FROM THE OFFICE OF PUBLIC AFFAIRS

“Taxation:  Toward a Level Playing Field” – is a fitting title for today’s session and for the efforts we have underway to make significant changes to U.S. tax laws.  In the case of the changes to U.S tax laws, we aim to level the playing field between debt and equity and between paying dividends and retaining earnings.  We also aim to level the playing field between the U.S. and its major trade partners with respect to the tax imposed on corporate income.

The U.S. interest in a level playing field does not suggest an interest in tax harmonization.  To the contrary, we believe tax competition is beneficial because it forces governments to create efficiencies.  Indeed it may be the only way of ensuring that governments create efficiencies, and harmonization may undercut it.  A level playing field is important to ensuring that healthy competition flourishes.

I’m going to cover three tax policy topics today that are at the center of our agenda at Treasury and that have implications both at home and abroad.  The President’s economic growth and jobs package, which is designed to ensure that the U.S. economy reaches its full potential.  The increasing significance of globalization for the U.S. tax system.  And the efforts to improve compliance with our tax laws.

The President’s Jobs and Growth Package

In January, President Bush proposed a package of tax changes aimed at improving economic growth and providing more jobs.  Although there is much positive to be said about the U.S. economy, particularly considering the bursting of the stock market bubble, the September 11th attacks, and the accounting and corporate governance scandals that have beset us, it is clear the economy is not running on all cylinders.  The President’s jobs and growth proposal is intended to put the U.S. economy on a path to long-term stable growth. 

There are three parts to the President’s tax proposals.  The first is an acceleration of the tax relief for families and workers that was enacted in 2001 but delayed until as long as the end of the decade.  These relief provisions include an expansion of the size of the 10% bracket, a reduction in rates from 27% to 38.6% to 25% to 35%, elimination of the marriage penalty for lower and moderate income families, and an increase in the child credit from $600 to $1000. 

The second part is a tripling of the amount of capital investment that can be expensed by small businesses. 

The third part is the end of the double tax on corporate earnings.

The effect of the double tax on corporate earnings is familiar to most of us in this room.  Still, the math is striking.  A tax as high as 60% on earnings paid out as dividends and as high as 48% on earnings retained.  And it is instructive to pause to consider those effects because they have grown more perverse as the years have passed.

The double tax creates a bias for debt.  The result is excessive debt that increases the risk of bankruptcy during economic downturns.

The double tax creates a bias for unincorporated entities, with the result that businesses make decisions on organizational form for tax rather than business reasons.  That effect is apparent from the statistics.  From 1980 to 1999, net income of U.S. C corporations fell from 78% to 57% of all business income with the net income of flow-through entities rising by a corresponding amount.  Similarly, the gross receipts of U.S. C corporations fell from 87% to 72% of all business receipts with the gross receipts of flow-through entities rising by a corresponding amount.

The double tax encourages corporations to retain earnings rather than pay dividends.  This too is illustrated by the statistics.  Dividends were paid by 75% of large U.S. companies in the mid-60s.  That number dropped to less than 25% by the mid-90s.  And during the 90s, the dividend payout of large publicly traded U.S. companies fell from 23% of pre-tax earnings in 1992 to 14% in 1999.  The incentive to retain earnings means reduced scrutiny of and a reduced hurdle for projects financed with retained earnings.  That is a distinct difference from the scrutiny given to projects for which the company must go to the market for financing.

There are secondary effects.  The double tax has led corporations to engage in complex and expensive planning of transactions that result in the distribution of earnings at capital gains rates instead of just paying dividends.  This too can be seen from the statistics.  The most familiar is the share repurchase.  In 1999, over 34% of large publicly traded companies engaged in share repurchases, up from 28% in 1992.  More striking is that fact that by 1999, almost 20% of earnings were paid out by share repurchase, nearly triple that of 1992.

And here is another secondary effect familiar to tax professionals everywhere.  The double tax encourages corporations to engage in transactions solely to minimize taxes.  That has promoted the acceptability of transactions serving no purpose other than minimization of tax liability.  The President’s proposal makes paying taxes an asset to shareholders.  Now that changes the math.

The goal of the President’s proposal is to end the double tax.  The basic mechanism is an exclusion for shareholders of dividends paid out of earnings on which the corporation has paid tax.  To avoid a new bias against retaining earnings, the President’s proposal includes an adjustment to shareholders’ stock basis that reflects retained earnings.

The tax free dividend is determined by the company on the basis of the tax liability it reports on its tax return.   The earnings on which the company has paid tax are determined on the basis of a 35% tax rate.  That amount less the tax paid is the amount that a company can distribute to shareholders tax free, and it is distributed on a proportionate basis.  If the company chooses to retain some of the taxed earnings, the company will advise shareholders of the amount by which they may adjust their stock basis.

The calculation of the previously taxed earnings will be based on the most recent tax return filed by the company before the year begins.  Any subsequent adjustments to the tax return will be reflected in the calculation of taxed earnings at the time of the adjustment, and not retroactively.  This will give companies and shareholders certainty about the tax free status of the dividends at the time the dividend is paid.

The current double taxation of corporate earnings makes the United States a standout among our major trading partners.  The United States is one of only 3 out of 30 OECD countries that do not provide any relief from double taxation of distributed corporate earnings.  The other two countries, Ireland and Switzerland, have very low corporate tax rates, so their combined corporate and personal tax burdens on distributed earnings are comparatively modest.  In contrast, the United States both has relatively high tax rates and fails to provide relief from double taxation of corporate earnings.  This combination gives the United States the highest combined corporate and individual tax burden on distributed earnings in the OECD.  This is one instance where we would rather not be number one!

Globalization

Recent events have conspired to create what has been referred to by some in the tax world as the perfect storm.   With the World Trade Organization having recently declared a feature of the U.S. international tax regime an export subsidy illegal under the WTO rules and the burst of corporate inversion transactions in the United States in the last couple of years, we find ourselves in a position where significant change to our international tax rules seems inevitable.  If change is inevitable, the question is what we should do. I would like to set a backdrop for reconsidering the fundamentals of the U.S. system of international tax rules.

From the vantage point of an increasingly global marketplace, our tax rules appear outmoded, at best, and punitive of U.S. economic interests, at worst.  Most other developed countries of the world are concerned with setting a competitiveness policy that permits their workers to benefit from globalization.  As former Deputy Secretary Dam has observed, however, the U.S. international tax policy seems to have been based on the principle that if we have a comparative advantage, we should tax it!

The U.S. income tax system as a whole dates back to shortly after the turn of the last century.  To put that in perspective, buggy whip makers had just gone out of business.  A bit has happened since then.  Of course, significant changes have been made to the tax code as well.  In the international area, we added the so-called subpart F rules back in 1962.  A lot of those rules haven’t aged very well.  We also made fairly significant changes to the U.S. international tax rules in 1986.  That would make those rules teenagers now, and they have the characteristics of the average teenager.  They’re hard to understand, messy, inconsistent, oftentimes irrational, and display little regard for the real world.

The global economy looked very different when key elements of our international tax rules were put in place in the early 1960s than it looks today.  The same is true of the U.S. role in the global economy.  Forty years ago the U.S. was dominant, accounting for over half of all multinational investment in the world.  We could make decisions about our tax system essentially on the basis of a closed economy, and we could generally count on our trade partners to follow our lead in tax policy.

Things have changed in 40 years.  In fact, a lot has changed in the 17 years since our last major revision of our international tax rules.  When the rules were first developed, they affected relatively few taxpayers and relatively few transactions. Today, there is hardly a U.S.-based company that is not faced with applying the U.S. international tax rules to some aspect of its business.

Let’s pause for a moment to consider what globalization means -  the growing interdependence of countries resulting from increasing integration of trade, finance, investment, people, information and ideas in one global marketplace.  Globalization results in increased cross-border trade, and the establishment of production facilities and distribution networks around the globe.   Technology has accelerated the pace of globalization. Advances in communications, information technology, and transport have dramatically reduced the cost and time taken to move goods, capital, people, and information around the world.  Firms in this global marketplace differentiate themselves by being smarter: applying more cost efficient technologies or innovating faster than their competitors.  The returns to being smarter are much higher than they once were as the benefits can be marketed worldwide.

The significance of globalization to the U.S. economy since the enactment of the framework of our international tax rules is apparent from the statistics on international trade and investment.  In 1960, trade in goods to and from the U.S. represented just over six percent of GDP.  Today, trade in goods to and from the U.S. represents over 20 percent of GDP, more than three times larger than in 1960, while trade in goods and services represents more than 25 percent of GDP today.  It is worth noting that numerous studies confirm a strong link between trade and economic growth.  Trade appears to raise income by spurring the accumulation of physical and human capital and by increasing output for given levels of capital.

Cross border investment, both inflows and outflows, also has grown dramatically in the last 40 years.  In 1960, cross border investment represented just over one percent of GDP.  In 2000, it was nearly 16% of GDP, representing annual cross-border flows of more than $1.5 trillion.  The aggregate cross border ownership of capital is valued at $15 trillion.  In addition, U.S. multinational corporations are now responsible for more than one-quarter of U.S. output and about 15 percent of U.S. employment.

At the same time companies are competing for sales, they are also competing for capital: U.S.-managed firms may have foreign investors, and foreign-managed firms may have U.S. investors.  Portfolio investment accounts for approximately two-thirds of US investment abroad and a similar fraction of foreign investment in the U.S.

The U.S. tax rules have important effects on international competitiveness both because of the integration of domestic activities of U.S. multinational companies with their foreign activities and because repatriated foreign earnings of foreign investments are subject to U.S. domestic tax.  Increasingly, the flow of goods and services is not through purchases between exporters and importers, but through transfers between affiliates of multinational corporations. The rules governing transfer pricing, interest allocation, withholding rates, foreign tax credits, and the taxation of actual or deemed dividends impact these flows. 

The U.S. tax system should not distort trade or investment relative to what would occur in a world without taxes.  Every country makes sovereign decisions about its own tax system, so it is impossible for the U.S. to level all playing fields simultaneously.  But we can ensure that our own rules minimize the barriers to the free flows of capital that globalization necessitates.

The question we must answer is what we can do to increase the competitiveness of U.S. businesses and workers.  Professor Michael Graetz observed in his book, The Decline (and Fall?) of the Income Tax: 

The internationalization of the world economy has made it far more difficult for the United States, or any other country for that matter, to enact a tax system radically different from those in place elsewhere in the world.  In today’s worldwide economy, we can no longer look solely to our own navels to answer questions of tax policy.

Professor Graetz’s point is right.  We must write tax rules that take into account what other countries are doing.  We must also reconsider the extent to which our rules impede the flow of capital of U.S. businesses, necessitate inefficient business structures and operations, and leave U.S. companies and workers in a less competitive position.  We must also give appropriate regard for the international institutions that support free trade, even when we dislike the decisions they hand down. That result should be obvious to Americans because no one has a greater stake in the WTO and in free trade than the U.S.  Despite the WTO decisions against our foreign sales corporation and extraterritorial income regimes, the WTO rules serve the economic interests of American businesses and workers by opening markets and ensuring fair play.

We must consider the ways in which our tax system (1) differs from that of our major trading partners to identify aspects that may hinder the competitiveness of U.S. companies and workers and (2) creates barriers to efficient capital flows.  About half of the OECD countries employ a worldwide tax system as does the U.S.  The practical effect of a worldwide system is a tax on U.S. companies repatriating their earnings to the extent foreign tax credits are unavailable to offset U.S. taxes.  That tax creates a hurdle to companies bringing profits back to the U.S.  It means U.S. investments face a higher hurdle than investments abroad.  That is a hurdle foreign competitors in territorial tax systems do not face, and a hurdle foreign competitors investing in the U.S. do not face.  The most important point here is that the system creates a bias against companies reinvesting in the U.S.  That is a result that disadvantages U.S. workers.  Yet rhetoric stands in the way of even fairly considering reform.

Even limiting comparison of our system to that of countries using a worldwide tax system, U.S. multinationals can be disadvantaged when competing abroad.  This is because the U.S. worldwide tax system, unlike other worldwide systems, can tax active forms of business income earned abroad before it has been repatriated and more strictly limit the use of the foreign tax credits that prevent double taxation of income earned abroad.

Let’s look at a couple of examples.  Under the U.S. subpart F rules, a U.S. company that uses a centralized foreign distribution company to handle sales of its products in foreign markets is subject to current U.S. tax on the income of that foreign distribution subsidiary.  In contrast, a local competitor is subject only to the tax imposed by that country.  Similarly, a foreign competitor with a centralized distribution company making sales into the same markets generally will be subject only to the tax imposed by the local country.  The practical effect is U.S. companies seeking the most efficient operation of their foreign distribution facilities face a tax penalty relative to their foreign competitors.

The subpart F rules also impose current U.S. taxation on income from certain services transactions, shipping activities and oil related activities performed abroad.  In contrast, a foreign competitor engaged in the same activities generally will not be subject to current home-country tax on its income from these activities.  While the purpose of these rules is to differentiate passive or mobile income from active business income, they operate to currently tax some classes of income arising from active business operations structured and located in a particular country for business reasons wholly unrelated to tax considerations.  The additional tax burden means that U.S. business must be more efficient just to be able to be competitive.

We have similar issues with the U.S. rules limiting foreign tax credits.  The rules for determining and applying the foreign tax credit are detailed and complex and can subject U.S.-based companies to double taxation on their income earned abroad.  An example is our interest expense allocation rules that allocate the interest expense of a U.S. parent to its foreign subsidiaries even where those subsidiaries are equally or more leveraged than the U.S. parent.  The result is an inappropriate reduction of foreign source income and, consequently, the foreign tax credit.  The effect can again be double taxation.
 
As noted above, the U.S. double tax on corporate earnings also sets us apart from our foreign competitors.

It is time for us to review the U.S. international tax rules based on the world we live in today and the world we imagine for the future. We must design rules that equip us to compete in the global economy – not fearfully, but hopefully.  We all benefit significantly from vigorous participation in the global economy - from the increased variety of products available to us as consumers to the increased opportunities for us to sell our products and services.  Over the past 20 years, U.S. companies that invest abroad exported more (exporting between one-half and three-quarters of all U.S. exports), paid their workers more, and spent more on R&D and physical capital than companies not engaged globally.  Foreign investment is not important just to the largest companies.  A recent Department of Commerce survey indicated 30 percent of mid-sized companies had foreign investment.

This is not just about winning the global competition or maintaining a competitive edge.  While 80 percent of U.S. investment abroad is located in high-income countries, our investment in developing countries may be far more important.  U.S. investment is vital to these countries achieving sustainable poverty-reducing growth and development. 

Too many people see foreign investment as a zero sum game, but the globalization of the economy is not - like a poker game - revenue neutral.  Healthy foreign economies mean more markets for our products.  They mean more opportunities for us to profitably invest.  But, foreign investment also means sharing our ideas, our knowledge, our values, and our capital to improve the lives of people around the world.  That is not a zero sum game. 

Cleaning Up Noncompliance

We are devoting significant resources at the IRS and Treasury to cleaning up noncompliance with the U.S. tax laws.  This focus is critical to maintaining the public’s confidence in the fairness and soundness of our U.S. tax system.

Last year we announced a multi-prong initiative aimed at curbing abusive corporate tax shelters.  The initiative includes administrative efforts, regulatory guidance and legislative proposals.  The centerpiece of all these efforts is increased disclosure, because with transparency we will have access to the information we need to pursue this activity and to shut down inappropriate transactions.  What we need is sunlight.

We are paying particular attention to U.S. tax evasion through the offshore sector.  In January, the IRS unveiled an initiative aimed at cleaning up the offshore sector.  Under the new initiative, the IRS is permitting taxpayers with money hidden in offshore accounts and accessed by credit card or other financial arrangement until April 15th to come in and get right with the IRS.  Taxpayers who wish to take advantage of the initiative will be spared the possibility of civil fraud penalties and of referral for criminal prosecution.  In exchange, they must provide the IRS with information on the promoter or advisor who put them into the offshore arrangement.

We see the initiative just launched as an important step in cleaning up the offshore sector.  About two years ago, the IRS began summons enforcement actions against the major U.S. credit card companies in an effort to identify taxpayers using offshore banks to hide their income.  That effort has borne considerable fruit, but there remains an enormous amount of work to do to identify and track down all of the account holders.  The IRS became aware that there were a number of taxpayers who would get straight if given the opportunity.  Taxpayers now have that opportunity.

One of Treasury’s roles in cleaning up the offshore sector is to facilitate tax information exchange with foreign governments that allow the IRS to more readily identify U.S. taxpayers hiding income offshore.  Over the past 18 months, Treasury has entered into tax information exchange agreements with eight significant offshore financial centers:  Antigua and Barbuda, the Cayman Islands, The Bahamas, the British Virgin Islands, the Netherlands Antilles, Guernsey, the Isle of Man, and Jersey.  These new tax information exchange agreements include jurisdictions in our neighborhood and those more distant.  These were the first tax information exchange agreements entered into in over a decade.  And we are not finished yet.

We also entered into a Mutual Agreement on tax information exchange with Switzerland, a key financial center. The Mutual Agreement, which builds on the information exchange provisions of our bilateral treaty with Switzerland, is a significant step forward in our information exchange relationship.  We look forward to working with Switzerland to further improve this relationship.

Access to information is vital to our efforts to ensure full and fair enforcement of our tax laws.  We do everything we can ourselves to gather the information we need.  And we look to our relationships with our partners around the world to ensure that we have access to needed information when U.S. taxpayers try to hide income through foreign accounts or offshore entities.  It is more important than ever that no safe haven exists anywhere in the world for the funds associated with illicit activities, including tax evasion.