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					Econ 4410
Instructor: Steven Beckman
2nd Paper
December 1, 2004

          U.S. TAX POLICY - EXPORT SUBSIDY OR LEVELING THE
                             PLAYING FIELD?



          On October 22th 2004, President Bush signed into law the American Jobs

Creation Act of 2004. This is a new tax law, which provides tax breaks for U.S.

manufacturers, multinational operations, and a host of other industries.1 The American

Job Creation Act was designed to replace the current Extraterritorial Income Act or ETI,

which the WTO had determined was a disguised export subsidy, and therefore, in

violation of international trade rules. However, the issue is much more involved. The

WTO failed to take into consideration equally strong arguments for the U.S.’s need for

export tax credits to counteract the European Union’s Value Added Tax. In order to

more fully understand the ramifications to trade, a review of the history of international

tax policy will shed some light on the on-going debate and controversy over U.S. and EU

tax law. In doing so, this paper seeks to inform the reader, and demonstrate the negative

impact of tax laws that provide a competitive advantage to one side or the other.

          International tax policies have existed for centuries. However, over time as trade

has evolved, these policies have needed to be revised. In the 19th century trade was much

less complex and more limited than it is now. Only two types of taxes were widely used

and these were defined as direct or indirect. Direct taxes were taxes that the producer



1
    American Jobs Creation Act of 2004, CCH Tax Briefing.


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paid and indirect taxes were taxes that the consumer paid via higher prices.2 In 1960, the

GATT clearly redefined the distinction between direct and indirect taxes.3 Using the

“origin” principle the GATT determined that direct taxes were taxes that could not be

adjusted at the border. Meaning the producer would pay the tax whether they exported or

not and that the tax could not be imposed on imports. In this situation, each country

would impose direct taxes on their exports or based on where they originated, which is

balanced. The goods upon arriving at the destination country would not need to be taxed

as they were already taxed from the country of origin. However, the “destination”

principle was used in determining how indirect taxes should be handled, which meant the

indirect tax could be adjusted at the border and either rebated to the producer or waived

altogether. Additionally, the indirect tax could be applied to imports. Individual

countries were permitted to decide whether to rebate the indirect taxes on exports and/or

to impose them on imports. This too would be balanced if all direct and indirect taxes

were defined the same way internationally, but this is not the case. The problem with

imposing indirect taxes on imports arises when for one country a direct tax has been

mislabeled as an indirect tax. When this occurs, countries without equivalent indirect

taxes do not get a tax rebate on their exports, but must pay the indirect tax when their

goods arrive at the destination country.

          When the GATT made the distinction between the two taxes, value added taxes or

VATs were rarely used. Since the VAT replaced the EU’s multi-stage sales tax system,




2
    Hufbauer, PB02-10.
3
    Hufbauer, PB02-10.




                                                                                            2
the GATT classified the VAT as an indirect tax.4 This was a mistake on the GATT’s part

as Hufbauer author of The Foreign Sales Corporation Drama: Reaching the Last Act?

explains “GATT alchemy transforms a series of direct taxes into a single indirect tax,

eligible for adjustment at the border. Lacking this magical transformation, a single direct

tax on corporate profits cannot be adjusted at the border.”5 In the 1960’s when this

transition occurred, the U.S. was the dominant exporter of manufactured goods. They

saw little threat from the VAT tax imposed on their exports because of the lack of

competition in the market. So though they could have brought charges of countervailing

duties (CVDs) against the EU to the GATT, they declined in an effort to maintain their

healthy trading relationship. Additionally, in 1962 the U.S. decided to enact Subpart F,

which prohibited multinational U.S. firms from deferring income tax on profits incurred

by a sales subsidiary in a foreign low-tax jurisdiction.6 Unfortunately, the U.S. decisions

to allow VATs to be handled as indirect taxes and the enactment of Subpart F were not

well thought out. As the U.S. soon found out, the ramifications of these two decisions

alone substantially weakened the U.S.’s ability to compete on the global market against

European exporters who enjoyed an unfair advantage as they chipped away at the

dominant export position that the U.S. had held.

        What had happened was that the VAT taxes that had seemed fairly harmless to the

U.S. were instead acting like an export subsidy, which aided European growth. Here is



4
  Hufbauer, Policy Brief 02-10.
5
  Hufbauer, Policy Brief 02-10.
6
  Hufbauer, Policy Brief 02-10.




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how it works. When the EU decided to have the VAT rebated or waived at the border for

its exports, it allowed them to either sell their goods abroad at a lower price and/or retain

the additional profits gained from the rebate. Either way they remained competitive in

the world market without having to cut into their profit margins. Conversely, when the

U.S. exports to the EU, the U.S. is assessed the VAT tax. As noted earlier, countries with

indirect taxes are allowed to elect whether they want to charge indirect taxes on imports

or not. Unfortunately, the EU chose to exercise their right to assess the VAT tax on

imports. Since the U.S. does not rebate or waive taxes on exported goods, the result for

U.S. exporters is that they wind up paying taxes twice on the same product, by paying

both U.S. income tax on their exports and the VAT tax at the EU border. The extra tax

paid on the exported goods from the U.S. ends up cutting into U.S. manufacturer’s

profits, reducing their ability to expand and remain competitive.

       The overall effect of the VAT tax being refunded to EU firms while the U.S. does

not have a similar system, results in the VAT acting as an export subsidy to aid the

expansion of EU firms by limiting the competition from U.S. firms. Instead of remaining

at a Cournot equilibrium, where each firm chooses to maximize output to the point where

both have no further financial gain from producing more, and therefore matching each

others output at a level about the monopoly output, the trade strategy shifts to Stackelberg

leader and follower. The Stackelberg leader selects an output level that if sustained

results in less profit for the Stackelberg follower. The follower is forced to reduce output

in order to remain profitable. Once the Stackelberg follower contracts, the Stackelberg

leader benefits in both greater profits and greater market share. In essence the Stackelberg

leader controls the follower’s output and profit, and transfers profits/market share from




                                                                                                4
the follower to the leader. Between the EU and the U.S., if the EU firms are allowed to

expand by benefiting from tax breaks at the border, which the U.S. does not receive, then

the EU is likely to become a Stackleberg leader. As they gain greater market share, less

profitable U.S. exporters will be forced to contract and reduce output. In other words,

U.S. exporters will become the Stackleberg follower and U.S. profits will shift to the EU.

           Obviously, shifting profits from the U.S. to the EU is not something the U.S.

wants to see happen. So as a countermeasure to the negative impact of the VAT rebate

on exports, the U.S. developed new international tax laws which would help offset the

damage. These laws have had a long and complicated history. With a growing trade

deficit, in 1971 the U.S. introduced the Domestic International Sales Corporation or

DISC, which allowed U.S. corporations a partial tax deferral of about 12 percentage

points on their export earnings.7 Other countries had made use of similar deferrals

through foreign subsidiary earnings in low-tax jurisdictions, but with the enactment of

Subpart F, the U.S. had to come up with another plan, such as DISC. From the U.S.’s

viewpoint DISC merely balanced out the inequitable situation brought about by the VAT

rebates. However, in 1974 the EU challenged the DISC, according to Hufbauer the

European Commission “argued that it was a prohibited export subsidy under the terms of

GATT Article 16.”8 The U.S. countered by challenging certain tax practices of the EU,

which also amounted to export subsidies. In the end, the GATT ruled that both the DISC

and the practice of exempting taxes for sales from foreign subsidiaries were prohibited

under GATT regulations. In other words, it amounted to a stalemate for both the EU and

the U.S.


7
    Hufbauer, Policy Brief 02-10.
8
    Hufbauer, Policy Brief 02-10.


                                                                                           5
           Given that the GATT rulings amounted to a stalemate for all parties, the various

countries involved determined to allow the DISC as long as they could continue with

their current tax deferrals and vice versa. Though, the GATT still prohibited these

practices, the EU and the U.S. mutually agreed to block acceptance of the panel rulings

and allow trade and tax to continue as before. In 1984, the U.S. repealed the DISC and

replaced it with the Foreign Sales Corporation Tax or FSC, which allowed for partial tax

exemption on income from exports from foreign subsidiaries of U.S. corporations.

Basically, the FSC was more closely tailored to the income tax deferral system for

foreign sales corporations that many of the European countries already used. These

international tax laws remained in effect under mutual agreement for 16 years, with each

side receiving some form of tax credit equivalent to the other.

           However, in 1997 the EU challenged this arrangement by claiming that the FSC

was a violation of WTO (formerly GATT) rules. Experts such as Hufbauer feel that “the

European union was motivated by a desire to create bargaining chips, not by a raft of

complaints from European firms.”9 They had lost earlier disputes regarding the

importation and labeling of beef that contained hormones and were possibly seeking to

gain leverage for other disputes, by threatening the benefit to U.S. exporters via their FSC

system of tax exemptions. Unfortunately, this time the U.S. did not go on the offensive

by challenging EU trade regulations. This proved to be an even more fatal mistake than

failing to impose countervailing duties on the VAT or enacting Subpart F in the 1960’s.

The WTO found the FSC to be in violation of WTO practices, and the U.S. opted to

avoid the charge of operating under an illegal export subsidy by altering the tax law and

enacting the Extraterritorial Income Exclusion Act or ETI. Perhaps they felt they were
9
    Hufbauer, Policy Brief 02-10.


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maintaining the peace by not challenging EU tax systems, but the result was that the

WTO found fault with the ETI, as well as the FSC, and ruled in favor of the EU,

awarding them massive punitive damages in the amount of $4.043 billion. A settlement

this large had never previously been awarded, which left both sides stunned at the

ramifications.

           The WTO ruling not only effectively validated European Union VAT practices,

but also prohibited the U.S. from seeking to balance the international trade playing field.

In other words, through the use of tax exemptions/deferrals, etc., the U.S. was striving to

prevent from becoming a Stackleberg follower by, in effect, subsidizing their own

exports and engaging in Stackleberg warfare. Stackelberg warfare reduces or eliminates

the profits for both sides, but eventually forces one side to give in and either cut back or

close down. Usually, in this situation a firm will cut back rather than forego profits and

possibly be driven out of business. If Stackelberg warfare ensued, the likely result is that

both the EU and the U.S. would end up with a Cournot equilibrium, if not a shared

monopoly. However, the WTO ruling not only weighted the playing field in the EU’s

favor, but also granted them an additional benefit in the form of damages.

           Naturally, the issue of export taxation and foreign sales corporation tax has

become a very highly charged issue. According to Hocking, author of Government –

Business Strategies in EU-US Economic Relations, “both sides are now wary of the great

amount of tension in the situation, a tension that could destroy many lines of trade.”10

Though the EU was awarded a substantial sum, they still have an interest in maintaining a

solid trading relationship with the U.S. As importers of American goods that are used in

manufacturing processes further down the line, they do not wish these goods to become
10
     Hocking and McGuire, Government-Business Strategies in EU-US Economic Relations, pg 456.


                                                                                                7
scarce, which would most likely result in a price increase on their imports. Likewise, the

U.S. has no desire to become uncompetitive in the world market and watch their profits

shift to the EU.

       Because of the likely damage to trade the WTO rightfully attempts to prevent

subsidies. Subsidies are given to promote the expansion of firms with the expectation

that competing firms will be forced to contract and shift profits. Subsidies do benefit

subsidized producers (by maintaining their profitability as they gain greater market share)

and world consumers (in the form of lower prices), but these benefits do not outweigh the

expense to realize them. Governments must invest large amounts of money to aid local

producers and competing producers suffer losses by being forced to compete against

firms with an unfair trading advantage. Basically, it is a very expensive way to help

domestic producers. Accordingly, the WTO regulates subsidies to help ensure that world

trade does not unfairly benefit one country over another and result in world losses.

However, the problem is that in the case between U.S. and EU export taxation, the WTO

has allowed the continuation of VAT rebates, while prohibiting U.S. export or foreign

sales tax exemptions. This amounts to allowing a disguised subsidy on the side of EU

exports to exist – the very thing the WTO sought to prevent.

         Accordingly, not willing to accept this situation the U.S. is still attempting to

offset the inequitable trade arrangements by developing yet another new tax law - the

American Jobs Creation Act. This new tax law changes things quite a bit, by providing

tax breaks not only to exporters, but also domestic manufacturers that do not export. It

also encourages the repatriation of foreign sales corporation earnings by reducing the tax




                                                                                             8
in most cases by 5.25%.11 The goal is to encourage overseas firms to bring money back

to the U.S., while simultaneously encouraging small business and counteracting the

disadvantaged position of exports to the EU. The U.S. is hoping that tax reduction versus

tax exemption will pass WTO regulations and not be considered an export subsidy as

previous tax laws were.

           In conclusion, as long as the EU continues to rebate or waive their VAT on

exports, the U.S. will be disadvantaged in terms of its export trade with the EU if they do

not enact a compensatory means of taxation. Currently, the U.S. is in the process of

phasing out the ETI per the WTO ruling. The new American Jobs Creation Act goes into

effect in 2005. It remains to be seen whether the EU will accept this new tax law or

whether it will challenge it. It also remains to be seen whether the WTO will rule against

it or not, if the EU decides to challenge its validity. Either way, it is clear that the U.S.

will continue to seek a means of leveling the playing field with the European Union. All

in all, it is clear that the ramifications from weighting trade in favor of one country or

another reduce the benefits to be gained from trade on a worldwide level. As the

U.S./EU tax debate demonstrates, gaining a competitive advantage via subsidies, no

matter what form they take, is at best a breakeven proposition when dealing with major

players and at worst a net loss for the world trading community.




11
     Gross, President signs American Jobs Creation Act.


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