- - - - - ~~ - -- - - - --- - - - ~ - - -~ ~ 

Optimal Taxation of Foreign-Source 

Investment Income 

0. H. Brownlee 

Comment 

Gary C. Hufbauer 
Optimal Taxation of Foreign-Source 

Investment Income 

0. H. Brownlee 

Analysis of the effects of imposing constraints on the movement 

of commodities and resources across geographic boundaries is an 

important part of both economic theory and measurement. The 

theory of the optimal tariff has occupied international trade theorists for many decades. That the movement of population affects 

the geographic pattern of wage rates has been recognized in immigration laws enacted by virtually every nation. Laws relating 

to capital movements also are widespread. Some regulations are 

designed to slow the flow of capital into a country. Just as domestic laborers favor restricting immigration, domestic owners of 

capital might be expected to support regulations that would deter 

the flow of capital into the home country. However, regulations 

restricting capital inflows also have been supported by labor in 

some countries. 

The policy of the United States toward both capital imports and 

exports has been ambiguous. Foreign ownership of certain kinds 

of assets has been prohibited or discouraged, implying that the 

United States was interested in restricting the importation of 

capital. On the other hand, special constraints have also been 

imposed upon the movement of capital out of the United Statesfor example, the "investment equalization tax" intro~uced in 

] 963. It might be argued that there is no inconsistency in impeding both the import and export of capital. Import controls either 

seek to prevent foreign control of strategic (defense related?) 

industries or to impede an increase in the relative prices of cer0. H. BROWNLEE is with the Department of Economics at the Uni.versity of Minnesota, Minneapolis. 

(183) 
184 COMPENDIUM OF TAX RESEARCH 

tain assets (farm land, for example). In contrast the objective of 

the "investment equalization tax" ·was to reduce the balance-ofpayments deficit during an era in which exchange rates were 

fixed. 

Examination of the effect of capital export controls on U.S. 

national income-its size and distribution over time and among 

classes of individuals-has only recently occurred. The recent 

analysis searches for optimal capital exports in a manner analogous to that in which earlier analysis sought an optimal tariff 

structure. It seeks to maximize some definition of national income 

with respect to controls on the export of capital. Among the 

means of influencing the movement of capital abroad is the way 

in which income from foreign investments is taxed. Consequently, 

it is almost inevitable that there would be a search for optimal 

taxation of foreign-source investment income. 

Hunting for an optimal tax structure for foreign-source income 

-if such a phenomenon exists-is not an easy task. Earlier discussions of the taxation of the income of U.S. taxable entities 

attributable to their capital invested abroad were concerned with 

an equitable division of tax revenue between the United States 

and the country in which the investment was made, the avoidance 

of double taxation, or the allocation of capital in such a way that 

the marginal contribution of capital to income tended to be the 

same throughout the world. Recent discussions have focused on 

the effects of such taxation on U.S. welfar~ which is not defined 

in the same manner by all participant's in a given discussion. 

And, of course, participants also hold different views about the 

relevant facts. 

Some of the work that has been done will be reviewed briefly 

in the next section. Unlike the optimal tariff literature, which is 

almost exclusively theoretical, some of the analyses relevant to 

optimal taxation of foreign-source income attempt to produce 

quantitative estimates that might be useful in deciding how best 

to tax such income. However, the view of the world that is employed in obtaining the numerical estimates is a very oversimplified one. Usually the rest of the world is treated as if it were a 

single economic unit; the effect of U.S. tax policy on foreign investment in the United States is ignored. Typically, only direct 

foreign investment is analyzed, although indirect investment and 

intergovernmental loans and grants also draw upon the capital 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 185 

available for domestic investment in about the same way as does 

direct investment. 

The kind of simplification that has been made is useful for obtaining some "feel" of the problem-for making it possible analytically or through simulation to ascertain how changes in certain 

parameters might affect some endogenous variables of general 

interest. However, the errors resulting from such simplification 

cannot be ascertained until the results of a more complicated 

model are available; the models constructed and simulated to date 

are unlikely to be adequate for determining how best to tax foreign-source income if the objective is to maximize the present 

value of a stream of future national income. · 

Furthemore, if it were decided that U.S. capital exports should 

be controlled in a way such that some national income concept 

were maximized, the foreign-source income tax structure would 

not be an adequate control mechanism. As has been noted above, 

capital exports can occur in forms other than direct, private, foreign investment; also, if controls are to be exercised, net exports 

probably should be the relevant quantity. The objectives of foreign-source income taxation thus seem to be no clearer than they 

have been. The utility, for purposes of tax policy, of analyses seeking a foreign-source income tax structure that maximizes U.S. 

national income may be small, given the feebleness· of the instrument and the many distortions in the economic environment introduced by various government regulations. 

The frustration encountered in trying to state and solve the 

problem of optimal taxation of foreign-source income strengthens 

the support for a tax structure in which the way in which income 

is obtained-its source, time distribution, etc.-is irrelevant for 

tax purposes. Taxing expenditure rather than income contains 

such a feature, although it also has other characteristics that may 

produce problems comparable to those encountered in income taxation. 

In spite of the large element of futility in trying to evaluate 

various proposals for taxing foreign-source income, this study will 

briefly describe and evaluate some recent work relating to the 

effects of capital exports on national income, will indicate modifications that might be made in such work, and will point out in 

more detail why the capital export approach to taxing foreignsource income is unlikely to be definitive. 
--~ -

186 COMPENDIUM OF TAX RESEARCH 

A Brief Review of Some Recent Studies 

There are several recently completed studies that deal with 

capital export controls that would maximize U.S. national income. 

Some have established theoretical frameworks for analyzing the 

problem, some have attempted to estimate relevant parameters, 

and some have produced estimates of certain effects of taxing 

foreign-source income in particular ways. In a study prepared by 

Musgrave for the Subcommittee on Multinational Corporations of 

the Committee on Foreign Relations, United States Senate 

(1975), estimates are made of the change in U.S. income and its 

distribution between wages and capital income that would have 

resulted if the U.S. capital invested abroad as of 1968 had been 

invested instead in the United States. A CES (constant elasticity 

of substitution) production function for the United States was 

assumed, and the elasticity of substitution was varied in order to 

obtain different shares of total income attributable to labor and 

capital. 

The effects upon the shares of labor and capital are of no interest in the present analysis. The result-total income rose when 

the capital was shifted from abroad to the United States-is of 

interest. It was obtained because increased wage income in the 

United States attributable to the increased capital investment 

within the country more than compensated for the reduced capital income due to its reduced rate of return. Musgrave does not 

solve for the optimal rate of foreign taxation-a rate that might 

have resulted in some foreign investment, though less than had 

been made through 1968-because she believes th.at no reasonably 

accurate estimate of foreign production functions employing U.S. 

capital is available. 

Musgrave treats the employment level as being independent of 

U.S. investment abroad. Also, she assumes that the total amount 

invested is invariant with respect to the distribution of capital 

between the United States and abroad, i.e., that the total stock of 

capital is fixed. 

Ture, in a study prepared for the National Association of 

Manufacturers (1977), employs a model similar to that of Musgrave except that he assumes (a) a foreign production function 

with parameters essentially identical to those of the U.S. production function, (b) explicit labor supply functions for both the 

United States and for U.S. overseas operations, (c) a desired 

capital: income ratio, and (d) an adjustment of the actual to 

the desired capital stock. The production function is Cobb-
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 187 

Douglas, both foreign and domestic labor forces increase with the 

real take-home pay of workers, and the desired capital stock 

varies directly with the disposable income of the U.S. economy. 

Parameter values for the model are estimated from such data as 

labor's share of total income and past capital: income ratios. With 

this model, estimates of the effects of changes in tax rates can 

be obtained. 

Another similar model has been employed by Thurow ( 1976) . 

He assumes that the U.S. and foreign production functions are 

Cobb-Douglas and identical, with labor's share equal to 0.7. Like 

the models of Musgrave and Ture, this one does not allow explicitly for trade nor for foreign investment on account of superior U.S. technology or management, although some conjectures 

regarding the impact of exporting technology and management 

are made. In Thurow's model both U.S. and foreign stocks of 

capital can be dependent upon their respective rates of return, 

but, like Ture's, Thurow's is not a dynamic model-Le., some 

exogenous change must occur to alter the static equilibrium 

values. 

In formulations such as those of Musgrave, Thurow, and Ture, 

the multinational firms can be viewed as channelers of capital 

across national boundaries. The amounts firms select to invest at 

home and abroad are assumed to be made in accordance with some 

rules such as "choose those allocations that equalize after-tax 

rates of return." The role played by multinational corporations in 

tr an sf erring management and technology is not an integral part 

of such models. An assumption such as that the production functions abroad and at home are the same or differ only by a scale 

factor implicitly accounts for the transfer of management and 

technology (the production functions would be identical if technology and management also were identical), but the principal 

role of the foreign investor is to act as a kind of capital broker 

equalizing rates of return, after tax, among the various investment opportunities. 

The impact of taxing foreign-source income in such a model are 

obtained by solving a system of equations whose unknowns include (a) the domestic level of employment, (b) the total amount 

of U.S. capital to be employed at home and abroad, (c) the 

amount of capital employed at home, (d) the amount of labor to 

be combined with U.S. capital abroad, (e) the after-tax rate of 

return to capital, (f) the after-tax real wage rate at home, (g) 

domestic gross national product, and (h) foreign-source income 

(after taxes have been collected by foreign governments). Param-
188 COMPENDIUM OF TAX RESEARCH 

eters or exogenous variables in the system in addition to the U.S. 

tax rate on foreign-source income could be the income tax on wage 

income in the United States, the tax rate on domestic capital income, the initial capital stock in the United States, the initial 

capital stock abroad (U.S.-owned capital plus the relevant portion of foreign-owned capital), labor's share of income in the 

United States (and abroad), the U.S. unemployment rate, the 

extent of capacity utilization at home (and abroad), and the foreign wage rate. 

Assume, for example, that there were initially no U.S. tax on 

capital income received by U.S. taxpayers and that a tax on foreign-source income were imposed. The overall average rate of 

return to U.S. capital owners would fall; the U.S. capital stock 

would rise; the amount of U.S. capital abroad would fall; domestic wage income, employment, and total income would rise; and 

foreign income would fall. Total income (domestic plus foreignsource) would rise initially but could be smaller in the future 

than it would have been with no tax on foreign-source income, 

because the overall future capital stock might be smaller. This 

growth of the capital stock depends critically upon how the desired capital stock reacts to the return on capital and total aftertax income. The effect of the increased labor income could more 

than offset the effect of the reduced capital income resulting from 

a higher tax rate on foreign-source income, if the elasticity of 

foreign demand for U.S. capital is sufficiently small. If this were 

the case, the optimal tax on foreign-source income would exceed 

that on domestic capital income-a result obtained by Thurow 

(1976). 

Assuming that the U.S. economy consists of two sectors, each 

producing a different product, and that the rest of the world can 

be described in a similar manner permits the terms of trade and 

the contribution of multinational firms to the technology and management of plants operated abroad to be incorporated into the 

analysis. Two-sector models have been employed by Thurow and 

White (1976) and Hartman (1977) in the analysis of taxation of 

foreign-source investment income. 

The model of Thurow and White assumes that the production 

functions at home and abroad are Cobb-Douglas or CES and that 

the U.S. functions have different coefficients than the foreign ones. 

Labor receives the same rate o.f return after tax in each employment within a country although it cannot move between countries. 

Capital receives the same after-tax rate of return regardless of 

where it is employed; i.e., it moves between countries as well as 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 189 

between industries in response to rates of return. There are also 

social welfare functions for each country, such welfare in any 

country depending upon the amounts of the two commodities available for consumption jn that country and not upon the distribution of the commodities. These social welfare functions also are 

assumed to be Cobb-Douglas or CES. The total amount of labor 

employed within a country is a constant, as is a country's capital 

stock. 

Thurow and White solve for the home tariff and the amount of 

capital to be exported by the home country that will maximize 

domestic utility rather than fur the optimal tax on foreign-source 

income. Obviously one could solve for the tax on foreign-source 

income that would result in the optimal capital export, so that 

the Thurow and White results are relevant to an analysis of optimal taxation of foreign-source income. The analysis assumes that 

the tariff and capital exp9rt restrictions imposed by the foreign 

country are independent of those imposed <at home. 

Although the economies (production and utility functions and 

supplies of labor and capital) selected by Thurow and White are 

not necessarily representative of any country and its complement 

("the rest of the world"), the results are of interest in that they 

show that the home country's utility is maximized when capital 

export is prohibited. Total income of the home and foreign country is, of course, maximized when there are no restrictions on 

trade or the export of capital. But, as was already well known, 

the home country can benefit from imposing a tariff-if the foreign country does not retaliate--and, jn addition, the home country can benefit even more by imposing a tax on foreign-source 

income that will discourage the export of capital. 

Hartman's model is similiar to that of Thurow and White in 

that it assumes two sectors in each of two countries, Cobb-Douglas 

production functions in all four sectors, fixed supplies of labor 

and capital in each country with labor mobility within a country 

(but not between countries), and capital mobility between countries as well as within them. Hartman assumes demand functions 

for the two commodities within each country, but these demand 

functions could have been derived from utility functions of the 

same form as those employed by Thurow and White. The principal 

difference between Hartman's model and that of Thurow and 

White is that Hartman assumes that a home-country firm investing abroad has a cost advantage over the foreign producer and 

that some of the capital employed by the home firm in its operations abroad is obtained abroad. There are thus four production 
190 COMPENDIUM OF TAX RESEARCH 

functions : one describes the home firms in their production of 

one commodity (that imported by the home country) at home and 

abroad; one is used by home firms for the commodity, which is 

exported by the home country; a third is employed by foreign 

firms producing the commodity, which is imported by the foreign 

country; and the remaining one describes the foreign firms that 

produce along with their (U.S.) competitors for export to the 

home market. 

Unlike Thurow and White, who assume that the elasticities en 

outputs with respect to factor inputs (the illustrative production 

functions being Cobb-Douglas) differ between the two countries, 

Hartman assumes that for any product the elasticities are the 

same in both countries. Export of U.S. capital need not occur in 

order for these to be foreign-source income. The cost advantage 

of U.S. firms, whether they produce at .home or abroad, due to 

their superior technology and/ or management, could result in 

U.S. firms producing abroad using only foreign capital. Of course, 

there may also be capital export because of -different factor endowments ; and one could assume both a cost advantage and 

different factor proportions in the two countries. Hartman assumes the factor endowments of the countries to be given, i.e., 

the capital stock of either country is independent of its rate of 

return after tax, and employment is a constant in each country. 

Hartman's results indicate that maximum income (and hence 

the optimal tax) depends upon (a) the percentage of the capital 

used by U.S. firms in their foreign operations that is obtained 

from the U.S., (b) the cost advantage of U.S. firms over foreign 

firms, and ( c) whether the foreign investment is for the production of the labor-intensive or the capital-intensive good. The optimal tax varies inversely with the proportion of U.S. funds 

obtained in the United States: it is higher when the U.S. foreign 

investment is for the production of the labor-intensive good than 

when it is for the production of the capital-intensive good, and 

it is directly related to the cost advantage of U.S. firms investing 

abroad. 

Hartman's model is more general than those of Musgrave or 

Thurow and White, but it is not comparable with those of Ture 

and Thurow since the latter permit the total stock of capital to 

depend upon the rate of return to capital after tax. The estimated 

gains from restricting capital export in Hartman's model could 

be greater than in the others, although-as noted earlier-the 

optimal tax policies might be similar. In Ture's formulation, the 

optimal tax on foreign-source capital income could be less than 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 191 

that on domestic capital income if the foreign elasticity of demand 

for U.S. capital is large and the overalJ stock of capital is sufficiently responsive to the rate of return received -by capital owners 

in the United States. 

In summary, the models of Musgrave, Thurow, and Ture characterize the U.S. economy and the rest of the world as two economies, each employing labor and capital and producing a single 

homogeneous product. Capital moves across national boundaries 

to equalize rates of return to capital owners, after payment of 

taxes. Musgrave assumes that supplies of both labor and capital 

within an economy are independent of wage rates and rates of 

return to capital. Consequently, the tax rate on foreign-source income that maximizes U.S. national income depends upon the relative U.S. and foreign elasticities of demand for U.S. capital. If 

the foreign demand for U.S. capital were infinitely elastic, so that 

the marginal rate of return to U.S. capital were equal to the constant rate of return on foreign investment after payment of foreign and U.S. taxes, the optimal U:S. tax on foreign-source income 

would be the same as that on domestic-source income. If the elasticity of demand by foreigners for U.S. capital were iess tha..n 

infinite, the tax on foreign-source capital income would exceed that 

on domestic-source income. The excess of the optimal tax on foreign-source income over the given tax on domestic-source income 

varies inversely with the elasticity of foreign demand for U.S. 

capital. 

Ture's and Thurow's results are similar except that because 

the stock of capital accumulated by U.S. capital owners varies 

directly with its rate of return, the present value of U.S. national 

income will be maximized for tax rates on foreign-source income 

that are smaller relative to those on domestic income than would 

be derived by Musgrave for identical production functions and 

supply functions for U.S. labor. For example, with an infinitely 

elastic foreign demand for U.S. capital, the optimal tax on foreign-source income would be less than the tax on domestic income 

-providing the latter were greater than zero. Given the (positive) elasticity of the capital accumuated by U.S. capital owners 

with respect to the rate of return on capital, there is some elasticity of foreign demand for U.S. capital at which the optimal 

foreign-source income tax is equal to the positive tax on domesticsource capital income. For elasticities of foreign demand for U.S. 

capital smaller than the one just denoted, the tax on foreignsource income should exceed that on domestic income; for larger 

elasticities of foreign demand for U.S. capital, the foreign-source 

tax should be less than the domestic tax. The foreign elasticity of 
192 COMPENDIUM OF TAX RESEARCH 

demand at which the two tax rates should be identical varies 

directly with the elasticity of the U.S. capital stock with respect to 

its rate· of return and inversely with the rate at which future income is discounted. 

In the models of Musgrave, Thurow, and Ture parameter values 

that are believed, by each of the authors of the models, to describe 

more or less accurately the framework within which the U.S. tax 

on foreign-source income ought to be selected are employed. Musgrave does not solve for the optimal tax but shows that prohibiting the export of U.S. capital would have made U.S. income larger 

than that achieved by tax regulations, resulting in the effective 

tax rates on foreign-source income and capital export that prevailed until 1968. Similiarly, Thurow shows that the United States 

should import capital. Ture concludes that the effective tax rates 

acieved by deferring tax liability until the income is repatriated 

and by crediting foreign taxes paid is better than taxing foreignsource income at a rate of 48 percent. 

None of these models accounts for effects upon terms of trade, 

nor does any explicitly incorporate differences in technology and/ 

or management that create cost advantages that in turn encourage 

direct investment abroad. 

Although the model proposed by Thurow and White permits 

analysis of the changes in the terms of trade and the model proposed by Hartman includes these effects plus inclusion of the 

impact of superior technology and management available to the 

capital exporting country, the parameters describing the capital 

stocks and labor availabilities of the two "countries" are not 

necessarily representative of the United States and the rest of the 

world. The general nature of the policy implications of the twosector models is not strikingly different from that of the onesector models that make similar assumptions with respect to production functions and resource endowments when the export of 

capital is for the labor-intensive commodity. Hartman's estimate 

of the potential increase in U.S. income from optimizing the export of capital is larger than those obtained from the other models 

when the export of capital is for the production of the capitalintensive good. 

Some Modifications in Procedures 

for Estimating Optimal Foreign-Source Rates 

There are many ways one might expand the kind of investigation that already has been undertaken and has been summarized 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 193 

in the previous section. Increasing the number of commodities and 

increasing the number of countries are obvious possibilities. If the 

impact of capital export on the terms of trade is of negligible importance, as appears to be the case in the model of Thurow and 

White and that of Hartman, then expanding the number of commodities is not likely to result in much change in the results. The 

assumptions regarding pref erence.s in the home country and 

abroad wiH affect the estimated changes in the terms of trade. 

However, I have no more knowledge about preferences than the 

other investigators have had and see no reason to alter their assumptions drastically. 

Adjusting for the Ratio of U .S.-Supplied Capital to a Country's 

Total Capital Stock 

Considering all of the foreign countries in which U.S. investment might take place as if they constituted a single country is 

likely to result in a different solution for the optimal foreign-tax 

structure than if there were some disaggregation. The result, derived from the one-sector models with a fixed stock of U.S. capital available for investment at home and abroad, that the tax on 

foreign-source income should exceed that on domestic income is 

due to the fact that the entire contribution of a domestic investment is a part of U.S. income whereas a part of the contribution 

of a U.S. investment abroad is captured by the other factors of 

production and is thus a part of foreign rather than U.S. income. 

Let XD be U.S. income, XF be foreign income, KD be the amount 

of capital employed in the United States, and KF be the amount 

of capital employed abroad of which K; is U.S. capital. If the 

amount of U.S. capital ava.ilable for use at home and abroad is a 

constant, then a small change in U.S. investment at home results 

in the following change in U.S. income from both foreign and 

domest;" Cll)urces : 

oXD - oXF +K* 0 2XF. 

oKD ax; F 0K~2 (1) 

The first term is the marginal productivity of capital used in 

the United States; the second term is the marginal productivity 

of capital abroad, and the third term is the change in the income 

of U.S. capital invested abroad due to the change in the marginal 

productivity of foreign capital. If the foreign and domestic elasticities of output with respect to capital were aF and av respectively, equation (1) could be written as 
194 

K* F 

COMPENDIUM OF TAX RESEARCH 

(2) 

If - were small (i.e., if U.S. investment abroad were a small 

KF 

percentage of the total foreign capital) then the expression in 

brackets would be unity and equation (2) would be approximately equal to zero when the marginal productivity of capital 

a.it home and abroad were equal. Taxing domeistic and foreignsource income at the same rates would induce U.S. capital to be 

B.llocated between domestic and foreign investment so that U.S. 

income from both foreign and domestic sources was approximately a maximum. However, if each U.S. investor abroad ignored the 

impact of his actions on the productivity of capital abroad and if 

K* F 

- is not negligible, then the tax on foreign-source income should 

KF 

exceed that on domestic income. This is the recipe proposed by 

some of the investigations described previously. 

Obviously, equation (2) could be replaced by a system of equations, one for each country, and the optimal tax raite in country 

i would depend upon the elasticity of ou:tput with respect to 

capital aFi and the ratio of U.S.-furnished capital to total capital 

K* F{ 

- in that country. Assuming that elasticities of output with re- KFi 

spect to capital were ,the same in. all countries, U.S. tax rates on 

foreign-source income should vary directly with the percentages 

of a oountry's capital supplied by the United States. 

There is considerable variance among countries in the ratio of 

U.S.-owned capital to the total capital of the country. Estimates 

have been made of the gross product of foreign affiliates of U.S. 

companies as percentages of the gross domestic product of the 

host country for 1966.1 There are also estimates of total U.S. 

assets in various regions of the world,-2 so that rough estimates of 

the ratio of U.S. assets to total assets can be obtained for various 

countries. Total U.S. capital is the sum of private investment 

(direct and indirect), U.S. claims on unaffiliated foreigners (reported by banks and nonbanks), and U.S. Government loans and 

other long-term assets. Direct investment made by U.S. firms and 

1 See Howenstine (1977). 

'See Scholl (1976). 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 195 

financed by loans from abroad is not differentiated from investment financed from U.S. sources. Subscriptions and contributions 

to international financial institutions are not included since they 

could not be allocated easily. These, together with U.S. Government grants and loans, are mixtures of additions to the stock of 

capital competing with private investment and consumption loans 

plus additions to "public capital"-roads, port facilities, communications, education, etc.-that might increase the marginal 

productivity of private investment. For the most part, the Government grants and loans are made to underdeveloped countries 

in which U.S. private investment is relatively unimportant. Also, 

such "investments" made up only about one-sixth of the relevant 

capital, so that the manner in which they are treated in this part 

of the analysis is not of major importance. 

If the country's production function is Cobb-Douglas and its 

labor supply is fixed so that substitution between capital and 

labor cannot occur, the elasticity of the marginal productivity of 

capital with respect to additional investment is equal to the elasticity of output with respect to capital minus 1. Assuming an elasticity of output with respect to capital of 0.25, the elasticity of 

the marginal productivity of capital with respect to capital is 

-0.75. If the labor supply varies directly with the wage, the absolute values of the elasticity of demand for capital with respect 

to its own price would be larger than the number cited above. 

However, the correction for this effect is not likely to be important. The ratios of foreign-source income tax rates to domestic 

income tax rates that would equate the marginal returns to the 

United States from foreign investment with the marginal returns 

to domestic investment for selected countries are presented in 

table 1. These estimates assume that the amount of U.S. capital 

for investment at home and abroad is independent of the rate of 

return to capital. 

If only a single tax rate can be applied to all foreign-source 

income, that rate that would maximize the contribution of U.S. 

foreign-source income to total income in the simplified circumstances that have been assumed here could be estimated. For the 

countries listed in table 1, the optimum single rate would be about 

17 percent above the rate applied to U.S. income, the estimated 

ratio 

total capital in the relevant group of countries 

total capital minus U.S.· capital in these countries 

being approximately 1.17. 
196 COMPENDIUM OF TAX RESEARCH 

TABLE 1.-Estimated percentages of U.S. capital to total capital and 

corresponding optimal U.S. tax rates on foreign-source investment income 

Ratio of 

U.S. direct U.S. assets U.S. assets "optimal" tax 

investment abroad-;-. U.S. as o/o of on foreignCountry as percent direct invest- total source income 

of total ment 2 capital 3 to tax on 

capital 1 domestic 

income4, 

Canada 14 1.90 26.6 1.36 

United Kingdom 5 1.57 7.9 1.08 

Belgium and 

Luxembourg 3 1.57 4.7 1.05 

France 2 1.57 3.1 1.03 

Germany 2 1.57 3.1 1.03 

Italy 2 1.57 3.1 1.03 

Nether lands 3 1.57 4.7 1.05 

Denmark 1 1.57 1.6 1.02 

Ireland 3 1.57 4.7 1.05 

Norway 2 1.57 3.1 1.03 

Spain 1 1.57 1.6 1.02 

Sweden 1 1.57 1.6 1.02 

Switzerland 3 1.57 4.7 1.05 

Japan 1 5.69 5.7 1.06 

Australia 5 2.95 14.8 1.17 

New Zealand 2 2.95 5.9 1.06 

South Africa 4 2.95 11.8 1.13 

Argentina 3 2.75 8.3 1.09 

Brazil 3 2.75 8.3 1.09 

Chile 9 2.75 25 1.33 

Colombia 4 2.75 11 1.12 

Mexico 4 2.75 11 1.12 

Panama 13 2.75 36 1.56 

Peru 9 2.75 25 1.33 

Venezuela 18 1.6 29 1.41 

Jamaica 16 1.6 26 1.35 

Liberia 21 1.6 34 1.52 

Libya 37 1.6 59 2.43 

Nigeria 1 2.95 3 1.03 

Iran 5 2.95 14.8 1.17 

India 1 2.95 3 1.04 

Philippines 4 2.95 11.8 1.13 

1 Estimates are for 1966 and are taken from Howenstine (February 1977, table 

4, p. 19). 2 Derived from data for 1975 presented by Scholl (August 1976, table 3, p. 32). 

For all Western European countries the number employed is the aggregate for 

Western Europe; for Latin America and other Western Hemisphere countries (except for Venezuela and Jamaica, which are considered as if they were Western' 

European), the estimate is from the aggregate for these countries; for Nigeria, Australia, New Zealand, and South Africa, the estimate is from the aggregate for 

"Other Foreign Countries"; and for Libya and Liberia, the Western European ratio 

was employed. 3 From Scholl (August 1976). 

'Total capital+(Total capital-U.S. assets abroad). 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 197 

Adjusting for Effect of Taxation on Saving 

That the stock of U.S. capital is independent of its rate of return is an assumption that-in a world of one-sector economiesforces the optimal tax rate on foreign-source income to be at 

least as large as that on domestic income. Ture assumes that the 

U.S. stock of capital for investment at home or abroad depends 

on its after-tax rate of return. From an initial stationary equilibrium, a change in the tax structure that increases the after-tax 

rate of return to capital would result in a new higher equilibrium 

capital stock achieved linea~ly ln 3 years. Thurow's assumption 

regarding the capital stock is equivalent to assuming that the 

stock adjusts instantaneously to its rate of return. In the evenrt 

that a policy change increases both current and future income·-

as would be the case with Thurow's model-the appraisal of the 

outcome is independent of the discount rate. If some future incomes are increased and some diminishe~, the ranking of the outcome will depend on the discount rate. 3 

The effect that a change in the rate of return to capital, resulting from a change in the tax rate on foreign-source income, might 

have upon total capital stock and U.S. income from both domestic 

and foreign sources over time can be indicated by an example. 

The numbers employed are approximations of some of those relevant for describing the U.S. economy. Assume that both foreign 

and domestic income are taxed at the same effective rate-say 60 

percent-and that the after-tax rate of return on income from 

both sources is 4 percent so that the before-tax rate is 10 percent. 

Let the tax rate on foreign-source iD!Come be reduced so that it is 

59 percent, and assume that the rate of return before taxes is independent of U.S. investment abroad and therefo~e remains at 10 

percent. In order that domestic investment yield an after-tax rate 

of return of 4.1 percent, it must yield a before-tax return of 10.25 

percent; i.e., the cost of capital for domestic investment will be 

increased by 2.5 percent· and there will be a loss in income of 

approximately" 0.125 percent for each unit of capital moved from 

the United States abroad as a result of the tax change, providing 

that the overall stock of capital for investment at home and 

abroad is independent of the tax structure. This is a limiting case 

for some of the studies described earlier. With an elasticity of 

output with respect to capital of 0.25 and a level of .emr 1 ,yment 

8 Hartman's outcomes are evaluated in terms of utility. He states that he 

did not wish to make intertemporal comparisons, i.e., to employ a utility 

function in which the amounts of commodities available at different times are 

the arguments. Consequently, he assumed that the capital st<> ~le was fixed. 
198 COMPENDIUM OF TAX RESEARCH 

of labor that is fixed, a U.S. domestic income of $1.5 trillion 

would require a domestic capital stock of $3.75 trillion. The reduction in the tax on foreign-source income would reduce employment of capital in the United States by 1.875 percent, moving 

about $70 billion abroad and reducing income by about $875 

million annually. 4 

However, if the reduction in the overall tax rate-the weighted 

average rate on foreign-source and domestic investment income--

induces a larger capital stock, this impact must also be included 

in the cost or benefit of the tax change. This larger capital stock 

is achieved at the expense of current consumption, .so some kind 

of "utility" or "valuation" function must be introduced if scalar 

comparisons are to be made. It is highly unlikely that all reasonable people will concur in the valuation function to be employed 

in this analysis, but the function could. be modified without drastically altering the conclusions. First, let income at any time be 

given the same value independent of its disposition between saving and consumption. This may seem unreasonable if individuals' 

utilities depend upon their consumption, but is not so strange if it 

is assumed that incomes are optimally allocated between consumption and saving-given the terms, established by "nature" and 

the government, by which current consumption can be exchanged 

for future income. Second, future and current income may be· 

aggregated by discounting future income. The appropriate discount structure is the subject of much debate. Where the discount 

rate is important, the effects of using different discount rates can 

be estimated. The adjustment in. the capital stock resultlng from 

a change in the rate of return to saving will take place over time. 

The more rapid the adjustment, the greater the importance of the 

outcome, for positive discount rates. Or, for a given adjustment, 

the importance of the outcome is inversely related to the discount 

rate. 

In most growth models, the rate of growth is independent of 

the rate of saving and depends upon the steady-state rate of 

growth in employment and in the improvement of technology. 

The capital stock and, therefore, income per capita, however, does 

vary directly with the saving rate. If one compared only the 

steady-state incomes at various levels of saving induced by vari4. This estimate would be smaller if the rate of return to U.S. investment 

abroad declined with the amount of such investment. For example, if foreign 

elasticity of demand for U.S. capital were zero, the tax change would not 

move any capital. For an average elasticity of about minus 7 (the elasticity 

implied in the previous section), the approximate annual loss would be $750 

million. 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 199 

ous tax structures, their rankings would be independent of the 

discount rate. 

Estimates of the response of saving to its rate of return vary 

considerably. Most estimates of the elasticity of saving with respect to its rate of return have net exceeded 0.2, and some analyses that were conducted assume that saving was independent of 

its rate of return. However, a recent study by Boskin (1976) indicates that the elasticity is likely to be considerably higher than 

the estimates previously reported, 0.4 being a reasonable estimate. 

Continuing with the numbers employed in the previous illustration in which it was assumed that the "before" (U.S.) tax rate 

of return on foreign-source income was 10 percent and the tax 

rate on income from both foreign and domestic investment was 60 

percent, a tax change that increased the after-tax rate of return 

on investment from 4.0 to 4.1 percent would increase saving by 1 

percent-if the elasticity of saving with respect to its rate of return were 0.4. This additional saving is assumed to have no impact on national income in the time period in which it is made, 

but it yields a rate of return of 10 percent. This is the same rate 

of return as would be obtained from any additional domestic income achieved by reducing foreign investment and increasing investment at home, so discounting is not required in order to obtain 

a ranking. 

Assuming that saving is 10 percent of income, the tax change 

that would bring a yield of 4.1 percent rather than 4 percent on 

saving would raise the saving level to 10.1 percent of income, i.e. 

by $1.5 billion and yield $150 million annually. This is considerably less than the $875 million loss in domestic income from the 

shift of capital abroad that otherwise would have been employed 

at home. Since the assumed elasticity of saving with respect to 

income is relatively large, no important differential between foreign-source and domestic tax rates seems warranted by the effect 

of taxation on saving. 5 A similar inference probably also is war~ 

ranted for other devices that reduce the overall tax cost of saving 

but distort the opportunities facing investors. Overall reduction 

in the cost of saving without distorting in.vestment opportunities 

obviously is a preferred policy. 

5 Because domestic employment varies with the real wage in Ture's model, 

the loss in domestic income from additional capital export would be larger 

than the number obtained here. Thurow assumes that additional capital export by the United States reduces saving abroad so that the total capital 

stock of the United States and the rest of the world would change by less 

than the estimate made here. 
200 COMPENDIUM OF TAX RESEARCH 

Effective U.S. Tax Rates on Foreign-Source Investment Income 

In the previous section, it was noted that the impact of reduced 

taxes on saving did not appear to warrant any substantial difference between the tax rate on domestic income and that on foreign-source income net of foreign taxes levied. The fact that the 

marginal social return to the U.S. from foreign investment may 

be less than the marginal productivity of U.S. capital in the 

country in which such investment is made does not mean that 

capital export should be prohibited, but rather that tax rates on 

foreign.-source income might be made higher than those on domestic income. If only direct foreign investment by the United 

States were affected by the tax treatment of foreign-source income relative to that of U.S. domestic income (i.e., if foreign investment in the United States and other forms of U.S. investment 

were held constant at 1975 levels), foreign-source income after 

deduction of foreign taxes paid should have been taxed at a rate 

15 to 20 percent above the rate on domestic income. 

A number of studies have presented summary descriptions of 

the effective tax rates on foreign-source and domestic income. 

Just as an aggregate production function for an economy or for 

one of two sectors of an economy cannot describe characteristics 

that may be of importance in the choice of economic policies, a 

single number describing an average effective tax rate on domestic 

capital income or foreign-source income obviously omits the 

differences in tax treatment accorded various taxpayers. These 

taxpayers choose different ways of producing, accounting for 

assets and income, etc., and these choices affect their fax liabilities and incomes and also obviously affect the ratios of tax to 

income. 

Among the estimates of effective tax rates on foreign-source income are those of Leftwich ( 197 4), who estimated that in 1970 

tax rates of majority-owned foreign affiliates of U.S. corporations 

averaged 42.5 percent compared with an average of 38.5 percent 

for the parent companies and 33.2 percent for all U.S. corporations. The rate on income from developed countries was 38.6 percent, whereas that for developing countries was 49 percent. The 

ratio of the average effective rate on income of foreign affiliates 

to that of all U.S. corporations was thus. 1.28. The ratio was 1.16 

for developed countries, and 1.48 for developing countries. Leftwich's estimates are based on data obtained from a survey conducted by the Bureau of Economic Analysis, U.S. Department of 

Commerce. 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 201 

Horst (1977a) has analyzed effective rates of taxation in five 

countries of corporation net income earned from investment in 

capital used for production and sale at home, from investment for 

export, and from foreign investment. For the United States, the 

statutory rate for income in excess of $50,000 per year is1 48 percent. Various allowances for depreciation, deferral of taxes, tax 

credits, etc. make the effective rates-the ratios of the present 

discounted" value of future tax payments to their respective present discounted values of income-vary among firms. However, an 

average effective rate on foreign investment income and an average effective rate on domestic (nonexport) income can be estimated u!lder various assumptions. 

Horst estimates the effective tax rate for a typical domestic 

(U.S.) corporation to be 36.7 percent. For a foreign subsidiary 

subject to a foreign tax of 50 percent with dividends equal to onehalf of after-tax income and a 15 percent withholding tax applicable to these dividends, the effective rate is estimated to be 

50.9 percent-if the subsidiary has surplus foreign-tax credits 

overall. If there are deficit foreign-tax credits overall, the effective rate for a foreign subsidiary subject to a foreign tax as 

described above is 47.5 percent. 

For a foreign subsidiary subject to a foreign tax rate of 10 

percent and with surplus tax credits overall, the effective tax rate 

is zero. If there are deficit tax credits overall, the effective rate is 

27.5 percent. 

The estimated effective tax rate of 36.7 percent in the United 

States for a domestic corporation is only about 76 percent of the 

statutory rate of 48 percent because of the reduced tax liability 

brought about by accelerated depreciation and the investment tax 

credit (10 percent). A U.S. investor can use neither average depreciation range nor the fovestment tax credit in computing his 

tax liability on foreign-source income. Consequently, the basic tax 

rate, before allowance for foreign taxes and the value of deferment, applicable to foreign-source income is 48 percent. The effective rate of 47.5 percent for a "high-tax" foreign subsidiary with 

deficit tax credits overall is very near this 48 percent basic rate, 

and the 50.9 percent effective rate for a "high-tax" foreign subsidiary with surplus tax credits overall is about 6 percent above 

this basic rate. For a "low-tax" fureign subsidiary with surplus 

tax credits overall and instantaneous depreciation of capital assets 

for tax purposes, the effective tax rate is zero since there is no 

taxable income. 
202 COMPENDIUM OF TAX RESEARCH 

Horst's estimate of the effective rate for a U.S. domestic corporation is about 10 percent higher than that of Leftwich. Horst's 

"high-tax" foreign subsidiary pays rates about the same as those 

estimated by Leftwich for a majority-owned foreign affiliate in a 

developing country. The rate (47.5 percent) for a "high-tax" 

foreign subsidiary with overall surplus tax credits is 1.29 times 

the effective rate on domestic income, and that (50.9 percent) for 

a "high-tax" foreign subsidiary with surplus tax credits overall 

is 1.39 times the effective domestic rate. A subsidiary in a lowtax country with an overall deficit of tax credits pays an effective 

rate of 27.5 percent, 0.75 times the effective U.S. rate. 

In another paper Horst (1977b) estimates the effective rate of 

global taxation of foreign subsidiary income for manufacturing 

subsidiaries to have been 42.8 percent in 197 4. Direct foreign investment in manufacturing constituted about 43 percent o.f total 

direct investment in 197 4, and its worldwide tax rate as estimated 

by Leftwich (1974) was 94 percent that of all investment. Hence, 

Horst's effective tax rate on foreign-source income appears to be 

about 124 percent of the domestic tax rate in 197 4. 

Because the effective tax rate depends upon choices made by 

the taxpayer with respect to depreciation, tax credits, dividends 

distribution, etc., one should interpret comparisons of effective 

tax rates with caution. However, assuming the numbers that have 

been employed here are reasonably accurate measures of the 

relevant variables and parameters, the major modification war;... 

ranted in the taxing of foreign-source income would be to treat 

the taxes paid to other governments as deductions rather than 

credits. If maximization of U.S. income, subject to the limitations 

of the foreign-source income tax as a control device for capital 

exports and imports, is the criterion to be employed in formulating the foreign-source income tax code. 

In the previous analysis, the conditionally optimal rate on foreign-source income was estimated at 115 to 120 percent of the 

domestic rate. The actual foreign-source rat;e was estimated at 120 

to 130 percent of the domestic rate with much of the foreign taxes 

paid being credited against U.S. tax liabilities. 

Taxation of Foreign-Source Income as an 

Instrument for Income Maximization 

Whether foreign-source income taxation should have as its objective the maximization of U.S. national income seems questionable, given the many other government regulations that could be 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 203 

altered in ways that could increase income by much more than 

could be achieved by a change in the foreign-source income tax 

code. Furthermore, the impact of foreign income taxation on income is not so clearly known that an optimal system of such taxation could be formulated-if maximum U.S. income were the 

goal. 

The analysis presented in this paper and those analyses in the 

reviewed studies examined the effect of taxation on the stock of 

capital employed in the United State.s and the U.S.-owned capital 

employed abroad. Foreign-source income taxation was considered 

to affect U.S. direct investment abroad without having any impact upon the investment by foreigners in the United States or 

other forms of U.S. investment abroad. As can be noted from 

table 2, total U.S. assets abroad ait the end of 1975, excluding 

U.S. official reserve assets, were estimated to be about $288 billion, of which $133 billion represented private direct foreign investment. Foreign assets in the United States totaled about $210 

billion, of which only about $27 billion was direct investment. 

U.S. direct investment abroad is believed to be of much greater 

importance, both absolutely and relatively, than foreign direct 

investment in the United States because of the supposed superiority of U.S. technology and management. It is thought that this 

comparative advantage can best be utilized through establishing 

foreign affiliates. 

Since foreign investment in the United States contributes to 

U.S. income in the same manner as does U.S. capital invested at 

home, regulations that decrease the export of U.S. capital but also 

reduce foreign investment in the United States may decrease U.S. 

income. I know of no studies relating foreign investment in the 

United States to the tax treatment of U.S. foreign-source income, 

and the terms granted U.S. investors abroad in tax treaties usually 

are related to the terms granted foreign investors in the United 

States rather than to the way in which the United States treats its 

foreign-source income for tax purposes. Nevertheless, if the 

United States pursued an avowed policy of restricting capital exports-through tax or other measures-other countries might react by imposing restraints on their citizens' investments in the 

United States. In the same manner that an optimal tariff structure in the absence of retaliation will not be the same as in the 

presence of retaliation, the best foreign-source tax structure 

based on the assumption that other countries will discourage investment in the United States as the U.S. discourages capital exports will not be the same as that which assumes that other coun-
204 COMPENDIUM OF TAX RESEARCH 

TABLE 2.-U.S. assets abroad and foreign assets in the United States at 

year end, 1975 1 

Type of asset 

U.S. assets abroad (excluding U.S. official reserve assets) 

U.S. gov't. loans and other long-term assets 

Private direct investment abroad 

Foreign bonds, privately held 

Foreign stocks, privately held 

N onbank claims on unaffiliated foreigners 

Bank claims 

Total 

Foreign assets in the United States 

Holdings of U.S. gov't. securities 

Holdings of other U.S. gov't. liabilities 

Direct foreign investment in the US. 

Corporate and other private bonds 

Corporate stocks 

Other private loans 

Other 

Total 

1

Data are taken from Scholl (August 1976, p. 32, table 3). 

Billions of $ 

41.8 

133.2 

25.6 

9.6 

18.3 

59.5 

287.9 

67.5 

21.2 

26.7 

9.8 

26.7 

55.1 

3.5 

210.5 

tries ignore our capital export policy in formulating their own 

policies. 

Diminishing direct private investment abroad by raising effective foreign-source income tax rates may serve to increase U.S. 

Government loans and grants as well as U.S. indirect private investment abroad. Indirect U.S. investment abroad, particularly 

the purchase of corporate stock, has been inhibited by the absence 

of well-organized markets for corporate shares in most countries 

outside of the United States. In a sense, the U.S. investor is placing his capital abroad by buying certain U.S. stocks rather than 

shares of foreign corporations. If U.S. foreign-source income were 

to be subject to higher tax rates, more lending abroad to foreign 

corporations by U.S. financial institutions might take place. U.S. 

technology and management could be used abroad through licensing agreements and management contracts. 

The structure of private capital export that would emerge if 

there were higher tax rates on foreign-source income cannot be 

accurately predicted. The present arrangements probably are most 

profitable for the present tax structure, but reducing private 

direct foreign investment may have little effect on total private 

investment abroad because of the relative ease by which new 

arrangements can be found to place capital abroad. 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 205 

It should be noted that capital employed by U.S. foreign affiliates has been treated in this analysis and in most others. as if it 

were available for investment in the United States, even though 

such capital is obtained from foreign sources. Similarly, I have 

made no distinction between "real" capital and "financial" capital, 

although some others have talked only about "real" capital. 

Aggregating capital obtained abroad with that obtained from 

U.S. sources is consistent with the notion that the tax revenues 

obtained from taxing foreign-source income are perfect substitutes for the revenues obtained from other. tax sources. Schmidt 

( 1975) contends that highet tax rates on foreign-source focome 

would permit a lower rate on domestic income. He does not consider the possibility that even if the stock of U.S. capital were 

fixed, a reduction in foreign investment of one dollar might result 

in less than a dollar of additional domestic investment. Adding the 

capital obtained abroad tp that obtained in the United States will 

have little effect on the estimated change""in foreign-source income 

due t:o a tax change, if the cost of the capital is equal to its. marginal productivity. The change in domestic income, however, would 

be smaller than the estimate obtained in the previous section. 

Making no distinction between "real" and "financial" capital 

assumes that dollars obtained from all sources are used productively and that funds obtained from reinvested earnings and loans 

from banks, for example, are perfect substitutes in financing purchases of equipment, in holding inventories, or in maintaining an 

optimum cash balance. Direct foreign investment, indirect investment, and Government grants and ,loans draw from the same 

"pool" of capital as domestic investment and Government expenditure. If Government lends an additional dollar abroad, it must 

obtain that dollar from taxpayers (who may borrow to pay the 

tax) or from the sale of bonds. The Government bond (or the 

taxpayer's note) competes with corporate bonds and stocks, 

mortgages, personal notes, and the other financial instruments 

issued by private borrowers. This view of the various U.S. assets 

abroad is analagous to the "crowding out" theory of the effects 

of Government borrowing. 

A final word on the inconsistency of restricting U.S. direct 

private investment abroad and the improvement in per capita incomes in some other countries, which is an avowed objective of 

U.S. foreign policy. Again, many actions of the U.S. Government 

affect incomes abroad, so that it would be asking too much of 

foreign-source tax policy to be consistent with not harming foreign countries, whereas trade and immigration policies are formu-
206 COMPENDIUM OF TAX RESEARCH 

lated according to other criteria. Nevertheless, the U.S. Government, through foreign grants and loans, might at least partially 

offset the impact of the tax system. To date the purpose of most 

Government grants and loans is to alleviate the effects of the economic policies of the recipient governments rather than to make 

up for deficienc;ies in the operations of U.S. investors abroad. The 

Government has talked about increasing the flow of both private 

and Government capital to developing countries. W 01ild those 

favoring tax policy designed to keep more capital in the United 

States also favor reducing Government grants and foans? 

References 

Boskin, Michael J. "Taxation, Saving and the Rate of Interest." (Working Paper No. 135). National Bureau of Economic Research, April 

1976. 

Hartman, David. "The Effects on National Income and Its Distribution 

of Taxation of Foreign-Source Investment Income." (Discussion Paper 

No. 539). Harvard University, Harvard Institute of Economic Research, March 1977. 

Horst, Thomas. "Income Taxation and the Competitiveness of Corporations in the United States, West Germany, France, the United Kingdom 

and Japan." February 1977. (Mimeo) (a) 

Horst, Thomas. "American Taxation of Multinational Firms." American 

Economic Review 67 :3 (June 1977), pp. 376-389. (b) 

Howenstine, Ned G. "Gross Product of Foreign Affiliates of U.S. Companies." Survey of Current Business 57 :2 (February 1977), pp. 17-28. 

Leftwich, Richard B. "U.S. Multinational Companies: Profitability, 

Financial Leverage and Effective Income Tax Rates." Survey of Current Business 54:5, Part 1 (May 1974), pp. 27-36. 

Musgrave, Peggy B. Direct -Investment Abroad and the Multinationals: 

Effects on the United States Economy. Senate Foreign Relations Committee Print, 94th Congress, 1st Session, August 1975. 

Schmidt, Wilson B. "U.S. Capital Export Policy: Backdoor Mercantilism." In G. C. Hufbauer, et al, U.S. Taxation of American Business 

Abroad. Washington, D.C. and Stanford, Calif.: American Enterprise 

Institute for Public Policy Research and Hoover Institution on War, 

Revolution and Peace, 1975. 

Scholl, Russell B. "The International Investment Position of the United 

States: Developments in 1975." Survey of Current Business 56 :8 

(August 1976), pp. 29-33. 

Thurow, Lester C. "International Factor Movements and the American 

Distribution of Income." Intermountain Economic Review 2 :·1 (Spring 

1976), pp. 13-24. 

Thurow, Lester C., and Halbert White. "Optimum Trade Restrictions and 

Their Consequences." Econometrica 44:4 (July 1976), pp. 777-786. 

Ture, Norman B. "Measuring the Economic and Federal Revenue Effects 

of Tax Changes." Mimeo, June 1977. 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 207 

COMMENT 

Gary C. Hufbauer, U.S. Department of the Treasury 

The complex array of U.S. legislation governing the taxation 

of income earned abroad can be compared with the standards of 

two competing philosophies-one instrumental, the other equitable. The instrumental philosophy evaluates tax policies in terms 

of national economic welfare: 1 "Tax foreign income so as to 

maximize economic benefits accruing to the United States.", The 

equitable philosophy, on the other hand, evaluates tax policies in 

terms of horizontal equity :2 "Tax all producers who compete in a 

single market equally." 

The instrumental and equitable principles may be loosely associated, respectively, with the disciplines of economics -and law. 

The strength of these associations should not be overrated, however, since an instrumental ~pproach can be translated into legal 

doctrine, while an equitable approach requires economic analysis 

for its implementation. 

Instrumental Taxation 

Professor Brownlee's paper evaluates the considerations that 

should govern a sophisticated application of the instrumental approach to international tax questions. Briefly stated, these considerations include at least four elements: 

1. The difference created by the tax wedge between the private 

and the social returns to capital (or, for that matter, between the 

private and social returns to know-how or labor); 

2. The effect of changes in the private return to capital on the 

rate of capital accumulation in the United States; 

1 Economic welfare has several dimensions, and diffe·rent dimensions may 

of course be emphasized by different advocates of the instrumental approach. 

~ Another aspect of the equitable philosophy-vertical equity between individual taxpayers who enjoy different levels of wealth or income-is not 

particularly relevant in the arena of international taxation. 

The views expressed in this paper are those of the author and do not necessarily reflect the views of the Department of the Treasury. 
- - - --

208 COMPENDIUM OF TAX RESEARCH 

3. The extent of U.S. power to affect the international terms of 

trade for goods and capital-either -directly or indirectly-via the 

use of tariff and tax policy; and -

4. The extent of retaliatory and avoidance measures that might 

be devised by foreign governments and corporations to avert the 

impact of tax policies adopted by the United States. 

Brownlee's paper suggests that, from the U.S. viewpoint, the 

"conditionally optimal" combined rate of -tax imposed by the 

Uniited States and the foreign host government on the foreign 

earnings of an American corporation should range between 115 

and 120 percent of the U.S. tax rate imposed on the domestic 

earnings of the same corporation. He contrasts this "conditionally optimal" rate with the combined rates tha.t would prevail if the 

foreign tax credit were repealed and foreign taxes were allowed 

as a deduction instead. Without the foreign tax credit, the combined tax rate would range from 120 to 130 percent of U.S. tax 

rates now imposed on domes.tically earned corporate income. In 

other words, Bro·wnlee suggests that the United States would be 

imposing too high a tax burden on the foreign income of U.S. 

corporations, if foreign taxes were treated as deductions rather 

than credits. 

It should be pointed out that any estimate of the "conditionally 

optimal" rates will turn not only on the particular parameter estimates, but also on the range of instrumental considerations taken 

into account. For example, if only the tax wedge difference between the private and social return to capital were considered, 

the United States should allow a deduction but not a credit for 

foreign taxes paid, and thereby impose a much higher combined 

rate of tax on foreign than domestic corporate income. On the 

other hand, if the effect of this differential tax burden would indirectly prompt an outflow of portfolio capital from the United 

States, different conclusions might be reached on the appropriate 

level of instrumental taxation. 

Equitable Taxation 

An intellectual genealogy can be traced from the just price to 

the principle of horizontal tax equity. 3 In the arena of international taxation, the concept of horizontal equity has traveled 

under the doctrinal banner of "avoiding double taxation," a banner that has inspired numerous statutory tax provisions in the 
TAXATION OF FOREIGN-SOURCE INVESTMENT INCOME 209 

United States and abroad and a vast web of international tax 

treaties. 

Broadly speaking, the goal of international tax specialists has 

been to equalize effective corporate tax rates both as between 

firms operating in different countries and as between firms operating in the same country but owned by shareholders residing in 

different countries. This broad goal would require harniony both 

in nominal tat rates and in the measurement of corporate income 

as between companies operating in different countries. Such harmony is far from practical realization. Accordingly, insofar as 

governments have been · guided by equitable principles, they have 

had to decide whether to equalize tax rates as between production 

abroad and production at home, or as between producers of diverse shareholder nationality operating in the same country. 

Faced with this choice, the United States blinked and said "both." 

If the corporate tax rate is higher on domestic income than on 

foreign income then, after allowing for the foreign tax credit, the 

U.S. domestic tax rate ultimately prevails; if the rate is higher 

abroad, then a credit is allowed (roughly speaking) for only so 

much tax as the United States would have imposed on the same 

income if earned domestically, and thus the higher foreign rate 

prevails.4 

Starting with these foundations, the U.S. tax law has witnessed 

numerous modifications. The resulting structure is far too complex to be described here. The important point, however, is that 

while the edifice was erected on equitable principles, instrumental 

considerations have influenced its subsequent design. 

Tension Bet ween Principles 

The reconciliation of instrumental and equitable principles of 

taxation is a maddening exercise, attempted anew each year by 

Congress. In the arena of international taxation, the tension between these principles creates three basic conflicts. 

First, while the instrumental approach is largely concerned 

with the distribution of tax revenues and economic benefits be3 The "scientific tariff" is another descendant of the just price. The scientific tariff was legislated in the United States by the Tariff Act of 1922 with 

the purpose of equating costs of production at home and abroad. Subject to 

ridicule by Gottfried Haberler and other scholars, the scientific tariff 

descended to the netherworld of academic economics, while retaining a 

tenacious hold on the congressional mind. 

' This brief outline neglects the many nuances of deferral, the overall limitation on the foreign tax credit, and other special features. 
---~-- ~--=--

210 COMPENDIUM OF TAX RESEARCH 

tween countries, the equitable approach concentrates on the 

equivalence of total tax burdens borne by competing producers. 

Second, under the instrumental approach, the ratio between the 

tax imposed on foreign income and the tax imposed on domestic 

income might well vary from place to place (raising conflicts with 

the most-favored-nation principle) and even industry to industry. 

By contrast, under the equitable approach, a fixed relationship 

would be set between the taxation of foreign and domestic income, 

and that relationship would presumably be the same for investment in different foreign countries and different industries. 

Finally, the two principles pose an inherent conflict between 

repose and change in the tax law. Equitable principles naturally 

stress repose. The history of the just price as applied to interest 

rate is instructive. The charging of interest on a money loan, defined as usury, was prohibited in England from approximately 

1300 to 1545 ; an interest rate of 10 percent was tolerated from 

1545 to 1624; an interest rate of 8 percent was legislated from 

1624 to about 1652; and then the magic figure was lowered to 6 

percent. 5 In much the same spirit, believers in equitable taxation 

share a Walter Mitty dream of a tax reform to end all reforms. 

By contrast, the instrumental approach calls for frequent change 

in tax legislation to accommodate changes both in the economic 

landscape and in political realities. 

Successive tax acts have gradually added instrumental goals to 

the basic equitable structure of the international tax system. The 

foreign tax credit has been subjected to progressively tighter 

limits, the deferral of taxes on income earned by foreign subsidiaries has been circumscribed, and in other ways foreign income earned by U.S. corporations has been subject to higher taxes 

than domestic income. Yet the Congress is a long distance from 

embracing a purely instrumental approach. It seems safe to predict that the tension between equitable and instrumental principles will occupy tax specialists for years to come. 

5 W. Cunningham, Growth of English Industry and Commerce in Modern 

Times, Part I: The Mercantile System, 4th ed. Cambridge: University Press, 

1907, pp. 153-154.