The FSC Conundrum

March 20, 2000

The United States and Europe are heading for a nasty little trade war that neither side wants and neither side seems to know how to prevent. The culprit is a heretofore little-known U.S. tax provision called the Foreign Sales Corporation (FSC).

The FSC is a tax device that allows U.S. taxpayers to reduce their U.S. income tax on the income they earn from certain exports. It’s not a huge deal in and of itself – the Joint Tax Committee estimates it will reduce Federal tax collections by only $2.7 billion in 2000. But for U.S. exporters in highly competitive industries, it is critical. And at a time when the U.S. trade deficit seems to be the only thing climbing faster than the NASDAQ, losing the FSC hurts.

In part, the U.S. adopted the FSC to offset a competitive advantage enjoyed by our European trading partners, an advantage that stems from their tax system. They levy a value-added tax (VAT) on imports but not on exports. This boost to European exporters is something we can’t match because we don’t have a VAT. As a substitute, the FSC reduces the U.S. tax so that the combined U.S. income and European VATs do not render U.S. exports uncompetitive, whether they are bound for Europe or other countries.

This worked until the World Trade Organization (WTO), responding to a complaint from the European Union, ruled that the FSC violates international law. The U.S. has until October 1, 2000 to repeal the FSC or suffer WTO-sanctioned retaliation.

Taking a step back, the FSC dispute highlights an unfortunate fiction defended with gusto in Europe, elsewhere around the world, and even in some quarters in the United States. When the original articles of the General Agreement on Tariffs and Trade (GATT), the WTO’s precursor, were written, it was popular in academic circles to make much of the distinction between “direct” taxes – those paid directly to the tax administrator, such as an income tax – and “indirect” taxes – those paid to the administrator indirectly when making a purchase, such as a sales tax or a VAT. Under the GATT, and now under the WTO, a country may employ border tax adjustments – export rebates and import levies – to reflect indirect taxes, but it may not employ these devices to reflect direct taxes. Upon this economically irrelevant distinction the WTO hangs its discrimination charge against the U.S. income tax, much to the detriment of U.S. trade.

Business taxes furnish an example of how silly this is. Under the WTO definition of the term, a sales tax is an indirect tax, as is an European-style VAT. The economic equivalence of an European-style VAT and a subtraction-method VAT is well-established. A subtraction-method VAT is essentially identical to a business income tax except that all purchases of plant and equipment may be expensed, rather than depreciated as under current U.S. law.

As Glenn Hubbard of Columbia University and others have argued elsewhere, the signal difference between expensing and economic depreciation is the time value of money, estimated in percentage terms at roughly 3 percent of the value of the principal annually. This means that for a relatively small amount of tax revenue, the U.S. could make its corporate income tax a WTO-sanctioned indirect tax.

Of course, the dispute is not merely one of economic vocabulary – there’s also the political absurdity that both sides appear incapable of a settlement that will avoid, or at least forestall a trade war.

The easy solution would be for the United States to admit it’s licked and to repeal the FSC by October 1. However, in an election year, the Clinton Administration does not want to appear defeated by the Europeans. The businesses who rely on the FSC obviously oppose this solution as well. And Congress rarely moves that quickly on anything difficult.

Another solution would be to tinker with the law so that the FSC abides by WTO rules. Thus far, no one has offered any credible, minor changes that do the trick.

Opponents of the WTO on the left and the right are using the FSC case as fodder for their campaigns to force a U.S. withdrawal. With the debate over China’s admission to the WTO, the upcoming vote to stay in was going to be very difficult anyway. The FSC loss has made the effort to stay in the WTO an even more uphill fight.

One suggestion to resolve the dispute is for the U.S. government to negotiate an accommodation with the Europeans. There are two problems with this. First, whatever the accommodation, it must mean some U.S. taxpayers or businesses will suffer to benefit those who currently use the FSC. That is a dubious formula on fairness grounds and almost sure to fail politically. The second problem is that other countries not party to the original WTO complaint will file their own complaints and insist on similar accommodations from the U.S. government. Thus, the accommodation route leads us to a form of worldwide extortion of U.S. taxpayers and businesses.

The most sensible solution might be for the WTO to abandon its allegiance to the direct tax—indirect tax fiction. Then the FSC would be as legal as any border tax adjustment. But since the Europeans benefit from the fiction, and since we do not have five or ten years to resolve the matter, this solution looks like another dead end.

Possibly the only other substantive resolution to the WTO dispute is to enact fundamental reforms of the corporate income tax that would permit the U.S. to maintain the FSC. Two of the key reforms would be to allow expensing of plant and equipment as discussed above, and to adopt a territorial tax system for foreign source income. These might seem an awfully big dog for such a small FSC tail, but if the true tail here is not the FSC but a trade war, the dog may be just the right size.

It is hard to imagine enacting such a major piece of legislation in short order in an election year. A more likely scenario is the Administration and the folks across the pond will blink at the eleventh hour as the trade war looms, concoct a completely incredible fiction that will allow each side to save face, buy time, and push the matter on to next year and a new Administration.


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