International Tax Reform: Oscillating between Capital Import and Capital Export Neutrality

By Kristen Fullenkamp

If there is one issue both Democrats and Republicans have agreed on in recent political seasons, it is the pressing need for international tax reform. Both conservatives and liberals agree that today’s economic realities no longer conform to the international tax provisions of yesterday’s Internal Revenue Code. While both groups acknowledge the need for intense international tax reform, their tax ideologies are incongruent. It is one thing to acknowledge the need to restructure international tax policies; it is, however, a very different matter to agree on the appropriate strategies for reform. Both sides agree that international tax policy reforms need to make American companies more competitive in the global marketplace – but what types of provisions will make American companies more competitive?

This paper examines the prominent defects in current U.S. international tax policy and explores potential solutions framed in terms of the competing philosophies of capital import neutrality and capital export neutrality. During the recent presidential campaign, Senator John Kerry and President George W. Bush both proposed plans to reform international tax policy. President Bush’s agenda will now dominate the political landscape, and already many of his proposals have been implemented via the American Jobs Creation Act of 2004. Despite his failure to win the presidency, Senator Kerry’s platform remains relevant because it reflects the key trends in international tax policy from a Democratic perspective. It is probable that many of these ideas will reemerge in 2008. This paper examines the respective platforms as a basis for analyzing the Democratic and Republican policy prescriptions regarding international tax reform, as well as for determining the feasibility of their proposed solutions. Finally, the paper explores the newly passed American Jobs Creation Act of 2004 and reviews the implications the new law will have on international tax reform. While the ideologies and approaches to reform may differ, a truly effective tax reform strategy should center on creating a neutral, equitable, and simple tax environment.


Underlying Philosophies

In order to understand the need for a restructuring of international tax policy, it is important to understand the United States’ historic stance toward international tax policy. The U.S. has generally promoted a capital export neutrality (CEN) philosophy as manifested in the worldwide tax system. Within this context, the U.S. taxes residents on their worldwide income, providing relief from double-taxation via the foreign tax credit. The CEN philosophy aims to eliminate biases between investing domestically or abroad, because entities will be taxed on all of their income irrespective of the country in which it was earned. As CEN emerged as the dominant U.S. tax policy, “the national interests of preserving the tax base and ensuring a steady stream of income tax revenue” became the concern of policymakers.1 The tax code, however, did not promote a pure worldwide tax system. It left a little room for capital import neutrality (CIN), a philosophy which seeks to eliminate biases for investors in the same country. This approach is manifested in a territorial system whereby countries tax entities only on the income earned in that country. Income earned in other countries is not included in the territorial system’s tax base, and therefore, entities conducting business in the same country are taxed at the same rates.


A Historical Look

During the 1950s and 1960s, U.S. companies realized the tax benefits of moving operations overseas due to deferral provisions in the tax code. In 1961, President John F. Kennedy proposed eliminating deferral on income earned by U.S. subsidiaries located overseas.2 This proposal essentially called for consistency in U.S. international tax policy by eliminating the CIN aspects of the tax code. Congress resisted such radical change but compromised by passing the Controlled Foreign Corporation rules and the Subpart F rules. These rules effectively allowed deferral for some taxpayers but disallowed deferral for those corporations designated as controlled foreign corporations with Subpart F income (see Internal Revenue Code §952 and §957) in order to limit avenues for abusive tax minimizing behaviors. With deferral provisions still partially in place, the 1970s saw a wave of manufacturing jobs relocate to foreign countries.3 The beginnings of “outsourcing” along with the belief that the territorial tax systems of foreign countries (particularly in Europe) disadvantaged U.S. companies caused Congress to create export incentives for domestic manufacturers. From 1971 to 2000, Congress enacted three different export incentives, all of which have been ruled as illegal trade subsidies by the World Trade Organization (WTO).4 According to the WTO Agreement on Subsidies and Countervailing Measures, these U.S. export benefits are considered illegal because they favor one trading country over another. Direct export benefits “are prohibited because they are specifically designed to distort international trade.” 5 In 2000, the extraterritorial income exclusion (ETI) was ruled an illegal export subsidy, and in 2004, the newly passed American Jobs Creation Act repealed this tax provision.

The international marketplace has drastically changed since the 1950s. With the emergence of the Internet, capital and labor mobility have increased. This development allows capital and labor to be located in tax-friendly countries and still remain electronically connected to their consumers and employers located in tax-hostile countries.6 The U.S.’s historical patchwork approach to tax reform, combined with changing global markets, makes it easy to see why international tax reform is now necessary. However, it is more challenging to devise a consistent, neutral, equitable, and simple policy to make American companies competitive in the global marketplace without bankrupting the U.S. Treasury.


The Democratic Proposal

Democrats have typically viewed solutions to international tax policy from a CEN standpoint. The recent Democratic presidential candidate, Senator John Kerry, has widely publicized his dissatisfaction with the current U.S. international tax policy. Senator Kerry echoes JFK’s call to eliminate deferral provisions in the code.7 He proposes removing deferral benefits with one major exception – controlled foreign corporations (CFCs), located in foreign markets, specifically providing goods and services to that foreign market, would retain their deferral benefits.8 He also claims that a reduction in the corporate tax rate for 99% of companies will encourage manufacturing in the United States. Kerry contends only the large multinational corporations that will lose their deferral privileges will not benefit from the corporate rate reduction.9

It is interesting to note that while Kerry seeks a reduction in the corporate tax rate, he supports a simultaneous increase in the individual tax rate, which is the rate applying to those conducting business in a non-corporate form, for income levels above $200,000.10 Kerry asserts that the combination of repealing deferral benefits and reducing the corporate tax rate will result in an increase in manufacturing jobs in the United States and a corresponding decrease in the “outsourcing” of jobs overseas.11 Specifically, John Kerry’s suggestions include reducing the corporate tax rate by 5 percent, providing a one-time tax repatriation holiday allowing companies to pay a ten percent tax on deferred income, partially repealing tax deferral on foreign-source income, and allowing a new jobs credit to offset certain employers’ payroll taxes.12 By eliminating deferral through a tax repatriation holiday, introducing a reduction in the corporate tax rate, and utilizing other deferral mechanisms, the U.S. would return to a stricter adherence to capital export neutrality.


The Republican Proposal

As expected, the Republicans propose international tax reforms that tend to promote CIN. This preference towards CIN policies can be found in the party’s traditional support of businesses and supply-side economics. The Republican Oath listed on the GOP’s website points to this tendency with phrases like, “allow individuals to keep more of the money they earn,” “the best government is that which governs least,” and “free enterprise…has brought this nation opportunity, economic growth and prosperity.”13 The Republican Party is the party of “Reaganomics,” and thus, the philosophy of stimulating the economy through tax cuts and deregulation is paramount in President George W. Bush’s economic plan.14 Bush and the Republican Party do not view the concept of deferral with the same disdain as does the Democratic Party. In “The President’s Budget for the United States Government, Fiscal Year 2005,” the Administration does specifically call for a repeal of the ETI regime in order to comply with the WTO. The Administration suggested several alternative regimes without endorsing a specific choice. Some suggestions include a reduction of the corporate tax rate, simplification and rationalization of the U.S. international tax code, and various alternative minimum tax (AMT) and net operating loss (NOL) reforms.15 The President’s 2005 Budget does not include a proposal for eliminating any of the deferral provisions that Democrats abhor. Permitting tax deferral is an indirect endorsement of CIN because it exempts a portion of income from the worldwide tax base and more closely approximates a territorial tax system.

In addition to his proposal in the Administration’s 2005 Budget, the President also seeks to make permanent two major tax relief packages passed in his first term: the 2001 Economic Growth and Tax Reduction Reconciliation Act and the 2003 Jobs and Growth Tax Reduction and Reconciliation Act. A key provision of both acts is a reduction in the individual income tax rates. The highest bracket has been reduced from 39.6 percent to 35 percent. The President also wants to make permanent the reduction in the capital gains rate to 15 percent.16


An Evaluation Dependent on an Economic Worldview

There is widespread debate as to which policy platform is the preferable for international tax reform. However, evaluating the respective plans becomes problematic because each plan must be situated with respect to the goals of its party and U.S. international tax policy on the whole. The effectiveness of each plan revolves around which economic worldview the U.S. intends to promote: capital import neutrality or capital export neutrality. Currently, this is the major source of contention.

Assuming each party is respectively attempting to promote either CIN or CEN, it is best to evaluate each plan in terms of the policy each party seeks to maximize. The first issue, deferral benefits, can be framed in terms of CIN or CEN. President Bush’s proposal only calls for a repeal of ETI and makes no mention of repealing deferral benefits. This is consistent with his party’s tendency to promote CIN. By allowing companies to defer income, the President’s plan more closely resembles a territorial system and allows U.S. companies operating abroad to remain equal to other investors in the same foreign country. On the other hand, John Kerry’s call for partial anti-deferral provisions and a one-time tax repatriation holiday promotes CEN and closes one apparent anomaly in the U.S. worldwide tax system. While this theoretically promotes more consistency in U.S. international tax policy as it currently sits, Kerry’s plan continues to disadvantage U.S. companies whose trading partners operate on the territorial system. Kerry’s plan remains problematic because it only offers partial anti-deferral provisions which do not allow for a promotion of pure CEN. Unfortunately, a partial anti-deferral provision could lead to abuses, such as having CFCs sell their entire output to a foreign-owned wholesaler in order to fall within Kerry’s narrow exception, and thus enable companies to retain their deferral benefits.17 However, Kerry believes that the enactment of these partial anti-deferral provisions will ultimately help correct the problem of outsourcing. According to some observers, however, “offshoring is a fairly small problem, and Kerry’s tax proposal won’t do much to solve it.”18 FactCheck.org, an independent political fact analyst, notes that even Kerry’s supporters concede that his tax proposal will not stop outsourcing.19

The second issue, reducing tax rates, can also be seen in terms of CEN and CIN. On this issue, both policymakers agree that the corporate tax rate should be reduced. John Kerry’s combined proposal of reducing the corporate tax rate and anti-deferral provisions constitute a stricter adherence to CEN. However, his plan to raise individual income tax rates is incongruent. The President, for his part, favors a corporate tax rate reduction as well as an individual tax rate reduction. This type of plan is much more neutral to all forms of business entities. Ironically, by giving across-the-board tax rate reductions regardless of the entity’s location, this aspect of Bush’s plan leans more toward a CEN perspective, contrary to his typically CIN perspective. Kerry’s oversight of individual income taxes is extremely important considering the number of U.S. businesses engaged in manufacturing and taxed at individual rates. In 2003, 360,000 sole proprietors engaged in manufacturing activities and grossed sales of $27 billion.20 The number of partnerships engaged in manufacturing activities stands at 251,000, grossing $182 billion.21 (No data for S-Corporations could be found). By decreasing the corporate tax rate for corporate manufacturers while simultaneously increasing individual income tax rates, Kerry’s plan indirectly increases taxes on the very industry his plan attempts to help: U.S. manufacturers. Therefore, the plan lacks neutrality and equity, and introduces biases into the tax system. To the extent that a plan fails to promote a neutral treatment across different business forms, its potential to effect significant change is diminished.

While President Bush’s tax cuts address these biases, his plan has its own oversights. By deregulating and cutting back taxes on both corporations and individuals, Bush’s plan attempts to promote “Reaganomics,” including supply-side measures. His plan also retains deferral benefits so as not to disadvantage U.S. companies operating in countries with a territorial regime. The motivation behind a Reaganomic strategy is the stimulation of business and economic growth, both domestically and abroad. However, Bush’s plan lacks several elements crucial to the fundamentals of Reaganomics, and it therefore could ultimately prove ineffective. In order to be fully effective, Reaganomic policies must (1) reduce the growth of government spending, (2) reduce tax rates, (3) reduce regulation, and (4) reduce inflation by controlling the money supply.22 The President’s policy only meets two of these objectives: it reduces tax rates and reduces regulation. The President’s policy does not reduce government spending. In fact, on November 19, 2004, the President signed legislation authorizing the U.S. debt limit to increase to $8.18 trillion. The measure was only narrowly passed in Congress along partisan lines, 208-204.23

The President’s policy also has not reduced inflation. On November 19, 2004, in a speech delivered in Europe, Federal Reserve Chairman Alan Greenspan noted that the weak dollar results from the U.S. trade deficit and the U.S. federal budget deficit.24 Additionally, both Bush’s and Kerry’s plans face the problem inherent in tax rate reductions: tax competition. Tax competition occurs when governments consistently decrease their tax rates to attract businesses to their countries. Tax competition leads to inefficient tax systems: “Rising tax competition has caused governments to also adopt defensive rules to prevent residents and businesses from enjoying lower tax rates abroad. In the United States, such tax rules are hugely complex and affect the ability of U.S companies to compete in world markets.”25


Policy Inconsistencies

The interesting aspect of both policymakers’ plans is their reflection of past U.S. international tax policy. Both plans continue to be patchworks of inconsistent policy. The U.S. needs to determine whether it will continue to promote CEN or whether it should convert to the territorial systems used by the majority of its trading partners. Many economists and analysts agree that the major problems in U.S. international tax policy are the clashes between worldwide and territorial systems, and border tax adjustments, like the Value-Added Tax (VAT) imposed by many European countries. Additionally, the U.S. continues to implement bipartisan plans which require continual compromise. Bipartisan policies definitely have advantages, but the trade-off can be inconsistency. This is the exact dilemma the U.S. currently faces in international tax reform. Unfortunately, “the consequence of a high incentive to long-term, stable compromise is higher spending. The consequence of higher spending is higher taxes.”26 Bipartisan compromises lead to an increased complexity in the code, which becomes more costly to enforce, resulting in higher revenue streams, but also an increase in spending. “A tax system that promotes various causes cannot be simple. It brims with provisions. Goals conflict; contradictions are unavoidable. Similarly, a system that favors some taxpayers must disfavor others. ‘Fairness’ suffers.”27 Instead of promoting one stable international tax policy, the U.S. oscillates between CEN and CIN, ultimately resulting in a lack of neutrality, equity, and simplicity.


The Latest Attempt at Reform

This scenario most recently occurred in the latest corporate tax reform package, the American Jobs Creation Act of 2004 (HR 4520).28 The impetus for this tax package was the ongoing dispute between the United States and the European Union over ETI benefits. Congress passed the Act in order to relieve U.S. corporations from $5 billion in sanctions for the use of an illegal export subsidy. In addition to repealing ETI, the Act establishes a production activities deduction which allows domestic manufacturers producing goods in the United States to deduct a portion of their “qualified production activities income.”29 Unfortunately, the Act is littered with special-interest provisions. Filmmakers, ceiling fan manufacturers, and tobacco producers, to name a few, all have special provisions. The Act does provide for several major changes in international tax policy, thus making both Bush’s and Kerry’s plans moot. Neither policymaker’s full agenda will be pursued, and again, the result is a patchwork of incongruent policies.

In addition to repealing ETI and establishing a production activities deduction, the Act also calls for an 85% dividends-received deduction from CFCs, repatriation of earnings at 5.25% for one year, a reduction in the number of baskets and other simplifications in calculating the foreign tax credit, a recharacterization of overall domestic losses into foreign-source income, and the elimination of some subpart F income.30 Even these few selected provisions contradict each other and do not pull U.S. international tax policy in one consistent direction. For example, a repatriation of earnings is a tax holiday to encourage U.S. companies to reinvest in the United States, thus discouraging deferral. However, by eliminating some subpart F income, which requires that certain types of income be taxed regardless of a distribution, deferral is again encouraged. While Congress’ intent was simplification and neutrality, these goals become diluted among contradictory provisions.


Pragmatic Solutions?

Economists note that “openness to trade boosts revenue by itself.”31 Currently, U.S. international tax policy as manifested in a worldwide tax system does not maximize openness to trade. Normally, a CEN philosophy would not be problematic, but it becomes an issue when the majority of the U.S.’s trading partners have adopted a CIN mentality. It is highly ironic that a worldwide tax system creates a larger tax base and larger potential revenue streams, but in the current global market it inhibits trade. Currently, other countries allow for a border adjustment, but the U.S.’s “system, based on directly taxing the incomes of companies and individuals, does not allow for a border adjustment. But it does allow Europeans to rebate indirect taxes on goods exported from Europe and impose taxes on goods when they are imported.”32 One very obvious solution is that the WTO needs to put the European Union on a level playing field by prohibiting indirect subsidies. The U.S. export incentives are only intended to offset the reliance of U.S. trading partners on value-added taxes (VAT).33

However, this resolution would only be temporary and would not completely fix the inherent clashes between worldwide and territorial tax systems: “It seems likely that we are at just the beginning of a long process of global integration.”34 The flux and uncertainty in U.S. policies cause many companies to be disadvantaged in international markets.35 Therefore, it would be wise of Congress to establish a consistent international policy in order to effect international tax reform that promotes neutrality, equity and simplicity. Unfortunately, “the simple fact is that good theoretical concepts can easily founder on rocky administrative problems.”36 Pragmatically, consistency will remain simply an ideal across partisan lines, and policy will continue to oscillate between competing worldviews.




Wray E. Bradley and Richard E. Nantz, p. 71.

2 Ibid., p. 71.

3 Ibid., p. 72.

4 Ibid., pp. 72-76.

5 “Understanding the WTO Agreements.”

6 Chris Edwards and Veronique de Rugy, p. 8.

7 “The Kerry-Edwards Plan to Revitalize Manufacturing and Invest in the Jobs of the Future.”

8 Martin Sullivan, “Good Politics.”

9 Ibid.

10 “The Kerry-Edwards Plan to Revitalize Manufacturing and Invest in the Jobs of the Future.”

11 Ibid.

12 William W Beach et al., pp. 5-10.

13 “Republican Oath.”

14 “Bush Cheney 2004.”

15 David Benson et al., pp. 598-600.

16 Beach et al., p. 4.

17 Gary Clyde Hufbauer and Paul Grieco, p. 2.

18 “Kerry Blames Corporate Tax Code for Shipping Jobs Overseas.”

19 Ibid.

20 “Total Number of U.S. Sole Proprietors.” 2003.

21 “Total Number of U.S. Partnerships.” 2003.

22 William A. Niskanen, “Reaganomics.”

23 “Bush signs $800 billion debt limit hike.”

24 “Greenspan concerned with weak dollar.”

25 Edwards and de Rugy, p. 1.

26 Andrew Gould, p. 5.

27 Robert J. Samuelson, A23.

28 American Jobs Creation Act of 2004. HR 4520.

29 The American Jobs Creation Act of 2004: Overview of Domestic and International Provisions, p. 8-10.

30 Ibid., pp. 18-27.

31 Gould, p. 17.

32 Lawrence Lindsey, A16.

33 U.S. Senate Committee on Finance, p. 1.

34 Edwards and de Rugy, p. 6.

35 Bradley and Nantz, p. 80.

36 Henry J. Aaron and Joel Slemrod, p.2.




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American Jobs Creation Act of 2004. HR 4520.


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Beach, William W., Ralph A. Rector, Rea S. Hederman Jr., Alfredo B. Goyburu, and Tim Kane. The Candidates’ Tax Plans: Comparing the Economic and Fiscal Effects of the Bush and Kerry Tax Proposals. The Heritage Foundation: Washington D.C., September 20, 2004.

Benson, David, Michael F. Mundaca, Marjorie A. Rollinson, and Peg O’Connor. “Current Status of Legislation Relating to International Tax Rules.” Tax Management International Journal 33.10 (Oct. 8, 2004), 597-607.

Bradley, Wray E. and Richard E. Nantz. “The Restructuring of U.S. International Tax Policy.” The International Tax Journal 28.3 (Summer 2002), 70-81.

Bush Cheney 2004. http://www.bushpresident2004.com/bush-


“Bush signs $800 billion debt limit hike.” CNN.com. November 19, 2004. /www.cnn.com/2004/ALLPOLITICS/11/19/congress.spending.debt.ap/index.html>.

Edwards, Chris and Veronique de Rugy. “International Tax Competition: A 21st-Century Restraint on Government.” Policy Analysis No. 431. Cato Institute. April 12, 2002.

“Greenspan concerned with weak dollar.” CNNMONEY. November 19, 2004.


Gould, Andrew. “Party Size and Policy Outcomes: An Empirical Analysis of Taxation in Democracies.” Studies in Comparative International Development 36.2 (Summer 2001), 3-26.

Hufbauer, Gary Clyde and Paul Grieco. “Senator Kerry on Corporate Tax Reform: Right Diagnosis, Wrong Prescription.” International Economics Policy Briefs. Institute for International Economics. Number PB04-3. April 2004.

“Kerry Blames Corporate Tax Code for Shipping Jobs Overseas.” Fact Check. July 28, 2004.


“The Kerry-Edwards Plan to Revitalize Manufacturing and Invest in the Jobs of the Future.” JohnKerry.com. 2004. /www.johnkerry.com/pdf/manufacturing.pdf>.

Lindsey, Lawrence. “Simplify, Simplify, Simplify.” The Wall Street Journal. New York, N.Y. September 16, 2004: A16.

Niskanen, William A. “Reaganomics.” The Concise Encyclopedia of Economics. 1988. /www.econlib.org/library/Enc/Reaganomics.html>

“Republican Oath.” GOP. June 28, 2004.


Samuelson, Robert J. “Tax Reform R.I.P.” Washington Post.

May 12, 2004: A23.

Sullivan, Martin. “Good Politics, Yes, But Can Kerry’s Plan Create Jobs?” Tax Notes. April 5, 2004. /www.taxanalysts.com/www/freefiles.nsf/Files/Sullivan.pdf/$file/Sullivan.pdf>.

“Total Number of U.S. Partnerships.” BizStats.com. 2003. /www.bizstats.com/numberparts.htm>.

“Total Number of U.S. Sole Proprietors.” BizStats.com. 2003. /www.bizstats.com/numbersp.htm>.

“Understanding the WTO Agreements.” World Trade Organization. /www.wto.org/english/thewto_e/whatis_e/tif_e/agrm8_e.htm#subsidies> November 8, 2004.

U.S. Senate Committee on Finance. An Examination of the U.S. Tax Policy and its Effect on the Domestic and International Competitiveness of U.S.-Based Operations. 108th Congress. July 8, 2003. Government Printing Office: Washington D.C., 2004.