The David R. Tillinghast Lecture: Trade Agreements and Income Taxation: Interactions, Conflicts, and Resolutions

Posted: 30 Jul 2004

See all articles by Paul McDaniel

Paul McDaniel

University of Florida (Deceased)


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.

Suggested Citation

McDaniel, Paul R., The David R. Tillinghast Lecture: Trade Agreements and Income Taxation: Interactions, Conflicts, and Resolutions. Tax Law Review, Vol. 57, No. 2, 2004, Available at SSRN:

Paul R. McDaniel (Contact Author)

University of Florida (Deceased)


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