(Archived Content)
FROM THE OFFICE OF PUBLIC AFFAIRS
JS-1449
My predecessor Pam Olson and I have often spoken of the need to reform the international provisions of the tax code. A year ago, one commentator described the situation as perhaps the perfect storm that would at last result in sorely needed changes to our international tax laws. Unfortunately, so far the perfect storm looks more like a tempest in a partisan teapot. The complexity of the international rules - that black box feel they have for everyone who doesn't play in them regularly - has left many legislators concerned that the much needed changes are in fact the recipe for shipping jobs offshore. Even reform stalwarts have expressed concerns about the potential effects of the changes.
Treasury and IRS have succeeded in making changes in recent months.
Last fall, we issued proposed regulations on transfer pricing for services transactions, including services transactions involving intangibles. The current transfer pricing regulations for services were issued in 1968, back when many of the types of services crossing borders regularly today were not even an idea in a grad student’s notebook. The proposed regulations represent a complete overhaul, reflecting the significant economic, legal and technological developments of the past 35 years. The proposed services regulations are just one part of our overall efforts to ensure that our transfer pricing rules are up-to-date, reflect international standards, and reach appropriate results. A major focus of this ongoing work is ensuring that cross-border transfers and other related party transactions, particularly transfers of intangible assets, cannot be used to shift income out of the United States.
We were very pleased that Congress approved our new tax treaty with Japan. The new treaty will significantly reduce existing tax barriers to trade and investment between the United States and Japan. It will foster even closer economic ties between our two countries, enhancing the competitiveness of our businesses and creating new opportunities in the combined markets of the two countries. A healthy trade and investment relationship between the United States and Japan, the world’s two largest economies, is critical to creating economic growth throughout the world.
The new Japanese treaty follows closely the ratification of changes to our treaties with the United Kingdom and Mexico – changes that like those in the Japanese treaty reduce tax barriers to trade and investment.
The Jobs and Growth Tax Act was significant because the dividend changes addressed a way in which the U.S. tax system differed from those of our major trading partners around the world. The 2003 Act reduced the U.S. tax on capital gains and dividends to 15%. The President’s goal was the complete elimination of the double tax on corporate income. Although we didn’t make it that far, we did get to a much more rational system. The change reduces the bias for debt, the preference for retained earnings over dividends, and the disadvantageous tax consequences of raising outside capital to grow a business. Our current system continues to favor passthrough entities, such as partnerships or S corporations, with a single layer of tax. But, the Jobs and Growth Tax Act changes reduce the cost of going to the market when a business needs additional capital to grow.
Reducing the tax on capital matters in the international arena because businesses today compete for capital on a global playing field. According to an OECD study, prior to the 2003 tax Act, the United States was ranked second highest in the world in income taxes on capital income. Secretary Snow noted that statistic at a Ways and Means. He was still testifying when we heard from our friends in Japan that the OECD study was out-of-date – that it failed to reflect a recent reduction in Japanese taxes. Conclusion, we were number one. This was not a competition we wanted to win. The 2003 changes didn’t move us way down on the OECD list. That’s the bad news. The good news is we’ve moved in the right direction and that we did so based on a political recognition of the economic realities of global competition and the importance of capital to jobs in America.
Global competition. That’s what it’s all about. Viewed from the vantage point of today’s global marketplace, our tax rules appear outmoded, at best, and punitive of U.S. economic interests, at worst. Since we’ve not succeeded in making any changes so far, that problem remains. And it is a problem that grows worse with each passing year as the world’s economies become more closely interrelated every year.
Before trying to talking about out what our international tax rules should be, let’s talk about where we are economically.
Over the course of the past year, concerns about the health of the U.S. economy, particularly the manufacturing sector, have soared. While it is clear we are at last on the road to recovery, concerns about the future have not evaporated. Those concerns stem in part from the fact that the past recession was unusually harsh for manufacturers, particularly for workers in manufacturing. Manufacturing always reacts more quickly and is affected more deeply by recession and recovery. In every other post-war recession, manufacturing has fallen roughly 7 percent, while the economy as a whole has dropped roughly 2-3 percent. Significantly, in this past recession, while total production fell less than 1 percent, manufacturing still fell by 6 percent. What is also clear is that manufacturing did not pick up as quickly in the past recession. It only began to expand 18 months into the recovery, rather than leading the recovery as it had in the past.
Despite what has occurred, the United States represents a growing share of the world economy. It is more than twice the size of the next largest economy, Japan. In addition, the United States continues to lead the world in terms of both invention (i.e., the number of patents filed each year) and innovation (the incremental changes in operations and business processes that yield greater productivity gains).
China is cited as a problem regularly in the press and on the Hill, but, in reality, China is a glass half empty or half full depending on whether you’re looking at what’s behind you or what’s in front of you, whether you fear the competition or are looking at the opportunities. Let’s take a look at the facts on manufacturing, which is what drives the China glass-is-half-full-half-empty debate.
Fact: Despite the 3½-year downturn in manufacturing, the U.S. manufacturing sector, standing alone, would be the 5th largest economy in the world.
- Fact: The U.S. manufacturing sector is larger than China’s entire economy.
- Fact: The U.S. is the largest producer of manufactured goods in the world.
- Fact: The U.S. is the world’s largest exporter. Of course, we are also the world’s largest importer!
- Fact: Our trade gap stems more from declining exports than rising imports because the economies to which we export – especially Japan and Germany – are stagnant.
- Fact: Our rising trade gap with China has come at the expense of other Asian nations that have lost market share to Chinese producers.
- Fact: China has lifted about one-quarter of its population out of poverty. That’s 300 million new consumers with another 900 million to go!
- Fact: China has lost more manufacturing jobs than there are in the U.S.
Changes in how we do business have been led by our vibrant service sector. The service sector has inspired new ways of doing business, with a vision for the future that recognizes the importance to the consumer of the reliability of the products they buy. Viewed one way, a computer manufacturer sells computers. Viewed another way, a computer manufacturer sells IT and data processing services. Viewed one way, an automaker sells cars; viewed another, the automaker sells transportation services. In either example, the consumer wins when the manufactured product performs reliably and when problems are quickly corrected. In the long run, the companies that provide the best service will win, and that’s what we do best in America.
What recent events suggest is that there are more fundamental, structural shifts under way in manufacturing – not just the cyclical effects of the recession.
Those structural shifts flow from three changes. The first -- and arguably the most important -- is technology. Rapid changes in technology – production technology, information technology, and transportation – have made it possible to operate a manufacturing enterprise on a global basis. They have also made it a competitive necessity to do so because we can’t afford not to do what our competitors are doing. In effect, what technology has done is eliminate many of the constraints physical geography imposed on trade in the past.
The second shift is due to the reduction in trade barriers. Those reductions have benefited consumers around the globe. They have also resulted in a real rising standard of living in the developing world.
The third shift has to do with the end of political divisions that have affected world trade since the onset of World War I. Experts tell us that the best way to think about this phenomena is that it represents the economic impact of reintegrating the Russian, Chinese, Eastern European, and Vietnamese economies back into world markets.
In the face of that, what should we do in terms of government policy? We cannot stop change and we cannot turn back the hands of time. Nor should we want to. Yes, we can long for an easier time when this country truly was “Fortress America,” where we could luxuriate in our splendid isolation. That longing is understandable, I long to be 18 again. But I’m also smart enough to know I’m not and that I have to behave and think like the 39 year old I really am! What we must do is focus on the fundamentals for growth here at home and abroad. That is the key to rising standards of living for all.
What does that mean for our international tax rules? Again, let’s review where we are. The subpart F rules date to 1962. At forty-something those rules are showing their age – and for those of us in the same situation, it seems that each year is a little less kind. We also made fairly significant changes to the international tax rules in 1986. That makes those rules teenagers and like most teenagers, they are hard to understand, messy, inconsistent, and display little regard for the real world. Things have changed dramatically in the global marketplace, but our tax rules have not. At this point, we wear them like a coat that is several sizes too small.
Given the importance of trade to our economy, it is critical that we move to bring our tax laws into compliance with the WTO rules. That means replacing the FSC/ETI rules with WTO compatible rules. There is bi-partisan agreement on this issue, but difficulty in ironing out the details. In fact, there is a lot more agreement than all the messy rhetoric would lead one to believe.
The tax-writing committees have proposed bills that would grant a reduced tax rate on manufacturing income. One has a broader definition than the other – for example, the Ways and Means bill includes architecture and engineering services, both of which were covered by ETI, and construction services. The broader definition is helpful because it eliminates some anomalies. Non-neutral taxation reduces national income by re-directing resources to less productive activities.
The proposal for a special tax rate for one category of business income also brings with it a lot of administrative complexity, essentially requiring companies to compute taxable income twice, or a third time if we include the AMT. As a consequence, we’ve suggested looking at other changes that would benefit manufacturers without the administrative and neutrality concerns. For example, we might remove the provisions of the AMT that have a particularly adverse impact on capital intensive industries such as manufacturing. We could reform the uniform capitalization rules and make the R&E credit permanent. We could also consider changes to the R&E credit to make it more beneficial to manufacturers
Another component of both FSC/ETI bills is some much-needed international tax reform. But despite the long history of support in both committees and from both sides of the aisle for international tax reform and simplification, as I noted those proposals have attracted considerable criticism. This is a most unfortunate development. The first post-1986 Act international tax simplification bill was introduced back in 1992 by Chairman Rostenkowski. And there have been bipartisan, bicameral international tax bills introduced in the last several Congresses.
Domestic and international are not opposites and this is not about trade-offs. There is much evidence about the complementarity between the foreign activities and outlook of U.S.-based multinational corporations and their contribution to the domestic economy.
The current rhetoric ignores the relationship between U.S. operations abroad and exports from the United States. When it comes to the export of American manufactured products, the foreign affiliates of U.S. multinationals are their own best customer. Rather than displacing exports from the United States, the international activities of U.S. multinational corporations generate a net trade surplus. A recent OECD study found that $1.00 of outward foreign direct investment is associated with $2.00 of additional exports and an increase in the bilateral trade surplus of $1.70.
There also is a positive relationship between the international activities of U.S. companies and employment and jobs here in the United States. Professor Tyson, former Chair of the Council of Economic Advisors, authored a study identifying a number of political, strategic, and economic reasons why maintaining a high share of U.S. control over global assets is important to our national interest. These include the fact that U.S. multinationals locate over 70 percent of their employment and capital assets in the United States; that is, over two jobs in the United States for every job abroad and more than $2.00 of capital assets for every $1.00 of assets abroad. Their pay and investment per employee in the United States is greater than in either developed or developing countries. Finally, U.S. multinationals conduct a very large percentage of their research and development domestically, which is critical to maintaining our technological leadership.
There have been reports that recently-released Commerce data on jobs show that over the 1996-2001 period employment in foreign subsidiaries of U.S. multinationals increased by 2.3 million. Of course, that is only part of the story. Over that same period, employment in the U.S. parents of U.S. multinationals increased by 4.8 million. During the 1996-2001 period when total U.S. employment grew by 10%, U.S. employment of U.S. multinationals grew by 26%. So U.S. multinationals are a source of U.S. employment growth.
Over half of U.S. exports are produced by multinational corporations and more than 40% of those exports are sold to foreign affiliates of the U.S. producer. The consequence of that relationship is that changes to the international tax rules under which U.S. multinational corporations operate affects their global competitiveness and, therefore, the competitiveness of their domestic operations. The competitiveness of U.S. exporters also affects the competitiveness of their domestic suppliers, who may not export themselves but, who through their sales to exporters, depend on and are part of the global marketplace. Changes to the international tax rules may have a less direct effect on U.S. operations, but the effect is particularly important in the increasingly global marketplace.
The bottom line is that the global success of U.S. companies competing in today’s economy matters in terms of economic growth and jobs in the United States. The raise-the-walls-and-widen-the-moat mentality is short-sighted and wrong. We must look to the future. If we handicap American businesses in today’s global economy, we harm the American workforce. We cost ourselves jobs.
Reforming our international tax rules is about enhancing the ability of U.S. businesses and American workers to compete and prosper in today’s global economy. It is about ensuring that we make the most of the tremendous opportunities that globalization and technological advances provide. If we do not, we can be sure that our neighbors both near and far will.
Thank you.
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