- The Washington Times - Wednesday, March 1, 2000

The World Trade Organization last week ruled that a U.S. policy of granting special tax preferences to companies that export is a violation of the rules. The United States now has until Oct. 1 to either change its tax laws or face retaliatory sanctions that could reach $6 billion annually.
At first glance, this puts U.S. policy-makers in a terrible position. If they get rid of the relevant section of tax law (which allows American corporations to set up tax-exempt subsidiaries in dependent territories such as the U.S. Virgin Islands), they impose a hefty tax increase on some of the nation's most successful exporters. Yet if they ignore the WTO, the Europeans would be allowed to impose an equivalent amount of taxes on U.S. products. In either case, American exporters get the short end of the stick.
Some have reacted to this ruling by condemning the WTO. Claims of anti-American bias, however, seem implausible. The WTO, after all, recently has handed the United States major victories in decisions regarding bananas and hormone-fed beef. Nor is this an attack on U.S. sovereignty. American lawmakers are free to leave the law as it is now albeit at the cost of letting the Europeans impose additional taxes on our exports.
Instead of attacking the WTO, policy-makers should point the finger of blame at themselves. For if this story has a villain, it is the tax code. More specifically, U.S. law taxes companies on both the profits that they earn in the United States and the profits that they earn overseas. This is bad tax policy. Indeed, if there is a silver lining to the dark cloud the WTO has created, it is that policy-makers will seize this opportunity to repeal our tax code's onerous foreign provisions and instead shift to a "territorial" tax system.
Making U.S. companies pay tax on their "worldwide" income, as we do now, is misguided and inefficient. While it may seem that taxing U.S. companies on the money they earn in other nations would be a sure money-raiser, this simplistic analysis overlooks the fact that companies also are given a credit to reflect the taxes that they pay to the governments of these other nations (this is done to prevent the same income from being taxed two times). And since most other countries impose higher tax burdens than the United States, these credits offset a big chunk of the revenues that otherwise would be collected. As a result, the biggest effect of the law is to impose huge compliance costs on business.
A territorial system, by contrast, would solve this problem. Under this type of system which is used by most other nations a government only taxes the income that is earned inside its borders. The U.S. government, for example, would tax General Motors and Microsoft on all profits earned in the United States. But it would also tax all profits earned in the United States by Toyota and British Petroleum.
Any profits earned in other nations, however, would be subject to taxation by those other nations. If Microsoft earns a profit because of its British operations, Britain would tax those profits. This type of system is both economically rational and dramatically simpler to administer. To be sure, some tax lawyers and IRS agents would lose their jobs, but most Americans would consider that a collateral benefit.
It also turns out that the right tax policy is the right trade policy. In its decision, the WTO clearly stated that a territorial tax system would comply with international trading rules.
This raises the obvious question: How will U.S. lawmakers respond to the WTO ruling? The options are limited. They can meekly comply with the WTO decision by eliminating the tax preference and thereby raise taxes on exporters. They can foolishly ignore the WTO and thereby expose U.S. exporters to additional trade taxes. Or they can do the right thing, simplifying our tax system and making U.S. companies more competitive by shifting to a territorial system.
In the final analysis, politicians will probably choose none of the above,and instead seek to replace the tax preference the WTO rejected with a new set of tax breaks that would benefit the same companies. Needless to say, this would not be the simple approach. And, yes, it could leave the U.S. vulnerable to another adverse ruling from the WTO.
So why would lawmakers reject the simple approach and instead do something risky and convoluted? Because doing the right thing solves the problem, meaning that companies would no longer need to contribute money in the endless chase for special tax breaks. Doing the right thing also would make it harder for legislative staff members to get lucrative jobs explaining what the tax law actually means.
In short, the territorial tax system would be good for the United States but bad for the political elites. That is why doing the right thing is always an uphill battle.

Daniel J. Mitchell is the McKenna senior fellow in political economy at the Heritage Foundation.

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