Reconsidering the Taxation of Foreign Income

Abstract

This paper evaluates the efficiency and distributional consequences of taxing foreign income, noting that home country taxation, as practiced by countries such as the United States, distorts the ownership of business assets, thereby reducing productivity and aggregate income, without advancing the distributional goals underlying most of the tax system. The alternative of exempting foreign income from domestic taxation would significantly influence patterns of capital ownership. In order to exempt foreign income from taxation in a way that does not distort capital ownership it is necessary to avoid making domestic expense deductions contingent on the allocation of investment and other income-producing activity between domestic and foreign locations. Thus it is not only the taxation of active foreign income, but also the expense allocation rules, that create the inefficient ownership incentives in the current U.S. tax system. The efficiency and fairness arguments typically advanced to justify taxing foreign income also imply that countries should subject foreign sales to domestic sales taxation, foreign value added to domestic value added taxation, foreign property to domestic property taxation, and similarly subject any and all foreign activities to the corresponding domestic taxes. In practice, however, no country attempts to apply its sales, value added, property, and all other non-income taxes to the foreign activities of its resident companies, reflecting the obvious associated economic distortions and lack of any clear justification for such extraterritorial taxation. Since the efficiency and fairness considerations are the same whether taxes are imposed on income or they are imposed on sales or value added, it is difficult to understand the rationale for taxing foreign income but not taxing foreign sales or value added. JEL Classifications: H87, H25, K34. James R. Hines Jr. Department of Economics University of Michigan 343 Lorch Hall 611 Tappan Street Ann Arbor, MI 48109-1220