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Financial Times

September 5, 2002

US gets no breaks in territorial dispute

By Amity Shlaes

The World Trade Organisation's arbitrators bashed America good this past week when it announced the US could be subject to up to Dollars 4bn in new tariffs. The US is to be punished, theoretically at least, because it does not comply with current WTO tax law.

At issue are preferential tax rates applied to income earned from exports abroad by US-based companies. Under the famous Foreign Sales Corporation rules, aka Extraterritorial Income Exclusion rules, US companies may receive tax breaks. The goal of the credits is to offset America's system of worldwide taxation. The WTO penalties are meant to compensate foreign groups for this "unfair" US advantage. It's not fun to be bullied by international bodies. What's more, Americans can make the case that US tax rates are none of the WTO's beeswax, taxation being a matter of sovereignty. One can also argue that the European groups and politicians leading this fight are not doing so out of pure dedication to the icon of tax neutrality; rather, they see a chance to use the WTO to undermine competitors.

Nonetheless, the WTO's ruling highlights the irrationality of the US's international tax laws. It also offers, in its negative way, an opportunity: to switch to a so-called territorial system.

To understand the story, you first have to know that there are, essentially, three different sorts of tax regime.

The first and worst of these systems, in terms of complexity, economic growth and sheer equity, is the global system. That is essentially what the US now has. In it, companies and individuals tend to be taxed twice - once in the non-US locality where they choose to do business and once in the US. Thus, a US company operating in Ireland is taxed both at Irish rates and at US rates (the latter being the fourth-highest in the world). The US company's Dutch competitor, by contrast, only pays Ireland's (low) corporate taxes. There are, of course, a number of offsets available here, such as the type of credits that triggered the WTO action. Still, it's a global system.

A deferral system, the second type, is an improvement in terms of WTO legality and clarity. It taxes income earned abroad but only if it is repatriated. This is what Congress, principally in legislation sponsored by Bill Thomas, chairman of the ways and means committee, is seeking. Still, there are some drawbacks to a deferral regime. The main one is that it is unnatural, and in economic terms distorting, to prevent companies from moving capital across borders whenever they feel like it. Rational activity - say, the repatriation of capital in order to make investments at home - is hampered by this system. Tax rules rather than sound business principles can come to dominate business decisions. What's more, it isn't exactly in America's long-term economic interest to institute a regime that discourages the flow of capital to the US.

Then there is a territorial system. This is what many other countries, but not the US, enjoy. Under this regime, Washington would tax Americans, and everyone else, solely on income earned stateside. Income earned abroad would be subject only to the tax laws of the relevant nation. Territoriality is legal by WTO standards; much of Europe already uses it.

So how to proceed? The first thing to realise, as with other tax stories, is that the problem is caused not merely by tax regimes' structures but also by relative tax rates among nations. After the 1986 tax reform act, the US corporate tax was 34 per cent, relatively low among developed nations. Since then, the US rate has gone up to 35 per cent (thank you, Clinton Administration). The rates of other nations have come down, often by dramatic amounts. This means that offsetting credits are commensurately smaller, making it more difficult for a US company to compete.

The second is that the global system is itself based on outdated theory. Public finance economists used to believe it most efficient to subject companies to the same US rates regardless of where they earned their income. Those economists believed economic output would be higher if companies based their decisions on pre- rather than post-tax rates of return. That theory would work fine - in a tax dreamworld where rates everywhere were the same. Economists today however are a little more realistic. They recognise both the distorting and discouraging effect of high tax rates and the encouraging effect of low rates. They also recognise that tax competition, something promoted by a territorial system, helps control otherwise greedy states and regimes. (For more, see the website of a pro-territoriality group, the Center for Freedom and Prosperity, at freedomandprosperity.org)

Which taxes us back to the WTO debate. Opponents of the ruling charge that this is all about helping Europe. If so, the best way the US can strike back is by going territorial. Tax territoriality would be a form of US unilateralism of which the scolding Europeans could for once approve.

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