I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

8 THE IMPACT OF THE TAX REFORM ACT 

OF 1986 ON TRADE AND CAPITAL FLOWS 

Harry Gruben and John Mutti 

I. INTRODUCfiON 

The effect of tax reform on the international position of the United States 

has been the subject of much debate. Some observers have expressed the 

concern that the United States would become deindustrialized because of a 

decline in international competitiveness. The direction of the change in 

capital flows has also been disputed. U.S. commentators have tended to worry 

about an outflow of capital from the United States because of higher taxes on 

business. In contrast, observers in other countries. such as Canada, fear a 

great inflow into the United States from their own countries because of the 

lower statutory corporate rates. 

This paper evaluates the international implications of tax reform using a 

general equilibrium model with both trade and international capital flows. A 

general equilibrium model is necessary because it is impossible to judge the 

change in a particular sector's competitiveness by looking only at its costs. 

without paying attention also to changes of costs in other industries and to 

changes in real wages and rates of return. A properly specified general 

equilibrium model also maintains a consistent relationship between capital 

flows and the current account. In fact, the dependence of the trade balance 

on capital flows is one of the major aspects of this analysis, because tax 

reform has a very modest direct impact ,on trade in the absence of capital 

mobility and international investment income. 

Before we proceed, it may be helpful to say a word on competitiveness. 

Unlike conventional old-fashioned terms used in trade theory, such as the 

terms of trade. welfare, comparative advantage etc., it is not clear what 

competitiveness is supposed to mean. In most people's minds. it seems to mean 

the trade (merchandise) balance. but why does one focus on certain kinds of 

U.S. products to the exclusion of others? Presumably it is the demand for U.S. 

71te authors thank Daniel Frisch. Don Fullerton. and Lowell Dworin for helpful comments on 

earlier drafts. and Elsa Vargas for assistance in the preparation of tltt manuscript and tablts. 

229 
230 Harry Grubert/John Mutti 

output as a whole that it is at issue. Most discussions of competitiveness 

seem to assume that if a foreigner buys a U.S. made computer, ships it back to 

his resident country and leases it there, that is desirable: on the other hand 

if the foreigner leaves the computer in the United States to be leased here. 

that is undesirable because it is a capital inflow and not an export. The 

reverse would appear to be true because the computer stays here to contribute 

to U.S. productivity. One cannot look at the trade balance alone to evaluate 

the impact of tax reform on the international economy. But, one must look at 

the capital account as well; the capital inflow finances both the import 

surplus and additional capital spending in the United States.1 Looking at all 

demands for U.S. resources, both from trade and investment flows, gives a 

better indication of U.S. welfare. 

II. GENERAL OVERVIEW OF MODEL 

The simulation model used in this paper was developed by the authors to 

study the impact of export incentives and the significance of capital mobility 

in altering the effects of personal and corporate taxation (Mutti and Grubert. 

1984a. t 98.5 and 1986). The purpose of the simulations is to determine the 

magnitude of price and output changes at a rather broad sectoral level. Other 

attempts to evaluate the impact of tax reform on trade (International Trade 

Commission, 1986 and Gravelle, 1986) have used a more detailed array of 

industries, but they have been essentially partial-equilibrium treatments with 

an attempt to make a general equilibrium correction through the use of a 

balance of payments equation. In particular, they overlook the non-traded 

sector entirely because they assume that consumers only choose between imports 

and similar competing domestic goods. In addition. they do not explicitly 

model changes in capital flows, rates of return, real wage rates or real 

income. but must depend on other analyses to provide information on them. The 

model in this paper solves simultaneously for the new trade flows. capital 

flows, real wages, rates of return and relative prices of traded and nontraded 

goods. 

The model used in this paper has two countries: the United States and the 

rest of the world. Each country produces 4 goods: equipment. a non-equipment 

net export good (from the U.S. point of view), a non-equipment net import 

good, and a non-traded good such as housing and services. Each good is 

produced from varying proportions of three factors: unskilled labor, skilled 

labor and physical capital. Capital used in each country is in tum a 

composite made up of domestically produced equipment. foreign-produced 

equipment. and the nontraded good, with the proportions depending on relative 

costs. 

Domestic output in an industry is not assumed to be perfectly substitutable 

in consumption with output from the same industry abroad. Consumers in each 

country therefore choose among the local non-traded ~ood and the 4 traded 

consumer goods, of which 2 are domestically produced. Similarly. residents 

in each country can allocate their saving to the acquisition of capital 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 
I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

The Impact of Tax Refon:n on Trade and Capital Flows 231 

located either at home or abroad. The real growth of capital used in each 

country thus depends upon savings by both foreign and domestic residents. 

Although foreign and domestic investment are not regarded as perfect substitutes in portfolios, an increase in after-tax returns in one location relative 

to another will attract more investment from both foreign and domestic savers. 

Foreign investment is, therefore, treated as a two-way flow; this pattern may 

be attributed to the decision of investors to diversify their asset holdings. 

The emphasis of the analysis will be on the effect of a policy change on 

long-run steady state income, trade, and the capital stock. However. the 

contrast with short-run results will also be noted. This contrast can be 

significant because, in the short run. any permanent shift in the accumulation 

of foreign assets does not yet yield significant investment income in relation 

to the additional expenditure on foreign assets. Any increase in the acquisition of foreign assets must therefore be fmanced in the short run by an 

increase of exports relative to imports. In the long run. however. investment 

income from abroad will increase as a result of the reallocation of assets, 

and this service flow can reverse the initial export surplus. 

We also note that the acquisition price of the composite capital good can 

be different in the two countries. One reason is that each contains a large 

component of nontraded goods. Jn addition. tariffs and export incentives can 

create differences even in the price of traded goods. 

III. SPECIFIC COMPONENTS OF THE MODEL 

In order to clarify how taxes enter into the model. it is helpful to 

describe its basic components: 

I . Zero-profit equations for each sector relate producers prices to input 

requirements and the cost of factor inputs. The cost of capital 

depends on the net (after personal and corporate tax) rate of return 

required by resident savers. the price of the capital good, and on the 

tax at both the corporate and personal level. To illustrate the role 

of each of these levels of tax, the cost of capital in a country is 

P / (1-tc )(1-tP) where P is the price of the capital good in the 

country, i is the after tax rate of return received by resident savers. 

and tc and tP are the marginal tax rates. at the corporate and personal 

level. 

2. Factor utilization equations relate total factor demands to factor 

supply. Factor demands depend upon relative gross-of tax factor 

prices, and a reduction in either capital tax variable reduces the 

desired ratio of labor to capital per unit of output. The size of this 

adjustment depends importantly upon the relevant partial elasticities 

of substitution in production. These factor demands are set equal to 

the factor supplies. Aggregate labor supply is exogenous while the 

supply of capital depends on endogenous savings decisions. 
232 Harry Grubert/John Mutti 

3. Product demand equations relate total (foreign and domestic) demand for 

each sector's output to relative prices and income. If there are (tax 

or non-tax) export incentives, prices paid by foreigners are less than 

those paid by domestic consumers. 

4 . Two savings or portfolio equations for residents of each country gene

-

rate the demand for capital located domestically and abroad. Portfolio 

demands by savers depend on total income and relative after-tax rates 

of return. In the case of income from foreign investment, the relevant 

after-tax return has to be spelled out more explicitly because domestic 

and foreign investors may face different taxes at the personal level on 

investment in a particular location. Let i,. represent the percentage 

return to capital after taxation at both the corporate and personal 

level that is received by A residents from capital used in A. The 

return to B residents who own capital assets in A is based on the 

after-corporate-tax rate of return in 

A, i,./(1-t), which is then 

reduced by any residual corporate-level tax in B. Pand fmally. by the 

personal tax paid by B residents on this foreign-source income. (There 

may aJso be corporate level foreign withholding taxes in A.) This 

personal level tax will be basically the normal domestic personal level 

taxes on that income because foreign withholding taxes tend to be small 

and are usually credited in the home country. Thus the final aftertax return of B savers who invest in A is (i,./(1-t))(l-~ )(1-~) where 

~ is the residual corporate-level tax (after credits) in B on foreign 

investment income. (See Mutti and Grubert ( 1985) for a discussion of 

the assumptions on the sectors to which foreign investment flows. The 

allocation of portfolios is a relevant issue because of sectoral differences in personal taxes. Therefore, t above is not unique and the 

p 

particular value relevant for foreign investors has to be specified. 

If there is only a single sector, then using the above expression for 

foreign investors· after-tax return from investments in A in order to 

determine the cost of capital in A yields the same equation as the one 

given in item I. That is, the cost of capital is the same irrespective 

of whether resident or nonresident after-tax returns are used as the 

starting point.) 

5. An income equation for each country defines income as a function of the 

market value of output, net international investment income and net 

tariff (or subsidy) collections (or payments). If the United States 

grants a general export incentive to foreigners. the lower price 

enjoyed by foreign consumers is financed by lower income available to 

U.S. residents. 

6. There are also two equations which relate annual investment in a 

country to the stock of capital in the steady state. As previously 

I 

I 

I 

I I· 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 
I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

The Impact of Tax Refonn on Trade and Capital Flows 233 

noted, the change in nominal investment in A depends upon the saving 

decisions of both A and B residents. In the steady state framework 

utilized in this analysis, the rate of growth of the real capital stock 

for each country must be constant and equal to the sum of exogenous 

growth of the labor force and Harrod-neutral productivity growth, 

assumed to be identical in each country. This steady state. 

equilibrium condition appears as follows for country A: 

--=g. ~ (8.1) 

where S,./PA is nominal investment in A divided by the price of capital 

goods, ~ is the initial capital stock in A, and g is the exogenous 

steady state rate of growth. The ch9!lge !n t~e capital stock from one 

steady state to another is therefore K A =SA-P A , where a carat denotes 

the percentage ch~ge in a variable. An analogous equilibrium 

condition exists for K8 • 

IV. ELEMENTS OF THE TAX REFORM ACT MODELED 

A. Changes in Sectoral Tax Rates at the Corporate and Personal Level 

The basic simulations include the "standard" changes in domestic taxation 

usually modeled in studies of the cost of capital. i.e. the reduction in the 

statutory personal and corporate rates, the eHmination of the investment tax 

credit, the modification of the Accelerated Cost Recovery System (ACRS). and 

the repeal of the capital gains exclusion. (Supplemental runs in which an 

attempt is made to include other major items are described below.) The 

changes in marginal effective tax rates by sector resulting from these 

"standard" reforms are based on the tax wedge and effective tax rate 

calculations described in the paper by Fullerton. Gilette and Mackie (1987) in 

this volume. Estimates on the cost of capital were provided for industries at 

the two-digit level of detail and these were classified into the four domestic 

sectors: equipment, non-equipment net export goods, non-equipment import 

goods, and non-traded goods. Sectoral costs of capital were then calculated 

using industry capital stocks as weights. The sectoral costs of capital were 

available for 3 situations: pre-tax reform law. fully phased-in business 

provisions under the Tax Reform Act but with pre-reform personal taxes, and 

fully phased-in tax reform. It was therefore possible to divide the percentage change in sectoral cost of capital into the component attributable to 

changes in personal taxation and to changes in business taxation. This 

division is necessary in an open economy model because foreign investors do 

not face the same personal tax rates as domestic investors. and domestic 
234 Harry Grubert/John Mutti 

investors can choose to invest in capital which is unaffected by the U.S. 

corporate tax. 

Before discussing the changes in the sectoral tax rates it may be useful to 

more specific about the composition of the sectors. Equipment includes 

electrical and nonelectrical machinery. aircraft and instruments. Nonequipment export goods includes most of agriculture, chemicals, and printing 

and publishing. The import-competing sector includes a large variety of 

mainly manufacturing industries such as textiles. primary metals and motor 

vehicles. The large non-traded good sector includes construction, transportation, utilities, finance. services, wholesale and retail trade and housing. 

The changes in the sectoral costs of capital are given in Table 8.1. The 

cost of capital in the import competing sector increases somewhat more than in 

the other sectors. This is due to the tax changes at the business level and 

results from the import-competing sector's heavier dependence on types of 

capital adversely affected by tax refonn, particularly equipment. At the 

personal level, the import-competing sector and the equipment sector have 

virtually identical changes, because in both sectors activity is almost 

exclusively in corporate form. The tax increase in these sectors at the 

personal level results from the increased tax rate on capital gains; it has a 

large weight because of the significance attributed to retained earnings under 

the "new view" of dividend taxatjon adopted by Fullerton, Gillette, and 

Mackie. The differing personal changes in the other two sectors are due to 

the greater significance of unincorporated business. such as in agriculture, . 

and in owner-occupied housing in the nontraded sector. Finally, it should be 

noted that even the largest percentage increase of the cost of capital in 

Table 8. 1, which is in the import-competing sector, is less than 10 percent 

and translates into a much smaller relative increase in prices once the share 

of capital in total costs is considered. 

Table 8.1 Changes in Sectoral Tax Rates Resulting from Basic Changes 

in Domestic Taxation• 

Percent Change in Cost of Capital Due to 

Business Personal 

Sector Tax Changes Tax Changes Total 

Equipment 0.5% 3.7% 4.2% 

Non-Equipment net export goods 4.0 -1.3 2.7 

Import-competing goods 5.0 3.6 8.6 

Non-traded goods 3.9 .8 4.7 

*Note that these are changes in percent. not percentage points. They are basically values 

for the expression dt/ 1-t. which represents the percentage change in the cost of capital 

directly attributable to the change in the tax rate. 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 
I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

The Impact of Tax Reform on Trade and Capital Flows 235 

B. Changes in the U.S. Corporate Tax on 

International Investment Income 

The Internal Revenue Code has various provisions governing the U.S. tax 

both on foreign income received by U.S. residents and the tax imposed on 

payments of U.S. income to nonresident investors. The Tax Reform Act made 

changes applying to both types of income. With respect to foreign income 

earned by U.S. corporations, there were a number of base-broadening changes, 

such as the provision on the allocation of interest expense to foreign income, 

described below, which increase U.S. tax.. On the other hand, the reduction of 

the U.S. statutory corporate rate has an offsetting effect. The tentative 

U.S. corporate tax on foreign source income is the U.S. statutory rate applied 

to the foreign income. This is then reduced by the amount of allowable 

foreign credits. Thus, if the corporation was not initially in an excess 

foreign tax credit position, a reduction in the U.S. statutory rate reduces 

the residual U.S. tax. 

The impact of these changes in the taxation of foreign income was, however. 

not estimated in a manner entirely comparable to the Fullerton-Gilette-Mackie 

calculations for domestic income. The system of taxing corporation foreign 

income, which involves many specific provisions, has not yet been modeled in a 

manner parallel to the hypothetical Hall-Jorgenson type of estimation undertaken by Fullerton. Gillette. and Mackie. In principle it would be possible 

to do so, but it would require starting with hypothetical investments having 

very specific characteristics. The additional sources of financing foreign 

investment. not relevant for domestic investment. could also be included. For 

example. investment abroad can be financed by earnings retained abroad, in 

particular the earnings of foreign corporations controlled by U.S. taxpayers. 

Income retained by the domestic parents can also be invested abroad, both in 

the form of new equity or of new foreign lending. There can also be portfolio 

investment abroad. either by U.S. individuals or through U.S. corporations. 

(The most important source of portfolio investment abroad is overseas lending 

by U.S. banks.) 

As indicated, no attempt was made to make these modeling extensions because 

they would have required a major new study by themselves. Instead, the 

revenue estimates for the foreign provisions were used. In order to convey 

the long run impact of the reforms. the ve.rsion of the revenue estimates 

employed were the "fully phased-in" changes at 1986 activity levels estimated 

by the Treasury Department. These fully phased-in estimates give the revenue 

change after all transition rules have expired and all short-run timing 

effects no longer play a role. 

The fully phased-in estimates for each of the foreign items are given in 

Table 8.2. They are divided into several categories because some of the 

provisions apply to investment in the United States and because the provisions 

vary in how closely they are linked to real investment in a given location. 

The first grouping applies to investment by U.S. corporations abroad that is 
236 Harry Grubert/John Mutti 

Table 8.2 Fully-Phased-In Annual Revenue Increase 

of Foreign Provisions 

(1986 levels at a 34 percent corporate rate) 

Provision 

1. General Foreign Investment Income 

Revenue Increase 

(millions of dollars) 

Separate foreign tax credit limitations 351 

Separate limitation for high withhoJding taxes on interest 1 ,500 

Treatment of losses in foreign tax credit 19 

Revision of deemed paid foreign tax credit 71 

Allocation of interest expenses to foreign source income 806 

Allocation of expenses other than interest and R&D 77 

U.S. transportation income of foreign entities 22 

Transfers of intangibles abroad J 0 1 

2. Foreign Investment in the United States 

Dual residence companies 

Income of foreign governments 

3. Financial Investment in Tax Havens 

Expand Subpart F income 

Revision of de minimis rule for tax haven income 

Captive insurance Companies 

Foreign investment companies 

Use of deficits in E&P 

4. Other 

Possession credit 

Memorandum item: 

Total in category ( 1) 

Reduced tax on foreign source income because 

of lower statutory corporate rate. 

109 

43 

155 

58 

105 

15 

19 

59 

2,947 

3,243 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 
I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

The Impact of Tax Reform on Trade and Capital Plows 237 

assumed to be directly linked to real investments there. The most important 

of these are the new interest allocation rules and the separate foreign tax 

credit limitation for interest on foreign loans which are subject to high 

withholding taxes. The first of these will generally require a larger 

allocation of U.S. interest expense to foreign income because U.S. companies 

will no longer be able to avoid an allocation by devising an advantageous tier 

structure for their domestic affiliates. The separate limitation for high 

withholding interest mainly applies to bank loans to certain countries that 

impose high gross withholding taxes. which heretofore could be credited to 

other, lightly-taxed foreign income. It is assumed that these loans lead to 

higher real investment abroad. 

The second category of foreign provisions apply to income from investment 

by foreigners in the United States. It is used to compute the additional U.S. 

tax paid by foreigners on their investments in the United States. The 

provision on dual residence companies applies to U.S. corporations which are 

also regarded by some jurisdictions as being resident in their own country 

because of differing definitions of residence. In these situations, it can be 

consolidated with affiliated companies in both countries. so that any loss can 

be used twice. The Tax Refonn Act restricted this double use of losses. The 

second item in this category reduces the scope of the tax exemption on 

investment income received by foreign governments by denying its use for 

"commercial" activities. 

The third grouping involves financial investments of U.S. corporations in 

tax havens. These are presented separately from the first category because 

they are anti-conduit (Subpart F) provisions where the ultimate location of 

the marginal real investment or business being financed may well be the United 

States. The provisions limiting the benefits of using captive insurance 

companies are a typical example. The captives are insurance companies 

organized in cenain low-rax locations which insure the U.S. parents' risks. 

The new provision applies to "group" captives (i.e. , those whose business is 

not restricted to a small number of controlling U.S. companies. and therefore 

not covered by pre-TRA rules). It requires the current recognition of income 

from the insurance of U.S. risks. The country-specific risk at issue. and 

probably the ultimate destination of most of the insurance companies' financial reserves is the United States. It would therefore be incorrect to regard 

this provision as an increased Lax on income from real investments abroad. 

The necessity for the rather arbitrary groupings in Table 8.2 is due to the 

fact that we do not in this paper explicitly model the relationship between 

real and financial assets. This has been attempted by the authors in the past 

(Mutti and Grubert, 1984b). but not in the detail required for the present 

analysis. The main problem is that international portfolios do not seem to 

obey any logical pattern. such as diversification. so that one cannot have any 

confidence in behavioral parameters based on standard portfolio models. (See 

Adler and Dumas. 1983.) 
238 Harry Grubert/John Mutti 

Some of the specific items do not of course fit neatly into a single 

category. For example. the major component of the separate foreign tax credit 

limitations in the first category might properly be regarded as principally a 

tax on passive financial investment income abroad and therefore placed in the 

third group, as is the closely related provision on Subpart F income. The 

conceptual problem arises because in these kinds of cases, a tax benefit 

depends on the interaction of two activities. For example, if a U.S. company 

received highly-taxed operating income from abroad, any excess credits 

generated by the income could (before the Tax Reform Act) shield some types of 

low-tax financial income. Depending on the position of any particular 

taxpayer. the benefit could be regarded as an incentive on the margin for 

increased operating investments abroad (if the taxpayer was not in an overall 

excess credit position) or as an incentive on the margin for passive financial 

income. The effect of marginal incentives of putting these two types of 

income in separate foreign-tax-credit-limitation categories will therefore 

depend on this pre-reform position. (In contrast. reduced opportunities for 

deferring passive income as a result of new Subpart F provisions always 

represent increased taxes on financial income). 

The provision applying to dual residence companies, referred to earlier. is 

also problematical. The restrictions on this type of arrangement can affect 

real investments in either country. Putting it in the second category rather 

than the first is therefore quite arbitrary. 

The quantitative estimate of the impact of tax reform on the U.S. corporate 

tax on investment abroad is derived by summing the tax increases in the first 

category in Table 8.2 ($2,947 million) and netting them against the reduction 

in U.S. tax on foreign corporate income due to the reduction in the statutory 

rate ($3,243 million)! The difference is then divided by total U.S. foreign 

income to arrive at the change in the tax rate in percentage points. The 

result of the procedure is a tax reduction of 0.3 percentage points.5 While 

this is small, it contrasts with the substantial increase in corporate tax on 

domestic investment evident in Table 8. 1 and in the overall business revenue 

estimates. 

The increased U.S. tax on investment by foreigners in the U.S. , over and 

above the changes that apply to all domestic investment, is derived in a 

similar fashion, by summing the items in the second group in Table 8.1. There 

is a very small increase in U.S. tax. 

One of the issues in the use of the fully phased-in long run estimates is 

whether they adequately capture changes in effective tax rates attributable to 

deferral of taxes. In the long run , the increased deferral of taxes would 

only affect annual revenue because of growth in income. For example, reduced 

opportunities for accelerated depreciation will not change tax revenues in 

the long run stationary steady state even though effective tax rates have 

clearly risen. However, this problem is not serious in the use of the 

estimates for the foreign provisions because the most important provisions. 

related to interest allocation and separate limitations for high-withholding 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 
I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

The Impact of Tax Reform on Trade and CapitaJ Flows 239 

tax interest income. do not have significant deferral or acceleration effects. 

The use of the fully-phased in estimates, rather than the actual 5 year 

revenue estimates is intended to reflect the impact of the tax reform after 

all the transition rules no longer play any role. 

Having calculated the change in the corporate level U.S. tax on foreign 

income. we are now faced with the question as to its role in the analysis. 

Some discussions of the residual U.S. corporate tax on foreign income seem to 

regard it as a tax on investment in the United States, i.e. the tax constitutes a barrier to repatriating foreign income and investing it in the United 

States. They therefore expect an increase in repatriations and presumably 

greater U.S. investment as a result of the TRA. However, David Hartman's 

analysis of dividend repatriation decisions is an effective refutation of this 

view. (See Hartman, 1984. and references therein.) Hartman has in a series 

of papers expressed the position that the residual U.S. tax on dividend 

repatriations is irrelevant for the choice of investments to be financed out 

of foreign earnings. The reason is that the tax has to be paid sooner or 

later. This parallels the "new view" of the taxation of dividends in the 

domestic context that is embodied in the Fullerton-Gilette-Mackie effective 

tax rate estimates. The Hartman analysis thus concludes that only the afterforeign-tax return on investments abroad and the U.S. after-tax return on 

competing domestic investment is relevant for dividend repatriation decision. 

The Hartman argument should. however, not be pushed too far. It applies 

only to dividend repatriations and not to the U.S. tax on other types of 

foreign income. These types of income are significant and play an important 

role in the estimation of the change in overall U.S. corporate taxes on 

foreign income. Statistics of Income (SOl) tabulations for 1982 indicate that 

dividend income only accounts for about 30.0 percent of foreign source gross 

income. (See SOl Bulletin, Spring, 1986.) There is substantial interest 

income. largely to U.S. banks, and because it is lightly taxed, this income is 

a major beneficiary of the statutory rate reduction. In addition. rents, 

royalties and service income are almost as significant as dividends. They 

represent income from investment abroad not in the form of corporate equity 

and therefore there is no opportunity for retaining it abroad. Any change in 

U.S. tax on this income is therefore a change in the tax on marginaJ foreign 

investment in this non-equity form. 

Another way of looking at this issue is to examine the financing sources 

for U.S. investment abroad. Retained earnings have not been the dominant 

source in recent years. For example. in the 7 years from 1979 through 1985. 

earnings retained abroad by incorporated affiliates accounted for 21.7 percent 

of all private gross U.S. capital outflows. Claims reported by banks. which 

presumably are bank loans. accounted for 72.6 percent of all private outflows 

for the period. 

In view of these considerations. no adjustment is made to reflect the 

Hartman argument. The small magnitude of the change in the U.S. corporate tax 

on foreign income makes the issue largely moot in any case. 
240 Harry Grubert/John Mutti 

The above discussion of funding sources for U.S. foreign investment is also 

relevant for the evaluation of the change in the personal-level tax on 

marginal foreign income. The Fullerton-Gilette-Mackie estimates for domestic 

investment used in Table 8. 1 assume that retained earnings account for 61 .4 

percent of any marginal investment. In view of the significance of debt flows 

abroad (of which only a small percentage could represent loans of the banks' 

own equity capital). the share of retained earnings is assumed to be 40.0 

percent, instead of the 61.4 percent used in the domestic context, with debt 

accounting for 50.0 percent and new equity the remaining 10.0 percent. The 

financing share attributed to debt is conservative in view of the role of debt 

in capital flows cited above. Because the risk characteristics of foreign 

investments may be different from domestic investments (e.g. assessing an 

equity investment abroad may be much more difficult). it is not illogical to 

assume different financing shares for domestic and foreign investment. 

The version of the model used in this paper does not distinguish between 

portfolio and direct investment abroad; that is. there is no distinction 

between locally-controlled or foreign-controlled production in a country. 

But. for the purposes of the current exercise, this fact does not seriously 

restrict the responses that are captured. Any increases or decreases in 

relative sectoral costs in the United States because of tax changes, and the 

resulting redistribution of trade, is reflected. The main advantage of a more 

detailed characterization of capital flows would be the ability to use U.S: 

tax rates for investment abroad in specific sectors. That is, while the 

average U.S. corporate tax rate on foreign investment income barely changes. 

it may change substantially for some sectors, e .g .• U.S.-controlled manufacturing. Any significant effect of this type seems unlikely, however. The 

reduction of the U.S. statutory rates to 34 percent only reduces the U.S. tax 

on foreign manufacturing income by about 4.0 percentage points and the 

significant revenue raisers such as interest allocation would narrow the 

reduction to perhaps 2.0 percentage points or less. The impact of this change 

would be further diluted because U.S.-controlled manufacturing abroad is only 

one of the (and in most cases a relatively insignificant) sources of U.S. 

manufacturing imports (or competition for domestically produced exports). 

C. Changes in Specific Tax Provisions Directed at Exports 

Exports can be affected because changes in domestic taxation change costs 

in the export sector relative to costs in other domestic sectors. In addition. there are specific tax provisions that apply specifically to export 

income and reduce the price of U.S. produced goods to foreigners for any given 

level of domestic costs. One of these provisions is the Foreign Sales 

Corporation (FSC) rules that exempt from U.S. tax the portion of export income 

attributable (by either administrative pricing rules or actual arm· s-length 

prices) to marketing activities by the offshore FSC. This general1y results 

in an exemption from tax of 15 percent of the total corporate income from FSC 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

.I 
I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

The Impact of Tax Reform on Trade and Capital Flows 241 

exports. Because the value of the provision to exporters depends upon the 

statutory tax rate. the reduction of the corporate rates from 46 to 34 percent 

reduces the effective FSC benefit. SpecificaJJy. Treasury data indicate that 

the average FSC benefit declines from 1.08 percent of sales to 0 .80 percent. 

There is. however. another change in international taxation which is an 

indirect consequence of the reduction of statutory corporate rates and more 

than offsets the reduction in FSC benefits. Under the rules for detennining 

the source of income (i.e., whether domestic or foreign), which were in large 

pan not changed by the Tax Reform Act, aU .S. producer exporting abroad can 

arrange to classify 50.0 percent of the total taxable income from the export 

as foreign source.

6 Thus. if the exporter is in an excess foreign tax credit 

position, 50.0 percent of the export income can be effectively exempt from 

U.S. tax. 

The foreign tax credit limitation. the amount of foreign taxes that be 

credited against U.S. tax liability. is basicaJJy the U.S. statutory rate 

applied to foreign source taxable income. In other words, it is limited to 

what the U.S. tax would be on the income. Therefore the reduction of the U.S. 

statutory corporate rate from 46 percent to 34 percent will greatly increase 

the number of U.S. companies in an excess foreign tax credit position. For 

example, Treasury data indicate that the percent of U.S. manufacturing 

companies (weighted by worldwide income) that are in an excess foreign tax 

credit position increases from 20.2 to 69.2 percent. Therefore, the 50 

percent rule becomes much more important at the lower corporate rate. 

The question is whether all or most of U.S. exporters who are in an excess 

credit position will choose not to use a FSC because they can get a higher 

level of tax exemption on export income simply by using the source rules. (An 

exporter who uses a FSC can also get some benefit from the source rules, but 

on only half of the export income so that the sum of the benefits (15 plus 25 

percent) is less than the pure 50.0 percent exemption). In this paper. we 

assume that all exporters in an excess credit position will avail themselves 

of the maximum benefit under the source rules. We also assume that the 

percent of exporters in an excess foreign tax credit position is the above 

mentioned 69.2 percent. (In other words, we assume that weighting by exports 

and weighting by worldwide income yield the same results.) 

When these two effects. the reduced FSC benefit and the enhanced value of 

the source rules, are added together. we conclude that export costs will fall 

by 0 .50 percent, holding the cost of the equivalent domestically consumed good 

constant. 

7 

In the model. there is a equivalent reduction in the cost of 

capital in the export sector because both the FSC and the source rule benefits 

are based on taxable corporate income from expons. 

D. Other Significant Changes in Domestic Taxation 

The changes in domestic taxation included in the basic model runs are those 

described above: the change in statutory tax rates. the elimination of the 
242 Harry Grubert/John Mutti 

general business credit. the revision of depreciation and the elimination of 

the capital gains exclusion. The reason for excluding the other major 

provisions is simply that they have not yet been put into a cost of capital 

framework. (See. however. the paper by Lowell Dworin on the Alternative 

Minimum Tax in this volume.) 

However it would be of interest to know if including items such as the 

passive loss rule. the corporate alternative minimum tax and the uniform 

capitalization rules would significantly change the results. The Conference 

Report indicates that these three items by themselves account for $92.0 

billion in increased revenue in fiscal years 198 7 through 1991. An attempt 

was therefore made to test the sensitivity of the results by using the revenue 

estimates for the passive loss rule. the corporate minimum tax. and the 

uniform capitalization rules. Most of these major domestic items relate to 

the deferral of taxable income. As a consequence, the long-run fully phasedin revenue gains or losses may not sufficiently reflect the significant 

acceleration of income recognition (or reduced deferral) that takes place. In 

order to correct this possible error. two alternative simulations were made. 

One is based on the fully phased in estimates and the other uses the average 

increase in revenue estimated for the initial 5 year 1987-1991 period (i.e .. 

the revenue estimates considered during the legislative process). This presumably overstates the actual increase in marginal effective tax rates. 

We assume that the passive Joss rules increase taxes only in the non-traded 

sector on the grounds that they mainly affect real estate partnerships. It is 

further assumed that the corporate minimum tax and the uniform capitalization 

rules increase business level taxes uniformly in alJ sectors because it is 

difficult to make judgments with respect to their sectoral impact. In each 

case the revenue increases are translated into percentage point changes in tax 

rate by expressing them as a percent of total capital income in the appropriate sector. 

V. PARAMETERIZATION OF THE MODEL 

The model described above contains a relatively small number of sectors and 

is solved in differential form. so that strictly analytical solutions could be 

derived from it. However. the purpose of this paper is to evaluate the 

quantitative significance of certain effects rather than simply their direction. Therefore. it is necessary to choose specific parameters for simuJation 

analysis. This section provides a summary of the data and parameter values 

used in addition to the measures of tax changes discussed earlier. 

The four aggregate goods produced in each country were created from the 85 

sector input-output table of the United States. As indicated above. nontraded 

goods and services. ~A. include utilities. construction. transportatjon and 

communication, wholesale and retail trade. social and personal services. 

finance, real estate, and government. U.S. net non-machinery export goods. 

~A. essentially are grains, and chemicals. U.S. net import goods. x1A. 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I. 

I 

I 

I 

I 

I 

I 

I 
I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

The Impact of Tax Reform on Trade and Capital Flows 243 

include many consumer durables and nondurables. The output of the U.S. 

machinery sector is ~. 

Allocations of factor inputs across industries are based upon the direct 

and indirect factors requirements necessary to produce current levels of 

output. The nontraded sector and the three traded goods sectors all have 

relatively similar capital requirements. The nontraded sector and the import 

competing sector are intensive in unskilled labor while the two export sectors 

are relatively skill intensive. The relative supply of these two types of 

labor depend on the real rate of return to investment and are therefore 

affected by changes in tax: for example a lower real rate of return encouraging more training. 

Partial elasticities of substitution between capital and unskilJed labor. 

unskilled labor and skilled labor, and capital and skilled labor are in part 

based on estimates reported in Hammermesh and Grant ( 1980). For example, they 

report a virtually zero degree of substitutability between capital and skilled 

labor. but the values applied to all industries in this study are aKL = asL = 

1.0 and au = 0.5. where Sis skilled labor and Lis unskilled labor. 

Demand elasticities for goods and portfolio elasticities for savings are 

based on a utility tree framework developed by Armington ( 1969). Residents in 

a particular country are assumed to first allocate their income between 

current consumption and total saving in view of the weighted worldwide aftertax rate of return. The current consumption branch has 3 sub-branches. net 

export goods. net import goods and the nontraded good. Thus U.S. consumers 

first allocate current consumption among the net export good. the net import 

good and the nontraded good and then within each of the first two categories 

allocate income between the domestic and foreign produced good. This formulation allows us to use a high elasticity of substitution within the inner nest 

of the utility function (between foreign and domestic output of the same 

good). If this nested utility function is CES in form. then as shown by 

Armington ( 1969) own and cross-price elasticities of demand can be derived 

directly from information regarding expenditure shares and elasticities of 

substitution at different levels of the utility tree. 

For a given allocation of income to current consumption the elasticity of 

substitution between the two traded goods in the same utility tree is assumed 

to be 3, and the corresponding elasticity between the three general categories 

X1 ,X2 and ~ is assumed to be . 75. A similar nested scheme is assumed to 

generate the demand for each of the capital goods used in production. with X11" 

and 8 in one branch and the nontraded good in the other. As examples of 

what these values imply with respect to more commonly estimated parameters. 

the import elasticity of demand in the U.S. for X18 equals -2.2 1. and the 

elasticities of demand for U.S. exports of X2" and ~A to the rest of the 

world are -2.63 and -2.64 respectively. 

The elasticities of demand for assets located at home and abroad are 

computed in a manner analogous to the commodity demand elasticities. Making 

the Armington separability assumption for foreign and domestic assets within 
244 Harry Gruben/ John Mutti 

the overall savings branch yields two basic parameters, the elasticity of 

substitution between foreign and domestic assets, a. and the elasticity of 

overall saving with respect to the weighted worldwide after-tax rate of 

return. t'l. Because values for a are not well established, a range of estimates is used: 0.0, 3.0. and 30.0. The 3 values of a represent zero, moderate 

or very high substitutability between U.S. and foreign assets. With respect 

to the overall saving elasticity, in this application we assume a zero 

interest elasticity of savings although a range has also been used in other 

simulations. The zero overall savings elasticity is used here to simplify the 

analysis and focus on the role of capital mobility. 8 

We can illustrate how these values are related to asset demand elasticities. For the case of a = 3.0 and t'l = 0.0, both the own-interest rate 

elasticity of demand by U.S. savers for U.S. assets and the cross-interest 

rate elasticity with respect to foreign interest rates are equal in absolute 

value to .67. The corresponding own and cross-interest rate elasticities of 

demand for U.S. assets by foreign savers are 2.87 in absolute value. These 

two figures yield a weighted average interest rate elasticity of demand for 

U.S. assets of 1. I 6. Model simulations in earlier work by the authors suggest 

how much capital actually ends up moving if these parameters are used (Mutti 

and Gruben 1985). For example. a 1.0 percent increase of after-tax capital 

income (or a one percent reduction of the cost of capital) as a result of a 

corporate tax cut would result in an increase of the U.S. capital stock of .18 . 

percent in the final general equilibrium solution. Consequently, the direct 

increase in demand of 1. 16 ·percent is substantially offset in the model by 

induced changes in returns at home and abroad. 

VI. SIMULATIONS 

In order to highlight the role of certain tax changes and behavioral 

parameters. as well as the time frame being considered, several different 

scenarios are simulated. All but the last case exclude consideration of the 

passive loss rule. the corporate alternative minimum tax and the uniform 

capitalization rules. 

Case 1. The short run. impact effect with moderate (a = 3.0) capital 

mobility. In the short run. a savings outflow from the United 

States induced by a tax change can affect the demand for 

sectoral output and the trade balance by increasing the demand 

for capital goods output abroad and reducing it at home. 

However. the change in savings flows is not yet reflected in the 

capital stocks use~. in each country. This case is simulated by 

setting the two Ks. the percentage change in each country's 

capital stock. equal to zero. 

Case 2. Long run. but with no interest sensitivity of international 

savings flows on the margin (a = 0). This identifies the 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 
I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

The Impact of Tax Refonn on Trade and Capital Flows 245 

changes in trade flows and sectoral output in the absence of a 

change in the capital account. There can, however, be an impact 

on merchandise trade due to changes in after-tax returns to 

capital which affect net international investment income. There 

is initial cross-ownership of capital reflecting the actual 

existing situation; but the stock does not respond to changes in 

rates of return. 

Case 3. Long run, with moderate asset mobility, (a = 3.0) 

Case 4. Long run, with very high asset mobility, (a = 30.0) 

Case 5. Moderate asset mobility (a = 3.0) with changes in the passive 

loss rule, corporate minimum tax and unifonn capitalization 

rules included in the tax changes modeled. 

Table 8.3 gives the simulation results for Case I, the immediate short run 

impact of the Tax Refonn Act before capital stocks have had a chance to adjust . 

(although the impact of asset mobility on sectoral demands is included). The 

increased corporate tax on domestic capital lowers the after tax return and 

leads to a reduced saving outflow of $11.4 billion (at an annual rate). 

Offsetting the outflow of savings somewhat is smaller net payments of investment income to foreigners because of lower after-tax returns earned in the 

United States. An improvement of the trade balance of $8.5 billion (rather 

than $11.4 billion) is thus necessary to finance the capital outflow indicated 

above. 

The short run improvement of the trade balance takes the fonn mainly of 

increased exports, not reduced imports. One reason for this split is the 

relatively large increase in the tax rate on capital in the import-competing 

sector presented in Table 8. 1. In addition there is the impact of the 

increased incentive for exports resulting from the increased frequency of 

excess foreign tax credits. 

The change in the pattern of sectoral output only weakly reflects the 

change in exports and imports. The import-competing sector declines in the 

United States in spite of the decrease in imports, which thus indicates that 

there is a shift away from these kinds of goods in general. (Imports of these 

goods become somewhat more expensive because the U.S. demand for foreign 

assets worsens the U.S. tenns of trade.) In addition. equipment output 

declines in spite of the increase in exports. This is due to the offsetting 

reduction in the demand for equipment because of lower investment spending in 

the United States when $1 J . 4 bi Ilion of savings flow out. An increase in 

savings outflows reduces equipment production in the United States because 

physical capital located in a country tends to have a much larger component of 

domestically produced equipment than imported equipment. 

The tables report the estimated change in real consumption, but it should 

be noted that this model focuses on the taxation of capital in the broad 
246 Harry Grubert/John Mutti 

Table 8.3 Short Run Impact of Tax Reform (a=3.0) 

Variable Change 

( ~· s refer to change in percent and 0 's to change in billions of dollars at 1986 levels) 

. 

~lA Output of import-competing sector - .59 

~a Output of non-equipment export sector 1.83 

~IU Output of equipment sector - .07 

~"" Output of nontraded sector - .39 

~ After tax return in U.S. - 4.41 

~ After tax return in rest of world .08 

oS._8 U.S. acquisitions of foreign assets l0.29 

OSSA Foreign acquisitions of U.S. assets - 1.11 

OF Net change in capital outflows 11 .40 

ox U.S. exports 7.31 

OM U.S. imports - 1.16 

08 Net change in trade balance (not including 

investment income) 8.47 

0~ Receipts of investment income .49 

OIP Payment of investment income - 2.45 

OR Net change in investment income 2.94 

G,. Real consumption - .193 

t U.S. terms of trade - .97 

~" 0.0 

KB 0.0 

sectors used and therefore abstracts from some behavioral changes which could 

increase real consumption. For example, the impact of real wages on total 

labor supply is not reflected in the model. 

With that proviso, we can note that in the simulations real consumption 

declines in the United States. even in the short run before capital stocks 

have adjusted. In part. this reflects the welfare loss attributable to higher 

export incentives. but it rs also a result of the decline of the U.S. terms of 

trade because of the increased demand for foreign capital. (This decline in 

the U.S. terms of trade. the equivalent of a real devaluation. promotes an 

expansion of exports.) It indicates that any improvement of the trade balance 

is not necessarily associated with any economic benefits to the United States. 

On the contrary. there is an increased overall (trade plus investment) demand 

for foreign output. 

Summers ( 1986) claims that an increase in U.S. corporate tax unambiguously 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 
I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

The Impact of Tax Reform on Trade and Capital Flows 247 

leads to a short run improvement in the trade balance. However, his conclusion results from his assumption that initial foreign ownership of capital, 

and therefore foreign investment income, is zero. The simulations indicate 

th.at the short run net change in investment income, which results from the 

change in after-tax returns, can be substantial, at least compared to the 

other changes. Because of the importance of this factor, an increase in U.S. 

corporate tax on capital could lead to a deterioration of the trade balance in 

the short run, given a somewhat lower degree of capital mobility than a =3.0. 

(For example, see the a =0 case in Table 8.4 where there is initial crossownership of capit.al but asset flows do not respond on the margin to changes 

in relative returns.) 

Table 8.4 Long Run Impact of Basic Tax Changes With 

Varying Degrees of Capital Mobility 

a=O a=3.0 a=30. 

( ft's refer to changes in percent. 6 's refer to changes in billions of dollars at 86 levels) 

-

~lA -1.46 -1.54 -1.59 

~2 ... 0.90 0.84 0.81 

~MI. 0.46 - .18 - .51 

~ ..... - .09 - .31 - .43 

~ ... -4.38 -3.01 -2.29 

~ 0.0 -0.43 -0.67 

6Su 0.0 5.64 35.75 

6SBA 0.0 1.38 29.16 

6F 0.0 -4.26 -6.59 

6X .24 0.57 0.76 

6M 2.63 2.00 1.68 

68 -2.39 -1.43 -0.92 

6~ - .01 5.52 37.17 

61p -2.40 - .18 29.69 

6R 2.39 5.70 7.48 

. 

~ ... U.S. capital stock 0.026 -1.17 -I. 79 

KB CapjtaJ stock in ROW 0.033 0.40 0.61 

-

c ... Steady state 

real consumption -0. 134 -0.240 -0.295 

- .26 - .25 - .25 
248 Harry Grubert/ John Mutti 

Table 8.4 gives the long run steady state results for each of the 3 different mobility cases, a =0.3.0, and 30.0. There is a small increase of the trade 

deficit in all three cases. When a =0, this reflects the net improvement in 

net investment income attributable to initial foreign ownership of capital. 

The reason for this improvement in net investment income is the lower U.S. 

rate of return earned by foreigners because of the increased U.S. taxes on 

business; the foreign returns received by the United States hardly change. 

(Note the changes in i" and~ in Table 8.4.) When capital is mobile, the increase in the trade deficit persists. although at a smaller level, because the 

continuing (in each year of the steady state) increased net demand for foreign 

capital is not large enough to completely offset the improvement in net foreign investment income. The latter increases as capital becomes more mobile 

because of the increased stock of capital abroad owned by U.S. residents. 

The impon competing sector bears the impact of these small changes in the 

trade balance and its output falls by about 1.5 percent. The equipment sector 

gains only in the a =0 case; it declines in the other cases because of the 

lower investment spending in the United States when capital is mobile and 

savings flows out. 

The U.S. capital stock declines by somewhat more than 1.0 percent in the 

moderate and high mobility cases. Note. however, that even when capital 

becomes highly mobile. the decline in the U.S. capita.l stock is not much 

larger than in the moderate mobility case. The reason is that the United 

States is not a small country in this simulation; the rate of return in the 

rest of the world is not constant. A shift toward U.S. asset holding abroad 

increases foreign capital stocks and reduces rates of return abroad. This in 

tum causes foreigners. whose own asset holdings are highly mobile, to shift 

their asset holdings to the United States. This large two-way flow of saving 

is clear in the a= 30 case where gross outflows increase by $35.75 billion and 

inflows by $29.16 billion in the steady state. 

Table 8.5 presents the long run steady state impact of the Tax Reform Act 

when estimates of the tax changes attributable to the passive loss rule, the 

uniform capitalization rules. and the corporate minimum tax are included. 

The two columns correspond to the two alternative bases for the tax change 

estimates, the fully phased-in estimates and the budget period estimates used 

in the legislative process. The main purpose of these simulations is to see 

how sensitive the results are to including these provisions that are left out 

of the standard cost of capital calculations. 

The results in Table 8.5 should be compared to the a= 3.0 results on Table 

8.4. Adding these "nonstandard" provisions has a visible effect on capital 

flows and the U.S. capital stock. Even when the lower bound. fully phased-in 

estimates are used. the decline in the capital stock goes from 1. 17 percent to 

1.43 percent. When the more familiar budget-period estimates for the Act are 

used. the decline in the capital stock becomes 2.48 percent. Leaving these 

"nonstandard" tax provisions out of the analysis may therefore seriously 

understate the impact of the Tax Reform Act. 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 
I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

The Impact of Tax Refonn on Trade and Capital Flows 249 

Table 8.5 Long Run Impact of Tax Reform Including Passive Loss Rule, 

Uniform Capitalization Rules, and AMT (cr=3.0) 

Changes using Tax Refonn 

Changes using fully Act revenue estimates 

Variable phased-in estimates (1987-1991 average) 

. 

~lA -1.63 -1.66 

~2A .76 .69 

~KA - .36 - .93 

XNA - .36 - .67 

. 

!" -3.34 -4.73 

18 - .52 - .91 

6SAB 6.19 8.32 

6SBA 1.02 - .70 

6F - 5. 17 -9.02 

6X .44 -1.12 

6M 2.02 1.04 

68 - 1.58 -2. 16 

6~ 6.01 7.84 

6) -.75 -3.34 

6Jf 6.76 I I. 18 

. 

~" -1.43 -2.48 

KB .48 .81 

. 

~" -.27 -.39 

t -.2 1 -.14 

While we make an effort to evaluate the significance of these "nonstandard" 

items. it is only fair to remember that the simulations leave out potentially 

significant affects of the Tax Refonn Act. Because of the aggregate nature of 

the study, the change in real consumption does not reflect the benefits of a 

more efficient allocation of U.S. capital among assets within one of the broad 

sectoral categories. These benefits are an important feature of the paper by 

Fullerton. Henderson and Mackie ( 1987). In addition . the specific simulations 

reported in this paper assume that aggregate saving is insensitive to the rate 

of return. 

Nevertheless, even in this simplified framework. the results are not the 

straightforward predictable outcome of the increased business level taxes in 
250 Harry Gruben/John Mutti 

the United States. For one thing. predicting the change in capital flows 

requires an analysis of also how the U.S. tax on foreign income changes. Just 

knowing the change in taxes on domestic income is inadequate. In addition 

there are other important components of the model. such as changes in the 

terms of trade in response to capital flows. which can have a significant 

impact on real income. Finally. the purpose of simulations is to evaluate the 

quantitative significance of cenain behavioral responses. not just their 

direction of change. 

VII. SUMMARY AND CONCLUSIONS 

The Tax Reform Act of 1986 has a relatively small impact on sectoral output 

and trade at the broad aggregate level examined in this paper. It does not 

have a dramatic effect on relative costs among sectors, and in the long run 

there is only a modest change in the trade balance. 

StilL some of the changes are not insignificant and seem fairly robust 

under different assumptions about behavioral parameters. In the long run 

output in the import competing sector declines by from 1.0 to 2.0 percent 

because of a relatively large increase in capital costs. the (indirect) 

incentives provided to exports. and the outflow of capital. The U.S. equipment sector is helped. on the one hand. because it fares relatively well in 

terms of domestic business tax provisions. but on the other hand it suffers 

from reduced investment spending in the United States. On net. output 

declines somewhat. but less than the output of the import-competing sector. 

There is a decrease in the trade deficit in the short run because of the 

capital outflow in response to lower after-tax returns in the United States. 

In the long run. there is a small ($1 to 2 billion) increased trade deficit 

because the increased stock of U.S.-owned capital abroad generates greater 

investment income and finances more imports. 

The changes in the U.S. capital stock appear to be more significant for 

U.S. welfare than the changes in sectoral output or the trade balance.9 When 

the analysis is restricted to the "basic" tax changes. the U.S. capital stock 

is estimated to decline in the long run by 1.0 to 2.0 percent. depending on 

whether moderate or very high asset mobility is assumed. Assuming vinually 

perfect mobility does not have a large net effect because any large allocation 

of assets abroad by U.S. residents drives down returns in the rest of the 

world and induces a large reverse flow of assets by foreign savers. However. 

the "nonstandard" tax provisions such as the corporate minimum tax and the 

uniform capitalization rules may increase the decline in the capital stock to 

the 2.0 to 3.0 percent range. 

The results demonstrate that the merchandise trade balance is not a good 

indicator of U.S. welfare or even a good predictor of sectoral outputs. In 

the short run . the capital outflow leads to a trade surplus but. since it is 

the result of an increased demand for foreign output (in the form of capital 

goods production) abroad. the U.S. tenns of trade decline and real consumption 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 
I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

The Impact of Tax Refonn on Trade and Capital Flows 25 J 

goes down. Furthennore, even though the U.S. equipment industry is nonnally a 

substantial net exponer. its output declines because of reduced investment 

spending in the United States. and the reduction in imports does not prevent a 

decline in the import competing sector. 

The simulations demonstrate that changes in taxation are unlikely to have a 

significant impact on trade and sectoral output in the absence of international capital mobility. In the pure case (not simulated here) in which 

capital is not mobile and there is no initial cross-ownership of assets, a 

change in taxation will only affect trade to the extent that sectors are not 

affected uniformly (in tenns of percentage cost changes), or if the overall 

size of the economy is altered. In addition. any increase in capital taxation 

in one sector relative to others translates into a much smaller percentage 

increase in price because of the significance of other costs such as wages. 

depreciation and purchases from other sectors. In contrast, if capit.al is 

mobile, a relatively modest change in the tax on U.S. capital income at the 

business level can have a significant effect on the trade balance in the short 

run, and can lead to a visible long run change in the capital stock. 

FOOTNOTES 

1 While Summers ( 1986) stresses the importance of capitaJ flows, he identifies competitiveness only with the size of the traded goods sector. 2 Note that U.S. residents can import goods in the net export category, e.g .. foreign agricultural products. We assume that equipment is not consumed directly by households. 

3

The particular estimates used assume a real after-tax return of 5 percent. an inflation rate 

of 4 percent. individual arbitrage of after-tax returns and the "new view" on dividend 

taxation. 4 This procedure assumes that only operating investments abroad benefit from the rate reduction . This does not seem to require adjustment because the income in the other categories 

initially in the base for purposes of computing the effect of the rate cut were small or zero. 5Total foreign income includes total U.S. corporate foreign source net income reported on 

corporate tax returns. investment income received by individuals and the amount of income 

retained abroad by U.S. owned foreign corporations. It was estimated to be $100.0 billion in 

1986. Some of the components were obtained from balance of payments data published in the 

Survey of Currem Business. 6

This refers to the special title-passage provision of the sales source rules. The Tax 

Reform Act requires the Treasury to conduct a study of source rules for inventory property. 

Nothing in this discussion should be taken as an indication of the results of the Treasury 

study. 7

1f we were fully consistent. we would increase the tax on real investment abroad computed in 

the previous section to balance the increased benefit on the margin to exports. In other words. 

some of the benefits of a lower statutory rate on foreign income should be anributed to 

exP,.Orts. 8

The zero elasticity of total saving implies that. for given income. nominal saving is fixed 

in terms of the numeraire good. If income is unchanged. real capital accumulation can only 

change if the price of the capital good changes relative to other goods. 9 As indicated earlier. this paper focuses on capital mobility and the allocation of capital 

among broad sectors while abstracting from other potential sources of welfare improvements. 
252 Harry Grubert/ John Mutti 

Labor supply and total saving do not respond to real wages or rates of return in these 

simulations. In addition. the simulations do not reflect the more efficient allocation of 

capital among specific assets within a broad sector. which is an important aspect of the paper 

in this volume by Fullerton. Gillette, and MaciUe. 

REFERENCES 

Adler. M .. and Dumas, B .. 1983. "International Portfolio and Choice and Corporation Finance: 

a Synthises. " Journal of Finan

ce 38: 925-984. · 

Armington. P .. 1969. "A Theory of Demand for Products Distinguished by Place of Origin." 

International Monetary Fund Staff Papers 16.159-177. 

Ballard, C 

.• D . Fullerton. J. Sboven andJ. Whalley, 1982, Complete Documentation oftht U.S. 

General Equilibrium Model, prepared for the Office of Tax Analysis. 

U.S. Treasury 

Department. 

Dworin, L .. 1987. "Impact of the Corporate Alternative Minimum Tax. A Monte Carlo Study." 

Chapter 9 in this volume. 

Fullerton D .. 

Y. Henderson. and J. MaciUe. 1987. "Investment Allocation and Growth Under 

the Tax Reform Act of 1986." Chapter 6 in this volume. 

Fullerton D 

.• R. Gillette. andJ. Mackie. 1987. "Investment Incentives Under the Tax Reform Act 

of 1986." Chapter 5 in this volume. . 

Goulder, L. J. Shoven and 

J. Whalley. 1983. "Domestic Tax Policy and the Foreign Sector. " 

in: M. Feldstein, ed . . Simulation Methods in Tax Policy Analysis (National Bureau of 

Economic Research, University of Chicago Press) 333-364. 

Gravelle, J .• 1986, Corporate Tax Reform and International Competitiveness, Congressional 

Research Service Report, No. 86

-42E. 

Hamermesh, D. and 

J. Grant, 1980. "Econometricstudiesoflabor substitution and their implica-

tions " Journal of Human Resources 16,518

-542. 

Hartman. D .. 1984. 

"Tax Policy and Foreign Direct Investment in the United States." National 

Tax Journal 37. 475-487. 

International Trade Commission. 1986. Effi•cts of Proposed Tax Reforms 011 the International 

Competitiveness of U.S. l11dustries, USITC. Publication 1832. 

Jones. R .. 1965. 

"The Structure of Simple General Equilibrium Models." Journal of Political 

Economy 73.557-572. 

Multi. J. and H . Gruben. 1984a. "DISC and Its Effect." in: R. Baldwin and A. Krueger. The 

Structure and Evolut

ion of Trade Policy(N ational Bureau of Economic Research. University of 

Chicago Press. Chicago) 279-317. 

Mutti. 

J. and H . Grubert. 1984b. "Taxation of International Investment Income in a Multi· 

Asset Model. • Presented at Stanford NBER Conference on General Equilibrium 

Models. 

Mutti. 

J. and H . Gruben. 1985. "The Taxation of Capital Income in an Open Economy: The 

Importance of Resident · Nonresident Tax Treatment, " Journal of Public Economics 

27.291-309. 

Multi, 

J. and H. Grubert. 1986. "A Model With Asset Mobility and Trade in Capital Goods With 

an Application to Alternative Export Incenti

ves." Presented at NBER Summer Tax 

Institute. 

Statistics of Income (SOl) Bulletin. Internal Re

venue Service. Spring 1986. Foreign tax credit 

by industry. 9-

30. 

Summers. L .. 1986. "Tax Policy and International Competitiveness." NBER Working Paper 

2017. 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I 

I