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Abstract:
This paper builds on prior short pieces I have done on trade and taxation. I drew three conclusions from that prior work:

1. A normative income tax structure and free trade principles do not conflict with each other.

2. The tax provisions that are part of a normative tax structure should be outside the scope of trade agreements and procedures.

3. Subsidies run through the tax system (tax expenditures) should be subject to scrutiny under trade agreements just as are direct subsidies. A country cannot insulate a subsidy from challenge under trade agreements simply by placing it in a tax system.

In Part I of the paper, I first review the history of the Domestic International Sales Corporation (DISC) provisions. commencing with the challenge by the European Communities (EC) and Canada under the then-existing GATT procedure. The DISC regime was found to violate U.S. obligations under GATT. Congress responded by enacting the Foreign Sales Corporation (FSC) system. The EC challenged this program and a WTO Dispute Panel found that the FSC regime violated U.S. WTO obligations. The decision was affirmed by a WTO Appellate Body. Congress tried again by enacting the Extraterritorial Income Exclusion Act (ETI) but this system too was stricken down by a WTO Dispute Panel and an Appellate Body affirmed the decision. I examine the arguments put forth by the EC and the U.S. in both the FSC and ETI cases as well as the basis for the decisions by the WTO bodies.

I briefly examine the standard by which the WTO body approved some $4 billion in countermeasures against the U.S. Those sanctions are scheduled to go into effect March 1, 2004 if the U.S. has not terminated the ETI regime.

I then turn to an assessment of the FSC and ETI decisions from three perspectives: legal/structural, economic, and sovereignty/political. From the legal/structural perspective, I conclude that the WTO decisions were correct under applicable WTO provisions and focus particularly on the methodology employed to determine whether a particular regime constitutes a "subsidy" or not.

Assessing the decisions from an economic perspective, I begin by sketching briefly the case for free trade and then examine whether the FSC and ETI regimes likely increased or decreased both U.S. and global welfare. Economic theory suggests that the welfare of each was decreased by the subsidies. Unfortunately, there is little empirical work available to test the theory. What little there is suggests that U.S. exports may have increased as a result of the subsidies, but the studies do not address whether this increase was achieved at an acceptable revenue cost or the welfare effects of the subsidies. I conclude this part of the paper by noting the impact of currency exchange rates on the effectiveness of the subsidies.

The final part of the paper examines the WTO decisions from what I call a sovereignty/political perspective. I first test out whether the U.S. sacrifices an acceptable level of sovereignty on entering into the WTO agreements in the first place and whether the WTO decisions represent a further and unacceptable invasion of U.S. sovereignty. Building on work by Professor Michael Schaefer, I conclude that the U.S. has sufficient built-in processes to protect it from intrusive invasion of its sovereignty by virtue of the WTO agreement and FSC/ETI decisions. From a political perspective, I assess the arguments that the FSC/ETI provisions are needed to put U.S. multinationals on a competitive level with multinationals from exemption countries. I show that this argument has no economic or factual basis and should be rejected.

Abstract:
The purpose of this paper is to explore whether the U.S. should amend its international tax rules in ways that might encourage U.S. companies to invest in developing countries (DCs). Some scholars, notably Professor Karen Brown, have argued that the current U.S. international tax regime works against the interests of DCs and should be replaced by one that, she asserts, would benefit DCs in general and African nations in particular. She has proposed that the U.S. replace its foreign tax credit mechanism with an exemption system for DCs (at least for Africa). One of the reasons for the proposal is that the current U.S. system prevents DCs from offering tax incentives, such as tax holidays, to attract foreign direct investment (FDI) by U.S. multinational corporations (MNCs).

Certainly it is the case that very little U.S. FDI finds its way to DCs. At the end of 2001, total U.S.-owned assets located abroad totaled $6.2 trillion (valued at cost), but little of these assets were in DCs.

But, proposals such as that put forward by Professor Brown raise several questions. Is FDI an unqualified good for DCs? What are the determinants in the location of FDI? Are tax incentives offered by DCs effective in attracting FDI, even in situations where home country tax rules do not thwart them? Can tax incentives alone attract FDI or are there necessary preconditions a DC must satisfy before there is FDI at all? Are home country unilateral tax incentives effective in increasing FDI by its MNCs? Is it better for developed countries to assist DCs by offering tax subsidies to its MNCs or by providing direct financial assistance to DCs? This paper explores these questions.

The paper first provides a broad overview of international tax systems that countries can adopt, i.e, the worldwide taxation of income with a foreign tax credit and exemption systems. The paper then demonstrates that the current U.S. foreign tax credit system defeats the objectives of DCs in offering tax holidays to U.S. MNCs only if the tax rate of the foreign country is lower than the U.S. and if the U.S. MNC is in an excess credit position. I propose a structural change in the U.S. foreign tax credit rules that would mitigate the impact of the U.S. international tax system on host country tax incentives to attract FDI. The proposal is not designed to be an incentive for greater FDI in developing countries by U.S. MNCs. Instead, it is intended to correct what I believe are defects in the current U.S. FTC rules.

The factors and forces that adversely affect developing countries then are identified in order to lay the groundwork for an assessment of whether particular tax changes by the U.S. would impact these forces and factors positively. Recent work by the United Nations and the OECD regarding the level and means by which developed countries can aid DCs is also analyzed with particular attention paid to the role of foreign direct investment in these reports. The rather minimal economic evidence on the impact of tax policies on the level and location of FDI is then reviewed.

Several different changes in the U.S. international tax system are assessed in terms of their efficiency and simplicity effects and in terms of their effectiveness in meeting the problems facing DCs: adopting an exemption system for DCs, reducing the corporate tax rate on DC income, adopting tax sparing for DC income, modifying Subpart F for DC income, and modifying transfer pricing rules to allow more profit to be allocated to DCs. The paper concludes that none of these proposals is likely to increase FDI by U.S. MNCs in DCs.

Abstract:
This paper builds on prior short pieces I have done on trade and taxation. I drew three conclusions from that prior work:

1. A normative income tax structure and free trade principles do not conflict with each other.

2. The tax provisions that are part of a normative tax structure should be outside the scope of trade agreements and procedures.

3. Subsidies run through the tax system (tax expenditures) should be subject to scrutiny under trade agreements just as are direct subsidies. A country cannot insulate a subsidy from challenge under trade agreements simply by placing it in a tax system.

In Part I of the paper, I first review the history of the Domestic International Sales Corporation (DISC) provisions. commencing with the challenge by the European Communities (EC) and Canada under the then-existing GATT procedure. The DISC regime was found to violate U.S. obligations under GATT. Congress responded by enacting the Foreign Sales Corporation (FSC) system. The EC challenged this program and a WTO Dispute Panel found that the FSC regime violated U.S. WTO obligations. The decision was affirmed by a WTO Appellate Body. Congress tried again by enacting the Extraterritorial Income Exclusion Act (ETI) but this system too was stricken down by a WTO Dispute Panel and an Appellate Body affirmed the decision. I examine the arguments put forth by the EC and the U.S. in both the FSC and ETI cases as well as the basis for the decisions by the WTO bodies.

I briefly examine the standard by which the WTO body approved some $4 billion in countermeasures against the U.S. Those sanctions are scheduled to go into effect March 1, 2004 if the U.S. has not terminated the ETI regime.

I then turn to an assessment of the FSC and ETI decisions from three perspectives: legal/structural, economic, and sovereignty/political. From the legal/structural perspective, I conclude that the WTO decisions were correct under applicable WTO provisions and focus particularly on the methodology employed to determine whether a particular regime constitutes a "subsidy" or not.

Assessing the decisions from an economic perspective, I begin by sketching briefly the case for free trade and then examine whether the FSC and ETI regimes likely increased or decreased both U.S. and global welfare. Economic theory suggests that the welfare of each was decreased by the subsidies. Unfortunately, there is little empirical work available to test the theory. What little there is suggests that U.S. exports may have increased as a result of the subsidies, but do not address whether this increase was achieved at an acceptable revenue cost or the welfare effects of the subsidies. I conclude this part of the paper by noting the impact of currency exchange rates on the effectiveness of the subsidies.

The final part of the paper examines the WTO decisions from what I call a sovereignty/political perspective. I first test out whether the U.S. sacrifices an acceptable level of sovereignty on entering into the WTO agreements in the first place and whether the WTO decisions represent a further and unacceptable invasion of U.S. sovereignty. Building on work by Professor Michael Schaefer, I conclude that the U.S. has sufficient built-in processes to protect it from intrusive invasion of its sovereignty by virtue of the WTO agreement and FSC/ETI decisions. From a political perspective, I assess the arguments that the FSC/ETI provisions are needed to put U.S. multinationals on a competitive level with multinationals from exemption countries. I show that this argument has no economic or factual basis and should be rejected.