What Are the Goals of Retaliatory Tax Policies?

On May 12th, the US Ways and Means CommitteeThe Committee on Ways and Means, more commonly referred to as the House Ways and Means Committee, is one of 29 U.S. House of Representative committees and is the chief tax-writing committee in the U.S. The House Ways and Means Committee has jurisdiction over all bills relating to taxes and other revenue generation, as well as spending programs like Social Security, Medicare, and unemployment insurance, among others. released the taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. portion of the House’s broader reconciliation bill. Notably, the “One, Big, Beautiful Bill” includes a retaliatory provision called Section 899, along with an expansion of the base erosion and anti-abuse tax (BEAT). These provisions could, in principle, apply to any country with extraterritorial or discriminatory taxes, but, in practice, they target three foreign taxes opposed by the US. First, the undertaxed profits rule (UTPR) associated with the global minimum tax deal known as Pillar Two. Second, digital services taxes (DSTs). And third, diverted profits taxes (DPTs) like the ones in the UK and Australia. The new US provisions could create an incentive for foreign jurisdictions to change their policies, or may simply be intended to raise revenue from foreign companies.

If adopted, these provisions will impact the US’s relationship with countries around the world, but negotiations between the US and EU Member States will play a significant role in determining whether the economic harms of these retaliatory provisions can be mitigated.

Both the threat and possible use of these measures can cause significant economic harm to the American economy. The retaliatory measures could apply very broadly to most of the wealthy countries from which the US receives foreign direct investment (FDI); using 2023 FDI stock data from the Bureau of Economic Analysis, we find Section 899 would hit inbound investment from countries that make up more than 80 percent of the US inbound FDI stock.

Below, we review the retaliatory measures—their substance, intended benefits, and costs—and ultimately question whether they are the best tools to accomplish those goals, while examining the particulars of the US-EU discussion on international taxes.

How Do the Retaliatory Tax Provisions Work?

The proposed provisions respond to extraterritorial or discriminatory taxes, and indeed, names the UTPR, the DST, and the DPT specifically. (They allow for retaliation against other offending taxes as well but explicitly rule out more longstanding traditional tax bases like ordinary income tax or value-added tax.) After identifying countries with the offending taxes, they raise US tax rates on businesses and other entities from those countries. The tax hike combines and modifies ideas present in previous bills introduced by Committee Chairman Jason Smith (R-MO) and Committee member Ron Estes (R-KS).

There are two parts to the retaliatory measures. The first is increased rates of income tax on the foreign entities. The measure is quite broad: it includes effectively any kind of passive or active investment income by foreigners, with very few exceptions. For these many classes of income, the rates would step up 5 percentage points every year until they eventually exceed their statutory levels by 20 percentage points.

The second part is an expansion of BEAT for applicable companies from those same countries. BEAT is an imprecise alternative minimum tax whose nominal purpose is to curb base erosion, but, in practice, it discriminates heavily against FDI. The retaliatory provisions both hike the rate to 12.5 percent and, even more impactfully, deny credits and make other changes to the BEAT base for these companies, effectively making it far more onerous.

Which Countries Would Be Affected?

Most large economies would qualify for retaliation. The UTPR is widely adopted through an EU Directive, making it more difficult for individual countries to unwind. Furthermore, many EU countries also have individual DSTs, including France and Italy. Outside the EU, the UK has both a DST and a DPT, while Canada has a DST and Australia has a DPT.

Asian economies may find it easier to avert the retaliation measures. Japan has only a UTPR, which is not yet in effect. Ironically, China, often a subject of US retaliation, has none of the offending policies. Overall, though, the retaliation could easily affect the majority of foreign investment in the US.

Some questions remain around the edges: What if Pillar Two taxes are effectively dormant through safe harbor provisions or repeated delay? Would the bill still require retaliation? The US often allows the executive branch a large degree of discretion in these matters, but one concern with this new version of the provision is it appears to offer less flexibility and require the retaliation to go into effect, even when a pause (for example, to negotiate) might be prudent.

What Are the Economics of These Policies?

The Joint Committee on Taxation (JCT) suggests the retaliatory policy will raise $116 billion over the next 10 years. This estimate is likely subject to extreme uncertainty, but the JCT estimate will reduce the reported cost of the tax law, and the provisions may indeed raise significant revenue if other countries do not abandon their UTPRs or DSTs.

The US retaliation plan, unfortunately, falls heavily on FDI. FDI is beneficial, allowing US labor to become more productive by working in combination with foreign capital and ideas. It also may facilitate consumption by helping companies reach US consumers. If the tax policy reduces foreign investment in the US, workers and consumers may end up worse off. This is a step backward on at least one goal of the administration—to attract investment and jobs in the US.

Even if the retaliation measures never come into effect, uncertainty may already be chilling FDI into the US. And even the harms that land on foreigners don’t land on the foreigners responsible for the offending taxes. US tax writers have legitimate grievances against tax writers in other countries, but retaliation against the most US-friendly elements of the foreign private sector is a rather poor proxy for litigating those grievances.

What Are the Fundamental Disagreements Between the US and EU?

This retaliatory effort implicates many policies in EU countries, meaning any agreement that avoids negative economic outcomes will require resolving international tax differences between the US and EU. There are several issues at play in US-EU tax negotiations.

Historically, international taxing rights are mostly given to the country where the value of a product is created. However, as products became more digital, it became more difficult to accurately attribute value. European countries, often the end market for US global tech companies, have argued for a greater share of the taxing rights, attempting to address this with Pillar One of the two-pillar approach. In the interim, some European governments have implemented DSTs to collect revenue they believe is rightfully theirs. The US sees this as an illegitimate preemption and, more generally, views DSTs as discriminatory against US tech companies.

Second, the Trump administration and Chairman Smith argue that the UTPR is extraterritorial and violates US fiscal sovereignty by effectively compelling a particular set of tax provisions even on US domestic policy.

Or, perhaps, it is simpler than that: both elements are simply cash grabs against non-voting taxpayers in their jurisdictions. It is politically easier for European parliaments to raise taxes on US firms than on average domestic voters.

DC’s Attempt at the “Brussels Effect”?

Codifying these retaliatory measures comes with three main advantages: US lawmakers can use the JCT score as wiggle room in their budget; enforcement of these policies becomes less subject to changing political winds than Section 301 tariffs; and tax policy is a Member State, not EU, competence. The latter could give the US an advantage if Member States are unable to maintain a united negotiating position.

However, inflexibility is also a weakness. The less an administration can turn these retaliations on or off, the more likely it is that there will be negative economic consequences.

Ironically, the US approach resembles a property of EU policy design in recent years called the “Brussels Effect.” The EU leverages access to the Single Market to put Brussels in the enforcement seat of international tax, trade, and environmental policy. For example, CBAM and Pillar Two don’t just allow Brussels to enforce its own laws but also have enforcement mechanisms that penalize foreign firms if their governments do not adopt the EU-approved standards in their domestic laws.

Similarly, Section 899 leverages access to the US market, by way of financial penalty on foreign firms, to inspire other countries to change their laws. This may put DC back in control of international tax enforcement at the expense of policymaking done at the EU, Organisation for Economic Co-operation and Development (OECD), or United Nations.

Are There Better Negotiating Tools?

Most of the policies mentioned above are bad for the global economy. The UTPR, Section 899, DSTs, and much of BEAT are more trouble than they’re worth, and both the US and the EU have been far too coercive in recent years. Getting rid of these negative incentives will be challenging for all. A better future would see policymakers lean more toward positive incentives than negative ones, prioritize regional agreements, and use those partnerships to encourage the rest of the world to come on board.

Share this article