A Clean Escape from $4 Billion in FSC Sanctions

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Introduction

Congress will face a stark choice in coming months: Eitherjettison a 30-year-old practice of granting tax breaks to U.S.exporters, or expose those exporters and others to $4 billion inpunitive trade sanctions by the European Union. Congress can try tofinesse the choice, as it has in the past, and risk an escalatingtrade war with our number one commercial ally, or it can excise theoffending section from the U.S. tax code and pass the savings on toall U.S. producers.

A Four-time Loser in the WTO

Beyond debate is the need to alter the way the U.S. corporatetax law treats earnings from exports and overseas production. TheU.S. government's existing policy has gone 0-for-4 in recentrulings by the World Trade Organization. In 1999, the EuropeanUnion initiated a challenge in the WTO against what was then calledthe U.S. Foreign Sales Corporation tax law. FSC allowed U.S.multinationals to claim a partial tax exemption for income thattheir foreign subsidiaries earned from handling U.S. export sales.The EU charged, and a WTO dispute settlement panel and appellatebody agreed, that the U.S. law constituted an illegal exportsubsidy under the WTO's code on Subsidies and CountervailingMeasures.

In October 2000, the U.S. Congress approved a replacement taxregime, called the Extraterritorial Income Exclusion Act (ETI). TheETI expanded the definition of foreign-derived income that could beexcluded, but it retained the condition that the goods must be soldoutside the United States and must contain at least 50 percent U.S.domestic content. To no one's real surprise, the EU challenged thenew law again in the WTO and once again prevailed before a disputesettlement panel and again on appeal.

The bottom line of all four rulings has been that WTO memberscannot make tax breaks conditional on export performance or thedomestic content of subsidiary sales abroad. The U.S. governmenthas reached the end of the appeal process and now must eitherchange its corporate tax code to eliminate any pro-export bias orface the consequences.

If Congress fails to bring the U.S. corporate tax code intocompliance with our commitments in the WTO, the European Union hasgained a green light from a WTO panel to impose $4 billion worth oftrade sanctions against U.S. exports. Additional duties of up to100 percent would be aimed at a list of 1,600 high-profile itemsdesigned to inflict maximum economic and political discomfort onthis side of the Atlantic. The targeted items include dairy andmeat products, sugar, cereals, toys, apparel, and machinery. The EUhas set a deadline of January 1, 2004, to impose the sanctions ifCongress fails to remove the offending provisions.

The Futility of Export Subsidies

The FSC law and its successor are relics of a bygone era. Theoriginal Domestic International Sales Corporation, or DISC, law wasenacted in 1971, at a time of fixed exchange rates and theattending obsession with the U.S. balance of payments. The DISC andFSC tax laws were aimed explicitly at boosting U.S. exports in themistaken belief that they would narrow the U.S. trade deficit andoffset any tax advantages enjoyed by foreign exporters. But taxbreaks conditioned on exports, like any export subsidy, cannotfundamentally change the balance of trade.

A nation's trade balance is determined by the flow of foreigninvestment.[1] A border adjustment tax such as the FSC or ETIdoes not directly affect capital flows and thus does not alter thebalance of trade. Targeted tax breaks do lower the cost to foreignbuyers of a certain small slice of favored U.S. exports--theCongressional Research Service estimates that the FSC tax breaksonly boosted exports by somewhere between two-tenths andfour-tenths of a percent.[2] But the increased demand for those favored U.S.exports causes the dollar to appreciate in the foreign exchangemarket, squeezing some non-favored exporters out of internationalmarkets and exposing some domestic producers to increased importcompetition. In fact, according to the CRS analysis, the FSC causedan increase in imports nearly equal to the increase in exports. Asa result, "The impact [of the law] on the trade balance wasprobably negligible."[3]

U.S. multinational companies do not need direct or indirectexport subsidies to compete in the global economy. Despitecomplaints of an unfairly tilted playing field, America remains theworld's top exporter of manufactured goods. American companies haveretained their edge even though the U.S. government has been morerestrained than others in directly subsidizing exports. From 1990to 2000, U.S. exports grew at a much faster rate (100 percent) thanthose of Germany (34 percent), France (36 percent), and Japan (66percent), even though each of those three countries subsidized amuch larger percentage of their exports than did the UnitedStates.[4]The implicit export subsidies of the FSC/ETI are not onlyWTO-illegal, they are economically unnecessary.

A Clean and Simple Escape

Two proposals are being discussed in Congress to bring the U.S.corporate tax code into compliance with our trade obligations.

One proposal, championed by House Ways and Means CommitteeChairman Bill Thomas (R-Calif.), would replace the FSC/ETI with anew set of tax incentives aimed at the same general group ofcompanies that benefit from the existing law. The new taxincentives, however, would not be conditioned on export performanceor the domestic content of offshore production. Among its manyprovisions, the Thomas proposal would extend a tax credit forresearch and development and create a six-month window of reducedrates on repatriated profits from U.S.-owned subsidiariesabroad.

A second proposal, a bill sponsored by senior Ways and Meansmembers Philip Crane (R-Ill.) and Charles Rangel (D-N.Y.), wouldreplace existing law with a new, lower tax rate for domesticmanufacturers. Their proposal would lower the basic corporate taxrate of 35 percent by as much as 10 percent, or 3.5 percentagepoints, depending on the share of a firm's income derived fromdomestic production of goods. The new regime would be phased inover five years. So far, the Crane-Rangel proposal has garnered abipartisan list of more than one hundred cosponsors in theHouse.

Both proposals would fix the problem by ending tax incentivesfor export performance, although the Crane-Rangel proposal could bechallenged on the grounds that it does not completely remove theoffending section of the tax code until the end of a five-yearphase-out period. Another legitimate criticism of Crane-Rangel isthat it targets the offsetting tax relief almost exclusively tomanufacturing firms, a narrow but politically influential sector ofthe U.S. economy that in 2002 employed fewer than 13 percent of allU.S. workers.[5]

A third alternative would be a more neutral corporate tax codewith a lower overall rate. If the FSC/ETI provision were exorcisedentirely, the tax liability of U.S. corporations would rise bybetween $4 billion and $5 billion a year. All that money and a bitmore could be returned to U.S. corporations by reducing theeffective corporate tax rate by 1 percentage point on the estimated$561 billion of taxable corporate income in 2003.[6] The beauty of this approachis that it would be absolutely immune from any further challenge inthe WTO, cleanly dodging the sanctions bullet, and would at thesame time move the corporate tax code incrementally toward theflat-tax ideal of greater neutrality at lower rates.

Conclusion

Congress should seize the latest and final challenge to theFSC/ETI provision as an opportunity to clean up the corporateincome tax code, dump an economically dubious provision, and reducethe tax burden on all U.S. corporations. U.S. multinationalcompanies do not need subsidies or tax exemptions to compete in theglobal economy. Congress can bring U.S. law into conformity withour international obligations without sacrificing thecompetitiveness of U.S. companies in the global marketplace bycleanly removing the offending section of the tax code andreturning the revenues to American producers.


[1] For amore detailed explanation of the U.S. trade deficit, see Daniel T.Griswold, "America's Record Trade Deficit: ASymbol of Economic Strength," Cato Trade Policy Analysis no.12, February 9, 2001.

[2] David L.Brumbaugh, "The Foreign Sales Corporation (FSC) Tax Benefit forExporting and the WTO," Congressional Research Service, PublicationRS20571, October 11, 2000, p. 3.

[3] Ibid.,p.3.

[4] AaronLukas, "Rethinking the Export-Import Bank,"Cato Trade Briefing Paper no. 15, March 12, 2002, pp. 9-11.

[5] JointEconomic Committee of Congress, Economic Indicators, March2003, p. 14.

[6]Congressional Budget Office, The Budget and Economic Outlook:Fiscal Years 2004-2013 (Washington: U.S. Government PrintingOffice, January 2003), Table 3-8, "Taxable Corporate Profits," p.65.