A country can make constructive use of some assaults on its sovereignty. The US should do so now, with European Union trade sanctions taking effect after a series of contrary rulings by the World Trade Organization.
The WTO has rebuffed every US effort to answer European objections to tax treatment of foreign earnings by American companies. On Mar. 1, EU countries began exercising WTO approval of retaliatory tariffs on US goods worth a total of $4 billion. The US has three ways to respond: submit, retaliate in defiance of the WTO, or overhaul relevant tax laws. The last option is the best. The laws need changing—and not just because the WTO says so.
Foreign pressure
In an election year, fear about seeming acquiescent to foreign pressure will make some lawmakers loath to act on the several bills introduced so far to address this issue. It should, however, be easy to show that WTO compliance is a secondary motivation. The economic reasons to untangle taxation of non-US corporate earnings are more compelling. A trade war threatening because of the WTO's ruling just gives urgency to repairs the US should make anyway in its own interests.
The US and Europe have been quarreling over issues in the WTO case since Congress enacted special tax provisions for domestic international sales corporations (DISCs) in 1971. The EU challenged those provisions, and the US countered by protesting several European tax schemes. In response to a 1981 understanding reached under auspices of the General Agreement on Tariffs and Trade, WTO's forerunner, the US replaced DISCs with foreign sales corporations (FSCs). In 1997, the EU challenged that system to the WTO, which ruled that FSC provisions amounted to prohibited export subsidies. Congress in 2000 replaced FSCs with the extraterritorial income exclusion, which the EU immediately challenged and WTO ultimately rejected in the ruling leading to the new trade sanctions.
Through much of this long and unsuccessful effort to keep American multinational corporations competitive and the WTO happy, Congress was contradicting itself with tax policy. It enacted perplexity after perplexity to assure that US companies active abroad don't get away with anything under the country's worldwide system of income taxation.
Corporate taxation of foreign earnings has become one of the most complex areas of US tax law. To prevent double-taxation of the foreign incomes of US corporations, the US provides a foreign tax credit designed to offset tax payments to other governments. But it limits availability of the credit. For example, tax laws subject investment earnings of foreign subsidiaries to immediate taxation at US rates whether or not the income flows back to the US. They enforce the credit's foreign-source income limit with a labyrinth of earnings categories. They allocate US interest expense to foreign income. And they apply special confusions to oil and gas earnings. As a sad consequence, many US companies don't get full use of a credit that's supposed to keep them from being overtaxed.
Complexity isn't the only problem. For corporations, the income-tax rate is too high. According to a Cato Institute report using KPMG data, the US corporate rate of 40%—35% federal and 5% state—is the second highest in the 30-member Organization for Economic Cooperation and Development. The average top corporate income-tax rate in the OECD fell to 30.9% last year from 37.6% in 1996.
The US government can't do anything about the WTO ruling and approval of EU sanctions over tax breaks for exporters. It can do something about its own assaults on the international competitiveness of American corporations.
Legislation
A few lawmakers are trying. Senate legislation proposed in response to the threat of EU sanctions would trim the corporate income tax rate by 2 percentage points. A bill in the House Ways and Means Committee would move the US toward territorial income taxation.
Those are steps in the right direction. But progress won't be easy. Besides the temptation to rebuke international pressure, an election year will generate populist resistance to anything that helps corporations, especially a tax cut. But the issue presents the choice between an economy that keeps growing and one that doesn't. Even for politicians in an election year, that should be an easy call.