US and EU on Collision Course Over Taxes

Published December 1, 2003

The World Trade Organization (WTO) ruled on November 10 that U.S. tariffs on imported steel, imposed in March 2002, violate global trade rules. The ruling, from the WTO’s Appellate Body, authorizes the European Union (EU) and other complaining parties to impose retaliatory sanctions against the U.S. if the tariffs are not lifted. U.S. officials were given just 30 days to lift the tariffs.

The complaint was brought by Brazil, China, the European Communities, Japan, Korea, New Zealand, Norway, and Switzerland. The EU has threatened to impose $2.2 billion in sanctions against the U.S.; Japan and China issued similar threats.

The steel ruling comes just six months after the WTO’s Dispute Settlement Body also ruled against the U.S., this time on a complaint over the Foreign Sales Corporation (FSC) mechanism used by U.S. corporations to protect revenues from the federal income tax. FSC law allows U.S. firms with foreign subsidiaries to exclude from federal income tax calculations a share of their net income from the export of goods made in the United States.

Opponents in the EU, who estimate U.S. exporters save as much as $5 billion a year through the FSC mechanism, say it gives U.S. firms an unfair trade advantage. The WTO agrees, first ruling against the FSC in February 2000. (See “History of the FSC Dispute.”)

On May 7, the WTO granted the EU permission to sanction the U.S. by increasing by $4 billion its import tariffs on U.S. goods–everything from agriculture and wool to jewelry and steel. U.S. officials have until the end of the year to correct the situation; the EU tariff is scheduled to go into effect March 1, 2004 if they don’t.

“The WTO decisions put the United States in a difficult position,” said Daniel J. Mitchell, Ph.D., a senior fellow in political economy at The Heritage Foundation. “If our law is not repealed, the EU has the right to impose more than $4 billion of compensatory tariffs on American products each year. These taxes on U.S. exports, which could be as high as 100 percent, would fall on over 1,800 different products including agriculture, jewelry, steel, machinery and mechanical appliances, wool and cotton textiles, and toys.

“Yet repealing the law,” continued Mitchell, “means higher corporate income taxes–also about $4 billion annually–for companies that benefit from the law. This seems like a no-win situation–either higher taxes on corporate income or higher taxes on exports.”

An Unexpected Opportunity?

But all is not lost, said Mitchell. “While not desirable, the WTO decisions could be a blessing in disguise if they spurred much-needed tax reform,” he explained in a September 25 Backgrounder for Heritage.

“Ideally, lawmakers should engage in wholesale change, junking America’s worldwide tax system (whereby companies are taxed on income earned in other countries) and replacing it with a territorial tax system (the common-sense practice of taxing only income earned inside national borders). This reform would allow U.S.-based companies to compete with foreign competitors, particularly if it is accompanied by a significant reduction in the corporate tax rate.”

Mitchell acknowledged that a wholesale shift to territorial taxation would be a major undertaking, especially given the pressure to act quickly in order to avoid EU sanctions. But even incremental reform, he said, could significantly improve U.S. competitiveness and boost economic performance. He recommended, for example, that lawmakers consider reforms that would:

  • Make interest expense allocation less onerous. Companies should not be required to pretend some interest costs are incurred overseas, a policy that results in higher tax burdens.
  • Reduce foreign tax credit baskets. Companies should not be required to engage in complicated calculations that limit their ability to avoid double taxation.
  • Allow deferral of foreign base company sales and services income. Companies should not be required to pay U.S. tax when a subsidiary in one foreign country sells to a subsidiary in another foreign country, so any delay in a U.S. tax liability is a positive step.
  • Protect against expiring foreign tax credits. Companies should be allowed to benefit fully from their foreign tax credits to minimize the adverse impact of worldwide taxation.
  • Permit repatriation of overseas income. Companies should be encouraged to bring profits back to the U.S., a policy that will boost domestic investment and move the tax code closer to a territorial system.

Other Economists Agree

In an October letter to Congress (see page 5), several economists joined Mitchell in asking for Congressional action on foreign tax reform. They urged a vote on H.R. 2896, a measure introduced on July 25 by Representative Bill Thomas (R-California). The measure would “amend the Internal Revenue Code of 1986 to remove impediments in the Code and make our manufacturing, service, and high-technology businesses and workers more competitive and productive both at home and abroad.” On October 28, a House committee ordered the bill to be reported and amended.

John Skorburg is managing editor of Budget & Tax News. His email address is [email protected].