Taxation in the Global Economy

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Taxation in the Global Economy

As global competitiveness has climbed higher on the policy agenda, it is no surprise that the role of tax policy in the decline of U.S. economic dominance has come under critical review. Tax policy has been blamed for our low saving rate--which leads to a current account deficit; the increase in foreign direct investment in the United States; and the inability of U.S.-based multinationals to compete abroad on a level playing field.

Much of my recent research has been aimed at rethinking the effects and structure of tax policy in an increasingly interdependent world economy. Globalization demands a rethinking of these issues, because it has profound implications for tax systems, raising new questions and changing the answers to old ones.

The Pitfalls of Myopic Tax Policymaking

Consider tax policymakers who mistakenly believe, or act as if, their country's economy were completely closed. What missteps would they be tempted to make? At least four come to mind.(1) They might:

1. see key sectors and tax revenues dwindle as other countries set their tax systems to complete away capital and the tax revenues from capital income;

2. forgo opportunities to take advantage of foreign investors and governments; large countries can exploit their market power, but all countries can take advantage of the arrangements that their trading partners use to alleviate double taxation;

3. overestimate the ability to place the burden of taxation on capital owners; the apparent progressivity of capital taxation may be illusory, as international capital mobility implies that it ultimately may be borne by owners of relatively immobile factors, such as labor and land; in that case, taxes levied directly on land and labor have about the same incidence as capital taxes but do not distort the locational efficiency of capital; and

4. underestimate the potential importance of multilateral tax agreements that help preserve the efficient functioning of the world economy.

Avoiding these missteps in designing policy requires a clear understanding of how taxes affect economic behavior in an open environment.

Foreign Direct Investment

Foreign direct investment (FDI) to and from the United States now is more than five times its level of a decade ago. The growing presence of foreign multinationals has prompted concern about the impact of FDI on the economy and the role of the tax system in encouraging it.

Tax policy can affect FDI in complicated ways, because often both the host country (where the FDI is located) and the home country (where the firm is headquartered) assert the right to tax the income from FDI, with limited harmonization of the tax systems. Of the major countries whose firms invest in the United States, some tax the income from FDI--but allow a credit for taxes paid to the United States--while others completely exempt the income from FDI from home country taxation. This raises the interesting possibility that, for investment from the first group of countries (predominantly Japan and the United Kingdom), taxation of inward FDI by the United States would raise revenue but would not be a disincentive to investment, because any taxes paid to the U.S. government would be offset by credits offered by the home country. This is an intriguing possibility; if true, it represents an opportunity to pass the burden of taxation along to nonresidents.

To test for this possibility, I disaggregated the data on inward FDI to the United States by the major capital-exporting countries to see if, as theory would suggest, FDI from countries that do not tax foreign-source income is more sensitive to U.S. tax rates than FDI from countries that attempt to tax foreign-source income but allow a credit for U.S. taxes.(2) The analysis did not reveal a clear differential responsiveness between these two groups of countries. …