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No.

431 April 12, 2002

International Tax Competition


A 21st-Century Restraint on Government
by Chris Edwards and Veronique de Rugy

Executive Summary

Globalization is knitting separate national hugely complex and affect the ability of U.S. com-
economies into a single world economy. That is panies to compete in world markets. Other defen-
occurring as a result of rising trade and invest- sive responses to tax competition include proposals
ment flows, greater labor mobility, and rapid to harmonize taxes across countries and to restrict
transfers of technology. countries from offering tax climates that are too
As economic integration increases, individuals hospitable to foreign investment inflows.
and businesses gain greater freedom to take advan- Those defensive responses to tax competition
tage of foreign economic opportunities. That, in are a dead end. They do nothing to promote eco-
turn, increases the sensitivity of investment and nomic growth or reform inefficient tax systems. A
location decisions to taxation. Countries feel pres- more constructive response to tax competition
sure to reduce tax rates to avoid driving away their would be to learn from foreign reforms and adopt
tax bases. International “tax competition” is pro-growth tax policies at home. The United
increasing as capital and labor mobility rises. States should be a leader but has fallen behind on
Most industrial countries have pursued tax tax reform. For example, the United States now
reforms to ensure that their economies remain has one of the highest corporate tax rates among
attractive for investment. The average top per- major nations. The chairman of the president’s
sonal income tax rate in the major industrial Council of Economic Advisers, Glenn Hubbard,
countries of the Organization for Economic believes that “from an income tax perspective, the
Cooperation and Development has fallen 20 per- United States has become one of the least attrac-
centage points since 1980. The average top cor- tive industrial countries in which to locate the
porate income tax rate has fallen 6 percentage headquarters of a multinational corporation.”
points in just the past six years. As international capital and labor mobility
Rising tax competition has caused governments rises, the risks associated with not having an effi-
to also adopt defensive rules to prevent residents cient federal tax structure increase. This country
and businesses from enjoying lower tax rates should respond to rising tax competition by mov-
abroad. In the United States, such tax rules are ing toward a low-rate consumption-based system.

_____________________________________________________________________________________________________
Chris Edwards is director of fiscal policy studies and Veronique de Rugy is a policy analyst at the Cato Institute.
High taxes on system would be more efficient if
capital create an Introduction these other factors were instead
taxed directly. 2
increasing drag In past decades, many governments
on growth as cap- shunned inflows of foreign investment and Two centuries ago Adam Smith similarly
restricted their citizens’ investments abroad. recognized that heavy taxes on mobile
ital mobility But a sea change in political attitudes toward “stock,” or capital, would cause a loss to
increases. foreign investment has occurred since the workers and the economy:
1970s. Most governments today actively
encourage inflows of foreign investment Secondly, land is a subject which
because they recognize that it is a key factor cannot be removed, whereas stock
in maximizing economic growth. easily may. The proprietor of land is
Foreign investment exploded with the necessarily a citizen of the particular
removal of capital controls and the deregula- country in which his estate lies. The
tion of financial markets in major economies proprietor of stock is properly a citi-
in the 1970s and 1980s. Many developing zen of the world, and is not necessar-
countries followed suit in the 1990s. Reforms ily attached to any particular coun-
included allowing foreign currency exchange, try. He would be apt to abandon the
allowing the purchase of foreign securities, country in which he was exposed to a
and allowing foreigners to buy domestic vexatious inquisition, in order to be
securities and acquire domestic firms. As has assessed to a burdensome tax, and
been widely observed, advances in technolo- would remove his stock to some
gy and communications have spurred capital other country where he could either
and labor flows, with the Internet and other carry on his business, or enjoy his
tools opening up global investment and fortune more at his ease. By remov-
work options for individuals and businesses. ing his stock he would put an end to
High tax rates are more difficult to sus- all the industry which it had main-
tain in the new economic environment. That tained in the country which he left.
is particularly true for taxes on capital, which Stock cultivates land; stock employs
include taxes on business profits and taxes labour. A tax which tended to drive
on individual receipts of dividends, interest, away stock from any particular coun-
and capital gains. Basic economic theory sug- try, would so far tend to dry up every
gests that high taxes on capital create an source of revenue, both to the sover-
increasing drag on growth as capital mobili- eign and to the society. Not only the
ty increases. High taxation of capital causes profits of stock, but the rent of land
capital flight, thus reducing domestic pro- and the wages of labour, would nec-
ductivity, wages, and incomes. 1 Martin essarily be more or less diminished
Feldstein, James Hines, and Glenn Hubbard, by its removal.3
the chairman of president’s Council of
Economic Advisers, have made that point What is new since Smith’s time is the greater
with respect to the corporate income tax: ability of corporations and individuals to move
themselves and their investments across bor-
Many economists argue that it is ders. In closed economies, high taxes on capital
inefficient to use corporate income income and skilled workers stunt economic
taxes to raise revenue in open growth. As economies open up, such bad tax
economies. If capital is internation- policy causes even larger economic losses due to
ally mobile, the burden of corporate greater impacts on investment and labor flows.4
taxes falls largely on other immobile As a result, tax competition is becoming more
factors (such as labor), and the tax important all the time.

2
Tax competition may be broadly defined to achievement of redistributive goals.”9
include the tax policy influence that countries Like many of the OECD report’s argu-
exert on each other. If neighboring countries ments, that one is internally contradictory.
are prospering under low tax rates, citizens Redistribution involves taxing some people
and policy experts may demand the same at high rates and others at low rates. The “free
from their own government. Consider Ireland. riders” would seem to be the latter group,
In 2000 that small country of 3.8 million peo- who pay a less than proportionate share of
ple attracted more foreign direct investment their income in taxes. In our view, interna-
(FDI) than either Japan or Italy.5 The main tional tax competition may indeed hamper
draw for foreign investors has been a 10 per- income redistribution, but that is a beneficial
cent corporate tax rate on manufacturing, outcome because redistribution has pro-
financial services, and other activities.6 As a gressed to a remarkably high degree in most
result, Ireland has boomed and now has one of industrial countries. 10
the highest standards of living in the world.7 A In addition to OECD and other interna-
United Nations report called Ireland “the tional efforts to dampen tax competition,
most dynamic country in the developed world governments are taking numerous defensive
in terms of recent growth and competitive per- measures on their own. For example, they are
formance” and hailed its change from “a back- imposing layers of complex tax rules on the Opposition to
ward low-productivity economy into a center foreign operations of corporations. In this international tax
of technology-intensive manufacturing and regard, the United States enacted its “subpart competition is
software activity.”8 F” regime in 1962 and has beefed up those
But such tax cut success stories concern rules a number of times since. Other coun- wrapped in the
some economists who view tax competition tries have followed suit with similar rules language of eco-
as distortionary. It is thought that if different designed to limit the benefits of investment
tax rates cause capital and labor to migrate in foreign countries that have lower taxes.
nomics but seems
across borders, those resources may not end But the U.S. rules are usually considered the to stem mainly
up in their most productive uses. So Ireland most complex, and they damage the ability of from political
is receiving “too much” investment because U.S. companies to compete abroad. Such
of its low tax rates, according to that view. rules are merely Band-Aids that cover the concerns.
But that loses sight of a larger issue: high tax need for more fundamental tax reforms.
rates shackle economic growth. Thus, to the This study examines the growth of global
extent that tax competition creates pressure capital and labor mobility, the global fall in
to reduce tax rates globally, all countries gain tax rates since the 1980s, the basics of U.S.
from increased growth and higher incomes. international tax rules, the responsiveness of
Opposition to international tax competi- investment flows to taxation, tax competi-
tion is wrapped in the language of economics tion theory, and government responses to tax
but seems to stem mainly from political con- competition. It concludes by examining poli-
cerns. In particular, some people worry that cy options for the United States, including
tax competition reduces governments’ ability replacing the individual and corporate
to redistribute income. When borders are income taxes with a low-rate consumption-
opened, businesses and individuals that are based tax system.
taxed heavily to pay for redistribution will
rationally look to better locations for work-
ing and investing. A high-profile 1998 report Growing Capital and Labor
from the Organization for Economic Mobility
Cooperation and Development on “harmful
tax competition” calls such tax avoidance Capital Mobility
behavior “free riding” that “may hamper the World economies have become more
application of progressive tax rates and the tightly integrated in recent decades. Rapid

3
Technology and growth in cross-border investment has been a kets have been deregulated around the world,
deregulation have key dimension of that integration. In past making them more attractive to foreign
decades, many countries erected barriers to investors. Coincident with that trend, large
worked in a virtu- foreign investment, but today most countries selloffs of state-owned companies increased
ous circle to spur realize that foreign investment means new investment opportunities in many formerly
jobs, new factories, and access to leading- closed economies.
international tax edge technology. As a result, governments Technology has also greatly boosted
competition. have removed the shackles they once placed investment flows. Dramatic reductions in
on international investment flows. communication and transportation costs,
Since the 1970s most countries have elimi- huge gains in computer power, and the rise
nated foreign exchange controls. 11 With the of the Internet have facilitated rising capital
widespread adoption of floating currency flows. 13 Richard McKenzie and Dwight Lee
exchange rates, countries were able to open explored those trends in their 1991 book,
their borders to free flows of investment capi- Quicksilver Capital.14 More recently, Vito Tanzi
tal, while still maintaining independent mon- described how globalization has combined
etary policies. Other deregulatory actions have with new technologies, such as electronic
also promoted investment flows. For example, commerce, to create “fiscal termites” that
hundreds of bilateral investment treaties have oblige governments to reduce tax rates so as
been signed to reduce investment barriers. A to retain their tax bases.15
United Nations report found that 95 percent Technology and deregulation have worked
of government FDI rules in the 1990s were in in a virtuous circle to spur international tax
the direction of deregulation.12 Financial mar- competition. For example, containerized ship-

Figure 1
World Foreign Direct Investment Flows

$1,400
$1,271

$1,200
$1,075

$1,000

$800
$693

$600
$478
$385
$400 $331

$204 $208 $226


$158 $168
$200

$-
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

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

4
Figure 2
World Foreign Portfolio Investment Flows

$1,600
$1,476
$1,433
$1,400

$1,200
$1,016
$1,000
$876
$782
$800
$642
$600 $517
$396 $402 $379
$400
$219
$200

$-
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

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 and
outflows.

ping has increased global transportation effi- than 10 percent) in any one company. Countries must
ciencies. That has coincided with reductions Portfolio investment is more volatile than work hard to pro-
in international trade barriers. Together, those direct investment and is usually undertaken
trends allow production in many industries to with shorter-term investment goals in mind. vide a competi-
be placed nearly anywhere in the world with World direct investment flows soared to tive business cli-
goods shipped cheaply to the final destina- $1.3 trillion in 2000, up from just $204 bil-
tion. As a result, countries must work hard to lion in 1990 (Figure 1). World portfolio
mate for global
provide a competitive business climate for investment flows increased to $1.4 trillion in corporations
global corporations scouting for new factory 2000, up from $219 billion in 1990 (Figure scouting for new
locations. 2). Foreign investment flows were down in
There have been dramatic increases in both 2001 because of the global economic slow- factory locations.
FDI and foreign portfolio investment. Direct down. In recent years, direct and portfolio
investment refers to investments by multina- investment, on net, has flowed out of Europe
tional corporations that result in a large own- and Japan and into the United States and
ership stake (more than 10 percent) in a for- fast-growing developing countries. 17 Figures
eign company, called an affiliate.16 Foreign 3 and 4 show the growth in direct and port-
affiliates may be established by creating a new folio investment flows to and from the
company or acquiring an existing company. United States. 18
Direct investments are usually made with Direct investment flows allow multina-
long-term investment goals in mind. tional corporations to establish global pro-
By contrast, foreign portfolio investment duction and sales networks. One-third of the
refers to financial investments that do not sales of the 500 largest U.S. companies is now
result in large ownership stakes (no more from their foreign affiliates.19 Those affiliates

5
Figure 3
U.S. Foreign Direct Investment Flows

350

300

Inflows
250

200

150

Outflows
100

50

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

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

serve as conduits for the movement of U.S. they do not have full information about for-
exports into foreign markets.20 U.S. corpora- eign markets.26 Therefore, it seems likely that
tions had about 24,000 foreign affiliates in we are at just the beginning of a long process
1998, up 40 percent from a decade earlier.21 of global integration and that economic
The bulk of those affiliates are in high- forces and technology will continue to drive
income industrial countries, not developing foreign investment flows even higher.
countries or tax havens.22 Globally, there are
now about 60,000 multinational corpora- Taxation and Capital Flows
It seems likely tions with 500,000 foreign affiliates.23 To attract foreign investment, countries
Portfolio investment flows have risen as must first get the economic fundamentals
that we are at just countries have expanded their stock markets, right. They need to establish a stable curren-
the beginning of debt has become securitized, and financial cy, have reliable legal rules to prevent expro-
a long process wealth holdings have risen. The Internation- priation of assets, and have liquid and trans-
al Monetary Fund reports that global assets parent financial markets. For example, an
of global managed by institutional investors topped unstable currency caused by loose monetary
integration. $30 trillion by 1998, having doubled since policy gives a clear signal to potential
1990.24 Market capitalization of foreign investors that a devaluation, which would
firms on the New York Stock Exchange is threaten to reduce the value of any profits
more than $3 trillion.25 made in that currency, is likely.
Despite the large volumes of cross-border Dozens of formerly socialist countries in
investment flows, research has suggested Latin America, Asia, and Eastern Europe have
that world capital markets are still far from begun to get the economic fundamentals
fully integrated. For example, investors have right in the past two decades. Many industrial
substantial “home-country bias” because countries have also made substantial market

6
Figure 4
U.S. Foreign Portfolio Investment Flows

500

450

400
Inflows
350

300

250

200

150

100
Outflows
50

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

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).

reforms. As a consequence, tax policy has risen Michigan Business School concludes that Empirical
in importance as a factor influencing global “recent evidence indicates that taxation sig-
investment flows. That is, as nontax factors nificantly influences the location of FDI, cor-
research finds
become more equalized between countries, tax porate borrowing, transfer pricing, dividend that FDI is
competition becomes more intensive. and royalty payments, and research and becoming more
Consider business location decisions. development performance.”28
Traditionally, an important reason to invest A study by Rosanne Altshuler, Harry sensitive to
abroad was to gain access to fixed resources, Grubert, and Scott Newlon found that U.S. taxation.
such as oil deposits. Today, more industries are multinationals became more sensitive to
footloose and can be located just about any- taxes on FDI between 1984 and 1992.29 For
where. Finance and services, for example, are the 1992, their results suggest that countries
two fastest growing areas of U.S. direct invest- with tax rates 10 percent higher than those of
ment aboard.27 Also, an increasing share of other countries received 30 percent less U.S.
product value is in the form of intangibles such FDI, controlling for other factors. Results
as knowledge, trademarks, and patents. The from other studies have found lower but still
profits from intangibles may be easily moved to substantial behavioral responses. The
low-tax countries. As a result, corporations are authors note that “most recent studies indi-
much more sensitive to different countries’ tax cate that taxes exert a strong influence on
rates today than they were previously. location decisions.”30
Indeed, empirical research finds that FDI Similarly, a recent IMF study found “strong
is becoming more sensitive to taxation. In a evidence” that direct investment flows are affect-
new compilation of studies on the issue, edi- ed by tax systems.31 The study’s results showed
tor James Hines of the University of that lower-tax countries had larger inflows of FDI

7
International tax than did the higher-tax countries examined. Four ed by mobile labor as well as mobile capital.
competition is European countries with favorable tax regimes— While national borders impose large barriers
Ireland, the Netherlands, Luxembourg, and to the free movement of persons, technologi-
generated by Switzerland—accounted for 9 percent of cal advances, regional trading zones, and
mobile labor as European GDP but attracted 38 percent of U.S. greater information about foreign opportu-
well as mobile FDI to Europe between 1996 and 2000.32 nities are creating rising cross-border labor
Evidence also indicates that taxes affect FDI flows flows. That is particularly the case for highly
capital. at the subnational level. One recent study found skilled labor in industries such as high-tech
that U.S. states with higher taxes attract fewer and finance. Countries sharing a common
new investments and plant expansions from for- language and culture, such as Canada and
eign corporations than do lower-tax states.33 the United States, may expect to feel the
Portfolio investment flows have also strongest tax competition pressure.
become more responsive to taxes. A recent Millions of people migrate each year for
IMF report noted that “amid widespread nonfinancial reasons, such as family reunifi-
capital account liberalization and increased cation or to escape from oppressive political
reliance on securities markets, these regimes. An analysis by the OECD found
investable funds became increasingly respon- that, while family and political factors
sive to changing opportunities and risks in a remain important causes for migration, there
widening set of regions and countries.”34 has been a rise in migration for economic rea-
Portfolio flows can be shifted in and out of sons. 37 One of those reasons is personal taxes,
foreign investments quickly and are more which vary substantially between countries,
sensitive to short-term returns than is FDI. particularly for people with high incomes.
Many countries have eliminated taxation Income taxes in most countries have margin-
altogether on certain inflows of portfolio al rates that rise with income, so it is the most
investment because of increased tax sensitivi- skilled workers with the highest incomes
ty. For example, the United States eliminated who are most responsive to tax competition.
taxation of portfolio interest earned by for- Numerous factors have increased the
eigners in the early 1980s for that reason. importance of taxes to international migra-
The effect of tax competition on portfolio tion. First, the Internet has increased infor-
investment flows is being felt intensely in the mation about foreign opportunities and
European Union. High-tax countries such as allowed firms to broaden international job
Germany and Sweden have had substantial searches. Second, falling travel and commu-
outflows of savings, often not reported to nication costs have made it easier for workers
authorities, to lower-tax EU countries.35 A 10 to take employment in foreign countries and
percent German withholding tax on domestic maintain close contact with relatives. Third,
interest payments was introduced in 1989 and emigration restrictions in many formerly
“caused a massive movement of funds to repressive regimes have been eliminated.
Luxembourg.”36 The tax was abolished. The A fourth trend is the increased technological
adoption of the euro has intensified tax com- ability to perform work in foreign countries
petition pressures because it eliminates cur- while residing elsewhere. The Internet allows
rency risk and narrows interest rate differen- software writers and other professionals to earn
tials across Europe. The introduction of the wages anywhere in the world and remain con-
euro adds to the pressure for tax competition nected to customers electronically, while living
created by prior reforms, such as the removal in countries with attractive tax climates.
of internal migration barriers in 1992, which Fifth, regional trading pacts have allowed
increased pressure to reduce tax rates on labor. increased worker mobility. The EU allows
complete mobility for workers in member
Labor Mobility countries. The North American Free Trade
International tax competition is generat- Agreement allows for some increased mobili-

8
ty of skilled professionals. Labor mobility each skilled American who moves to Canada
often increases as a side effect of trade agree- there are six Canadians who migrate to the
ments because trade and investment flows United States under this visa category. 45
are facilitated by the cross-border movement Canadian studies have identified the differ-
of technicians and managers. 38 ences in tax rates as an important factor caus-
Sixth, a number of countries have raised ing the brain drain.46
immigration limits for highly skilled work- Anecdotal evidence of the brain drain has
ers. 39 In the United States, the H1-B annual substantially affected Canadian tax debates.
work visa limit for skilled professionals was John Roth, when he was head of Canada’s
substantially increased until 2003.40 Some top high-tech firm, Nortel, routinely warned
countries, notably Canada, have tilted their the Canadian government that tax rates
immigration systems toward people who are needed to be cut because his best engineers
highly skilled or have money to invest. In and managers were moving to the United
addition, many countries have signed bilater- States, often to work for Nortel’s U.S. opera-
al immigration and tax treaties, which ease tions. 47 Roth also noted that when top man-
immigration and prevent double taxing of agers left, they often took some of their best
labor income.41 workers with them.
The success of immigrants in the high-tech Since the removal of internal migration Corporate tax
sector illustrates the gains that accrue to the restrictions in the EU in 1992, Europeans have cuts, followed by
U.S. economy as a result of encouraging those also become more sensitive to tax differences individual tax
with high skill levels to immigrate. One study between countries. Although there are still
found that Chinese and Indian immigrants large language and cultural barriers to migra- cuts, reversed the
were running 24 percent of Silicon Valley tion within Europe, there has been an influx Irish migration
high-tech firms in 1998.42 Other studies have of young, skilled workers to cities, such as
found that some immigrant groups, includ- London, with more opportunities and lower
pattern.
ing Koreans and Middle Easterners, have taxes, particularly in fields such as technology
strong propensities to start businesses.43 The and finance. London’s workforce is about 23
message to policymakers is that building an percent foreign, and many of those workers
attractive economic climate with low tax rates are from higher-tax France.48 About 500,000
can give the economy a substantial boost from French citizens now live in Britain, and hun-
highly skilled imported labor. dreds of high-growth entrepreneurial French
companies have moved to Britain in recent
Taxation and Labor Flows years.49 A French government report notes
In a world where the cost of and restrictions that a large share of the country’s engineering
on labor mobility are falling, citizens dissatis- graduates leaves the country each year and
fied with government benefits received com- that 40,000 French high-tech workers have left
pared to taxes paid can vote with their feet and to work in Silicon Valley.50
move to more favorable economic climates. Ireland is another interesting case study of
Because nonfinancial factors play a large role in taxes and migration. For years, many young
immigration, we expect to see the largest effects Irish, who were English speaking and often
of tax competition when those other factors are well educated, sought a better life in England
equalized. A good example is the tax competi- or the United States. But corporate tax cuts,
tion pressure on Canada from its lower-tax followed by individual tax cuts, reversed the
neighbor, the United States. Irish migration pattern. Ireland now has
The Canadian “brain drain” to the United record net immigration of more than 20,000
States has been a top concern of Canadian annually, caused by a marked increase in
policymakers. 44 NAFTA intensified labor immigration and a fall in emigration during
mobility with a new work visa for skilled pro- the past decade.51 The Irish brain drain was
fessionals called “TN.” It is estimated that for plugged with tax cuts.

9
International tax competition with give them incentives to take their skills and
respect to labor is highly visible in the high- investment capital elsewhere.
paid celebrity world of musicians, models,
actors, and sports stars. In 1999 French
supermodel Laetitia Casta was selected to be Global Reduction in
the new Marianne, the country’s national Tax Rates
symbol of virtue and beauty. But soon after,
Casta became notorious by moving to The vast majority of industrial nations
Britain to escape high French taxes. Casta have reduced their personal and corporate
was not alone. Many top French soccer and income tax rates since the 1980s. The average
tennis players, artists, and models have top corporate tax rate for national govern-
moved to Switzerland, Britain, the United ments in the OECD fell from 41 percent in
States, and elsewhere. Tax avoidance has long 1986 to 32 percent in 2000 (Table 1). The U.S.
been a popular game among celebrities in federal rate is 35 percent. A new survey by the
Europe. Luciano Pavarotti long claimed resi- accounting firm KPMG, which takes into
dence in Monte Carlo but was chased down account both national and subnational taxes,
by the Italian government for $12 million in found that the average 40 percent U.S. federal
unpaid taxes.52 Tennis star Boris Becker, who and state corporate rate combined is almost 9
claimed residence in Monaco and later percentage points higher than the OECD
Switzerland, has had trouble with the average in 2002 of 31.4 percent (Table 2).
German tax authorities. 53 The average top national individual
Although the United States has generally income tax rate in OECD countries fell from
been a beneficiary of skilled labor migration, it 55 percent in 1986 to 41 percent by 2000.57
cannot rest on its laurels. As noted, other That rate is comparable to the current top U.S.
major economies have cut income tax rates in federal rate of 38.6 percent, which is scheduled
recent years. If foreign skilled professionals to fall to 35 percent by 2006.58 The annual
stay home because of tax cuts in their home Economic Freedom of the World report, which
countries, the United States loses brainpower. includes both national and subnational taxes,
And U.S. emigration for tax reasons may be found that the average top individual tax rate
increasing, although accurate numbers are in OECD countries fell from 67 percent in
not available. Somewhere between 1 and 6 1980 to 47 percent by 2000 (Table 3).59
million Americans live abroad.54 Unfortu- Capital gains taxes have also been cut in
nately for them, the United States is one of numerous countries. For example, Canada
The vast majority just a small handful of countries that tax their cut its capital gains income inclusion from
citizens’ foreign earnings (above an exemption 75 percent to 50 percent in 2000, thus reduc-
of industrial amount) even when they live abroad.55 As a ing the effective gains rate to half of the ordi-
nations have consequence, some Americans living abroad nary marginal tax rate.60 In many countries
reduced their per- have renounced their U.S. citizenship to avoid such efforts have been spurred by the desire
U.S. taxes. The federal government responded to emulate U.S. high-tech success, which was
sonal and corpo- in 1996 with a law that taxes earnings of such fueled by investment sensitive to capital
rate income tax individuals for 10 years after they have given gains taxes, including “angel” financing, ven-
up their citizenship.56 Chasing after ture capital, and public stock offerings.61
rates since the Americans living abroad seems an overly Note that a number of countries, such as the
1980s. aggressive and unfair tax policy that misses Netherlands, New Zealand, Hong Kong, and
the point that U.S. tax rates are too high and Taiwan, generally do not tax capital gains.62
should be reduced in accordance with foreign Corporate capital gains taxes are also an
trends. The United States should adopt tax important tax factor. The Netherlands, for
rates that encourage workers and high-wealth example, does not tax corporate capital gains,
individuals to remain resident, rather than thus reducing taxes on corporate restructur-

10
Table 1
Top Corporate Income Tax Rates (percent), 1986–2000 (national-level taxes only)

Change
Country 1986 1991 1995 2000 1986–2000

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

Average for 26
OECD countries 41 35 33 32 -9

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

ings. That and other tax factors make the installed dual income tax systems that fea- A group of
Netherlands a good location for holding com- ture a low flat rate on capital income (inter-
panies and multinational headquarters. 63 est, dividends, and capital gains) but retain Nordic countries
Germany’s recent corporate tax reforms abol- progressive rates on labor income. Denmark, has installed dual
ished its 50 percent capital gains tax on sales Finland, Norway, and Sweden implemented income tax sys-
of stakes in other companies because of com- such reforms a decade ago. The Netherlands
petitiveness concerns. Those reforms prompt- and Austria have recently enacted similar tems that feature
ed the European Union to express concern reforms, and other European countries have a low flat rate on
that this may constitute “unfair tax competi- moved in that direction.65 The OECD notes
tion” because it will attract foreign holding that those “moves toward a lower and flat tax
capital income.
companies to Germany.64 on capital income have often reflected the
Tax competition has spurred other tax need to remain competitive on the interna-
reforms. A group of Nordic countries has tional capital markets.”66 Dual income tax

11
Table 2
Top Corporate Income Tax Rates (percent), 1996–2002
(national and state or provincial taxes)

Change
Country 1996 1997 1998 1999 2000 2001 2002 1996–2002

Australia 36.0 36.0 36.0 36.0 36.0 34.0 30.0 -6


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

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

has driven down Source: KPMG, “Corporate Tax Rate Survey,” January 2002, www.us.kpmg.com/microsite/Global_Tax/TaxFacts.
withholding taxes
on payments to systems with lower tax rates on capital lect those redistributionist taxes. In the
foreigners of income are a constructive response to the 1990s Norway and Sweden reduced their
interest, divi- widespread tax avoidance and evasion that wealth taxes, and Denmark, the Netherlands,
have occurred under Europe’s high tax rates. Austria, and Germany abolished them.67 One
dends, and other Another policy response to tax competi- survey of 19 countries found that the average
investment tion has been the reduction and elimination wealth tax has fallen 40 percent since the
returns. of special taxes on wealth in Europe. Capital mid-1980s. 68
mobility has undermined the ability to col- Tax competition has also driven down with-

12
Table 3
Top Personal Income Tax Rates (percent), 1980–2000
(national and state or provincial taxes)

Change
Country 1980 1985 1990 1995 2000 1980–2000

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

Average for 26
OECD 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.
Britain and the
holding taxes on payments to foreigners of inter- 35 percent and the United States followed in
United States
est, dividends, and other investment returns. 1986 by cutting its rate from 46 to 34 per- jump-started the
Withholding taxes create an investment disincen- cent. Substantial cuts followed in Australia worldwide move
tive by placing an “exit fee” on repatriated earn- in 1988, Canada between 1986 and 1988,
ings. For example, businesses are dissuaded from France between 1986 and 1993, Germany in toward lower tax
building factories in countries that place a high 1990, and Japan between 1989 and 1991.70 rates in the 1980s.
tax on repatriated dividends. One survey of 19 Both the direct threat of a disappearing
major economies found that the withholding tax tax base and general intellectual trends led to
on bank interest has been more than cut in half in those reforms. Countries that have close eco-
the past decade.69 nomic ties will naturally respond more
Britain and the United States jump-start- strongly to each other’s tax reforms. After the
ed the worldwide move toward lower tax 1986 U.S. tax cut, Canadian policymakers
rates in the 1980s. Between 1982 and 1986 were very concerned that U.S. corporations
Britain cut its corporate tax rate from 52 to would shift profits from their high-tax

13
Corporate tax Canadian subsidiaries back to their U.S. par- excessive regulation. For example, Indonesia
rates have been ent companies. 71 They could do that fairly and India frequently offer such tax incentives
easily by increasing their debt financing in to lure investment and yet rank 72nd and
recently cut in their Canadian subsidiaries to shift taxable 92nd, respectively, in the world in terms of
Australia, income out of Canada. As a consequence, basic economic freedoms. 79
Germany, Canada moved quickly to cut its corporate In summary, tax competition has caused
tax rate to avoid losing its tax base. substantial cuts in individual and corporate
Canada, and Since the mid-1990s, another round of statutory income tax rates. Other reforms
Denmark. marginal rate cuts has occurred. Major have included reductions in wealth taxes;
economies that have reduced top personal tax withholding taxes; and taxes on individual
rates in recent years include Germany, the interest, dividends, and capital gains.
Netherlands, and the United States. Although those reductions in tax rates have
Corporate tax rates have been recently cut in been very beneficial, tax competition has not
Australia, Germany, Canada, and Denmark.72 yet reduced overall tax levels in most coun-
For example, Canada is phasing in a cut of its tries. Total taxes as a percentage of GDP rose
federal corporate rate from 28 percent in 2000 from 32.1 percent in 1980 to 37.3 percent by
to 21 percent by 2004.73 1999, on average, in the OECD countries.80
Note that, with regard to the corporate Therefore, international tax competition has
income tax, the statutory rate is just one fac- not yet caused Big Government to melt away.
tor in the attractiveness of a business tax cli- That is due in part to the numerous defensive
mate. The overall, or effective, marginal tax measures governments have taken to protect
rate is affected by depreciation deductions, their tax bases, including the enactment of
investment credits, and other provisions. complex tax rules on income earned abroad.
Effective corporate tax rates have fallen in the
OECD countries in recent years, but not by as
much as statutory rates.74 Nonetheless, U.S. International Tax Rules
statutory rates are the relevant tax factor to and Their Effects
consider in making many corporate deci-
sions. For example, tax advantages gained by Theories of International Taxation
shifting corporate borrowing between coun- With regard to domestic taxation, econo-
tries depend on statutory rates. 75 As one mists support more neutral tax systems that
study found, “Reported income of corpora- allow investment to flow to the highest-val-
tions can be highly elastic with respect to the ued uses. Taxation can distort neutrality by
statutory tax rate since income can be easily favoring some investments over others or by
shifted from one tax jurisdiction to another favoring consumption over investment.
without moving real assets.”76 However, neutrality can have a number of
In addition to broad-based tax cuts, some different meanings in an international con-
governments offer special narrowly focused text, thus making the choice of the most effi-
tax breaks to firms scouting for new loca- cient tax rules tricky.81
tions. 77 Those types of special deals are often Capital export neutrality (CEN) posits
made by subnational governments to attract that investors should face the same tax rate
highly valued investments such as computer on a marginal investment both at home and
chip plants.78 But targeted tax breaks are dis- abroad, taking into account taxes in both the
couraged by economists, who favor broad- home country of the investor and the host
based tax reductions. Narrow tax incentives country where the investment is located.
add complexity and unfairness and increase CEN suggests, for example, that “too much”
opportunities for corruption. Also, special investment would flow to the United States if
incentives are often Band-Aids that cover a German company faced, say, a 40 percent
more fundamental policy problems such as tax on a German investment but only a 35

14
percent tax on a similar U.S. investment. States.85 For those reasons, we conclude that
CEN may be achieved by taxing residents on the United States should adopt a territorial
a worldwide basis and providing a credit for approach to international business taxation.
foreign taxes paid to prevent double taxation.
Supporters of CEN believe that it would Background on U.S. International Tax
maximize world economic efficiency by Rules
removing tax considerations from location The United States taxes U.S. residents and
decisions on investments. corporations on their worldwide income. For
Capital import neutrality (CIN) posits example, a U.S. resident who owns stock in a
that investments in a particular country British corporation, or a U.S. corporation that
should face the same tax rate no matter has a production facility in Germany, reports
where the investor resides. That standard the income from his foreign activities on his
would be violated, for example, if a U.S. com- U.S. tax return. That worldwide approach to
pany faced a 35 percent tax on a British taxation follows from the CEN principle,
investment, but a British company faced a 30 which seeks to equalize tax on investments by
percent tax on the same British investment. U.S. residents and businesses regardless of
That situation occurs under current law where the investments are located.
because a U.S. company would pay the U.S. With regard to individuals, most, but not There is growing
government a residual 5 percent tax on the all, countries follow a more or less expansive concern that the
investment, in addition to the British tax. worldwide taxation approach.86 That is, most U.S. adherence to
Supporters of CIN argue that the U.S. com- countries tax the foreign investment income
pany should face the same 30 percent British of their residents to some extent. With regard CEN creates
tax as the British company without any resid- to businesses, some countries follow the excessive tax
ual U.S. claim. CIN may be achieved under a worldwide tax approach of the United States,
“territorial” tax system that would not place but many do not. About half of OECD coun-
complexity and
a U.S. tax on foreign investments of tries, such as France and the Netherlands, damages the abil-
Americans. have territorial systems of business taxation, ity of U.S. corpo-
The United States developed its complex which means that foreign-source income is
and jerry-built international tax structure not taxed.87 However, most countries do not rations to com-
around the CEN principle, although with follow either approach strictly. pete in world
many exceptions. 82 Since the early 1960s, Much of the focus of international tax com-
Congress has used CEN as justification to petition is on the activities of multinational cor-
markets.
expand the taxation of U.S. firms doing busi- porations. To understand some of the tax
ness abroad. Meanwhile, the CEN view of tax incentives and disincentives for corporate
neutrality has become less achievable and investment decisions, it is necessary to grasp
more irrelevant in a global economy with large some of the basic features of U.S. international
portfolio capital flows and many countries tax rules under the corporate income tax.
that do not adhere to CEN.83 It often seems U.S. foreign affiliates are generally struc-
that the federal government claims allegiance tured as either branches or subsidiaries.
to CEN simply to promote tax proposals the Branches are not separately incorporated
sole aim of which is to raise money from large abroad, and their profits are immediately
corporations, unseen by average citizens who subject to the U.S. income tax. By contrast,
ultimately bear the burden. subsidiaries are separately incorporated
There is growing concern that the U.S. abroad. Most are “controlled foreign corpo-
adherence to CEN creates excessive tax com- rations” (CFCs), that is, subsidiaries that are
plexity and damages the ability of U.S. corpo- more than 50 percent owned by U.S. share-
rations to compete in world markets.84 It also holders.88 U.S. tax is generally assessed on
creates a disincentive to locate headquarters CFC profits only when they are repatriated,
of multinational corporations in the United or sent home to the United States. Put anoth-

15
er way, U.S. tax is “deferred” until profits are time. As a result, many U.S. companies were
repatriated. expected to be pushed into an excess foreign
In addition to U.S. tax, U.S. foreign affili- tax credit position. That provided increased
ates face tax in the host countries where incentives for U.S. firms to locate new invest-
investments are located. To avoid double tax- ments in low-tax countries; U.S. foreign invest-
ation, the United States provides a tax credit ment became more tax sensitive. As a conse-
for foreign taxes paid on that income. quence, many foreign governments reduced
However, the foreign tax credit is limited to their own corporate tax rates after 1986 for
the 35 percent U.S. corporate tax rate. As a fear of losing U.S. investment inflows.90
result, U.S. affiliates in high-tax countries
pay the higher foreign tax rate. For example, The Intolerable Complexity of
profits of a U.S. affiliate in Belgium that pays International Business Taxation
a 40 percent Belgium tax receive a 35 percent Although the federal government claims
tax credit to offset the 35 percent U.S. tax on the right to tax the worldwide income of U.S.
that income. As a result, that foreign income businesses, there have traditionally been limits
will be taxed at an overall rate of 40 percent. to that claim. As noted, business profits
By contrast, U.S. affiliates in low-tax earned abroad in CFCs are generally not taxed
countries must pay at least the U.S. tax rate by the federal government until repatriated to
on foreign income. For example, the profits the United States. And firms may average
of a U.S. affiliate in the United Kingdom are income in high-tax and low-tax countries to
assessed the 35 percent U.S. tax and the 30 reduce residual U.S. tax on foreign income
percent U.K. tax. A foreign tax credit can be and take full advantage of foreign tax credits.
taken up to the 30 percent level of the U.K. However, in recent decades the federal
tax. On net, that income will end up facing a government has aggressively expanded the
30 percent U.K. tax plus a residual 5 percent taxation of foreign income of U.S. compa-
tax paid to the U.S. government. nies. Legislation in 1962, 1986, and other
Within limits, U.S. corporations can blend years has added layers of new rules designed
income from their affiliates located in high- to deny U.S. taxpayers the benefits of invest-
tax and low-tax countries to reduce the resid- ing in low-tax foreign jurisdictions. In some
ual U.S. tax on their foreign operations and cases, those rules end up double taxing the
take maximum advantage of foreign tax cred- foreign income of U.S. businesses. Many
its. U.S. businesses that operate in high-tax other countries have followed the U.S. lead by
foreign countries generate “excess foreign tax beefing up their own tax rules on foreign
Many foreign credits” and cannot offset all their foreign income. The flood of such anti-avoidance
taxes with U.S. foreign tax credits. Firms in and anti-deferral legislation has muted inter-
governments this situation have a strong incentive to shop national tax competition.
reduced their own around for investments in low-tax countries to A key thrust of government efforts has
corporate tax use the excess credits.89 By contrast, U.S. busi- been to limit the ability of firms to defer tax on
nesses that have most of their operations in CFC earnings until repatriated. The primary
rates after 1986 low-tax countries do not have excess foreign U.S. anti-deferral rules, called “subpart F,”
for fear of losing tax credits. As a result, they are less interested were introduced in 1962 and have since been
in shopping around for other low-tax jurisdic- expanded a number of times.91 For example,
U.S. investment tions when making new investments abroad. rules under TRA86 expanded subpart F to end
inflows. The effect of the foreign tax credit on deferral of the tax on income earned by finan-
investment incentives can be illustrated with cial services subsidiaries.92
reference to the Tax Reform Act of 1986 Subpart F aims to tax when earned a
(TRA86). TRA86 reduced the U.S. corporate CFC’s passive investment income, such as
tax rate from 46 to 34 percent, a rate below the dividends and interest. For example, if a
rates of many other major countries at the U.S. subsidiary in Ireland earned profits

16
in its computer manufacturing plant that ment that foreign income be placed in nine dif- Foreign opera-
it then invested in U.K. equities, the earn- ferent categories, or “baskets,” that cannot be tions are seen,
ings of those financial investments would blended. For example, financial services
be immediately taxed in the United States. income, shipping income, and passive invest- incorrectly, as a
The subpart F rules also aim to immedi- ment income are placed in separate baskets loss to the U.S.
ately tax foreign “base company” sales and requiring separate foreign tax credit calcula-
services income, meaning sales into third tions. Other countries do not have such exces-
economy. The
countries from certain U.S. foreign sub- sively complex foreign tax credit systems.96 evidence shows
sidiaries. 93 For example, profits from All in all, U.S. rules raise the tax rate on for- the contrary.
export sales to Germany from a U.S.-owed eign investment higher than that on foreign
Swiss affiliate may be immediately taxable investment by firms headquartered in other
in the United States. major countries.97 The complexity of tax rules
The subpart F regime has been joined by on U.S. foreign income is so great that one
other anti-deferral rules in the U.S. tax estimate found that 46 percent of federal tax
code.94 In all there are six often-overlapping compliance costs for Fortune 500 companies
anti-deferral regimes that create a complex stemmed from rules on foreign income.98 As a
web for Americans to navigate through when result, U.S. companies are at a tax disadvan-
investing abroad. The U.S. international tax tage in world markets. The chairman of the
rules are generally considered the most com- Council of Economic Advisers, Glenn
plex and aggressive among the industrial Hubbard, noted that “in many instances, cur-
nations. In a 1999 report, the National rent law creates barriers that harm the com-
Foreign Trade Council concluded that “U.S. petitiveness of U.S. companies. These rules are
anti-deferral rules have been subject to con- also horribly complex both for U.S. multina-
stant legislative tinkering, which has created tionals to comply with and for the Internal
both instability and a forbiddingly arcane Revenue Service to administer.”99
web of rules, exceptions, exceptions to excep- The anti-competitive U.S. business tax
tions, interactions, cross references, and rules are due in part to policymakers who
effective dates, giving rise to a level of com- view multinational corporations as “cash
plexity that is intolerable.”95 cows” able to absorb tax hikes, unseen by vot-
In addition to the anti-deferral rules, ers. 100 In addition, many policymakers seem
numerous other provisions raise taxes on to view foreign business activity with suspi-
U.S. firms’ foreign income and add great cion. Foreign operations are seen, incorrectly,
complexity. For example, the United States as a loss to the U.S. economy. The evidence
has special rules to allocate interest and shows the contrary.101 For example, about
research and development (R&D) expenses two-thirds of U.S. export trade is facilitated
between domestic and foreign income. Those by U.S. multinational companies and their
rules can result in firms being denied legiti- foreign affiliates. 102
mate business deductions. The constant
changes to the R&D rules during the past Tax Rules for Foreign Investment in the
decade have been a poster child for the insta- United States
bility and complexity of the U.S. internation- The complex tax rules on U.S. investment
al tax system. abroad are paired with different tax rules for
Limits on foreign tax credits also greatly investment by foreigners in the United
increase the complexity of the U.S. corporate States.103 The corporate income tax rules for
tax system. The operation of the foreign tax U.S.-incorporated businesses owned by for-
credit makes it advantageous for firms to bal- eigners are similar to those for U.S.-owned
ance income earned in high-tax and low-tax corporations. There is a separate set of rules
countries. But the ability to average high- and for taxing foreign-owned businesses operat-
low-tax foreign income is limited by the require- ing as branches in the United States.

17
When U.S.-source financial payments, haven for all types of portfolio and direct
such as dividends, interest, and royalties, are investment flows from abroad.
made to foreigners, the United States with-
holds taxes. Withholding taxes attempt to Three Business Responses to
roughly duplicate the individual-level taxes International Tax Competition
that would apply if a U.S. resident received Complex tax rules on international invest-
those forms of income. The basic flat rate ment mean that investment decisions are mul-
U.S. withholding tax is 30 percent, but that tifaceted and involve more than simply finding
rate is generally reduced in bilateral tax the jurisdictions with the lowest statutory rates.
treaties to a range of from 0 to 15 percent. As Businesses may be repelled or attracted by tax
noted, tax competition has caused U.S. and rules in different countries. Multi-national cor-
foreign withholding taxes to trend down- porations respond in three ways to different tax
ward in recent years. structures. First, firms can move the physical
Important exceptions to U.S. withholding location of their facilities, including corporate
tax rules are made for interest and capital headquarters, manufacturing plants, and R&D
gains. Bank deposit interest paid to foreign- facilities. Different aspects of tax systems affect
ers has long been exempt from U.S. taxa- the attractiveness of jurisdictions for each of
If the United tion.104 And since 1984 portfolio interest those activities. For example:
States adopted a earned by foreigners on government and pri-
low-rate con- vate securities is not taxed by the United • Rapid depreciation deductions, or
States. These rules were implemented immediate write-off of capital purchas-
sumption-based because of the realization that competition es (expensing), attracts capital-inten-
tax system, it from low-tax foreign jurisdictions for the sive industries, such as manufacturing.
would become a funds of international investors would make • Large R&D tax credits and the ability
any U.S. tax on those forms of interest to expense R&D investments attract
tax haven for all uncompetitive.105 Similarly, capital gains, R&D facilities.
types of portfolio except for gains on real estate, earned by for- • Territorial tax systems attract corpo-
eigners in the United States are exempt from rate headquarters of multinational
and direct invest- U.S. taxation. firms. Under a territorial system, affili-
ment flows from Those rules have attracted large flows of ates are able to compete in foreign mar-
foreign investment to the United States. kets without an extra layer of taxation
abroad. Today, there is more than $1.1 trillion of for- imposed in the headquarters country.
eign deposits in U.S. banks. 106 That mobile
investment capital helps fuel our economy Some of the ways that tax rules affect loca-
and would end up elsewhere if not for favor- tion decisions are illustrated by TRA86,
able tax policies. For example, Miami has which reduced the U.S. corporate income tax
become an international banking center for rate from 46 to 34 percent, a rate lower than
Latin America because of the tax exemption that of other major countries at the time.
on interest, in combination with the fact that Increased investment flows into the United
a number of Latin American countries have States were expected. But TRA86 also elimi-
territorial tax systems with respect to their nated the investment tax credit and reduced
residents’ foreign income.107 depreciation deductions, thus making the
Some experts have argued that the inter- United States a less attractive location for
est and capital gains tax exemptions ought to investment. Joel Slemrod of the University of
be expanded to include dividends, so as to Michigan Business School examined the off-
further attract foreign investment flows to setting effects of TRA86 and figured that
the United States.108 Even better, if the overall effective tax rates on investment in
United States adopted a low-rate consump- the United States rose slightly.109 At the same
tion-based tax system, it would become a tax time, the tax rate on foreign investment by

18
U.S. businesses fell because repatriations of setting prices on purchases from and sales to
foreign profits faced the lower U.S. tax rate foreign affiliates too high or too low in order
but were not affected by the less generous to effectively move taxable income between
capital investment rules. So, on net, TRA86 countries. For example, if a U.S. corporation
was expected to create a modest outflow of overbills its Belgium subsidiary for materials
direct investment from the United States. purchased, it has shifted profits from high-
The second business response to different tax Belgium to the lower-tax United States.
countries’ tax systems is to financially restruc- Evidence indicates that tax avoidance
ture so as to pay the lowest overall global tax through transfer pricing is substantial, but it
rate. There are many ways that firms can do is unclear exactly how large the activity is. In
that: fact, it is often very difficult to determine what
the correct price or profit margin on particu-
• Firms may optimally time dividend lar transactions should be. Although intra-
repatriations from high- and low-tax company transactions are supposed to be car-
foreign affiliates in order to maximize ried out at arm’s-length or market prices,
usage of foreign tax credits. many transactions are unique and have no
• Firms may repatriate money from market comparison. Many intracompany
abroad in different forms, including transactions, for example, involve the returns
dividends, interest, rent, and royalties. to unique intangible assets. As a result, some
Each type of payment may be subject experts think that the transfer pricing rules are
to different taxes, such as different “economically illogical” and “inherently unad-
withholding tax rates. ministerable.”110 Many countries, led by the
• Firms may change their debt/equity United States, have implemented increasingly
structure and the allocation of debt complex rules, including greater reporting
and equity issuance between parent and penalties, to thwart perceived abuses and
company and subsidiaries. For exam- protect the tax base.
ple, firms can maximize borrowing in Empirical studies have confirmed the
countries with high tax rates to maxi- importance of each of the three different
mize the benefit of interest deductions. types of business response to international
• Firms may move the profits attribut- tax incentives. In summarizing recent stud-
able to intangible assets, such as ies, the University of Michigan’s James Hines
patents and copyrights, to low-tax finds that “evidence indicates that taxation
countries and shift the expense pay- significantly influences the location of FDI,
ments for using those intangibles to corporate borrowing, transfer pricing, divi- According to
high-tax countries. dend and royalty payments, and research and
• Firms may use different business struc- development performance.”111 Tiebout’s analy-
tures to operate abroad, including sis, competition
branches, subsidiaries, holding compa- between local
nies, partnerships, and “hybrids.” Tax Competition Theory
(Hybrids are considered different busi- and Politics governments for
ness structures under foreign and U.S. mobile house-
laws.) For example, operations in low- Tiebout Theory
tax countries can be set up as CFCs, The economics literature on tax competi-
holds enhances
not branches, in order to benefit from tion traces its lineage to a 1956 study by society’s overall
deferral of U.S. income tax. Charles Tiebout examining the provision of welfare.
public goods by local governments.112
The third response of companies to differ- According to Tiebout’s analysis, competition
ent tax systems is to use “transfer pricing” to between local governments for mobile house-
shift profits to low-tax countries. That means holds enhances society’s overall welfare. To

19
Tax competition avoid losing residents, jurisdictions must tai- get its low-tax member countries to raise
provides politi- lor public spending and tax levels to suit local their taxes. A European Parliament fact sheet
preferences. Individuals choose the jurisdic- says that harmonization of business taxes
cians with incen- tions in which they live according to their “may be required to prevent distortions of
tives to improve demand for public goods relative to local tax competition, particularly of investment deci-
levels. If some households desire well-financed sions. Where tax systems are non-neutral . . .
government public schools, they may choose to pay higher resources will be misallocated.”114
efficiency. property taxes. If not, they may move to juris- Similar concerns have led the OECD to
dictions with lower taxes and more efficient, pursue a global program of curtailing “harm-
or more limited, government services. ful tax competition.” In an important 1998
Competition between governments is report, Harmful Tax Competition: An Emerging
akin to market competition for products. Global Issue, the OECD concluded that
Market competition encourages production “harmful” tax policies create “potential dis-
efficiency and satisfaction of consumer tortions in the patterns of trade and invest-
demands. Tax competition provides politi- ment and reduce global welfare.”115 Reports
cians with incentives to improve government by the OECD, the EU, and other critics of tax
efficiency and satisfy voter demands. The competition are wrapped in seemingly neu-
result of tax competition should be that the tral language such as “distortion,” “welfare,”
level of taxes reflects typical preferences with- “nonneutral,” and “misallocated.” But the
in each jurisdiction. Tiebout’s theory focused economics of the critics is often contradicto-
on local governments, but with growing ry or based on questionable assumptions.
international flows of labor and capital, Often, beneath the economic language, are
national governments are becoming more political goals, not economic theory.
like local governments as they compete for
taxpayers across national borders. Do Low Taxes Harm Global Welfare?
What is the harm in “harmful” tax competi-
Finding Inefficiencies in Tiebout’s Theory tion? The 1998 OECD report launched a
Since Tiebout’s study, many theorists robust international debate on the issue, so it is
have constructed highly stylized models of useful to examine the report’s assumptions in
tax competition to judge its effect on social detail. The report identifies six negative effects
welfare.113 As in other areas of academic eco- of harmful low-tax regimes.116 Of the six, it
nomics, these mathematical models rely on appears that at least four harms—“distorting
underlying assumptions that often end up financial and, indirectly, real investment flows,”
driving the conclusions. Some theorists have “undermining the integrity and fairness of tax
tweaked the assumptions and concluded structures,” “discouraging compliance by all
that tax competition is efficient. Others have taxpayers,” and “increasing the administrative
tweaked the assumptions and concluded costs and compliance burdens on tax authori-
that tax competition is inefficient because it ties and taxpayers”—are probably more true of
leads to a “race to the bottom” with tax levels high-tax regimes. The fifth harm cited is hollow
that are too low. bureaucrat-speak: “re-shaping the desired level
The latter results have been used to argue and mix of taxes and public spending.” The
that tax competition between countries is sixth harm—”causing undesired shifts of part
inefficient. As investment flows to low-tax of the tax burden to less mobile tax bases, such
countries, inefficiency is thought to occur as labour, property and consumption”—gets it
because resources may not end up in the backwards. The last effect is a desired and
highest-valued uses. The idea is that the tax expected shift in a globalized economy.
system ought to be “neutral” and have no From the report’s perspective, a key source
effect on investment decisions. The EU uses of harm occurs when tax policy in one coun-
these arguments in its ongoing program to try affects the tax base of other countries.

20
Those effects are called “spillover effects” or to partner countries in term of eco-
“externalities.” The 1998 OECD report said nomic activity and in terms of tax
that harmful tax policies erode the tax bases revenues.122
of other countries by “bidding aggressively”
for foreign investment flows. 117 A follow-up Such criticisms of tax competition purport
OECD report in 2000 said that harmful tax to examine the effects on “global welfare.”
practices “unfairly erode the tax bases of Suppose the United States cut taxes to boost
other countries and distort the location of investment but did not take into account the
capital and services.”118 At the same time, the effect on Germany. That would be deemed an
OECD says it supports recent income tax inefficiency or “externality” of tax competition.
rate reductions that have occurred in many If countries do right by their own citizens with
countries in response to globalization. But tax cuts, they supposedly harm other nations.
the reforms that the OECD supports also That conclusion can clearly fly in the face of
attract foreign investment inflows and national sovereignty and therefore cannot be a
“erode” other nations’ tax bases. That is a key guide for U.S. tax policy. U.S. policymakers seek
inconsistency in the OECD position. first and foremost to design policies that bene-
The 1998 OECD report finds that “globali- fit the American economy. It would not make
sation has also been one of the driving forces sense to hold off on U.S. tax cuts because of
The allegation of
behind tax reforms,” including rate cuts.119 A concerns of foreign jurisdictions that have harmful “fiscal
2001 OECD report on the issue finds that “the more inefficient high-rate systems. externalities”
more open and competitive environment of the
last decades has . . . encouraged countries to Tax Competition Is Not Zero-Sum assumes a false
make their tax systems more attractive to The allegation of harmful “fiscal externali- zero-sum view of
investors. In addition to reducing overall tax ties” assumes a false zero-sum view of tax pol-
rates, a competitive environment can promote icy. In reality, the large economic gains made
tax policy.
greater efficiency in government expenditure possible by tax rate cuts mean that tax compe-
programs.”120 To the OECD, cutting taxes to tition is not a negative-sum game for the
attract investors is sometimes good policy, but United States or the world as a whole. As any
other times it “erodes” tax bases. one country adopts a more efficient tax sys-
Public finance expert Wallace Oates tem to maximize growth, other countries fol-
describes the harm of tax competition as “a low suit, with the result that global investment
kind of fiscal externality in that local officials and output rise. The round of income tax
do not take into account the impact their reductions following U.S. tax reforms in 1986
decisions have on the tax bases of other juris- is a good example. All countries end up better
dictions. This typically leads to decisions off as each country pursues its own interest.
involving suboptimal tax rates.”121 A The supposed “global welfare” cost of tax
European Parliament study similarly competition is based on how tax differences
described the supposed problem: alter the allocation of an assumed fixed
amount of investment across countries. But far
The second goal of tax harmoniza- more serious welfare costs occur within coun-
tion is to avoid the negative external- tries that have high income tax rates, particu-
ities that can follow an individual tax larly on capital and skilled workers. High mar-
reform in one country. . . . More ginal income tax rates create large “deadweight
specifically, cutting taxes in one losses.” Those losses, or inefficiency costs, rise
country raises the competitiveness more than proportionally as marginal tax rates
and/or attractiveness of this country increase, so even modest rate reductions lead to
relative to others. The resulting flows large economic gains.123 For example, Martin
of goods, capital—and also, possibly, Feldstein, president of the National Bureau of
high-skilled labour—is detrimental Economic Research, estimated that President

21
Bush’s income tax cut plan of last year would According to the public choice view, inter-
reduce deadweight losses caused by the tax sys- national tax competition enhances welfare
tem by about $600 billion over 10 years.124 Tax because it constrains government from grow-
competition creates downward pressure on ing inefficiently large. Governments that do
income taxes, particularly inefficient capital not face competition operate like private
income taxes, and thus boosts investment and monopolists and have little incentive to
economic growth worldwide. reduce waste and increase quality. Just as
globalization limits the power of private
Public Interest vs. Public Choice monopolies in domestic markets, it also acts
Most policymakers would probably not dis- to limit the power of government monopo-
agree that tax rate reductions enhance econom- lies. The “race to the bottom” proposition
ic growth. But the concern is that tax competi- focuses only on the outcome of mathemati-
tion ends up driving tax rates “too low.” But cally stylized competition and ignores the
how low is too low? As University of Chicago real-world benefits of the competitive process
professor Julie Roin notes, “Advocates of tax itself. That process involves forcing tough
harmonization appear to regard any departure choices to be made, creating innovations, dis-
from the level and distribution of the tax bur- carding bad ideas, and organizational learn-
den set in the non-competitive world as unduly ing to produce better products at lower costs.
low.”125 That is in large part because of the Nobel prize–winning economist Gary Becker
assumptions built into their models. The status observed that “competition among nations
quo government is taken to be the optimal size, tends to produce a race to the top rather than
determined by efficient political decisionmak- to the bottom by limiting the ability of pow-
ing. In a recent study, the European Parliament erful and voracious groups and politicians in
exhibited the status quo mindset by criticizing each nation to impose their will at the
tax competition on the basis that “each country expense of the interests of the vast majority
has an incentive to lower corporate taxes below of their populations.”128
the level that would be consistent with its nat-
ural position.”126 But what in the world is the Neutrality and Diversity
“natural” position? Harmful tax competition Another key idea behind concerns about
theories implicitly assume the “public interest” international tax competition is tax “neutral-
theory of government. Government is assumed ity.” Economists generally support tax sys-
to be a benevolent maximizer of citizens’ wel- tems that do not distort economic decisions,
fare. Tax competition is seen as throwing a for example, by favoring one industry over
Governments that wrench into the optimal fiscal balance achieved another. No tax is completely neutral, but
when governments have monopoly control governments should collect revenue in a
do not face com- over capital and labor. manner that minimizes distortions of the
petition operate An alternative model of government, the domestic economy. But the good idea of tax
like private “public choice” view, regards public officials neutrality within national borders is not eas-
as engaged in self-interested behavior that ily translated to cross-border economic
monopolists and may or may not maximize social welfare. issues. We noted that CEN and CIN both aim
have little incen- Instead of steering fiscal policy toward for “neutrality” of international taxation, but
achieving the general public good, policy- each results in different policy prescriptions.
tive to reduce makers and bureaucrats “seek to maximize The broader issue is that taxation is but
waste and budgets, and thereby to obtain greater power, one of many government policies that impact
increase quality. larger salaries, and other perquisites. Budget international trade and investment flows.
maximization results in higher government Many policy decisions create what may be
spending overall, inefficient allocation viewed as nonneutralities. Consider two
among government agencies, and inefficient countries that have identical tax systems. The
production within them.”127 government in one country spends mainly

22
on efficiency-enhancing education and tional organization. Those policy reforms It is not clear why
transportation infrastructure. The other gov- resulted from countries acting for their own tax policies
ernment spends mainly to support declining domestic benefit after learning from other
industries and redistribution programs. The countries’ experiences. Attempts to place require interna-
difference in government spending may global restrictions on tax systems through tional harmo-
cause investment to flow to the former coun- international bodies will put a straightjacket
try, which practices “unfair infrastructure on the beneficial evolution of independent
nization when
competition.” International agreements national fiscal systems. huge nonneutral-
could be drafted to require countries to have Such a straightjacket would be particular- ities exist in
minimum levels of inefficient redistribution ly harmful for lower-income countries pursu-
spending and place maximum limits on effi- ing tax reduction strategies. Attraction of pri- many other
ciency-enhancing infrastructure spending. vate foreign capital is crucial to the develop- government
In the real world, national governments ment of poorer countries, and tax cuts are
differ substantially in their priorities. one method of pursuing growth that should
attributes.
“Government competition” between coun- be open to every country. As Julie Roin notes,
tries occurs in many dimensions, including residents of a wealthy area may not want a
taxation, spending, regulation, efficiency of new automobile plant because of added con-
court systems, and other items. All those pol- gestion or pollution, but an area with high
icy differences may generate cross-border unemployment would be happy to forgo
investment and labor flows. For example, substantial tax revenues to lure the plant.131
countries known for greater political stability Regions and countries are very diverse in
and efficient legal systems will attract more many ways, so international policies that pre-
foreign investment than unstable and cor- vent poor countries from expressing their
rupt regimes. It is not clear why tax policies preference for more growth through less tax-
require international harmonization when ation are very unfair.
huge nonneutralities exist in many other
government attributes.
Tax harmonization would have countries Defensive Responses to Tax
impose similar taxes regardless of substantial Competition
material or cultural differences, with the
result that some countries would have taxes Layering New Tax Rules on Foreign Income
that were too high from their citizens’ per- Countries have responded to internation-
spective.129 For example, research by Richard al tax competition in a variety of ways. Like
Baldwin and Paul Krugman finds that har- the United States, most major countries have
monizing tax rates across “core” and “periph- cut statutory tax rates on individual and cor-
ery” regions within Europe would be ineffi- porate income. Many countries have also fol-
cient because those two areas have different lowed the U.S. lead with the enactment of
economic structures. 130 defensive measures that increase tax com-
Allowing diversity in fiscal systems is plexity and limit tax competition, including
superior to enforcing global harmonization. anti-deferral rules and tougher transfer pric-
With diversity and competition, different tax ing rules.132 For example, after Britain abol-
policies may result in different levels of suc- ished exchange controls in 1979, the tax base
cess. Citizens gain knowledge about policies became more vulnerable. Britain responded
that work in neighboring jurisdictions and with substantial corporate and individual tax
would demand the same from their own leg- cuts, but it also enacted anti-deferral legisla-
islature. Recent global pro-growth trends, tion for CFCs in 1984.133
such as the privatization revolution and Similarly, as Germany has opened its bor-
income tax rate cuts, did not result from a ders under European economic integration,
top-down scheme imposed by an interna- it has both cut tax rates and added new tax

23
rules on foreign income. Germany had a par- to prohibit the use of low tax environ-
ticularly high corporate tax rate to defend, ments and other tax planning ideas. By
and German corporations have been aggres- their nature, these rules contain many
sive in reducing their German taxable elements of overkill and prohibit
income.134 German firms have found many establishment of a tax efficient group
lower-tax investments abroad, including U.S. structure. It is therefore very important
real estate and Irish financial services. The to choose a holding location that does
German government responded by cutting not have CFC rules.140
the corporate tax rate from about 60 percent
in the early 1990s to 38 percent by 2002.135 The overkill the Dutch warn about is
The title of a 1994 tax cut law indicates the already evident in U.S. tax rules. For example,
tax competition pressure Germany felt: “Law U.S. efforts to increase the taxation of foreign
to Secure the Competitiveness of Germany as shipping income have evidently caused the
a Location for Enterprises in a Common U.S.-owned “open registry” shipping fleet to
Market.”136 The government also responded nearly disappear. Oceangoing ships often fly
with anti-deferral rules for CFCs to stem the the flags of open-registry countries such as
outflow of capital to lower-tax countries. Panama, while their owners reside elsewhere.
Efforts to expand The OECD has been urging countries to The U.S.-owned share of the open-registry
the taxation of adopt anti-deferral and anti-avoidance rules, fleet plummeted from 26 percent in 1975 to
foreign income and by the mid-1990s about half of OECD just 5 percent by 1996, apparently because of
member countries had done so.137 Other the aggressive expansion of U.S. taxation of
can backfire countries have added rules since then, such that income source.141 Before 1975 foreign
because corpora- as Italy in 2000. The U.S. rules, however, are shipping income could be deferred until repa-
still generally considered the most aggressive triated to the United States. But U.S. anti-
tions have the and complex. The 1999 National Foreign deferral legislation in 1975 and 1986 made
option of migrat- Trade Council study found that, while other foreign shipping income immediately taxable.
ing abroad. countries have mimicked the U.S. rules, “in That raised the costs of U.S. ship ownership
virtually every scenario considered, however, and led to the transfer of U.S. ships to foreign
the U.S. imposed the severest regime.”138 For ownership. So that federal effort to raise
example, most countries limit deferral for money from corporations ended up losing
just passive investment income, but the money as the tax base disappeared.
United States also limits deferral for some Efforts to expand the taxation of foreign
types of active business income.139 income can backfire because corporations
Some countries have not followed the U.S. have the option of migrating abroad. U.S.
path of expanding the taxation of foreign firms are reincorporating abroad with
income. The Netherlands, as noted, has a increasing frequency. 142 Certainly, govern-
very attractive environment for corporate ments need to put efforts into reducing tax
location given its territorial tax system and evasion. But those efforts have substantial
absence of capital gains taxation. The costs, including high complexity, reduced
Netherlands officially touts its lack of CFC business efficiency, and disappearance of the
rules as an important advantage for compa- tax base. Some level of avoidance and evasion
nies considering investment locations, as is normal for any tax system, so the knee-jerk
described on the Netherlands Foreign response to every international tax issue
Investment Agency website: should not be a new layer of rules.
As noted, overall levels of taxation in most
The Netherlands is one of the few OECD countries are still at record highs, so
countries in Europe that does not (yet) tax competition is not causing the tax base to
bear the burden of Controlled Foreign disappear overnight. In the meantime, gov-
Company (CFC) rules. CFC rules aim ernments need to implement simpler, lower-

24
rate, consumption-based systems that are to impose withholding taxes on outflows of
easier to police and provide fewer incentives capital income to prevent citizens from benefit-
for taxpayers to avoid and evade. ing from lower taxes on their savings in other
countries. The German chancellor recently
Curbing Tax Competition through called for fully integrating European taxa-
International Cartels tion.149 The head of the European Central Bank
Another government response to rising recently said that the euro would lead to greater
tax competition is the various efforts to coor- harmonization of all taxes in Europe.150
dinate tax systems across countries to limit France’s prime minister has condemned tax
competition in the manner of a cartel. The competition as “fiscal dumping” and said that
EU has been a leader in this response to tax “the corporate tax system as a whole will have to
competition and has pushed its member be harmonised” since it is unfair for corporate
countries to harmonize their tax systems. A headquarters to move to low-tax EU regions.151
recent European Parliament fact sheet Those developments are important for
explains: “The objective of more recent the United States because the same argu-
moves towards a general taxation policy has ments used to support tax harmonization
been to prevent the harmful effects of tax within Europe are being heard in global
competition, notably the migration of forums. For example, a high-level United
national tax bases as firms move between Nations panel has proposed creating a
Member States in search of the most International Tax Organization that would
favourable tax regime.”143 Another fact sheet develop norms for tax policy, engage in sur-
called for further harmonization of business veillance of tax systems, and negotiate with
taxation “to prevent the undermining of rev- countries to “desist from harmful tax compe-
enues through ‘tax competition.’”144 tition.”152 The ITO would be akin to the
To date, the most far-reaching EU harmo- World Trade Organization, which handles
nization effort was the imposition in 1992 of trade disputes. But economists nearly univer-
a minimum standard value-added tax (VAT) sally agree on the benchmark of free trade.153
rate of 15 percent. The EU has also tried to There is no such agreement in the tax world:
get member countries to harmonize income proponents of broad-based income taxes and
tax rates. The 1992 Ruding Commission pro- proponents of consumption-based tax sys-
posed creating a minimum corporate tax rate tems would come to vastly different conclu-
of 30 percent.145 Going back further, a 1975 sions about what an ITO should enforce.
European Commission draft directive called Another important reason to oppose a
for harmonizing corporate rates at between new international tax bureaucracy is the large The same argu-
45 and 55 percent.146 Luckily for European bias it would have toward tax increases. The
citizens, those plans were not enacted UN report proposing an ITO makes that ments used to
because they could have prevented the reduc- clear. The report suggests creation of a “glob- support tax har-
tions in corporate tax rates that have al source of funds” from a “high yielding tax monization with-
occurred in EU countries in recent years. The source.”154 The report suggests future study
average EU corporate tax rate fell from 38.2 of a “Tobin tax” on foreign exchange market in Europe are
percent in 1996 to just 32.5 percent in transactions to finance “global public being heard in
2002.147 The drop in rates has improved the goods.” The report says that an ITO “could
efficiency of European taxation, a benefit take a lead role in restraining the tax compe-
global forums.
that would not have occurred if harmoniza- tition designed to attract multinationals.”155
tion had put a straightjacket on reform. Another suggestion in the UN report, which
While EU documents admit that tax com- is very disturbing from a civil liberties point
petition has some good aspects, there is a of view, is for the proposed ITO to operate a
strong movement to squelch it.148 For example, global system of taxing emigrants because
the EU has pushed low-tax European countries brain drains “expose source countries to the

25
The United States risk of economic loss when many of their more hospitable locations. The OECD calls
should be very most able citizens emigrate.”156 The idea such tax avoidance behavior “free riding.” A
seems to be that the proposed ITO would recent European Parliament report echoed
concerned that assess a tax on, say, new U.S. citizens of that view, calling it “free loading.”160
the OECD or Chinese origin and send the money back to That is an odd characterization. “Free rid-
the government of China. ing” better describes those on the receiving end
other internation- Although the UN has not yet acted on its of government redistribution, who face little or
al bodies do not proposals, the OECD has been at the fore- no taxation while others carry a heavy burden.
start creating front of global efforts to stifle tax competi- IRS data show that the highest-income 5 per-
tion.157 Its April 2000 report on the issue cent of U.S. taxpayers paid 55 percent of all fed-
international found that “harmful tax competition is by its eral income taxes in 1999.161 So, while interna-
“standards” that very nature a global phenomenon and there- tional tax competition may indeed hamper
fore its solution requires a global endorse- income redistribution, that seems to be a posi-
preclude pro- ment and global participation.”158 The tive outcome because redistribution has
growth consump- United States needs to decide where it stands reached severe proportions. Curtailment of
tion-based tax on this new international crusade. redistribution is an advantage, not a disadvan-
“Global participation” so far includes pres- tage, of international tax competition.
reform. suring a list of tax haven countries to change The redistribution issue also highlights the
various laws deemed harmful and requiring underlying “income tax–centric” view of the
changes to a long list of “harmful preferential world that critics of tax competition hold. A
tax regimes” in major industrial countries, central feature of “harmful tax competition” is
including one tax break in the United said to be no or low taxation of capital income.
States.159 In tax havens, the OECD focus is on But many economists think that consump-
indirect methods of nullifying tax competi- tion-based taxes are superior to income-based
tion, such as information sharing between taxes, which aim to heavily tax capital income.
governments. The idea is to give tax collectors Treasury Secretary Paul O’Neill has suggested
in each country access to information about that the United States consider scrapping the
the economic activities of its citizens abroad, corporate income tax. 162 Such reforms, aimed
in hopes that this will eliminate the attractive- at reducing the tax burden on capital income,
ness of low-tax countries. Many countries tax would be deemed harmful because they would
individual residents on some portion of their “poach” flows of capital from high-tax coun-
income on a worldwide basis, so gaining tries and cause “fiscal externalities.”
access to foreign information helps high-tax The OECD says that “countries should
countries sustain their high rates. Information remain free to design their own tax systems
exchanges raise serious issues of financial pri- as long as they abide by internationally
vacy and national sovereignty accepted standards in doing so.”163 The
What is really driving the efforts to sup- United States should be very concerned that
press tax competition is the politics of redis- the OECD or other international bodies do
tribution. The primary tax used for redistrib- not start creating international “standards”
utive purposes, the income tax, has the most that lock in high-rate income tax systems and
mobile of tax bases and thus is most affected thus preclude pro-growth consumption-
by international tax competition. The 1998 based tax reform.
OECD report concluded that international
tax competition “may hamper the applica-
tion of progressive tax rates and the achieve- Options for U.S. Tax Policy
ment of redistributive goals.” That occurs
because, when borders are opened, business- Cut Tax Rates
es and individuals that are taxed heavily to While the United States raised tax rates in
pay for redistribution move their activities to the 1990s, other major countries were cut-

26
ting tax rates and pursuing other tax reforms. greatly reduce the need for the complex
As noted in a recent European Parliament defensive measures that the federal govern-
report, “Since the 1990s, a wind of tax ment has taken in areas such as anti-deferral
reforms has been blowing through the rules and transfer pricing. Lower marginal
European Union . . . most reforms can be tax rates would reduce tax evasion and tax
seen as supply-side oriented.”164 The presi- avoidance behavior by individuals and corpo-
dent of the International Fiscal Association rations. 172 Empirical studies have shown that
noted that tax cuts would likely continue and over time lower rates produce a larger tax
that the average corporate rate in Europe base due to reduced avoidance and evasion
would eventually fall to about 25 percent.165 and increased economic activity.173
That rate would be 10 percentage points
lower than the 35 percent U.S. federal corpo- Oppose Efforts to Curtail Tax Competition
rate tax rate. The combined U.S. federal and The release of the 1998 OECD report on
average state corporate tax rate of 40 percent “harmful” tax competition created continu-
is currently higher than the rates in all but 3 ing controversy over the broad sweep and
of 30 OECD countries. 166 Effective corporate aggressive stance taken by the organization.
rates have also been falling in Europe.167 The The OECD followed up with a report in 2000
United States should move to get back the that identified harmful tax practices by The combined
business tax advantage it gained in 1986 by member countries and listed 35 tax havens U.S. federal and
immediately reducing its corporate income that could face a variety of proposed sanc- average state cor-
tax rate to 20 percent. tions. A further update report was issued in
Personal income tax rate cuts enacted in 2001. As the largest OECD member country, porate tax rate of
2001 were a step in the right direction for the the United States has a key role to play in the 40 percent is cur-
U.S. tax system. But more must be done. As a debate. The following discussion provides a
step toward a low-rate consumption-based brief overview of where the debate stands.174
rently higher
tax system, Congress could consider the Since coming to office, the Bush adminis- than the rates in
Nordic approach of retaining the current tax tration has slowed down the ambitious plans all but 3 of 30
rates on labor income but taxing capital of the OECD to build an international cartel
income at a low, flat rate. That would help to to curb tax competition. Treasury Secretary OECD countries.
rectify the heavy taxation on dividend O’Neill expressed his reservations about the
income in the United States, which is taxed at OECD project in congressional testimony
the corporate level and again at the individ- last year: “I felt that it was not in the interest
ual level. Two-thirds of OECD countries of the United States to stifle tax competition
partly or fully relieve the double taxation on that forces governments—like businesses—to
dividend income.168 But the United States create efficiencies.”175 For example, he dis-
does not and as a result has the fourth high- agreed with OECD efforts to prevent coun-
est overall tax rate on dividends in the tries from offering preferential tax treatment
OECD.169 This heavy taxation has a negative to foreign investors (so-called ring fencing).
effect on competitiveness because it raises the Much of the debate has focused on indi-
cost of capital for U.S. companies.170 To rect efforts to curb tax competition. In par-
begin reducing capital income taxation, the ticular, the OECD is pressuring offshore
United States could adopt a flat 10 percent financial centers, or tax havens, to agree to
tax rate for dividends, interest, and capital exchanges of tax information or face sanc-
gains at the individual level. tions from OECD countries. There are also
As noted, tax rate cuts would increase eco- demands for more transparency in those
nomic growth by reducing the distortions, or jurisdictions, which means eliminating spe-
deadweight losses, that the tax system impos- cial reduced tax rates and reducing bank
es on the economy. 171 Aside from the growth secrecy. Offshore financial centers combine
advantages of tax rate cuts, lower rates would low-tax climates with high levels of financial

27
privacy, so these demands strike at core fac- national banking organization noted, if this
tors behind their economic success. Not sur- regulation were finalized and the IRS
prisingly, targeted jurisdictions have resisted breached the financial privacy of those
outside demands to change their tax and deposits, it “could trigger massive with-
financial policies. After all, attracting finan- drawals of foreign deposits from U.S.
cial services can be a successful development banks.”183 The money would flee to more
strategy for poorer countries in the attractive investment climates with stricter
Caribbean and elsewhere that have few nat- privacy standards.
ural resources on which to build an economy. O’Neill also testified to Congress with
There has also been substantial opposi- respect to the OECD initiative that the
tion in Congress, led by House Majority United States should “not interfere in the
Leader Dick Armey (R-Tex.), to U.S. involve- internal tax policy decisions of other coun-
ment with the OECD initiative. Armey has tries.”184 But hunting for income tax evaders
argued that the United States should not in countries that do not have tax systems
support “a global network of tax police” and similar to ours does indeed intrude on the
that it is unfair for large wealthy countries to tax policy of those countries. There is an
bully small, often poorer nations to change underlying OECD bias in favor of high-rate,
successful economic policies.176 In fact, tar- broad-based income tax systems. Since many
geted nations have argued that the OECD tax havens do not have income taxes, or have
pressure and threatened sanctions are low rates, their tax systems are eyed with sus-
breaches of international law and violations picion. Without an income tax, governments
of their sovereignty. 177 They resent the unfair- generally do not need to know personal
ness of the whole process, including the fact financial investment information. A benefit
that many OECD countries also have sup- of replacing the income tax with some ver-
posedly harmful tax rules that have not been sion of a consumption-based tax in this
fixed.178 Nonetheless, more than a dozen tar- country would be added financial privacy.
geted jurisdictions have made deals to For example, under Armey’s flat tax there
change some of their laws in order to call off would be no need for citizens to report sav-
the OECD dogs.179 ings income (dividends, interest, and capital
One part of the OECD initiative that gains) to the government as they currently
O’Neill supports is pushing foreign coun- do. Thus, it does not seem fair to tell other
tries to enter into taxpayer information countries to change their higher standards of
exchange agreements. The United States financial privacy for the benefit of OECD
House Majority already has agreements for such information income tax systems that many economists
exchanges with about 60 countries. O’Neill agree should be replaced with consumption-
Leader Dick says those should be limited to particular based tax systems.
Armey has argued investigations and not general “fishing expe- Since September 11, concerns about off-
that the United ditions.”180 But the United States needs to be shore financial centers as tax havens have
very careful with the idea of information taken a back seat to concerns about criminal
States should not exchanges because the United States is itself activity in those jurisdictions. The United
support “a global a large tax haven. An immediate threat is a States has stepped up its efforts against
proposed U.S. Treasury regulation that money laundering and financing of terror-
network of tax would require U.S. banks to report interest ism activities. Tax policy and financial priva-
police.” earned by foreigners to the IRS and then cy rules of offshore centers need not conflict
share that information with other coun- with these important criminal investigation
tries.181 As noted, the tax exemption for for- priorities. Many banking centers such as
eigners on U.S. bank interest has helped Switzerland and the Cayman Islands have
attract more than $1.1 trillion in bank mutual legal assistance agreements with the
deposits to the United States. 182 As one United States to exchange information on

28
criminal matters. 185 But the United States with the heavy lifting of consumption-based The United States
should pressure jurisdictions that do refuse tax reform to allow us to avoid the troubles does not need a
to cooperate on criminal matters to do so. of chasing tax avoiders and evaders to the far
So far, it appears that offshore centers ends of the earth. global tax super-
have not stood in the way of U.S. law enforce- structure on top
ment. The September 11 terrorists apparent- Reform U.S. International Business Taxation
ly did not rely on offshore or tax haven The U.S. response to intensified internation-
of its current
banks; instead they relied on banking sys- al tax competition must include an overhaul of 45,662-page tax
tems in the United States, Europe, and the the worldwide system of business taxation. rule book.
Middle East, including the informal That system greatly complicates business plan-
“hawala” system. 186 A large share of criminal ning and raises taxes on U.S. firms’ foreign
money is laundered in wealthy industrial income above those on firms headquartered in
nations, not tax havens. For example, it is other countries.193 Yet the worldwide tax system
estimated that about half of all laundered is thought to raise little federal revenue, and it
money goes through U.S. financial institu- may actually lose revenue in comparison with
tions.187 Smart criminals often avoid tax the alternative of a territorial tax system.194
havens because of the obvious red flag their Hubbard has noted that “the present U.S. sys-
use provides to authorities. tem of taxing multinationals’ income may be
For those reasons, the United States should raising little U.S. tax revenue, while stimulating
not participate in international efforts to bully a host of tax-motivated financial transac-
foreign jurisdictions to weaken their own tions.”195 Hubbard believes that “from an
economies in order to prop up inefficient tax income tax perspective, the United States has
policies in some OECD countries.188 Armey become one of the least attractive industrial
believes that applying such pressure could countries in which to locate the headquarters of
make those countries less willing to aid us in a multinational corporation.”196 So the current
the more important mission of stemming ter- rules impose a high cost with apparently no rev-
rorism and other criminal activity.189 Besides, enue benefit to the government.
as noted, the United States is itself a large tax Calls for reform have come from many
haven in certain respects with more than $1.1 quarters. The vice president for taxes at Intel
trillion of foreign deposits in U.S. banks Corporation testified before Congress a few
attracted by low taxation, security, and finan- years ago that “the degree to which our tax
cial privacy.190 code intrudes upon business decision-mak-
Stomping out tax competition through a ing is unparalleled in the world . . . other
cartel may seem to be an easy way out of the countries do not have such complex rules.”197
new realities of globalization. 191 But going The American Bar Association recently
down the global tax cartel road is not an easy concluded that “these rules may never be
way out. The tone and content of OECD, EU, truly simple, but actions can be taken to tem-
and UN reports and comments by political per the extraordinary complexity of the cur-
leaders suggest that the ultimate end goal is rent regime.”198 The ABA notes that it is
to morph initial international tax agree- becoming increasingly difficult to comply
ments into a permanent global tax law. But with the foreign tax credit rules and that the
the ambiguity and contradictions of the eco- subpart F rules “sorely need to be updated to
nomics behind “harmful” tax competition deal with today’s global environment.”199
would make this an area for continuous Calls for reform have been especially strong
expansion of stiflingly complex bureaucratic since the passage of TRA86, which made U.S.
laws and regulations. The United States does tax rules on business much more complex
not need a global tax superstructure on top and uncompetitive.200
of its current 45,662-page tax rule book.192 Price Waterhouse and the U.S. Chamber
Instead, the United States should proceed of Commerce completed a major study in

29
1991 illustrating how U.S. international tax the more headquarters functions will be
rules put U.S. companies at a disadvantage in required in the United States.
foreign markets. 201 Most of the problems Current U.S. tax rules put U.S. foreign
that were identified still plague the tax code. affiliates at a competitive disadvantage com-
In a major report on U.S. tax rules in 1999, pared with affiliates of firms headquartered
the NFTC concluded that “no other country in other countries. Thus the United States is
taxes the active business income of CFCs as currently a poor tax choice for the location of
aggressively as the United States.”202 multinational headquarters. Intel’s vice pres-
There is growing support for replacing the ident for taxes testified before Congress that,
U.S. worldwide method of taxation with a “if I had known at Intel’s founding what I
territorial method. As noted, about half of know today about the international tax rules,
OECD countries already have a territorial I would have advised that the parent compa-
system.203 Switching to a territorial tax sys- ny be established outside of the U.S.”207
tem would entail generally exempting the The United States may be beginning to
foreign business income of U.S. companies have a problem with “runaway” corporate
from U.S. tax. Both fairness and economic headquarters. High-tax Sweden has had this
reasons support such a policy. On fairness problem as firms such as IKEA have moved
The United States grounds, it is not clear why business opera- out.208 In the United States, numerous mid-
is currently a tions located abroad should be subject to sized companies, such as Fruit-of-the-Loom,
poor tax choice U.S. tax at all. Foreign affiliates are primarily have moved abroad. Moving is particularly
staffed by foreign workers, and more than attractive to firms that already have most of
for the location of three-quarters of affiliate financing is from their operations outside the United States. 209
multinational foreign sources.204 Foreign affiliates primari- The U.S. Treasury recently announced that
ly benefit from infrastructure offered by for- there has been a “marked increase” in the
headquarters. eign countries, not by the U.S. government. number and size of companies that are rein-
So foreign affiliates create foreign economic corporating abroad, and the Treasury finds
activity that does not impose costs on U.S. that taxes are a key reason for those moves. 210
taxpayers. In fact, as numerous studies have The most prominent example of a U.S.
documented, U.S. foreign affiliates are very corporate expatriation was the 1998
beneficial to the U.S. economy; for example Daimler-Chrysler merger. The merged com-
they boost U.S. foreign trade.205 pany established corporate headquarters in
On economic grounds, a territorial sys- Germany, in part because of its more favor-
tem is superior to a worldwide system in able tax rules.211 A PricewaterhouseCoopers
numerous ways. A territorial system would study found that uncompetitive tax rules
make the United States an excellent location may be causing numerous U.S. companies to
for headquarters of multinational corpora- migrate abroad through mergers and acqui-
tions. Under a territorial system, foreign affil- sitions. The study reported that “in 1998,
iates could earn profits abroad and not face a 1999, and 2000, U.S. companies were the tar-
tax disincentive to repatriating earnings to get (and foreign companies the acquirer) in
U.S. shareholders. Multinational headquar- 86, 73, and 79 percent, respectively, of the
ters bring to the United States highly skilled large cross-border mergers and acquisitions
workers and high-income jobs in manage- as measured by value.”212 Note that cross-
ment, finance, marketing, R&D, and other border mergers and acquisitions used to be
high-level corporate functions. For example, rare, but in the past decade or so they have
while 71 percent of U.S. multinational firms’ exploded in number and value. This is one of
employees are located in the United States, many changes occurring in the global econo-
87 percent of their R&D is performed here.206 my that demand that the United States revis-
The larger and more successful the foreign it its antiquated system of taxing interna-
affiliates of U.S. firms are in world markets, tional businesses.

30
Gary Hufbauer of the Institute for retail sales tax and the flat tax introduced by
International Economics, who is a promi- Armey. 217 Consumption-based tax reform
nent advocate of moving to a territorial tax would be good domestic tax policy, and it
system, has noted that “the worldwide tax would be the best response to rising interna-
approach is justified by emotion not tional tax competition. A replacement con-
logic.”213 He thinks that “the tensions sumption-based tax would increase invest-
stretching back to 1918 between the imprac- ment and economic growth and greatly sim-
tical general [worldwide] rule and the practi- plify federal taxation. In addition, the lower
cal exceptions have generated an extraordi- tax rate under most tax reform proposals
narily complex U.S. tax code.” Hufbauer con- would reduce wasteful tax avoidance and eva-
cludes that we should replace the current sion activities. To replace the revenue cur-
impractical general rule with the practical rently raised by the corporate and individual
general rule of territoriality. income taxes, the sales tax or flat tax rate
Others have pointed out that the world- would need to be roughly 20 percent.218
wide tax system, based on the idea of CEN, is a The consumption base and territorial
form of tax protectionism or “beggar-my- nature of the retail sales tax and the flat tax
neighbor neutrality.”214 It ends up making all would eliminate most U.S. international tax
countries worse off by increasing capital taxa- rules. There would be no need for rules on
tion and reducing the worldwide capital stock. foreign affiliates’ earnings, foreign tax cred-
In pursuit of the questionable notion of “neu- its, or other parts of the current internation-
trality,” it hurts U.S. companies and foreign al tax apparatus. As noted, a territorial tax
economies without aiding the U.S. economy. would allow U.S. businesses to compete in
Norman Ture and George Carlson observed a foreign markets without tax burdens
decade ago that “capital export neutrality, in imposed by the federal government.
effect, is preoccupied with the respective A reform as large as adopting a sales or flat
domestic and foreign shares of a smaller pie tax could have substantial effects on interna-
(the stock of capital) rather than making a big- tional investment flows. Changes may cause
ger pie.”215 That focus on redistributing the investment to flow into the United States in
“pie” rather than making it bigger is a preoc- some situations and out of the country in
cupation of people who oppose international other situations. On net, most experts think
tax competition in general. that a low-rate consumption-based tax would
The United States could move to a territo- make this country a tax haven and attract sub-
rial tax system for businesses within the stantial net investment inflows.
framework of the current income tax, which Under a territorial tax, U.S. individuals A consumption-
at its simplest would mean exempting from could search for low-tax investment opportuni-
U.S. taxation the active business profits of ties abroad, free of U.S. tax on foreign earnings. based tax would
U.S. foreign affiliates.216 Some taxation of However, neither the retail sales tax nor the flat increase invest-
foreign portfolio income would still be need- tax would be imposed on domestic investment ment and eco-
ed if the United States retained a broad-based returns either, so individuals would likely keep
income tax system. Better still, we could most financial investments in the United nomic growth
move to a full territorial system for individu- States.219 For foreign individuals, the United and greatly sim-
als and businesses if we adopted a major con- States would be a tax haven because interest,
sumption-based tax reform. dividends, and capital gains would not be taxed
plify federal
by the federal government. This policy would taxation.
Pursue Consumption-Based Tax Reform expand on the current tax exemption for bank
In recent years, there has been great inter- and portfolio interest earned by foreigners in
est in replacing the individual and corporate the United States. Overall, there likely would be
income taxes with a consumption-based tax a net increase in portfolio investment flows to
system. Proposals have included a national the United States.

31
Table 4
Investment Location Decisions under a U.S. Income Tax

Investment Location
United States Foreign A Foreign B

Tax rate 35% 10% 45%


Net cost of machine 1,000 1,000 1,000
Return, before tax 100 100 100
Foreign income tax – 10 45
U.S. income tax 35 35 35
Foreign tax credit – 10 35
Total tax 35 35 45
Return, 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 of
a Broad-Based Consumption Tax, June 1998, www.usitc.gov, p. 17.
Note: Except as otherwise indicated, values are dollars.

The territorial The elimination of individual taxation on for capital-intensive industries to locate in
savings and investment returns would substan- the United States. “Expensing” means allow-
nature of the flat tially reduce tax avoidance and evasion activity. ing firms to immediately deduct capital pur-
tax and sales tax However, it is likely that any new tax system chases, such as buildings and equipment.
would make the would provide some channels for tax evasion. Tables 4 and 5 illustrate the location advan-
For example, a national retail sales tax would tage for a U.S. investor that the United States
United States an create incentives for people to shop abroad. would achieve under a 20 percent flat tax
attractive location However, evasion is likely to be lower under a with expensing. Table 4 shows that, under an
consumption tax than an income tax because income tax, an investment in the United
for corporate consumption is less mobile than flows of States or a low-tax country, A, would earn a
headquarters. investment capital, which are taxed under the 6.5 percent after-tax rate of return. A lower
current system. Therefore, a consumption- 5.5 percent return would be earned in a high-
based tax would provide a more stable tax base tax country, B. Table 5 indicates that, under a
in the face of increasing global tax competition. U.S. flat tax, the return on investment would
For multinational corporations, con- rise the most for investments in the United
sumption tax reform would lead to changes States. And it shows that Americans would
in incentives for real investment, financial have an even greater disincentive to invest in
restructuring, and transfer pricing. For real high-tax countries, thus increasing interna-
investment, the low rate of the flat tax, and tional tax competition.
lack of a business-level tax under a sales tax, The territorial nature of the flat tax and
would make the United States a great loca- sales tax would make the United States an
tion for domestic and foreign businesses. 220 attractive location for corporate headquar-
Direct investment would flow into the ters, since foreign operations would not be
United States, particularly from countries taxed by the U.S. government. A territorial
with territorial tax systems because firms system would eliminate the current disincen-
based in those countries would receive the tive to repatriate foreign profits because they
full benefit of the lower U.S. tax rate. could be brought home tax-free. Hines con-
The provision for business expensing cludes that “on net, the attractiveness of the
under the flat tax would create an incentive United States as a profit location after fun-

32
Table 5
Investment Location Decisions under a U.S. Flat Tax

Investment Location
United States Foreign A Foreign B

Tax rate 20% 10% 45%


Net cost of machine 800 1,000 1,000
Return, before tax 100 100 100
Foreign income tax – 10 45
U.S. flat tax 20 – –
Foreign tax credit – – –
Total tax 20 10 45
Return, 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 of
a Broad-Based Consumption Tax, June 1998, www.usitc.gov, p. 17.
Note: Except as otherwise indicated, values are dollars.

damental tax reform implies that U.S. firms exempt. By contrast, the flat tax, like the cur-
will very likely shift some of their invest- rent income tax, is not border adjustable and
ments from foreign countries back to the thus would tax export receipts but allow
United States, and that foreign investors will deductions for imports. 224 Most economists
locate more of their investment in the United think border adjustability would not have
States as well.”221 large effects in the long run since the
Incentives related to R&D and intangible exchange rate would adjust for the tax differ-
assets may also change. Under the sales tax, roy- ence.225 But to the extent that the exchange
alties received from licensing intangibles to for- rate did not offset border adjustability, these
eigners would not create any taxable income in taxes might have somewhat different effects
the United States, thus increasing incentives for on international trade.
performing R&D domestically. Under the flat It is true that under a territorial tax, such as
tax, foreign royalties received probably would the flat tax, some businesses may move some
be taxable since the tax base includes export activities to foreign jurisdictions that have tax Most studies con-
receipts. Nonetheless, the lower tax rate under rates even lower than a 20 percent flat tax.
the flat tax would still make the United States Replacing the income tax with a flat tax may clude that a con-
an attractive location for R&D.222 In addition, cause both outflows and inflows of foreign sumption-based
the current R&D expense allocation rules, investment. However, most studies, including a territorial tax
which create an R&D disincentive for some 1998 report by the U.S. International Trade
firms, would be eliminated under both propos- Commission, conclude that a consumption- would, on net,
als. Overall, tax reform would be expected to based territorial tax would, on net, attract attract invest-
increase U.S. R&D expenditures.223 investment inflows and encourage U.S. firms to
There are a number of differences between increase domestic capital investment.226
ment inflows and
a flat tax and a sales tax with regard to inter- With regard to corporate financial trans- encourage U.S.
national trade. Although both tax proposals actions, tax reform would change a number firms to increase
are territorial, they differ with regard to of incentives. As noted, a territorial tax would
imports and exports. A retail sales tax would encourage the repatriation of profits from domestic capital
be “border adjustable” so that imports would foreign affiliates. As a result, some share of investment.
face U.S. taxation, but exports would be the large stock of currently unrepatriated for-

33
Just as the United eign earnings would flow back to the United own tax systems along the lines of the new
States led the States with the adoption of a flat tax or sales U.S. tax system.231 Countries would be put
tax.227 Also, there would be an incentive for under great pressure to reduce tax rates on
world in tax businesses to shift interest income to the capital income because the United States
reform in the United States under the flat tax and sales tax, would become an even bigger magnet for
as those receipts would not be taxed. global capital flows than it already is.
1980s, U.S. con- On the other hand, new financial strategies The territorial nature of a consumption-
sumption-based to reduce U.S. taxes could be expected under based tax in the United States would put great
tax reforms any major tax reform. For example, the flat pressure on high-tax countries. That would
tax’s exclusion of interest would create an occur because of the elimination of the U.S.
would launch a incentive to relabel export receipts as interest foreign tax credit, which currently shields
new round of tax income to avoid taxes. In addition, companies some tax paid by U.S. firms in high-tax coun-
would want to repatriate foreign earnings as tries because of the partial ability to blend
reforms around interest because it would be deductible in the high- and low-tax foreign income. Without
the world. foreign country and not taxable in the United that mechanism, U.S. companies would
States. In general, since the United States reduce investment in high-tax countries.232
would be a low-tax country after tax reform, Countries dependent on income taxes would
U.S. and foreign firms would alter debt and have a strong incentive to adopt a consump-
equity financing structures to move taxable tion-based system to prevent investment from
income into this country. Overall, the United flooding to the United States.
States would be expected to gain from such As other countries reduced tax rates on
financial adjustments. capital income, global output would rise as
Under the sales tax, the need for U.S. trans- capital investment increased and tax-induced
fer pricing rules would be eliminated. Under distortions were reduced. Just as the United
the flat tax, U.S. firms would continue to have States led the world in tax reform in the
incentives to use transfer pricing to shift tax- 1980s, U.S. consumption-based tax reforms
able income to low-tax countries. But the would launch a new round of tax reforms
United States itself would have a low tax rate, around the world.
so both U.S. and foreign firms would likely
shift profits into the United States. Experts
conclude that the overall pressure on U.S. Notes
transfer pricing would be reduced under a flat 1. “A domestic corporate tax increase will there-
tax.228 Hines finds that “all of the proposed fore tend to cause an outflow of corporate capital,
fundamental tax reforms greatly reduce incen- and in the long run, the resulting shortage of cap-
tives created by the U.S. tax system to relocate ital in the domestic economy will drive up the pre-
tax rate of return to wage earners, because the
profits abroad.”229 He also notes that “on net, lower capital intensity of domestic production
the tax base of the United States would will reduce labour productivity and real wage
increase, not decrease, through transfer pric- rates. Part of the burden may also fall on owners
ing of American and foreign multinationals of immobile factors of production such as falling
land rents and land prices.” Organization for
after fundamental tax reform.”230 Economic Cooperation and Development
What would be the reaction of other gov- (OECD), Taxing Profits in a Global Economy (Paris:
ernments to consumption-based tax reform OECD, 1991), p. 34.
in this country? Governments could take
2. Martin Feldstein, James Hines, and Glenn
measures to defend their tax bases from Hubbard, Introduction to Taxing Multinational
increased U.S. competition. There is, for Corporations, ed. Martin Feldstein, James Hines,
example, concern that some countries may and Glenn Hubbard (Chicago: University of
revoke benefits of U.S. investors under cur- Chicago Press, 1995), p. 3. See also Lucy
Chennells and Rachel Griffith, Taxing Profits in a
rent tax treaties. But most governments Changing World (London: Institute for Fiscal
would have a strong incentive to reform their Studies, September 1997), p. 67.

34
3. Adam Smith, An Inquiry into the Nature and Causes 17. IMF, International Capital Markets (Washington:
of the Wealth of Nations (1776; Chicago: University of IMF, August 2001), p. 6.
Chicago Press, 1976), vol. 2, p. 375.
18. These data are for flows of portfolio invest-
4. For a discussion of taxation and capital flows, see ment in securities, including stocks and bonds.
A. Lans Boverberg et al., “Tax Incentives and U.S. Department of Commerce, Survey of Current
International Capital Flows,” in Taxation in the Global Business, March 2002, Tables F.1, G.1.
Economy,ed. Assaf Razin and Joel Slemrod (Chicago:
University of Chicago Press, 1990), p. 293. 19. “U.S. Firms Find Global Progress Is a Two-
Edged Sword,” Wall Street Journal, August 17,
5. United Nations, World Investment Report 2001 1998.
(New York: United Nations Conference on Trade
and Development (UNCTAD), 2001), p. 291. 20. U.S. Department of Commerce, Survey of Cur-
rent Business, July 2000, p. 29, and March 2002, p. 24.
6. That rate is scheduled to rise to 12.5 percent in See also National Foreign Trade Council (NFTC),
2003, and the domestic corporate rate is sched- The NFTC Foreign Income Project: International Tax
uled to be cut to conform to the same 12.5 per- Policy for the 21st Century (Washington: NFTC, 1999),
cent rate. part 1, pp. 5–6, 6–13.

7. “Economic and Financial Indicators,” The Econo- 21. Ray Mataloni, U.S. Department of Commerce,
mist, March 2, 2002, p. 98. Ireland’s per capita gross Bureau of Economic Analysis, e-mail to authors,
domestic product in 2001 on a purchasing power par- June 22, 2001.
ity basis is the sixth highest in the OECD.
22. In 1999, 78 percent of the gross product of
8. United Nations, “Developed Country FDI Soars U.S. majority-owned affiliates was produced in
by 21%,” UNCTAD press release, September 18, Europe, Canada, Australia, and Japan. U.S.
2001. Department of Commerce, Survey of Current
Business, March 2002, p. 28. See also Peter Merrill
9. OECD, Harmful Tax Competition: An Emerging Global and Carol Dunahoo, “Runaway Plant Legislation:
Issue (Paris: OECD, April 1998), p. 14. Rhetoric and Reality,” Tax Notes, July 8, 1996.

10. In the United States, Internal Revenue Service data 23. United Nations, World Investment Report (New
show that the highest-income 5 percent of federal tax- York: UNCTAD, 1999), p. 1.
payers paid 55 percent of all income taxes in 1999. U.S.
Congress, Joint Economic Committee, “New IRS data 24. IMF, International Capital Markets, chap. 2, p. 4.
on Income Tax Shares Now Available,” Press release,
January 14, 2002, www.house.gov/jec. 25. NFTC, part 1, p. 5-7.

11. International Monetary Fund (IMF), World 26. For a discussion, see Roger Gordon and Vitor
Economic Outlook (Washington: IMF, October Gaspar, “Home Bias in Portfolios and Taxation of
2001), chap. 4, p. 145. Asset Income,” National Bureau of Economic
Research (NBER) Working Paper 8193, March
12. United Nations, World Investment Report 2001, 2001.
p. 12.
27. U.S. Department of Commerce, Survey of
13. Ibid., pp. 12, 14. Current Business, July 2000, p. 32.

14. Richard McKenzie and Dwight Lee, Quicksil- 28. James Hines, Introduction to International
ver Capital: How the Rapid Movement of Wealth Has Taxation and Multinational Activity, ed. James Hines
Changed the World (New York: Free Press, 1991). (Chicago: University of Chicago Press, 2001), p. 1.
See also James Hines, “Lessons from Behavioral
15. Vito Tanzi, “Globalization, Technological Responses to International Taxation,” National
Developments, and the Work of Fiscal Termites,” Tax Journal, June 1999, p. 305.
IMF Working Paper 181, November 2000.
29. Rosanne Altshuler, Harry Grubert, and Scott
16. Different sources use somewhat different def- Newlon, “Has U.S. Investment Abroad Become
initions of foreign direct investment, including More Sensitive to Tax Rates?” in International
variations on the ownership, or voting power, Taxation and Multinational Activity, p. 28
threshold of 10 percent. Another variation has to
do with whether earnings retained by foreign 30. Ibid.
affiliates are counted as a direct investment flow
or not. 31. Reint Gropp and Kristina Kostial, “The Dis-

35
appearing Tax Base: Is Foreign Direct Investment States: The Economic Basis of the Brain Drain,”
Eroding Corporate Income Taxes?” IMF Working in The International Migration of the Highly Skilled, ed.
Paper 173, October 2000, www.imf.org/external/ Wayne Cornelius, Thomas Espenshade, and
pubind.htm. See also Agness Benassy-Quere, Lionel Idean Salehyan (San Diego: University of
Fontagne, and Amina Lahreche-Revel, “Foreign California, Center for Comparative Immigration
Direct Investment and the Prospects for Tax Co- Studies, 1991), pp. 291–323.
Ordination in Europe,” Centre D’Etudes Prospec-
tives et Information Internationales Working Paper 45. Mahmood Iqbal, “Are We Losing Our Minds?
6, April 2000. Trends, Determinants and the Role of Taxation in
Brain Drain to the United States,” Conference
32. Martin Sullivan, “Data Show Europe’s Tax Board of Canada, 1999.
Havens Soak Up U.S. Capital,” Tax Notes, February
4, 2002. 46. Ibid. See also Pascal Salin, “International Tax
Problems: between Coordination and Competi-
33. Deborah Swenson, “Transaction Type and tion,” Paper presented to the Mont Pèlerin
the Effect of Taxes on the Distribution of Foreign Society General Meeting, Vancouver, Canada,
Direct Investment in the United States,” in August 30, 1992.
International Taxation and Multinational Activity, pp.
89–112. The study, however, found that high state 47. Valerie Lawton, “Job Drain Overshadows
taxes did not deter company acquisitions by for- Brain Drain,” Toronto Star, December 2, 1999.
eign investors.
48. Grimsley.
34. IMF, International Capital Markets, chap. 2, p. 4.
49. Jack Anderson, “A Misery Index,” Forbes, Febru-
35. Sven-Olaf Lodin, “International Tax Issues in ary 21, 2001. See also Jean Francois-Poncet, “Brain
a Rapidly Changing World,” International Drain: Myth or Reality?” Senate of France, Report
Bureau of Fiscal Documentation Bulletin, January no. 388, 1999–2000 sess., June 7, 2000.
2001, p. 6.
50. Ibid. Anderson says that there are 60,000
36. European Parliament, “Tax Co-ordination in French engineers in Silicon Valley.
the European Union,” Working Paper ECON 125,
December 2000, p. 15, www.europarl.eu.int/ 51. Ireland Central Statistical Office, “Population
workingpapers/econ/default_en.htm. and Migration Estimates,” August 2001,
www.cso.ie/publications/demog/popmig.
37. OECD, Trends in International Migration (Paris:
OECD, 2001). See also Kirstin Downey Grimsley, 52. Lisa Ugur, “One Tenor and a Taxman,” July
“Global Migration Trends Reflect Economic 31, 2000, www.tax-news.com.
Options,” Washington Post, January 3, 2002, p. E2.
53. Ulrika Lomas, “Becker Could Face Jail over
38. Steven Globerman, “Trade Liberalisation and £13m Tax,” July 3, 2001, www.tax-news.com.
the Migration of Skilled Professionals and
Managers: The North American Experience, 54. Association of Americans Resident Overseas,
World Economy 23, no. 7 (July 2000): 901–22. “FAQ,” http://aaro-intl.org.

39. Grimsley. 55. Jon Dougherty, “The Power to Destroy:


Global Reach of the IRS, Americans Living
40. Sheela Murthy, “Major Immigration Bill Passes Overseas,” Offshore Center Headline News,
Both Houses of Congress,” October 3, 2000, August 24, 2001, www.theoffshorecentre.com.
www.murthy.com/UDh1f.html.
56. “U.S. Makes it Harder to Renounce Citizenship,”
41. OECD, Trends in International Migration. U.S. Visa News Headlines, January 4, 1999,
www.usvisanews.com.
42. Anna Lee Saxenian, “Silicon Valley’s Skilled
Immigrants: Generating Jobs and Wealth for 57. OECD, “Tax Rates Are Falling,” OECD in
California,” Public Policy Institute of California Washington, March–April 2001. Does not include
Research Brief, June 1999, www.ppic.org. state or provincial taxes.

43. Joel Kotkin, “Welcome to the Casbah,” 58. Income tax rates are scheduled to fall under the
American Enterprise, January 1999. Economic Growth and Tax Relief Reconciliation Act
of 2001. For details of the act, see U.S. Congress,
44. Mahmood Iqbal, “The Migration of Highly- Joint Committee on Taxation, “Summary of
Skilled Workers from Canada to the United Provisions Contained in the Conference Agreement

36
for H.R. 1836, the Economic Growth and Tax Relief Corporate Tax Rate Reductions,” January 2002,
Reconciliation Act of 2001,” JCX-50-01, May 26, www.fin.gc.ca.
2001, www.house.gov/jct.
74. The average EU effective corporate rate has
59. James Gwartney and Robert Lawson, Economic fallen substantially since the mid-1980s. See
Freedom of the World: Annual Report 2001 (Vancouver: European Parliament, “The Reform of Taxation
Fraser Institute, 2001). in EU Member States,” Working Paper ECON
127, May 2001, p. 55, www.europarl.eu.int/work-
60. Canadian Department of Finance, “Canadian ingpapers/econ/default_en.htm. See also
Tax Advantage,” January 2002, www.fin.gc.ca/ Benassy-Quere; Fontagne, and Lahreche-Revel;
toce/2002/cantaxadv_e.html. Lodin, “The Competitiveness of EU Tax Systems”;
and Gropp and Kostial.
61. Chris Edwards, “Entrepreneurial Dynamism and
the Success of U.S. High-Tech,” U.S. Congress, Joint 75. Joel Slemrod, “Tax Effects on FDI in the U.S.,”
Economic Committee, 106th Cong., October 1999. in Taxation in the Global Economy, p. 104. Average
tax rates may also be relevant for decisionmaking
62. Paul van den Noord and Christopher Heady, by investors in some situations.
“Surveillance of Tax Policies: A Synthesis of
Findings in Economic Surveys,” OECD Working 76. Jack Mintz and Michael Smart, “Income
Paper 303, July 17, 2001, p. 51. Shifting, Investment, and Tax Competition:
Theory and Evidence from Provincial Taxation in
63. Sven-Olof Lodin, “The Competitiveness of EU Canada,” University of Michigan Business School
Tax Systems,” International Bureau of Fiscal Docu- Working Paper 2001-15, July 2001, p. 2.
mentation European Taxation, May 2001, p. 169.
77. The Internet site, www.siteselection.com, has
64. Ulrika Lomas, “European Union Concerned numerous news stories about U.S. and foreign tax
over Germany’s Abolition of Capital Gains Tax,” breaks and other government incentives for par-
April 12, 2001, Tax-News.com. ticular investment deals.

65. Alessandro Bavila, “Moving away from Global 78. Alex Easson, “Tax Incentives for Foreign Direct
Taxation: Dual Income Tax and Other Forms of Investment: Part 1,” International Bureau of Fiscal
Taxation,” International Bureau of Fiscal Documen- Documentation Bulletin, July 2001, p. 266.
tation European Taxation, June 2001, p. 216. See also
van den Noord and Heady, pp. 29, 46. 79. Lawson and Gwartney.

66. Isabelle Joumard, Tax Systems in European 80. van den Noord and Heady.
Union Countries (Paris: OECD, June 2001), p. 26.
81. Daniel Frisch, “The Economics of International
67. Ken Messere, “Tax Policy in Europe: A Tax Policy: Some Old and New Approaches,” Tax
Comparative Survey,” International Bureau of Notes, April 30, 1990. A third theory of “national neu-
Fiscal Documentation European Taxation, Decem- trality” also has some supporters.
ber 2000, pp. 528, 531.
82. Carl Dubert and Peter Merrill, Taxation of U.S.
68. Harry Huizinga and Gaetan Nicodeme, “Are Corporations Doing Business Abroad: U.S. Rules and
International Deposits Tax-Driven?” European Competitiveness Issues (Morristown, N.J.: Financial
Commission Economic Paper no. 152, July 2001, Executives Research Foundation and Pricewater-
p. 31. houseCoopers, 2001), p. 68.

69. Ibid., p. 32. 83. NFTC, p. viii.

70. Chennells and Griffith, p. 28 and Appendix C. 84. Ibid., part 1.

71. John Whalley, “Foreign Responses to U.S. Tax 85. Dubert and Merrill, p. 75.
Reform,” in Do Taxes Matter? The Impact of the Tax
Reform Act of 1986, ed. Joel Slemrod (Cambridge, 86. Frisch.
Mass.: MIT Press, 1990), pp. 293, 305.
87. Dubert and Merrill, Table 10-2.
72. KPMG, “Corporate Tax Rate Survey,” January
2002 and prior years, www.us.kpmg.com/ 88. To be more precise, CFCs are foreign corpo-
microsite/Global_Tax/TaxFacts. rations that are at least 50 percent owned by U.S.
individuals or corporations who hold stakes of at
73. Canadian Department of Finance, “Federal least 10 percent each.

37
89. Hugh Ault and David Bradford, “U.S. Taxation U.S. exports in 1999. U.S. Department of
of International Income,” in Taxation in the Global Commerce, Survey of Current Business, March 2000,
Economy, pp. 38, 41. p. 24. See also NFTC, part 1, pp. 5-6, 6-13.

90. Mintz and Smart, p. 2. See also Andrew Lyon, 103. For a summary of portfolio investment rules,
“International Implications of U.S. Business Tax see Yaron Reich, “Taxing Foreign Investors’ Portfo-
Reform,” Canadian Department of Finance lio Investments: Developments and Discontinui-
Working Paper 96-6, December 1996, p. 14. ties,” Tax Notes International, February 1998.

91. A good discussion of these rules is contained 104. Marshall Langer, “Harmful Tax Competition:
in Dubert and Merrill. See also Ault and Bradford, Who Are the Real Tax Havens?” Tax Notes, January
pp. 11–52. 29, 2001, p. 667. See also Reich, p. 9.

92. Glenn Hubbard and Rosanne Altshuler, “The 105. Langer.


Effect of the Tax Reform Act of 1986 on the
Location of Assets in Financial Services Firms,” 106. U.S. Department of Commerce, Survey of
Seminar presentation, American Enterprise Current Business, March 2002, Table G.1.
Institute, February 19, 1999, p. 7. Under the
recent economic stimulus law, Congress allowed 107. Frisch.
firms to defer tax on active financial services
income until repatriated under a temporary pro- 108. Reich, p. 36.
vision expiring in 2006.
109. Joel Slemrod, “Impact of Tax Reform Act of
93. For a precise description of these rules, see 1986 on Foreign Direct Investment,” in Do Taxes
Dubert and Merrill. Matter? pp. 172, 173.

94. Ibid., p. 85. 110. Brian Lebowitz, “Transfer Pricing and the
End of International Taxation,” Tax Notes,
95. NFTC, part 1, p. A-18. September 10, 1999.

96. Dubert and Merrill, p. 29. 111. James Hines, Introduction to International
Taxation and Multinational Activity, p. 1.
97. For example, see National Chamber
Foundation and Price Waterhouse, U.S. Interna- 112 Charles Tiebout, “A Pure Theory of Local
tional Tax Policy for a Global Economy (Washington: Expenditures,” Journal of Political Economy,
National Chamber Foundation, May 1991). This October 1956, pp. 416–24.
study found a tax rate on U.S. foreign business
income that was higher than the rates of six other 113. For a recent survey of the literature, see John
major countries examined. Douglas Wilson, “Theories of Tax Competition,”
National Tax Journal, June 1999, pp. 269–301.
98. Joel Slemrod and Marsha Blumenthal, “The
Income Tax Compliance Cost of Big Business,” 114. European Parliament, “Fact Sheet 3.4.8:
Tax Foundation, November 1993. Personal and Company Taxation,” October 19,
2000, www.europarl.eu.int/factsheets.
99. Glenn Hubbard, “Comments on Sen. McCain’s
Tax Policy toward U.S. Multinationals,” Tax Notes, 115. OECD, Harmful Tax Competition, p. 14.
March 6, 2000, p. 1433.
116. Ibid., p. 16.
100. Norman Ture and George Carlson, “Tax Policy
to Address the Challenges and Opportunities of the 117. Ibid. See also European Parliament, “Tax Co-
Growing World Marketplace,” in U.S. Foreign Tax ordination in the European Union,” p. 18,
Policy: America’s Berlin Wall, Conference proceedings www.europarl.eu.int/workingpapers/econ/default
(Washington: Institute for Research on the _en.htm.
Economics of Taxation, 1991), p. 26. For example,
the 1986 tax act added layers of complex new tax 118. OECD, Towards Global Tax Co-operation:
rules in an effort to raise about $9 billion extra from Progress in Identifying and Eliminating Harmful Tax
multinational corporations. Practices (Paris: OECD, 2000), p. 5.

101. NFTC, part 1. 119. OECD, Harmful Tax Competition, p. 13.

102. U.S. exports associated with the U.S. multi- 120. OECD, The OECD’s Project on Harmful Tax
national corporations were 63 percent of total Practices: The 2001 Progress Report (Paris: OECD,

38
November 2001), p. 4. 2002 and prior annual surveys, www.us.kpmg.
com/microsite/Global_Tax/TaxFacts. This rate
121. Wallace Oates, “Fiscal Competition or includes the basic corporate income tax rate, now
Harmonization? Some Reflections,” National Tax 25 percent, plus a “trade tax.”
Journal, September 2001, p. 507.
136. Weichenrieder, pp. 37–58.
122. European Parliament, “The Reform of Taxation
in EU Member States,” p. 7, www.europarl. 137. OECD, Harmful Tax Competition, pp. 40, 41.
eu.int/workingpapers/econ/default_en.htm.
138. NFTC, part 1, p. xiv.
123. Chris Edwards, “Economic Benefits of
Personal Income Tax Rate Reductions,” U.S. 139. Dubert and Merrill, p. 85.
Congress, Joint Economic Committee, 107th
Cong., April 2001. 140. Helmar Klink, Netherlands Foreign
Investment Agency, “Dutch Tax Policy Lightens
124. Martin Feldstein, “The 28% Solution,” Wall the Burden on High-Tech Companies,”
Street Journal, February 16, 2001. This estimate www.nfia.com.
relates to Bush’s original proposal of a $1.6 tril-
lion tax cut. 141. NFTC, part 1, p. 6-6.

125. Julie Roin, “Competition and Evasion: Another 142. “Treasury Study to Look at Reincorporation
Perspective on International Tax Competition,” of U.S. Multinationals in Foreign Countries,”
Georgetown Law Journal, March 2001, p. 553. Daily Report for Executives, March 1, 2002.

126. European Parliament, “The Reform of 143. European Parliament, “Fact Sheet 3.4.9:
Taxation in EU Member States,” p. 10, www. Fiscal Policy and Taxation,” October 20, 2000.
europarl.eu.int/workingpapers/econ/default_ www.europarl.eu.int/factsheets.
en.htm.
144. European Parliament, “Fact Sheet 3.4.8.”
127. Paul Starr, “The Meaning of Privatization,” Yale
Law and Policy Review 6 (1988): 6–41. See also Geoffrey 145. Ibid.
Brennan and James Buchanan, The Power to Tax:
Analytical Foundations of a Fiscal Constitution (Cambridge: 146. Ibid.
Cambridge University Press, 1980).
147. Cato calculations based on KPMG, “Corporate
128. Gary Becker, “What’s Wrong with a Centralized Tax Rate Survey,” January 2002 and prior annual
Europe? Plenty,” Business Week, June 29, 1998. surveys,www.us.kpmg.com/microsite/Global_Tax/
TaxFacts.
129. Roin, p. 564.
148. European Parliament, “Tax Co-ordination in the
130. Cited in “Not So Harmonious,” The Economist, European Union.” This document lists some good
March 31, 2001. and bad aspects of tax competition, although we don’t
think most of the bad ones are really bad. For example,
131. Roin, p. 559. “tax competition makes it extremely difficult to pur-
sue social and environmental objectives through the
132. For a view regarding the United States lead- tax system” strikes us as a good thing.
ing countries in the wrong direction with TRA86,
see Stanford Ross, “International Tax Law: The 149. Robert Lee, “Schroeder Calls for EU Tax
Need for Constructive Change,” in Tax Policy in the Powers, www.tax-news.com, February 25, 2002.
Twenty-First Century, ed. Herbert Stein (New York:
John Wiley & Sons, 1988), pp. 87–100. 150. “ECB Head Predicts Harmonisation Call,”
Financial Times, January 24, 2002, p. 8.
133. Harry Grubert, “Tax Planning by Companies
and Tax Competition by Government,” in 151. “The French Plan Ideas Confirm Worst Fears
International Taxation and Multinational Activity, p. 120. of Skeptics,” Daily Telegraph, May 29, 2001.

134. Alfons Weichenrieder, “Fighting International 152. United Nations, Recommendations of the High-
Tax Avoidance: The Case of Germany,” Fiscal Level Panel on Financing for Development (New York:
Studies (London: Institute for Fiscal Studies, United Nations, June 22, 2001), www.un.org/
1996), pp. 37–58. reports/financing. See also Diana Gregg, “UN
Panel Says Global Tax Organization Should Be
135. KPMG, “Corporate Tax Rate Survey,” January Explored at 2002 Conference,” Bureau of

39
National Affairs Daily Tax Report, July 6, 2001. 168. National Chamber Foundation and Price
Waterhouse, p. E-12.
153. Charles McLure, “Globalization, Tax Rules and
National Sovereignty,” International Bureau of 169. Joumard, p. 29.
Fiscal Documentation Bulletin, August 2001, p. 341.
170. For a discussion of taxation and the cost of
154. United Nations, Recommendations of the High- capital, see Joosung Jun, “Corporate Taxes and
Level Panel on Financing for Development. the Cost of Capital for U.S. Multinationals,” in
Taxing Multinational Corporations.
155. Ibid.
171. See Edwards, “Economic Benefits of
156. Ibid. Marginal Rate Cuts.”

157. For an extensive collection of documents 172. For a survey of the literature, see James
regarding the OECD initiative, see www.freedo- Andreoni, Brian Erard, and Jonathan Feinstein,
mandprosperity.org. “Tax Compliance,” Journal of Economic Literature,
June 1998.
158. OECD, Towards Global Tax Co-operation, p. 22.
173. For a summary of empirical estimates, see
159. For the U.S. tax system, the foreign sales cor- Edwards, “Economic Benefits of Marginal Rate Cuts.”
poration incentive is listed as a potentially harm-
ful preferential tax regime. 174. For a full discussion and documentation of
the debate, see www.freedomandprosperity.org.
160. European Parliament, “Tax Co-ordination in
the European Union,” p. xv, www.europarl. 175. Paul O’Neill, “OECD Harmful Tax Practices
eu.int/workingpapers/econ/default_en.htm. The Initiative,” Statement before the Permanent
study notes that “tax competition makes it Subcommittee on Investigations of the Senate
extremely difficult to pursue social and environ- Committee on Governmental Affairs, July 18, 2001.
mental objectives through the tax system: for
example, income redistribution . . . only co-ordi- 176. Dick Armey, Letter to U.S. Treasury Secretary Paul
nation will prevent ‘free-loading.’” O’Neill, March 16, 2002; and Letter to U.S. Treasury
Secretary Lawrence Summers, September 7, 2000.
161. U.S. Congress, Joint Economic Committee, “New
IRS Data on Income Tax Shares Now Available,” Press 177. Bruce Zagaris, “Issues Low-Tax Regimes
release, January 14, 2002, www.house.gov/jec/. The Should Raise When Negotiating with the
Economist reports that the top 5 percent of income OECD,” Tax Notes International, January 29, 2001,
earners in Germany pay 40 percent of German income p. 524. See also Dan Mitchell, “An OECD
taxes. “A Survey of the New Rich,” The Economist, June Proposal to Eliminate Tax Competition Would
16, 2001, p. 9. Mean Higher Taxes and Less Privacy,” Heritage
Foundation, September 18, 2000, p. 20.
162. Amity Shlaes, “O’Neill Lays Out Radical
Vision for Tax,” Financial Times, May 19, 2001, p. 1. 178. Langer. See also Reich, p. 9.

163. OECD, Harmful Tax Competition, p. 15. 179. OECD, The OECD’s Project on Harmful Tax
Practices.
164. European Parliament, “The Reform of Taxation
in EU Member States,” p. 13, www.europarl. 180. O’Neill.
eu.int/workingpapers/econ/default_en.htm.
181. Proposed U.S. Treasury regulation REG-
165. Lodin, “The Competitiveness of EU Tax 126100-00. The United States shares such informa-
Systems,” p. 167. With scheduled cuts, the average tion only with Canada currently. For background,
European corporate rate will be 29.5 percent by see Institute for Research on the Economics of
next year. European Parliament, “The Reform of Taxation (IRET), “IRET Congressional Advisory,”
Taxation in EU Member States.” no. 116, June 28, 2001, www.iret.org.

166. KPMG, “Corporate Tax Rate Survey,” 182. U.S. Department of Commerce, Survey of
January 2002, www.us.kpmg.com/microsite/ Current Business, March 2002, Table G.1.
Global_Tax/TaxFacts.
183. Robert Davis, America’s Community
167. European Parliament, “The Reform of Bankers, Letter to Kate Hwa, IRS, Office of
Taxation in EU Member States,” pp. 55, 66, 95. General Council, May 31, 2001.

40
184. O’Neill. Policy toward U.S. Multinationals,” p. 1435.

185. Dan Mitchell, “Money-Laundering Bill 197. Bob Perlman, Testimony before the Senate
Should Target Criminals, Not Low Taxes,” Finance Committee, March 11, 1999.
Heritage Foundation, October 16, 2001.
198. This comment referred to the foreign tax credit
186. Dan Mitchell, “U.S. Government Agencies rules in particular. American Bar Association, “Tax
Confirm That Low-Tax Jurisdictions Are Not Simplification Recommenda-tions,” February 2001,
Money Laundering Havens,” Prosperitas 2, no. 1 www.abanet.org/tax/pubpolicy/2001/01simple/
(January 2002), www.freedomandprosperity.org. home.html.

187. Julie Wakefield, “Following the Money,” 199. Ibid.


Government Executive, October 1, 2000, www. gov-
exec.com. See also William Schroeder, “Money 200. Soon after passage of TRA86, experts realized that
Laundering: A Global Threat and the International many of the new tax rules would damage the ability of
Community’s Response,” Law Enforcement Bulletin U.S. firms to compete in world markets. For example,
70, no. 5 (May 2001); and United Nations, a 1991 Ernst & Young report concluded, “The United
“Financial Havens, Banking Secrecy, and Money States subjects the foreign operations of its multina-
Laundering,” 1998, www.imolin.org/finhaeng.htm. tionals to the severest constraints and the heaviest tax
burden of any of the four countries studied [the
188. For a further discussion, see Mitchell, “An United States, Germany, Japan, and the Netherlands].”
OECD Proposal to Eliminate Tax Competition Ernst & Young, “The Competitive Burden: Tax
Would Mean Higher Taxes and Less Privacy.” Treatment of U.S. Multinationals,” Tax Foundation
Special Report, 1991, p. 2.
189. Armey.
201. National Chamber Foundation and Price
190. U.S. Department of Commerce, Survey of Waterhouse. Problems include interest and R&D
Current Business, March 2002, Table G.1. See also allocation rules, the fact that foreign govern-
Langer, p. 665. ments allow tax deferral for a wider scope of sub-
sidiary activities, the foreign tax credit basket sys-
191. Arthur Wright, “Harmful Tax Competition: tem, the general complexity of U.S. rules, and a
Response to Messrs. Osterweil and Francke,” Tax lack of U.S. provisions for tax sparing.
Notes, November 30, 1998.
202. NFTC, part 1, p. viii.
192. This is a page count of the tax code, regula-
tions, and related items. Commerce Clearinghouse, 203. Ibid., part 1, p. 6-2.
Inc., News release, January 14, 2000, www.cch.com,
as updated in a May 2001 e-mail from CCH. 204. In 1994, U.S. CFCs were financed 77 percent
by foreign debt, equity, and reinvestment of for-
193. For example, a 1991 report by the National eign earnings. U.S. Department of Commerce,
Chamber Foundation and Price Waterhouse U.S. Direct Investment Abroad, 1994 Benchmark
found that there were higher tax rates on U.S. Survey, January 1997.
firms’ foreign income than on foreign income
earned by firms based in the U.K., Japan, or the 205. For example, 63 percent of U.S. exports are asso-
Netherlands. See National Chamber Foundation ciated with U.S. multinational corporations. See
and Price Waterhouse. Department of Commerce, Survey of Current Business,
March 2002, p. 24. See also David Riker and Lael
194. For a summary of studies on this and related Brainard, “U.S. Multinationals and Competition from
issues, see Rosanne Altshuler, “Recent Low Wage Countries,” NBER Working Paper 5959,
Developments in the Debate on Deferral,” Tax Notes, March 1997, http://papers. nber.org
April 10, 2000. See also Harry Grubert, “Dividend
Exemption,” Paper presented at Brookings 206. Department of Commerce, Survey of Current
Institution Conference on Territorial Taxation, Business, March 2002, p. 24. See also NFTC, part 1,
April 30, 2001. p. 6-14.

195. Glenn Hubbard and James Hines, “Coming 207. Perlman.


Home to America: Dividend Repatriations by U.S.
Multinationals,” NBER Working Paper 2931, 208. NFTC, part 1, p. 6-21.
April 1989, http://papers.nber.org.
209. Ian Springsteel, “No Place to Hide?” CFO
196. Hubbard, “Comments on Sen. McCain’s Tax Magazine, February 1, 2001, www.cfo.com.

41
210. “Treasury Study to Look at Reincorporation 219. James Hines, “Fundamental Tax Reform in
of U.S. Multinationals in Foreign Countries.” an International Setting,” Paper presented at the
Brookings Institute Conference on the Economic
211. Dubert and Merrill, p. 78. Effects of Fundamental Tax Reform, February
15–16, 1996, p. 26.
212. Ibid., p. 75.
220. For example, Harry Grubert and Scott
213. Gary Hufbauer, “A Critical Assessment and Newlon conclude that under a consumption tax,
an Appeal for Fundamental Tax Reform,” “MNCs would likely shift tangible investment,
Institute for International Economics, March 11, intangible assets, and R&D to the United States.”
2000, www.iie.com. Harry Grubert and Scott Newlon, “The
International Implications of Consumption Tax
214. Ture and Carlson. Proposals,” U.S. Department of the Treasury,
September 13, 1995, p. 2.
215. Ibid., p. 23.
221. Hines, “Fundamental Tax Reform in an
216. One modest step toward territoriality would International Setting,” p. 23.
be “tax sparing” for U.S. investments in develop-
ing countries. Most other wealthy countries, 222. Ibid., p. 26.
including Japan, Germany, and Britain, have
some form of tax sparing, which exempts busi- 223. U.S. International Trade Commission,
nesses from tax on investments in low-income Implications for U.S. Trade and Competitiveness of a
countries to encourage them to adopt tax cuts. Broad-Based Consumption Tax, Publication 3110,
For example, under tax sparing if a developing June 1998, p. 21, www.usitc.gov.
country adopted a 10 percent corporate tax, U.S.
investors would benefit from the low rate’s pro- 224. Another way to describe this difference is to say
viding an added investment incentive. Under cur- that a retail sales tax is a “destination-based” tax,
rent law, the United States imposes the 35 percent whereas the flat tax is an “origin-based” tax. Note that
corporate tax on foreign income, thus reducing royalty and leasing receipts received from abroad may
the incentive effect of the lower foreign rate. Tax be considered U.S. exports and therefore taxed under a
sparing would allow developing countries to grow flat tax. For a full discussion of these issues, see Harry
their economies with private investment instead Grubert and Scott Newlon, Taxing Consumption in a
continuing to rely on foreign aid subsidies. See Global Economy (Washington: American Enterprise
James Hines, “Tax Sparing and Direct Investment Institute Press, 1997).
in Developing Countries,” in International Taxation
and Multinational Activity, p. 41. 225. U.S. International Trade Commission, p. 2. For a
different view, see Ernest Christian, “The International
217. Other consumption-based tax plans include a Components of Tax Reform,” Institute for Policy
consumed-income tax proposed by the Institute for Innovation Policy Report no. 66, February 2002.
Research on the Economics on Taxation. See IRET,
“The Inflow-Outflow Tax—A Savings-Deferred 226. U.S. International Trade Commission.
Neutral Tax System,” http://www.iret. org. Rep. Phil
English (R-Pa.) has introduced H.R. 86, which is a 227. J. D. Foster, “U.S. International Tax Policy:
simplified “USA Tax.” See Chris Edwards, Tax Neutrality or Investment Protectionism?”
“Simplifying Federal Taxes: The Advantages of Tax Foundation, November 1994, p. 13.
Consumption-Based Taxation,” Cato Institute
Policy Analysis no. 416, October 2001. 228. Lyon, p. 20.

218. A national retail sales tax may need a some- 229. Hines, “Fundamental Tax Reform in an
what higher rate than a flat tax. The particular International Setting,” pp. 19, 20, 21.
rate depends on the size of the exemption provid-
ed to low-income families and other factors. See 230. Ibid., p. 23.
Gary Robbins and Aldona Robbins, “Which Tax
Reform Plan? Developing Consistent Tax Bases 231. Lyon, p. 23.
for Broad-Based Tax Reform,” Institute for Policy
Innovation Policy Report no. 135, January 1996. 232. Ibid., p. 19.

42
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