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EXEMPTING FOREIGNSOURCE DIVIDENDS FROM U.S. TAXATION Presentation to the President’s Advisory Panel on Federal Tax Reform James R. Hines Jr. May 12, 2005 The current U.S. tax regime. The United States taxes the worldwide incomes of American individuals and corporations. Hence dividends received from foreign subsidiaries of American corporations are subject to U.S. tax. Taxpayers may claim foreign tax credits for foreign income tax payments. U.S. tax obligations are generally deferred until dividends are repatriated. A special 85% dividend exclusion applies to 2005. Why tax foreign income this way? The Capital Export Neutrality concept: income is taxed at the same total (foreign plus domestic) rate wherever earned. As a result, market considerations, rather than taxes, determine investment. A common claim: that such taxation by the U.S. promotes global efficiency. Note that the same logic implies that U.S. national interests would be best served by taxing foreign income, permitting only a deduction (not a credit) for foreign taxes paid. The hybrid U.S. system. The current U.S. tax system does not correspond to Capital Export Neutrality in two key respects: Foreign tax credits are limited. U.S. taxation of unrepatriated foreign income is deferred. As a result of foreign tax credit limitations and taxation of income upon repatriation, the system distorts: Ownership of business assets in the U.S. and abroad. Investment in plant and equipment. The financing of investment in the U.S. and abroad. R&D spending. Repatriation of dividends from foreign subsidiaries. Transfers of intangible assets within firms. International trade. The magnitude of the associated economic distortion can greatly exceed the amount of revenue collected from foreign investment. Would it be better for the U.S. system to correspond to capital export neutrality? In a word, no. Taxing U.S. investors at the same total rate regardless of investment location promotes neither global efficiency nor national welfare. Matters would be even worse if foreign taxes were merely deductible and not creditable. Why? Because investors from other countries are not subject to such a tax regime. Consequently, the U.S. tax system distorts capital ownership. Downsides of worldwide taxation. The logic behind worldwide taxation presumes the United States is the only country in the world. This is simply inaccurate. American firms are subject to higher total tax burdens on their foreign operations than are firms from many other countries. Tax differences cause them to be outbid in some foreign acquisitions, and encourage American firms to outbid foreign competitors in other acquisitions. Taxation on the basis of ownership, rather than production, has the predictable effect of distorting capital ownership. The problem is that ownership is critical to productivity. Realities of FDI. Foreign direct investment consists primarily of firms in rich countries acquiring, and then operating, firms in other rich countries. In 2001, more than 96% of foreign direct investment in the United States represented acquisitions of existing American firms. Foreign investment by American firms is heavily concentrated other G-7 countries, which, in 1999, together accounted for 57% of their total foreign gross product. International investment is largely about who owns and manages capital, rather than being about movements of plant and equipment. Would exempting foreign income from taxation reduce U.S. prosperity? No, current policies reduce U.S. prosperity by subjecting foreign income to taxation that is burdensome and distortionary. As a consequence, the tax system indirectly reduces the productivity of businesses located in the United States, which thereby reduces the return to labor in the U.S. Exempting foreign income from taxation would not cause plant and equipment to flee from the U.S., but would instead rationalize ownership and thereby increase productivity. Domestic productivity is enhanced by treating foreign taxes as costs of doing business, but not imposing added home-country tax burdens merely because a foreign operation is owned by a U.S. business. Equity considerations. Consider two American businesses, one that earns $100 in the U.S., and one that earns $100 in a country that does not tax business profits. Is it fair to exempt the second business from U.S. taxation on the $100 profit? After all, the first business must pay taxes on the $100, whereas the second business would then not pay taxes to anyone. The point to keep in mind is that earning pre-tax $100 in a country without taxes is more difficult than earning $100 in a country with a 35% tax rate, since international competition is more keen in the zero-tax place. Investors from countries that exempt foreign income from taxation drive down local pre-tax rates of return. Hence it is misleading to consider only pre-tax returns. Methods of exempting foreignsource income from tax. Exempt foreign-source dividends by statute. Many countries do this. Exempt foreign-source dividends as provisions of U.S. treaties. A number of other countries go this route. Alternatively, the U.S. could impose border cash-flow taxation: permit a deduction for funds invested abroad, and include repatriations as taxable U.S. income. Reform considerations. Exempting foreign income increases the importance of correctly allocating income and expenses between foreign and domestic sources, since it increases the tax consequence of the distinction. An example: if foreign dividends are statutorily exempt from domestic taxation, then royalties received from foreign source are properly taxed as domestic income. Expenses incurred in producing intangible property should then be fully deductible against domestic income. Transition rules need to account for changes in regime. This is not as difficult as it appears. For example, a transition to border cash-flow taxation could be accompanied by granting American firms deductions for accumulated unrepatriated foreign earnings and profits.