James%20R.%20Hines%20Jr.

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EXEMPTING FOREIGN-SOURCE DIVIDENDS FROM U.S.
TAXATIONPresentation to the Presidents
Advisory Panel on Federal Tax Reform

• James R. Hines Jr.
• May 12, 2005

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• The current U.S. tax regime.
• The United States taxes the worldwide incomes of
  American individuals and corporations.
• Hence dividends received from foreign
  subsidiaries of American corporations are subject
  to U.S. tax.
• Taxpayers may claim foreign tax credits for
  foreign income tax payments.
• U.S. tax obligations are generally deferred until
  dividends are repatriated.
• A special 85 dividend exclusion applies to 2005.

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• Why tax foreign income this way?
• The Capital Export Neutrality concept income is
  taxed at the same total (foreign plus domestic)
  rate wherever earned.
• As a result, market considerations, rather than
  taxes, determine investment.
• A common claim that such taxation by the U.S.
  promotes global efficiency.
• Note that the same logic implies that U.S.
  national interests would be best served by taxing
  foreign income, permitting only a deduction (not
  a credit) for foreign taxes paid.

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The hybrid U.S. system.

• The current U.S. tax system does not correspond
  to Capital Export Neutrality in two key respects
• Foreign tax credits are limited.
• U.S. taxation of unrepatriated foreign income is
  deferred.
• As a result of foreign tax credit limitations and
  taxation of income upon repatriation, the system
  distorts
• Ownership of business assets in the U.S. and
  abroad.
• Investment in plant and equipment.
• The financing of investment in the U.S. and
  abroad.
• RD spending.
• Repatriation of dividends from foreign
  subsidiaries.
• Transfers of intangible assets within firms.
• International trade.
• The magnitude of the associated economic
  distortion can greatly exceed the amount of
  revenue collected from foreign investment.

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• Would it be better for the U.S. system to
  correspond to capital export neutrality?
• In a word, no.
• Taxing U.S. investors at the same total rate
  regardless of investment location promotes
  neither global efficiency nor national welfare.
  Matters would be even worse if foreign taxes were
  merely deductible and not creditable.
• Why? Because investors from other countries are
  not subject to such a tax regime. Consequently,
  the U.S. tax system distorts capital ownership.

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• Downsides of worldwide taxation.
• The logic behind worldwide taxation presumes the
  United States is the only country in the world.
  This is simply inaccurate.
• American firms are subject to higher total tax
  burdens on their foreign operations than are
  firms from many other countries. Tax differences
  cause them to be outbid in some foreign
  acquisitions, and encourage American firms to
  outbid foreign competitors in other acquisitions.
• Taxation on the basis of ownership, rather than
  production, has the predictable effect of
  distorting capital ownership. The problem is
  that ownership is critical to productivity.

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• Realities of FDI.
• Foreign direct investment consists primarily of
  firms in rich countries acquiring, and then
  operating, firms in other rich countries.
• In 2001, more than 96 of foreign direct
  investment in the United States represented
  acquisitions of existing American firms.
• Foreign investment by American firms is heavily
  concentrated other G-7 countries, which, in 1999,
  together accounted for 57 of their total foreign
  gross product.
• International investment is largely about who
  owns and manages capital, rather than being about
  movements of plant and equipment.

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• Would exempting foreign income from taxation
  reduce U.S. prosperity?
• No, current policies reduce U.S. prosperity by
  subjecting foreign income to taxation that is
  burdensome and distortionary.
• As a consequence, the tax system indirectly
  reduces the productivity of businesses located in
  the United States, which thereby reduces the
  return to labor in the U.S.
• Exempting foreign income from taxation would not
  cause plant and equipment to flee from the U.S.,
  but would instead rationalize ownership and
  thereby increase productivity.
• Domestic productivity is enhanced by treating
  foreign taxes as costs of doing business, but not
  imposing added home-country tax burdens merely
  because a foreign operation is owned by a U.S.
  business.

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• Equity considerations.
• Consider two American businesses, one that earns
  100 in the U.S., and one that earns 100 in a
  country that does not tax business profits.
• Is it fair to exempt the second business from
  U.S. taxation on the 100 profit? After all, the
  first business must pay taxes on the 100,
  whereas the second business would then not pay
  taxes to anyone.
• The point to keep in mind is that earning pre-tax
  100 in a country without taxes is more difficult
  than earning 100 in a country with a 35 tax
  rate, since international competition is more
  keen in the zero-tax place. Investors from
  countries that exempt foreign income from
  taxation drive down local pre-tax rates of
  return.
• Hence it is misleading to consider only pre-tax
  returns.

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Methods of exempting foreign-source income from
tax.

• Exempt foreign-source dividends by statute. Many
  countries do this.
• Exempt foreign-source dividends as provisions of
  U.S. treaties. A number of other countries go
  this route.
• Alternatively, the U.S. could impose border
  cash-flow taxation permit a deduction for funds
  invested abroad, and include repatriations as
  taxable U.S. income.

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• Reform considerations.
• Exempting foreign income increases the importance
  of correctly allocating income and expenses
  between foreign and domestic sources, since it
  increases the tax consequence of the distinction.
• An example if foreign dividends are statutorily
  exempt from domestic taxation, then royalties
  received from foreign source are properly taxed
  as domestic income. Expenses incurred in
  producing intangible property should then be
  fully deductible against domestic income.
• Transition rules need to account for changes in
  regime. This is not as difficult as it appears.
  For example, a transition to border cash-flow
  taxation could be accompanied by granting
  American firms deductions for accumulated
  unrepatriated foreign earnings and profits.