Taxation in the Global Economy pot

This Page Intentionally Left Blank
Taxation in the Global Economy
A
National
Bureau
of
Economic Research
Project Report
Taxation in
the
Global
Economy
Edited by
Assaf Razin and
Joel Slemrod
The University
of
Chicago Press
Chicago
and London
The University
of
Chicago Press, Chicago 60637
The University of Chicago Press, Ltd., London
0
1990 by the National Bureau
of
Economic Research
All rights reserved. Published 1990
Paperback edition 1992

Printed in the United States of America
99 98 97 96 95 94 93 92 5432
Library of
Congress
Cataloging-in-Publication Data
Taxation in the global economy
/
edited by Assaf Razin and Joel
Slemrod. p.
cm (A National Bureau of Economic
Research project report)
Includes bibliographical references.
1.
Income tax-United States-Foreign income.
2. Corporations, American-Taxation,
enterprises-Taxation-United States.
I.
Razin, Assaf.
11. Slemrod,
Joel.
111.
Series.
HJ4653.F65T39 1990
336.24'3-dc20 90-30262
3.
International business
CIP
ISBN 0-226-70591-9 (cloth)
ISBN 0-226-70592-7 (paperback)
@The paper used in this publication meets the minimum requirements of

the American National Standard for Information Sciences-Permanence
of
Paper
for
Printed Library Materials, ANSI 239.48-1984.
National Bureau
of
Economic Research
Officers
George
T.
Conklin, Jr., chairman
Paul W. McCracken, vice chairman
Martin Feldstein, president and
Geoffrey Carliner, executive directot
Charles A. Walworth, treasurer
Sam Parker, director
of
finance and
chief executive ofJicer administration
Directors at Large
John H. Biggs
Andrew Brimmer
Carl F. Christ
George
T.
Conklin,
Jr.
Kathleen B
.

Cooper
Jean A. Crockett
George C. Eads
Morton Ehrlich
Martin Feldstein Robert T. Parry
George Hatsopoulos Peter
G.
Peterson
Lawrence R. Klein Robert V. Roosa
Franklin A. Lindsay Richard N. Rosett
Paul
W.
McCracken Bert Seidman
Leo
Melamed Eli Shapiro
Michael
H.
Moskow
James J.
O’Leary
Donald
S.
Wasserman
Directors by University Appointment
Jagdish Bhagwati, Columbia
William C. Brainard, Yule
Franklin Fisher, Massachusetts Institute
Jonathan Hughes, Northwestern
Saul H. Hymans, Michigan
Marjorie B. McElroy, Duke

James
L.
Pierce, California, Berkeley
Andrew Postlewaite, Pennsylvania
Nathan Rosenberg, Stunford
Harold
T.
Shapiro, Princeton
Burton A. Weisbrod, Wisconsin
Michael Yoshino, Harvard
Arnold Zellner, Chicago
of
Technology Craig Swan, Minnesota
Directors by Appointment
of
Other Organizations
Richard
A.
Easterlin, Economic History
Gail Fosler, The Conference Board
A. Ronald Gallant, American Statistical
Bruce Gardner, American Agricultural
Robert
S.
Hamada, American Finance
Robert C. Holland, Committee for Economic
Association
Association
Economics Association
Association

Development
David Kendrick, American Economic
Ben E. Laden, National Association
of
Rudolph A. Oswald, American Federation
of
Association
Business Economists
Labor and Congress
of
Industrial
Organizations
Association
CertiJied Public Accountants
Douglas D. Purvis, Canadian Economics
Charles A. Walworth, American Institute
of
Directors Emeriti
Moses Abramovitz
Thomas D. Flynn George B. Roberts
Emilio
G.
Collado
Gottfried Haberler Willard
L.
Thorp
Frank W. Fetter
Geoffrey H. Moore William
S.
Vickrey

Relation
of
the Directors to the
Work and Publications
of
the
National Bureau
of
Economic Research
1.
The object of the National Bureau of Economic Research is to ascertain and to present to
the public important economic facts and their interpretation in a scientific and impartial manner.
The Board
of
Directors is charged with the responsibility of ensuring that the work
of
the
National Bureau is carried on in strict conformity with this object.
2.
The President of the National Bureau shall submit to the Board
of
Directors,
or
to its
Executive Committee, for their formal adoption all specific proposals for research to be
instituted.
3.
No research report shall be published by the National Bureau until the President has sent
each member of the Board a notice that a manuscript is recommended for publication and that in
the President’s opinion it is suitable for publication in accordance with the principles of the

National Bureau. Such notification will include an abstract
or
summary
of
the manuscript’s
content and a response form
for
use by those Directors who desire a copy of the manuscript for
review. Each manuscript shall contain a summary drawing attention to the nature and treatment
of the problem studied, the character of the data and their utilization in the report, and the main
conclusions reached.
4.
For
each manuscript
so
submitted, a special committee
of
the Directors (including
Directors Emeriti) shall be appointed by majority agreement of the President and Vice
Presidents
(or
by the Executive Committee in case
of
inability to decide on the part of the
President and Vice Presidents), consisting of three Directors selected as nearly as may be one
from each general division of the Board. The names
of
the special manuscript committee shall
be stated
to

each Director when notice of the proposed publication is submitted to him. It shall
be the duty
of
each member of the special manuscript committee to read the manuscript.
If
each
member of the manuscript committee signifies his approval within thirty days of the transmittal
of the manuscript, the report may be published. If at the end of that period any member of the
manuscript committee withholds his approval, the President shall then notify each member of
the Board, requesting approval
or
disapproval of publication, and thirty days additional shall be
granted for this purpose. The manuscript shall then not be published unless at least a majority
of
the entire Board who shall have voted on the proposal within the time fixed for the receipt of
votes shall have approved.
5.
No manuscript may be published, though approved by each member of the special
manuscript committee, until forty-five days have elapsed from the transmittal of the report in
manuscript form. The interval is allowed for the receipt of any memorandum
of
dissent
or
reservation, together with a brief statement
of
his reasons, that any member may wish to
express; and such memorandum of dissent
or
reservation shall be published with the manuscript
if

he
so
desires. Publication does not, however, imply that each member of the Board has read
the manuscript,
or
that either members of the Board in general
or
the special committee have
passed on its validity in every detail.
6.
Publications
of
the National Bureau issued for informational purposes concerning the work
of the Bureau and its staff,
or
issued to inform the public of activities of Bureau staff, and
volumes issued as a result of various conferences involving the National Bureau shall contain a
specific disclaimer noting that such publication has not passed through the normal review
procedures required in this resolution. The Executive Committee of the Board is charged with
review of all such publications from time to time to ensure that they do not take on the character
of formal research reports of the National Bureau, requiring formal Board approval.
7.
Unless otherwise determined by the Board
or
exempted by the terms of paragraph
6,
a
copy of this resolution shall be printed in each National Bureau publication.
(Resolution adopted October
25,

1926,
as
revised through September
30,
1974)
Contents
Preface
Introduction
Assaf Razin and
Joel
Slemrod
I.
AN OVERVIEW
OF
THE
U.S.
SYSTEM
OF
TAXING INTERNATIONAL TRANSACTIONS
1.
Taxing International Income: An Analysis
of
the
U.S.
System and Its Economic
Premises
Hugh
J.
Ault and David F. Bradford
Comment:

Daniel J. Frisch
11.
TAXATION
AND
MULTINATIONALS
2.
U.S.
Tax Policy and Direct Investment
Abroad
Joosung Jun
Comment:
Michael
P.
Dooley
the United States: Evidence from a
Cross-country Comparison
Joel Slemrod
Comment:
David
G.
Hartman
3.
Tax Effects on Foreign Direct Investment in
4.
Multinational Corporations, Transfer Prices,
and Taxes: Evidence from the
U.S.
Petroleum Industry
Jean-Thomas Bernard and Robert
J.

Weiner
Comment:
Lorraine Eden
ix
1
11
55
79
123
vii
viii
Contents
5.
Coming Home to America: Dividend
Repatriations by
U.S.
Multinationals
161
James R. Hines, Jr., and R. Glenn Hubbard
Comment:
Mark A. Wolfson
111.
THE EFFECT
OF
TAXATION
ON
TRADE
AND
CAPITAL
FLOWS

6.
International Spillovers
of
Taxation
Jacob A. Frenkel, Assaf Razin, and
Steve Symansky
Comment:
Willem
H.
Buiter
21
1
7.
International Trade Effects
of
Value-Added
Taxation
263
Martin Feldstein and Paul Krugman
Comment:
Avinash Dixit
8.
Tax Incentives and International Capital
Flows: The Case
of
the United States and
Japan
283
A. Lans Bovenberg, Krister Anderson,
Kenji Aramaki, and Sheetal K. Chand

Comment:
Alan J. Auerbach
IV. IMPLICATIONS
FOR
OPTIMAL TAX POLICY
9.
10.
11.
Integration
of
International Capital Markets:
The Size
of
Government and Tax
Coordination
33
1
Assaf Razin and Efraim Sadka
Comment:
Jack M. Mintz
The Linkage between Domestic Taxes and
Border Taxes
357
Roger
H.
Gordon and James Levinsohn
Comment:
John Whalley
The Optimal Taxation
of

Internationally
Mobile Capital in an Efficiency Wage
Model
397
John Douglas Wilson
Comment:
Lawrence
F.
Katz
Contributors 433
Author Index 437
Subject Index
44
1
Preface
This volume includes eleven papers that were prepared as part of a research
project
on
International Aspects
of
Taxation by the National Bureau of
Economic Research. The papers examine the role of taxation in cross-border
flows of capital and goods, the real and financial decisions
of
multinational
corporations, and the implications
of
growing economic interdependence for
a country’s choice
of

a tax system. These papers were presented at a
conference attended by academics, policymakers, and representatives of
international organizations. The conference was held in Nassau, the
Bahamas on
23-25
February
1989.
We would like to thank the Ford Foundation for financial support of this
project. The success of the project also depended on the efforts
of
Kirsten
Foss Davis, Ilana Hardesty, Robert Allison, and Mark Fitz-Patrick.
Assaf
Razin
and
Joel
Slemrod
ix
This Page Intentionally Left Blank
Introduction
Assaf Razin and Joel Slemrod
The globalization of economic activity over the past three decades is widely
recognized. Despite recent indications of renewed protectionism, this trend
is likely to continue. With the integration of international activity has come the
awareness that countries are linked not only by the cross-border transactions
of private firms and citizens but also by the cross-border ramifications of their
governments’ fiscal policies. The tax policy of one country can affect economic
activity in other countries, and in the choice of tax policy instruments a
policymaker must consider its international consequences.
Examples of the growing awareness of fiscal interdependence abound. The

rate-reducing, base-broadening
U.S.
tax reform of
1986
has been followed
by similar reforms in many countries. In some cases, such as that of Canada,
the tax reform was clearly hastened by a sense of the adverse economic
consequences that would follow from a failure to harmonize to the new
U.S.
system. In other cases, the link may have been as much intellectual
stimulation as economic necessity.
The move toward European integration in
1992
has also focused attention
on fiscal issues. Many observers are concerned that, as barriers to trade and
investment come down, cross-country differences in the taxation of
economic activity will loom larger and cause inefficient decisions and
self-defeating tax competition among member nations. Initial proposals to
harmonize European systems of value-added taxes and to impose a uniform
withholding tax rate on portfolio investments have not met with much
success, however.
Assaf
Rain
is the Daniel
Ross
Professor of International Economics at Tel Aviv University, a
research associate
of
the National Bureau of Economic Research, and a visiting scholar at
the

International Monetary Fund.
Joel
Slemrod
is professor
of
economics, professor of business
economics and public policy, and director
of
the Office
of
Tax
Policy Research at the University
of
Michigan, and a research associate
of
the National Bureau of Economic Research.
1
2
Assaf
Razin
/Joel
Slemrod
Finally, there is a growing sense that the internationalization of financial
markets and the increased importance of multinational enterprises
are
making it increasingly difficult to administer and enforce efficient and
equitable income tax systems.
Tax
authorities must balance, on the one
hand, their desire to preserve their national revenues and, on the other hand,

their unwillingness to harm the international competitiveness of their
domestic business interests. Thus there is not only heightened international
competition among business but also heightened awareness of the possibili-
ties and perils
of
international fiscal competition.
The research presented in this volume is an attempt to lay some
intellectual groundwork for an understanding
of
these issues, which
are
destined to command the increasing attention of policymakers in the years to
come. It represents an unusual exercise in academia, because it brings
together people from two branches of economics-taxation and international
economic relations. Our hope was that our joint expertise, perspectives, and
methods would be more productive than our separate efforts. Both
theoretical and empirical papers
are
represented. All the papers share the
common goal of shedding light on the role of tax policy in a more highly
integrated world economy.
A pervasive problem in international taxation, and one that makes the
subject
so
complicated, is the existence of overlapping tax jurisdictions.
Every country
in
the world asserts the right to tax income earned within its
borders, regardless of the citizenship
of

the wealthowner or controller of the
income-earning capital. Many countries, including the largest economies in
the world, also assert the right to tax the income of their residents,
individuals and corporations, regardless of where the income is earned (the
“worldwide” system
of
taxation). In order to reduce the tax burden that
would result from taxation by both host and home countries, those countries
that use the worldwide system of taxation generally allow taxes paid to
foreign governments to be credited against domestic tax liability, but this is
subject to various limitations. In addition, a network of bilateral treaties has
sprung up to coordinate taxation in the case
of
overlapping jurisdictions. The
United States is an example of a country that operates a worldwide system of
taxation and
is
also party to a number of bilateral tax treaties. Its system of
taxing foreign-source income has had a great influence on other countries.
This system, though, has undergone continual change, and the Tax Reform
Act
of
1986
continued the process of change.
In the opening chapter of this volume, Hugh
J.
Ault and David
F.
Bradford
describe the basic rules that govern the U.S. taxation of international

transactions and highlight the changes brought by the Tax Reform Act of
1986.
The
U.S.
attempts to tax the worldwide income of its residents, both
individuals and corporations. It does, however, differentiate domestic-
source and foreign-source income, principally by taxing foreign subsidiaries’
foreign-source income only on repatriation of dividends, at which time a
3
Introduction
credit for foreign corporate taxes paid in association with these dividends is
offered. This allows a deferral advantage to foreign-source income. The Tax
Reform Act lowered the statutory rate of tax applied to these dividends, but
also substantially tightened the limitation of foreign tax credit by creating
several additional categories of income (called ‘‘baskets”) across which
averaging of foreign taxes is not allowed. It also revised the rules for
allocating expenses between domestic- and foreign-source income, requiring
a greater allocation of expenses to foreign operations.
Ault and Bradford go on to explore the economic policies or principles
that the tax system reflects. They argue that the assignment of income to a
geographic location is often an ill-defined concept, and therefore any
operational rules that do
so
must be essentially arbitrary. There are
competing theoretical frameworks for analysis in the international area that
lead to quite different results. Real-world phenomena, they believe, are
inconsistent with any single unifying framework. They conclude that the
most important task for policy analysis is to try to determine with more
accuracy exactly what impact the complex system of rules has on the form
and extent of international activity. That charge is taken up in the remainder

of the book.
Taxation and Multinationals
Multinationals pose special problems for taxing authorities because the
geographic source of income is not easily determined. Overlapping tax
jurisdictions, which generally employ different tax bases and rules, add
enormously to the complexity of tax compliance and administration. They
also can create opportunities for multinational companies to play the national
tax systems against each other to reduce their worldwide tax payments. The
concern for tax minimization can create incentives for real and financial
strategies that would, in the absence of taxation, make little sense.
The next set of four papers examines several ways that the tax system
affects the decisions of multinational corporations. The first two papers study
its impact on foreign direct investment, and the next two examine two
aspects of financial behavior that are affected by taxation.
Foreign direct investment (FDI) has surged dramatically in recent years.
FDI
into the United States reached $57 billion in 1988, after averaging only
$4.1 billion in the 1970s and $18.5 billion in the 1980-85 period. Outward
foreign investment from the United States in 1987 was $45 billion compared
to an average of only
$10
billion in 1977-84. The FDI of some other
countries, particularly Japan, has grown even more rapidly than that of the
United States.
The taxation system of the potential host country of an investment and
home country
of
the multinational can affect the
after-tax return, and
therefore the incentive, for foreign direct investment. Each of the following

4
Assaf
Razin
/Joel
Slemrod
two papers uses time-series data on FDI flows to assess how important the
tax effects on FDI to and from the United States have been.
The paper by Joosung Jun examines the effect of U.S. tax policy on
outward FDI. He delineates the three channels through which domestic tax
policy can affect firms’ international investment flows. First, tax policy can
affect the way in which foreign-source income is shared among the firm, the
home country government, and the host country government. Second, tax
policy can affect the relative net profitability of investments in different
countries. Finally, it can affect the relative cost of raising external funds in
different countries.
Using this three-channel framework, Jun examines the aggregate time-
series data on outward flows of FDI and concludes that U.S. tax policy
toward U.S. domestic investment has had an important effect on outflows of
direct investment by influencing the relative net rate of return on investment
located in the United States and investment located in foreign countries.
The paper by Joel Slemrod investigates how the U.S. tax system, in
conjunction with the tax system of a capital exporting country, affects the
flow of foreign direct investment into the United States. First, using
aggregate data, the paper corroborates earlier work suggesting that the
effective U.S. tax rate does influence the amount of FDI financed by transfer
of funds from parent companies, but not the amount financed by retained
earnings. Next, it disaggregates FDI by exporting country to see if, as theory
would suggest, FDI from countries that exempt foreign-source income from
taxation is more sensitive to U.S. tax rates than FDI from countries that
attempt to tax foreign-source income on a residual basis. The data analysis

does not show a clear differential responsiveness between these two groups,
suggesting either difficulties in accurately measuring effective rates of
taxation or the existence of financial strategies that render ineffective
attempts by the home country to tax foreign-source income.
Two of the chapters focus on how multinationals adjust their accounting
and financial policies in response to the tax system. Jean-Thomas Bernard
and Robert J. Weiner present a case study of transfer pricing practices in the
petroleum industry. By setting the price of interaffiliate transactions, a
multinational enterprise can affect the allocation of taxable profits among the
countries in which its subsidiaries operate in order to reduce the worldwide
tax burden of the multinational. Using data on oil imports in the United
States from
1973
to
1984,
they find that the prices set in interaffiliate
transactions differed from the price set by unaffiliated parties
(“arm’s
length” prices) for oil imported from some, but not all, countries. The
average difference in price was small, however, representing
2
percent or
less of the value of crude oil imports. Furthermore, the observed differences
across exporting countries between
arm’s
length and transfer prices are not
easily explained by average effective tax rates in the exporting countries.
Their results thus provide little support for the claim that multinational
5
Introduction

petroleum companies set their transfer prices to evade taxes. These findings
may not be readily generalizable to other industries, particularly because
petroleum is a relatively homogeneous good for which market prices are
easily observable, thus facilitating the job of tax authorities in the
U.S.
and
abroad concerned with transfer price manipulation.
James R. Hines, Jr., and R. Glenn Hubbard investigate how tax policy
affects
U.
S
. multinationals’ policy of repatriating dividends from subsidiar-
ies to the parent company. The income earned by foreign subsidiaries is
subject to
U.S.
tax only when dividends are repatriated. At that time the
taxes deemed to have been paid to foreign governments on the earnings
behind the dividend payment may be credited against
U.S.
tax liability. The
credit that may be taken in any given year is limited to the amount of
U.S.
tax liability on the foreign-source income. This system provides multination-
als with an incentive to defer dividend repatriations that will incur a net
U.S.
tax liability and to favor repatriations from firms in high-tax countries for
which the tax credit will exceed the
U.S.
tax liability. In order to study the
quantitative significance

of
these incentives, Hines and Hubbard examined
data collected from tax returns for 1984 on financial flows from
12,041
foreign subsidiaries to their 453
U.S.
parent corporations. They found that,
although on average dividend repatriations composed 39 percent of
subsidiaries’ after-foreign-tax profits, most subsidiaries paid no dividends at
all. The pattern of repatriations was related to the tax cost,
so
that in net
terms the
U.S. government collected very little revenue on the foreign
income of
U.S.
multinationals while at the same time the
tax
system is
apparently distorting their internal financial transactions.
The Effect
of
Taxation on Trade and Capital Flows
The international ramifications of tax policy go far beyond the impact on
multinationals’ behavior. The tax policy of one country can “spill over” to
other countries’ economies thereby affecting trade patterns, the volume of
saving and investment, and the desired portfolios of wealthholders. Each of
the next set
of
three papers addresses one aspect of how tax policy in one

country can affect the cross-border flow of goods and claims to assets.
Jacob A. Frenkel, Assaf Razin, and Steve Symansky deal directly with the
international spillovers of taxes in a stylized two-country model. Adopting
the saving-investment balance approach to the analysis of international
economic interdependence, they emphasize dynamic effects of domestic tax
restructurings on interest rates, investment, employment, consumption, and
the current account position. They show that a domestic budget deficit,
under a consumption tax system, raises the world rate of interest and crowds
out domestic and foreign investment. It also lowers the growth rates of
domestic consumption while raising those of foreign consumption. In
contrast, under
an
income tax system, the same budget deficit lowers the
6
Assaf
Razin
I
Joel
Slemrod
world rate of interest, reduces the growth rates of domestic and foreign
consumption, and crowds out domestic investment while crowding in foreign
investment. The analysis of revenue-neutral tax conversions in a single
country and revenue-neutral tax conversions in the context of a two-country
VAT harmonization reform (as planned for the European Community in
1992)
highlights the crucial role played by trade imbalances resulting from
intercountry differences in saving and investment propensities. Existence of
such international differences implies that tax harmonization may result in
output and employment expansion in some countries and contraction in
others, thereby generating conflicting interests among the various countries.

The analytical results are supplemented by detailed dynamic simulations
which highlight the variety of mechanisms through which the effects of tax
policies spill over
to
the rest of the world.
Martin Feldstein and Paul Krugman scrutinize the view, common among
many businesspersons, that reliance on the VAT aids
a
country’s interna-
tional competitiveness since such a tax is levied on imports but rebated on
exports. They claim that in practice VATS are selective and fall more heavily
on internationally traded goods than on nontraded goods and services. In this
case, use of a VAT causes a substitution of nontraded goods and services
which reduces both exports and imports, but the trade balance can either
improve
or
worsen. The only pro-competitive aspect of a VAT may be the
fact that substituting a consumption tax for an income tax encourages saving
which, by itself, tends to improve the trade balance in the short run.
A. Lans Bovenberg, Krister Anderson, Kenji Aramaki, and Sheetal
Chand deal with the effects of the tax treatment of investment and savings on
international capital flows. They evaluate changes in tax wedges on savings
and investment in the
U.S.
and Japan and examine how recent reforms
of
capital income taxation created incentives for bilateral capital
flows
between
these countries during the

1980s.
The results reveal that the tax burden on
assets located in Japan exceeded the tax burden on assets located in the
U.S.,
while a
U.S.
saver faced a heavier tax burden than a Japanese saver for assets
located in both countries. They suggest that these differential tax burdens
could to some extent explain the pattern of bilateral flows
of
savings and
investment between the
U.S.
and Japan in the
1980s.
Some Implications
For
Optimal Tax Policy
Much of the research reported here has suggested that taxation can exert a
potentially powerful influence on both real and financial decisions about
cross-border movements of capital and goods. At the same time, it is clear that
the increasing internationalization
of
economic affairs has profoundly changed
what is appropriate
tax
policy. The last set of papers in this volume explore the
implications for optimal tax design of several aspects of openness.
7
Introduction

Assaf Razin and Efraim Sadka address two policy issues in the context of
world capital market integration: (a) the effects of relaxing restrictions
on
the
international flow of capital
on
the fiscal branch
of
government and (b) the
degree
of
international tax coordination needed to ensure a viable equil-
ibrium in the presence of international tax-arbitrage opportunities.
First, Razin and Sadka show that notwithstanding the use of distortionary
taxes as part of the optimal program, it requires an efficient allocation of
investment between home and foreign uses
so
that the marginal product of
capital is equated across countries. Consequently, capital-market liberaliza-
tion tends to lower the cost of public funds and increase the optimal
provision of public goods and services. More public goods are demanded
because of the increase in real income resulting from the improved trade
opportunities and because broadening the tax base lowers the marginal cost
of public funds through a distortion-reducing change in the marginal tax
rates.
Second, they remind us that a complete integration of the capital markets
between two countries requires that the residents of each country face the
same net-of-tax rate of return
on
foreign and domestic investments.

Otherwise, there must exist profitable arbitrage opportunities. These
conditions will be met only if taxes by the home country levied on domestic
residents on their domestic-source income and foreign-source income, and
taxes
on
nonresidents’ income in the home country are related to the cor-
responding foreign country taxes in a specific way.
To
assure such a
relationship without arbitrage opportunities, the countries must coordinate to
some degree their domestic and foreign tax structures.
The net effect of a country’s
tax
system on international trade and factor
flows is only partly revealed by how it taxes international transactions.
As
Roger
H.
Gordon and James Levinsohn point out, what are ostensibly
“domestic” taxes can have
an
important impact
on
international transac-
tions. They study the optimal coordination between domestic taxation and
both tariff and nontariff trade policies. When the set of tax instruments is
restricted, perhaps owing to administrative cost considerations, then tax
policies that distort trade patterns may be optimal, although the direction of
trade loss may be of either sign.
Gordon and Levinsohn next investigate to what extent the observed use of

border distortions (tariffs, export subsidies, etc.) may result from a country’s
attempt to offset the trade distortions created by their domestic tax structure.
To
examine this hypothesis, they look at International Monetary Fund
financial statistics for thirty countries during the period
1970-87.
The data
suggest that, while for poorer countries border taxes do seem to offset the
trade impact of domestic taxes, the richer countries have significant
trade-discouraging distortions caused by domestic taxation that are not offset
by border taxation.
8
Assaf Razin
/Joel
Slemrod
The final chapter, by John Douglas Wilson, deals with the optimal tax
structure for an open economy in which similar types of workers are paid
different wages since worker productivity in some industries depends on the
level of wages (the efficiency wage model). The first-best optimal policy, an
industrial policy which subsidizes high-wage firms, is not obtainable either
due to asymmetric information between the government and the firms or
because employment subsidies lead to increased efficiency at the cost of a
less equitable income distribution. Consequently, a second-best policy of
capital-market intervention is desirable.
A
role for capital-market interven-
tion as a second-best policy emerges only when there exist capital-market
asymmetries.
A
somewhat surprising result of the analysis is that if the

government does not know the identity of firms in which supervision
problems lead to the dependence of labor productivity on wages, then
high-wage firms should face a positive tax
on
capital at the margin while
low-wage firms should face a positive subsidy. In this way the optimal tax
policy encourages capital investment in the sector that lacks a supervision
problem, the low-wage sector. This form of capital-market intervention
enables the government to make greater use of employment subsidies for
high-wage firms, because it discourages low-wage firms from masquerading
as high-wage firms in an attempt
to
obtain these subsidies.
Conclusion
A
major challenge to policymakers faced with a more integrated world
economy lies in the area of taxation. In fact, the international effects
of
taxation are now attracting increased interest in both professional circles and
governments. This volume provides a first attempt to deal with the complex
issues associated with the taxation of internationally mobile goods, services,
and factors of production. We hope that the book will stimulate further
intensive research in this important new area, international taxation
economics.
An
Overview
of
the
U.S.
System

of
Taxing International
Transactions
This Page Intentionally Left Blank
1
Taxing International Income: An
Analysis
of
the U.S. System
and Its Economic Premises
Hugh
J.
Ault and David
F.
Bradford
International tax policy has been something of a stepchild in the tax
legislative process. The international aspects of domestic tax changes are
often considered only late in the day and without full examination. As a
result, the tax system has developed without much overall attention to
international issues. This paper is an attempt to step back and
look
at the
system that has evolved from this somewhat haphazard process.
We will describe in general terms the basic
U.S.
legal rules that govern the
taxation
of
international transactions and explore the economic policies or
principles they reflect. Particular attention will be paid to the changes made

by the Tax Reform Act of 1986, but it is impossible to understand these
changes without placing them in the context of the general taxing system
applicable to international transactions.
The first part (secs. 1.1
-
1.4)
contains a description
of
the legal rules, and the second part (secs. 1.5- 1.9)
undertakes an economic analysis
of
the system. We have tried to make both
parts intelligible to readers with either legal or economic training.
Hugh J. Ault is professor of law at Boston College Law School. David F. Bradford is
professor
of
economics and public affairs at Princeton University and director of the Research
Program in Taxation at the National Bureau of Economic Research.
The authors would like to thank Daniel Frisch, James Hines, Thomas Horst, Richard
Koffey, Joel Slemrod, Emil Sunley, and participants in the NBER Conference on International
Aspects
of
Taxation for helpful discussions
of
various aspects of this research, and the
National Bureau of Economic Research for financial support. This paper was completed while
Bradford was a fellow at the Center for Advanced Study in the Behavioral Sciences. He is
grateful for the Center’s hospitality and for financial support arranged by the Center from the
Alfred P. Sloan Foundation and the National Science Foundation (grant #BNS87-00864).
Bradford would also like

to
acknowledge financial support provided by Princeton University
and by the John
M.
Oh Program at Princeton University for the Study of Economic
Organization and Public Policy.
11
12
Hugh
J.
AddDavid F. Bradford
1.1
Basic Jurisdictional Principles
1.1.1
Domiciliary and Source Jurisdiction
U.S.
persons are subject to tax on a worldwide basis, that is, regardless of
the geographic “source” of their income. Traditionally, this principle has
been referred to as “domiciliary”- or “residence”-based jurisdiction since it
is based on the personal connection of the taxpayer to the taxing jurisdiction.
In contrast, foreign persons are subject to tax only on income from “U.S.
sources” and then only on certain categories of income. Individuals are
considered U.S. persons if they are citizens of the United States (wherever
resident) or if they reside there.’ Corporations are considered U.S. persons if
they are incorporated in the United States. The test is purely formal, and
residence
of
the shareholders, place of management of the corporation, place
of business, and
so

forth are all irrelevant. “Foreign persons” are all those
not classified as U.S. persons.
As
a result of the rules outlined above, a foreign-incorporated corporation
is treated as a foreign person even if its shareholders are all U.S. persons.
The foreign corporation is taxed by the United States only on its U.S source
income, and the
U.S.
shareholder is taxed only when profits are distributed
as a dividend.
Thus,
the
U.S.
tax on foreign income
of
a foreign subsidiary
is “deferred” until distribution to the U.S. shareholder.
A
special set of
provisions introduced in
1962
and modified in
1986,
the so-called Subpart F
rules, limits the ability to defer U.S. tax on the foreign income of a
U.
S
.
-controlled foreign corporation in certain circumstances.
This pattern of taxing rules depends crucially on identifying the source of

income.
A
complex series of somewhat arbitrary rules is used to establish
source. For example, income from the sale of goods is sometimes sourced
in
the country in which the legal title to the goods formally passes from the seller
to the buyer.
1.1.2
Overlapping Tax Jurisdiction and Double Taxation
Where several countries impose both domiciliary- and source-based
taxation systems, the same item of income may be taxed more than once. For
example, if a
U.S.
corporation has a branch in Germany, both the United
States (as the domiciliary country) and Germany (as the country of source)
will in principle assert the right to tax the branch income. It has been the
long-standing policy of the United States to deal with double taxation by
allowing U.S. taxpayers to credit foreign income taxes imposed on
foreign-source income against the otherwise applicable
U.
S.
tax liability.
The United States as domiciliary jurisdiction cedes the primary taxing right
to the country of source. Nevertheless, the United States retains the
secondary right to tax the foreign income to the extent that the foreign rate is
lower than the U.S. rate. Thus, if a
U.S.
taxpayer realizes
$100
of

foreign-source income subject to a
50
percent U.S. rate and a
30
percent
13
U.S.
Taxation
of
International Income
foreign rate, the entire foreign tax of
$30
could be credited and a residual
U.S.
tax of
$20
would be collected on the income. If the foreign rate were
60
percent,
$50
of the
$60
of foreign taxes would be creditable. Thus,
subject to a number of qualifications discussed below,4 the amount of foreign
taxes currently creditable is limited to the U.S. tax on the foreign income.
The credit cannot offset U.S. taxes on U.S source income.
If
the
U.S.
taxpayer pays “excess” foreign taxes-that is, foreign taxes in excess of the

current U.S. tax on the foreign-source income-the excess taxes can be
carried back two years and forward five years, but they can be used in those
years only to the extent that there is “excess limitation” available, that is, to
the extent that foreign taxes on foreign income in those years were less than
the
U.S.
tax. In effect, the carryforward and carryback rules allow the
U.S.
taxpayer to average foreign taxes over time, subject to the overall limitation
that the total of foreign taxes paid in the eight-year period does not exceed
the
U.S.
tax on the foreign-source income.
The foreign tax credit is also available for foreign income taxes paid by
foreign corporate subsidiaries when dividends are paid to
U.S.
corporate
shareholders, the so-called deemed-paid credit
.5
Thus, if a foreign subsidiary
earns
$100
of foreign income, pays
$30
of foreign taxes, and later distributes
a dividend
of
$70
to its
U.S.

parent, the parent would include the
$70
dis-
tribution
in
income, “gross up” its income by the
$30
of foreign tax, and then
be entitled to credit the foreign tax, subject to the general limitations discussed
above, in the same way as if it had paid the foreign tax directly itself.
It should be emphasized that the credit is limited to foreign income taxes
and is not available for other types of taxes. The determination of what
constitutes an income tax is made under
U.S.
standards, and detailed
regulations have been issued to provide the necessary definitions (Treasury
Regulations, sec.
1.901-2).
In general, the foreign tax must be imposed on
net realized income and cannot be directly connected with any subsidy that
the foreign government is providing the taxpayer. Special rules allow a credit
for gross-basis withholding taxes.
1.1.3
Source of Income Rules
The source rules are central to the taxing jurisdiction asserted over both
U.
S
.
and foreign persons. For foreign persons (including
U.

S
. -owned
foreign subsidiaries), the source rules define the
U.S.
tax base. For
U.S.
persons, the source rules control the operation of the foreign tax credit since
they define the situations in which the United States is willing to give
double-tax relief.6 In general, the same source rules apply in both situations,
though there are some exceptions. The following are some
of
the most
important of the source rules.
Sale
of
Property
As
a general rule, the source of a gain from the purchase and sale of
personal property is considered to be the residence of the seller. Gain on the