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Taxing Foreign Source Income: The Economic and Equity Issues

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Download Government Finance Brief No. 25

Government Finance Brief No. 25

Executive Summary With the growth of U.S. private investment abroad over the past decade, the U.S. Federal income 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. provisions pertaining to foreign source income have been increasingly targets of tax reform.

Those who urge increasing the U.S. tax on foreign source income argue that the present tax treatment (1) is inequitable because it imposes a lower U.S. tax burden on foreign income of U.S. companies than is levied on the income of domestic U.S. corporations, and (2) subsidizes investment abroad by U.S. multinational companies at the expense of domestic U .S. investment, production, and employment.

Neither the equity nor the economic case for increasing the U.S. tax on foreign source income is analytically correct. The basic tax reform proposals—for reducing if not eliminating the foreign tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. and for requiring current payment of U.S. tax on undistributed foreign earnings—would neither enhance the equity in the taxation of those who bear these tax burdens nor contribute to greater productivity and efficiency of the U.S. economy. On the contrary, these tax changes would aggravate the inequities in the corporation income tax: they would differentiate corporation income tax liabilities on the basis of the location of the economic activity giving rise to corporations’ incomes without regard to the differing economic situations of those who actually bear the corporation income tax burden. They would, moreover, distort the allocation of capital resources and impair the productivity and efficiency of the U.S. economy.

This statement is addressed to both the equity and economic issues involved in determining the appropriate treatment in the U.S. income tax of the foreign earnings if U.S. companies. My analysis urges that on the score of both equity and economics, not only should the basic reform proposals be rejected, but foreign earnings—or losses–should be completely excluded from the U.S. tax.