Full Text: Progressive Policy Group's Studies Of Corporate Taxation.

The Progressive Policy Institute has released an October 1994 report that includes two studies citing the need to reform the U.S. corporate tax system.

A paper by Harvard law professor Alvin Warren Jr., "Alternatives for Corporate Tax Reform," proposes a single, uniform tax for all forms of capital income. Warren argues that this would improve U.S. competitiveness. Alternatives Warren proposes include turning the corporate income tax into a withholding tax so that shareholders would get credit for taxes paid at the corporate level, and the possibility of allowing corporations to deduct dividends.

"U.S. Taxation of International Business Income: Agenda for the 1990s," by Gary Clyde Hufbauer, senior fellow at the Institute for International Economics, and Joanne van Rooij, an assistant professor at Erasmus University, Rotterdam, also states a need for corporate tax reform. Hufbauer and van Rooij favor a tax based on the receipts of a corporation minus its purchase inputs. Wage payments would be taxed in a similar fashion. Hufbauer says that this approach is pro-savings and pro-investment and would help reduce the deficit. Hufbauer and van Rooij also support reform of tax rules concerning foreign income of multinational companies.

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ENTERPRISE ECONOMICS

Promoting U.S. Growth

WORKING PAPERS -- VOLUME I

Gary Clyde Hufbauer and Joanna M. van Rooij

Robert J. Shapiro, Editor

October 1994

PROGRESSIVE FOUNDATION

The Progressive Foundation is an independent center in Washington, DC for public po1icy research and innovation. It works to fashion a new agenda for progressive reform based on individual liberty, equal opportunity, civic responsibility, and non- bureaucratic governance.

Its substantive work revolves around some of the most difficult challenges facing America in the 1990s: restoring public confidence in our political system and governmental institutions; stimulating job-creating growth to ensure expanding opportunities for working Americans; striking a new balance between the rights and responsibilities of citizenship; and maintaining civic unity as Americans build the world's foremost multiethnic democracy.

The Foundation explores public controversies over cultural questions -- race, ethnicity, gender, religion, morality, and civic education -- that are often ignored in conventional political discourse.

The Foundation's Project for Tax Reform and Economic Growth seeks to identify and design new policies that would -- consistent with a progressive distribution of the tax burden -- promote higher national savings and investment, stronger job and business formation, and higher economic productivity and growth. The papers published by the Foundation for this Project represent the views of their authors.

The Progressive Foundation is a private, non-partisan institute organized under Section 501(c)(3) of the Internal Revenue Code and as such is a non-profit, tax-exempt institution according to the Internal Revenue Code. Donations from individuals, corporations, unions, campaign treasuries, or other sources are accepted and considered deductible as charitable contributions for federal income tax purposes.

The President of the Progressive Foundation is Dr. Seymour Martin Lipset, a political sociologist who is the Virginia E. Hazel and John T. Hazel, Jr. Professor of Public Policy, Professor of Public Affairs, and Professor of Sociology at George Mason University. The Foundation's Director is Will Marshall, President of the Progressive Policy Institute (PPI), and the director of economic studies is Robert J. Shapiro, Vice President of PPI. For more information call (202) 546-4482.

The Foundation wishes to acknowledge an unrestricted grant from Mars incorporated.

ABOUT THE AUTHORS

GARY CLYDE HUFBAUER is the Reginald Jones Senior Fellow at the Institute for International Economics. Formerly, he was the Marcus Wallenberg Professor of International Financial Diplomacy at Georgetown University. From 1977 to 1980 he served as Deputy Assistant Secretary in the U.S. Treasury where he was responsible for trade and investment policy during the Tokyo Round. Previously, he was Director of the International Tax Staff at the U.S. Treasury Department. A Harvard and Cambridge graduate in economics, and a Georgetown graduate in law, he has published books and articles on international trade, finance, and tax policy including Western Hemisphere Economic Integration (1994), Reviving the European Union (1994), NAFTA: An Assessment (1993), U.S. Taxation of International Income (1992), and Economics Sanctions Reconsidered (second edition 1990).

ROBERT J. SHAPIRO is the director of economic studies of the Progressive Foundation and the Vice President of the Progressive Policy Institute. He served as a principal economic advisor to Bill Clinton, chief economic policy adviser in the Dukakis-Bentsen campaign, and legislative director and tax counsel for Senator Daniel Patrick Moynihan. Dr. Shapiro also has been a Fellow of the National Bureau of Economic Research and of Harvard University, where he earned his doctorate.

JOANNA M. VAN ROOIJ is an Assistant Professor of Economic Aspects of the Business Environment at the Erasmus University Rotterdam. Previously she was a research associate at the Institute for International Economics, where she co-authored U.S. Taxation of International Income (1992).

ALVIN C. WARREN, JR., is a law professor at Harvard Law School, where he has taught tax law since 1979. He teaches courses and seminars in income taxation, corporate income taxation, U.S. taxation of international transactions, and tax policy. He is also Director of the Harvard Law School Fund for Tax and Fiscal Research. Prior to teaching at Harvard, he was a member of the law faculties of the University of Pennsylvania, Duke University, and the University of Connecticut. He has also been a visiting professor at Stanford and Yale, as well as the recipient of a Guggenheim Foundation Fellowship.

Professor Warren has been active in professional organizations concerned with tax law and policy. At the American Law Institute, he is the author of a report on integration of the U.S. corporate and individual income taxes. He sat on the Council of the Section of Taxation at the American Bar Association and was the Chairman of its Committee on Basic Tax Structure and Simplification. He is a past Chair of the Section of Taxation of the Association of American Law Schools.

Professor Warren has published numerous articles on tax law and policy. His current research projects include integration of European company taxes, the competitive effects of the U.S. international tax regime, and tax policy considerations relating to new financial instruments.

CONTENTS

Introduction

U.S. Taxation of International Business Income:

Alternatives for Corporate Tax Reform

INTRODUCTION

Robert J. Shapiro

With this monograph, the Progressive Foundation Project for Tax Reform and Economic Growth and the Progressive Policy Institute inaugurate a new series of policy studies examining different approaches to tax reform. The project's mission is to identify and design new policies that would -- consistent with progressive distribution of the tax burden -- promote higher national savings and investment, stronger job and business formation, and higher economic productivity and growth. The essays in this series will examine the personal income tax, payroll taxes, the corporate income tax, pollution taxes, value-added taxes, and the tax burdens on labor and capital in the major industrial countries. This first volume presents two approaches to the reform of corporate taxes, in "U.S. Taxation of International Business Income: Agenda for the 1990s" by Gary Hufbauer and Joanna van Rooij and "Alternatives for Corporate Tax Reform" by Alvin Warren, Jr.

This interest in reforming the tax code is part of a commitment by the Progressive Foundation and the Progressive Policy Institute to help develop a new ENTERPRISE ECONOMICS that places the valid insights of both traditional liberal and conservative economics in the new global economic context. This approach seeks to focus policy not simply on financial capital or aggregate demand, but on the resources for greater innovation and higher efficiency and productivity by American firms and workers. In addition to tax reform, the policy agenda of Enterprise Economics includes budget reform to restrain the growth of public spending while revitalizing genuine public investment, and strategies to strengthen market competition by phasing-out subsidies for particular industries and unproductive economic regulation. Through far-reaching reforms in labor-market policies, education and training, Enterprise Economics also seeks to endow America's workers with the skills and opportunities they need to create their own economic security in an era of intense global competition.

For many years, the federal corporate income tax has been both a recurring object of ideological debate between liberals and conservatives and an intense subject of congressional interest-group politics. The melding of these cross-purposes has resulted in a corporate tax code that lacks substantial economic or social purpose while raising just 10 percent of federal revenues. To restore such purpose, it either should be amended in fundamental ways, as Warren suggests, or replaced entirely, as Hufbauer and van Rooij advise.

The current corporate tax is comprised of tax rates of 34 and 35 percent covering most businesses and hundreds of closely defined exclusions for specified activities and industries. /1/ By one conservative estimate, these special exclusions shrink the corporate tax base by more than $175 billion a year and will reduce 1994 corporate tax revenues by more than $60 billion -- or nearly half again as much as the tax raises. /2/ The corporate code's particular susceptibility to so many complicating exceptions arises, in part, from the way its base is defined. As a levy on profits or net revenues, the tax has become, perhaps inevitably, a creature of technical accounting rules subject to limitless fine-tuning.

The primacy of accounting definitions in corporate taxation has another effect: It effectively excludes most Americans from informed debate on the subject, limiting this debate largely to business interests with strong incentives and resources to participate. This interest-group dynamic, in turn, ensures the steady proliferation of new corporate tax preferences, a largely nonpartisan process equally promoted by liberals and conservatives, Democrats and Republicans. /3/

Alongside such efforts to selectively reduce corporate taxes for specific industries and activities, the tax also is a periodic subject of ideological contention over the proper role of government and direction of public policy. Liberals who see government as an appropriate instrument of social justice often press for a higher corporate tax rate as a way of redistributing more of the tax burden to shareholders with high incomes. Conservatives, while often defending particular exclusions, also generally argue for a smaller corporate tax or even for its repeal as a way of limiting the government's ability to affect business and reducing public resources for social initiatives.

There is some truth on both sides. Liberals are correct that as a matter of social policy, the federal tax burden is NOT at present very progressive, and higher corporate taxes would shift more of that burden up the income scale. However, conservatives are also correct that as a matter of economic policy, lower taxes on business are better for job creation and productivity than higher taxes.

In addition to these problems, the corporate tax is no longer a very important source of federal revenues. Since 1960, revenues from the corporate tax have declined steadily as a share of total federal revenues and of U.S. gross domestic product (GDP) and remained roughly steady in inflation-adjusted dollars (see Table 1).

              TABLE 1 -- CORPORATE INCOME TAX REVENUES

           Amount Raised (billions)

     Source: Budget of the United stated Government, Fiscal Year

Through the 1970s and 1980s, the corporate tax was amended repeatedly, ostensibly to promote national economic goals such as higher productivity and growth, and/or advance broad social purposes such as greater economic equality or broad economic development. These changes didn't work. The evidence shows, for example, that throughout this period, rates of growth in overall U.S. output, productivity, and net business investment all continued to erode (see Table 2).

         TABLE 2. KEY MEASURES OF U.S. ECONOMIC PERFORMANCE

                                                  Net

     Sources: GDP: Economic Report of the President, January 1993,

In many economists' view, the corporate tax cannot be an effective instrument of growth and productivity so long as it remains a tax on the profits from business investment -- a direct tax on capital which thereby discourages capital formation. In practice, corporate taxes are not PURELY taxes on capital, because some firms can, to some degree, preserve profits by squeezing wages. Similarly, many product markets are imperfect and under some conditions, companies can protect profits by raising prices. But neither market is VERY imperfect, and so the bulk of the corporate tax burden does fall on capital.

Nor is there evidence that the corporate tax has advanced any important social goals, such as greater economic opportunity, reduced economic inequality, or lower poverty rates. The share of all American families that are poor has, in fact, jumped by more than one-fifth since the late 1970s and now stands at nearly 12 percent. /4/ In the inner cities, poverty rates have increased by one-third since the late 1970s and now reach over 20 percent. /5/ Moreover, these higher poverty rates have been tied to greater economic inequality, not to any more general economic decline. From 1979 to 1992, while the poorest fifth of American families saw their real incomes -- after taxes and INCLUDING government food, housing, and income benefits -- fall by more than 8 percent, the richest fifth of American families averaged real after-tax income gains of 15 to 20 percent. Similarly, while the average real incomes of the second poorest fifth of families edged down by about 5 percent over this period, the second richest fifth of families gained 6 to 7 percent. /6/

The case for reforming the current corporate income tax is strong. Our analysis suggests several important aspects of this reform, including simplification to support a lower tax rate and promote public understanding of the issues involved, and general incentives for elements associated with higher economic growth such as savings and investment.

EXECUTIVE SUMMARIES

The first essay in this monograph, "U.S. Taxation of International Business Income: Agenda for the 1990s" by Gary Clyde Hufbauer of the Institute for International Economics and Joanna van Rooij of Erasmus University, presents an outline for very broadbased reform of the corporate tax, plus a series of specific changes in the tax treatment of international business income. The Hufbauer-van Rooij analysis posits as the essential purpose of corporate tax reform the promotion of higher U.S. business investment and the international competitiveness of U.S. firms. The center of their reform is a BUSINESS CASHFLOW TAX which would replace both the current corporate tax and the personal income tax so far as it covers earnings from partnerships and unincorporated businesses.

"The U.S. system for taxing business income no longer meets the

The Hufbauer-van Rooij business cashflow tax, in essence, is a consumption-based levy applied to the difference between a firm's total domestic sales and the purchasing costs for its inputs. The only major exclusion from its corporate tax base -- and thus the major incentive it provides -- is for direct business investment expenses, including training expenditures. The cashflow tax, the authors argue, also would create a more level playing field for U.S. exporters and importers by adopting the procedure of all foreign value-added taxes that exempts all exports from tax and imposes the tax on imports. Hufbauer and van Rooij also call for important reforms in the tax rules covering the foreign income of multinational companies, based on the principle that all income should be taxed where it is produced. Thus, they would exclude from their cashflow tax any financial receipts from the foreign subsidiaries of American firms, while ending the current deduction for financial payments by U.S. subsidiaries to their foreign-based parent firms. Finally, under their reforms, portfolio income earned from foreign holdings by American firms would be taxed as domestic income.

By ending virtually all current corporate tax preferences EXCEPT direct business investment, this sweeping proposal aims to not only promote investment, but also to radically simplify business taxation and place all industries and all forms of business organization on an equal tax footing. Although businesses that today invest relatively little and still claim large tax exclusions would pay MORE under this approach than under the corporate income tax, the authors calculate that a business cashflow tax could raise as much revenues as the current corporate tax with a 10-percent tax rate.

Hufbauer and van Rooij also try to protect the international competitiveness of those firms and industries that would bear a higher tax burden under their proposal by suggesting that all goods and services, whether produced domestically or imported, be taxed on an equivalent basis at the place where they are used or consumed. Therefore, domestic firms would receive a rebate for cashflow taxes paid on goods and services that they export to another country, while paying an equivalent tax on goods and services they import. This is the same arrangement followed in other Organisation for Economic Co- operation and Development member nations (except Australia) for their broad-based value-added taxes.

"The existing U.S. system for taxing international income was

The cashflow tax reform also provides the basis for their proposed changes in the taxation of international business income. These additional reforms are designed to encourage greater direct foreign investment by American firms, much as the authors expect the cashflow tax would promote greater business investment in the United States by both domestic and foreign firms.

The principal behind these additional reforms is based on the typical pattern of business organization for multinational firms. Such companies typically find that they can reduce their average costs by concentrating their headquarter services in one place -- principally corporate finance, legal affairs, and research and development, which generate significant economies of scale -- while dispersing production and distribution facilities around the world, wherever wages and input costs, productivity levels, and market access are most favorable. Hufbauer and van Rooij argue that the United States today is the world's most efficient provider of headquarter services, and thus our corporate tax law should not discourage foreign or domestic firms from using these services. (This is another reason for exempting export receipts from the cashflow tax.) Nor, they explain, should our corporate tax code inhibit American firms from producing and distributing their products abroad because networks of foreign affiliates ultimately increase our exports of other goods and services. At the same time, they reason, their provision subjecting all imports to the cashflow tax would eliminate any encouragement or incentives for our own firms to produce abroad for American consumption.

The Hufbauer-van Rooij proposals also would include new tax rules covering business financial flows across borders, so that American firms would face the same tax rate on their investments regardless of where they invest. First, they would exempt from the cashflow tax any dividend and interest income received by American firms from foreign subsidiaries; investment income earned at home also would be excluded from the tax. Second, they would tax interest or dividends PAID OUT by an American firm to a foreign parent or sister firm or to foreign investors. And third, they would end the current U.S. tax credits for business taxes paid to foreign governments by the foreign subsidiaries of American firms.

Finally, Hufbauer and van Rooij propose more extensive international coordination among the industrial countries, including common international surveillance of tax evasion -- especially on income earned from foreign investments -- and new international forums to write common accounting standards and definitions and to reform current transfer pricing rules. The North American Free Trade Agreement, as they see it, would become a test case for such international cooperation, with the three countries moving toward a common tax rate on consumption -- the business cashflow tax here and value-added taxes in Mexico and Canada -- that would enable them to drastically reduce border tax surveillance.

* * *

In our second study, "Alternatives for Corporate Tax Reform," Alvin Warren, Jr, of Harvard Law School proposes a different strategy: a series of modifications of the current corporate tax. The basic aim is to produce a uniform tax on all income from investment, principally by ending the current double taxation of corporate earnings. This approach, commonly called "integration," focuses on a number of serious distortions in the economy that are driven by current corporate tax provisions -- perverse disincentives against investing in corporate stock, because the dividend earnings are taxable to both the corporation and its shareholder; related incentives for firms to hold on to their earnings rather than distribute them to the shareholders; and other incentives for firms to finance new capital investment by borrowing money rather than by issuing new stock. Integration reforms have been the focus of recent studies by several tax authorities, including the Treasury Department, the Tax Division of the American Institute of Certified Public Accountants, and the American Law Institute. /7/

"The basic case for integration is economic."

There can be little doubt, as Warren documents, that the current corporate tax system raises the cost of capital for American firms, discourages new investment in corporations, and promotes too much corporate reliance on debt. Estimates of the annual cost to the economy of these distortions range from $2.5 billion to $25 billion. Yet addressing these distortions through integration reforms would also involve costs -- as much as $30 billion a year in foregone federal revenues, which likely would be offset by higher taxes on ALL capital income. Indeed, this prospect of paying for integration reform has led American business generally to support the status quo. Noting this, Warren points to a cashflow tax as an alternative, while analyzing weaknesses such as its inability to affect the economic treatment of existing equity.

Warren's analysis thereupon returns to the first principle of integration, namely to ensure that capital income distributed as dividends is taxed only once. To accomplish this, he reviews four alternatives. The first would abolish the corporate tax and tax business earnings only through the shareholders. This approach, however, would create its own inappropriate incentive to retain corporate income rather than distribute it at all.

A second variation would permit corporations to deduct their dividend payments, which again would be taxable only for the shareholders; this alternative he rejects on the grounds that tracking dividend payments would be a daunting administrative task. His third option, proposed in a 1992 Treasury Department study, would tax dividends at the corporate level while allowing the shareholders to deduct them. This approach, however, has a serious social policy defect: Like all personal deductions, it would produce the greatest tax benefits for shareholders with the highest incomes taxed at the top personal rate.

Instead, Warren urges a fourth approach which, in essence, would convert the corporate tax into a withholding tax for the shareholders. Both corporations and shareholders would be taxed on dividends, but the shareholders would receive a tax CREDIT for their corporate taxes paid on their dividends. This more progressive approach would end the current double taxation of dividends by providing an EQUAL tax benefit to all shareholders, regardless of income.

Warren follows up this proposal with additional reforms designed to ease or eliminate other tax-driven distortions of business decisions; these mainly concern whether to retain earnings or distribute them as dividends. He proposes a consistent tax rate for both corporations and high-income taxpayers, as well as tighter rules to prevent firms from avoiding taxes on their retained earnings. He suggests ways of ending the current tax incentive for firms to raise their capital by borrowing it rather than by issuing new stock. He outlines a uniform tax rate on the investment income of tax-exempt enterprises. Finally, he sketches a new tax on investment income earned in the United States by foreign corporations or foreign investors, along with a refundable credit for taxes previously paid by corporations on this income.

In his final analysis, Warren presses the logic for a shareholder tax credit on social policy as well as economic grounds. Despite its complications, his strategy would produce a tax system neutral among the various categories of investment, while still retaining progressive tax rates on corporate income.

* * *

The choice between these two approaches to corporate tax reform rests fundamentally on questions of priority. The Hufbauer-van Rooij approach assigns great weight to simplifying the corporate tax, lowering its rate, and actively promoting higher investment. The Warren reforms build on the current system while deferring to markets in promoting tax neutrality. On one matter there is absolute agreement: The economic interests of the United States demand far- reaching reforms of the current corporate tax system.

* * *

I am truly grateful to Gary Hufbauer, Joanna von Rooij, and Al Warren for their superb contributions to this Project and their patience with its director. I also want to thank many fine friends and colleagues who have advised this Project, including Frank Arnold, David Bradford, Gail Fosler, Al From, Joseph Gale, Jonathan Gruber, Jeff Hamond, James Kiss, Will Marshall, Cliff Massa, Tom Neubig, Perry Quick, David Raboy, Alice Rivlin, Joel Slemrod, Ed Stegemann, Eugene Steuerle, Joseph Stiglitz, and Lawrence Summers. I also want to acknowledge the generous support of Mars Incorporated, which provided an unrestricted grant for this Project. My sincere thanks as well go to my confederates at the Progressive Foundation and the Progressive Policy Institute who made this publication and its public presentation realities -- Chuck Alston, Julie Kizer Ball, Debbie Boylan, Anne Saunders, Marlowe Greenberg, and Nita Congress.

FOOTNOTES

/1/ The corporate tax does not cover all business entities, but only those legally chartered as corporations to protect owners from personal liability for actions by the entities they own. The corporate tax rate for firms with annual taxable income of less than $50,000 is 15 percent, and firms earning between $50,000 and $75,000 are subject to a 25 percent tax rate. The 34 percent rate covers most corporations earning $75,000 to $10 million. The 35 percent corporate tax rate applies only to businesses with annual taxable income exceeding $10 million.

/2/ See Budget of the United States Government, Fiscal Year 1995, Analytical Perspectives, Table 6.2.

/3/ For example, liberals have adeptly protected corporate deductibility for workers' fringe benefits, while conservatives have maintained generous provisions exempting much of the revenues of natural resource companies.

/4/ See Bureau of the Census 1990, Table 5, p. 228.

/5/ See 1994 Green Book, U.S. Congress, House Committee on Ways and Means 1994, Table H-4, p. 1158.

/6/ Ibid., Table H-17, pp. 1186-87.

/7/ Professor Warren is the author of the American Law Institute study.

END OF FOOTNOTES

REFERENCES

Bureau of the Census. 1990. 1990 Census of Population and Housing,

Budget of the United States Government, Fiscal Year 1995, Analytical

U.S. Congress, House Ways and Means Committee. 1994. Overview of

* * *

U.S. TAXATION OF INTERNATIONAL BUSINESS

Gary Clyde Hufbauer

and

Joanna M. van Rooij

The United States is engaged in a long-term economic competition with Europe, Japan, and the emerging industrial nations of Asia and Latin America. In this era of global competition, the United States has two goals: to advance American prosperity as a leading economic power and to promote an open international system. In light of these goals, the United States should re-examine its domestic and international tax policies.

For several decades, U.S. tax policy has been driven by competing DOMESTIC priorities; tax acts have aimed for either economic growth or economic fairness. Thus, for example, President Kennedy's Tax Act of 1962 and President Reagan's Economic Recovery Tax Act of 1981 can be characterized as growth-oriented, while the Tax Reform Acts of 1976 and 1986 were fairness-oriented. The only INTERNATIONAL objective of any of these acts, however, involved their increase in revenues. This objective reflected a bygone era when the United States was preoccupied with the proper division of revenue between different national tax authorities. Driven by revenue considerations, the Tax Reform Act of 1986 attempted to increase the taxation of overseas income of U.S. multinational firms; later, the Revenue Reconciliation Act of 1990 included provisions to curb perceived transfer pricing abuses by foreign multinational firms doing business in the United States. In both pieces of legislation, the competitive consequences of pursuing international revenue objectives were largely ignored -- a failing shared by all recent tax policy legislation.

The Omnibus Budget and Reconciliation Act of 1993 shares this flaw. Its international tax sections are essentially revenue-driven, as its main provisions affecting U.S. multinational firms demonstrate: tightening traditional compliance techniques to address transfer pricing abuses; treating passive foreign income earned by U.S. oil and gas extraction firms like other passive income; limiting earnings stripping opportunities by foreign firms doing business in the United States; curtailing Section 936 for Puerto Rican operations, limiting the portfolio interest exemption; and implementing a 50-percent allocation and apportionment rule for R&D expenditures. While a highly controversial proposal to put all royalty income in a separate category for foreign tax credit purposes was eliminated by the House Ways and Means Committee, all in all, revenue objectives dominated the drafting of the international provisions. /1/

It is time to reconsider the focus of international tax policy. To do so, we propose five major changes; these are detailed in the remainder of this paper.

o The United States should adopt a business cashflow tax to

o The United States should exempt exported goods and services

o The United States should adopt a territorial approach for

o The United States should adopt the residence-based principle

o The United States should push for international adoption of

In addition to reforming its own system of business taxation, the United States should launch broad tax cooperation talks with its major commercial partners. This proposed initiative is discussed in the last section of this paper, where we tentatively assign different parts of the cooperation agenda to the Organisation of Economic Co- operation and Development (OECD), General Agreement on Tariff and Trade (GATT), North American Free Trade Agreement (NAFTA), and the Asian-Pacific Economic Cooperation (APEC).

In the sections that follow, we start with the important question of border adjustment rules under consumption-based taxation. We then propose new approaches that the United States and its trading partners should apply to taxing the earnings of multinational firms and international portfolio income. Last, and very important, we suggest how different elements in the future agenda of tax cooperation should be assigned to different international forums.

THE FOUNDATION: CORPORATE TAX REFORM

Our 1992 book accepted the premise that the corporate income tax, however inefficient and anachronistic, was here to stay. Since its inception in 1913, the corporate income tax has been widely criticized as an inefficient and deceptive vehicle for raising public revenue. It is hopelessly complex -- the leading primer on corporate taxation (Bitter and Eustice 1994) exceeds 1,700 pages -- and extremely costly to administer. But the corporate tax has seemed to be an indestructible feature of the U.S. fiscal landscape. Its durability reflects the political economy of U.S. taxation: From the standpoint of the public, the corporate income tax is widely perceived as a way of taxing the rich; from the standpoint of Congress, the corporate income tax disguises who is paying; from the standpoint of the IRS, the corporation serves as a welcome associate tax collector.

Political developments since 1992 suggest that there may be room for corporate tax reform. Specifically, we see some possibility for transforming the corporate income tax from its present structure as a complex tax that imposes highly uneven burdens on different sectors of the economy and discourages business investment throughout the United States into a tax that is much simpler; a tax that is far more uniform in its application to different goods and services; and a tax that does not discourage business investment. /2/

Consequently, in evaluating international tax reforms, we take as our point of departure the proposition that the United States will first reform its domestic system for taxing corporate income. The broad outlines of this reform are described by the business cashflow tax advocated by the Center for Strategic Tax Reform (see Table 1). The center sees the corporation as continuing to play the role of revenue collector, but envisages a far different system of corporate taxation. This reformed system would be much simpler, reduce distortion between sectors, promote investment in comparison with the existing corporate tax, and lay the foundation for more rational taxation of international income.

            TABLE 1. ELEMENTS OF A BUSINESS CASHFLOW TAX

INCLUDED IN TAXABLE INCOME         DEDUCTIONS ALLOWED

Receipts from all domestic         All purchases of inputs and

                                   Purchases of imported goods and

EXCLUDED FROM TAXABLE INCOME       DEDUCTIONS NOT ALLOWED

Receipts from exports of goods     Employee compensation (but see

Receipts from operations outside   Costs incurred by foreign

All financial receipts, such as    All financial payments such as

TAX RATE                           PAYROLL TAX CREDIT

A tax rate of approximately        Credit for present 7.65% employer

The same tax rate (approximately

     Source: Adapted from Hufbauer and Gabyzon 1993.

The business cashflow tax would be imposed on the domestic sales of goods and services less allowable deductions for purchased inputs. The business cashflow tax would NOT be imposed on the foreign operations of U.S. multinational firms, and thus the costs of foreign operations would not be an allowable deduction. The tax also would not be imposed on EXPORTS of goods and services. But it would be imposed on IMPORTS of goods and services, and the costs of imported inputs would be an allowable deduction. Finally, the business cashflow tax would not be imposed on financial receipts, and financial payments would not be allowed as deductions. To raise approximately the same amount of revenue as present income taxes on corporate and noncorporate business firms, the business cashflow tax rate could be fairly low, about 10 percent.

The business cashflow tax is not a radically new idea. The United States has flirted with precursor concepts for the past 20 years. So far, Congress, reflecting public opposition, has remained skeptical. In 1970, President Nixon unsuccessfully proposed a value- added tax to replace part of existing local property taxes to finance public education. In 1979, Congressman Al Ullman (D-OR), as Chairman of the House Ways and Means Committee, proposed a 10-percent value- added tax to reduce personal and corporate income taxes. He lost his seat in 1980. In 1986, Congressman Dan Rostenkowski (D-IL), then Chairman of the House Ways and Means Committee, declared at a major conference: "Let me say straight away, that I oppose a broad-based federal consumption tax" (Rostenkowski 1987).

Congressional attitudes have been slowly changing, however, and in 1992, Congressmen Rostenkowski and Bill Gradison, Jr. (R-OH), introduced a bill -- the Foreign Tax Rationalization and Simplification Act of 1992 -- that would require the Treasury to conduct a study of administrative and compliance issues related to the value-added tax. As a small step, the Omnibus Budget Reconciliation Act of 1993 introduced a federal excise tax of 4.3 cents per gallon on transportation fuels. In 1993, President Clinton called for a national debate on whether to substitute a progressive value-added tax for lower income or payroll taxes, once his economic plan and health care reforms are adopted (Loeb, et al., 1993). Subsequently, in February 1994, President Clinton created the Bipartisan Commission on Entitlement and Tax Reform to study revisions in the federal tax system as well as entitlement reforms. Taxes under consideration as partial substitutes for the individual income tax are a national sales tax or a value-added tax at a rate of up to 7 percent (Tax Notes 1994).

Budget realities also point toward a broad-based consumption tax. The Office of Management and Budget concedes that, under present policies, the federal deficit will remain at $175 to $200 billion for the indefinite future. Additionally, the Congressional Budget Office has priced Clinton's health care proposals at at least $74 billion over five years (The Washington Post 1994). /3/ These dismal budget facts raise the question of new revenue sources on a large scale. This prospect of new revenue sources adds urgency to the issue of tax structure: if new taxes must be imposed, they should be imposed in a way that does least damage to the national economy.

Consumption-based taxes are often initially unpopular, but public disapproval should not be the guiding principle of U.S. tax policy. Other governments have faced severe public opposition before introducing consumption-based taxes. /4/ In Japan, the 3-percent goods and services tax was one of the least popular proposals of Prime Minister Yasuhiro Nakasone's government and was only enacted on the third try -- taking effect after Nakasone was out of office, in April 1989. In Canada, the 7-percent goods and services tax similarly contributed to Prime Minister Brian Mulroney's unpopularity and could only be enacted after Mulroney appointed two new senators. Nonetheless, in both cases the governments recognized that consumption taxes make sense in an era of global competition.

In the sections that follow, we start with the important question of border adjustment rules under consumption-based taxation. We then propose new approaches that the United States and its trading partners should apply to taxing the earnings of multinational firms and international portfolio income. Last, we suggest how different elements in the future agenda of tax cooperation should be assigned to different international forums. /5/

BORDER ADJUSTMENT RULES

Like the United States, other industrialized countries have faced the choice between direct taxes (such as personal income taxes and property taxes) or indirect taxes (such as value-added, goods and services, and excise taxes). While Americans usually debate this choice in terms of fairness, the impact on national competitiveness should receive equal consideration.

Other advanced economies, in shaping their tax systems, have turned increasingly to higher indirect taxes rather than additional direct taxes on corporate or personal income or on property. The members of the European Community pioneered the value-added tax after the Neumark Committee recommended the replacement of the turnover tax with the value-added tax. Recent converts to the value-added tax include New Zealand, Switzerland, Canada, and Japan, although these countries frequently have other names for the tax (see Tables 2 and 3, next page). The United States and Australia are the only country members of the Organisation of Economic Co-operation and Development (OECD) without broad-based consumption taxes at the national level.

The most important competitive dimension of the choice between direct or indirect taxes for raising a given amount of revenue is the way to which each alternative affects business investment. Rhetorically, the United States has long encouraged business investment; but its tax system has usually belied the rhetoric. This would dramatically diminish if the United States shifted its tax structure away from direct taxes, which generally discourage business investment, toward indirect taxes, which are usually less hostile. Direct tax systems seldom allow a full deduction, in the first year, for the purchase of capital assets; by contrast, indirect tax systems, including the cashflow system, usually tax capital assets at a low rate or a zero rate. This simple distinction makes a big difference in business investment decisions.

The second competitive dimension of the direct-indirect tax choice is the difference in border adjustment systems.

Border adjustment rules are basically designed to promote an open international economy. These rules determine whether taxes are imposed at the country of origin (the place of production of goods and services) or at the country of destination (the place of use or consumption). If a good or service that a firm sells across international boundaries is taxed BOTH in the place of production and in the place of use, double taxation will clearly act as a barrier to open competition: The domestic firm selling at home will pay only one tax, while the foreign firm exporting into the same market will pay two taxes.

The DESTINATION PRINCIPLE calls upon trading partners to agree to tax goods or services that move across international borders only in the jurisdiction where the goods or services are used as intermediate inputs or consumed as final products. Under this principle, all firms pay the SAME tax: the tax levied by the destination country. This principle is implemented by two measures: first, by the exemption or remission of domestic taxes when goods or services are exported; and second, by the imposition of taxes equivalent to domestic rates when like goods or services are imported. Thus, under the destination principle, domestic taxes are adjusted at the border.

   TABLE 2. DIRECT AND INDIRECT TAXES AS A SOURCE OF REVENUE, 1991

                             Taxes on personal        Taxes on

     NAFTA Member States

     Selected EC Member States

     Selected APEC Member States

                        FOOTNOTES TO TABLE 2

     /a/ Value-added, goods and services, excise, and other

     /b/ Data are for 1989.

                      END OF FOOTNOTES TO TABLE

     Sources: International Monetary Fund, Government Finance

       TABLE 3. INTRODUCTION OF BROAD-BASED CONSUMPTION TAXES

                       Year of VAT/GST    Current general VAT

     France                 1968                18.6%

     VAT = value-added tax; GST = goods and services tax. In 1993,

                        FOOTNOTES TO TABLE 3

     /a/ In the context of the 1994 fiscal stimulus program, the

     /b/ Canadian provinces generally impose retail sales taxes at

                      END OF FOOTNOTES TO TABLE

     Note: France introduced a partial VAT in 1954 and went to a full

     Sources: Price Waterhouse, Corporate Taxes: A Worldwide Summary

The ORIGIN PRINCIPLE, by contrast, calls upon trading partners to agree to tax goods or services that move across international borders only in the jurisdiction where the goods or services are produced. Under this principle, firms pay only their own home country tax -- but of course, these rates can differ between countries. Under the origin principle, there is no exemption or remission of taxes when goods or services are exported, and there is no imposition of taxes when like goods or services are imported. In other words, under the origin principle, taxes are NOT adjusted at the border. One great advantage of this principle is that no border surveillance is required to ensure that the right amount of taxes are rebated or imposed.

The international rules on border tax adjustment are enunciated by the General Agreement of Tariffs and Trade (GATT), and related understandings. The 1947 Havana Charter that preceded GATT permitted destination principle adjustments for indirect taxes. However, the Havana Charter stated that direct taxes could not be adjusted at the border: they must be levied according to the origin principle. The basic rationale for the distinction held that indirect taxes would be reflected in product prices, but direct taxes would come out of workers' and shareholders' "factor incomes." In a world of immobile labor and capital, it was reasoned that a tax on factor incomes would not distort competition in product markets. While this rationale was flawed even in a world of factor immobility, it is even more flawed in a world of highly mobile capital flows. Nevertheless, the concepts embodied in the Havana Charter were carried over into the GATT text and endure to this day. /6/

The rules on permitted border tax adjustments were further enunciated by a 1960 GATT Working Party, the 1979 Tokyo Round Code on Subsidies and Countervailing Duties, and the 1993 Uruguay Round revisions to that. While these agreements developed many refinements and addressed new situations, the basic distinction was preserved between destination principle adjustments for indirect taxes and origin principle nonadjustment for direct taxes.

In summary, the GATT rules permit the remission of indirect taxes levied on the product itself, and on inputs that are incorporated in the product, when the product is exported. Corresponding indirect taxes can be imposed on imported goods. Under the newly negotiated General Agreement on Trade in Services (GATS) and the revised Uruguay Code on Subsidies and Countervailing Duties, the same rules are carried over to taxes on services. However, under both GATT and GATS rules, direct taxes such as personal and corporate income taxes cannot be adjusted at the border.

There remains the critical question whether the international community will classify a business cashflow tax as an indirect tax. A close reading of current GATT understandings suggests that a cashflow tax should be grouped with indirect taxes and should, therefore, be susceptible to destination principle adjustments at the border. The cashflow tax can be readily apportioned to individual goods and services as they are exported or imported, a significant difference from the current corporate income tax. Moreover, while the cashflow tax is structured as a tax on factor incomes (with an exclusion for investment), it bears a strong resemblance to the value-added tax. Finally, there is ample precedent for GATT to take an accommodating view toward the tax practices of major nations: In the 1960s and 1970s, the European Community persuaded the GATT to allow border adjustments for the value-added tax (see Hufbauer and Gabyzon 1993).

Should the different treatment of direct and indirect taxes under GATT and GATS influence U.S. domestic tax policy? Does the choice between direct taxes (not rebated on exports and not imposed on imports) or indirect taxes (rebated on exports and imposed on imports) make a difference to U.S. competitiveness? The answer is that only in highly unusual circumstances does this choice make no difference. /7/ Under most circumstances, the choice between a direct tax or an indirect tax makes a considerable difference, as detailed below. Thus, the United States should choose an indirect tax that GATT rules say can be adjusted at the border.

If the tax in question applies unevenly to goods and services produced in the economy, or to factor incomes earned in different sectors, and if the tax is not adjusted at the border, it will cause both a domestic contraction and an international contraction of those industries that are more heavily taxed than other sectors of the economy. As a simple illustration of this proposition, consider an industry that pays a 10-percent tax on its products, while the remaining industries in the economy pay zero tax. Assume that the 10- percent tax is not adjusted at the border. If firms in the industry try to pass along the 10-percent tax in the form of higher prices, users will buy less of their product; alternatively, if firms keep their prices constant and retire inefficient plants, industry output will shrink. This is domestic contraction.

The international contraction comes on top of the domestic contraction: the heavily taxed industry will concede sales, both in its home and overseas markets, to foreign firms that are not so heavily taxed. Any offsetting exchange rate depreciation will be much smaller than 10 percent and will ripple through the economy to stimulate all producing sectors to some degree. /8/ In short, the benefits of an economy-wide exchange rate adjustment will not be concentrated on the industry that pays a 10-percent tax. Thus, in most circumstances, only the destination principle can effectively prevent the international contraction of heavily taxed sectors.

If a business cashflow were to replace the present corporate income tax, it should be highly uniform across industries. The reason is simple. The political force required to implement a business cashflow tax will draw on two main arguments: tax simplification and better economic performance. Both arguments would be seriously undercut if different tax rates were applied to different industries. There is thus a good prospect for uniform tax burdens across industries. This prospect might, in turn, prompt a recommendation that no border adjustment be made for the cashflow tax. This recommendation would be naive. In the first place, some industries will inevitably pay higher taxes under a business cashflow system than under the current corporate and partnership tax system. These industries will fear adverse international contraction effects as they adjust to the new system. If the new tax is an indirect tax, adjusted at the border, this fear can be at least allayed, if not completely dispelled. Second, few firms are likely to believe that exchange rates will adjust -- and the dollar depreciate -- at the right time and in the right amount to offset the international competitive disadvantage associated with a new tax.

If the current corporate tax is replaced by a cashflow tax, an underlying premise of the reform will work to reinforce this skepticism. The cashflow tax is designed to encourage investment. As a side effect, therefore, the tax should encourage more capital inflow into the United States (or less capital outflow from the United States). By itself, the additional capital inflow should cause an APPRECIATION of the dollar. /9/ Hence, the core design of the cashflow tax invites the skepticism that exchange rate DEPRECIATION would deliver an appropriate offset.

Finally, there is the matter of future international tax cooperation. At some point in the future, the United States might like to engage Canada, Mexico, the European Union, and perhaps some Asian countries, in tax convergence talks. One component of those talks would be to establish upper and lower brackets on broad consumption-based taxes. To simplify international trade in goods and services, these negotiations would help enlist industry support in case higher taxes were needed. Moreover, border adjustments will sidestep a debate over the likely evolution of exchange rates, and they will create a bargaining chip for future tax convergence negotiations.

One important consideration weighs against the case for indirect taxation; this consideration might be termed the "inflation indexation effect." As Milton Friedman pointed out years ago, and as Latin American countries discovered in the 1970s and 1980s, the indexation of individual wages and prices erodes the strength of political opposition to accelerating inflation. In brief, when a sensible compensating microeconomic policy, in that instance indexation for inflation, is extended broadly enough, it can have terrible macroeconomic consequences. Drawing on this analogy, the combination of higher indirect taxation and "friendly" border adjustment rules could make additional taxes easier to enact, which in turn could promote a huge expansion of social spending.

If the taxes in question are clearly linked to the production and sale of goods and services, and it is obvious that higher taxes necessarily mean higher prices, strong political resistance should emerge to limit the runaway expansion of social spending. As an economic matter, an extra $10 billion in revenue collected under the present corporate income tax would be reflected in higher prices virtually to the same extent as an extra $10 billion collected under the business cashflow tax. But public perceptions do not always track economic logic. In the public mind, the corporate tax system conveys the illusion of "soaking the rich," rather than raising prices. In terms of public perception, the connection between higher taxes and higher prices should be far stronger under a cashflow system.

INTERNATIONAL TAX REFORM

If the United States implements a business cashflow tax, it will pave the way for reforming U.S. taxation of international business income. The two main sources of international income are direct foreign investment income (earned by multinational firms) and portfolio income (earned by banks and pension funds). In 1992, income earned on U.S. direct investments abroad amounted to about $50 billion, while income earned on U.S. portfolio assets abroad was about $54 billion. In the same year, the United States paid $2 billion to foreign firms on their direct investments in the United States and $62 billion to foreigners holding portfolio assets in the United States. /10/

The proposals outlined here for international reform would reduce the tax impediments to direct investment abroad by U.S. firms. Over a period of time, therefore, U.S. receipts of direct investment income should rise. Meanwhile, the replacement of the corporate income tax by a cashflow tax should spur investment in the U.S. economy, including investment by foreign firms. For this reason, U.S. payments of direct investment income to foreign firms should also rise.

The probable effect of these reforms on portfolio income flows is more complicated. REPORTED portfolio income flows in both directions would likely rise, because the proposals are designed to defeat tax evasion schemes, which, among other things, lead to underreporting of taxable income. On the other hand, ACTUAL portfolio income flows might decline from their present levels (which are larger than the figures reported above) simply because the opportunity for tax evasion would be curtailed.

DIRECT INVESTMENT INCOME

The proposals outlined here for taxing direct investment income are based on the modern theory of the multinational firm. /11/ Thirty years ago it was thought that the success of multinationals was based on their ability to mobilize capital in countries where interest rates were low and to invest resources where interest rates were high. This theory no longer commands widespread adherence. In fact, multinationals no longer play a major role in ensuring the efficient allocation of capital among national economies. That role is now dominated by vast international markets for portfolio investment bank lending, pension funds, mutual funds, and the like.

Multinational firms continue to flourish not because they bridge capital markets, but because they efficiently combine two operations: They provide headquarters services on the one hand and carry out traditional production and distribution activities on the other. When a multinational enterprise can combine these two operations in a successful way, it has the special characteristics that enable it to prosper.

Most headquarters services are used throughout the firm, and many headquarters services such as corporate finance, legal affairs, and research activities can be efficiently conducted in a single location or very few locations. Economies of scale and coherence are decisive. In contrast, most production and distribution activities exhibit lesser economies of scale; instead, they are highly sensitive to the cost and incentive conditions of different environments. Typically, it makes sense to disperse these activities over many locations.

A firm operating on a global scale, therefore, can spread the expensive overhead costs associated with headquarters activities over a larger volume of sales, and thereby lower its average costs, and pick and choose between production locations to obtain the best combination of wage rates, input costs, productivity levels, and market access.

As a country, the United States derives several benefits when U.S. and foreign multinationals can operate without tax handicaps or other barriers. One benefit is that the costs of headquarters services -- an activity that creates well-paid professional jobs and in which the United States enjoys a comparative advantage -- can be spread on a global scale. /12/ A second benefit is that foreign production by U.S. firms acts as a magnet for U.S. exports of other goods and services. Without networks of international affiliates, firms cannot successfully export to high-technology markets which require extensive adaptation of U.S. goods and services to local conditions, and which call for fast and reliable after-service (see Graham 1993). Since U.S. export sectors typically pay better wages than the U.S. average, an expansion of exports helps raise U.S. wage levels (Walters 1992). A third benefit arises from the fact that when additional firms compete head to head in a particular market, prices are more quickly driven down, thereby immediately benefiting the consumer. In addition, more intense competition prompts all market participants to develop new cost-cutting innovations and introduce better products.

To help secure these benefits, certain approaches new to U.S. tax experience should be implemented.

o First, THE BUSINESS CASHFLOW TAX SHOULD BE DESIGNED TO

o Second, THE BUSINESS CASHFLOW TAX SHOULD BE IMPOSED ON ALL

Border adjustments on imports should eradicate the fear of

o Third, THE UNITED STATES SHOULD ADOPT THE TERRITORIAL APPROACH

Many observers connect the territorial approach with the

o Fourth, THE U.S. TREASURY SHOULD THUS SEEK UNDERSTANDINGS BOTH

If the United States adopts the business cashflow tax and adheres to the territorial principle, transfer pricing and cost allocation disputes could take a different turn. Under current U.S. international tax rules, multinational firms often have an incentive to understate their U.S. export receipts and overstate their U.S. import payments, using these misstatements to lodge income in tax haven countries. In contrast, under the business cashflow tax system, multinational firms would often have an incentive to OVERSTATE the value of exports and UNDERSTATE imports. This shift in incentives would reflect two changes: the fact that exports of goods and services would be exempted from U.S. taxation, while imports would be fully taxed; and the fact that, with territorial rules, financial payments would no longer be deductible and financial receipts would no longer be taxable.

Whatever the incentive structure, most tax authorities agree that market forces cannot always be relied upon to ensure reasonable transfer prices and appropriate cost allocations. Even when a multinational derives no overall tax saving from pricing intrafirm transactions "too high" or "too low," the firm may simply wish to favor one revenue authority by declaring more income in its jurisdiction. Better administration of the rules should thus be a priority issue.

PORTFOLIO INCOME

How would portfolio income moving across international borders be taxed under the business cashflow tax system? As noted in Table 1, when a U.S. firm pays interest or dividend income to a foreign recipient (whether a foreign parent firm, a sister firm, or a portfolio investor), that payment would not be allowed as a deduction in calculating its cashflow tax. Conversely, when a foreign firm pays interest or dividends to a U.S. firm, the financial receipts from abroad (just like financial receipts from domestic sources) would not be subject to the cashflow tax.

That is the beginning, not the end, of efficient tax rule for international flows of portfoilo income. To strengthen the efficiency of capital allocation and to curb tax evasion, the United States and other industrial countries should introduce an EFFECTIVE residence- based system for taxing international portfolio income when it is paid out to individual investors or pension funds. /17/ This would require the major nations both to abandon taxation at source of portfolio interest, dividends, and capital gains, and to put "teeth" in tax collection on a residence basis.

There are two main reasons for advocating residence-based taxation. First, it would help ensure that portfolio capital moves between countries without regard to differentials in the taxation of personal income. The analysis is simple: Any individual investor would face the same home country tax rate on investment whether his or her money was placed in Australia, Mexico, the United Kingdom, or any other country. With tax rates the same, each investor would efficiently allocate his or her investments on a global basis, taking into account both risk and return.

To illustrate, suppose the world interest rate on dollar- denominated 10-year bonds is 10 percent. If the United States wished to tax the interest income of its residents, whether received from investment at home or abroad, at a rate of 20 percent, the tax will not cause U.S. residents to alter their portfolio decisions. Wherever they put their money, the after-tax return on 10-year bonds is now 8 percent rather than 10 percent. In other words, residence-based taxation, if applied to all portfolio income, does not distort the way residents allocate their portfolio investments.

The second argument for residence taxation is that each country would collect all the tax revenue on the portfolio income of its own residents, thereby reaping the fiscal rewards of policies that encourage personal savings.

To ensure effective residence-based portfolio income, taxing authorities should jointly devise a clearinghouse mechanism. The clearinghouse should be designed to curtail the scope for tax evasion, and thereby raise more public revenue. For example, in 1992, U.S. portfolio income was about $54 billion. An average tax of just 10 percent on this income would generate $5 billion of U.S. tax revenue; practically all of this amount would be additional to what is now collected. To get the clearinghouse started, the United States should mount an initiative along the following lines.

o U.S. residents paying interest or dividends to nonqualifying

o The nonqualifying foreign recipient would present the

o Nonqualifying foreigners would include all foreigners other

PROPOSED CONDITIONS FOR U.S. REIMBURSEMENT OF

o The foreign government must implement an effective system so

o The foreign government must impose a similar 10-percent backup

o The foreign government must prohibit the issuance of anonymous

o The foreign government must enter into an effective exchange-

Source: Gary C. Hufbauer and Joanna M. van Rooij, U.S. Taxation of

INTERNATIONAL TAX COOPERATION

Like other industrial countries, the United States has tried to attract investments with competitive tax breaks in a form of international tax competition. Within the United States, this tax competition is largely conducted by the states, which sometimes offer aggressive inducements to attract corporate investment. However, the federal government has also engaged in competitive tax inducements. In the mid-1980s, for example, the Reagan Administration made the United States a more attractive location for portfolio investment by relaxing withholding taxes on interest paid to foreign residents.

An important question for the late 1990s is whether the United States should simply pursue the process of piecemeal tax competition, or whether it should embark on a path of planned convergence between its system for taxing business income and the systems of its major industrial partners. There are two strong reasons for planned convergence. First, it would mitigate the geographic and industry distortions caused by piecemeal tax competition. Second, it would limit the cost of devising new industrial subsidies or trade barriers to offset foreign tax advantages. The United States should therefore challenge its partners in the North American Free Trade Agreement (NAFTA), together with Japan and the European Union, to embark on a program of meshing systems of business taxation.

The previous sections outlined proposals for U.S. taxation of multinational firms in a global economy. These reform proposals also furnish the foundations for a program of planned tax convergence. To make progress, appropriate forums must be designated for tax negotiations. This section suggests issues the United States should address in various forums.

First, note that key components of the reform package outlined here can be implemented unilaterally through appropriate congressional legislation. In particular, the proposals to adopt a business cashflow tax, accept the territorial approach, and repeal the foreign tax credit can be enacted unilaterally. Other important components of the reform package can only be implemented with the acquiescence or cooperation of U.S. trading partners. Most importantly, adjustment at the border for the business cashflow tax will require the acquiescence of important GATT members. Further, residence-based taxation of portfolio income and monitoring transfer prices and cost allocations will require intense coordination between national fiscal authorities. Even more demanding will be political cooperation to help converge national systems for taxing business income.

The customary vehicle for international tax cooperation has been the bilateral tax treaty. Most tax treaties are designed to solve fringe problems that arise in meshing different national systems for taxing income and to provide mutual assistance in collecting revenue. As a result, tax treaty negotiations were never focused on deep cooperation or broad tax convergence.

Greater progress can be made by linking tax cooperation with trade liberalization. Tax policy can play a supporting role in ensuring an open international trade and investment system. Well- designed steps toward the convergence of national tax systems can ease the barriers multinational firms face daily in doing business in a global economy. As trade barriers are gradually removed on a worldwide scale, the presence of diverging national tax systems will emerge as an important residual barrier to freer trade. /18/

The end of 1993 saw a wave of trade agreements. In late November 1993, the U.S. Congress approved NAFTA, to create a regional free trade bloc between the United States, Canada, and Mexico. Shortly after, the members of the Asian-Pacific Economic Cooperation (APEC) met in Seattle to reaffirm greater economic partnership in the Pacific Rim. In December 1993, the 115 GATT nations agreed to a comprehensive package that will reduce tariff and nontariff barriers on goods and services and will revamp GATT rules and institutions. To move the process of tax cooperation forward, the United States should harness its efforts to these successful endeavors.

The European experience provides a clear lesson that tax convergence proceeds faster under the umbrella of regional economic integration than in isolation. Within the European 1992 framework, the European Community launched efforts aimed at the convergence of value-added and excise tax systems, corporate income tax systems, and taxation of portfolio income. Closer to home, the United States and Mexico quickly negotiated a tax treaty, once it became evident that such a treaty would naturally complement NAFTA.

Against this background, the following are suggestions for assigning various tax cooperation issues to different international organizations.

Organisation for Economic Co-operation and Development

For many years, the tax authorities of industrial countries have worked together within the OECD both to review fiscal systems and to design model tax treaties. The OECD would thus provide a natural home for a clearinghouse mechanism to sort out revenue claims, once the principle of taxing portfolio income on a residence basis has been accepted. Assuring this role should be an early OECD project.

In the medium term, the OECD can also provide a forum for work toward the convergence of existing corporate tax systems. In particular, OECD countries might harmonize their definitions of taxable corporate income and underlying accounting standards. Since it is now enlarging its membership to include Mexico and South Korea (and perhaps other successful developing countries), the OECD will soon encompass most countries with an interest in convergence.

Once the United States adopts a business cashflow tax, the OECD could initiate a work program to study broad-based consumption taxes. Perhaps in 10 or 15 years, circumstances will be ripe for talks on meshing the main consumption taxes -- value-added taxes, goods and services taxes, and cashflow taxes. In particular, OECD understandings might gradually evolve as to appropriate upper and lower standard tax rates.

General Agreement on Tariffs and Trade

GATT provides the framework for negotiating agreements on border adjustment rules. The first challenge for the United States is to ensure that a business cashflow tax is recognized as an indirect tax, eligible for border adjustments. After that, an ongoing GATT activity will be surveillance against tax discrimination in the application of border adjustments. /19/

GATT should become the forum for devising better transfer pricing and expense allocation rules for multinational firms and for arbitrating disputes. GATT, rather than the OECD, should handle this task first, because its membership is far larger, and second, because it has an established dispute settlement mechanism.

North American Free Trade Agreement

NAFTA, which went into effect January 1994, will help integrate the economies of Canada, Mexico, and the United States over the next decade. Once a significant degree of trade and investment liberalization has been achieved and the consultative machinery is working, the NAFTA partners should consider the gradual convergence of their systems for taxing business firms.

As intra-NAFTA trade and investment flows expand, the appropriate division of income and the proper allocation of expenses between jurisdictions will become important topics. In the very near term (much sooner than GATT can create useful machinery), the NAFTA partners should establish mechanisms for resolving their own transfer pricing and cost allocation disputes. These mechanisms should rely heavily on advance pricing agreements and expert arbitration panels.

In the medium term, the NAFTA partners should discuss the rate and structure of their broad-based consumption taxes. The stage will be set if a second-term Clinton Administration adopts a business cashflow tax. Currently, the standard Mexican value-added tax rate is 15 percent, while the combined Canadian federal goods and services tax and the provincial retail sales tax rates are about 15 percent for the major provinces. If the United States settles for a federal cashflow tax of around 10 percent, the combined federal-state rate (cashflow plus retail sales tax) would also be in the range of 15 percent.

If the broad-based consumption tax rates in the three countries do in fact evolve to within a few percentage points of each other, the NAFTA partners should consider applying the origin principle for North American trade, thereby reducing the need for border surveillance. At the same time, they should maintain the destination principle for trade with non-NAFTA members.

Asian Pacific Economic Cooperation

In November 1993, the APEC members came together in Seattle to discuss the future of Pacific basin economic cooperation. While the leaders stopped far short of establishing a formal economic community, they agreed to meet again in Jakarta in 1994. Meanwhile, they called for an early meeting of finance ministers to discuss macroeconomic developments and investment questions. These discussions provide an obvious bridge to tax cooperation.

The APEC countries are at the beginning of a long road toward greater economic integration. Tax cooperation in the near term will therefore be shallow rather than deep. A useful start would be the design of a common APEC model tax treaty, which could borrow extensively from the OECD model. Together with traditional issues, the model APEC tax treaty should include arbitration procedures to solve transfer pricing and cost allocation disputes.

The United States could draw on this model in negotiating bilateral tax treaties with its APEC partners. Currently, the United States only has income tax treaties with Australia, Canada, China, Indonesia, Japan, and New Zealand, among the APEC countries. Some of these treaties are badly dated (notably the Japan treaty), and they should be renegotiated in line with the APEC model. The United States should also initiate tax treaty negotiations with Taiwan, Singapore, Brunei, South Korea, and the Philippines. Finally, the United States should encourage the APEC countries to negotiate treaties among themselves in order to create an APEC-wide network of compatible bilateral treaties by the year 2000.

CONCLUSION

The U.S. system for taxing business income no longer meets the needs of the American economy. It discourages investment and encourages inefficiency. It is prodigiously complex and very costly to administer. Although these negative consequences cannot be quantified precisely, the present business tax system unquestionably drags down U.S. economic growth.

The problems with the current system for taxing domestic business income are compounded at the international level. The existing U.S. system for taxing international income was conceived in the 1920s and solidified in the 1950s; it consequently reflects the doctrines of a bygone era when the United States was solely concerned with the proper division of revenue between U.S. and foreign taxing authorities, and was not concerned with global competition.

We advocate a broad-based, low-rate business cashflow tax to replace the current narrow-based, high-rate tax. Extending the logic of the reformed system to U.S. taxation of international income results in an approach that would dramatically reduce the tax impediments that now confront U.S. firms when they do business abroad. It would also raise substantial new revenue on portfolio income flows. Further, the new approach would dovetail with U.S. efforts to advance international economic integration in the OECD, GATT, NAFTA, and APEC.

What difference would these reforms make to the average American? The answer is simple but powerful: quality jobs. A tax system that promotes capital formation, attracts the headquarters activities of multinational firms, and encourages U.S. production of goods and services for the global marketplace is one that will create high-skilled jobs in the U.S. economy.

FOOTNOTES

/1/ For further discussion of the Omnibus Budget and Reconciliation Act of 1993, see Hufbauer and van Rooij (1992).

/2/ For a recent estimate of the negative relationship between investment and the capital income tax rate, see Mendoza, Razin, and Tesar (1993). For an international comparison of the uneven application of direct taxes on industry sectors, assets, sources of finance, and ownership, see Jorgenson and Landau (1993).

/3/ The Clinton Administration had claimed budget savings of $59 billion over five years for its plan. The difference represents an adverse budget swing of $133 billion.

/4/ For example, the Liberal leader in Australia, John Hewson, campaigned in 1992 on a goods and services tax and lost the election.

/5/ This paper starts from the premise that the current corporate income tax will be replaced by the business cashflow tax. The core international proposals advanced in our earlier book (Hufbauer and van Rooij 1992) can rest comfortably on the foundation of a domestic cashflow tax. However, the introduction of the cashflow tax would particularly affect two of our earlier proposals: (1) the suggestion to tax portfolio interest on a "pure" residence basis; and (2) the proposal to tax royalties and fees only in the country that paid for the underlying research and development that created the intellectual property. More importantly, the business cashflow tax, unlike the current corporate income tax, would be adjusted at the border on all imports and exports of goods and services. These changes in detail do not alter our basic objective: to reform the U.S. international tax system in ways that promote both American prosperity and an open international system.

/6/ For a detailed discussion of border tax adjustments, see Hufbauer and Gabyzon (1993).

/7/ For example, the choice makes no difference if the tax in question is a general tax, namely one that applies proportionately to all goods and services produced in the economy, or to all factor incomes earned in the economy; if all prices and wages are perfectly FLEXIBLE, or, more realistically, if the exchange rate is perfectly flexible; and if capital flows to the economy are not affected by the tax system. For a technical exposition of these restrictive conditions, see Lockwood (1992); an earlier exposition appears in Whalley (1979).

/8/ The exchange rate depreciation will be less than 10 percent because the tax only worsens the trade balance for a single sector of the economy. By contrast, the exchange rate depreciation will improve the trade balance in all sectors of the economy, so a depreciation of less than 10 percent is needed to restore the trade balance to its previous position.

/9/ In a similar fashion, the pro-investment features of the early Reagan tax acts partially accounted for dollar appreciation in the first half of the 1980s.

/10/ Survey of Current Business 1993. These direct investment income figures do not include receipts and payments of royalties and fees.

/11/ For a detailed discussion of the proposals, see Hufbauer and van Rooij (1992). For a critique, see Grubert and Mutti (1994).

/12/ The United States has long enjoyed a comparative advantage as an exporter of headquarters services to world markets. More recently, other countries -- particularly those in the Pacific basin -- have begun to use tax incentives to attract headquarters activity. For an update on tax measures in the Pacific basin, see Pickard (1994).

/13/ Of course, income earned by ultimate recipients -- wages paid to production workers, salaries paid to research technicians, interest paid to bondholders, dividends paid to shareholders -- would all be subject to U.S. tax at the personal level. The practical problems created by adjusting personal taxes at the border would be overwhelming: Not only would such adjustments contravene a long history of international rules, but also the mechanical difficulties of identifying personal taxes with particular exports of goods and services are virtually insurmountable.

/14/ Since U.S. exports of goods and services would be exempt from the tax, any exports used as inputs into subsequent U.S. imports would be subject to the cashflow tax only once, not twice.

/15/ Repeal of the foreign tax credit would, of course, require renegotiation of most U.S. tax treaties. When a country changes its tax system in a fundamental way (e.g., switching from corporate to cashflow taxation), renegotiation of tax treaties is to be expected.

/16/ See Hufbauer and van Rooij (1992), Chapter 6. For a summary of the OECD Task Force Reports on transfer pricing, see International Bureau of Fiscal Documentation (1993) and Pagan (1993).

/17/ Because the cashflow system does not permit deductions for interest, we have modified our earlier advocacy of a "pure" residence system for taxing portfolio interest income; i.e., the position that such income be taxed only by the resident country. Instead, taxation in the source country should be allowed to the extent interest is taxed as part of business cashflow.

/18/ For example, with the introduction of the Single Banking License in the European Community, the trade-inhibiting character of diverging national tax systems became more evident. See Dassesse (1993).

/19/ In February 1994, for example, the United States launched a complaint against the application of border adjustments by the Canadian province of New Brunswick (Inside U.S. Trade 1994). While this dispute will be handled by NAFTA, with the growing scope of indirect taxes, many more disputes of this type could reach GATT.

END OF FOOTNOTES

REFERENCES

Bitter, Boris I., and James S. Eustice. 1994. Federal Taxation of

Dassesse, Marc. 1993. "Tax Obstacles to the Free Provision of

Graham, Edward M. 1993. "Territorial Taxation, U.S. Direct

Grubert, Harry, and John Mutti. 1994. Taxing Multinationals in a

Hufbauer, Gary C., and Carol Gabyzon. 1993. "The Evolution of Border

___. "U.S. Taxation of Multinationals: Scoring the Clinton Proposals."

___ and Joanna M. van Rooij. 1992. U.S. Taxation of International

International Bureau of Fiscal Documentation. 1993. "The U.S.

Jorgenson, Dale W., and Ralph Landau. 1993. Tax Reform and the Cost

Lockwood, Ben. 1992. Commodity Tax Competition under Destination and

Loeb, Marshall, Richard Kirkland, and Ann Reilly Dowd. 1993. "Clinton

Mendoza, Enrique G., Assaf Razin, and Linda L. Tesar. 1993. "An

Messere, Ken. 1993. "Recent Tax Revenue Developments in OECD

Murray, Frank. 1994. "Consumption Taxes High on Agenda of Entitlement

Pagan, Jill C. 1993. "Indications of Future Policy in the Latest OECD

Pickard, Daniel P. 1994. "World Trade Institute Examines International

Priest, Dana and Spencer Rich. 1994. "Health Plan Will Swell Deficit,

Rostenkowski, Dan. 1987. "A View from the Ways and Means Committee."

U.S. Department of Commerce, Bureau of Economic Analysis. 1993.

"U.S. Launches First NAFTA Dispute: Challenge on Canadian Border

Walters, David. 1992. "U.S. Exports Create High-Wage Employment."

Whalley, John. 1979. "Uniform Domestic Tax Rates, Trade Distortions,

* * *

ALTERNATIVES FOR CORPORATE TAX REFORM

Alvin C. Warren, Jr.

This Paper provides an introduction to alternative proposals for fundamental reform of the U.S. corporate income tax. The first section examines integration of the corporate and individual income taxes, which is the reform that has been most widely adopted by our trading partners. The next section discusses other major reform proposals, including cash flow corporate taxation and incentives for certain investments. Conclusions and recommendations are found in the last section.

INTEGRATION OF CORPORATE AND INDIVIDUAL INCOME TAXES

Our discussion of integration is divided into three sections: (a) current U.S. taxation of corporate income and the resulting economic distortions; (b) tax policy issues involved in integration; and (c) economic effects of integration.

U.S. Taxation of Corporate Income

The United States has long had what is usually called a classical income tax system, under which income is taxed to shareholders and to corporations as distinct taxpayers. Taxable income earned by a corporation and then distributed to individual shareholders as a dividend is thus taxed twice, once to the corporation, and once to the shareholder on receipt of the dividend. As a result, the current regime is often characterized as a "double tax" system. The actual U.S. situation is considerably more complex. For example, some income earned through corporate enterprise is taxed only once, at the corporate level, as in the case of corporate taxable income distributed as dividends to exempt shareholders. Other income earned through corporate enterprise is taxed only once, but at the investor level, as in the case of corporate earnings distributed as deductible interest payments to taxable debtholders. Finally, some income earned through corporate enterprise is not taxed in the United States at either the corporate or investor level, as in the case of interest paid to certain foreign and tax-exempt holders of U.S. corporate debt. /1/ As a result, corporate income is sometimes taxed twice in the United States, sometimes once, and sometimes not at all.

This system involves several undesirable economic distortions, of which the following four are usually considered the most important:

o DISINCENTIVE FOR INVESTMENT IN NEW CORPORATE CAPITAL: U.S.

o INCENTIVE FOR CORPORATE FINANCING BY DEBT OR RETAINED

o INCENTIVE TO DISTRIBUTE OR RETAIN CORPORATE EARNINGS: There

o INCENTIVE TO DISTRIBUTE CORPORATE EARNINGS IN TAX-PREFERRED

Integration of the corporate and individual income taxes refers to various means of eliminating the separate, additional burden of the corporate income tax where it exists, and substituting a system in which investor and corporate taxes are interrelated. This would produce a uniform levy on capital income, whether earned through corporate enterprise or not. Integration would accordingly reduce or eliminate the distortions of the current system.

Thirty years ago, the corporate tax systems of most other major developed countries were similar to ours. In the last three decades, however, most of our major trading partners have fully or partially integrated their individual and corporate income taxes, thereby eliminating or reducing the disparities that still exist in the United States. /3/ While integration has been discussed periodically in the United States, this discussion has not been identified with any political party or movement. The Treasury Department has, for example, developed proposals in both Democratic and Republican Administrations, and the House of Representatives included a modest step toward integration in the initial version of the Tax Reform Act of 1986.

Tax Policy Issues

Integration of the corporate and individual income taxes involves a number of tax policy decisions, the sum of which determines the structure and effects of the integration system. The most important of these issues are considered in this paper in the context of two recent U.S. integration studies, which are the most comprehensive to date: Early in 1992, the Treasury Department released the results of a multi-year study of integration (U.S. Treasury 1992a); and the American Law Institute Federal Income Tax Project subsequently published the results of its own multi-year study (Warren 1993). /4/ The range of tax policy choices involved in any program of integration can be elucidated by comparing the recommendations of these two studies in eight areas: (1) basic integration structure; (2) untaxed corporate income; (3) treatment of debt; (4) retained earnings; (5) exempt shareholders and creditors; (6) international income; (7) nondividend distributions; and (8) transition to the new system.

1. BASIC INTEGRATION STRUCTURE: In theory, there are a variety of ways in which the individual and corporate income taxes could be integrated to reduce the distortions of current law. The corporate tax could, for example, be repealed and shareholders taxed currently on corporate earnings, but that approach would require annual allocation of undistributed corporate income to a myriad of complex capital interests. Alternatively, the corporate tax could be repealed and shareholders taxed annually on changes in stock values, but that approach would require abandoning the realization criterion of income taxation. For these reasons, the SHAREHOLDER ALLOCATION and ANNUAL VALUATION approaches to integration have not generally been pursued here or abroad. Instead, integration, as proposed in the United States and adopted abroad, has usually involved one of the following DISTRIBUTION-RELATED approaches:

o SHAREHOLDER CREDIT FOR CORPORATE TAXES PAID: When a

o CORPORATE DEDUCTION FOR DIVIDENDS PAID: Dividends, like

o SHAREHOLDER EXCLUSION FOR DIVIDENDS RECEIVED: Dividends would

Each of these approaches has advantages and disadvantages. The ALI study develops shareholder credit integration for the United States, on the grounds that it offers the fullest solution to the defects of current law. The American Institute of Certified Public Accountants Tax Division (1993) also recently endorsed this approach, in part because it has become the international norm. If fully implemented, the shareholder credit approach would tax all income earned through corporate enterprise once, but only once, at the PROGRESSIVE RATE applicable to the individual investor. The dividend deduction approach has the same result, but without the compliance advantage of corporate withholding. The Treasury's 1992 integration study favored the dividend exclusion approach because of its simplicity and minimal departure from current law. If fully implemented, this approach would tax all income from corporate enterprise once, but only once, at the FLAT RATE applicable to corporations.

2. UNTAXED CORPORATE INCOME: Any integration system must take into account the fact that some corporate income is distributed to shareholders without bearing a full corporate tax. The ALI study follows the European practice of imposing an auxiliary withholding tax on corporate distributions to ensure that shareholders do not receive credits for taxes that have not been paid at the corporate level. This approach permits a uniform tax credit for all dividends to all shareholders, making the system very simple for individual taxpayers. No double tax would result, because payments of regular corporate tax would be considered prepayments of this auxiliary withholding tax. On the other hand, certain dividends may be free of corporate tax as a result of deliberately enacted corporate tax preferences that should be passed through to shareholders. Accordingly, the ALI study would permit the flow-through to shareholders of congressionally-designated tax preferences.

Under the Treasury's dividend exclusion, shareholders would be taxed on dividends that had not been taxed at the corporate level. Like the ALI approach, this system would require a corporate-level account to keep track of what income had borne corporate taxes. Individual taxpayers would treat dividends as taxable or nontaxable, based on a report from each corporation. The Treasury study originally rejected the possibility of passing through corporate tax preferences to shareholders, but a subsequent version of its dividend exclusion would permit some such pass-through (Treasury 1992b).

3. TREATMENT OF DEBT: One important goal of integration is to reduce the differential income tax treatment of corporate equity and debt. Equivalent treatment is achieved under the ALI study by imposing a withholding tax on corporate interest payments. The withholding credit for interest functions in the same manner as the shareholder credit for dividends.

Under the Treasury's dividend exclusion, equivalence would not be achieved because corporate earnings distributed as dividends would be taxed at the corporate level at a flat rate, whereas corporate earnings distributed as interest would be taxed at the investor level at graduated rates. Equivalence would, however, be achieved under the fullest implementation of the Treasury's preferred integration approach, which is called a COMPREHENSIVE BUSINESS INCOME TAX. Under this proposal, neither interest nor dividends would be deductible by corporations, nor would they be taxable to recipients. The same regime would apply to noncorporate business entities. In effect, all business income would be taxed at a flat rate applied to business entities. The Treasury indicated that this approach would take a decade to phase in.

Accordingly, corporate interest, like dividends, would be taxable at the investor's graduated rate under the ALI study, but at the flat rate applicable to business units under the fullest implementation of the preferred approach of the Treasury study.

4. RETAINED EARNINGS: Under shareholder credit integration, retained corporate earnings would present two problems. First, shareholders whose marginal tax rates were below the corporate rate would be disadvantaged by such retentions, creating a tax incentive for distributions of corporate earnings. Second, taxation of shareholder capital gains due to retained corporate earnings would, as under current law, constitute multiple taxation of the same gain. The second problem could be eliminated by preferential taxation of gains on corporate stock, but such a preference would be overbroad because not all gains on corporate stock are due to retained corporate earnings.

Both problems are addressed in the ALI study by a constructive dividend option, under which corporations could make tax credits available to shareholders without the requirement of a cash distribution. If the corporate tax rate was equal to the highest individual rate, constructive dividends could not disadvantage shareholders, who would either pay no taxes or receive a refund as a result of the constructive distribution. In addition, the increase in shareholder basis due to the constructive reinvestment would eliminate the possibility of double taxation on sale of the stock.

Current taxation of retained earnings at the corporate rate is consistent with the goal of dividend exclusion integration to tax all corporate income at that rate. Accordingly, the Treasury report addresses only the second problem identified above: multiple taxation of corporate income as a result of shareholder capital gains. The Treasury's recommended approach is also a constructive dividend option.

5. EXEMPT SHAREHOLDERS AND CREDITORS: Nominally exempt suppliers of corporate capital, such as charitable organizations and pension funds, do not always receive their share of corporate income free of tax under current law. The portion of corporate income distributed to such investors is sometimes taxed (due to the corporate tax on income distributed as dividends) and sometimes not (due to the corporate deduction for interest payments and to corporate preferences for some income distributed as dividends). Since one of the goals of integration is elimination of such discontinuities, any comprehensive system of integration will necessarily affect currently exempt shareholders.

The approach of the ALI study is to maintain a single level of tax on corporate income received by such investors, and to rationalize that tax in order to eliminate tax-induced distortions in investment decisions. Accordingly, entities that are nominally exempt under current law would be subject to an explicit tax on corporate investment income, against which the shareholder and creditor withholding credits could be used, with any excess refundable. The basic idea of this proposal is that the rate of tax on income from corporate investment received by exempt entities should be uniform and explicitly determined as a matter of tax policy. That rate could be set to maintain the same amount of revenue as is currently collected on corporate income distributed to exempt shareholders, to increase that amount, or to decrease it.

A similar uniform tax on investment income is discussed in the Treasury study, but is not proposed. In the absence of such a proposal, the distortions of current law due to differential treatment of debt and equity would remain in effect with respect to tax-exempt investors under the dividend exclusion approach.

6. INTERNATIONAL ISSUES: Two important international questions must be addressed in designing an integration system. First, what should be the extent of U.S. taxation of U.S. corporate income paid to foreign parent companies or investors under integration? Second, how should foreign taxes paid by U.S. companies on foreign income affect the U.S. taxation of U.S. shareholders on distribution of those earnings? Resolution of these issues is complicated by the existence under current law of nonrefundable withholding taxes on U.S. dividends and interest paid to certain foreign recipients. Where applicable, these taxes substitute for the income tax applied to domestic recipients of such income. /5/

With respect to foreign parent companies and investors, the approach of the ALI study is similar to that applicable to exempt organizations. Foreign parents and investors would be subject to a new U.S. tax on investment income and would receive fully-refundable integration credits. This tax would replace the current nonrefundable withholding tax, which applies to some, but not all, U.S. corporate income distributed outside the United States. The rationale for this proposal is again that the rate of tax on U.S. income should be uniform and explicitly determined as a matter of tax policy, first by legislation and then by treaty negotiation. The uniform tax developed in the ALI study would be an innovation in international taxation and would therefore require discussion with our treaty partners. The Treasury study discusses the possibility of a uniform tax on foreign parent companies and investors along these lines, but limits its conclusion to the proposition that changes should not be made unilaterally by the United States in order to preserve our bargaining power for treaty negotiation with our trading partners.

A fundamental feature of U.S. tax law is a credit (up to the amount of the U.S. tax) for foreign taxes paid on income earned abroad by U.S. companies or individuals. /6/ The purpose of this credit is to avoid double taxation of foreign income. Converting the U.S. corporate income tax into a withholding tax suggests that credits for foreign tax paid by U.S. corporations should be passed through to U.S. shareholders upon distribution of foreign income. The ALI study approximates that result with considerably less complexity by treating an appropriate amount of corporate foreign income as tax- exempt when distributed as dividends. Like the proposal regarding foreign investors, this proposal could be limited to income from countries with reciprocal provisions. Such a limitation would initially seem advisable because foreign integration systems have not generally included comparable provisions. The Treasury study discusses pass-through of foreign tax credits, but again limits its conclusions to stating that the United States should not make any changes unilaterally. A subsequent Treasury proposal would pass through some foreign tax credits to shareholders (Treasury 1992b).

7. NONDIVIDEND DISTRIBUTIONS: There are a variety of transactions other than dividends by which corporate income can be distributed to shareholders, including repurchases by a corporation of its stock, purchases by one corporation of the stock of another corporation from noncorporate shareholders, and payments in liquidation. Under current law, the tax treatment of such nondividend distributions to individuals can be less onerous than that of dividends because basis recovery and a capital gains preference may be available with respect to the former, but not the latter. /7/ In recent years, there has been a significant increase in the use of tax-preferred nondividend distributions by public companies (Bagwell and Shoven 1989).

The principal issue presented by nondividend distributions in the design of an integration system is the extent to which the benefits of integration will be available for such distributions, in order to achieve neutrality with dividends. Under the ALI study, nondividend distributions would generally carry out shareholder credits to achieve parity with dividends. The Treasury study concludes that no change in current law would be necessary because the incentive to engage in nondividend distributions would be reduced under integration.

8. TRANSITION: As with any major change in tax law, integration could be made immediately effective, phased-in over time, or accompanied by exceptions for pre-existing transactions. With respect to the last possibility, it is sometimes argued that integration should be available only for corporate equity acquired after the date of enactment because the capital markets have already discounted the price of pre-enactment corporate equity to take into account any double taxation under current law. Under this argument, integration for pre-enactment equity would result in unjustified windfalls to current shareholders. The ALI and Treasury studies both prefer phasing-in of integration to permanently limiting the new system to postenactment equity. Concern about integration unduly benefiting current shareholders could be addressed in the method chosen to finance integration, which is discussed below. Windfall gains from integration could also be captured by a special tax on such windfalls, although such levies have not been popular in recent years (Auerbach 1990).

9. SUMMARY: As indicated by the foregoing discussion, any integration proposal involves a number of fundamental tax policy decisions regarding domestic and foreign companies and their investors. The ALI study would convert the separate U.S. corporate income tax into a withholding tax in order to eliminate or reduce the economic distortions and intractable legal distinctions that arise under current law. The Treasury study would pursue the same goals by exempting corporate dividends from shareholder taxation. The principal tax policy question posed by the difference between the two approaches is whether income earned through corporate enterprise should ultimately be taxed at the investor's graduated rate or at a flat rate applicable to business organizations.

Economic Effects

Analysis of integration proposals requires consideration of the effects of the proposals on economic efficiency, tax revenues, and distribution of the tax burden across income classes.

1. ECONOMIC EFFICIENCY: In principle, the effects of the tax- induced distortions of current law are straightforward. The tax biases of the current system produce a misallocation of resources, resulting in a diminution in economic welfare. It is much more difficult to quantify the improvement in economic welfare that would follow from elimination of these biases by enactment of integration.

The 1992 Treasury study includes a comprehensive economic analysis of the benefits of integration. Four different versions of integration (shareholder allocation, shareholder credit, dividend exclusion, and a comprehensive business income tax) are examined, using four different models of the economy and two different financing assumptions, in order to generate a range of estimates of the change in economic welfare. As would be expected, integration generally increases the flow of assets into corporations, reduces corporate reliance on debt finance, and results in a lower and more uniform cost of capital for U.S. companies. The estimated increases in economic welfare range from an amount equivalent to 0.07 percent of annual consumption to an amount equivalent to 0.73 percent of consumption, or from approximately $2.5 billion to $25 billion per year. Much of the variation in results is due to differences in the economic models and to differences in financing assumptions, rather than differences among the integration alternatives. Indeed, the report states that "one striking feature of the calculations is that within each model, and for a given financing assumption, structurally different [integration] prototypes often have similar overall effects on economic well-being" (Treasury 1992a, at 111).

These calculations were made using computable general equilibrium models, which are computer representations of the U.S. economy. To avoid confusing the results of integration with the results of simply reducing taxes, these calculations include replacement of lost revenue by either lump-sum taxes or increases in the rate of taxes applicable to capital income. Lump-sum taxes are levies that are unavoidable, so their introduction permits an estimate that does not involve further distortions of economic behavior. On the other hand, lump-sum taxes, such as a poll tax requiring payment of an equal amount by all adults, are politically unlikely. The alternative financing assumption -- that integration would be accompanied by offsetting adjustments in the tax rate applicable to capital income -- follows from the view of many economists that the burden of the current corporate tax is largely shifted to the holders of all capital. Additional discussion will appear later in this report.

Like all such calculations, the Treasury estimates are not without limitations. For example, as the Treasury study indicates, the models do not take into account many of the details of the integration proposals, such as whether corporate tax preferences are passed through to shareholders. Moreover, the results ignore transition effects and focus on long-term equilibria. Finally, the Treasury report adopts a particular view of the effects of current law that is not universally accepted by financial economists. Essentially, the Treasury adopts the "traditional" view of corporate finance that a dollar invested in a corporate equity will, all other things being equal, increase share value by a dollar. Under this view, corporations are encouraged by the capital markets to pay dividends, in spite of any tax disadvantages. The alternative, or "new" view is that the separate taxation of corporations under current law will be taken into account when share prices are determined by the capital markets, reducing share values. /8/ Under this second view, much of the additional tax burden of the current corporate tax system will have been capitalized into share prices, reducing the economic benefits to be expected from integration (Auerbach 1990).

As in the 1992 Treasury study, previous estimates of the economic benefits of integration have been significant, although they have varied in amount. For example, in the 1970s, the Congressional Joint Committee on Taxation estimated the welfare gains to be about $6 billion a year for shareholder allocation and about $3 billion a year for distribution-related integration (U.S. Congress 1977). Fullerton, King, Shoven, and Whalley (1981) reported an annual welfare gain of up to 0.8 percent of expanded national income. Henderson (1987) found that the annual cost of an unintegrated tax on corporations was about 3.5 percent of expanded national income, or about $150 billion in 1986 dollars. More recently, a Congressional Research Service report estimated that current law reduced economic welfare by 1.34 percent of annual consumption (Gravelle 1991).

Given the state of the art, these estimates should not be regarded as precise. /9/ Rather, the most important conclusion to be drawn from these studies is that the 1992 Treasury report confirmed the conclusion of previous analyses that there are significant gains in economic welfare to be had from integration in the United States. A more concrete estimate of benefits would depend on the details of the integration proposal, the model of the economy used to estimate the gains, and the method of financing integration.

2. REVENUE EFFECTS: The revenue effects of integration depend on not only the details of the integration proposal, but also on assumptions regarding the behavior response to integration. Using the behavioral consequences described above with regard to economic efficiency, the Treasury study estimated the annual revenue loss to be $13.1 billion for dividend exclusion integration and $14.6 billion for shareholder credit integration. The annual revenue loss from shareholder allocation was estimated to be $36.8 billion. On the other hand, the study concluded that its comprehensive business income tax would INCREASE revenues by $3.2 billion annually (or $41.5 billion with capital gains taxation of assets also subject to the business-level tax). It will be recalled that this proposal would tax all capital income at the entity level, so that, for example, corporate interest payments that now flow tax-free to foreign portfolio lenders and U.S. exempt institutions would be fully taxed because such payments would no longer be deductible.

Previous estimates also concluded that the revenue costs of integration would be significant. The Joint Committee on Taxation estimated the revenue cost of shareholder credit integration in the 1970s at $5 billion if corporate tax preferences were not passed through to shareholders, and exempt taxpayers were not eligible for credits (U.S. Congress 1977). The Treasury Department estimated the revenue cost of the President's 1985 proposal for a deduction of 10 percent of dividends to be about $6 billion after phasing-in (U.S. President 1985). And a 1991 Congressional Research Service study estimated the revenue costs of full shareholder credit integration to be about $30 billion annually (Gravelle 1991).

It seems likely that any integration alternative, other than the comprehensive business income tax, would by itself involve a revenue loss, although the amount of that loss will depend on the exact program proposed. Simply eliminating the double taxation of dividends would obviously lose more revenue than also assuring that all corporate income is taxed once, but only once. A shareholder credit for the full amount of corporate taxes paid with respect to dividends would involve a greater revenue loss than a partial credit, which has often been the initial approach to integration abroad. In the current budgetary climate, any integration program would have to be constructed with its revenue consequences taken into account, as well as plans for financing the program.

3. DISTRIBUTIONAL EFFECTS: Estimating the distributional effects of integration involves still further complexities. Once the behavioral responses to integration are identified and the resulting revenue costs are estimated, the distribution of those costs across income classes must be compared with the distribution of the current corporate tax. The current distribution has, however, long been controversial (McLure 1979, at 29-42). Although corporations pay corporate taxes, the burden of those taxes must ultimately be borne by some human beings. In theory, there are a variety of possibilities. Most obviously, shareholders might bear the burden as a result of lower dividends. On the other hand, corporate taxes might be shifted to consumers through higher prices or to workers through lower wages. Still another possibility is that investors respond to the separate corporate tax by investing less in corporate enterprise, and more in noncorporate enterprise, until the after-tax rates of return from the two kinds of investment are equal. The result of this equilibrating process would be that all owners of capital (corporate and noncorporate, business and residential) would bear the burden of the corporate income tax, because the after-tax return to all capital would be lower as a result of the tax. A final possibility is that the burden of the corporate tax system with respect to existing corporate capital has already been capitalized into share prices that are lower than they would be in the absence of the current system. On this hypothesis, current buyers of stock from other shareholders do not incur any significant detriment from present law.

The distributional consequences of any major corporate tax reform will depend on who is assumed to bear the burden of the current system. Consider the alternative hypotheses that the tax is borne entirely by shareholders or entirely by consumers. Because shareholding is more concentrated in upper-income brackets than is consumption, simple elimination of the additional burden of the corporate tax would have different distributional consequences under the two assumptions. Although the distributional burden of current law remains controversial, most economists probably accept the view that the corporate tax is borne by shareholders in the short run, but holders of all corporate capital, and perhaps workers, in the long run (Treasury 1992a).

The Treasury report accordingly analyzes the distributional consequences of integration under the alternative hypotheses that the long run incidence of the current corporate tax is entirely on holders of capital and that it is divided evenly between holders of capital and workers. As indicated above, the Treasury also assumed that revenue losses due to integration would be offset by increasing tax rates applicable to capital income generally. Under these assumptions, the Treasury concluded that shareholder credit integration dividend exclusion integration, and a comprehensive business income tax would have only a slight effect on the distribution of the tax burden across income groups.

As in the case of its estimates of welfare gains and revenue losses from integration, the Treasury's estimates of distributional consequences should not be accorded more precision than is warranted by the current state of the art. Rather, the most important conclusion to be drawn from the Treasury's discussion of the distributional consequences is simply that integration need not have a major effect on the distributional burden of corporate and individual income taxes. As emphasized in the Treasury report and previous studies (Feldstein and Frisch 1977; Gravelle 1991), the method of financing integration will have an important effect on these consequences.

Recapitulation

The basic case for integration is economic. The additional burden of the corporate income tax increases the cost of capital for U.S. companies, discourages new investment in corporate enterprise, and encourages the issuance of corporate debt. Thirty years ago, these were also the attributes of the corporate tax systems of our major trading partners. Since then, most other developed countries have adopted some version of integration, generally the shareholder credit approach. Integration of the U.S. corporate and individual income taxes would increase economic welfare by taxing all corporate income once, but only once.

There are a variety of tax policy choices to be made in designing an integration system, the most fundamental of which is whether the single tax to be applied uniformly to corporate-source income should be the individual investor's graduated rate (as in the ALI study) or a flat rate for business income (as in the Treasury study). The gains in economic welfare, as well as the revenue and distributional consequences of integration, would depend on the details of the program and how it was financed. On the assumption that the long run burden of the current tax falls most heavily on the holders of all capital, the Treasury study concludes that negative revenue and distributional consequences could be avoided by financing integration with an increase in tax rates applicable to capital income generally. Alternative means of financing integration, such as the adoption of a value-added tax, would have different consequences (Fullerton and Rogers 1993).

Given the case for integration, are there countervailing reasons for keeping a separate, additional corporate income tax? It is some times argued that an additional corporate tax is justified to offset the benefits of incorporation (Goode 1951), to capture windfall gains (Rudnick 1989), or to increase the progressivity of the federal income tax (Pechman 1985). None of these views provides a convincing reason for retention of the current U.S. system for taxing corporate income. First, it is widely agreed today that the burden of the corporate tax is ultimately borne by human beings, although there is less agreement about the identity of those human beings. Second, the current tax is not limited to windfall gains. (Proposals for a corporate tax limited to "extraordinary" gains are discussed below in Part II.) Third, the corporate income tax is a very inefficient and distortionary means of accomplishing income tax progressivity. Moreover, as discussed above, adoption of integration need not affect the current distribution of the tax burden.

Given the advantages of integration and its widespread adoption in other developed economies, why has it not already been enacted in the United States? When the matter was raised by the Carter and Reagan Administrations in the late 1970s and early 1980s, the U.S. corporate community was not uniformly enthusiastic, especially when the alternative was a reduction of corporate tax rates. This lack of enthusiasm is sometimes attributed to the myriad of tax preferences that selectively reduced corporate taxes for many industries prior to the Tax Reform Act of 1986. For some industries, adoption of corporate tax integration would have meant loss of their preferred tax position, considerably diluting their enthusiasm. The Tax Reform Act of 1986 eliminated many of these preferential provisions and reduced corporate tax rates generally, so this reaction should be less widespread today, particularly in light of increased concern about the international competitiveness of American companies.

OTHER PROPOSALS FOR REFORM

This part discusses four proposals for major corporate tax reform other than integration: (a) cash flow taxation of corporations; (b) a corporate deduction for the return on equity capital; (c) reform of the U.S. taxation of corporate mergers and acquisitions; and (d) tax incentives for certain corporate investments. The first and second proposals are often considered alternatives to integration, while the third and fourth address other issues.

Cash Flow Corporate Taxation

A longstanding alternative to personal income taxation is personal consumption (or expenditure) taxation, under which individuals would be taxed on what they spent on consumption, rather than on what they earned, during the taxable period. /10/ Since income is usually defined as the sum of consumption plus savings during the taxable period, personal consumption could be measured by subtracting savings from income. As shown in the following example, this form of CASH FLOW taxation is similar to taxing income from labor, but not capital. /11/

Consider a taxpayer who receives $100 in labor income in year 1, which he invests at a 10 percent rate of return for disinvestment and consumption in year 2. Under an income tax levied on both labor and capital income at the rate of 50 percent, the taxpayer would have $50 to invest in year 1, earn $5 in capital income in year 2, and have $52.50 to consume after paying year 2 taxes. Under an equivalent-rate expenditure tax that permitted a deduction for savings, the taxpayer could invest the entire $100 in year 1, earn $10 in capital income in year 2, and have $55 to consume after paying $55 in year 2 taxes. Under an income tax that reached labor income, but not capital income, the taxpayer would have $50 to invest in year 1, earn $5 in capital income in year 2, and again have $55 to consume because no taxes would be due in year 2. This equivalence often leads to the conclusion that capital income is implicitly exempt under an expenditure tax because the results are essentially similar to those under an income tax that explicitly exempts capital income. /12/ The government's revenue is distributed differently under the two taxes, but is equal in present value.

Although the Internal Revenue Code purports to levy an income tax, it is actually something of a hybrid. Some capital income, such as interest on bank deposits, is fully taxable under income tax principles. Other income, such as that deposited in qualified retirement accounts, is taxed under expenditure tax principles because it is not taxed until drawn down for consumption after retirement. Still other income, such as that on state and local bonds, is explicitly exempt. Proponents of moving the Internal Revenue Code further in the direction of pure consumption taxation usually argue that economic welfare would be increased by reducing the distortion between present and future consumption under an income tax, and that the tax system would be simpler as a result of effectively exempting capital income. Proponents of moving the Internal Revenue Code further in the direction of a pure income tax usually emphasize the goal of taxing the return from capital to the same extent as the return from labor.

This longstanding debate about whether personal income taxation should be replaced by a personal tax on cash flow has produced the correlative proposal that corporate income taxation be replaced by a corporate tax on cash flow (Institute for Fiscal Studies 1978; King 1987). There are several ways in which a corporate cash flow tax could be structured. First, all positive and negative cash flows from real, as opposed to financial, transactions could be taken into account in determining the corporation's annual tax base. The major changes from current law required by this approach would be: (a) the immediate deduction (or "expensing") of capital expenditures, such as the purchase of equipment; (b) the exclusion of interest receipts; and (c) the disallowance of interest deductions. A second approach to corporate cash flow taxation would be to take all business cash flows, real and financial, into account. Under this approach, all business receipts would be included in the tax base, while all business expenditures (including capital expenditures) would be deducted. This implementation would include gains from financial, as well as real, investments in the tax base. Finally, since the result of subtracting all business expenditures from all business receipts is net cash distributed to shareholders, a third way to implement a tax on corporate cash flow would be simply to tax distributions to shareholders. Net inflows from shareholders should produce refundable tax credits under this last approach.

As illustrated by the example above of a personal cash flow tax, the general effect of a corporate cash flow tax would be to reduce the effective rate of the tax to zero. What then are the advantages of such a levy over simple repeal of the corporate tax? First, the cash flow tax, in any of the three versions described above, would continue to collect revenue on income produced by pre-enactment corporate equity, which did not benefit from a deduction at the moment of investment. This approach would therefore avoid the possibility under integration of a windfall to current shareholders if the detriment of the current system has been capitalized in share prices. Second, the tax would allow the government to participate in the private sector return on new corporate equity. The Treasury would, in effect, contribute resources to corporations as a result of either the tax benefit from expensing capital outlays or the negative taxes on net cash inflows from shareholders. The Treasury would collect its proportionate share of the income produced by investment of those resources when it taxed business receipts that were not reinvested.

To recapitulate, a corporate cash flow tax would continue the current tax burden on income from old equity, while the return on new equity would be effectively exempt. Income earned through corporate enterprise would actually be tax-preferred under this proposal because, unlike other capital income, there would be no current tax burden at either the corporate or investor level on reinvested income. The proponents of a cash flow corporate tax usually also advocate replacing the personal income tax with a personal consumption tax, so that income from capital would be effectively exempt from taxation whether earned through corporate enterprise or not.

Deduction for the Return on Corporate Equity

As indicated above, one of the principal distortions of current law is that returns on corporate debt capital are deductible by the corporation if distributed as payments of interest, while returns on corporate equity capital distributed as payments of dividends are generally subject to double taxation. Two major proposals for a deduction for the return on equity have been recently developed.

1. DEDUCTION FOR PAYMENTS ON NEW EQUITY: The American Law Institute (1982, 1989) has published studies proposing a deduction for dividend payments with respect to new equity. These proposals are intended to address the distortions of current law described above, but without creating windfall gains for current shareholders. There are four principal proposals:

o Corporate Debt: Interest payments would be deductible only to

o Corporate Equity: Dividends on qualified equity capital would

o Nondividend Distributions: Major distributions to shareholders

o Intercorporate Equity Investments: Dividends received by one

The first proposal would limit the deductibility of interest payments to a return typical of corporate debt. The second proposal would eliminate the differential treatment of debt and equity under current law by extending the limited deduction for interest to dividends paid with respect to qualified contributed capital, which is essentially equity capital contributed after the date of the reform's enactment. Restriction of qualified capital to post- enactment contributions is intended to avoid the possibility of windfall gains to current shareholders, who are assumed to have benefited from reduced share prices because the additional burden of the unintegrated tax system has been capitalized into current share prices. The third and fourth proposals would achieve similar results for nondividend distributions.

Taken together, these four proposals would eliminate the additional burden of the corporate tax on income earned on corporate assets up to a specified return, by means of a deduction for interest and dividends paid with respect to debt and new equity. There would continue to be a double tax on the return on debt and new equity capital in excess of the specified rate and on the entire return to old equity. The minimum tax on nondividend distributions and related provisions would remove the preference for such distributions. These proposals thus differ from integration in two important respects. First, they attempt to avoid windfall gains by limiting the new system to new equity capital. Second, they continue a separate, additional corporate-level tax for corporate income in excess of the cost of debt capital, presumably on the theory that the excess is due primarily to economic rents.

2. ALLOWANCE FOR CORPORATE EQUITY: The Institute for Fiscal Studies recently published a proposal for reforming corporate taxation by introducing an annual deduction for the product of a specified rate of interest and the amount of a corporation's equity capital. According to the proposal, the "effect of such an allowance is to put equity finance in a company on a similar basis to that of debt finance, but without the inevitable cash out-flow associated with the payment of interest" (Institute for Fiscal Studies 1991, at 2). Like the ALI studies discussed immediately above, this proposal would limit deductibility of an equity return to the cost of debt capital, but unlike the ALI study, the deduction would not depend on actual payment of dividends. As a result, income from investment in corporate stock would be taxpreferred relative to other forms of investment income subject to current taxation, including corporate debt, because the interest component of the return on equity would not be taxed until distributed to the shareholder. The position of the British study is that the corporate tax should be considered separately from the individual income tax, and that defects in the latter, such as the failure to tax changes in share values, should be corrected at the shareholder level. This position should be contrasted with the premise of both integration and the limited deduction for payments on equity. These latter two reforms are based on the premise that corporate and individual income taxation should be designed together to implement a coherent system.

In summary, corporate profits under the allowance for corporate equity would be taxed at the corporate level only to the extent they exceeded a "normal" return and at the shareholder level only on distribution. /13/ This result would be more consistent with cash flow taxation at the investor level than with income taxation of investors as in the United States.

Like a corporate cash flow tax, a deduction for the return on corporate equity can be considered an alternative response to the defects of current law addressed by integration. Our discussion of these two alternatives has not been at the level of detail of our discussion of integration because these alternative approaches have not yet resulted in proposals as fully developed as those for integration. Nonetheless, many of the issues discussed above with respect to integration, such as the treatment of exempt and foreign shareholders, would also have to be addressed in the design of a legislative program based on these alternatives.

We now turn to two proposals for reform that address other issues, the taxation of corporate acquisitions and the possibility of preferring certain corporate investments.

Mergers and Acquisitions

U.S. tax law has long distinguished between nontaxable and taxable corporate acquisitions. /14/ Transactions in the first category, such as a merger of two companies pursuant to a state corporate law statute, benefit from nontaxability at both the corporate and the shareholder levels. The basic rationale is that these transactions only involve changes in the form of business organization. The web of statutory and judicial rules that categorize asset sales, stock purchases, mergers, and other transactions as either taxable acquisitions or nontaxable reorganizations is extraordinarily complex. As a result of this complexity, corporate acquisition transactions in the United States are often structured to satisfy the tax law, creating additional transactions costs. Quite apart from these problems, there has been ongoing congressional concern in recent years that the tax system not create incentives for corporate mergers (U.S. Congress 1989a and 1989b).

The American Law Institute (1982, 1989) has proposed that the longstanding and extremely complex provisions of current law be replaced for corporate tax purposes by a simple dichotomy between carryover-basis transactions and cost-basis transactions. /15/ In carryover-basis transactions, the transferring company does not recognize gain on the transfer, and the acquiring company carries over the transferor's cost basis in its assets, so any currently untaxed gain will be taxed on a future disposition of the assets. In cost-basis transactions, the transferring company recognizes gain, and the acquiring company increases asset basis to reflect its cost. This dichotomy has long been implicit in existing law in that purchases of shares by one corporation in another receive carryover- basis treatment, as do nontaxable reorganizations, while sales of corporate assets receive cost-basis treatment.

Whether or not a particular transaction would be subject to cost-basis or carryover-basis taxation at the corporate level would be elective. /16/ As long as the parties were consistent in terms of corporate taxation, they could choose to classify a transaction as either carryover-basis or cost-basis regardless of (1) whether the consideration paid by the acquiring corporation was stock, debt, or cash; and (2) whether the acquiring corporation obtained the target's assets or stock. The major constraint on electivity would be that nonrecognition of gain to the target corporation in a carryover-basis acquisition of assets would require the target to liquidate and distribute to its shareholders the consideration received in the transfer.

The recommendation that the choice between carryover-basis and cost-basis taxation be made explicitly elective is justified in the proposals primarily on the ground that the choice is often effectively elective under current law because taxpayers are free to cast their transactions in the corporate form (asset sale, stock sale, or reorganization) that produces the desired tax results. On the other hand, where nontax reasons control the form of the transaction, tax consequences under current law can differ for substantially similar transactions. Explicit electivity would accordingly further the goals of simplification and transactional neutrality.

This explicit electivity has been controversial because it would appear to be inconsistent with the very idea of levying a tax on realized corporate gain. What could be more clearly realized corporate gain than the sale of corporate business assets for cash? Why then should a sale of a corporate business for cash be eligible for carryover-basis taxation, even if internal corporate tax consistency is maintained? The usual answer to these questions is found in the limitation of carryover-basis treatment of such sales to cases in which the target corporation liquidates and distributes to its shareholders the consideration received from the acquiring company. Accordingly, the ALI approach would mandate EITHER corporate or shareholder realization on the sale of a corporate business for cash.

This reform would be consistent with the view that the corporate tax should be designed to protect the individual income tax base. From this perspective, a corporate income tax on operating income is needed in order to prevent the corporation from becoming a tax shelter, in which income could be accumulated without current taxation at the shareholder level. On this protective rationale, a corporate level tax is not necessary upon the sale of an entire corporate business for cash, as long as shareholder gain is then realized because gain on business assets would not be taxable until sale, whether held in corporate form or not.

The ALI approach would not, on the other hand, be consistent with a view of the corporate tax as fundamentally separate from, rather than protective of, individual taxation, so all corporate gain should be taxed as soon as realized even if there is simultaneous shareholder taxation. From this perspective, the approach of current law to mergers and acquisitions should be substantially simplified and refined, but not radically restructured. The American Bar Association Tax Section (1981) has formulated reform proposals based on this more limited premise.

Incentives for Certain Corporate Investments

Because of its pervasive reach, the corporate income tax has often been used as a policy instrument to encourage or discourage corporate investment choices. As in many countries, the effective tax rate on different categories of corporate income in the United States has varied greatly as a result of depreciation schedules and an investment tax credit that applied differently to different corporate investments (King and Fullerton 1984). The fundamental policy decision embodied in the historic Tax Reform Act of 1986 was to reduce this differential treatment in exchange for a general reduction in corporate tax rates. There was both an economic and an administrative reason for this decision. The economic reason was that the market, rather than the political process, was thought to be better at allocating corporate investment among competing alternatives. From this perspective, the tax system should strive for neutrality among investments in order to avoid distorting economic decisions. The administrative reason was that a system of generally high tax rates with preferential treatment of particular categories of income creates expensive disputes about whether certain transactions fall within the preferred category. One of the prime examples of this tendency was the development of the tax shelter industry in the United States prior to 1986. An income tax system that is neutral with respect to economic decisions avoids the waste of transaction costs incurred to take advantage of tax nonneutralities.

The basic philosophy behind the Tax Reform Act of 1986 is not universally shared. Groups promoting their own views of good economic policy continue to urge use of the tax system to accomplish their goals. For example, the Bush Administration attempted to convince Congress to substantially lower capital gains rates to stimulate investment. The Council on Competitiveness (1993) has urged adoption of an investment tax credit to improve the competitiveness of certain U.S. industries. And the Clinton Administration's initial tax program included a proposal for a tax credit for incremental investment. In some cases, proposals to favor certain categories of corporate investment are made without a solid grounding in economic theory and empirical analysis (Gravelle 1993).

It has, however, recently been argued that investment in equipment is empirically associated with economic growth, so that an investment tax credit limited to equipment would be justified by the beneficial externalities associated with this type of asset (De Long and Summers 1991 and 1992). If it could indeed be demonstrated that there were significant economic benefits to society that would not be fully valued by private purchasers of equipment, a corporate tax subsidy for this category of investment could be justified as correcting a market failure. To date, however, the empirical basis of the assertion that investment in equipment has a causal relationship with economic growth has not been generally accepted by economists (Auerbach, Hassett, and Oliner 1993). Accordingly, the case for abandoning the principle of tax neutrality remains undemonstrated.

CONCLUSIONS AND RECOMMENDATIONS

There is very little dispute about the defects of the current U.S. corporate income tax system. Its principal distortions include: a disincentive for individuals to invest in new corporate equity; an incentive for corporations to finance new projects by issuing debt or using retained earnings, rather than issuing equity; an incentive to retain, rather than distribute, corporate earnings under certain rate relationships; and an incentive to make distributions in tax- preferred forms. The result of these distortions is an increase in the cost of capital for U.S. companies, as well as legal distinctions that are difficult, if not impossible, to apply in practice. In addition, certain areas of corporate tax law, such as that applicable to mergers and acquisitions, impose considerable transaction costs due to their extraordinary complexity.

Given the defects of current law, which reform alternatives should be pursued? The answer depends largely on the goals considered appropriate for income tax policy at the end of the 20th century because different proposals would accomplish different goals. For example, a corporate cash flow tax would implement the policy goals of taxing income on new corporate investment at an effective corporate rate of zero, thereby creating a tax preference for such income, which would not be taxed to shareholders until distributed. The dividend exclusion preferred by the Treasury in 1992 would, on the other hand, reduce the distortions of current law on the premise that all corporate income should be taxed only once, at a flat rate as it is earned. The limited deduction for dividends on new equity is a response to those distortions that is premised on the primacy of avoiding wind-falls to current shareholders.

What then should be the goals of U.S. tax policy with respect to corporate income in the 1990s? Economic theory and practical experience suggest that economic welfare is maximized when the tax system is as neutral as possible among different categories of investment. American political history suggests that Americans want a progressive income tax to be a principal source of federal revenue. If economic neutrality and progressive taxation are accepted as premises for U.S. corporate tax policy at the end of the 20th century, the preferable response to the defects of current law is shareholder credit integration, which is also the approach that has been most widely adopted by other countries with large developed economies. Under this approach, all corporate income is ultimately taxed once, but only once, at the shareholder's graduated rate. Concerns about the distributional effects of integration, including the possibility of windfalls to current shareholders, could be taken into account in considering financing alternatives.

Shareholder credit integration would be fully consistent with reform of the taxation of corporate mergers and acquisitions, whether along the lines proposed by the ALI or otherwise. It would also be consistent with preferential treatment of certain categories of corporate investments, although the current budgetary situation suggests that any such preference should be supported by a convincing showing of the economic benefits to be realized.

FOOTNOTES

/1/ Internal Revenue Code of 1986 (hereinafter I.R.C.) Section 871(h) exempts interest paid to foreign holders of portfolio debt.

/2/ The reaction of the capital markets to taxation may also affect the incentive to retain or distribute corporate earnings.

/3/ Countries with fully or partially integrated tax systems

/4/ The author of this paper was also the author of the ALI

/5/ I.R.C. Sections 871, 881. The level of these taxes is a

/6/ I.R.C. Section 901.

/7/ Corporate shareholders, on the other hand, would generally

/8/ For an explication and comparison of the two views, see

/9/ Nor should they be regarded as indicating that the

/10/ The literature on the advantages and disadvantages of personal consumption taxation, as compared with personal income taxation, is extensive. For discussions of the principal issues in the United States, see Andrews (1974), Graetz (1979), Warren (1980), and Bradford (1984).

/11/ This equivalence was first noted in Brown (1948). In terms of simple algebra, a tax at a rate of t on labor income of I would leave (1-t)I after taxes, which would compound to produce (1- t)I(1+r)y for consumption if invested at a pre-tax rate of return r for y years. A consumption tax would permit the entire amount of labor income to be invested in the year it was earned, yielding I(1+r)y after y years and (1-t)I(1+r)y in after-tax consumption.

/12/ The exact equivalence in this simple example assumes that interest and tax rates would be the same under the two taxes. For a discussion of these and other assumptions underlying the equivalence, see Graetz (1979).

/13/ As proposed, the allowance for corporate equity would replace the integration system currently in effect in the United Kingdom.

/14/ I.R.C. Sections 354-368.

/15/ The staff of the U.S. Senate Finance Committee subsequently developed legislative recommendations that followed the basic approach of the ALI proposals. (U.S. Congress, 1983 and 1985).

/16/ Whether shareholders would be taxed would depend on the nature of the consideration received. In general, stock for stock exchanges would not be taxed, on the theory that the underlying investment had not significantly changed.

END OF FOOTNOTES

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