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CF&P Strategic Memo, Janauary 6, 2003

Center for Freedom and Prosperity
Strategic Memorandum

Date:  Monday, January 6, 2003

To:      Supporters of Tax Competition

From: Daniel J. Mitchell, Heritage Foundation Senior Fellow

Re:      Analysis of 2002 and Prospects for 2003
__________________________________________________________

The holiday season is over and the tax competition battle is set to resume, which creates a good opportunity to review last year and do a little prognosticating for 2003.

For those who don't want to read more than one paragraph, 2002 was a remarkably successful year. The hard work of many people inside and outside the Administration helped convince the White House to reject the European Union's (EU) proposed savings tax cartel. This decision combined with Switzerland's emphatic opposition to the Directive ensures that fiscal competition will continue to act as a liberalizing influence in the world economy. But that is not the only good news. The "harmful tax competition" scheme of the Organization for Economic Cooperation and Development (OECD) remains moribund, largely thanks to leaders in many low-tax jurisdictions and free-market groups in the United States. Supporters of tax competition even overcame immense odds and blocked a proposed IRS regulation that would force U.S. banks to put foreign tax law above American tax law. And most impressive of all, advocates of international fiscal competition managed to prevent or neutralize all efforts either to prohibit companies from re-chartering in jurisdictions with better tax laws or to subject them to fiscal protectionism if they made the decision to "invert."

But this does not mean that the news is all good, or that the battles have all been won. Indeed, every single victory should be viewed as a temporary respite. The EU, for instance, has announced that it will continue to push for the Savings Tax Directive. The OECD is still trying to bully low-tax jurisdictions. The IRS regulation could be finalized any day. And the American left intends to renew its campaign against corporate "inversions." Unfortunately, there will never be a permanent (or at least long-term) victory in the battle for tax competition, financial privacy, and fiscal sovereignty until there is fundamental tax reform in the United States. Simply stated, IRS and Treasury bureaucrats will continue to agitate for tax harmonization policies such as "information-exchange" as long as America has a "worldwide" tax system. But if the internal revenue code is replaced by a simple and fair system like the flat tax, the United States government no longer will have any reason to care about income earned in other nations. And if this happened, Europe's welfare states would have almost no chance of convincing the United States to oppose tax competition. This would be the death knell of tax harmonization. The United States is the 800-pound gorilla in the world economy, and any effort to create a global tax cartel is bound to fail without American support.

Fortunately, there is growing evidence that the Bush Administration wants to reform the tax code. Proposals to reduce the double-taxation of corporate income are a sign that the White House understands the need to make America's tax code more competitive. President Bush's new Treasury Secretary, John Snow, should be a major ally in this regard. Mr. Snow is an economist who received his Ph.D. studying under Nobel Laureate (and avid tax competition supporter) James Buchanan. Snow also served on the National Commission for Economic Growth and Tax Reform in 1995-1996, displaying a solid understanding of tax policy. The President also named a new National Economic Council Chairman, Stephen Friedman, whose views on tax competition issues are a mystery. The optimistic view is that Friedman's Wall Street experience will make him very sensitive to the need to attract and retain financial capital, but only time will tell whether he is a strong ally.

So what happens next? There is every reason to believe that victories will outnumber defeats in 2003. Thanks to the Center for Freedom and Prosperity, the coalition supporting tax competition gets stronger every day, and the Center's work will be even more effective now that Republicans control the Senate. Most important of all, time is an ally. International competition is forcing governments to lower tax rates and reform tax codes continuing a process that began when Margaret Thatcher and Ronald Reagan slashed tax rates 20 years ago. The politicians usually do not like having to respond to this competitive pressure, which is why they want the OECD and EU to create tax cartels, but they will be forced to make additional pro-growth reforms if the battle to protect tax competition is successful. This is why the following battles are so important (for more information visit CF&P's web page at
http://www.freedomandprosperity.org/):

EU Savings Tax Directive:
Notwithstanding a steady stream of misleading propaganda throughout the year, the EU failed to achieve its primary tax harmonization goal. The EU Savings Tax Directive would have required low-tax jurisdictions to inform high-tax nations about the private financial affairs of selected non-resident investors. That was the bad news. The good news was that the EU required unanimous support from all member nations a difficult hurdle. Moreover, Luxembourg, Austria and Belgium promised to veto the Directive unless the bureaucrats in Brussels could trick six non-EU nations (including the United States and Switzerland) into participating in the cartel even though it was contrary to their national interests. 

Needless to say, this did not happen. Responding to a vigorous campaign organized by the Center for Freedom and Prosperity, the United States decided in July 2002 to oppose the EU scheme. The Treasury Department attempted to undermine this position, acting as if the White House had not made a decision. Fortunately, separate announcements in September and October by two of President Bush's senior advisers removed any ambiguity. Perhaps more importantly, Switzerland held firm a critical outcome since the EU claimed that the Directive could move forward if the Swiss capitulated. The debate become so heated that some European politicians even threatened the Swiss with sanctions even though EU nations routinely engage in unfettered commerce with some of the world's most barbaric and totalitarian nations. Fortunately, Luxembourg announced that it would use its national veto to block any protectionism against Switzerland.

Victory in 2002 does not mean the war is over. The EU already has announced that the Directive remains a top priority. As such, supporters of market liberalization will need to maintain pressure on the Bush Administration (and also keep their fingers crossed that Swiss lawmakers continue to defend their nation's interests).

2003 Prognosis: The EU Directive is dead. Many EU member nations are secretly relieved that the proposal failed. The bureaucracy will continue to make noise, but there is almost no way to resuscitate the proposed cartel.

OECD Anti-Tax Competition Initiative
Early last year, the OECD was able to get a large number of low-tax jurisdictions to send so-called commitment letters to the Paris-based bureaucracy. These letters, which promise changes to tax and privacy laws that will make it easier for high-tax nations to tax income earned outside their borders, were sent because the OECD was threatening these jurisdictions with financial protectionism. But these letters contained a "virus" the jurisdictions promised to implement bad tax and privacy laws only if all OECD member nations agreed to the same misguided policies. This put the bureaucrats in a difficult situation since several member nations (including the United States, the United Kingdom, Switzerland, and Luxembourg) are "tax havens" according to OECD criteria. This explains why it was so important to defeat the EU Savings Tax Directive. Had the Directive been approved, it would have created a tax cartel among 21 of the world's most powerful nations - and also obligated more than 30 blacklisted low-tax jurisdictions to implement the policies contained in the commitment letters.

Even though the EU Savings Tax Directive collapsed, the OECD is still trying to pressure low-tax jurisdictions. This comes as no surprise to those who have observed the OECD's dishonest tactics over the last two-three years. Fortunately, the low-tax jurisdictions have performed admirably. They have refused to implement the OECD wish-list, and two nations Panama and Antigua have sent letters to Paris explaining that they no longer are bound by the earlier commitment letters. Hopefully, this will be the start of a trend.

Last but not least, the seven nations (Andorra, Liechtenstein, Liberia, Monaco, The Marshall Islands, Nauru and Vanuatu) that refused to capitulate to the OECD deserve special praise. Their defense of national sovereignty was seen as risky. Yet none of these jurisdictions has been subjected to financial protectionism.

2003 Prognosis: The OECD "harmful tax competition" campaign will remain stalled. More low-tax jurisdictions will disavow their commitment letters. The OECD may even face budget cuts because many U.S. lawmakers now see it as a counter-productive bureaucracy.

IRS Interest Reporting Regulation
In the waning days of the Clinton Administration, the IRS proposed a regulation to force American banks to report the interest paid to all nonresident aliens. This proposal was bad policy for a number of reasons. It would drive capital from U.S. banks. It would undermine tax reform. And it represented a flagrant abuse of the regulatory process. This proposal drew heated opposition from both industry and the public policy community. More than 99 percent of the submissions during the public comment period were hostile, and 100 percent of the testimony at the public hearing was negative. Numerous members of Congress weighed in against the proposed regulation, and CF&P mounted a strong lobbying campaign against the IRS scheme. About 18 months after the regulation was first proposed, this effort bore fruit. The IRS was forced to withdraw the regulation.

But in a duplicitous move, the IRS almost immediately re-issued the regulation after some cosmetic changes. Even worse, it appeared that certain segments of the financial services industry were tricked by the IRS bait-and-switch routine and planned to remain neutral, weakening the pro-tax competition coalition. Notwithstanding the odds, the Center for Freedom and Prosperity re-launched its battle against the regulation. Once again, the proposal attracted overwhelming opposition. In a mirror-image of the first fight, more than 99 percent of the public comments were against the regulation and the public testimony was unanimously negative to the IRS scheme as well. Many members of Congress also announced opposition to the new proposal.

There was considerable fear that the IRS would try to finalize the regulation before the end of the year (in part to give back-door support to the EU since the regulation could be misinterpreted as an "equivalent measure" and thus a sign of U.S. support for the Savings Tax Directive). Fortunately, this did not happen. But this may only be a short-term victory. The Treasury Department is actively pushing the proposal even though it puts the interests of foreign tax collectors above U.S. law and before the interests of the American economy. The Coalition for Tax Competition will continue to fight hard to block the regulation, and opponents also believe that a legal challenge will be successful if the proposal is finalized.

2003 Prognosis: The President's new economic team probably will decide this issue. If the decision goes the wrong way, expect a legal challenge since the regulation contravenes existing law and the IRS also failed to obey regulatory procedures such as preparation of a cost-benefit analysis.

Anti-Inversion Campaign
The United States has a very anti-competitive worldwide tax regime. Combined with the fourth highest corporate tax rate in the developed world, this makes it very difficult for U.S.-chartered companies to compete overseas. A U.S.-based company operating in Ireland, for instance, faces a tax burden that is three times bigger than its Dutch competitor. In an effort to remain competitive, some companies have chosen to re-incorporate (or invert) in jurisdictions such as Bermuda and the Cayman Islands that have better tax laws.

The left has jumped on this issue, using demagoguery to attack these companies as "unpatriotic" tax cheats. Some members of Congress sought to block inversions by introducing legislation that would treat these companies as U.S. taxpayers regardless of where they are chartered (nicknamed the "Dred Scott Tax Act" after the infamous 1857 Supreme Court decision that ruled slave remained property even if they escaped to a free state). Other members sought to bar the companies from competing for government contracts, even though this would mean higher costs for taxpayers. And some politicians even think that raising taxes on the U.S operations of foreign-based companies is a good way to discourage inversions.

Because 2002 was an election year, it was widely believed that these protectionist proposals would be approved. But the Coalition for Tax Competition worked very hard to explain that inversions were a way for American companies to compete on a level playing field. The companies keep their jobs and headquarters in America, but can compete overseas since they no longer have to pay an extra layer of tax to the IRS on income that is earned and taxed in other nations. Most important of all, lawmakers were told that inversions were evidence of the need to reform the tax code and shift to a territorial system (more on this in the next section).

2003 Prognosis: The left will launch several legislative initiatives and may even succeed in attaching anti-inversion amendments to legislation. Such efforts likely will be emasculated during House-Senate conference committees. There is some possibility that an anti-inversion provision could be included in a tax package that improves the competitiveness of U.S.-based companies.

FSC/ETI International Tax Reform
The World Trade Organization has ruled several times that the Foreign Sales Corporation/Extraterritorial Income Exclusion Act (FSC/ETI) provisions of the internal revenue code are impermissible "export subsidies." Because the European Union (which brought the case against the United States) has the right to impose $4 billion in "compensatory" tariffs if nothing happens, this decision almost surely forces U.S. policy makers to address the tax treatment of foreign-source income and creates a golden opportunity to make the American tax code more competitive. The best option would be territorial taxation, the common-sense notion that foreign-source income is no longer subject to U.S. tax. This approach is WTO-compliant and is the approach used by most nations. An intermediate option is expanded deferral, a policy that protects a U.S.-based company from having to pay tax on foreign-source income unless and until the money is repatriated to America.

Bill Thomas, Chairman of the House Ways & Means (tax-writing) Committee, already has introduced legislation to address the FSC/ETI issue. While it is closer to the "expanded deferral" approach instead of territorial taxation, it still would dramatically improve the tax treatment of foreign-source income for U.S.-based companies. This also is an issue where the shift to Republican control in the Senate should make a difference. Senator Grassley is the new Chairman of the Finance (tax-writing) Committee. And while he has been a nemesis on the issue of corporate inversions, it is likely that he will be an ally on the topic of international tax reform.

The Administration has made plenty of sympathetic noises about international tax reform, but they have yet to endorse an approach, much less a specific proposal. This may or may not change very soon when the President's budget is released. Regardless, the White House will support legislation to comply with the WTO and improve the competitiveness of U.S.-based companies.

2002 Prognosis: Legislation will be enacted that shifts America closer to a territorial system for corporate income. The legislation will be modest, but it will nonetheless signify an important weakening of America's foolish use of worldwide taxation. It is also possible that lawmakers will approve a one-time preferential rate to encourage companies to repatriate funds to America.

Conclusion
Supporters of tax competition, financial privacy, and fiscal sovereignty should be proud of their efforts. Fighting battles that few thought could be won, we have emasculated the OECD and stopped the EU cold. We have battled the IRS effectively and blunted the demagogic anti-inversion campaign. We even have a chance to finally go on the offensive and make the tax code better for internationally active companies. This does not mean we will win all these fights, though that is a possibility. But it does mean that individuals can make a difference.

If there is a dark cloud on the horizon, it is probably the project to create a European Constitution. The EU's high-tax welfare states will seek to use this opportunity to get rid of the "national veto" so that it will be easier to implement tax harmonization policies such as the Savings Tax Directive. This is an enormous long-term threat, but low-tax nations like Ireland, Luxembourg, Austria and the United Kingdom may not realize the danger. This also should be an important issue for the 10 accession nations. Why, after all, should the Baltic nations join the EU if it means that Brussels-based bureaucrats will soon have the ability to undermine market-based tax policies?

And while we are looking at long-term threats, we should not forget the United Nation's proposal for an International Tax Organization.  Giving the UN power over tax policy, to paraphrase P. J. O'Rourke, would be like giving whiskey and car keys to teenage boys. Another threat on the horizon is the OECD's campaign to interfere with national incorporation policies. Under the rubric of corporate governance, the OECD wants to interfere with jurisdictions (including many American states) that have low-cost, market-based incorporation policies.

Last but not least, we note with a mixture of sorrow and appreciation the retirement of House Majority Leader Dick Armey. Congressman Armey was the first member of Congress to join the fight against tax harmonization. His initial letter to the Clinton Administration (September 7, 2000 --
http://www.freedomandprosperity.org/armey.pdf) triggered a series of events that changed the course of history and made the world a better and freer place. Thank you, Mr. Armey.

_____________________________________________

Center for Freedom and Prosperity
P.O. Box 10882
Alexandria, Virginia 22310-9998
Phone: 202-285-0244    Fax: 208-728-9639
cfp@freedomandprosperity.org
www.freedomandprosperity.org
 

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