High tax rates at root of tariff battles

Another Monday, another rough week ahead for the US Congress. Today the European Commission is set to impose retaliatory tariffs on US exports. The idea is to punish the recalcitrant US for granting its exporters tax breaks repeatedly ruled impermissible by the World Trade Organisation.

That means there are already any number of complex plans and compromises on the legislative table in Washington. The real challenge is to find a simple solution. But that is probably too much to expect of a body as confused and beholden as Congress.

Consider the seemingly endless international tax saga. The problem is obvious: America's corporate tax rate of 35 per cent is too high - particularly so considering how other nations have lowered their rates in recent years. You do not have to be Spinoza, or even a tax lawyer, to see the solution here. Lower the US corporate tax rate enough and corporations will no longer need to spend huge amounts lobbying for export breaks. The US would grow like Ireland or an Asian tiger, not just for the occasional quarter, but year in, year out; and Europe would have no grounds for a trade war. Sounds like a job for those tax-hating Republicans - an urgent one, which is why John Snow, the US Treasury secretary, urged Congress last week to act fast.

There is another solution that is nearly as obvious: end the US system of global taxation. Currently Washington taxes US companies on their activities worldwide. Companies are obliged to pay taxes to two governments: the foreign government where they maintain subsidiaries and the US government. Despite offsetting arrangements, sometimes the rate effectively ends up higher than 35 per cent. This contrasts with the territorially based tax regimes of many other nations.

The US claims that any external challenge to its global tax empire is a challenge to its sovereignty. That is correct. But there is also no denying that America's worldwide system hurts US competitiveness. It encourages start-ups to base themselves abroad. It also encourages US companies to defer their tax obligations to Washington by reinvesting profits earned by foreign subsidiaries in those same subsidiaries. Opportunities at home are sometimes forgone. This is one area where the protectionist allegation that cash might be better spent within US borders could be correct.

All this, however, is too straightforward for US lawmakers, who prefer travelling the long way round to reach their destination - with plenty of stops to help the Boeings of this world and squabbling with fellow party members. After all, Congress spent decades designing tax breaks for exporters to mitigate the pain of high rates, from the current Extraterritorial Income Exclusion Act back to the Foreign Sales Corporation (FSC) provision to, even before it, the oxymoronic Domestic International Sales Corporation regime, or Disc - even though the WTO and its forerunner, the General Agreement on Tariffs and Trade, objected to or threw out one break after another.

And so the complexity grows. Some members of Congress, for example, see in the European threat a chance to get into the already red-hot outsourcing debate. They want to use the European Union challenge to subsidise US manufacturing jobs. Charles Grassley, the Republican chairman of the Senate Finance Committee, supports breaks for manufacturers, as do many Democrats.

But such a perverse switch would widen incentives to sustain manufacturing jobs when the US is amid an inevitable shift to a service economy. In other words, the plan distorts the allocation of capital in the name of conforming with the WTO's free trade ideal.

Then there are the lawmakers who see in the whole debate a chance for extra revenue. Repealing the export tax breaks alone would be worth tens of billions; but some lawmakers have other projects that might mean yet more cash. Phil English, a Republican congressman from Pennsylvania, for example, would like to grant companies a year's holiday during which they might repatriate their profits at a low "toll tax" rate of 5.25 per cent. The lure of the instant revenue - estimated at $4bn - appeals to a deficit-obsessed Congress.

Yet another idea comes from Bill Thomas, a Republican from California and chairman of the House Ways and Means Committee. Mr Thomas would like to streamline the practice of deferring tax by reinvesting profits overseas. In the world of ideal tax policy this may be another form of distortion. Still, it would move the US towards the system of territoriality, thereby enhancing the competitiveness of US companies abroad. It would also smooth out other infelicities in the US arrangement. As Dan Mitchell of the Heritage Foundation notes, the Thomas bill "makes lemonade out of lemons" - it uses the EU threat to make the US code more competitive. Or at least a bit more.

But we almost forgot: some lawmakers are doing the simplest thing. Senators Jon Kyl and Don Nickles want to lower the corporate tax rate by several percentage points for all companies. This plan has the advantage of being clear, obvious and universal. It also has the least chance of passage: Mr Grassley, their fellow Republican, has made a point of opposing it.

© Copyright 2004 Financial Times

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