COMMENT ON GRUBERT AND NEWLON, THE INTERNATIONAL IMPLI- CATIONS OF CONSUMP- TION TAX PROPOSALS REUVEN S. AVI-YONAH * Abstract - Grubert and Newlon present a thorough, well-considered, and wellbalanced analysis of the international implications of the current proposals to adopt one of several consumption tax regimes in the United States. While agreeing with most of their conclusions, this comment (a) points out that Grubert and Newlon s article implies, even though it does not explicitly state, that a destination-based consumption tax (like the USA business tax) is superior to an origin-based consumption tax (like the flat tax) on several grounds and (b) takes partial issue with Grubert and Newlon s assessment of the likely reaction of other countries to the replacement by the United States of its income tax with a consumption tax, especially in regard to the likelihood that other developed countries may terminate their income tax treaties with the United States. INTRODUCTION Grubert and Newlon (1995) present a thorough, well-considered, and wellbalanced analysis of the international * Harvard Law School, Cambridge, MA 02138. implications of the current proposals to adopt one of several consumption tax regimes in the United States. They reach the following conclusions. (1) The impact on the total U.S. capital stock is uncertain, because while investment in U.S. equity from abroad should increase, debtfinanced investment in the United States may decrease if U.S. interest rates fall as a result of the switch to a consumption tax. However, the decline in interest rates may be dampened to the extent world debt markets are integrated. (2) The exemption of foreign income under a consumption tax is unlikely to cause a runaway plant problem; indeed, multinational corporations (MNCs) are more likely to shift tangible investment, intangible assets, and R&D to the United States. (3) The destination and origin principles for the taxation of exports and imports are equivalent for international trade and investment at the margin and should therefore have no effect. However, under the origin 259
NATIONAL TAX JOURNAL VOL. XLIX NO. 2 principle, but not under the destination principle, inframarginal, supernormal returns are taxed, and therefore, some incentive may remain for MNCs to locate production in low-tax countries to avoid U.S. tax on supernormal returns. (4) The transition effects of a destination-based consumption tax fall entirely on U.S. residents (on both their U.S. and foreign assets), while the transition effects of an origin-based tax fall on both U.S. and foreign residents on their U.S. (but not their foreign) assets. (5) An origin-based, but not a destination-based, tax would continue the incentive for income shifting by MNCs out of the United States through transfer pricing. (6) Under a destination-based, but not under an origin-based tax, it would be necessary to identify nondeductible foreign services and to allocate implicit service fees of financial intermediaries between foreign and domestic sources. (7) A destination-based consumption tax creates an incentive for crossborder shopping and consumption. (8) The reaction of foreign governments to the erosion of their tax base through transfer price manipulation and shifting of interest expense should be taken into account. However, foreign governments may not find it in their interest to terminate their income tax treaties with the United States. I agree with most of these conclusions. In this comment, I would like to accomplish two things. First, to highlight that Grubert and Newlon s article implies, even though it does not explicitly state, that a destination-based consumption tax (like the USA business tax) is superior to an origin-based consumption tax (like the flat tax) on several grounds. Second, to take partial issue with Grubert and Newlon s assessment of the likely reaction of other countries to the replacement by the United States of its income tax with a consumption tax, especially in regard to the likelihood that other developed countries may terminate their income tax treaties with the United States. THE SUPERIORITY OF A DESTINATION- BASED CONSUMPTION TAX In Avi-Yonah (1995b), it was argued that the destination-based USA business tax is superior to the origin-based flat tax proposal, not because of the usually cited reason (encouraging exports), which economists (including Grubert and Newlon) have shown to be fallacious, but rather because of the administrative complexity involved in an origin-based tax. Specifically, an originbased business tax does nothing to resolve the transfer pricing problem, which has been vexing the IRS for many years and is likely to continue as a major source of difficulty in years to come, despite the adoption of new regulations to deal with the problem (Avi-Yonah, 1995a). 1 In addition, McLure and Zodrow (1995) have pointed out the avoidance potential inherent in deducting imports but not interest, because a foreign seller will be indifferent to receiving payment on a sale of sellerfinanced goods in the form of payment for the goods (deductible) or interest (nondeductible from a U.S. perspective). A destination-based value added tax (VAT) like the USA business tax eliminates both of these problems and is therefore significantly superior to the origin-based flat tax on administrative grounds. Grubert and Newlon identify both these issues and add other reasons for preferring a destination-based tax: In 260
an origin-based tax, there is some incentive for MNCs to locate production in low tax countries to avoid U.S. tax on supernormal returns; and the transition incidence of a destination-based tax falls solely on U.S. residents, where it is easier to deal with (if transition relief is considered necessary). On the other hand, the problems identified by Grubert and Newlon in a destination-based tax (which are grounds for preferring an origin-based tax) seem less compelling than its advantages. The identification of nondeductible foreign services and the allocation of service fees of financial intermediaries between foreign and domestic sources seem no more difficult than the many sourcing issues that arise under the current income tax, or under the destination-based VAT, as adopted throughout the world. The incentive to shop abroad and to emigrate in a destination-based consumption tax can perhaps be countered through adequate customs enforcement and through imposing a tax upon emigration (the latter provision needs to be tougher, however, than current I.R.C. section 877, which has been adopted by the drafters of the USA proposal despite universal admission that it does not work). 1 Moreover, as Hines (1996) points out, Americans have traditionally showed little inclination to emigrate en masse in response to tax incentives. Thus, 1 Grubert and Newlon would probably agree that the USA proposal is superior on those technical and administrative grounds to the flat tax proposal, although they do not quite say so. THE REACTION OF FOREIGN GOVERNMENTS The fundamental problem with the consumption tax proposals from an international perspective is that they exacerbate the two biggest problems currently facing the international tax regime. That regime, as it has developed since the 1920s, has allocated the right to tax passive (portfolio) income primarily to the country of residence of the individual earning the income, while the source country retains the primary right to tax active business income (earned primarily by MNCs). In each case, the other country retains the residual right to tax income that goes untaxed by the country having the primary right: In the case of portfolio income, by withholding at source unless the income can be shown (by a tax treaty) to be subject to tax in the hands of its recipient; and in the case of active income, 2 by imposing residual residencebased taxation on the worldwide income of MNCs with a foreign tax credit, 2 resulting in residence based taxation where there are no foreign taxes to be credited (or the foreign tax rate is lower). As pointed out in Avi-Yonah (1996), there are two major problems in the current regime, both of which are likely to be made harder to solve by the adoption of any of the consumption tax proposals. The first is the difficulty faced by many countries of residence to tax the foreign source portfolio income of their residents, which is made worse by the unilateral decision of countries like the United States to forego withholding tax on portfolio interest. The flat tax and USA proposals exacerbate this problem by abolishing the withholding tax on dividends, royalties, and other forms of portfolio income, confirming the status of the United States as a giant tax haven. 2 The second problem is the difficulty faced by source countries in adequately taxing MNCs on their active income because of transfer pricing abuse and 261
NATIONAL TAX JOURNAL VOL. XLIX NO. 2 erosion of the tax base through thin capitalization. This problem likewise will be exacerbated by both the flat tax and USA business tax proposals: Since in each case no tax is due on new investment in the United States, as Grubert and Newlon point out, a definite incentive is created for both foreign and domestic MNCs to shift their operations (or at least their taxable profits) to the United States, even as compared to investment in low-tax countries ; in fact, the United States will be a low-tax country. While the United States will have solved the problem by simply giving up on taxing MNCs, other countries will find it much more difficult to tax MNCs given the incentive to shift operations to the United States, at the expense of global efficiency. Moreover, as Grubert and Newlon point out, MNCs will have considerable incentives to shift profits artificially to the United States, either through transfer pricing manipulation, or through thin capitalization and interest deductions (given that interest income will be untaxed in the United States under either the USA or the flat tax proposal). Given this situation, how are other countries likely to react? There are two basic possible reactions. In the first, the reduction of taxes by the United States will force other countries to reduce their taxes on capital as well, and perhaps adopt similar reforms, as envisaged by McLure (1992). Grubert and Newlon seem to consider this the most likely outcome and state that the overall effect on global efficiency is unclear: While the distortionary tendency to shift capital to the United States would be muted, other countries may have to raise other taxes to make up for the lost revenue, especially on labor income, which could lead to other types of distortion. The choice facing those other countries may be more politically difficult than envisaged by Grubert and Newlon: Countries which have a VAT already tax consumption at much higher rates than the United States, and individual income tax rates also tend to be higher. Thus, countries with little leverage, 3 especially developing countries, may have no choice but to reduce taxes on capital without replacing the foregone revenue, with significant policy effects. However, there is another possible reaction, especially for developed countries like our major trading partners. Those countries could try to capture the tax revenue unilaterally foregone by the United States. Taxation abhors a vacuum : In the past, whenever situations arose that enabled MNCs to channel their profits to low-tax jurisdictions, the members of the Organisation for Economic Co-operation and Development (OECD) took steps (like the adoption of Subpart F by the United States and thereafter by other OECD members) to capture the tax on those profits. In the case of foreign MNCs, the reaction of foreign countries would be relatively simple: To extend the worldwide taxation of their resident MNCs to capture the U.S.-source profits. In that situation, the United States will ironically have to make the same argument that it has consistently ignored in refusing to grant tax-sparing credits in its treaties: that other countries are essentially transferring revenue from its fisc to their own, thus nullifying the effect of the tax holiday granted by the United States. Other countries may then reply, as the United States has done consistently since the 1960s, that the United States should not have made the tax holiday possible in the first place. The reason foreign countries with major MNCs (i.e., the other OECD members) are likely to adopt this attitude is that they are unlikely to be harmed by it, in 262
the sense of losing investments by their MNCs to the United States. From the point of view of a foreign MNC, the adoption of consumption taxation and the abolition of the U.S. corporate income tax (except on supernormal returns, under an origin-based tax) represent a pure windfall, which would lead it to expand investment in the United States. The imposition of home country tax on that income would restore the situation to the status quo before the windfall, and investment patterns would return to their normal state. Grubert and Newlon consider this option unlikely, and believe investment in the United States would increase even if (as is likely) no credit is given abroad for the consumption-based taxes, because of deferral and cross-crediting. However, deferral is unlikely to be granted to the United States given that the effective U.S. tax rate will be zero, and even countries that currently exempt active foreign income may rethink this position in the face of such a tax haven; while cross-crediting can be eliminated by the simple expedience of a per-country limitation for the United States (since all U.S. income from capital will be taxed at the zero rate), no internal averaging is possible. As for U.S.-based MNCs, other developed countries, which can count on some level of continued U.S. direct investment, may be able to capture some of the revenue foregone by the United States on those entities as well. Grubert and Newlon point out the likely imposition of transfer pricing rules and thin capitalization requirements by foreign governments as a reaction to the adoption of consumption tax reform by the United States; in addition, changes in the source rules are possible to make more income of U.S. MNCs sourced in the foreign countries where they conduct business. Once again, the U.S. MNCs may refrain from penalizing foreign countries by pulling out altogether as long as the overall effect of those changes is simply to reverse the windfall resulting from the abolition of the U.S. corporate income tax. The end result is not only less distortion in the allocation of global capital investment than in the absence of such reactions by foreign governments, but also a direct transfer of funds from the U.S. fisc to those of our trading partners. The ability of foreign governments to impose rules specifically targeted at U.S. MNCs depends on the rejection of the current tax treaty network, which forbids such discrimination. Grubert and Newlon argue counterintuitively that, even though the flat tax and USA tax are not income taxes and therefore the foreign governments would be entitled to terminate the treaties, they would not do so because of their fear that, in the absence of a treaty, the United States would impose its high statutory withholding rate on investments from the foreign country into the United States. However, retaining the treaty would force the United States (because of the nondiscrimination provision) to impose no withholding taxes on foreign investment, because no tax is imposed on domestic investment. This point seems inconsistent with the rest of Grubert and Newlon s argument. The entire thrust of their paper up to this point has been to show that foreign residents (especially MNCs) would have significant incentives to move their investments into the United States because of the effective zero tax rate. Foreign governments presumably would not welcome this development and may indeed (as Grubert and Newlon state) face considerable pressure to reduce their own tax rate to counter it. Thus, it seems unlikely that foreign governments 263
NATIONAL TAX JOURNAL VOL. XLIX NO. 2 would object to high U.S. withholding taxes on foreign direct investment, which would at least reduce, if not eliminate, the incentive to shift investment into the United States. Foreign governments may terminate their treaties precisely to achieve the imposition of withholding taxes, as well as to have the right to discriminate against U.S. investment in the case of a tax war; and for the same reasons, the United States seems unlikely to want to impose such taxes. In fact, none of the current proposals envisage retaining the 30 percent withholding rate for corporations, while individuals already benefit from no withholding on portfolio interest investment (the USA proposal in its legislative form retains the 30 percent withholding rate for individuals, but for the reasons stated in Shay (1995), this is unlikely to be effective and in any case is not a sufficient incentive for foreigners to retain their tax treaties). 3 Grubert and Newlon, as well as Hines (1996), make one further argument for the proposition that tax treaties will be retained: Foreign governments might not wish their own statutory withholding rates to apply to U.S. investors, since that would make their country even less competitive with the United States. But surely if they wish to do so, foreign governments can abolish their own withholding taxes on U.S. investors even in the absence of a treaty, just as the United States did when it adopted the portfolio interest exemption in 1984. 4 To sum up: Grubert and Newlon s analysis is balanced and well considered, and most of their specific conclusions seem correct; but their description of the likely reaction by other countries underestimates the possibility that the adoption of the USA or flat tax proposal may lead to unrestrained tax competition (either as a race to reduce taxes or as countermeasures designed to capture the foregone revenue base). Green (1993) has extensively documented the negative effects of such tax competition. It seems unlikely to be beneficial either to the world or to the United States in the long run and unfortunate that the United States, which has traditionally taken the lead in combatting the offshore tax havens, may be at the brink of becoming (from the perspective of countries that wish to retain an income tax) the largest haven ever. ENDNOTES I would like to thank Louis Kaplow, Stephen Shay, and Alvin Warren for their extremely helpful comments on an earlier version of this comment. 1 Hines (1996) agrees with this point but argues that transfer pricing abuse is unlikely given the low U.S. tax rate under the flat tax. Nevertheless, transfer pricing abuse is an issue under any positive rate if the alternative is to locate profits in a tax haven or a country with a tax holiday. Moreover, rates are subject to change. 2 The USA proposal in its legislative form retains the withholding tax on dividends and royalties but applies it only to individuals, not legal entities; thus, as Shay (1995) points out, it would be very easy to avoid through conduit entities. While this problem can perhaps be fixed through anticonduit rules such as the current I.R.C. section 7701(l), the administrative costs are likely to be significant, and withholding taxes are easy to avoid by other means (like dividends disguised as interest under the portfolio interest exemption or as payments under equity swaps, which are not treated as U.S.-source income and are therefore not subject to withholding). 3 Shay (1995) also notes that the point made by Grubert and Newlon would only apply to countries that export more capital to the United States than they import from it. Most OECD members, and almost all non-oecd member countries, currently import more capital from the United States than they export into it, especially when portfolio investment (which is generally not subject to withholding taxes) is excluded; although this relationship could shift if the United States adopts a consumption tax. 4 Hines (1996) also points out that other countries may not wish to terminate their tax treaties with the United States because of their general diplomatic relationship with the U.S. government. While this may be true, it seems very risky to rely on the 264
general diplomatic relations to avoid termination of treaties when such termination is in the economic interest of the treaty partner and the treaty partner has the legal right to terminate the treaty under the Vienna Convention. It may even be possible, as Shay (1995) points out, to terminate the withholding tax reductions in a treaty while leaving the nondiscrimination article in place. REFERENCES Avi-Yonah, Reuven S. The Rise and Fall of Arm s Length: A Study in the Evolution of U.S. International Taxation. Virginia Tax Review 15 (Summer, 1995a): 89 159. Avi-Yonah, Reuven S. The International Implications of Tax Reform. Tax Notes 69 No. 7 (November, 1995b): 913 23. Avi-Yonah, Reuven S. The Structure of International Taxation: A Proposal for Simplification. Texas Law Review (forthcoming, May, 1996). Green, Robert A. The Future of Source-Based Taxation of the Income of Multinational Enterprises. Cornell Law Review 79 (1993): 18 70. Grubert, Harry, and T. Scott Newlon. The International Implications of Consumption Tax Proposals. National Tax Journal 48 No. 4 (December, 1995): 619 47. Hines, Jr., James R. Fundamental Tax Reform in an International Setting. Paper presented at The Brookings Institution, Washington, D.C., February 15, 1996. McLure, Charles E. Substituting Consumption-Based Direct Taxation for Income Taxes as the International Norm. National Tax Journal 45 No. 2 (March, 1992): 145 54. McLure, Charles E., and George R. Zodrow. A Hybrid Approach to the Direct Taxation of Consumption. Proceedings of a Conference Sponsored by the Hoover Institute, Washington, D.C., May 11, 1995. Shay, Stephen E. Memorandum to ABA Tax Section Tax Systems Task Force on Selected International Tax Issues Raised by the Domenici-Nunn USA Tax Act of 1995 (S. 722) and the Armey Shelby Freedom and Fairness Restoration Act (H.R. 2060, S. 1050) (October 4, 1995). 265