United States International Tax Policy: Tax Neutrality or Investment Protectionism?
Background Paper No. 12
Executive Summary There has been little debate about international tax policy design since the 1986 Tax Reform Act, in stark contrast to the growing tensions between U.S. international tax policy and the increasingly international economy in which U.S. businesses compete. The debate on international tax policy has historically been couched in terms of two competing theories of tax neutrality. One of these theories, known as territoriality, seeks to prevent domestic tax considerations from diminishing or improving the competitiveness of any domestic taxpayer’s foreign investments. Under territoriality, the taxpayer’s home country forgoes taxing all foreign source income as long as the income is not afforded special tax treatment in the country in which the investment is made.
The alternative theory, known as capital export neutrality, seeks a domestic tax policy that eliminates tax considerations for investors choosing between domestic and foreign investment opportunities. The measures it suggests are simple: impose domestic tax on foreign source income and allow a tax credit in the amount of foreign taxes paid to be used against domestic tax liability from both foreign and domestic source income.
U.S. policy was founded on the theory of capital export neutrality, but in practice, however, current policy varies significantly from the theory. U.S. policy seeks to ensure that U.S. taxpayers’ income from foreign investment is subject to at least as much tax (foreign and U .S.) as domestic investment .This policy is driven by a desire to prevent the U.S. tax code from creating a tax incentive for U.S. businesses to invest abroad. According to proponents of this policy, such an incentive would exist if U .S .citizens’ foreign source income, which may be taxed more lightly abroad than it would be if it were earned and taxed in the United States, was exempt from tax at home. This concern is buttressed by the notion that it may be unfair to allow U.S. taxpayers to pay a lower rate of tax on foreign than on domestic income.
Current U.S. policy is not without its consequences. Unquestionably, imposing U.S. tax on foreign source income puts many U.S. businesses at a competitive disadvantage relative to foreign-based businesses .In some cases, this disadvantage can be substantial .For example, according to a recent Tax Foundation study a U .S .investment in Japan must be well over 15 percent more productive than a similar domestic Japanese investment to overcome the extra burden imposed by U.S. taxes.
This paper argues that current U.S. tax policy ultimately aims to preserve the U.S. as a place to invest by creating a tax disincentive to foreign investment. This policy bears a striking resemblance to tariff and non-tariff barriers, such as voluntary restraint agreements, which are designed to shield U.S. markets from foreign competition. While trade protectionism is designed to preserve domestic investment and jobs in the face of foreign competition, investment protectionism is designed to preserve domestic investment in the face of more competitive foreign opportunities.