Hiding Protectionism in the Tax Code

February 2, 1999

Free trade rules. Even facing a large and growing trade deficit, Americans today would find a call for higher tariffs on imported goods laughable. Yet we have had a highly protectionist system in place for decades, and the U.S. Treasury in both Republican and Democratic Administrations continue to defend it.

Where is this protectionist scourge? In the federal income tax, specifically the taxation of income that Americans earn abroad.

This policy of taxing Americans’ foreign income raises only a modest amount of revenue. The real purpose is to use the tax code as a sneaky system of tariffs to discourage U.S. individuals and companies from investing abroad.

Protectionism generally arises when a government sees a threat to domestic employment from lower-cost or higher-quality foreign goods. These competitive pressures force domestic suppliers to become more efficient or go out of business. Companies whose shareholders and employees are clearly suffering from foreign competition often appeal to the government for protection. When the foreign competition is selling goods below cost, such as has been reported recently with Japanese and Russian steel imports into the United States, the government can and should take action to halt the imports. When foreign companies are just good competitors, the U.S. government must, and usually does, resist calls for protectionist tariffs and quotas.

Taxes are rarely a determining factor when a company decides where to establish operations. But taxes do play a role. When a U.S. company can locate operations in a lower-cost foreign jurisdiction, it becomes more competitive whether the lower costs are due to lower wages or lower taxes. U.S. tax policy is to eliminate lower foreign taxes as a reason for establishing foreign operations by imposing tax on the foreign income of its citizens as though the income were earned at home.

To mitigate double taxation, the U.S. taxpayer is allowed to take a limited credit against its U.S. tax liability for foreign income taxes paid. Suppose, for example, General Motors made $100 million in Canada. Suppose it paid $30 million in Canadian income tax. It would then owe on a pre-credit basis $35 million to the U.S. government, but it would get a credit for the $30 million paid to Canada, so it would owe $5 million to Uncle Sam on an after-credit basis.

The concern addressed by U.S. international tax policy is that the U.S.-owned foreign operation could export lower-taxed goods to the U.S. or could replace higher-taxed U.S.-source exports. Either way, domestic producers and their employees would come under even stiffer competition. While this rationale is popular in some quarters, it is fundamentally protectionist in nature and indistinguishable in intent from a simple tariff.

Even the language used by proponents of tariffs and the defenders of current tax law is the same. A tariff is defended because foreign plants would otherwise be able to sell lower-cost goods in the U.S. and U.S. jobs would be lost as a result. Defenders of current international tax law argue it is needed to prevent “runaway plants,” that is, to discourage U.S. companies from setting up plants abroad instead of in the U.S., thereby costing U.S. jobs.

The defenders of current tax law argue that it comports with tax neutrality and therefore is on a sound theoretical basis. The notion of neutrality they reference, however, is very different from any definition of neutrality used in domestic tax policy. It is, in fact, a counterfeit erected to justify a protectionist policy.

In fairness, many defenders of current tax law are adamant free traders. Many were convinced long ago that current law is essentially correct and so they fail to see its protectionist consequences. However, many of them also know full well how current U.S. international tax law hinders the ability of U.S. companies to compete in international markets.

Thus they find themselves in the intellectual box of arguing for a balance between competitiveness and neutrality, as the defenders of current law define neutrality. What these fundamental free traders must realize is that there is no balance between competitiveness and true tax neutrality. They must realize that neutrality properly defined and codified in the tax law allows U.S. companies to be as competitive as they can be without moving into the realm of tax subsidies.

Countries generally protest when one of their trading partners engages in unfair, protectionist practices. A fair question to ask then is, if U.S. tax policy is protectionist, why do our trading partners not protest? The answer is simple. The only parties injured by protectionist U.S. international tax policy are U.S. citizens. Foreign companies and foreign workers actually benefit.

When a U.S. company is deterred from making a competitiveness-enhancing foreign investment due to U.S. international tax policy, in today’s world it is highly likely that a foreign company will be ready and willing to take its place. Perhaps the U.S. company saw a cost advantage that will now go to the foreign competition. Perhaps the U.S. company saw a market opportunity that will now go to the foreign competition. It does not matter where the foreign operation’s sales take place. Because of U.S. tax policy sales which could have been made by a U.S. company now belong to a foreign company.

Like most forms of protectionism, U.S. international tax policy is a double-edged sword. Usually, however, U.S. consumers suffer to benefit U.S. companies. In the case of U.S. international tax policy, U.S. citizens get cut with both edges since both consumer and producers suffer.


About the Author


Related Research