted, the United States is itself a large taxhaven in certain respects with more than $1.1trillion of foreign deposits in U.S. banksattracted by low taxation, security, and finan-cial privacy.190

Stomping out tax competition through acartel may seem to be an easy way out of thenew realities of globalization.191 But goingdown the global tax cartel road is not an easyway out. The tone and content of OECD, EU,and UN reports and comments by politicalleaders suggest that the ultimate end goal isto morph initial international tax agree-ments into a permanent global tax law. Butthe ambiguity and contradictions of the eco-nomics behind “harmful” tax competitionwould make this an area for continuousexpansion of stiflingly complex bureaucraticlaws and regulations. The United States doesnot need a global tax superstructure on topof its current 45,662-page tax rule book.192

Instead, the United States should proceed

with the heavy lifting of consumption-basedtax reform to allow us to avoid the troublesof chasing tax avoiders and evaders to the farends of the earth.

Reform U.S. International Business TaxationThe U.S. response to intensified internation-

al tax competition must include an overhaul ofthe worldwide system of business taxation.That system greatly complicates business plan-ning and raises taxes on U.S. firms’ foreignincome above those on firms headquartered inother countries.193Yet the worldwide tax systemis thought to raise little federal revenue, and itmay actually lose revenue in comparison withthe alternative of a territorial tax system.194

Hubbard has noted that “the present U.S. sys-tem of taxing multinationals’ income may beraising little U.S. tax revenue, while stimulatinga host of tax-motivated financial transac-tions.”195 Hubbard believes that “from anincome tax perspective, the United States hasbecome one of the least attractive industrialcountries in which to locate the headquarters ofa multinational corporation.”196 So the currentrules impose a high cost with apparently no rev-enue benefit to the government.

Calls for reform have come from manyquarters. The vice president for taxes at IntelCorporation testified before Congress a fewyears ago that “the degree to which our taxcode intrudes upon business decision-mak-ing is unparalleled in the world . . . othercountries do not have such complex rules.”197

The American Bar Association recentlyconcluded that “these rules may never betruly simple, but actions can be taken to tem-per the extraordinary complexity of the cur-rent regime.”198 The ABA notes that it isbecoming increasingly difficult to complywith the foreign tax credit rules and that thesubpart F rules “sorely need to be updated todeal with today’s global environment.”199

Calls for reform have been especially strongsince the passage of TRA86, which made U.S.tax rules on business much more complexand uncompetitive.200

Price Waterhouse and the U.S. Chamberof Commerce completed a major study in

29

The United Statesdoes not need aglobal tax super-structure on topof its current45,662-page taxrule book.

1991 illustrating how U.S. international taxrules put U.S. companies at a disadvantage inforeign markets.201 Most of the problemsthat were identified still plague the tax code.In a major report on U.S. tax rules in 1999,the NFTC concluded that “no other countrytaxes the active business income of CFCs asaggressively as the United States.”202

There is growing support for replacing theU.S. worldwide method of taxation with aterritorial method. As noted, about half ofOECD countries already have a territorialsystem.203 Switching to a territorial tax sys-tem would entail generally exempting theforeign business income of U.S. companiesfrom U.S. tax. Both fairness and economicreasons support such a policy. On fairnessgrounds, it is not clear why business opera-tions located abroad should be subject toU.S. tax at all. Foreign affiliates are primarilystaffed by foreign workers, and more thanthree-quarters of affiliate financing is fromforeign sources.204 Foreign affiliates primari-ly benefit from infrastructure offered by for-eign countries, not by the U.S. government.So foreign affiliates create foreign economicactivity that does not impose costs on U.S.taxpayers. In fact, as numerous studies havedocumented, U.S. foreign affiliates are verybeneficial to the U.S. economy; for examplethey boost U.S. foreign trade.205

On economic grounds, a territorial sys-tem is superior to a worldwide system innumerous ways. A territorial system wouldmake the United States an excellent locationfor headquarters of multinational corpora-tions. Under a territorial system, foreign affil-iates could earn profits abroad and not face atax disincentive to repatriating earnings toU.S. shareholders. Multinational headquar-ters bring to the United States highly skilledworkers and high-income jobs in manage-ment, finance, marketing, R&D, and otherhigh-level corporate functions. For example,while 71 percent of U.S. multinational firms’employees are located in the United States,87 percent of their R&D is performed here.206

The larger and more successful the foreignaffiliates of U.S. firms are in world markets,

the more headquarters functions will berequired in the United States.

Current U.S. tax rules put U.S. foreignaffiliates at a competitive disadvantage com-pared with affiliates of firms headquarteredin other countries. Thus the United States iscurrently a poor tax choice for the location ofmultinational headquarters. Intel’s vice pres-ident for taxes testified before Congress that,“if I had known at Intel’s founding what Iknow today about the international tax rules,I would have advised that the parent compa-ny be established outside of the U.S.”207

The United States may be beginning tohave a problem with “runaway” corporateheadquarters. High-tax Sweden has had thisproblem as firms such as IKEA have movedout.208 In the United States, numerous mid-sized companies, such as Fruit-of-the-Loom,have moved abroad. Moving is particularlyattractive to firms that already have most oftheir operations outside the United States.209

The U.S. Treasury recently announced thatthere has been a “marked increase” in thenumber and size of companies that are rein-corporating abroad, and the Treasury findsthat taxes are a key reason for those moves.210

The most prominent example of a U.S.corporate expatriation was the 1998Daimler-Chrysler merger. The merged com-pany established corporate headquarters inGermany, in part because of its more favor-able tax rules.211 A PricewaterhouseCoopersstudy found that uncompetitive tax rulesmay be causing numerous U.S. companies tomigrate abroad through mergers and acqui-sitions. The study reported that “in 1998,1999, and 2000, U.S. companies were the tar-get (and foreign companies the acquirer) in86, 73, and 79 percent, respectively, of thelarge cross-border mergers and acquisitionsas measured by value.”212 Note that cross-border mergers and acquisitions used to berare, but in the past decade or so they haveexploded in number and value. This is one ofmany changes occurring in the global econo-my that demand that the United States revis-it its antiquated system of taxing interna-tional businesses.

30

The United Statesis currently a

poor tax choicefor the location of

multinationalheadquarters.

Gary Hufbauer of the Institute forInternational Economics, who is a promi-nent advocate of moving to a territorial taxsystem, has noted that “the worldwide taxapproach is justified by emotion notlogic.”213 He thinks that “the tensionsstretching back to 1918 between the imprac-tical general [worldwide] rule and the practi-cal exceptions have generated an extraordi-narily complex U.S. tax code.” Hufbauer con-cludes that we should replace the currentimpractical general rule with the practicalgeneral rule of territoriality.

Others have pointed out that the world-wide tax system, based on the idea of CEN, is aform of tax protectionism or “beggar-my-neighbor neutrality.”214 It ends up making allcountries worse off by increasing capital taxa-tion and reducing the worldwide capital stock.In pursuit of the questionable notion of “neu-trality,” it hurts U.S. companies and foreigneconomies without aiding the U.S. economy.Norman Ture and George Carlson observed adecade ago that “capital export neutrality, ineffect, is preoccupied with the respectivedomestic and foreign shares of a smaller pie(the stock of capital) rather than making a big-ger pie.”215 That focus on redistributing the“pie” rather than making it bigger is a preoc-cupation of people who oppose internationaltax competition in general.

The United States could move to a territo-rial tax system for businesses within theframework of the current income tax, whichat its simplest would mean exempting fromU.S. taxation the active business profits ofU.S. foreign affiliates.216 Some taxation offoreign portfolio income would still be need-ed if the United States retained a broad-basedincome tax system. Better still, we couldmove to a full territorial system for individu-als and businesses if we adopted a major con-sumption-based tax reform.

Pursue Consumption-Based Tax ReformIn recent years, there has been great inter-

est in replacing the individual and corporateincome taxes with a consumption-based taxsystem. Proposals have included a national

retail sales tax and the flat tax introduced byArmey.217 Consumption-based tax reformwould be good domestic tax policy, and itwould be the best response to rising interna-tional tax competition. A replacement con-sumption-based tax would increase invest-ment and economic growth and greatly sim-plify federal taxation. In addition, the lowertax rate under most tax reform proposalswould reduce wasteful tax avoidance and eva-sion activities. To replace the revenue cur-rently raised by the corporate and individualincome taxes, the sales tax or flat tax ratewould need to be roughly 20 percent.218

The consumption base and territorialnature of the retail sales tax and the flat taxwould eliminate most U.S. international taxrules. There would be no need for rules onforeign affiliates’ earnings, foreign tax cred-its, or other parts of the current internation-al tax apparatus. As noted, a territorial taxwould allow U.S. businesses to compete inforeign markets without tax burdensimposed by the federal government.

A reform as large as adopting a sales or flattax could have substantial effects on interna-tional investment flows. Changes may causeinvestment to flow into the United States insome situations and out of the country inother situations. On net, most experts thinkthat a low-rate consumption-based tax wouldmake this country a tax haven and attract sub-stantial net investment inflows.

Under a territorial tax, U.S. individualscould search for low-tax investment opportuni-ties abroad, free of U.S. tax on foreign earnings.However, neither the retail sales tax nor the flattax would be imposed on domestic investmentreturns either, so individuals would likely keepmost financial investments in the UnitedStates.219 For foreign individuals, the UnitedStates would be a tax haven because interest,dividends, and capital gains would not be taxedby the federal government. This policy wouldexpand on the current tax exemption for bankand portfolio interest earned by foreigners inthe United States. Overall, there likely would bea net increase in portfolio investment flows tothe United States.

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A consumption-based tax wouldincrease invest-ment and eco-nomic growthand greatly sim-plify federal taxation.

The elimination of individual taxation onsavings and investment returns would substan-tially reduce tax avoidance and evasion activity.However, it is likely that any new tax systemwould provide some channels for tax evasion.For example, a national retail sales tax wouldcreate incentives for people to shop abroad.However, evasion is likely to be lower under aconsumption tax than an income tax becauseconsumption is less mobile than flows ofinvestment capital, which are taxed under thecurrent system. Therefore, a consumption-based tax would provide a more stable tax basein the face of increasing global tax competition.

For multinational corporations, con-sumption tax reform would lead to changesin incentives for real investment, financialrestructuring, and transfer pricing. For realinvestment, the low rate of the flat tax, andlack of a business-level tax under a sales tax,would make the United States a great loca-tion for domestic and foreign businesses.220

Direct investment would flow into theUnited States, particularly from countrieswith territorial tax systems because firmsbased in those countries would receive thefull benefit of the lower U.S. tax rate.

The provision for business expensingunder the flat tax would create an incentive

for capital-intensive industries to locate inthe United States. “Expensing” means allow-ing firms to immediately deduct capital pur-chases, such as buildings and equipment.Tables 4 and 5 illustrate the location advan-tage for a U.S. investor that the United Stateswould achieve under a 20 percent flat taxwith expensing. Table 4 shows that, under anincome tax, an investment in the UnitedStates or a low-tax country, A, would earn a6.5 percent after-tax rate of return. A lower5.5 percent return would be earned in a high-tax country, B. Table 5 indicates that, under aU.S. flat tax, the return on investment wouldrise the most for investments in the UnitedStates. And it shows that Americans wouldhave an even greater disincentive to invest inhigh-tax countries, thus increasing interna-tional tax competition.

The territorial nature of the flat tax andsales tax would make the United States anattractive location for corporate headquar-ters, since foreign operations would not betaxed by the U.S. government. A territorialsystem would eliminate the current disincen-tive to repatriate foreign profits because theycould be brought home tax-free. Hines con-cludes that “on net, the attractiveness of theUnited States as a profit location after fun-

Table 4Investment Location Decisions under a U.S. Income Tax

Investment LocationUnited States Foreign A Foreign B

Tax rate 35% 10% 45%Net cost of machine 1,000 1,000 1,000Return, before tax 100 100 100

Foreign income tax – 10 45U.S. income tax 35 35 35Foreign tax credit – 10 35

Total tax 35 35 45Return, after tax 65 65 55

Net after-tax rate of return 6.5% 6.5% 5.5%

Source: Adopted from U.S. International Trade Commission, Implications for U.S. Trade and Competitiveness ofa Broad-Based Consumption Tax, June 1998, www.usitc.gov, p. 17.Note: Except as otherwise indicated, values are dollars.

32

The territorialnature of the flattax and sales taxwould make theUnited States an

attractive locationfor corporateheadquarters.

damental tax reform implies that U.S. firmswill very likely shift some of their invest-ments from foreign countries back to theUnited States, and that foreign investors willlocate more of their investment in the UnitedStates as well.”221

Incentives related to R&D and intangibleassets may also change. Under the sales tax, roy-alties received from licensing intangibles to for-eigners would not create any taxable income inthe United States, thus increasing incentives forperforming R&D domestically. Under the flattax, foreign royalties received probably wouldbe taxable since the tax base includes exportreceipts. Nonetheless, the lower tax rate underthe flat tax would still make the United Statesan attractive location for R&D.222 In addition,the current R&D expense allocation rules,which create an R&D disincentive for somefirms, would be eliminated under both propos-als. Overall, tax reform would be expected toincrease U.S. R&D expenditures.223

There are a number of differences betweena flat tax and a sales tax with regard to inter-national trade. Although both tax proposalsare territorial, they differ with regard toimports and exports. A retail sales tax wouldbe “border adjustable” so that imports wouldface U.S. taxation, but exports would be

exempt. By contrast, the flat tax, like the cur-rent income tax, is not border adjustable andthus would tax export receipts but allowdeductions for imports.224 Most economiststhink border adjustability would not havelarge effects in the long run since theexchange rate would adjust for the tax differ-ence.225 But to the extent that the exchangerate did not offset border adjustability, thesetaxes might have somewhat different effectson international trade.

It is true that under a territorial tax, such asthe flat tax, some businesses may move someactivities to foreign jurisdictions that have taxrates even lower than a 20 percent flat tax.Replacing the income tax with a flat tax maycause both outflows and inflows of foreigninvestment. However, most studies, including a1998 report by the U.S. International TradeCommission, conclude that a consumption-based territorial tax would, on net, attractinvestment inflows and encourage U.S. firms toincrease domestic capital investment.226

With regard to corporate financial trans-actions, tax reform would change a numberof incentives. As noted, a territorial tax wouldencourage the repatriation of profits fromforeign affiliates. As a result, some share ofthe large stock of currently unrepatriated for-

Table 5Investment Location Decisions under a U.S. Flat Tax

Investment LocationUnited States Foreign A Foreign B

Tax rate 20% 10% 45%Net cost of machine 800 1,000 1,000Return, before tax 100 100 100

Foreign income tax – 10 45U.S. flat tax 20 – –Foreign tax credit – – –

Total tax 20 10 45Return, after tax 80 90 55

Net after-tax rate of return 10.0% 9.0% 5.5%

Source: Adopted from U.S. International Trade Commission, Implications for U.S. Trade and Competitiveness ofa Broad-Based Consumption Tax, June 1998, www.usitc.gov, p. 17.Note: Except as otherwise indicated, values are dollars.

33

Most studies con-clude that a con-sumption-basedterritorial taxwould, on net,attract invest-ment inflows andencourage U.S.firms to increasedomestic capitalinvestment.

eign earnings would flow back to the UnitedStates with the adoption of a flat tax or salestax.227 Also, there would be an incentive forbusinesses to shift interest income to theUnited States under the flat tax and sales tax,as those receipts would not be taxed.

On the other hand, new financial strategiesto reduce U.S. taxes could be expected underany major tax reform. For example, the flattax’s exclusion of interest would create anincentive to relabel export receipts as interestincome to avoid taxes. In addition, companieswould want to repatriate foreign earnings asinterest because it would be deductible in theforeign country and not taxable in the UnitedStates. In general, since the United Stateswould be a low-tax country after tax reform,U.S. and foreign firms would alter debt andequity financing structures to move taxableincome into this country. Overall, the UnitedStates would be expected to gain from suchfinancial adjustments.

Under the sales tax, the need for U.S. trans-fer pricing rules would be eliminated. Underthe flat tax, U.S. firms would continue to haveincentives to use transfer pricing to shift tax-able income to low-tax countries. But theUnited States itself would have a low tax rate,so both U.S. and foreign firms would likelyshift profits into the United States. Expertsconclude that the overall pressure on U.S.transfer pricing would be reduced under a flattax.228 Hines finds that “all of the proposedfundamental tax reforms greatly reduce incen-tives created by the U.S. tax system to relocateprofits abroad.”229 He also notes that “on net,the tax base of the United States wouldincrease, not decrease, through transfer pric-ing of American and foreign multinationalsafter fundamental tax reform.”230

What would be the reaction of other gov-ernments to consumption-based tax reformin this country? Governments could takemeasures to defend their tax bases fromincreased U.S. competition. There is, forexample, concern that some countries mayrevoke benefits of U.S. investors under cur-rent tax treaties. But most governmentswould have a strong incentive to reform their

own tax systems along the lines of the newU.S. tax system.231 Countries would be putunder great pressure to reduce tax rates oncapital income because the United Stateswould become an even bigger magnet forglobal capital flows than it already is.

The territorial nature of a consumption-based tax in the United States would put greatpressure on high-tax countries. That wouldoccur because of the elimination of the U.S.foreign tax credit, which currently shieldssome tax paid by U.S. firms in high-tax coun-tries because of the partial ability to blendhigh- and low-tax foreign income. Withoutthat mechanism, U.S. companies wouldreduce investment in high-tax countries.232

Countries dependent on income taxes wouldhave a strong incentive to adopt a consump-tion-based system to prevent investment fromflooding to the United States.

As other countries reduced tax rates oncapital income, global output would rise ascapital investment increased and tax-induceddistortions were reduced. Just as the UnitedStates led the world in tax reform in the1980s, U.S. consumption-based tax reformswould launch a new round of tax reformsaround the world.

Notes1. “A domestic corporate tax increase will there-fore tend to cause an outflow of corporate capital,and in the long run, the resulting shortage of cap-ital in the domestic economy will drive up the pre-tax rate of return to wage earners, because thelower capital intensity of domestic productionwill reduce labour productivity and real wagerates. Part of the burden may also fall on ownersof immobile factors of production such as fallingland rents and land prices.” Organization forEconomic Cooperation and Development(OECD), Taxing Profits in a Global Economy (Paris:OECD, 1991), p. 34.

2. Martin Feldstein, James Hines, and GlennHubbard, Introduction to Taxing MultinationalCorporations, ed. Martin Feldstein, James Hines,and Glenn Hubbard (Chicago: University ofChicago Press, 1995), p. 3. See also LucyChennells and Rachel Griffith, Taxing Profits in aChanging World (London: Institute for FiscalStudies, September 1997), p. 67.

34

Just as the UnitedStates led the

world in taxreform in the

1980s, U.S. con-sumption-based

tax reformswould launch a

new round of taxreforms around

the world.

3. Adam Smith, An Inquiry into the Nature and Causesof the Wealth of Nations (1776; Chicago: University ofChicago Press, 1976), vol. 2, p. 375.

4. For a discussion of taxation and capital flows, seeA. Lans Boverberg et al., “Tax Incentives andInternational Capital Flows,” in Taxation in the GlobalEconomy,ed. Assaf Razin and Joel Slemrod (Chicago:University of Chicago Press, 1990), p. 293.

5. United Nations, World Investment Report 2001(New York: United Nations Conference on Tradeand Development (UNCTAD), 2001), p. 291.

6. That rate is scheduled to rise to 12.5 percent in2003, and the domestic corporate rate is sched-uled to be cut to conform to the same 12.5 per-cent rate.

7. “Economic and Financial Indicators,” The Econo-mist, March 2, 2002, p. 98. Ireland’s per capita grossdomestic product in 2001 on a purchasing power par-ity basis is the sixth highest in the OECD.

8. United Nations, “Developed Country FDI Soarsby 21%,” UNCTAD press release, September 18,2001.

9. OECD, Harmful Tax Competition: An Emerging GlobalIssue (Paris: OECD, April 1998), p. 14.

10. In the United States, Internal Revenue Service datashow that the highest-income 5 percent of federal tax-payers paid 55 percent of all income taxes in 1999. U.S.Congress, Joint Economic Committee, “New IRS dataon Income Tax Shares Now Available,” Press release,January 14, 2002, www.house.gov/jec.

11. International Monetary Fund (IMF), WorldEconomic Outlook (Washington: IMF, October2001), chap. 4, p. 145.

12. United Nations, World Investment Report 2001,p. 12.

13. Ibid., pp. 12, 14.

14. Richard McKenzie and Dwight Lee, Quicksil-ver Capital: How the Rapid Movement of Wealth HasChanged the World (New York: Free Press, 1991).

15. Vito Tanzi, “Globalization, TechnologicalDevelopments, and the Work of Fiscal Termites,”IMF Working Paper 181, November 2000.

16. Different sources use somewhat different def-initions of foreign direct investment, includingvariations on the ownership, or voting power,threshold of 10 percent. Another variation has todo with whether earnings retained by foreignaffiliates are counted as a direct investment flowor not.

17. IMF, International Capital Markets (Washington:IMF, August 2001), p. 6.

18. These data are for flows of portfolio invest-ment in securities, including stocks and bonds.U.S. Department of Commerce, Survey of CurrentBusiness, March 2002, Tables F.1, G.1.

19. “U.S. Firms Find Global Progress Is a Two-Edged Sword,” Wall Street Journal, August 17,1998.

20. U.S. Department of Commerce, Survey of Cur-rent Business, July 2000, p. 29, and March 2002, p. 24.See also National Foreign Trade Council (NFTC),The NFTC Foreign Income Project: International TaxPolicy for the 21st Century (Washington: NFTC, 1999),part 1, pp. 5–6, 6–13.

21. Ray Mataloni, U.S. Department of Commerce,Bureau of Economic Analysis, e-mail to authors,June 22, 2001.

22. In 1999, 78 percent of the gross product ofU.S. majority-owned affiliates was produced inEurope, Canada, Australia, and Japan. U.S.Department of Commerce, Survey of CurrentBusiness, March 2002, p. 28. See also Peter Merrilland Carol Dunahoo, “Runaway Plant Legislation:Rhetoric and Reality,” Tax Notes, July 8, 1996.

23. United Nations, World Investment Report (NewYork: UNCTAD, 1999), p. 1.

24. IMF, International Capital Markets, chap. 2, p. 4.

25. NFTC, part 1, p. 5-7.

26. For a discussion, see Roger Gordon and VitorGaspar, “Home Bias in Portfolios and Taxation ofAsset Income,” National Bureau of EconomicResearch (NBER) Working Paper 8193, March2001.

27. U.S. Department of Commerce, Survey ofCurrent Business, July 2000, p. 32.

28. James Hines, Introduction to InternationalTaxation and Multinational Activity, ed. James Hines(Chicago: University of Chicago Press, 2001), p. 1.See also James Hines, “Lessons from BehavioralResponses to International Taxation,” NationalTax Journal, June 1999, p. 305.

29. Rosanne Altshuler, Harry Grubert, and ScottNewlon, “Has U.S. Investment Abroad BecomeMore Sensitive to Tax Rates?” in InternationalTaxation and Multinational Activity, p. 28

30. Ibid.

31. Reint Gropp and Kristina Kostial, “The Dis-

35

appearing Tax Base: Is Foreign Direct InvestmentEroding Corporate Income Taxes?” IMF WorkingPaper 173, October 2000, www.imf.org/external/pubind.htm. See also Agness Benassy-Quere, LionelFontagne, and Amina Lahreche-Revel, “ForeignDirect Investment and the Prospects for Tax Co-Ordination in Europe,” Centre D’Etudes Prospec-tives et Information Internationales Working Paper6, April 2000.

32. Martin Sullivan, “Data Show Europe’s TaxHavens Soak Up U.S. Capital,” Tax Notes, February4, 2002.

33. Deborah Swenson, “Transaction Type andthe Effect of Taxes on the Distribution of ForeignDirect Investment in the United States,” inInternational Taxation and Multinational Activity, pp.89–112. The study, however, found that high statetaxes did not deter company acquisitions by for-eign investors.

34. IMF, International Capital Markets, chap. 2, p. 4.

35. Sven-Olaf Lodin, “International Tax Issues ina Rapidly Changing World,” InternationalBureau of Fiscal Documentation Bulletin, January2001, p. 6.

36. European Parliament, “Tax Co-ordination inthe European Union,” Working Paper ECON 125,December 2000, p. 15, www.europarl.eu.int/workingpapers/econ/default_en.htm.

37. OECD, Trends in International Migration (Paris:OECD, 2001). See also Kirstin Downey Grimsley,“Global Migration Trends Reflect EconomicOptions,” Washington Post, January 3, 2002, p. E2.

38. Steven Globerman, “Trade Liberalisation andthe Migration of Skilled Professionals andManagers: The North American Experience,World Economy 23, no. 7 (July 2000): 901–22.

39. Grimsley.

40. Sheela Murthy, “Major Immigration Bill PassesBoth Houses of Congress,” October 3, 2000,www.murthy.com/UDh1f.html.

41. OECD, Trends in International Migration.

42. Anna Lee Saxenian, “Silicon Valley’s SkilledImmigrants: Generating Jobs and Wealth forCalifornia,” Public Policy Institute of CaliforniaResearch Brief, June 1999, www.ppic.org.

43. Joel Kotkin, “Welcome to the Casbah,”American Enterprise, January 1999.

44. Mahmood Iqbal, “The Migration of Highly-Skilled Workers from Canada to the United

States: The Economic Basis of the Brain Drain,”in The International Migration of the Highly Skilled, ed.Wayne Cornelius, Thomas Espenshade, andIdean Salehyan (San Diego: University ofCalifornia, Center for Comparative ImmigrationStudies, 1991), pp. 291–323.

45. Mahmood Iqbal, “Are We Losing Our Minds?Trends, Determinants and the Role of Taxation inBrain Drain to the United States,” ConferenceBoard of Canada, 1999.

46. Ibid. See also Pascal Salin, “International TaxProblems: between Coordination and Competi-tion,” Paper presented to the Mont PèlerinSociety General Meeting, Vancouver, Canada,August 30, 1992.

47. Valerie Lawton, “Job Drain OvershadowsBrain Drain,” Toronto Star, December 2, 1999.

48. Grimsley.

49. Jack Anderson, “A Misery Index,” Forbes, Febru-ary 21, 2001. See also Jean Francois-Poncet, “BrainDrain: Myth or Reality?” Senate of France, Reportno. 388, 1999–2000 sess., June 7, 2000.

50. Ibid. Anderson says that there are 60,000French engineers in Silicon Valley.

51. Ireland Central Statistical Office, “Populationand Migration Estimates,” August 2001,www.cso.ie/publications/demog/popmig.

52. Lisa Ugur, “One Tenor and a Taxman,” July31, 2000, www.tax-news.com.

53. Ulrika Lomas, “Becker Could Face Jail over£13m Tax,” July 3, 2001, www.tax-news.com.

54. Association of Americans Resident Overseas,“FAQ,” http://aaro-intl.org.

55. Jon Dougherty, “The Power to Destroy:Global Reach of the IRS, Americans LivingOverseas,” Offshore Center Headline News,August 24, 2001, www.theoffshorecentre.com.

56. “U.S. Makes it Harder to Renounce Citizenship,”U.S. Visa News Headlines, January 4, 1999,www.usvisanews.com.

57. OECD, “Tax Rates Are Falling,” OECD inWashington, March–April 2001. Does not includestate or provincial taxes.

58. Income tax rates are scheduled to fall under theEconomic Growth and Tax Relief Reconciliation Actof 2001. For details of the act, see U.S. Congress,Joint Committee on Taxation, “Summary ofProvisions Contained in the Conference Agreement

36

for H.R. 1836, the Economic Growth and Tax ReliefReconciliation Act of 2001,” JCX-50-01, May 26,2001, www.house.gov/jct.

59. James Gwartney and Robert Lawson, EconomicFreedom of the World: Annual Report 2001 (Vancouver:Fraser Institute, 2001).

60. Canadian Department of Finance, “CanadianTax Advantage,” January 2002, www.fin.gc.ca/toce/2002/cantaxadv_e.html.

61. Chris Edwards, “Entrepreneurial Dynamism andthe Success of U.S. High-Tech,” U.S. Congress, JointEconomic Committee, 106th Cong., October 1999.

62. Paul van den Noord and Christopher Heady,“Surveillance of Tax Policies: A Synthesis ofFindings in Economic Surveys,” OECD WorkingPaper 303, July 17, 2001, p. 51.

63. Sven-Olof Lodin, “The Competitiveness of EUTax Systems,” International Bureau of Fiscal Docu-mentation European Taxation, May 2001, p. 169.

64. Ulrika Lomas, “European Union Concernedover Germany’s Abolition of Capital Gains Tax,”April 12, 2001, Tax-News.com.

65. Alessandro Bavila, “Moving away from GlobalTaxation: Dual Income Tax and Other Forms ofTaxation,” International Bureau of Fiscal Documen-tation European Taxation, June 2001, p. 216. See alsovan den Noord and Heady, pp. 29, 46.

66. Isabelle Joumard, Tax Systems in EuropeanUnion Countries (Paris: OECD, June 2001), p. 26.

67. Ken Messere, “Tax Policy in Europe: AComparative Survey,” International Bureau ofFiscal Documentation European Taxation, Decem-ber 2000, pp. 528, 531.

68. Harry Huizinga and Gaetan Nicodeme, “AreInternational Deposits Tax-Driven?” EuropeanCommission Economic Paper no. 152, July 2001,p. 31.

69. Ibid., p. 32.

70. Chennells and Griffith, p. 28 and Appendix C.

71. John Whalley, “Foreign Responses to U.S. TaxReform,” in Do Taxes Matter? The Impact of the TaxReform Act of 1986, ed. Joel Slemrod (Cambridge,Mass.: MIT Press, 1990), pp. 293, 305.

72. KPMG, “Corporate Tax Rate Survey,” January2002 and prior years, www.us.kpmg.com/microsite/Global_Tax/TaxFacts.

73. Canadian Department of Finance, “Federal

Corporate Tax Rate Reductions,” January 2002,www.fin.gc.ca.

74. The average EU effective corporate rate hasfallen substantially since the mid-1980s. SeeEuropean Parliament, “The Reform of Taxationin EU Member States,” Working Paper ECON127, May 2001, p. 55, www.europarl.eu.int/work-ingpapers/econ/default_en.htm. See alsoBenassy-Quere; Fontagne, and Lahreche-Revel;Lodin, “The Competitiveness of EU Tax Systems”;and Gropp and Kostial.

75. Joel Slemrod, “Tax Effects on FDI in the U.S.,”in Taxation in the Global Economy, p. 104. Averagetax rates may also be relevant for decisionmakingby investors in some situations.

76. Jack Mintz and Michael Smart, “IncomeShifting, Investment, and Tax Competition:Theory and Evidence from Provincial Taxation inCanada,” University of Michigan Business SchoolWorking Paper 2001-15, July 2001, p. 2.

77. The Internet site, www.siteselection.com, hasnumerous news stories about U.S. and foreign taxbreaks and other government incentives for par-ticular investment deals.

78. Alex Easson, “Tax Incentives for Foreign DirectInvestment: Part 1,” International Bureau of FiscalDocumentation Bulletin, July 2001, p. 266.

79. Lawson and Gwartney.

80. van den Noord and Heady.

81. Daniel Frisch, “The Economics of InternationalTax Policy: Some Old and New Approaches,” TaxNotes, April 30, 1990. A third theory of “national neu-trality” also has some supporters.

82. Carl Dubert and Peter Merrill, Taxation of U.S.Corporations Doing Business Abroad: U.S. Rules andCompetitiveness Issues (Morristown, N.J.: FinancialExecutives Research Foundation and Pricewater-houseCoopers, 2001), p. 68.

83. NFTC, p. viii.

84. Ibid., part 1.

85. Dubert and Merrill, p. 75.

86. Frisch.

87. Dubert and Merrill, Table 10-2.

88. To be more precise, CFCs are foreign corpo-rations that are at least 50 percent owned by U.S.individuals or corporations who hold stakes of atleast 10 percent each.

37

89. Hugh Ault and David Bradford, “U.S. Taxationof International Income,” in Taxation in the GlobalEconomy, pp. 38, 41.

90. Mintz and Smart, p. 2. See also Andrew Lyon,“International Implications of U.S. Business TaxReform,” Canadian Department of FinanceWorking Paper 96-6, December 1996, p. 14.

91. A good discussion of these rules is containedin Dubert and Merrill. See also Ault and Bradford,pp. 11–52.

92. Glenn Hubbard and Rosanne Altshuler, “TheEffect of the Tax Reform Act of 1986 on theLocation of Assets in Financial Services Firms,”Seminar presentation, American EnterpriseInstitute, February 19, 1999, p. 7. Under therecent economic stimulus law, Congress allowedfirms to defer tax on active financial servicesincome until repatriated under a temporary pro-vision expiring in 2006.

93. For a precise description of these rules, seeDubert and Merrill.

94. Ibid., p. 85.

95. NFTC, part 1, p. A-18.

96. Dubert and Merrill, p. 29.

97. For example, see National ChamberFoundation and Price Waterhouse, U.S. Interna-tional Tax Policy for a Global Economy (Washington:National Chamber Foundation, May 1991). Thisstudy found a tax rate on U.S. foreign businessincome that was higher than the rates of six othermajor countries examined.

98. Joel Slemrod and Marsha Blumenthal, “TheIncome Tax Compliance Cost of Big Business,”Tax Foundation, November 1993.

99. Glenn Hubbard, “Comments on Sen. McCain’sTax Policy toward U.S. Multinationals,” Tax Notes,March 6, 2000, p. 1433.

100. Norman Ture and George Carlson, “Tax Policyto Address the Challenges and Opportunities of theGrowing World Marketplace,” in U.S. Foreign TaxPolicy: America’s Berlin Wall, Conference proceedings(Washington: Institute for Research on theEconomics of Taxation, 1991), p. 26. For example,the 1986 tax act added layers of complex new taxrules in an effort to raise about $9 billion extra frommultinational corporations.

101. NFTC, part 1.

102. U.S. exports associated with the U.S. multi-national corporations were 63 percent of total

U.S. exports in 1999. U.S. Department ofCommerce, Survey of Current Business, March 2000,p. 24. See also NFTC, part 1, pp. 5-6, 6-13.

103. For a summary of portfolio investment rules,see Yaron Reich, “Taxing Foreign Investors’ Portfo-lio Investments: Developments and Discontinui-ties,” Tax Notes International, February 1998.

104. Marshall Langer, “Harmful Tax Competition:Who Are the Real Tax Havens?” Tax Notes, January29, 2001, p. 667. See also Reich, p. 9.

105. Langer.

106. U.S. Department of Commerce, Survey ofCurrent Business, March 2002, Table G.1.

107. Frisch.

108. Reich, p. 36.

109. Joel Slemrod, “Impact of Tax Reform Act of1986 on Foreign Direct Investment,” in Do TaxesMatter? pp. 172, 173.

110. Brian Lebowitz, “Transfer Pricing and theEnd of International Taxation,” Tax Notes,September 10, 1999.

111. James Hines, Introduction to InternationalTaxation and Multinational Activity, p. 1.

112 Charles Tiebout, “A Pure Theory of LocalExpenditures,” Journal of Political Economy,October 1956, pp. 416–24.

113. For a recent survey of the literature, see JohnDouglas Wilson, “Theories of Tax Competition,”National Tax Journal, June 1999, pp. 269–301.

114. European Parliament, “Fact Sheet 3.4.8:Personal and Company Taxation,” October 19,2000, www.europarl.eu.int/factsheets.

115. OECD, Harmful Tax Competition, p. 14.

116. Ibid., p. 16.

117. Ibid. See also European Parliament, “Tax Co-ordination in the European Union,” p. 18,www.europarl.eu.int/workingpapers/econ/default_en.htm.

118. OECD, Towards Global Tax Co-operation:Progress in Identifying and Eliminating Harmful TaxPractices (Paris: OECD, 2000), p. 5.

119. OECD, Harmful Tax Competition, p. 13.

120. OECD, The OECD’s Project on Harmful TaxPractices: The 2001 Progress Report (Paris: OECD,

38

November 2001), p. 4.

121. Wallace Oates, “Fiscal Competition orHarmonization? Some Reflections,” National TaxJournal, September 2001, p. 507.

122. European Parliament, “The Reform of Taxationin EU Member States,” p. 7, www.europarl.eu.int/workingpapers/econ/default_en.htm.

123. Chris Edwards, “Economic Benefits ofPersonal Income Tax Rate Reductions,” U.S.Congress, Joint Economic Committee, 107thCong., April 2001.

124. Martin Feldstein, “The 28% Solution,” WallStreet Journal, February 16, 2001. This estimaterelates to Bush’s original proposal of a $1.6 tril-lion tax cut.

125. Julie Roin, “Competition and Evasion: AnotherPerspective on International Tax Competition,”Georgetown Law Journal, March 2001, p. 553.

126. European Parliament, “The Reform ofTaxation in EU Member States,” p. 10, www.europarl.eu.int/workingpapers/econ/default_en.htm.

127. Paul Starr, “The Meaning of Privatization,” YaleLaw and Policy Review 6 (1988): 6–41. See also GeoffreyBrennan and James Buchanan, The Power to Tax:Analytical Foundations of a Fiscal Constitution (Cambridge:Cambridge University Press, 1980).

128. Gary Becker, “What’s Wrong with a CentralizedEurope? Plenty,” Business Week, June 29, 1998.

129. Roin, p. 564.

130. Cited in “Not So Harmonious,” The Economist,March 31, 2001.

131. Roin, p. 559.

132. For a view regarding the United States lead-ing countries in the wrong direction with TRA86,see Stanford Ross, “International Tax Law: TheNeed for Constructive Change,” in Tax Policy in theTwenty-First Century, ed. Herbert Stein (New York:John Wiley & Sons, 1988), pp. 87–100.

133. Harry Grubert, “Tax Planning by Companiesand Tax Competition by Government,” inInternational Taxation and Multinational Activity, p. 120.

134. Alfons Weichenrieder, “Fighting InternationalTax Avoidance: The Case of Germany,” FiscalStudies (London: Institute for Fiscal Studies,1996), pp. 37–58.

135. KPMG, “Corporate Tax Rate Survey,” January

2002 and prior annual surveys, www.us.kpmg.com/microsite/Global_Tax/TaxFacts. This rateincludes the basic corporate income tax rate, now25 percent, plus a “trade tax.”

136. Weichenrieder, pp. 37–58.

137. OECD, Harmful Tax Competition, pp. 40, 41.

138. NFTC, part 1, p. xiv.

139. Dubert and Merrill, p. 85.

140. Helmar Klink, Netherlands ForeignInvestment Agency, “Dutch Tax Policy Lightensthe Burden on High-Tech Companies,”www.nfia.com.

141. NFTC, part 1, p. 6-6.

142. “Treasury Study to Look at Reincorporationof U.S. Multinationals in Foreign Countries,”Daily Report for Executives, March 1, 2002.

143. European Parliament, “Fact Sheet 3.4.9:Fiscal Policy and Taxation,” October 20, 2000.www.europarl.eu.int/factsheets.

144. European Parliament, “Fact Sheet 3.4.8.”

145. Ibid.

146. Ibid.

147. Cato calculations based on KPMG, “CorporateTax Rate Survey,” January 2002 and prior annualsurveys,www.us.kpmg.com/microsite/Global_Tax/TaxFacts.

148. European Parliament, “Tax Co-ordination in theEuropean Union.” This document lists some goodand bad aspects of tax competition, although we don’tthink most of the bad ones are really bad. For example,“tax competition makes it extremely difficult to pur-sue social and environmental objectives through thetax system” strikes us as a good thing.

149. Robert Lee, “Schroeder Calls for EU TaxPowers, www.tax-news.com, February 25, 2002.

150. “ECB Head Predicts Harmonisation Call,”Financial Times, January 24, 2002, p. 8.

151. “The French Plan Ideas Confirm Worst Fearsof Skeptics,” Daily Telegraph, May 29, 2001.

152. United Nations, Recommendations of the High-Level Panel on Financing for Development (New York:United Nations, June 22, 2001), www.un.org/reports/financing. See also Diana Gregg, “UNPanel Says Global Tax Organization Should BeExplored at 2002 Conference,” Bureau of

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National Affairs Daily Tax Report, July 6, 2001.

153. Charles McLure, “Globalization, Tax Rules andNational Sovereignty,” International Bureau ofFiscal Documentation Bulletin, August 2001, p. 341.

154. United Nations, Recommendations of the High-Level Panel on Financing for Development.

155. Ibid.

156. Ibid.

157. For an extensive collection of documentsregarding the OECD initiative, see www.freedo-mandprosperity.org.

158. OECD, Towards Global Tax Co-operation, p. 22.

159. For the U.S. tax system, the foreign sales cor-poration incentive is listed as a potentially harm-ful preferential tax regime.

160. European Parliament, “Tax Co-ordination inthe European Union,” p. xv, www.europarl.eu.int/workingpapers/econ/default_en.htm. Thestudy notes that “tax competition makes itextremely difficult to pursue social and environ-mental objectives through the tax system: forexample, income redistribution . . . only co-ordi-nation will prevent ‘free-loading.’”

161. U.S. Congress, Joint Economic Committee, “NewIRS Data on Income Tax Shares Now Available,” Pressrelease, January 14, 2002, www.house.gov/jec/. TheEconomist reports that the top 5 percent of incomeearners in Germany pay 40 percent of German incometaxes. “A Survey of the New Rich,” The Economist, June16, 2001, p. 9.

162. Amity Shlaes, “O’Neill Lays Out RadicalVision for Tax,” Financial Times, May 19, 2001, p. 1.

163. OECD, Harmful Tax Competition, p. 15.

164. European Parliament, “The Reform of Taxationin EU Member States,” p. 13, www.europarl.eu.int/workingpapers/econ/default_en.htm.

165. Lodin, “The Competitiveness of EU TaxSystems,” p. 167. With scheduled cuts, the averageEuropean corporate rate will be 29.5 percent bynext year. European Parliament, “The Reform ofTaxation in EU Member States.”

166. KPMG, “Corporate Tax Rate Survey,”January 2002, www.us.kpmg.com/microsite/Global_Tax/TaxFacts.

167. European Parliament, “The Reform ofTaxation in EU Member States,” pp. 55, 66, 95.

168. National Chamber Foundation and PriceWaterhouse, p. E-12.

169. Joumard, p. 29.

170. For a discussion of taxation and the cost ofcapital, see Joosung Jun, “Corporate Taxes andthe Cost of Capital for U.S. Multinationals,” inTaxing Multinational Corporations.

171. See Edwards, “Economic Benefits ofMarginal Rate Cuts.”

172. For a survey of the literature, see JamesAndreoni, Brian Erard, and Jonathan Feinstein,“Tax Compliance,” Journal of Economic Literature,June 1998.

173. For a summary of empirical estimates, seeEdwards, “Economic Benefits of Marginal Rate Cuts.”

174. For a full discussion and documentation ofthe debate, see www.freedomandprosperity.org.

175. Paul O’Neill, “OECD Harmful Tax PracticesInitiative,” Statement before the PermanentSubcommittee on Investigations of the SenateCommittee on Governmental Affairs, July 18, 2001.

176. Dick Armey, Letter to U.S. Treasury Secretary PaulO’Neill, March 16, 2002; and Letter to U.S. TreasurySecretary Lawrence Summers, September 7, 2000.

177. Bruce Zagaris, “Issues Low-Tax RegimesShould Raise When Negotiating with theOECD,” Tax Notes International, January 29, 2001,p. 524. See also Dan Mitchell, “An OECDProposal to Eliminate Tax Competition WouldMean Higher Taxes and Less Privacy,” HeritageFoundation, September 18, 2000, p. 20.

178. Langer. See also Reich, p. 9.

179. OECD, The OECD’s Project on Harmful TaxPractices.

180. O’Neill.

181. Proposed U.S. Treasury regulation REG-126100-00. The United States shares such informa-tion only with Canada currently. For background,see Institute for Research on the Economics ofTaxation (IRET), “IRET Congressional Advisory,”no. 116, June 28, 2001, www.iret.org.

182. U.S. Department of Commerce, Survey ofCurrent Business, March 2002, Table G.1.

183. Robert Davis, America’s CommunityBankers, Letter to Kate Hwa, IRS, Office ofGeneral Council, May 31, 2001.

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184. O’Neill.

185. Dan Mitchell, “Money-Laundering BillShould Target Criminals, Not Low Taxes,”Heritage Foundation, October 16, 2001.

186. Dan Mitchell, “U.S. Government AgenciesConfirm That Low-Tax Jurisdictions Are NotMoney Laundering Havens,” Prosperitas 2, no. 1(January 2002), www.freedomandprosperity.org.

187. Julie Wakefield, “Following the Money,”Government Executive, October 1, 2000, www. gov-exec.com. See also William Schroeder, “MoneyLaundering: A Global Threat and the InternationalCommunity’s Response,” Law Enforcement Bulletin70, no. 5 (May 2001); and United Nations,“Financial Havens, Banking Secrecy, and MoneyLaundering,” 1998, www.imolin.org/finhaeng.htm.

188. For a further discussion, see Mitchell, “AnOECD Proposal to Eliminate Tax CompetitionWould Mean Higher Taxes and Less Privacy.”

189. Armey.

190. U.S. Department of Commerce, Survey ofCurrent Business, March 2002, Table G.1. See alsoLanger, p. 665.

191. Arthur Wright, “Harmful Tax Competition:Response to Messrs. Osterweil and Francke,” TaxNotes, November 30, 1998.

192. This is a page count of the tax code, regula-tions, and related items. Commerce Clearinghouse,Inc., News release, January 14, 2000, www.cch.com,as updated in a May 2001 e-mail from CCH.

193. For example, a 1991 report by the NationalChamber Foundation and Price Waterhousefound that there were higher tax rates on U.S.firms’ foreign income than on foreign incomeearned by firms based in the U.K., Japan, or theNetherlands. See National Chamber Foundationand Price Waterhouse.

194. For a summary of studies on this and relatedissues, see Rosanne Altshuler, “RecentDevelopments in the Debate on Deferral,” Tax Notes,April 10, 2000. See also Harry Grubert, “DividendExemption,” Paper presented at BrookingsInstitution Conference on Territorial Taxation,April 30, 2001.

195. Glenn Hubbard and James Hines, “ComingHome to America: Dividend Repatriations by U.S.Multinationals,” NBER Working Paper 2931,April 1989, http://papers.nber.org.

196. Hubbard, “Comments on Sen. McCain’s Tax

Policy toward U.S. Multinationals,” p. 1435.

197. Bob Perlman, Testimony before the SenateFinance Committee, March 11, 1999.

198. This comment referred to the foreign tax creditrules in particular. American Bar Association, “TaxSimplification Recommenda-tions,” February 2001,www.abanet.org/tax/pubpolicy/2001/01simple/home.html.

199. Ibid.

200. Soon after passage of TRA86, experts realized thatmany of the new tax rules would damage the ability ofU.S. firms to compete in world markets. For example,a 1991 Ernst & Young report concluded, “The UnitedStates subjects the foreign operations of its multina-tionals to the severest constraints and the heaviest taxburden of any of the four countries studied [theUnited States, Germany, Japan, and the Netherlands].”Ernst & Young, “The Competitive Burden: TaxTreatment of U.S. Multinationals,” Tax FoundationSpecial Report, 1991, p. 2.

201. National Chamber Foundation and PriceWaterhouse. Problems include interest and R&Dallocation rules, the fact that foreign govern-ments allow tax deferral for a wider scope of sub-sidiary activities, the foreign tax credit basket sys-tem, the general complexity of U.S. rules, and alack of U.S. provisions for tax sparing.

202. NFTC, part 1, p. viii.

203. Ibid., part 1, p. 6-2.

204. In 1994, U.S. CFCs were financed 77 percentby foreign debt, equity, and reinvestment of for-eign earnings. U.S. Department of Commerce,U.S. Direct Investment Abroad, 1994 BenchmarkSurvey, January 1997.

205. For example, 63 percent of U.S. exports are asso-ciated with U.S. multinational corporations. SeeDepartment of Commerce, Survey of Current Business,March 2002, p. 24. See also David Riker and LaelBrainard, “U.S. Multinationals and Competition fromLow Wage Countries,” NBER Working Paper 5959,March 1997, http://papers. nber.org

206. Department of Commerce, Survey of CurrentBusiness, March 2002, p. 24. See also NFTC, part 1,p. 6-14.

207. Perlman.

208. NFTC, part 1, p. 6-21.

209. Ian Springsteel, “No Place to Hide?” CFOMagazine, February 1, 2001, www.cfo.com.

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210. “Treasury Study to Look at Reincorporationof U.S. Multinationals in Foreign Countries.”

211. Dubert and Merrill, p. 78.

212. Ibid., p. 75.

213. Gary Hufbauer, “A Critical Assessment andan Appeal for Fundamental Tax Reform,”Institute for International Economics, March 11,2000, www.iie.com.

214. Ture and Carlson.

215. Ibid., p. 23.

216. One modest step toward territoriality wouldbe “tax sparing” for U.S. investments in develop-ing countries. Most other wealthy countries,including Japan, Germany, and Britain, havesome form of tax sparing, which exempts busi-nesses from tax on investments in low-incomecountries to encourage them to adopt tax cuts.For example, under tax sparing if a developingcountry adopted a 10 percent corporate tax, U.S.investors would benefit from the low rate’s pro-viding an added investment incentive. Under cur-rent law, the United States imposes the 35 percentcorporate tax on foreign income, thus reducingthe incentive effect of the lower foreign rate. Taxsparing would allow developing countries to growtheir economies with private investment insteadcontinuing to rely on foreign aid subsidies. SeeJames Hines, “Tax Sparing and Direct Investmentin Developing Countries,” in International Taxationand Multinational Activity, p. 41.

217. Other consumption-based tax plans include aconsumed-income tax proposed by the Institute forResearch on the Economics on Taxation. See IRET,“The Inflow-Outflow Tax—A Savings-DeferredNeutral Tax System,” http://www.iret. org. Rep. PhilEnglish (R-Pa.) has introduced H.R. 86, which is asimplified “USA Tax.” See Chris Edwards,“Simplifying Federal Taxes: The Advantages ofConsumption-Based Taxation,” Cato InstitutePolicy Analysis no. 416, October 2001.

218. A national retail sales tax may need a some-what higher rate than a flat tax. The particularrate depends on the size of the exemption provid-ed to low-income families and other factors. SeeGary Robbins and Aldona Robbins, “Which TaxReform Plan? Developing Consistent Tax Basesfor Broad-Based Tax Reform,” Institute for PolicyInnovation Policy Report no. 135, January 1996.

219. James Hines, “Fundamental Tax Reform inan International Setting,” Paper presented at theBrookings Institute Conference on the EconomicEffects of Fundamental Tax Reform, February15–16, 1996, p. 26.

220. For example, Harry Grubert and ScottNewlon conclude that under a consumption tax,“MNCs would likely shift tangible investment,intangible assets, and R&D to the United States.”Harry Grubert and Scott Newlon, “TheInternational Implications of Consumption TaxProposals,” U.S. Department of the Treasury,September 13, 1995, p. 2.

221. Hines, “Fundamental Tax Reform in anInternational Setting,” p. 23.

222. Ibid., p. 26.

223. U.S. International Trade Commission,Implications for U.S. Trade and Competitiveness of aBroad-Based Consumption Tax, Publication 3110,June 1998, p. 21, www.usitc.gov.

224. Another way to describe this difference is to saythat a retail sales tax is a “destination-based” tax,whereas the flat tax is an “origin-based” tax. Note thatroyalty and leasing receipts received from abroad maybe considered U.S. exports and therefore taxed under aflat tax. For a full discussion of these issues, see HarryGrubert and Scott Newlon, Taxing Consumption in aGlobal Economy (Washington: American EnterpriseInstitute Press, 1997).

225. U.S. International Trade Commission, p. 2. For adifferent view, see Ernest Christian, “The InternationalComponents of Tax Reform,” Institute for PolicyInnovation Policy Report no. 66, February 2002.

226. U.S. International Trade Commission.

227. J. D. Foster, “U.S. International Tax Policy:Tax Neutrality or Investment Protectionism?”Tax Foundation, November 1994, p. 13.

228. Lyon, p. 20.

229. Hines, “Fundamental Tax Reform in anInternational Setting,” pp. 19, 20, 21.

230. Ibid., p. 23.

231. Lyon, p. 23.

232. Ibid., p. 19.

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