This Page Intentionally Left Blank
Taxation in the Global Economy
A
National
Bureau
of
Economic Research
Project Report
Taxation in
the
Global
Economy
Edited by
Assaf Razin and
Joel Slemrod
The University
of
Chicago Press
Chicago
and London
The University
of
Chicago Press, Chicago 60637
The University of Chicago Press, Ltd., London
0
1990 by the National Bureau
of
Economic Research
All rights reserved. Published 1990
Paperback edition 1992

the American National Standard for Information Sciences-Permanence
of
Paper
for
Printed Library Materials, ANSI 239.48-1984.
National Bureau
of
Economic Research
Officers
George
T.
Conklin, Jr., chairman
Paul W. McCracken, vice chairman
Martin Feldstein, president and
Geoffrey Carliner, executive directot
Charles A. Walworth, treasurer
Sam Parker, director
of
finance and
chief executive ofJicer administration
Directors at Large
John H. Biggs
Andrew Brimmer
Carl F. Christ
George
T.
Conklin,
Jr.
Kathleen B
.

James
L.
Pierce, California, Berkeley
Andrew Postlewaite, Pennsylvania
Nathan Rosenberg, Stunford
Harold
T.
Shapiro, Princeton
Burton A. Weisbrod, Wisconsin
Michael Yoshino, Harvard
Arnold Zellner, Chicago
of
Technology Craig Swan, Minnesota
Directors by Appointment
of
Other Organizations
Richard
A.
Easterlin, Economic History
Gail Fosler, The Conference Board
A. Ronald Gallant, American Statistical
Bruce Gardner, American Agricultural
Robert
S.
Hamada, American Finance
Robert C. Holland, Committee for Economic
Association
Association
Economics Association
Association

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1926,
as
revised through September
30,
1974)
Contents
Preface
Introduction
Assaf Razin and
Joel
Slemrod
I.
AN OVERVIEW
OF
THE
U.S.
SYSTEM
OF
TAXING INTERNATIONAL TRANSACTIONS
1.
Taxing International Income: An Analysis
of
the
U.S.
System and Its Economic
Premises
Hugh
J.
Ault and David F. Bradford
Comment:

Weiner
Comment:
Lorraine Eden
ix
1
11
55
79
123
vii
viii
Contents
5.
Coming Home to America: Dividend
Repatriations by
U.S.
Multinationals
161
James R. Hines, Jr., and R. Glenn Hubbard
Comment:
Mark A. Wolfson
111.
THE EFFECT
OF
TAXATION
ON
TRADE
AND
CAPITAL
FLOWS

Comment:
Alan J. Auerbach
IV. IMPLICATIONS
FOR
OPTIMAL TAX POLICY
9.
10.
11.
Integration
of
International Capital Markets:
The Size
of
Government and Tax
Coordination
33
1
Assaf Razin and Efraim Sadka
Comment:
Jack M. Mintz
The Linkage between Domestic Taxes and
Border Taxes
357
Roger
H.
Gordon and James Levinsohn
Comment:
John Whalley
The Optimal Taxation
of

a tax system. These papers were presented at a
conference attended by academics, policymakers, and representatives of
international organizations. The conference was held in Nassau, the
Bahamas on
23-25
February
1989.
We would like to thank the Ford Foundation for financial support of this
project. The success of the project also depended on the efforts
of
Kirsten
Foss Davis, Ilana Hardesty, Robert Allison, and Mark Fitz-Patrick.
Assaf
Razin
and
Joel
Slemrod
ix
This Page Intentionally Left Blank
Introduction
Assaf Razin and Joel Slemrod
The globalization of economic activity over the past three decades is widely
recognized. Despite recent indications of renewed protectionism, this trend
is likely to continue. With the integration of international activity has come the
awareness that countries are linked not only by the cross-border transactions
of private firms and citizens but also by the cross-border ramifications of their
governments’ fiscal policies. The tax policy of one country can affect economic
activity in other countries, and in the choice of tax policy instruments a
policymaker must consider its international consequences.
Examples of the growing awareness of fiscal interdependence abound. The

International Monetary Fund.
Joel
Slemrod
is professor
of
economics, professor of business
economics and public policy, and director
of
the Office
of
Tax
Policy Research at the University
of
Michigan, and a research associate
of
the National Bureau of Economic Research.
1
2
Assaf
Razin
/Joel
Slemrod
Finally, there is a growing sense that the internationalization of financial
markets and the increased importance of multinational enterprises
are
making it increasingly difficult to administer and enforce efficient and
equitable income tax systems.
Tax
authorities must balance, on the one
hand, their desire to preserve their national revenues and, on the other hand,

the wealthowner or controller of the
income-earning capital. Many countries, including the largest economies in
the world, also assert the right to tax the income of their residents,
individuals and corporations, regardless of where the income is earned (the
“worldwide” system
of
taxation). In order to reduce the tax burden that
would result from taxation by both host and home countries, those countries
that use the worldwide system of taxation generally allow taxes paid to
foreign governments to be credited against domestic tax liability, but this is
subject to various limitations. In addition, a network of bilateral treaties has
sprung up to coordinate taxation in the case
of
overlapping jurisdictions. The
United States is an example of a country that operates a worldwide system of
taxation and
is
also party to a number of bilateral tax treaties. Its system of
taxing foreign-source income has had a great influence on other countries.
This system, though, has undergone continual change, and the Tax Reform
Act
of
1986
continued the process of change.
In the opening chapter of this volume, Hugh
J.
Ault and David
F.
Bradford
describe the basic rules that govern the U.S. taxation of international

of the book.
Taxation and Multinationals
Multinationals pose special problems for taxing authorities because the
geographic source of income is not easily determined. Overlapping tax
jurisdictions, which generally employ different tax bases and rules, add
enormously to the complexity of tax compliance and administration. They
also can create opportunities for multinational companies to play the national
tax systems against each other to reduce their worldwide tax payments. The
concern for tax minimization can create incentives for real and financial
strategies that would, in the absence of taxation, make little sense.
The next set of four papers examines several ways that the tax system
affects the decisions of multinational corporations. The first two papers study
its impact on foreign direct investment, and the next two examine two
aspects of financial behavior that are affected by taxation.
Foreign direct investment (FDI) has surged dramatically in recent years.
FDI
into the United States reached $57 billion in 1988, after averaging only
$4.1 billion in the 1970s and $18.5 billion in the 1980-85 period. Outward
foreign investment from the United States in 1987 was $45 billion compared
to an average of only
$10
billion in 1977-84. The FDI of some other
countries, particularly Japan, has grown even more rapidly than that of the
United States.
The taxation system of the potential host country of an investment and
home country
of
the multinational can affect the
after-tax return, and
therefore the incentive, for foreign direct investment. Each of the following

does not show a clear differential responsiveness between these two groups,
suggesting either difficulties in accurately measuring effective rates of
taxation or the existence of financial strategies that render ineffective
attempts by the home country to tax foreign-source income.
Two of the chapters focus on how multinationals adjust their accounting
and financial policies in response to the tax system. Jean-Thomas Bernard
and Robert J. Weiner present a case study of transfer pricing practices in the
petroleum industry. By setting the price of interaffiliate transactions, a
multinational enterprise can affect the allocation of taxable profits among the
countries in which its subsidiaries operate in order to reduce the worldwide
tax burden of the multinational. Using data on oil imports in the United
States from
1973
to
1984,
they find that the prices set in interaffiliate
transactions differed from the price set by unaffiliated parties
(“arm’s
length” prices) for oil imported from some, but not all, countries. The
average difference in price was small, however, representing
2
percent or
less of the value of crude oil imports. Furthermore, the observed differences
across exporting countries between
arm’s
length and transfer prices are not
easily explained by average effective tax rates in the exporting countries.
Their results thus provide little support for the claim that multinational
5
Introduction

of
these incentives, Hines and Hubbard examined
data collected from tax returns for 1984 on financial flows from
12,041
foreign subsidiaries to their 453
U.S.
parent corporations. They found that,
although on average dividend repatriations composed 39 percent of
subsidiaries’ after-foreign-tax profits, most subsidiaries paid no dividends at
all. The pattern of repatriations was related to the tax cost,
so
that in net
terms the
U.S. government collected very little revenue on the foreign
income of
U.S.
multinationals while at the same time the
tax
system is
apparently distorting their internal financial transactions.
The Effect
of
Taxation on Trade and Capital Flows
The international ramifications of tax policy go far beyond the impact on
multinationals’ behavior. The tax policy of one country can “spill over” to
other countries’ economies thereby affecting trade patterns, the volume of
saving and investment, and the desired portfolios of wealthholders. Each of
the next set
of
three papers addresses one aspect of how tax policy in one

The analytical results are supplemented by detailed dynamic simulations
which highlight the variety of mechanisms through which the effects of tax
policies spill over
to
the rest of the world.
Martin Feldstein and Paul Krugman scrutinize the view, common among
many businesspersons, that reliance on the VAT aids
a
country’s interna-
tional competitiveness since such a tax is levied on imports but rebated on
exports. They claim that in practice VATS are selective and fall more heavily
on internationally traded goods than on nontraded goods and services. In this
case, use of a VAT causes a substitution of nontraded goods and services
which reduces both exports and imports, but the trade balance can either
improve
or
worsen. The only pro-competitive aspect of a VAT may be the
fact that substituting a consumption tax for an income tax encourages saving
which, by itself, tends to improve the trade balance in the short run.
A. Lans Bovenberg, Krister Anderson, Kenji Aramaki, and Sheetal
Chand deal with the effects of the tax treatment of investment and savings on
international capital flows. They evaluate changes in tax wedges on savings
and investment in the
U.S.
and Japan and examine how recent reforms
of
capital income taxation created incentives for bilateral capital
flows
between
these countries during the

Assaf Razin and Efraim Sadka address two policy issues in the context of
world capital market integration: (a) the effects of relaxing restrictions
on
the
international flow of capital
on
the fiscal branch
of
government and (b) the
degree
of
international tax coordination needed to ensure a viable equil-
ibrium in the presence of international tax-arbitrage opportunities.
First, Razin and Sadka show that notwithstanding the use of distortionary
taxes as part of the optimal program, it requires an efficient allocation of
investment between home and foreign uses
so
that the marginal product of
capital is equated across countries. Consequently, capital-market liberaliza-
tion tends to lower the cost of public funds and increase the optimal
provision of public goods and services. More public goods are demanded
because of the increase in real income resulting from the improved trade
opportunities and because broadening the tax base lowers the marginal cost
of public funds through a distortion-reducing change in the marginal tax
rates.
Second, they remind us that a complete integration of the capital markets
between two countries requires that the residents of each country face the
same net-of-tax rate of return
on
foreign and domestic investments.

border distortions (tariffs, export subsidies, etc.) may result from a country’s
attempt to offset the trade distortions created by their domestic tax structure.
To
examine this hypothesis, they look at International Monetary Fund
financial statistics for thirty countries during the period
1970-87.
The data
suggest that, while for poorer countries border taxes do seem to offset the
trade impact of domestic taxes, the richer countries have significant
trade-discouraging distortions caused by domestic taxation that are not offset
by border taxation.
8
Assaf Razin
/Joel
Slemrod
The final chapter, by John Douglas Wilson, deals with the optimal tax
structure for an open economy in which similar types of workers are paid
different wages since worker productivity in some industries depends on the
level of wages (the efficiency wage model). The first-best optimal policy, an
industrial policy which subsidizes high-wage firms, is not obtainable either
due to asymmetric information between the government and the firms or
because employment subsidies lead to increased efficiency at the cost of a
less equitable income distribution. Consequently, a second-best policy of
capital-market intervention is desirable.
A
role for capital-market interven-
tion as a second-best policy emerges only when there exist capital-market
asymmetries.
A
somewhat surprising result of the analysis is that if the

of
Taxing International
Transactions
This Page Intentionally Left Blank
1
Taxing International Income: An
Analysis
of
the U.S. System
and Its Economic Premises
Hugh
J.
Ault and David
F.
Bradford
International tax policy has been something of a stepchild in the tax
legislative process. The international aspects of domestic tax changes are
often considered only late in the day and without full examination. As a
result, the tax system has developed without much overall attention to
international issues. This paper is an attempt to step back and
look
at the
system that has evolved from this somewhat haphazard process.
We will describe in general terms the basic
U.S.
legal rules that govern the
taxation
of
international transactions and explore the economic policies or
principles they reflect. Particular attention will be paid to the changes made

to
acknowledge financial support provided by Princeton University
and by the John
M.
Oh Program at Princeton University for the Study of Economic
Organization and Public Policy.
11
12
Hugh
J.
AddDavid F. Bradford
1.1
Basic Jurisdictional Principles
1.1.1
Domiciliary and Source Jurisdiction
U.S.
persons are subject to tax on a worldwide basis, that is, regardless of
the geographic “source” of their income. Traditionally, this principle has
been referred to as “domiciliary”- or “residence”-based jurisdiction since it
is based on the personal connection of the taxpayer to the taxing jurisdiction.
In contrast, foreign persons are subject to tax only on income from “U.S.
sources” and then only on certain categories of income. Individuals are
considered U.S. persons if they are citizens of the United States (wherever
resident) or if they reside there.’ Corporations are considered U.S. persons if
they are incorporated in the United States. The test is purely formal, and
residence
of
the shareholders, place of management of the corporation, place
of business, and
so

income.
A
complex series of somewhat arbitrary rules is used to establish
source. For example, income from the sale of goods is sometimes sourced
in
the country in which the legal title to the goods formally passes from the seller
to the buyer.
1.1.2
Overlapping Tax Jurisdiction and Double Taxation
Where several countries impose both domiciliary- and source-based
taxation systems, the same item of income may be taxed more than once. For
example, if a
U.S.
corporation has a branch in Germany, both the United
States (as the domiciliary country) and Germany (as the country of source)
will in principle assert the right to tax the branch income. It has been the
long-standing policy of the United States to deal with double taxation by
allowing U.S. taxpayers to credit foreign income taxes imposed on
foreign-source income against the otherwise applicable
U.
S.
tax liability.
The United States as domiciliary jurisdiction cedes the primary taxing right
to the country of source. Nevertheless, the United States retains the
secondary right to tax the foreign income to the extent that the foreign rate is
lower than the U.S. rate. Thus, if a
U.S.
taxpayer realizes
$100
of

current U.S. tax on the foreign-source income-the excess taxes can be
carried back two years and forward five years, but they can be used in those
years only to the extent that there is “excess limitation” available, that is, to
the extent that foreign taxes on foreign income in those years were less than
the
U.S.
tax. In effect, the carryforward and carryback rules allow the
U.S.
taxpayer to average foreign taxes over time, subject to the overall limitation
that the total of foreign taxes paid in the eight-year period does not exceed
the
U.S.
tax on the foreign-source income.
The foreign tax credit is also available for foreign income taxes paid by
foreign corporate subsidiaries when dividends are paid to
U.S.
corporate
shareholders, the so-called deemed-paid credit
.5
Thus, if a foreign subsidiary
earns
$100
of foreign income, pays
$30
of foreign taxes, and later distributes
a dividend
of
$70
to its
U.S.

S
. -owned
foreign subsidiaries), the source rules define the
U.S.
tax base. For
U.S.
persons, the source rules control the operation of the foreign tax credit since
they define the situations in which the United States is willing to give
double-tax relief.6 In general, the same source rules apply in both situations,
though there are some exceptions. The following are some
of
the most
important of the source rules.
Sale
of
Property
As
a general rule, the source of a gain from the purchase and sale of
personal property is considered to be the residence of the seller. Gain on the