January 2, 2002

Overview of the Foreign Sales Corporation/Extraterritorial Income (FSC/ETI) Exclusion

Since the early 1960s, the U.S. has maintained a series of export-related tax benefits for export-intensive corporations 1. While clearly designed to spur U.S. exports, these provisions were also seen as a way of leveling the playing field with countries that employ “border tax adjustments” to remove the Value Added Taxes (VATs) from the price of export products before they are shipped abroad. This is estimated to save European exporters as much as $100 billion a year in tax payments on export sales 2.

Border tax adjustments (BTAs) can be precisely calculated in a VAT system because the tax is levied on the products themselves. However, BTAs are more difficult to employ in a country like the U.S. that relies on direct taxes such as corporate income taxes. While it is widely recognized that corporate taxes are borne by consumers, workers, or shareholders, there is no agreement as to what share of the tax each group ultimately bears 3. In fact, the proportions change all the time. As a consequence, it is difficult to determine how much of the corporate income tax should be stripped out of a U.S. product’s price before it is exported abroad.

This clash of direct and indirect tax systems has been a source of continual conflict between the U.S. and its European trading partners for more than thirty years. The first U.S. export-related tax law, known as DISC, for “domestic international sales tax corporations,” was challenged by the Europeans in the 1970s as violating the General Agreement on Tariffs and Trade (GATT). This dispute continued until 1984 when Congress replaced the DISC with a new law called the Foreign Sales Corporation (FSC).

In 1997, the European Union (EU) challenged the legality of the FSC regime before the World Trade Organization (WTO). A WTO panel eventually agreed with the EU and struck down the FSC regime. In 2000, the U.S. Congress replaced the FSC with a new export-related regime call the Extraterritorial Income Exclusion Act (ETI), which lawmakers believed would bring the U.S. into compliance with the WTO ruling.
Once again, the EU challenged the ETI regime and, in January 2002, a WTO Appellate Body ruled that the ETI constituted a prohibited export subsidy. In August 2002, the WTO ruled that if the U.S. did not come into compliance with the Appellate decision, then the EU could impose more than $4 billion worth of sanctions against U.S. products.

The economic consequences of repealing the ETI/FSC regime are mixed. The immediate effect, of course, will be a roughly $4.5 billion annual tax hike on export companies that take advantage of the ETI/FSC regime. The impact of this tax hike will vary according to which direction a company can pass along the tax – forward to consumers through higher prices, down to workers through lost jobs, or back to shareholders through lower share prices.

Companies in highly competitive markets are less able to pass the tax along to consumers and will likely either cut jobs or dividends. In the short-run, this will cause job losses in certain industries. A recent study estimated that more than 1 million jobs were directly attributable to ETI/FSC-benefited exports 4. The effect of the ETI/FSC repeal on this group of workers will depend upon how each firm reacts to the tax increase.

Another immediate impact will be on the share price of ETI/FSC beneficiary companies. Desai and Hines investigated the impact on share prices solely from the EU’s filing of its complaint with the WTO on November 18, 1997. Their findings demonstrate the extent to which taxes and tax benefits are capitalized into share prices:

Generally speaking, major American exporters evidenced the largest negative abnormal stock market returns on November 18, 1997. This effect was greatly attenuated for exporters with net operating loss carryforwards, for whom tax subsidies are less valuable than they are for others…[T]he prices of more profitable firms exhibited the most pronounced negative reactions to news of the European complaint 5.

Companies that dominate various markets, or those who are essentially sole-sources for certain products, can more easily pass along the tax hike to consumers. Ironically, this will prove detrimental to European consumers who have benefited from these lower-priced goods. To some extent then, the tax hike resulting from the repeal of the ETI/FSC regime will be borne by European consumers and taxpayers.

Although it may seem counterintuitive to non-economists, repealing ETI/FSC could create the conditions for increased exports. One of the unseen effects of ETI/FCS is that it boosts the value of the dollar which, in turn, boosts the quantity of imports. As Brumbaugh explains, “The tax benefits increase foreign purchases of U.S. exports, but to buy the U.S. products, foreigners require more dollars. The increased demand for U.S. dollars drives up the price of the dollar in foreign exchange markets, making U.S. exports more expensive … [and] imports cheaper. The net result is a higher level of both imports and exports, but no change in the overall balance of trade.” 6

Desai and Hines studied the impact of the events surrounding the WTO controversy on the value of the U.S. dollar relative to other major currencies such as the British pound sterling. They found that events favorable to the European position led to a weakening in the value of the dollar relative to other major currencies. 7 This suggests that the repeal of the ETI/FSC regime will further weaken the value of the dollar which will make the price of U.S. export goods cheaper to foreign consumers. This, in turn, will lead to an increase in U.S. exports which will benefit all domestic exporters.

While a weaker dollar may benefit all exporters, it is not likely to fully compensate those industries affected by the repeal of the ETI/FSC law. Moreover, the issue of European border tax adjustments still lingers as a problem for the global competitiveness of U.S. products.

1. For an extensive history of these measures, see: JCT Description (JCX-83-02) of Extraterritorial Income Exclusion, Foreign Sales Corporation for Finance Committee Hearing July 30, 2002; and, Gary C. Hufbauer, “A Critical Assessment and an Appeal for Fundamental Tax Reform,” Institute for International Economics, March 11, 2000.
2. Ibid., Hufbauer, p. 6.
3. For a primer on border tax adjustments, see: William P. Orzechowski, “Border Tax Adjustments and Fundamental Tax Reform,” Tax Foundation Background Paper No. 39, November 2001.
4. “FSC-Benefited Exports and Jobs in 1999: Estimates for Every Congressional District,” PriceWaterhouseCoopers, July 2, 2002.
5. Mihir A. Desai and James R. Hines Jr., “The Incidence of Export Subsidies as Revealed by Market Reactions,” March 2001, p. 2.
6. Brumbaugh, Ibid., p. 5.
7. Mihir A. Desai and James R. Hines Jr., “Exchange Rates and Tax-Based Export Promotion,” NBER Working Paper 8121, February 2001.