**OVERVIEW OF PRESENT-LAW RULESAND ECONOMIC ISSUES IN INTERNATIONAL TAXATION**

Scheduled for a Hearing 

Before the

SENATE COMMITTEE ON FINANCE

on March 11, 1999

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

March 9, 1999

JCX-13-99

----

**CONTENTS**
**INTRODUCTION**

**I.  SUMMARY**

**II.  PRESENT LAW**

	A.	U.S. Taxation of U.S. Persons with Foreign Income

		1.	Overview		2.	Foreign operations conducted directly		3.	Foreign operations conducted through a foreign corporation		4.	Transfer pricing rules		5.	Foreign tax credit rules		6.	Foreign sales corporations

	B.	U.S. Taxation of Foreign Persons with U.S. Income

		1.	Overview		2.	Net-basis taxation		3.	Gross-basis taxation

	C.	Income Tax Treaties

**III.  BACKGROUND AND DATA RELATING TO INTERNATIONALTRADE AND INVESTMENT**

	A.	Trade Deficits and Cross Border Capital Flows

	B.	Trends in the United States' Balance of Payments

	C.	Trends in the United States' Capital Account

**IV.  ECONOMIC ISSUES IN THE TAXATION OF INTERNATIONAL	TRANSACTIONS**

	A.	Overview

	B.	The Location of Investment Without Taxation

	C.	The Location of Investment With Equal Tax Rates

	D.	The Location of Investment With Unequal Tax Rates

**APPENDIX:  DATA ON U.S. INTERNATIONAL TRANSACTIONS,
	Appendix Table A.1--U.S. International Transactions, 1962-1997

	Appendix Table A.2--U.S. Gross Domesic Product, Gross Saving, Gross			Investment, and Net Foreign Investment, 1959-1998

	Appendix Table A.3--Increase in U.S. Assets Abroad and Foreign				Assets in the United States, 1962-1997

	Appendix Table A.4-Selected Nongovernmental Foreign Holdings of U.S.				Assets (portfolio and Direct Investments), 1982-1996

**INTRODUCTION**

	The Senate Committee on Finance has scheduled a public hearing on March 11, 1999, onissues relating to international tax reform. This document,(1) prepared by the staff of the JointCommittee on Taxation, provides an overview of certain aspects of present law and economicissues relating to international taxation.

	Part I of this document is a summary of the discussions contained in the remainder of thepamphlet. Part II provides an overview of certain present-law income tax rules that apply to U.S.persons doing business abroad and foreign persons doing business in the United States. Part IIIcontains background and data relating to international trade and investment. Part IV discusseseconomic issues relating to international transactions. The Appendix presents data used inFigures 1-7 and 10. 

**I.  SUMMARY**

**Present law**

	Under the present-law Federal income tax system, U.S. persons are subject to U.S.income tax on all income, whether derived in the United States or abroad. However, the UnitedStates generally allows a credit against the U.S. tax imposed on income derived from foreignsources for foreign income taxes imposed on such income. Foreign persons are subject to U.S.tax only on income that has a sufficient connection to the United States.

	Within this basic framework, there are a variety of rules that affect the U.S. taxation ofinternational transactions. Detailed rules govern the determination of the source of income andthe allocation and apportionment of expenses between foreign-source and U.S.-source income.Such rules are relevant not only for purposes of determining the U.S. taxation of foreign persons(because foreign persons are subject to U.S. tax only on income that is from U.S. sources orotherwise has sufficient U.S. nexus), but also for purposes of determining the U.S. taxation ofU.S. persons (because the U.S. tax on a U.S. person's foreign-source income may be reduced oreliminated by foreign tax credits). Authority is provided for the reallocation of items of incomeand deduction between related persons in order to ensure the clear reflection of the income ofeach person and to prevent the evasion of tax. Although U.S. tax generally is not imposed on aforeign corporation that operates abroad, several anti-deferral regimes apply to impose currentU.S. tax on certain income from foreign operations of a U.S.-owned foreign corporation.

	An international transaction potentially gives rise to tax consequences in two (or more)countries. The tax treatment in each country generally is determined under the tax laws of therespective country. However, an income tax treaty between the two countries may operate tocoordinate the two tax regimes and minimize the double taxation of the transaction. In thisregard, the United States' network of bilateral income tax treaties includes provisions affectingboth U.S. and foreign taxation of both U.S. persons with foreign income and foreign personswith U.S. income.

**Trends in U.S. international trade and investment**

	Foreign trade has become increasingly important to the United States economy.  Exportsand imports each have risen from less than six percent of GDP in 1962 to more than 14 percentin 1997. The United States generally was a net exporter of goods and services prior to 1982.Since that time, the United States has been a net importer of goods and services.

	Trade deficits, capital inflows, investment, savings, and income are all connected in theeconomy. The value of an economy's total output must be either consumed domestically (byprivate individuals and government), invested domestically, or exported abroad. If an economyconsumes and invests more than it produces, it must be a net importer of goods and services. Ifthe imports were all consumption goods, in order to pay for those imports, the country musteither sell some of its assets or borrow from foreigners. If the imports were investment goods,foreign persons would own the investments. Thus, an economy that runs a trade deficit will alsoexperience foreign capital inflows as foreign persons purchase domestic assets, make equityinvestments or lend funds (purchase debt instruments).

	Net foreign investment has become a larger proportion of the economy and a moresignificant proportion of total domestic investment than in the past.  In 1982, the United Stateschanged from being a modest exporter of capital in relation to GDP to being a large importer ofcapital.  In 1997, gross investment in the United States was $1,351 billion and net foreigninvestment was $141 billion, or 10.4 percent of gross domestic investment.  The value of foreignassets owned by private U.S. persons has grown from $295.1 billion in 1980 to $3,477 billion in1996.  This growth in value has not been as rapid as the growth in the value of assets in theUnited States owned by foreign persons.

**Economic issues in the taxation of international transactions**

In general.--International investment plays an important role in determining the totalamount of worldwide income as well as the distribution of income across nations. In addition,international investment flows can substantially influence the distribution of capital and laborincome within nations. Because each government levies taxes by its own method and at its ownrates, the resulting system of international taxation can distort investment and contribute toreductions in worldwide economic welfare.

	The nature of these distortions depends on the method of taxing income frominternational investment. If investment income is taxed only at the source, substantial amounts ofcapital could be diverted to jurisdictions with the lowest tax rates instead of flowing toinvestment projects with the highest pre-tax rate of return. If a system of residence taxation is theworldwide norm, enterprises resident in low-tax countries might be able to attract moreinvestment capital or perhaps increase their market share through lower prices to the detriment ofenterprises resident in high-tax jurisdictions, even though the latter are more efficient. In eithercase, capital is diverted from its more productive uses, and worldwide income and efficiencysuffer. The most straightforward solution to this problem is equalization of effective tax rates, butthis may not be a practical solution given differences in national preferences for the amount andmethod of taxation. There is no consensus on what method of taxing international investmentincome minimizes distortions in the allocation of capital when nations tax income at differenteffective rates, but the alternatives of capital export neutrality and capital import neutrality arethe most cited guiding principles. These two standards are each desirable goals of internationaltax policy. The problem is that, with unequal tax rates, these two goals are not mutuallyattainable.

Capital export neutrality.--Capital export neutrality refers to a system where an investorresiding in a particular locality can locate investment anywhere in the world and pay the sametax. Under capital export neutrality, decisions on the location of investment are not distorted bytaxes. Capital export neutrality is a principle describing how investors pay tax, not to whom theypay. Capital export neutrality primarily is a framework for discussing the efficiency andincentives faced by private investors, and not the distribution of the revenues and benefits ofinternational investment.

Capital import neutrality.--Capital import neutrality refers to a system of internationaltaxation where income from investment located in each country is taxed at the same rateregardless of the residence of the investor. Some commentators refer to the principle of capitalimport neutrality as promoting "competitiveness." Under capital import neutrality, capitalincome from all businesses operating in any one locality is subject to uniform taxation. Thenationality of investors in a particular locality will not affect the rate of tax.

	Although they have important implications for national welfare as well as the distributionof income between capital and labor, the debate on the relative merits of capital export neutralityand capital import neutrality centers on which of these more efficiently allocates capital aroundthe world and therefore on which better promotes worldwide economic welfare.

**II.  PRESENT LAW**

**A.  U.S. Taxation of U.S. Persons with Foreign Income**

**1.  Overview**

	The United States taxes U.S. citizens, residents, and corporations (collectively, U.S.persons) on all income, whether derived in the United States or elsewhere. By contrast, theUnited States taxes nonresident alien individuals and foreign corporations only on income with asufficient nexus to the United States.

	The United States generally cedes the primary right to tax income derived from sourcesoutside the United States to the foreign country where such income is derived. Thus, a creditagainst the U.S. income tax imposed on foreign-source taxable income is provided for foreigntaxes paid on that income. In order to implement the rules for computing the foreign tax credit,the Code and the regulations thereunder set forth an extensive set of rules governing thedetermination of the source, either U.S. or foreign, of items of income and the allocation andapportionment of items of expense against such categories of income.

	The tax rules of foreign countries that apply to foreign income of U.S. persons varywidely. For example, some foreign countries impose income tax at higher effective rates than theUnited States. In such cases, the foreign tax credit allowed by the United States is likely toeliminate any U.S. tax on income from a U.S. person's operations in the foreign country. On theother hand, operations in countries that have low statutory tax rates or generous deductionallowances or that offer tax incentives (e.g., tax holidays) to foreign investors are apt to be taxedat effective tax rates lower than the U.S. rates. In such cases, after application of the foreign taxcredit, a residual U.S. tax generally is imposed on income from a U.S. person's operations in theforeign country.

	Under income tax treaties, the tax that otherwise would be imposed under applicableforeign law on certain foreign-source income earned by U.S. persons may be reduced oreliminated. Moreover, U.S. tax on foreign-source income may be reduced or eliminated by treatyprovisions that treat certain foreign taxes as creditable for purposes of computing U.S. taxliability.

**2.  Foreign operations conducted directly**

	The tax rules applicable to U.S. persons that control business operations in foreigncountries depend on whether the business operations are conducted directly (through a foreignbranch, for example) or indirectly (through a separate foreign corporation). A U.S. person thatconducts foreign operations directly includes the income and losses from such operations on suchperson's U.S. tax return for the year the income is earned or the loss is incurred. Detailed rulesare provided for the translation into U.S. currency of amounts with respect to such foreignoperations. Thus, the income from the U.S. person's foreign operations is subject to current U.S.tax. However, a foreign tax credit may reduce or eliminate the U.S. tax on such income.

**3.  Foreign operations conducted through a foreign corporation**

In general.--Income earned by a foreign corporation from its foreign operations generallyis subject to U.S. tax only when such income is distributed to any U.S. persons that hold stock insuch corporation. Accordingly, a U.S. person that conducts foreign operations through a foreigncorporation generally is subject to U.S. tax on the income from those operations when theincome is repatriated to the United States through a dividend distribution to the U.S. person. Theincome is reported on the U.S. person's tax return for the year the distribution is received, and theUnited States imposes tax on such income at that time. A foreign tax credit may reduce the U.S.tax imposed on such income.

	A variety of complex anti-deferral regimes impose current U.S. tax on income earned bya U.S. person through a foreign corporation. The main anti-deferral regimes set forth in the Code(in order of enactment) are the foreign personal holding company rules (secs. 551-558), thecontrolled foreign corporation rules of subpart F (secs. 951-964), and the passive foreigninvestment company rules (secs. 1291-1298). Additional anti-deferral regimes set forth in theCode are the personal holding company rules (secs. 541-547), the accumulated earnings tax(secs. 531-537), and the foreign investment company and electing foreign investment companyrules (secs. 1246 and 1247).

Foreign personal holding companies.--The Revenue Act of 1937 established an anti-deferral regime for foreign personal holding companies ("FPHCs"). A FPHC generally is definedas any foreign corporation if five or fewer U.S. individual citizens or residents own (directly,indirectly, or constructively) more than 50 percent of the corporation's stock (measured by voteor value), and at least 60 percent of the corporation's gross income consists of certain types ofpassive income (such as dividends, interest, certain royalties and certain rents).(2) If a foreigncorporation is a FPHC, all the U.S. shareholders of the corporation are subject to U.S. taxcurrently on their pro rata share of the corporation's undistributed foreign personal holdingcompany income.

Controlled foreign corporations.--The Revenue Act of 1962 established an anti-deferralregime for controlled foreign corporations ("CFCs") under subpart F of the Code. A CFCgenerally is defined as any foreign corporation if U.S. persons own (directly, indirectly, orconstructively) more than 50 percent of the corporation's stock (measured by vote or value),taking into account only those U.S. persons that own at least 10 percent of the stock (measuredby vote only). Under the subpart F rules, the United States generally taxes the U.S. 10-percentshareholders of a CFC on their pro rata shares of certain income of the CFC (referred to as"subpart F income"), without regard to whether the income is distributed to the shareholders.Subpart F income typically is passive income or income that is relatively movable from onetaxing jurisdiction to another. Subpart F income consists of foreign base company income(defined in sec. 954), insurance income (defined in sec. 953), and certain income relating tointernational boycotts and other violations of public policy (defined in sec. 952(a)(3)-(5)).Foreign base company income, in turn, includes foreign personal holding company income,foreign base company sales income, foreign base company services income, foreign basecompany shipping income and foreign base company oil-related income. For example, foreignpersonal holding company income includes, among other items, dividends, interest, rents androyalties (subject to certain exceptions). In effect, the United States treats the U.S. 10-percentshareholders of a CFC as having received a current distribution out of the CFC's subpart Fincome. In addition, the U.S. 10-percent shareholders of a CFC are required to include currentlyin income for U.S. tax purposes their pro rata shares of the CFC's earnings invested in U.S.property. The U.S. tax on such amounts may be reduced through foreign tax credits.

Passive foreign investment companies.--The Tax Reform Act of 1986 established an anti-deferral regime for passive foreign investment companies ("PFICs"). A PFIC generally isdefined as any foreign corporation if 75 percent or more of its gross income for the taxable yearconsists of passive income, or 50 percent or more of its assets consists of assets that produce, orare held for the production of, passive income.(3) Alternative sets of income inclusion rules applyto U.S. persons that are shareholders in a PFIC, regardless of their percentage ownership in thePFIC. One set of rules applies to PFICs that are "qualified electing funds," under which electingU.S. shareholders currently include in gross income their respective shares of the PFIC'searnings, with a separate election to defer payment of tax, subject to an interest charge, onincome not currently received. A second set of rules applies to PFICs that are not qualifiedelecting funds, under which U.S. shareholders pay tax on certain income or gain realized throughthe PFIC, plus an interest charge that is attributable to the value of deferral. A third set of rulesapplies to PFIC stock that is marketable, under which electing U.S. shareholders currently takeinto account as income (or loss) the difference between the fair market value of their PFIC stockas of the close of the taxable year over their adjusted basis in such stock (subject to certainlimitations).

	Detailed rules for coordination among the anti-deferral regimes are provided to preventU.S. persons from being subject to U.S. tax on the same item of income under multiple regimes.For example, the PFIC rules generally do not apply to U.S. shareholders that are subject to thesubpart F rules.

**4.  Transfer pricing rules**

	In the case of a multinational enterprise that includes at least one U.S. corporation and atleast one foreign corporation, the United States taxes all of the income of the U.S. corporation,but only so much of the income of the foreign corporation as is determined to have sufficientnexus to the United States. The determination of the amount that properly is the income of theU.S. member of a multinational enterprise and the amount that properly is the income of aforeign member of the same multinational enterprise thus is critical to determining the amount ofincome the United States may tax (as well as the amount of income other countries may tax).

	Due to  the variance in tax rates and tax systems among countries, a multinationalenterprise may have a strong incentive to shift income, deductions, or tax credits amongcommonly controlled entities in order to arrive at a reduced overall tax burden. Such a shifting ofitems between commonly controlled entities could be accomplished by establishing artificialtransfer prices for transactions between group members.

	Under section 482, the Secretary of the Treasury is authorized to redetermine the incomeof an entity subject to U.S. taxation, when it appears that an improper shifting of income betweenthat entity and a commonly controlled entity has occurred. This authority is not limited toreallocations of income between different countries; it permits reallocations in any commoncontrol situation, including reallocations between two U.S. entities. However, it has significantapplication to multinational enterprises due to the incentives for taxpayers to shift income toobtain the benefits of significantly different effective tax rates.

	Section 482 grants the Secretary of the Treasury broad authority to allocate income,deductions, credits or allowances between any commonly controlled organizations, trades, orbusinesses in order to prevent evasion of taxes or to clearly reflect income. The statute generallydoes not prescribe any specific reallocation rules that must be followed, other than establishingthe general standards of preventing tax evasion and clearly reflecting income. Treasuryregulations adopt the concept of an arm's-length standard as the method for determining whetherreallocations are appropriate. Thus, the regulations attempt to identify the respective amounts oftaxable income of the related parties that would have resulted if the parties had been uncontrolledparties dealing at arm's length. The regulations contain extremely complex rules governing thedetermination of an arm's-length charge for various types of transactions. The regulationsgenerally attempt to prescribe methods for identifying a relevant comparable unrelated partytransaction and for providing adjustments for differences between such transactions and therelated party transactions in question. In some instances, the regulations also provide safeharbors.

	Determinations under section 482 that result in the allocation of additional income to theUnited States theoretically might subject a taxpayer to double taxation if, for example, both theUnited States and another country imposed tax on the same income and the other country did notagree that the income should be reallocated to the United States. Tax treaties generally providemechanisms that attempt to resolve such disputes in a manner that may avoid double taxation ifboth countries agree. Such mechanisms include the designation of a "competent authority" byeach country to act as that country's representative in the negotiation attempting to resolve suchdisputes. Such competent authority procedures, however, do not guarantee that double tax willnot be imposed in a particular case.

	One method for addressing the issue of double taxation is through the recently-developedadvance pricing agreement ("APA") procedures. An APA is an advance agreement establishingan approved transfer pricing methodology entered into between the taxpayer, the InternalRevenue Service ("IRS"), and a foreign tax authority. The taxpayer generally is required to usethe approved transfer pricing methodology for the duration of the APA. The IRS and the foreigntax authority generally agree to accept the results of such approved methodology. An APA alsomay be negotiated between only the taxpayer and the IRS; such an APA establishes an approvedtransfer pricing methodology for U.S. tax purposes. The APA process may prove to beparticularly useful in cases involving industries such as financial products and services for whichtransfer pricing determinations are especially difficult.(4)

**5.  Foreign tax credit rules**

	Because the United States taxes U.S. persons on their worldwide income, Congressenacted the foreign tax credit in 1918 to prevent U.S. taxpayers from being taxed twice on theirforeign-source income: once by the foreign country where the income is earned and again by theUnited States. The foreign tax credit generally allows U.S. taxpayers to reduce the U.S. incometax on their foreign-source income by the foreign income taxes they pay on that income. Theforeign tax credit, however, does not operate to offset U.S. income tax on U.S.-source income.

	A credit against U.S. tax on foreign-source income is allowed for foreign taxes directlypaid or accrued by a U.S. person (the "direct" foreign tax credit). In addition, a credit is allowedto a U.S. corporation for foreign taxes paid by certain foreign subsidiary corporations anddeemed paid by the U.S. corporation upon a dividend received by, or certain other incomeinclusions of, the U.S. corporation with respect to earnings of the foreign subsidiary (the"deemed-paid" or "indirect" foreign tax credit).

	The foreign tax credit provisions are elective on a year-by-year basis. In lieu of electingthe foreign tax credit, U.S. persons generally are permitted to deduct foreign taxes. For purposesof the alternative minimum tax, foreign tax credit s generally cannot be used to offset more than90 percent of the U.S. person's pre-foreign tax credit tentative minimum tax.

	A foreign tax credit limitation, which is calculated separately for various categories ofincome, is imposed to prevent the use of foreign tax credits to offset U.S. tax on U.S.-sourceincome. Under this limitation, the credit for foreign taxes on income in a particular category maynot exceed the same proportion of the taxpayer's U.S. tax liability which the taxpayer's foreign-source taxable income in that category bears to the taxpayer's worldwide taxable income for thetaxable year. Detailed rules are provided for the allocation of expenses against foreign-sourceincome. Special rules apply to require the recharacterization of foreign-source income for a yearsubsequent to a foreign loss year as U.S.-source income.

	The amount of creditable taxes paid or accrued (or deemed paid) in any taxable yearwhich exceeds the foreign tax credit limitation is permitted to be carried back to the twoimmediately preceding taxable years and carried forward to the first five succeeding taxableyears, and credited in such years to the extent that the taxpayer otherwise has excess foreign taxcredit limitation for those years. For purposes of determining excess foreign tax credit limitationamounts, the foreign tax credit separate limitation rules apply.

**6.  Foreign sales corporations**

	A foreign sales corporation ("FSC") typically is owned by a U.S. corporation thatproduces goods in the United States. The U.S. corporation either supplies goods to the FSC forresale abroad to unrelated persons or pays the FSC a commission in connection with its sales tounrelated persons. Under special tax provisions, a portion of the export income of an eligibleFSC is exempt from U.S. income tax (secs. 921-927). In addition, a U.S. corporation is notsubject to U.S. tax on dividends distributed from the FSC out of earnings attributable to certainexport income. Thus, there generally is no corporate level tax imposed on a portion of the incomefrom exports of a FSC.(5)

**B.  U.S. Taxation of Foreign Persons with U.S. Income**

**1.  Overview**

	The United States imposes tax on nonresident alien individuals and foreign corporations(collectively, foreign persons) only on income that has a sufficient nexus to the United States. Incontrast, the United States imposes tax on U.S. persons on all income, whether derived in theUnited States or in a foreign country.

	Foreign persons are subject to U.S. tax on income that is "effectively connected" with theconduct of a trade or business in the United States, without regard to whether such income isderived from U.S. sources or foreign sources. Such income generally is taxed in the same mannerand at the same rates as income of a U.S. person. An applicable tax treaty may limit theimposition of U.S. tax on business operations of a foreign person to cases where the business isconducted through a permanent establishment in the United States.

	In addition, foreign persons generally are subject to U.S. tax at a 30-percent rate oncertain gross income derived from U.S. sources. Pursuant to an applicable tax treaty, the30-percent gross-basis tax imposed on foreign persons may be reduced or eliminated.

	The source of income for U.S. tax purposes is determined based on various factors,including the location or nationality of the payor, the location or nationality of the recipient, thelocation of the activities that generate the income, and the location of the assets that generate theincome.  For example, income from the sale or exchange of inventory property that is produced(in whole or in part) within the United States and sold or exchanged outside the United States, orproduced (in whole or in part) outside the United States and sold or exchanged within the UnitedStates, is treated as partly from U.S. sources and partly from foreign sources. In general, 50percent of such income is treated as attributable to production activities and is sourced based onthe location of the production assets; the other 50 percent of such income is treated as attributableto sales activities and generally is sourced where the sale occurs.

**2.  Net-basis taxation**

	The United States taxes on a net basis and at the generally applicable U.S. tax rates theincome of foreign persons that is "effectively connected" with the conduct of a trade or businessin the United States. Any gross income earned by the foreign person that is not effectivelyconnected with the person's U.S. business is not taken into account in determining the rates ofU.S. tax applicable to the person's income from such business.

	The determination of whether a foreign person is engaged in a U.S. trade or business isbased on the facts and circumstances. Basic issues involved in the determination include whetherthe activity constitutes business rather than investing, whether sufficient activities in connectionwith the business are conducted in the United States, and whether the relationship between theforeign person and persons performing functions in the United States with respect to the businessis sufficient to attribute those functions to the foreign person.

	The factors taken into account in determining whether income, gain or loss is effectivelyconnected with a U.S. trade or business include, for example, in the case of U.S.-source capitalgains and certain U.S.-source passive income, whether the amount is derived from assets used orheld for use in the conduct of the U.S. trade or business and whether the activities of the trade orbusiness were a material factor in the realization of such amount. In the case of any otherU.S.-source income, gain, or loss, such amounts are all treated as effectively connected with theconduct of the trade or business in the United States. Only specific types of foreign-sourceincome are considered to be effectively connected with a U.S. trade or business (sec. 864(c)(4)).Foreign-source income of a type not specified generally is exempt from U.S. tax.

**3.  Gross-basis taxation**

	In the case of U.S.-source interest, dividends, rents, royalties, or other similar types ofincome (known as fixed or determinable, annual or periodical gains, profits and income), theUnited States generally imposes a flat 30-percent tax on the gross amount paid to a foreignperson if such income or gain is not effectively connected with the conduct of a U.S. trade orbusiness. This tax generally is collected by means of withholding by the person making thepayment to the foreign person receiving the income. Accordingly, the 30-percent gross-basis taxis generally referred to as a withholding tax. In most instances, the amount withheld by the U.S.payor is the final tax liability of the foreign recipient and, thus, the foreign recipient files no U.S.tax return with respect to this income.

	Certain exclusions or exceptions from the withholding tax apply. For example, the UnitedStates generally does not tax capital gains of a foreign corporation that are not connected with aU.S. trade or business. Capital gains of a nonresident alien individual that are not connected witha U.S. business generally are subject to the 30-percent gross-basis tax only if the individual waspresent in the United States for 183 days or more during the year (sec. 871(a)(2)). In addition,certain types of interest (for example, interest from certain bank deposits and from certainportfolio obligations) are not subject to the withholding tax.

**C.  Income Tax Treaties**

	In addition to the U.S. and foreign statutory rules for the taxation of foreign income ofU.S. persons and U.S. income of foreign persons, bilateral income tax treaties limit the amountof income tax that may be imposed by one treaty partner on residents of the other treaty partner.For example, treaties often reduce or exempt withholding taxes imposed by a treaty country oncertain types of income (e.g., dividends, interest and royalties) paid to residents of the othertreaty country. Treaties also contain provisions governing the creditability of taxes imposed bythe treaty country in which income was earned in computing the amount of tax owed to the othercountry by its residents with respect to such income. Treaties further provide procedures underwhich inconsistent positions taken by the treaty countries with respect to a single item of incomeor deduction may be mutually resolved by the two countries.

**III.  BACKGROUND AND DATA RELATING TO INTERNATIONALTRADE AND INVESTMENT**

	This part presents background data relating to the scope of the international trade sectorin the United States economy. This part discusses the economic relationship between tradedeficits, capital inflows, investment, and savings in the economy. It briefly reviews trends in boththe current account (the trade surplus or deficit) and the capital account (U.S. investment abroadand foreign investment in the United States).

**A. Trade Deficits and Cross Border Capital Flows**

**National income accounting**

	In popular discussion of trade issues, much attention is given to the trade deficit orsurplus, that is, the difference between the exports and imports of the economy. In the late 1980s,there was also attention given to inflows of capital from abroad. Capital inflows can take theform of foreign purchases of domestic physical assets, of equity interests, or of debt instruments.These two phenomena, trade balances and capital inflows, are not independent, but are related toeach other. Trade deficits, capital inflows, investment, savings, and income are all connected inthe economy. The connection among these economic variables can be examined through thenational income and product accounts, which measure the flow of goods and services and incomein the economy.(6)

	The value of an economy's total output must be either consumed domestically (by privateindividuals and government), invested domestically, or exported abroad. If an economyconsumes and invests more than it produces, it must be a net importer of goods and services. Ifthe imports were all consumption goods, in order to pay for those imports, the country musteither sell some of its assets or borrow from foreigners. If the imports were investment goods,foreign persons would own the investments. Thus, an economy that runs a trade deficit will alsoexperience foreign capital inflows as foreign persons purchase domestic assets, make equityinvestments or lend funds (purchase debt instruments).

	For example, when the United States imports more than it exports, the United States paysfor the imports with dollars. If foreigners are not buying goods with the dollars, then they willuse the dollars to purchase U.S. assets. (An alternate way of viewing these relationships is thatdollars flowing out of the U.S. economy in order to purchase goods or to service foreign debtmust ultimately return to the economy as payment for exports or as capital inflows.)

	The previous discussion focuses on the disposition of the economy's output. If theeconomy is a net importer, it must attract capital inflows to pay for those imports. If the economyis a net exporter, it must have capital outflows to dispose of the payments it receives for itsexports. Another way of looking at the connection between capital flows and the goods andservices in the economy is to concentrate on the sources of funds for investment. Becausedomestic investment must be financed either through saving or foreign borrowing, net capitalinflows must also equal the difference between domestic investment and saving.

	These relationships can be summarized as follows (the equation ignores relatively smallunilateral transfers such as foreign aid and assumes, without loss of generality, that thegovernment budget is balanced):

		Net Foreign Borrowing 	=   Investment - Saving,

								=   (Imports - Exports) - Net Investment Income

For this purpose, imports and exports include both goods and services, and net investmentincome is equal to the excess of investment income received from abroad over investmentincome sent abroad.(7) The excess of imports over exports is called the trade deficit in goods andservices. Net investment income can be viewed as payments received on previously-acquiredforeign assets (foreign investments) less payments made to service foreign debt.

	If the investment in an economy is larger than that country's saving, the country musteither be running a trade deficit or the economy is increasing its foreign borrowing. Similarly, acountry cannot run a trade surplus without also exporting capital, either by increasing its foreigninvestments, or by servicing previously-acquired foreign debt. Because the level of netinvestment income in any year is fixed by the level of previous foreign investment (except forchanges in interest rates), changes in investment or saving that are associated with capital inflowswill have a negative impact on a country's trade balance.

**Economic implications of trade deficits**

	A trade deficit is not necessarily undesirable. What is important is the present and futureconsumption possibilities of the economy. That will depend in part on whether the trade deficit isfinancing consumption or investment. For example, if a country uncovers profitable investmentopportunities, then it will be in that country's interest to obtain funds from abroad to invest inthese profitable projects.(8) If the economy currently does not have enough domestic savings toinvest in these projects, it could reduce its consumption (generating more domestic saving) orlook to foreign sources of funds (thus allowing investment without reducing currentconsumption). For example, suppose new oil reserves that could be profitably recovered throughincreased investment are discovered in the United States. The investment may be financed byforeigners. In order to invest in U.S. assets, foreigners will have to buy dollars, thus increasingthe value of the dollar. This dollar appreciation makes U.S. goods more expensive to foreigners,thereby reducing their demand for U.S. exports. At the same time, the dollar appreciation makesforeign goods cheaper for U.S. residents, increasing the demand for imports and resulting in atrade deficit. Eventually, the flow of capital will be reversed, as the U.S. demand for newinvestment falls, and foreigners receive interest and dividend payments on their previousinvestments.

	The foreign borrowing in the above example was used to finance investment. Thisborrowing did not reduce the living standards of current or future U.S. residents, because theinterest and dividends that were paid to foreigners came from the return from the newinvestment. If foreign borrowing finances consumption instead of investment, there are no newassets created to generate a return that can support the borrowing. When the debt eventually isrepaid, the repayments will come at the expense of future consumption. For instance, consider asituation in which the domestic supply of funds for investment decreases because domesticsaving rates fall. Foreign borrowing in this case is not associated with increased investment, but  instead is devoted to investment that was previously financed with domestic savings. Because theforeign borrowing is not associated with increased investment, future output does not increase,and interest and dividends on the investment will be paid to foreign persons at the expense offuture domestic consumption. In this case, there may be an increase in the standard of living forcurrent U.S. residents at the expense of a decrease in the standard of living of future residents.

	During the period that foreign borrowing finances U.S. consumption, the United Statesruns a trade deficit. Although the United States could service its growing foreign debt byincreased borrowing, and hence larger trade deficits, in the long run trade deficits cannot keepgrowing. In fact, the United States must eventually run a trade surplus. If the United Statesimported more goods than it exported every year, there also would be an inflow of foreign capitalevery year. This capital inflow would be growing with the increasing costs of servicing theforeign debt. Eventually, foreigners would be unwilling to continue lending to the United States,and the value of the dollar would fall. The fall in the dollar would eliminate the trade deficit, andthe United States would eventually run a trade surplus, so that the current account deficit (thesum of the trade deficit in goods and services and the net interest on foreign obligations) wouldbe small enough for foreigners to be willing to lend again to the United States.

	Even when foreign investment finances domestic consumption, trade deficits and capitalinflows themselves should not necessarily be viewed as undesirable, because the foreign capitalinflows help to keep domestic investment, and hence labor productivity, from falling. Forinstance, the large inflow of foreign capital to the United States in the 1980s is widely viewed tobe a result of low U.S. saving rates. If the mobility of foreign capital had been restricted (throughcapital or import controls, for example), then the low saving rate could have led to higherdomestic interest rates and lower rates of investment. That decreased investment would have ledto decreases in future living standards because the lower growth rate of the capital stock wouldhave resulted in lower growth rates of U.S. labor productivity. The fact that foreign capital wasnot restricted and did finance U.S. investment helped mitigate the negative effects on economicgrowth of low domestic saving.

	The above observations support the argument that the trade deficit does not in itselfprovide a useful measure of international competitiveness, since trade deficits and trade surplusescan be either good or bad for the United States. The example of oil discovery discussed aboveshows that even increases in a country's stock of exportable goods can have ambiguous effects onthe trade deficit. If the discovery of oil also increases the demand for investment, then the tradedeficit may actually increase in the short run. Increases in natural resources, advances intechnology, increases in worker efficiency, and other wealth-enhancing innovations haveambiguous effects on the trade deficit in the short and medium run. Because these innovationsincrease the productivity of U.S. workers and lower production costs, they increase theattractiveness of U.S. goods, and may result in increased exports. To the extent these innovationsincrease the demand for investment, however, they can have the opposite effect on the tradedeficit. Nonetheless, each of these innovations increases the output of the economy, and hencethe incomes of U.S. residents.

**B.  Trends in the United States' Balance of Payments**

	Foreign trade has become increasingly important to the United States economy. Figure 1presents the value of exports from the United States and imports into the United States as apercentage of GDP for the period 1962-1997.(9) As depicted in Figure 1, exports and imports eachhave risen from less than six percent of GDP in 1962 to more than 14 percent in 1997. Figure 1also shows that the United States generally was a net exporter of goods and services prior to1982. Since that time, the United States has been a net importer of goods and services.

**FIGURE 1**
	The net trade position of a country is commonly summarized by its current account. TheU.S. current account as a whole, which compares exports of goods and services and incomeearned by U.S. persons on foreign investments to imports of goods and services and incomeearned by foreign persons on their investments in the United States (plus unilateral remittances),was positive as recently as 1981, but generally has been in deficit by over $90 billion per yearnine times since 1984. Figure 2 reports the current account balance of the United States for theperiod 1963 through 1997 in nominal (non-inflation-adjusted) dollars.(10) Figure 2, like Figure 1,shows the United States' change in status from net exporter to net importer since the early 1980s.Figure 2 reflects a substantial reduction in the current account deficit for 1992. In that year, theUnited States received substantial payments from abroad related to the Persian Gulf war. 

**FIGURE 2**
	The aggregate data reported in Figures 1 and 2 mask differences in the trade position ofvarious sectors of the economy. As explained above, the current account compares exports ofgoods and services and payments of income earned by U.S. persons on foreign investments toimports of goods and services and payments of income earned by foreign persons on theirinvestments in the United States. Figures 3, 4, and 5 separately chart the nominal dollar value ofexported and imported goods (Figure 3), exported and imported services (Figure 4), andinvestment income earned by U.S. and foreign persons (Figure 5).(11) The sum of the export curvesin Figures 3, 4, and 5 less the sum of the import curves (plus unilateral remittances) equals thecurrent account balance curve of Figure 2.

	Figures 3, 4, and 5 reveal different trends. As has been widely reported, the merchandise(goods only) trade deficit has been over $100 billion per year since 1984. On the other hand, theUnited States has been a net exporter of services since the mid-1970s (Figure 4). Only since 1994have payments of income to foreign persons on their U.S. investments exceeded U.S. receipts ofincome on investments abroad (Figure 5).

**FIGURE 3**
**FIGURE 4**
**FIGURE 5
	These aggregate data also do not reveal the extent to which growing trade flows resultfrom trade between related parties.  For example, a domestic company might ship componentsmanufactured in the United States to its foreign subsidiary for final assembly and sale.  Suchshipments would be counted as exports from the United States.  A domestic company mightproduce components abroad and ship them to the United States for final assembly and sale.  Suchshipments would be counted as imports to the United States.  Likewise, a foreign parentcompany might ship components from abroad to its U.S. affiliate for final assembly and sale inthe United States.  Such shipments would be counted as imports into the United States.  Theforeign affiliate might ship components to another country for assembly and sale.  Suchshipments would be counted as exports from the United States.

	The preceding paragraph suggests that intra-firm trade involves the shipment ofcomponents across borders.  Other intra-firm trade may involve the shipment of raw materialsabroad for manufacture abroad or shipment of finished goods to a foreign sales affiliate.  Thedata do not permit such distinctions to be drawn.  Nevertheless, the extent of this intra-firmcross-border trade is large and growing.  In 1994, large foreign-owned domestic corporationsreported sales of tangible goods to related foreign persons (exports) of $70.5 billion, a figurerepresenting 14 percent of total U.S. merchandise exports in 1994.  Large foreign-owneddomestic corporations reported purchases of tangible goods from related foreign persons(imports) of $180.6 billion, a figure representing 27 percent of total U.S. merchandise imports in1994.(12)  Similarly, in 1994, U.S. multinational enterprises shipped $136.1 billion of goods totheir foreign affiliates, a figure representing 26 percent of U.S. merchandise exports in 1994. Foreign affiliates of U.S. multinational enterprises $113.4 billion of goods to their U.S. parententerprise, a figure representing 17 percent of U.S. merchandise imports in 1994.(13)  Thus, intotal, in 1994 intra-firm trade accounted for at least 40 percent of U.S. merchandise exports and44 percent of U.S. merchandise imports.

	The balance of payments accounts, presented in Table 1, are analogous to a sources anduses of funds statement of the United States with the rest of the world. As demonstrated in PartIII.A. above, the current account balance, which consists primarily of the trade balance, shouldbe exactly offset by the capital account balance, which measures the net inflow or outflow ofcapital to or from the United States. The difference between the current account surplus or deficitand the capital account deficit or surplus is recorded as a statistical discrepancy. Seriousproblems of measurement cause the accounts to be somewhat mismatched in practice, but basicpatterns are unlikely to be significantly distorted by these problems. 

**TABLE 1**
**C.  Trends in the United States' Capital Account**

**Overview of the United States' capital account**

	As explained in Part III.A., above, when the United States imports more than it exports,the dollars the United States uses to buy the imports must ultimately return to the United Statesas payment for U.S. exports or to purchase U.S. assets. As Figure 2 and Table 1 document theUnited States' current account has been in deficit since the early 1980s. Figure 6 plots gross(before depreciation) U.S. investment and gross U.S. saving as a percentage of GDP for theperiod 1959-1998.(14) Figure 6 also plots net foreign investment as a percentage of GDP. In Figure6, when the United States is a net exporter of capital, net foreign investment is measured as apositive number and when the United States is a net importer of foreign capital net foreigninvestment is measured as a negative number. Net foreign investment became a larger proportionof the economy since 1982. At the same time, the United States changed from being a modestexporter of capital in relation to GDP to being a large importer of capital. Net foreign investmenthas become a larger proportion of the economy and a more significant proportion of totaldomestic investment than in the past. In 1997, gross investment in the United States was $1,351billion and net foreign investment was $141 billion, or 10.4 percent of gross domesticinvestment. In 1993, net foreign investment comprised 8.9 percent of gross domestic investment.

**FIGURE 6**
	The net foreign investment in the United States is measured by the United States' capitalaccount. The capital account measures the increase in U.S. assets abroad compared to theincrease in foreign assets in the United States. Figure 7 plots the annual increase of U.S. assetsabroad and of foreign assets in the United States in nominal dollars for the period 1962-1997.(15)

**FIGURE 7**

**Growth in foreign-owned assets in the United States**(16)

	The amount of foreign-owned assets in the United States grew more than 700 percentbetween 1975 and 1988 and more than 300 percent between 1980 and 1988.(17) The total amountof foreign-owned assets in the United States exceeded $4.5 trillion by the end of 1996.(18) Therecorded value of U.S.-owned assets abroad grew less rapidly during the same period. TheDepartment of Commerce reports that in 1975 the amount of U.S.-owned assets abroad exceededforeign-owned assets in the United States by $74 billion. By the end of 1988, however, thesituation had reversed, so that the amount of foreign-owned assets in the United States exceededU.S.-owned assets abroad by $162 billion. By 1996, the amount of foreign-owned assets in theUnited States exceeded U.S.-owned assets abroad by $871 billion.(19) These investments aremeasured by their book value. Some argue that the market value of U.S.-owned assets abroad issimilar to, or greater than, the market value of foreign-owned assets in the United States, ifmarket values were measured accurately.(20) Figures 8 and 9 display the value of U.S.-ownedassets abroad and foreign-owned assets in the United States for selected years measured underboth current (or book) cost and based on estimates of current market values. Whether thisargument is correct with respect to the current net investment position, it is clear thatforeign-owned U.S. assets are growing more rapidly than U.S.-owned assets abroad as depictedin Figure 7.

**FIGURE 8**
**FIGURE 9
	Foreign assets in the United States (and U.S. assets abroad) can be categorized as directinvestment, non-direct investment, and official assets. Direct investment constitutes assets overwhich the owner has direct control. The Department of Commerce defines an investment asdirect when a single person owns or controls, directly or indirectly, at least 10 percent of thevoting securities of a corporate enterprise or the equivalent interests in an unincorporatedbusiness. Foreign persons held direct investments of $729 billion in the United States in 1996,having grown from $83 billion in 1980.(21)

	The largest category of investment is non-direct investment held by private(non-governmental) foreign investors, commonly referred to as portfolio investment. Thiscategory consists mostly of holdings of corporate equities, corporate and government bonds, andbank deposits. The portfolio investor generally does not have control over the assets that underliethe financial claims. In 1996, portfolio assets of foreign persons in the United States were morethan triple the recorded value of direct investment, $2,576 billion compared to $729 billion,respectively.(22) Bank deposits account for approximately one-third of this total, and reflect, inpart, the increasingly global nature of banking activities. Figure 10 reports the dollar value offoreign holdings of selected U.S. assets, both portfolio investment and direct investment, for1984, 1990, and 1996. Foreign investment in bonds, corporate equities, and bank deposits, likeother types of financial investment, provide a source of funds for investment in the United Statesbut also represent a claim on future U.S. resources.

	The final category of foreign-owned U.S. assets is official assets: U.S. assets held bygovernments, central banking systems, and certain international organizations. The foreigncurrency reserves of other governments and banking systems, for example, are treated as officialassets. Levels of foreign-held official assets have grown more slowly than foreign-held direct andportfolio investment of private investors.

	The value of investments by private U.S. persons abroad has grown from $295.1 billionin 1980 to $3,477 billion in 1996.(23) This growth has not been as rapid as the growth in the valueof investments by foreign persons in the United States.

**FIGURE 10**
**IV.  ECONOMIC ISSUES IN THE TAXATION OF				 				INTERNATIONAL TRANSACTIONS**

**A.  Overview**

	As the previous section documents, cross border trade and investment has grownsubstantially over the past decade. International investment plays an important role indetermining the total amount of worldwide income as well as the distribution of income acrossnations. In addition, international investment flows can substantially influence the distribution ofcapital and labor income within nations. Because each government levies taxes by its ownmethod and at its own rates, the resulting system of international taxation can distort investmentand contribute to reductions in worldwide economic welfare. A government's tax policies affectthe distribution of income directly, by collecting tax from foreigners earning income within itsborders and from residents earning income overseas, and indirectly by inducing capitalmovements across national borders.(24)
	Analysts usually assess any system of taxation in terms of four general principles.
- 	Efficiency.  Does the tax system minimize economic distortions or are taxconsiderations important to investment and employment decisions?  Generally,neutrality promotes economic efficiency.
- 	Equity.  Does the tax system meet the revenue needs determined by the Congress in afair manner?  "Fairness," of course, is a subjective criteria.  In the internationalcontext, one might ask whether domestic businesses are treated fairly  vis-á-vis foreign-based businesses.  Ultimately, the burden of taxes are borne by individuals,either as investors, workers, or consumers.
- 	Growth.  Does the tax system promote economic growth?  A growing economycreates economic opportunities and increases real income for U. S. persons.
- 	Simplicity.  Does the tax system economize on compliance and administrativeburdens?  Complexity increases the burden of the tax on the taxpayer andadministrative burdens reduce the net revenue available to the government for otherpurposes.
In the international context, some have offered an additional principle.
	Harmonization.  To what extent does the tax system conform with internationalnorms? Does the tax system help promote other policy goals in the United States'dealings with foreign countries?

Policymakers cannot apply these principles in a mutually exclusive fashion.  Decisions regardingfairness or growth may affect efficiency or harmonization.  Decisions regarding efficiency andharmonization may create complexity.  Tradeoffs among these principles are inevitable.  Thediscussion in the remainder of this pamphlet will relate only to the principle of efficiency.

	The next three sections (B., C., and D.) discuss in sequence the economic anddistributional effects of international investment flows in a world with no taxes, in a world withequal taxes, and finally in a world with unequal taxes. Section B examines the relatively simplecase of international investment in a world without taxation. In this case, each government(independent of the actions of other governments) can pursue both worldwide interests andnational interests simultaneously. To maximize economic welfare, no government would restrictor subsidize the free flow of capital. Besides increasing wealth, the free flow of capital can alsoresult in a redistribution of income between capital and labor. In particular, labor in thecapital-importing countries benefits at the expense of labor in the capital-exporting countries.

	Section C begins by examining the economics of capital flows when income taxes areimposed at equal rates on all income no matter the source. With taxation, it is not necessarily thecase that each government can pursue maximum national economic welfare and maximumworldwide economic welfare simultaneously. With these goals now potentially inconsistent, acountry undertaking policies consistent with worldwide economic welfare may not be promotingits own national interest. Although detrimental to worldwide economic welfare, the nationalinterest could in some degree be furthered by subsidizing domestic investment and discouragingoutbound investment. It is in this context that section C introduces the concept known as nationalneutrality. Under a system of national neutrality, a government taxes outbound investment by itsresidents more heavily than domestic investment, in order to redirect capital investment todomestic locations, and therefore maximize domestic economic income. This concept isinappropriately labeled "neutrality" since it is deliberately non-neutral in its disincentives foroutbound investment, which are intended to maximize domestic income.(25)

	Section D further relaxes the assumption that taxes are imposed at the same rate on allincome. With unequal taxation, it is much more difficult to determine the design of a tax systemthat best promotes worldwide economic welfare. At this juncture, the concepts of capital exportneutrality and capital import neutrality are introduced.  Sometimes the concept of capital importneutrality is referred to as the goal of "competitiveness." As a whole, the U.S. system of taxationis a hybrid containing elements consistent with both capital import neutrality and capital exportneutrality.

**B.  The Location of Investment Without Taxation**

**Maximizing income**

	Just as free international markets for goods and services result in beneficial "gains fromtrade," the free flow of funds in capital markets also promotes worldwide economic welfare. U.S.citizens and corporations may invest directly in overseas operations over which they exercisesubstantial control, or they may invest indirectly in securities and other financial instruments inwhich they generally are passive investors. Similarly, foreign residents and corporations investdirectly in U.S. operations or indirectly by purchase of a wide variety of U.S. financialinstruments, such as bank deposits, government bonds, and securities of private corporations.

	In general, investors seek to place their funds in projects with the highest risk-adjustedrate of return, regardless of location. If this were not the case, capital markets would inefficientlyallocate capital by not matching savings with the most productive investment opportunities, andeconomic welfare would suffer. Any impediments to the free flow of capital generally reduceworldwide economic welfare. For example, if there were no international capital flows, and theU.S. rate of return were 10 percent while the rate of return in the rest of the world were 8 percent,the opening of international capital markets would reallocate capital from abroad to the UnitedStates, and the United States would become a net capital importer. Worldwide welfare wouldimprove because foreign investors would now export funds in order to reallocate capital fromlower-return foreign investment projects to more productive investment opportunities in theUnited States.

	To maximize worldwide economic welfare, government policies should not interfere withthe free flow of traded goods or of traded capital.(26) For this reason, tariffs on imported goods andrestrictions on inflows of capital are widely recognized as policies reducing worldwide economicwelfare, although they can certainly increase the income of particular domestic producers orparticular domestic investors. However, it is not the case that all policies that increaseinternational trade and capital flows increase economic welfare. Export subsidies may increaseinternational trade, and they may indeed produce economic benefits for the favored industriesand their consumers, but they are also likely to reduce worldwide economic welfare. Similarly,policies to promote outbound investment in excess of free-market levels result in a misallocationof capital that reduces worldwide output and income. If capital is perfectly mobile, investors willequalize rates of return for all investments worldwide. If the United States subsidized outboundinvestment by its residents and corporations, the underlying (before-subsidy) rate of return onoutbound investment would fall below that on investment in the United States. In this case, fromthe standpoint of promoting worldwide efficiency, too much capital would be located outside theUnited States.

**The distribution of income between capital and labor**

	The location of investment has important implications for the distribution of income. Ingeneral, increased capital formation increases the productivity of labor. With more output perworker, labor income (including wages and other forms of compensation) increases. Anyreallocation of investment from the United States to foreign localities, for whatever reason, willreduce the productivity of U.S. workers and therefore their compensation. The remaining smallerpool of capital in the United States will receive a higher rate of return as investors drop the leastprofitable domestic investment projects in favor of investment opportunities abroad.

	It is important to note that despite the decline in wages resulting from the reallocation ofcapital, an increase in overall income may nonetheless occur. As noted above returns ondomestic investments rise and, presumably, the U.S. investors who funded offshore investmentsdid so because such investments would generate a greater return than domestic investments. Asituation of unrestricted capital flows is considered optimal because it maximizes total income. Iftotal national income increases due to the freedom of capital flows, and an outflow of capitalreduces domestic wages, then the increase in capital income necessarily exceeds the decline inwages.(27)

	Similarly, any increase in inbound investment into the United States increases theproductivity of U.S. workers and their income.(28) Increased investment by foreign persons in theUnited States also reduces the return on capital in the United States. If capital inflows are theresult of free-market policies, they increase national welfare. However, as in the case ofoutbound investment, not all sectors of the economy will necessarily be better off.

**The effect of outbound investment on domestic investment**

	A critical factor in determining the effects of international capital flows on thedistribution of income is whether domestic saving increases in response to the availability ofoutbound investment opportunities. If outbound investment does not reduce domesticinvestment, then outbound investment will not reduce labor income (although by increasingreturns on capital it may reduce labor's share of income). However, if outbound investmentresults in a reduction of the U.S. capital stock, labor income will also decline. The importance ofone's assumption about the effect of outbound investment on domestic savings can hardly beoveremphasized. Many conclusions and policy prescriptions derived from the theory ofinternational taxation depend on this assumption.(29)  Unfortunately, little empirical research hasbeen undertaken to determine the direct effect of investment overseas by U.S. investors on U.S.savings and on investment in the United States.(30)

	One way that outbound investment can affect domestic investment is illustrated by thecase of a so-called "runaway plant." The term "runaway plant" usually refers to the relocation toa foreign country of a U.S. production facility owned by U.S. persons. Even if this phenomenonis observed, it does not necessarily lead to the conclusion that U.S. investors collectively reduceinvestment in the United States by the amount of the outbound investment or by any otheramount. Facilities that had been located in the United States may have been substantially fundedby domestic debt and now could be funded by foreign debt. If this were the case, outboundinvestment may make available domestic debt capital for other investments in the United States.Similarly, unemployed workers and other resources made available as a result of the plantrelocation may provide new investment opportunities for other domestic investors. Therefore, if aU.S. plant does relocate, it is uncertain how much (or, strictly speaking, whether) U.S.investment has declined by virtue of that fact. If lower rate financing and inexpensive laborbecome available as a result of outbound investment, runaway plants conceivably might notreduce U.S. domestic investment. However, it is unclear to what extent these newly availableresources might increase domestic investment.

	An indication of the effect of outbound investment on domestic investment may beavailable in the evidence of the responsiveness of domestic saving to changes in domestic ratesof return. For example, if domestic saving is not responsive to changes in domestic rates ofreturn, then domestic saving may be similarly unresponsive to changes in rates of return onoutbound investment. However, there is no conclusive evidence on the responsiveness of savingto changes in rates of return.(31)

**C.  The Location of Investment with Equal Tax Rates**

	If all investors face the same overall rate of tax on capital income, regardless of theirresidence or the source of their income, the allocation of capital across national borders generallywill not be distorted. Although investors receive lower returns as a result of taxation, the rates ofreturn on investments across countries relative to each other are not affected. As in the case offree trade and no taxes, worldwide economic welfare is promoted by international investment.However, unlike the case of a world with no taxes, despite the worldwide increase in welfare,one country may be worse off as the result of international capital movements.

	The wedge between promotion of worldwide welfare and national economic welfareoccurs because taxation of international investment redistributes income across nationaljurisdictions. The net benefit to each country depends on whether tax is collected by the countrywhere the investment is located ("source taxation") or the country of residence of the investor("residence taxation").

	The upper panel of Chart 1 displays a system of international taxation in which tax rateson income earned by all capital--of residents of all countries no matter where their investment islocated--is taxed at the same rate. In this situation, total neutrality prevails in the capital markets.Capital flows freely to its most efficient uses, and investors from different countries withbusinesses located in and competing in the same market pay the same rate of tax. This systemallows capital to flow freely and maximizes worldwide income.

**Chart 1**

	Panel A of Chart 1 provides a taxonomy of the tax that would apply to income from aninvestment by location of the investment and by residence of the investor in a world withidentical tax rates.  If taxes are the same around the world, total neutrality may result fromseveral different international tax arrangements. First, total neutrality will result if each countryimposes a purely residence-based tax (arrangement 1). In that case, each country taxes all incomeof its residents no matter where earned, but does not tax income of foreigners earned within itsborders. Alternatively, total neutrality will result under an exemption system where each countrytaxes all income earned within its borders regardless of the residence of the investor earning thatincome, and no country taxes income from outbound investment of its residents (arrangement2a). Finally, total neutrality will result if each country imposes tax on the worldwide income ofits residents but allows credits for taxes paid to foreign governments, and each country alsoimposes tax on all income earned by foreigners within its borders (arrangement 2b).

	Although all of these systems maximize worldwide income through total neutrality, andeach of these systems collect the same amount of total tax, the choice among these systemsgreatly affects the distribution of tax revenue across countries. Under a purely residence-basedsystem (arrangement 1 above), governments collect tax revenue on income from outboundinvestment and collect no tax on income on inbound investment. Under a territorial system(arrangement 2a above) or a worldwide/source system with credits (arrangement 2b above),governments collect tax on income from inbound investment and no tax on income fromoutbound investment. Thus, both from the perspective of the government's treasury and from theperspective of national income, a capital exporting country may find a residence system morebeneficial, while a capital importing country may find a territorial or a worldwide/source systemwith credits more beneficial.

	Since nations usually reserve to themselves primary taxing jurisdiction over income frominvestments located within their borders, it is important to focus on the welfare implications oftaxation by nations in which the investment is located. If countries generally impose tax onincome arising from within their borders (without regard to the residence of the recipient), themovement of investment--whether foreign or domestically owned--from a foreign to a domesticlocation, can increase national income by the amount of tax collected.  However, with equal ratesof tax worldwide, the taxpayer is indifferent as to which country collects the tax.

	These principles can be illustrated by a simple example. Assume the rate of return is 10percent in the United States and 12 percent in France. With no taxes, worldwide economicwelfare, as well as the economic welfare of each nation, is promoted by the United Statesexporting some capital to France. By relocating a $100 investment, U.S. investors receive $12where they had previously received $10. Suppose, in addition, that each nation imposes a30-percent income tax. It is still in a U.S. investor's interest to seek the relatively more profitableinvestment opportunities in France, and worldwide efficiency is still promoted by free flows ofinternational capital. Furthermore, if effective tax rates are equal around the world, the U.S.investor is indifferent to whether governments impose source or residence taxation. However,those governments are not indifferent. Whether source or residence taxation prevails is of majorimportance to the distribution of income across nations. In this example, even though the Frenchrate of return is higher, if France taxes income at the source, U.S. national income is reduced byinvestment in France. For the relocation of $100 of investment abroad, the United States as awhole now only receives $8.40 of income (after a 30-percent French tax amounting to $3.60)while the U.S. would have received $10 ($7 of after-tax return plus $3 of U.S. tax) forinvestment located in the United States. National income of the United States is reduced by $1.60as a result of the relocation of $100 of investment.(32)

**National neutrality through deductions instead of credits for foreign taxes**

	As just explained, because countries typically tax income arising within their borders, anation can increase its income through policies that reduce outbound investment by its residentsand encourage inbound investment by foreigners. This is the case even if net outboundinvestment is driven below the level that would prevail in a free and efficient international capitalmarket. In contrast to the case of a world with no taxes, promoting national economic interestdoes not coincide with promoting worldwide economic income. Furthermore, in a world ofsource taxation, the national interest and the interests of outbound investors do not coincide.

	To further its national interest, a government can reduce outbound investment byreducing the after-tax rate of return on outbound investment and driving its before-tax returnabove that on domestic investment. It can penalize outbound investment by imposing a layer oftaxation in addition to foreign taxation at source. Panel B of Chart 1 provides the taxamony ofthe tax that would apply to income from an investment by location of the investment and byresidence of the investor under such a tax system.

	Outbound investment is only in the national interest if the return after foreign tax (butbefore domestic tax) equals or exceeds the before-tax return on domestic investment. Thiscondition is achieved when a capital exporting nation, in response to foreign source taxation,does not cede taxing jurisdiction over foreign source income (for example, through a foreign taxcredit) and allows only a deduction for foreign taxes.(33)

	The policy of allowing only deductions for foreign taxes is sometimes known as "nationalneutrality." A deduction penalizes outbound investment and aligns the interests of the taxpayerwith the interests of its home country--but only at the expense of reduced worldwide economicwelfare. Despite the potential to maximize national welfare, self-interested nations generally donot adopt tax systems designed to achieve national neutrality. There are at least three possibleexplanations for this. First, there is reason to expect that one nation's unilateral attempt toimprove its own welfare through a policy of national neutrality would meet with retaliation byother nations with similar policies.  Such tax competition would reduce worldwide income evenfurther.(34) If, on the other hand nations can coordinate their tax policies, a tax system can bedesigned to increase worldwide income above the inefficient level produced by nationalneutrality. With international coordination, there is potential for adopting a system in whichworldwide income could be maximized (and, if necessary, redistributed) so all nations could bebetter off.

	Second, the disincentives to outbound investment embodied in the concept of nationalneutrality only increase national welfare if outbound investment increases at the expense ofdomestic investment. If the economy responds to increased outbound investment with increaseddomestic saving instead of reduced domestic investment, policies to discourage outboundinvestment may have little positive effect on domestic labor and, furthermore, may reducenational welfare in addition to worldwide welfare.

	Third, even if the first two rebuttals to national neutrality do not hold, there is someevidence that outbound investment increases exports by more than it increases imports. Thisincrease in net exports may provide benefits to domestic labor and increase overall domesticincome. If this is the case, policies discouraging outbound investment could increase themerchandise trade deficit and reduce national output.(35)

**D.  The Location of Investment with Unequal Tax Rates**

	If tax rates are not equal across national jurisdictions, taxes have the potential not only toredistribute income across nations, but also to distort investment decisions in a manner thatreduces worldwide economic welfare. The nature of these distortions depends on the method oftaxing income from international investment. If investment income is taxed only at the source,substantial amounts of capital could be diverted to jurisdictions with the lowest tax rates insteadof flowing to investment projects with the highest pre-tax rate of return. If a system of residencetaxation is the worldwide norm,(36) enterprises resident in low-tax countries might be able toattract more investment capital or perhaps increase their market share through lower prices to thedetriment of enterprises resident in high-tax jurisdictions, even though the latter are moreefficient. In either case, capital is diverted from its more productive uses, and worldwide incomeand efficiency suffer. The most straightforward solution to this problem is equalization ofeffective tax rates, but this may not be a practical solution given differences in nationalpreferences for the amount and method of taxation. There is no consensus on what method oftaxing international investment income minimizes distortions in the allocation of capital whennations tax income at different effective rates, but the alternatives of capital export neutrality andcapital import neutrality are the most cited guiding principles. These two standards are eachdesirable goals of international tax policy. The problem is that, with unequal tax rates, these twogoals are not mutually attainable. Satisfying both principles at the same time is possible only ifeffective tax rates on capital income are the same in all countries.

Capital export neutrality*.--*Capital export neutrality refers to a system where an investorresiding in a particular locality can locate investment anywhere in the world and pay the sametax. 

Capital import neutrality*.--*Capital import neutrality refers to a system of internationaltaxation where income from investment located in each country is taxed at the same rateregardless of the residence of the investor. 

	Chart 2 below, compares capital import neutrality with capital export neutrality. The chartprovides a taxonomy of the tax that would apply to income from an investment by location of theinvestment and by residence of the investor under the principle of capital export neutrality (panelA) and under capital import neutrality (panel B).  Tax rates are always equal for investorsresiding in the same country under capital export neutrality. Tax rates are always equal forinvestments located in the same country under capital import neutrality.

**Chart 2**

	Under capital export neutrality, decisions on the location of investment are not distortedby taxes. Capital export neutrality is a principle describing how investors pay tax, not to whomthey pay. Unlike national neutrality (described above), capital export neutrality primarily is aframework for discussing the efficiency and incentives faced by private investors, and not thedistribution of the revenues and benefits of international investment. Tax systems may adhere tothe principle of capital export neutrality by taxing worldwide income and granting credits forincome and profits taxes paid to foreign governments. As an alternative to the system of foreigntax credits, capital export neutrality could be achieved with the source country relinquishing itsjurisdiction to tax income derived from investments within its borders and allowing the countryof residence the exclusive right to tax this income.

	Under capital import neutrality, capital income from all businesses operating in any onelocality is subject to uniform taxation. The nationality of investors in a particular locality will notaffect the rate of tax. Capital import neutrality may be achieved by the residence countryexempting income earned from foreign jurisdictions entirely from tax and allowing the sourcecountry's taxation to be the only taxation on the income of international investors. This iscommonly referred to as a "territorial" or an "exemption" system of international taxation.

	Some commentators refer to the principle of capital import neutrality as promoting"competitiveness."  This notion of competitiveness(37) refers to the ability of U.S. multinationals(firms headquartered in the United States that operate abroad) that locate production facilitiesoverseas to compete in foreign markets.  Overseas production facilities owned by U.S. interestsmay compete with firms owned by residents of the host country or with multinational firmsbased in other countries.  The notion of capital import neutrality promoting the competitivenessof such businesses focuses on the after-tax returns to investments in production facilities abroad. As described above, under the principle of capital export neutrality, any business would see thereturn from its investment in any given foreign country taxed only by that foreign country. Under present law, residual U.S. taxation in the case of a U.S. multinational may applydifferently than residual taxation by another capital-exporting country.  The result may be thatthe after-tax return to an investment by a U.S. multinational in a given foreign country may beless than the after-tax return earned by another investor, even if that investor makes an identicalinvestment to that of the U.S. multinational.  Some argue that this puts the U.S. multinational at acompetitive disadvantage. 

**The distribution of income between capital and labor**

	Although they have important implications for national welfare as well as the distributionof income between capital and labor, the debate on the relative merits of capital export neutralityand capital import neutrality centers on which of these more efficiently allocates capital aroundthe world and therefore on which better promotes worldwide economic welfare. Before exploringthe relative efficiency of capital import and capital export neutrality, however, it is useful toexamine the distributional effects of each, and in this context, to examine how the concepts ofcapital export neutrality and capital import neutrality compare with the principle of nationalneutrality.

	One argument in favor of capital export neutrality is that it promotes horizontal equity.Under capital export neutrality, two investors with identical income would be taxed equallyregardless of the location of their investment. Capital import neutrality may reduce income taxon income from outbound investment below the level of tax on domestic investment income,and, on average, capital income may be treated more favorably than income from other sources.National neutrality, on the other hand, would increase taxes on income from outboundinvestment. It would also reduce the pre-tax rate of return on saving by foreclosing investmentopportunities abroad.  However, horizontal equity may be a more important factor in the shortrun than in the long run.  In the long run, under any tax system, financial markets should tend tovalue investments such that the after-tax return to investments is equalized.

**Strategic trade policy and capital import neutrality**

	Another possible argument for capital import neutrality comes from recent literature oninternational trade. Strategic trade theory abandons the traditional assumption of perfectcompetition and provides a framework for maximizing national economic welfare in the presenceof oligopolistic markets. According to strategic trade theory, and contrary to the traditionaltheory of free trade, it may be in the national interest to subsidize certain industries if firms inthese industries inevitably will exercise considerable market power.  For example, intangiblecapital such as developed through research and development expenditures or the creation ofbrand names may create monopolistic advantages in worldwide markets. In this case, subsidiescan hasten the development of domestic industry which can prevent exploitation by foreignoligopolists. A capital import neutral tax policy is one method of providing such a subsidy to theoutbound investing sector of the U.S. economy.(38)

	It is not clear that strategic trade policy would achieve greater national welfare than freetrade policy.(39)  Furthermore, even if a government chose to implement strategic trade policy, andit chose to implement this policy through the tax system, presumably it would not provide taxsubsidies solely for outbound investing sectors of the U.S. economy. Instead, strategic tradepolicy implemented through the tax system would presumably provide tax incentives to alldomestic import-competing sectors and domestic export sectors.

**Which principle better promotes worldwide efficiency?**

	In a world of unequal taxes, where it is not possible to achieve both capital exportneutrality and capital import neutrality, which is preferable from the perspective of worldwideefficiency?   No consensus exists. The Treasury Department has been a proponent of capitalexport neutrality. In a study on tax reform issued at the outset of 1977, the Treasury Departmentfavored the concept of capital export neutrality in the particular form of residence-based taxation:

		A number of considerations point to the residence principle as the moredesirable principle to establish. First, the concept of income as consumption pluschange in net worth implies that attribution of income by source is inappropriate.Income, by this definition, is an attribute of individuals, not of places. Second, ifowners of factor services are much less mobile internationally than the factorservices they supply, variations among countries in taxes imposed by residencewill have smaller allocation effects than tax variations among places of factoremployment. Third, the income redistribution objective manifested by the use ofprogressive income taxes implies that a country should impose taxes on the entireincome of residents.(40)

	Explicitly comparing it with capital import neutrality and national neutrality, theAdministration reaffirmed its support of the principle of capital export neutrality in its 1985 TaxReform proposals:

		In reaching the decision to continue the worldwide taxation of U.S.taxpayers with allowance of foreign tax credits, the Administration consideredand rejected the alternatives of exempting foreign source income from U.S. tax, ortaxing foreign source income but only allowing a deduction for foreign taxes.While an exemption approach would in some circumstances facilitate overseascompetition by U.S. business with competitors from countries that tax foreignincome on a favored basis, such an approach also would favor foreign over U.S.investment in any case where the foreign country's effective tax rate was less thanthat of the United States. Moreover, there would be a strong incentive to engage inoffshore tax haven activity. The long-standing position of the United States that,as the country of residence, it has the right to tax worldwide income is consideredappropriate to promote tax neutrality in investment decisions. Exempting foreignincome from tax would favor outbound investment at the expense of U.S.investment. The other alternative, to allow only a deduction for foreign taxes,would not satisfy the objective of avoiding double taxation. Nor would it promotetax neutrality; it would be a serious disincentive to make outbound investments incountries where there is any foreign income tax.(41)

	The literature on the theory of international taxation provides no clear direction as to thebetter of the two principles. Although there are advocates for capital export neutrality and forcapital import neutrality, it is sometimes unclear whether authors consider capital exportneutrality superior to capital import neutrality since the two principles are frequently notexplicitly compared. For example, authors usually agree that ideally both capital importneutrality and capital export neutrality are desirable, but then they must also acknowledge thatwhen tax rates are not equal across national jurisdictions, these two principles are not mutuallyattainable. The authors then usually leave the reader with little guidance as to their preference.Richard Caves favors neither principle, but does point out that the superiority of one principleover the other depends on the responsiveness of saving.(42)  Joel Slemrod favors capital exportneutrality as the better policy objective, but also notes that this conclusion does not take intoaccount that capital export neutrality may distort business decisions on where to incorporate andinvestors' decisions on where to reside.(43)

	Peggy Musgrave and Thomas Horst were the first authors who explicitly attempted toascertain the relative efficiency of capital export neutrality and capital import neutrality.(44) Horst'sanalysis explores the relative merits of capital import neutrality and capital export neutrality byfocusing on the response of domestic savings to increased outbound investment opportunities. Acentral tenet of his analysis is that worldwide efficiency suffers under a system of capital exportneutrality if domestic savings is responsive to changes in taxes, and that worldwide efficiencysuffers under capital import neutrality if savings is fixed. However, as discussed below, therelative merits of capital export neutrality and capital import neutrality can be better understoodin a framework broader than that of Horst's model.

**The effect of alternative policies on the two distortions to saving and investment**

	It is perhaps easiest to understand the competing objectives of capital export neutralityand capital import neutrality by recognizing that there are two types of potential distortions tosaving and investment. The first is a distortion in the level of overall saving. The second is adistortion in the allocation of saving among alternative investments. Capital export neutralitypromotes the efficient allocation of savings by taxing all capital income at an equal rateregardless of the source. If the rate of domestic saving is inefficiently low, capital importneutrality promotes efficiency by reducing the tax burden on savings and thereby providing anincentive to increase the level of savings. However, since it provides incentive only for savingthat produces foreign source income, capital import neutrality distorts the allocation of savings.Therefore, a tax rate on outbound investment lower than the tax rate on domestic investment canonly increase economic welfare if the improvement in efficiency from the increase in saving isgreater than the reduction in efficiency from the misallocation of savings.

	On the other hand, capital export neutrality promotes worldwide efficiency in theallocation of savings.  Thus, if there are costs resulting from an inefficient worldwide allocationof savings, capital export neutrality increases efficiency by providing an incentive to allocatecapital to locations that promote the greatest pre-tax return to investment.  However, given thatthe taxation of income from investments generally distorts the decision to save, capital exportneutrality may provide for an overall increase in economic welfare only when the costs arisingfrom an inefficient allocation of saving is large relative to the costs from an inefficient level ofsaving.(45)

	A policy that reduces all tax rates (applied to domestic and foreign source incomeequally) is superior to a policy of equal revenue cost that reduces tax rates only on foreign sourceincome. With a broad reduction in rates, there is a comparable increase in the rate of saving withno distortion of the allocation of capital. For example, a $10 billion across-the-board reduction intax rates on all capital income (i.e., income from both domestic and outbound investment) ismore efficient than a $10 billion reduction in tax rates only for outbound investment. However, iftax rates on domestic source capital income are for some reason fixed,(46) a policy of reducingtaxes only on foreign source income would be the only method of increasing saving. While sucha targeted rate reduction is clearly less desirable, it still might improve economic efficiency.However, even if it is desirable to reduce capital income taxes and the only way to do so is byreducing taxes on foreign source income, strong economic assumptions are required for capitalimport neutrality to be a desirable policy objective. If the foreign country in which domesticfunds are invested taxes all income generated within its borders at the same rate, capital importneutrality would require a U.S. tax rate of zero on foreign source income. Only if the outboundinvestment encouraged by a reduction in taxes on foreign source income has no effect ondomestic investment, and it is assumed that tax rates on domestic investment cannot be altered,will capital import neutrality maximize worldwide efficiency.(47)

**APPENDIX.  DATA ON U.S. INTERNATIONAL TRANSACTIONS
**APPENDIX A.1.--DATA ON U.S. INTERNATIONAL TRANSACTIONS**

**APPENDIX A.2.--DATA ON U.S. GROSS DOMESTIC PRODUCT, GROSS SAVING, GROSS INVESTMENT, AND NET FOREIGN INTESTMENT**

**APPENDIX A.3.--DATA ON INCREASE IN U.S. ASSETS ABROAD AND FOREIGN ASSETS IN THE UNITED STATES**

**APPENDIX A.4.--DATA ON SELECTED NONGOVERNMENTAL FOREIGN HOLDINGS OF U.S. ASSETS**
**FOOTNOTES**
1.   This document may be cited as follows: Joint Committee on Taxation,*Overview ofPresent-Law Rules and Economic Issues in International Taxation* (JCX-13-99), March 9, 1999.
2.   Once the corporation qualifies as a FPHC, the gross income threshold for eachsubsequent year generally is 50 percent.
3.   For purposes of applying the PFIC asset test, a foreign corporation that is publiclytraded measures its assets using fair market value, a CFC that is not publicly traded measures itsassets using adjusted basis, and any other foreign corporation that is not publicly traded measures its assets using fair market value unless the corporation elects to use adjusted basis.
4.   There is ongoing litigation in the U.S. District Court between the Bureau of NationalAffairs, Inc. ("BNA"), a tax publisher, and the IRS involving the public release of APAs. TheIRS announced on January 11, 1999, that it was conceding that APAs are subject to disclosureunder section 6110. (See IR-1999-05). The continuing issues are, among other things, the processof redacting confidential information from the APAs and the schedule under which such APAswill be released.
5.   Two export-related provisions preceded the enactment of the FSC provisions. Underprovisions enacted in 1962, CFCs that qualified as export trade corporations were permitted toreduce their subpart F income by the amount of certain export trade income (secs. 970 and 971).No CFC may qualify as an export trade corporation unless it so qualified as of 1971. Underprovisions enacted in 1971, domestic international sales corporations ("DISCs") were permittedto defer U.S. tax on certain export receipts (secs. 991-997). The FSC rules generally wereenacted to replace the DISC rules to address concerns with General Agreement on Tarriffs andTrade subsidy rules. Upon enactment of the FSC provisions in 1984, a special rule permitted anyDISC to transfer its deferred earnings to a FSC. An interest charge is now imposed on thedeferral of tax on the earnings of any remaining DISC. In July 1998, the European Unionrequested that a World Trade Organization ("WTO") dispute panel investigate the FSC regimeand its compliance with WTO rules including the Agreement on Subsidies and CountervailingMeasures. A WTO dispute panel was established in September 1998 to address these issues. 
6.   The national income and product accounts measure the flow of goods and services(product) and income in the economy. The most commonly reported measure of nationaleconomic income is gross domestic product (GDP). Related to GDP is gross national product(GNP). GNP is GDP plus the net factor income received by residents of United States fromabroad. Thus, wages earned by a U.S. resident from temporary work abroad constitutes part ofGNP but not GDP. Similarly, the returns from investment abroad constitute part of GNP but notGDP. To help understand the connection between trade deficits and cross border capital flows, inthe following it is useful to use GNP, which includes cross border returns to investment, ratherthan the more commonly reported GDP concept. The GNP of the economy is the total annualvalue of goods and services produced by the economy and may be measured in several ways.One way to measure GNP is by expenditures on final product. By this measure, 

	(1) GNP = C + I + G + (X-M) + NI. 

	Equation (1) is an accounting identity which states that gross national product equals thesum of private consumption expenditures (C), private investment expenditures on plant,equipment, inventory, and residential construction (I), government purchases of goods andservices (G), net exports (exports less imports of goods and services and net interest payments toforeigners, or X-M), plus net investment income (the excess of investment income received fromabroad over investment income sent abroad or NI). 

	An alternative is to measure GNP by the manner in which income is spent. By thismeasure, 

	(2) GNP = C + S + T. 

	Equation (2) is another accounting identity which states that gross national product equalsthe sum of private consumption expenditures (C), saving by consumers and businesses (S), andnet tax payments to the government (T) (net tax payments are total tax receipts less transfer,interest, and subsidy payments made by all levels of government). 

	Because both measures of GNP are simple accounting identities, the right hand side ofequation (1) must equal the right hand side of equation (2). From this observation can be derivedan additional national income accounting identity: 

	(3) I = S + (T - G) + (M - X) - NI 

	Equation (3) states that private investment equals private saving (S), plus public saving(T-G) and net imports (M - X), less net investment income.
7.   This equation in the text can be seen from equation (3) in footnote 6 above if thegovernment budget is assumed to be balanced, that is, if G = T. It follows that if the governmentruns a deficit, that is, if G>T, for a given level of investment, saving, and net investment income,net foreign borrowing must be greater.  
8.   This scenario describes the experience of the United States in the mid to late 1800s,when foreign capital inflows financed much of the investment in railroads and other assets.  
9.   Data for Figure 1 are from the U.S. Commerce Department, Bureau of EconomicAnalysis and are reprinted in Appendix Tables A.1. and A.2.
10.   Data for Figure 2 are from the U.S. Commerce Department, Bureau of EconomicAnalysis and are reprinted in Appendix Table A.1.  
11.   Data for Figures 3, 4, and 5 are from the U.S. Commerce Department, Bureau ofEconomic Analysis and are reprinted in Appendix Table A.1.
12.  Michael G. Seiders, "Transactions Between Large Foreign-Owned DomesticCorporations and Related-Foreign Persons, 1994," *SOI Bulletin*, 17, Winter 1997-1998, pp. 123-140.  The figures reported in the text are the sum of reported "sales of stock in trade" and "salesof other tangible property."  See Figure B.  In 1991, such inter-affiliate trade by large foreign-owned domestic corporations represented 11 percent of merchandise exports and 24 percent ofmerchandise exports. 
13.   Raymond J. Mataloni, Jr., "U.S. Multinational Companies: Operations in 1995,"*Survey of Current Business*, 77, October 1997, p. 50.
14.   Data for Figure 6 are from the U.S. Department of Commerce, Bureau of EconomicAnalysis and are reprinted in Appendix Table A.2.  
15.   Data for Figure 7 are from the U.S. Department of Commerce, Bureau of EconomicAnalysis and are reprinted in Appendix Table A.3.
16.   For a more complete discussion of issues relating to foreign investment in the UnitedStates, see Joint Committee on Taxation, *Background and Issues Relating to the Taxation ofForeign Investment in the United States* (JCS-1-90), January 23, 1990. 
17.   Russell B. Scholl, "The International Investment Position of the United States in1988," *Survey of Current Business*, U.S. Department of Commerce, Bureau of EconomicAnalysis, June 1989, p. 43. 
18.   Russell B. Scholl, "The International Investment Position of the United States in1996," *Survey of Current Business*, U.S. Department of Commerce, Bureau of EconomicAnalysis, June 1997 pp. 22-33. 
19. *Ibid*. 
20.   Some commentators also have observed that the statistical discrepancies in the tradedata are becoming large enough to question any conclusions which might be drawn from suchdata. See "Statistical Discrepancy" in Table 1 above. The distinction between book valuation andmarket valuation is only relevant for the category of investment labeled "direct investment," notfor "portfolio investment." The distinction between direct and portfolio investment is explainedin the text below. 
21.   Russell B. Scholl, "The International Investment Position of the United States in1994," *Survey of Current Business*, U.S. Department of Commerce, Bureau of EconomicAnalysis, June 1995, pp. 52-60, and Scholl, "The International Investment Position of the UnitedStates in 1996."
22.   Scholl, "The International Investment Position of the United States in 1996."
23.   Scholl, "The International Investment Position of the United States in 1994," andScholl, "The International Investment Position of the United States in 1996."
24.   For a discussion of the economic effects of U.S. taxation with particular focus on therules affecting inbound investment, see Joint Committee on Taxation, *Background and IssuesRelating to the Taxation of Foreign Investment in the United States*(JCS-1-90), January 23,1990.

25.   This nonneutrality is only the case, however, if revenue from taxation is not used forthe direct benefit of the taxpayer (i.e., it is not a fee for government services rendered).
26.   When conditions approximating "perfect competition" are not present, it may beadvantageous for a particular country to distort free trade. For example, the government of anation with a competitive domestic sector and dominant in a particular natural resource cannationalize its resources and raise the worldwide price to monopoly levels. Alternatively, thegovernment can leave the industry competitive, and extract monopoly profits by raising taxes onthe natural resource. Under certain conditions, "strategic trade policy" (described below) couldincrease national welfare by distorting free trade.
27.   Because the investors who earn the capital income may be different from the workerswhose wages decline, the distribution of income across households may change.
28.   The Council of Economic Advisors emphasized this point in reviewing the net inflowof foreign investment in the United States that began in the 1980s as documented in Figure 6.

	The unhindered flow of foreign direct investment leads to additional productiveresources in the United States and facilitates the realization of cost efficient scalesof business by consolidating under one corporate roof separate, but related,operations. These boost the productivity and international competitiveness of theUnited States, create jobs, and promote innovation and productivity. The inflowof capital helps to sustain U.S. investment despite the current low U.S. nationalsaving rate, and thus contributes to economic growth.

	When U.S. multinational firms first set up in Europe during the 1950s and 1960s,many Europeans feared that Europe was being bought out by Americans and thattheir economies were being Americanized. U.S. direct investment has benefittedthe European economy. The recent increase in foreign direct investment in theUnited States will similarly benefit the U.S. economy.

Council of Economic Advisors, *Economic Report of the President*, (Washington: U.S.Government Printing Office), 1991, p. 258.
29.   As explained in more detail below, if domestic investment does not decline as a resultof increased outbound investment, then the relevance of national neutrality is greatly diminished,and capital import neutrality becomes a more attractive policy goal relative to capital exportneutrality.
30.   Some studies have looked at changes in investment in particular industries which havemade foreign investments.  That is not relevant to this discussion as in a vibrant marketeconomy, reduced investment in one sector may be offset by increased investment in anothersector.  One study that has attempted to measure the effect on gross domestic investment fromchanges in foreign direct investment is Martin Feldstein, "The Effects of Outbound ForeignDirect Investment on the Domestic Capital Stock," in Martin Feldstein, James R. Hines, Jr., andR. Glenn Hubbard (eds.), *The Effects of Taxation on Multinational Corporations*, (Chicago:University of Chicago Press), 1995.  Using data on OECD countries from the 1970s and 1980s,Feldstein finds that, on average, one dollar of foreign direct investment by residents of OECDcountries reduces gross domestic investment in OECD countries by approximately one dollar. Feldstein uses this estimate, along with the observation that the aggregate capital stock of U.S.foreign affiliates is financed by foreign borrowing in addition to direct investment, to estimatethat each dollar of assets in U.S. foreign affiliates reduces the U.S. domestic capital stock bybetween 20 and 40 cents.  These estimates should be considered tenuous.  Kenneth A. Froot,"Comment," in Martin Feldstein, James R. Hines, Jr., and R. Glenn Hubbard (eds.), *The Effectsof Taxation on Multinational Corporations*, (Chicago: University of Chicago Press), 1995,argues that measurement problems with the available data create a bias such that a one dollarincrease in foreign direct investment results in a less than one dollar decrease in domestic grossinvestment, albeit still a decrease.    
31.   Substantial disagreement exists among economists as to whether taxpayers willrespond to increases in net return on savings by increasing or reducing their saving. Some studieshave argued that theoretically one should expect substantial increases in saving from increases inthe net return. Other studies have argued that, theoretically, large behavioral responses tochanges in the after-tax rate of return need not occur. Empirical investigation of theresponsiveness of personal saving to after-tax returns provides no conclusive results. Somestudies find personal saving responds strongly to increase in the net return, while others find littleor a negative response. For a discussion of the determinants of the rate of saving, see JointCommittee on Taxation, *Present Law and Background Relating to Tax Incentives for Savings*(JCX-7-99), February 24, 1999.
32.   Many authors have discussed these types of welfare effects on taxation. See, forexample, Michael J. Boskin, "Tax Policy and the International Location of Investment," inMartin Feldstein (ed.) *Taxes and Capital Formation*, Chicago: University of Chicago Press,1987, p. 79:

	[D]omestic welfare falls when U.S. firms substitute [outbound investment] forinvestment at home, because the nation receives only the net-of-foreign-tax return(and only when it is repatriated) rather than the gross return. These welfare effectsare augmented by the beneficial effects on labor productivity of greater foreign ordirect investment in the United States. Thus, a reduction in taxation of newcorporate investment improves welfare through three channels: the standardmechanism, through which the lowering of the marginal tax rate generates newdomestic investment opportunities for U.S. firms; a reallocation of the location ofinvestment by U.S. firms toward home and away from abroad; and an increase in[inbound investment by foreign investors.]
33.   Several authors provide a description of how deductions for foreign taxes maximizedomestic welfare of a capital-exporting country. See Richard E. Caves, *Multinational Enterprisesand Economic Analysis,* Cambridge, England: Cambridge University Press, 1982, pp. 229-231;and Peggy B. Musgrave, *United States Taxation of Foreign Investment Income: Issues andArguments*, Cambridge, Massachusetts: International Tax Program, Harvard Law School, 1969,p. 134.
34.   In the context of international trade, policies that attempt to promote domesticeconomic welfare at the expense of the rest of the world are referred to as "beggar-thy-neighbor"policies.
35.   For a discussion of the positive effects of outbound U.S. investment, see Council ofEconomic Advisers, *Economic Report of the President*, Washington, D.C.: U.S. GovernmentPrinting Office, February 1991, pp. 258-261. The discussion on outbound investment concludes(p. 259): "On a net basis, it is highly doubtful that U.S. direct investment abroad reduces U.S.exports or displaces U.S. jobs."  Empirical studies find either no effect or a positive effect ofoverseas production in a host-county market on home-country exports to that market.  Robert E.Lipsey reports that, on average, studies find one dollar of overseas production by U.S. affiliatesgenerates $0.16 of exports from the United States.  Robert E. Lipsey, "Outward DirectInvestment the U.S. Economy," in Martin Feldstein, James R. Hines, Jr., and R. Glenn Hubbard(eds.), *The Effects of Taxation on Multinational Corporations*, (Chicago: University of ChicagoPress), 1995.  There is no definitive conclusion about the effect of outbound investment on U.S.employment.  Lipsey concludes, "[T]he evidence suggests that the effect of overseas productionon the home-country labor market involves the composition of a firm's home employment ratherthan the total amount.  That change in composition is mainly a shift toward more managerial andtechnical employment...."  *Ibid*. p. 31.  However, most of the evidence Lipsey reviews examinesindividual industries rather than aggregate economic effects.
36.   The text envisions a system of residence taxation applied to enterprizes.  A pureresidence system would fully integrate corporate and individual income taxes and tax individualsbased upon their residence.
37.   The term "competitiveness" encompasses different concepts.  In the present context itmight be better labeled "multinational competitiveness."  Multinational competitiveness refers tothe competitiveness of certain types of firms or industries relative to other types of firms orindustries.  The term "competitiveness" also is used in the context of measuring the ability offirms located in the United States to sell their output in foreign markets and to compete indomestic markets with output produced in foreign countries.  In that context, competitivenessmight be better labeled "trade competitiveness."  Trade competitiveness often is measured by theU.S. trade deficit.  Competitiveness also is used to describe comparisons of the current U.S.living standard and the prospects for future U.S. living standards with those of other countries. This notion of competitiveness focuses on the productivity growth of U.S. labor and the savingrate of the United States, because both of these factors affect future living standards.
38.   Some analysts have questioned the empirical basis of claims that intangible capitalcreate oligopolistic markets.  See, Harry Grubert and John Mutti, "Taxing Multinationals in aWorld with Portfolio Flows and R&D: Is Capital Export Neutrality Obsolete?"  *InternationalTax and Public Finance*, 1995.
39.   See Daniel J. Frisch, "The Economics of International Tax Policy: Some Old and NewApproaches," *Tax Notes*, April 30, 1990, p. 584.
40.   U.S. Treasury Department, *Blueprints for Basic Tax Reform* (January 17, 1977), p. 99.
41. *The President's Tax Proposals to the Congress for Fairness, Growth, and Simplicity*,(May 1985), p. 383.
42.   Richard E. Caves, *Multinational Enterprise and Economic Analysis*, Chapter 8.
43.   Joel Slemrod, "Competitive Advantage and the Optimal Tax Treatment of the ForeignSource Income of Multinational: The Case of the U.S. and Japan," paper prepared for theConference on International Tax Policy, sponsored by the American College of Tax Counsel andALI-ABA, April 20-21, 1990, Washington D.C. p. 10.
44.   Peggy B. Musgrave, *United States Taxation of Foreign Investment Income: Issues andArguments*; and Thomas Horst, "A Note on the Optimal Taxation of International InvestmentIncome," *Quarterly Journal of Economics*, Vol. 93, June, 1980, pp. 793-798. Horst notes that hisanalysis is a mathematical formalization of Musgrave's earlier work.
45.   This discussion highlights the importance of empirical investigation of the costsarising from market distortions in the level and allocation of saving.  For more discussion of thispoint see R. Glenn Hubbard, "U.S. Tax Policy and Foreign Direct Investment: Incentives,Problems, and Reform," in *Tax Policy and Economic Growth*, (Washington, D.C.: AmericanCouncil for Capital Formation, Center for Policy Research), 1995, fn. 8.
46.   This is implicitly assumed in Horst, "A Note on the Optimal Taxation of InternationalInvestment Income."
47. *Ibid.*********