Center for Freedom and Prosperity Strategic Memorandum

Date: Monday, January 21, 2002

To: Supporters of tax competition, financial privacy, and fiscal sovereignty

From: Dan Mitchell, Heritage Foundation Senior Fellow

Re: Turning WTO Lemons into Territorial Lemonade
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Last week, the World Trade Organization sided with the European Union and ruled that a section of U.S. tax law is an unfair trade subsidy. According to the Geneva-based institution, America's treatment of corporate income from exports (as governed by ETI – the Extraterritorial Income Exclusion Act) violates trade rules.

In many ways, this is a troubling decision. Most importantly, a dangerous precedent has been established. What happens, for instance, when the French argue that America's low tax rates are an export subsidy? As the Wall Street Journal stated on January 17, "Once tax policy is on the table, there's no end to what the WTO might meddle in. Which may be exactly what some Europeans want. Saddled with their own anti-competitive, high-tax regimes, they'd love to use the global trade bureaucracy to force Britain, the U.S. and other lower-tax countries to become just as uncompetitive. This is an offer the U.S. can refuse."

The decision also reeks of hypocrisy and double standards. The WTO has decided that America cannot choose how to tax certain types of income, but European governments are allowed to rebate the value-added tax (which can reach 25 percent) on exported goods.

In the final analysis, however, the WTO decision is good news. Why? Because the WTO has given U.S. policy makers a reason to junk worldwide taxation of corporate income and instead implement a territorial tax system. A territorial system is based on the common-sense notion that a government should impose tax only on income earned inside its borders, which is in stark contrast to a worldwide system that imposes tax on income earned in other jurisdictions. Territorial taxation is good tax policy for several reasons:

• A territorial system will make American companies more competitive. When an American-based company tries to compete overseas, it is hobbled by the fact that foreign profits are subject to the U.S. corporate income tax (minus a credit for any taxes paid to the country where the money is earned). This may not make much difference when the company is operating in a high-tax environment like France, but there are many jurisdictions that have very low corporate income taxes. And worldwide taxation makes it difficult for U.S. companies to compete in places like Ireland and Bermuda. The fact that policy makers created the Foreign Sales Corporation - and its short-lived ETI replacement - is good evidence that they understand that worldwide taxation harms America's export-oriented companies.
   
• A territorial system will stop companies from fleeing America. In recent years, major corporations such as Accenture, Ingersoll-Rand, Tyco, and Fruit-of-the-Loom have shifted their headquarters out of America. In every case, protecting shareholders from worldwide taxation was a major reason for the move. Indeed, America's punitive system of worldwide taxation helps explain why a recent merger resulted in Daimler-Chrysler and not Chrysler-Daimler. Simply stated, worldwide taxation is a burden that is driving American companies to other nations. Bermuda, a fiscal paradise that does not tax either personal income or corporate income, is a favorite destination.
   
• A territorial system will significantly reduce compliance costs. The current worldwide tax regime is one of the most complicated parts of the internal revenue code. Internationally active companies have to file tax returns overseas. But they also must list all their foreign earnings when preparing a U.S. tax return. In an effort to minimize double-taxation, they get to claim a dollar-for-dollar credit for the taxes they pay to foreign governments. But the paperwork burden generated by this process is extraordinary, especially because of the myriad rules and restrictions associated with foreign tax credits.
   
• A territorial system is an important step toward tax reform. Every significant tax reform proposal, especially the flat tax, is based on territorial taxation. Shifting to a territorial system for corporate income will be an important step in that direction. Once policy makers see how well the new system works, they then will be more willing to adopt territorial taxation for individual labor income and individual investment income. And once that happens, the U.S. will never have any reason to conspire with Europe's welfare state on schemes to undermine tax competition.
   
• Last but not least, a territorial system is clearly WTO-compliant. Indeed, most of our trading partners in Europe already have territorial tax systems for corporate income. European governments may impose oppressive tax burdens on productive activity inside their borders, but at least they are smart enough not to hamstring their companies that are competing for business in other nations. This is one of the few aspects of European taxation that is more pro-competitive than the American tax system.

The Bush Administration already has issued some very positive statements about territorial taxation, as have important lawmakers such as Ways & Means Chairman Bill Thomas. These officials should not hesitate to turn these good words into concrete action. Territorial taxation is pro-tax reform and pro-competitive. It also is the only reasonable response to the WTO. The only other two options – repealing ETI, which would impose a big tax increase on U.S. export-oriented companies, and doing nothing, which would allow the European Union to slap steep tariffs on a wide range of American exports – are clearly not very attractive.

Shifting to a territorial system is the only good response to the most recent TO decision. Best of all, it will be a fitting revenge against the tax-harmonizing bureaucrats at the European Union. The EU began this attack on our tax code in hopes of forcing America to raise corporate taxes and become less competitive. But if U.S. lawmakers shift to territorial taxation, the Brussels-based paper-pushers will have given us lemons and we will have turned them into lemonade.

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