FROM THE OFFICE OF PUBLIC AFFAIRS

I thought I would briefly examine the challenges that the tax system, and those fortunate enough to have some responsibility for it, will face in the coming years caused by changes in the economy, particularly globalization and e-commerce. Then I will turn briefly to discussing two other topics of interest, the status of the FSC replacement dispute and the subpart F study.

Much has changed since I entered the Government 8-1/2 years ago. Globalization and information technology have ushered in an economic transformation as profound as that of the Industrial Revolution of the 19th century. The scale of change is enormous, as are the potential benefits.

Trade barriers are falling, the market for capital is international, and access to information from around the world is instantaneous. As a result, economies are increasingly interdependent. As national borders become less relevant, business enterprises will be increasingly global in scale and mobile with regard to the location of their management and activities. But while capital, goods, and services increasingly move without regard to borders, national borders will continue to confine tax authorities.

As that great philosopher Dr. Seuss once wrote:

We [as tax administrators] have come to a place where the streets are not marked.

Some windows are lighted, but mostly they're darked.

A place you could sprain both your elbow and chin!

Do you dare to stay out? Do you dare to go in?

How much can you lose? How much can you win?

You can tell that I have three children under the age of 10. Don't worry, I'll return to Seuss later.

Obviously, we are on our way in and must quickly gain an understanding of the implications of globalization and e-commerce for tax policy. We, at Treasury, are actively examining and responding to the challenges raised by the emerging global environment.

Let me be clear at the outset, however, that we do not believe that globalization has changed the fundamental goals of tax policy: that our revenue needs be met in a fair manner, that we maintain neutrality and minimize distortions, and that we limit compliance and administrative burdens, to the extent possible. However, without vigilance, it may significantly increase the impact of other jurisdictions' choices on our ability to raise revenue in a fair manner. The challenge for us is how to tax the activities of our citizens and residents on a fair and neutral basis when their activities increasingly transcend our borders and thus are more difficult for us to discover and evaluate.

We believe this is best achieved by dialogue with other sovereign jurisdictions to ensure that our practices do not encroach upon each other's ability to make fundamental tax policy choices (such as foreclosing the ability to tax capital, corporate income, consumption, etc.) and that we do not limit each other's ability to apply those choices in a fair, non-discriminatory manner.

Critics of the Administration's pursuit of bilateral or multinational solutions to the increasingly difficult tax policy issues raised by globalization often assert that such solutions necessarily restrict our freedom to conduct tax policy as we see fit and require that we harmonize our tax systems with others. Precisely the opposite is true. The status quo is not an option. It is only through cooperation on an international level that we can maximize the power to conduct tax policy as we see fit and preserve the availability of tax policy options to our government in the future.

The challenge of maintaining our traditional tax policies in the face of a changing world is most directly reflected in our initiatives to identify and combat harmful tax competition.

International tax competition occurs when one country provides a tax inducement to attract capital from another country. The most aggressive forms of tax competition are practiced by countries we commonly think of as tax havens. When practiced unfairly, tax competition can severely erode the capital tax base of the losing country. Harmful tax competition also distorts investment decisions and undermines fiscal stability. Eventually, this means that the losing country may have to make up the lost tax revenue through higher taxes on the income it still can get a hold of -- like wages or other relatively immobile income.

There has been significant confusion regarding the distinction between fair and unfair tax competition. This confusion has been fueled by certain opponents of the OECD's harmful tax competition initiative, who have mischaracterized the efforts as attempts to establish high tax cartels and establish minimum levels of taxation across the globe. Let me be clear: Countries are free to choose the method and rate of taxation appropriate to fund their public sectors. However, countries have gone beyond that right when they have regimes that lack transparency, that are "ring fenced" or shielded from their own economies and core tax base, or with respect to which there is no information exchange. Tax systems with those features erode other countries' tax bases and infringe on their ability to implement their own tax policy decisions. Thus, the work at the OECD is limited to regimes with these harmful features - lack of transparency, lack of information exchange, or discrimination between residents and nonresidents -- in especially mobile sectors of the economy, and thus is narrowly targeted at the problem of harmful tax competition.

By tackling this problem, we should help businesses compete on a level playing field and help encourage investment growth and jobs. It also will play an important role in promoting the health of the global economy and global financial system.

We have pursued in this area a parallel track of unilateral initiatives and working in multilateral forums such as the OECD. For example, our recent "QI" regulations which streamline the procedures by which banks can verify the foreign residence of recipients of interest income from the U.S., impose special, more rigorous requirements on banks based in tax havens. These requirements are geared to ensure that such banks have access to and can provide information regarding the beneficial owners of the interest income. We also have opened a regulations project to consider the imposition of a withholding tax on portfolio interest paid to accounts or corporations in tax havens even though portfolio interest paid to nonresidents generally is exempt from U.S. withholding tax.

We believe, however, that an effective response in this area must also include efforts at a multilateral or global level to establish international standards that countries commit to meet. As evidenced by initiatives at the EU and the OECD, there has been a growing international consensus on the importance of addressing this problem on a multilateral basis. The EU on November 27 announced that its member countries' Finance Ministers approved a Code of Conduct whereby 66 preferential tax regimes within the EU are to be eliminated by January 1, 2003. Closer to home, we have taken an active role in the OECD's work in the area of harmful tax competition. Over thirty countries already have committed to eliminate their harmful tax practices within five years and more, including identified tax havens, are expected to do so in the near future. Indeed, recently, the Netherlands Antilles has committed to eliminate its harmful tax practices.

The work of the EU and the OECD is a first step to ensuring that the policy objectives of their respective member countries can be realized without the fear of an eroding tax base and other distortions that could undermine the benefits of enhanced capital mobility in today's global economy. Non-member countries have much to gain from joining such an effort. For example, at a 60-nation conference on tax competition this past summer, delegates from developing countries noted that these harmful practices constitute a more severe threat to their countries than to that of developed countries, in part because tax base erosion can translate directly into increased poverty. These delegates warned that tax competition could contribute significantly to a backlash against globalization, already seen in many quarters as benefiting the developed world at the expense of the developing world. One of our primary interests in the OECD's initiative, which should be shared by the U.S. business community, is to prevent distortions that could undermine the substantial benefits that arise from global capital mobility.

The most important lesson from the ongoing work on harmful tax competition is the extent to which countries have decided that it is in their interest to commit to meet international standards in the short term in order to maximize their tax policy and economic development options in the long term. If harmful tax practices are allowed to flourish, they could severely constrain the right of countries like the U.S. to implement their desired tax policies, including tax reduction policies. For example, a tax haven's secrecy practices may prevent us from finding out about citizens who hide money offshore. This deprives us of the revenue due on the hidden money and the income it produces, which constrains our policy options, including the option of reducing taxes on honest citizens and businesses.

The OECD recently has agreed to co-sponsor multilateral meetings in the South Pacific and the Caribbean to further the dialogue with tax haven jurisdictions. We are pleased that the OECD's work to eliminate harmful tax practices is evolving into the cooperative effort among developed and developing countries required to resolve the difficult tax policy issues these practices present.

III. Tax Arbitrage

A similar challenge to tax systems is the use of tax arbitrage. Tax arbitrage involves the exploitation of differences in the tax laws of two or more jurisdictions that result in the lowering of a taxpayer's worldwide tax liability by ensuring that income is not taxed anywhere.

Tax laws are written based upon certain assumptions, including fundamentally that income should not be subject to double taxation. In the cross-border context, this has been implemented through international conventions that have been widely adopted. For example, interest generally is permitted to be deducted by the payor in the source country but is generally included in income upon receipt by the investor in the country of residence. In this circumstance, the source country cedes primary taxing jurisdiction of the interest to the country of residence. Conversely, because dividends generally represent underlying earnings that have been subject to tax by the source country and are generally not deductible when paid, the country of residence of the recipient will generally cede primary taxing jurisdiction to the source country through an exemption or credit mechanism. In each instance, the ceding of primary taxing jurisdiction by one country is based on the assumption that the amount is more appropriately taxed in the other country.

If, however, both countries characterize a transaction differently, tax arbitrage can arise in which both countries cede taxing jurisdiction simultaneously and the income is not taxed by any jurisdiction. Countries may characterize a transaction differently because of a variety of reasons including differences in rules with respect to ownership, entity characterization, instrument characterization, timing, or source

Some would argue that the arbitrage is not troubling because a transaction is characterized correctly under domestic tax rules. Under this view, as long as a transaction does not rise to the level of being a tax shelter, the taxpayers should obtain the tax results as permitted by each individual jurisdiction's laws.

At Treasury, however, we believe that tax arbitrage is problematic for several policy reasons. By creating double non-taxation, tax arbitrage distorts economic behavior because taxpayers will tend to favor cross-border tax arbitrage transactions over domestic transactions or other types of cross-border transactions, thereby undermining the principle of neutrality. Furthermore, taxpayers who do not have access to arbitrage opportunities will have higher costs of operations and will thus be prejudiced because they will not have the benefit of such de facto subsidies. Taxpayers who do engage in tax arbitrage transactions tend to be the wealthy and well advised because the nature of such transactions often require many resources and the expertise of tax advisors. Finally, as with harmful tax competition, governments may ultimately need to compensate for a shortfall in revenue by shifting the burden of tax to other constituents, such as to labor.

The Internet and e-commerce pose similar (and sometimes overlapping) fundamental questions to which we must respond. In a world where cyber-transactions are growing at a rapid pace, tax administrations face the challenge of adapting existing tax systems to an economy that increasingly ignores physical borders and that increasingly operates under new business models and by new business methods.

In such a world, our traditional rules for determining each country's jurisdiction to tax and for determining the source and character of taxable income will come under increasing pressure. For example, income from the performance of services traditionally has been taxable in the place where the services have been performed. New technologies and business methods, such as the Internet, corporate intranets and other communications and service delivery advances, will make such determinations more difficult, and may increase the opportunities for manipulation and tax avoidance.

Similarly, it will be increasingly easy for companies to avoid taxes by taking advantage of different tax rules and tax systems that do not operate well together. For example, many countries' tax rules regarding the provision of software products and services are not in agreement regarding whether such income is a royalty, income from the sale of a good or income from the sale of service. Such discrepancies may provide inappropriate tax arbitrage possibilities. Or, I should add, may just as easily result in double taxation.

Additional problems could arise regarding tax collections and tax administration. For example, the increasing sophistication of Internet encryption methods, which may be used for valid reasons of commercial secrecy, can also be used to conceal relevant tax details from tax administrators.

How can we best respond to these challenges?

Some have argued that we should respond to the challenge of e-commerce and new technologies by suspending taxes on Internet transactions. Others have suggested that we create new tax rules or even new taxes that specially target certain aspects of the virtual economy. We reject both views. Our view is that the current tax policies and rules can continue to provide appropriate results, albeit with some modifications. Tax administrations should provide an environment in which e-commerce can flourish, while at the same time ensuring that the Internet does not become a tax haven that undermines the revenues that allow public services to function.

This Administration's main objective has been to work with both our OECD and non-OECD partners, in consultation with the private sector, to build an international consensus on the framework underlying any taxation of e-commerce. We are conducting an on-going dialogue to this end, with two principles in mind:

• Any taxation of the Internet and electronic commerce should be clear, consistent, neutral and non-discriminatory. Neutrality and non-discrimination must be the fundamental principles that guide the development of taxation rules with respect to electronic commerce. The rules should be transparent and easy to administer.
• Close cooperation and mutual assistance are necessary between the U.S. and its trading partners to ensure effective tax administration and combat illegal activities on the Internet. The global nature of e-commerce necessitates global consensus on the principles underlying any e-commerce taxation. In the absence of such consensus, unintentional non-taxation or stifling multiple taxation may result.

Let me turn briefly to two other issues of interest.

As you know, President Clinton signed the FSC replacement legislation into law on November 15. Subsequently, the EU requested a special meeting of the World Trade Organization's Dispute Settlement Body to consider its request for authority to impose sanctions in the FSC dispute worth more than $4 billion annually. That action was consistent with the procedural agreement we reached with the EU at the end of September regarding the sequencing of procedures in the WTO for this dispute. Nonetheless, we contest the level of damages alleged by the EU. We do not believe that European companies have been disadvantaged.

Pursuant to our procedural agreement, the EU agreed to request consultations with the US, and those consultations were held earlier this week in Geneva. As expected, after the consultation, the EU has requested the establishment of a WTO compliance panel to assess whether the new legislation is WTO-consistent. As the U.S. and EU agreed at the end of September, we would then jointly request that the EU's existing retaliation request be suspended, pending the outcome of this review.

A final verdict in this case is not expected until the middle of next year. If the FSC replacement legislation is found to be WTO-consistent, then that will be the end of the matter. If the legislation is found to be WTO-inconsistent, the appropriateness of the EU's request for retaliation worth more than $4 billion will then be addressed by the arbitration panel. Under WTO dispute settlement procedures, these proceeding will take a minimum of 7 months. We remain confident that our new legislation will be found WTO-compliant, as it is neither a subsidy nor is it export-contingent.

VI. Subpart F Study

The subpart F study is imminent and should be released this month. I apologize for the delay. I can only explain it by returning to Dr. Seuss:

How did it get so late so soon?

December is here before it's June.

It's night before it's afternoon.

My goodness how the time has flewn.

Let me briefly describe the study's framework. The study begins by examining the events that led to the introduction of the statute and its legislative history. The study then asks what subpart F should achieve: how should we tax foreign income in order to maximize our economic welfare? It asks whether there is continuing validity to the economic views that helped to mold subpart F forty years ago. In studying this we have been particularly interested in trying to determine whether new economic research -- particularly that done in the last ten years -- has affected the validity of the standard analysis that the best policy is to tax domestic income at the same rates as foreign income. The study also looks at the issue of competitiveness.

Our study also evaluates the extent to which subpart F is achieving what it should be achieving. In other words, are the current rules being easily circumvented? Are they well-suited to the way business is done today? Are they well-suited to the way business will be done in the new millennium? In particular, we are looking at the extent to which the rules may need to change in light of new technologies, including new communications technologies and electronic commerce.

The issues I discussed today -- harmful tax competition, tax arbitrage and e-commerce --demonstrate the importance of international coordination in this increasingly global economy. Such coordination is necessary to set minimum standards for the operation of tax systems, while at the same time preserving the right of each country to choose its own tax system to the greatest extent possible. It is important to reiterate that we do not believe that this kind of coordination requires harmonization, whereby countries adopt similar tax systems. What is important, however, is that when there are differences in our tax systems, we coordinate on a multilateral basis to establish and meet certain minimum standards that prevent practices that undermine our respective tax systems.

I also want to stress the importance of continued involvement by all of you in meeting these important challenges. With the rapid pace of change in our economy, we will need to rely even more heavily on those involved in the international tax community for your help and guidance. Thank you for the opportunity to be here.