Taxation in the global economy.

Slemrod, Joel B.

Taxation in the Global Economy

As global competitiveness has climbed higher on the policy agenda, it is no surprise that the role of tax policy in the decline of U.S. economic dominance has come under critical review. Tax policy has been blamed for our low saving rate--which leads to a current account deficit; the increase in foreign direct investment in the United States; and the inability of U.S.-based multinationals to compete abroad on a level playing field.

Much of my recent research has been aimed at rethinking the effects and structure of tax policy in an increasingly interdependent world economy. Globalization demands a rethinking of these issues, because it has profound implications for tax systems, raising new questions and changing the answers to old ones.

The Pitfalls of Myopic Tax Policymaking

Consider tax policymakers who mistakenly believe, or act as if, their country's economy were completely closed. What missteps would they be tempted to make? At least four come to mind.(1) They might:

1. see key sectors and tax revenues dwindle as other countries set their tax systems to complete away capital and the tax revenues from capital income;

2. forgo opportunities to take advantage of foreign investors and governments; large countries can exploit their market power, but all countries can take advantage of the arrangements that their trading partners use to alleviate double taxation;

3. overestimate the ability to place the burden of taxation on capital owners; the apparent progressivity of capital taxation may be illusory, as international capital mobility implies that it ultimately may be borne by owners of relatively immobile factors, such as labor and land; in that case, taxes levied directly on land and labor have about the same incidence as capital taxes but do not distort the locational efficiency of capital; and

4. underestimate the potential importance of multilateral tax agreements that help preserve the efficient functioning of the world economy.

Avoiding these missteps in designing policy requires a clear understanding of how taxes affect economic behavior in an open environment.

Foreign Direct Investment

Foreign direct investment (FDI) to and from the United States now is more than five times its level of a decade ago. The growing presence of foreign multinationals has prompted concern about the impact of FDI on the economy and the role of the tax system in encouraging it.

Tax policy can affect FDI in complicated ways, because often both the host country (where the FDI is located) and the home country (where the firm is headquartered) assert the right to tax the income from FDI, with limited harmonization of the tax systems. Of the major countries whose firms invest in the United States, some tax the income from FDI--but allow a credit for taxes paid to the United States--while others completely exempt the income from FDI from home country taxation. This raises the interesting possibility that, for investment from the first group of countries (predominantly Japan and the United Kingdom), taxation of inward FDI by the United States would raise revenue but would not be a disincentive to investment, because any taxes paid to the U.S. government would be offset by credits offered by the home country. This is an intriguing possibility; if true, it represents an opportunity to pass the burden of taxation along to nonresidents.

To test for this possibility, I disaggregated the data on inward FDI to the United States by the major capital-exporting countries to see if, as theory would suggest, FDI from countries that do not tax foreign-source income is more sensitive to U.S. tax rates than FDI from countries that attempt to tax foreign-source income but allow a credit for U.S. taxes.(2) The analysis did not reveal a clear differential responsiveness between these two groups of countries. Although this could be in part the result of difficulties in measuring effective tax rates accurately, it suggests the availability of financial strategies that render the home country tax system immaterial in affecting the return on FDI. It implies that the U.S. taxation of inward FDI does provide a disincentive, and that the tax burden is not shifted without cost to foreign governments and, ultimately, to foreign residents.

Immediately after the passage of the Tax Reform Act of 1986 (TRA86), FDI both into and from the United States surged. Inward FDI reached an all-time high of $58.4 billion in 1988, continuing a secular increase that began in the late 1970s. Outward FDI also reached an all-time high of $44.5 billion in 1987, a sharp turnaround from the downtrend of the early 1980s. In 1988, though, outward FDI fell back to $17.5 billion, approximately its 1985 level, which, after adjusting for capital gains and tax haven transactions, is lower as a fraction of GNP than it was in the late 1970s.

Was tax reform responsible for this surge in FDI, or was its post-TRA86 performance merely a coincidence? In a recent study, I concluded that the link between tax reform and the FDI boom is difficult to make, both because the net incentive effect of several TRA86 provisions concerning FDI is not clear and because it is impossible, with less than four years of post-TRA86 data, to sort out any tax effect from other influences on FDI.(3) However, several aspects of recent FDI performance are consistent with the effect of TRA86 on incentives. Perhaps most striking is the recent strength of outward FDI to low-tax countries. The drop in the corporate statutory rate from 46 to 34 percent means that, for most U.S. multinationals, taxes paid to foreign governments are no longer offset at the margin by foreign tax credits. This situation makes low-tax host countries an especially attractive outlet for investment. The post-TRA86 data suggest that U.S. multinationals have noticed, with recent FDI favoring low-tax European countries over high-tax European countries.

For inward FDI, the predominance of Japanese and U.K. investment is consistent with a tax story: for multinationals based in these countries, the increased effective tax rate on investment in the United States is offset by increased credits offered by their home countries, giving them a relative advantage over domestic U.S. or other foreign investors. Although this story is consistent with the 1987 and 1988 pattern of inward flows, I believe it is too early to be sure that the tax incentives played a major role in the strength of British and Japanese investment in the United States.

The Spillover Effects of Taxation--A Case Study of the United States and Canada

Tax reform in one country, particularly a large country such as the United States, potentially can affect economic activity in other countries through macro-economic channels, such as the level of interest rates, and through the relative attractiveness of locales for production, incorporation, and the reporting of taxable income. The high degree of integration between the U.S. and Canadian economies makes Canada a natural place to look for empirical evidence of spillover effects.

In a recent study, I investigated the impact of TRA86 on Canadian business.(4) Tax reform in the United States could spill over and affect the profitability of Canadian business through at least three different channels: 1) by affecting the cost of capital of U.S. competitors to Canadian business: 2) by affecting the future course of Canadian tax reform; and 3) by directly affecting the taxation of U.S. subsidiaries of Canadian multinationals. I assessed the quantitative importance of these avenues of impact by examining the abnormal returns to Canadian stocks during key periods in the legislatve history of TRA86. I did find evidence that during these events there was an abnormal negative relationship between the returns of Canadian industries and their U.S. counterparts, suggesting that the first avenue is important. However, I was not successful in relating the abnormal behavior of Canadian stocks to industry characteristics that proxy for the relative importance of the three potential avenues of impact.

Tax Policy toward Multinational Corporations

How to tax U.S. and foreign-based multinationals is as controversial a question as ever. For decades, U.S corporations have argued that relatively high U.S. levels of taxation put them at a competitive disadvantage with respect to their foreign competitors. More recently, as FDI in the United States has grown in importance, some have argued that foreign subsidiaries operating in the United States are not paying their fair share of taxation.

My work with James A. Levinsohn begins an analysis of the appropriate tax treatment of domestic multinationals by bringing to bear the lessons of the strategic trade literature.(5) We develop some simple models of optimal tax and tariff policy in the presence of global corporations that operate in an imperfectly competitive environment--that is, where there are excess profits that, from a national standpoint, are better earned by "our" firms than "their" firms. We find that, in cases in which tax policy cannot be industry-specific and tariffs cannot be levied on the foreign output of domestic firms, the optimal policy may be implemented by a preferential tax on foreign income combined with an export subsidy targeted to the strategic sector.

Here, as in trade policy analysis, the leap from simple models to policy prescriptions is a dangerous one. The modern theories of optimal taxation provide no definite justification for diverging from the traditional prescription that, in the interest of maximizing national income, foreign-source income should be fully taxed while allowing the deductibility of taxes paid to foreign governments.(6) Although Levinsohn and I show that, in some situations, preferential taxation of foreign income combined with export subsidies is called for, this result is not general and depends critically on the strategic makeup of industries in particular. Even more importantly, the ability of the political process to correctly identify which industries are "strategic" (that is, appropriate targets for this kind of intervention) remains an open question.

Tax Evasion and North-South Capital Flows

One fact of life in the global economy is that it is more difficult to collect revenue from tax bases that are located outside the country. In fact, most developing countries (the "South") lack the administrative capability to effectively levy any tax on the foreign-source income of their residents. Combining this fact with the move of developed countries (the "North") to abolish their own withholding taxes on income paid to foreigners implies that funds flowing from South to North may be completely untaxed.

In a recent paper, I argue that the result of this state of affairs is excessive tax-induced flows of capital across borders and insufficient investment in the South.(7) Surprisingly, national income of the South under certain conditions actually could be improved if the North would impose a withholding tax on portfolio income, even though the South sacrifices revenues to the North.

Tax Systems in a Global Economy

A critical, but often overlooked, element of the design of a tax system is its enforceability and administrability, which influence both fairness and economic impact.(8)

The enforceability of tax rules is especially important in the context of the rapid dismantling of barriers to cross-border transactions. Income that crosses borders is especially difficult for tax authorities to monitor. This difficulty has led some commentators to predict the "erosion" of the global fiscal commons," and has led others to question whether capital income taxes can survive at all (an outcome decried by some but applauded by others).(9) The geographical location of the income earned by multinationals is also difficult to pinpoint, and the conceptual basis for such an exercise is even suspect.(10)

One possible response to the erosion of the capital income tax base is increased multilateral cooperation among tax authorities, along the lines of the GATT. From a global perspective, each country pursuing its national interest will not ensure a rational allocation of resources, as each country ignores the repercussions of its actions on the others. Although the potential benefit of multilateral cooperation is arguably large, the likelihood for multilateral action is limited severely by the unwillingness of countries to cede their sovereignty over tax policy. Nevertheless, an agreement to harmonize statutory corporate tax rates and withholding rates and to maintain a common policy toward tax havens has the potential for reducing the incentives for costly tax base competition and cross-border investments motivated solely by tax considerations.

(1)J. B. Slemrod, "Tax Principles in an International Economy," in M. L. Boskin and C. E. McLure, Jr., eds., World Tax Reform: Case Studies of Developed and Developing Countries San Francisco: ICS Press, 1990. (2)J. B.. Slemrod, "Tax Effects on Foreign Direct Investment in the United States: Evidence from a Cross-Country Comparison," in A. Razin and J. B. Slemrod, eds., Taxation in the Global Economy, Chicago: University of Chicago Press, 1990. (3)J. B. Slemrod, "The Impact of the Tax Reform Act of 1986 on Foreign Direct Investment to and from the United States," NBER Working Paper No. 3234, January 1990, and in J. B. Slemrod, ed. Do Taxes Matter? The Impact of the Tax Reform Act of 1986, Cambridge, MA: The MIT Press, forthcoming. (4)J. B. Slemrod, "The Impact of U.S. Tax Reform on Canadian Stock Prices," in J. B. Shoven and J. Whalley, eds., U.S.-Canadian Tax Comparisons, Chicago: University of Chicago Press, forthcoming. (5)J. A. Levinsohn and J. B. Slemrod, "Taxes, Tariffs, and the Global Corporation," NBER Working Paper No. 3500, October 1990. (6)J. B. Slemrod, "Competitive Advantage and the Optimal Tax Treatment of the Foreign-Source Income of Multinationals: The Case of the United States and Japan," in American Journal of Tax Policy, forthcoming. (7)J. B. Slemrod, "A North-South Model of Taxation and Capital Flows," NBER Working Paper No. 3238, January 1990. (8)J. B. Slemrod, "Optimal Taxation and Optimal Tax Systems," NBER Working Paaper, forthcoming, and Journal of Economic Perspectives (Winter 1990). (9)R, H. Gordon, "Can Capital Income Taxes Survive in Open Economies?" NBER Working Paper No. 3416, August 1990. (10)D. H. Bradford and H. Ault, "Taxing International Income: An Analysis of the U.S. System and Its Economic Premises," in A. Razin and J. B. Slemrod, eds., Taxation in the Global Economy, Chicago: University of Chicago Press, 1990.

Joel B. Slemrod became an NBER faculty research fellow in 1978 and was promoted to research associate in 1985. Since 1987, he also has been coordinator of the NBER's Project on the International Aspects of Taxation.

Slemrod received his A.B. from Princeton University in 1973 and his Ph.D. from Harvard University in 1980. From 1979-87, he taught at the University of Minnesota. He has been at the University of Michigan since 1987, where he is currently a professor of economics, business economics, and public policy, and director of the Office of Tax Policy Research.

In addition to his teaching, Slemrod was a senior staff economist at the Council of Economic Advisers in 1984-5. He also has been a consultant to the Canadian Department of Finance (1985-6) and the World Bank (1987 and 1989-90).

Slemrod edited the recent MIT Press book, Do Taxes Matter? The Impact of the Tax Reform Act of 1986, and was coeditor of the 1990 NBER volume, Taxation in the Global Economy.

He and his wife, Ava, live in Ann Arbor with their six-year-old daughter, Anna, and their three-year-old son, Jonathan. Ava coordinates curriculum development for gifted children at a local school district, Joel's hobbies are playing tennis, reading history, listening to Anna practice the violin, and reading "truck books" to Jonathan.