The term "outsourcing" has recently assumed a prominent place in the public debate over economic policy. In general, the debate concerns the impact various federal policies are thought to have on outsourcing, including the policy that is the focus of this report, taxes. But "outsourcing" is not a formally-defined term of economic theory, and has no specific meaning in economics. And its usage in the popular debate varies. Thus, the first step in applying economic analysis to the outsourcing debate is to clarify the term's meaning—to define it, using terms that do have a precise meaning in economic theory. In one common usage, outsourcing simply means the use by a firm of inputs produced outside the firm, either by foreigners or unrelated domestic firms—the important fact is simply that someone else performs the function. Here, a firm's manager might speak of "outsourcing" a task, meaning that another firm does that particular job. Similarly, outsourcing sometimes refers to the use by government agencies of services provided by the private sector—for example, legislation has recently been introduced in Congress that would "outsource" certain debt-collection functions of the Internal Revenue Service. The focus of this report, however, is the international economy; its analysis is confined to what might be termed "offshore" outsourcing. But here, too, the term's usage varies. For example, one focus of the recent public debate has been the use by U.S. firms of skilled foreign technological workers who reside and work abroad, but who provide services to customers in the United States. A prominent example of this usage is in the 2004 Economic Report of the President , which cited "the increased use of offshore outsourcing in which a company relocates labor-intensive service industry functions to another country." The report, along with a subsequent statement by the President's chief economic advisor that such outsourcing "is just a new way of doing international trade" sparked a heated debate in Congress and elsewhere. In economic terms, this particular usage of outsourcing refers to international trade, specifically the importation of services. A second use of "outsourcing" has also referred to international trade, but to flows of goods rather than services. This use may have been more frequent in past years than in the current debate. For example, a 1983 Fortune magazine article that was among the first sources to use the term described an increasing tendency for U.S. automakers to "buy more and more parts abroad" and further stated that "to a large extent the products to be out-sourced are low-technology items such as window cranks, seat fabrics, and plastic knobs." Another use of the term in the current debate refers to foreign investment rather than trade. Here, the term refers to a U.S. firm that shifts its domestic production of an item to a foreign location or to a U.S. firm that establishes a new production facility abroad rather than in the United States. One example of this type of outsourcing that has been prominently featured by the media is the closing of a Chicago plant by Radio Flyer, Inc.—maker of a popular children's wagon—and the moving of production to China. In a usage that directly applies to taxes, Senator John Kerry called for the closing of "loopholes in international tax law that encourage outsourcing." (The question of whether the U.S. tax system does, in fact, encourage this type of outsourcing is one focus of this report, and is addressed below.) In economic terms the three popular usages of outsourcing that are mentioned here can be described respectively as the import of services from abroad, the import of goods from abroad, and the use of domestic capital in foreign locations. Given this economic view of outsourcing, the analysis in the following sections of this report looks at the impact of taxes on two key economic variables: trade and investment. The basic analysis of taxes and trade is the same whether the trade is in services or goods; thus, it is important to look at the first two examples of outsourcing together, combining our assessment of the direct use of foreign labor with that of the importation of goods. The analysis continues by assessing the impact of taxes on foreign investment, the third type of outsourcing. The results of the following analysis are summarized briefly in advance. First, according to economic theory, tax policy does not alter the country's balance of trade, as long as it does not also produce a change in foreign investment flows. In terms of the outsourcing debate, taxes do not affect the net amount of the first type of outsourcing identified above, the use of foreign labor services or inputs made by foreign firms. Taxes can, however, alter both the composition and level of trade and reduce economic efficiency and economic welfare if they distort either how much a country trades or what it trades. Second, tax policy can affect the extent to which firms invest abroad; in terms of outsourcing, it can affect the extent to which firms use overseas production facilities to produce inputs for their domestic operations. Current U.S. tax law poses a mix of incentives and disincentives towards overseas investment; its net result is uncertain. However, in a manner similar to trade, economic theory suggests that taxes best promote world economic efficiency when they are neutral towards investment location. In a divergence from trade theory, investment theory suggests taxes can promote national economic welfare (though not world welfare) if they pose a small impediment to overseas investment. An underlying concern of the outsourcing debate is employment. The debate is sometimes conducted in terms of the export of jobs, yet the economic analysis just summarized does not mention employment effects of outsourcing. In part, this is because the focus of this report is on how taxes affect outsourcing, not how outsourcing, in turn, affects variables such as employment. The last section of the report does, however, briefly turn to employment questions and summarizes how economic theory applies to outsourcing and employment. Economic theory indicates that outsourcing does not play an important role in determining the aggregate level of employment in the economy, although it can affect the division of income in broad terms between labor on the one hand, and owners of investment capital, on the other. In its discussion of outsourcing through trade in services, the 2004 Economic Report of the President used the example of a U.S. firm that might use a call-center in India to answer customer service-related questions. For goods, an example might be a U.S. firm that uses foreign-made components as part of an overall product made in the United States. Importantly, in this usage of the term "outsourcing" we rule out items produced by the U.S. firm's own foreign facilities. In economic terms, we are thus assessing the impact of taxes on trade, while at least initially holding investment flows constant. In this setting, economic theory indicates that taxes have little impact on the country's balance of trade—the excess of imports over exports. As applied to the outsourcing debate, theory thus indicates that taxes have little impact on the extent to which the economy as a whole engages in this type of outsourcing, at least as compared to the country's level of exports. (In the context of the outsourcing debate, we might term a country's trade balance its "net" outsourcing.) This result is an important one, and since it may counter the reader's intuition, it is worth examining more closely. First, economics points out that a country's trade deficit is the excess of what a country uses over what it produces. And just as an individual who spends more than he earns must necessarily borrow to finance the difference, a country that uses more than it produces and that runs a trade deficit must borrow from other countries to finance the deficit. In terms of the international economy, the borrowing consists of imports or inflows of investment capital from abroad. It follows from this fact of economic life that a country's trade balance mirrors its balance on capital account. Countries normally both import and export investment capital. But if a country runs a trade deficit, it must likewise import more capital than it exports, with the difference making the trade deficit possible. The trade deficit (or surplus) thus moves in parallel with the balance on the capital account and net imports can increase only if net capital inflows also increase; identically, net exports can only increase if net capital outflows increase. In effect, if an economy does not increase its own production, it can increase its use of goods and services only if it borrows to do so. The mechanism by which this identity is enforced in the current international economy is exchange rate adjustments. If there is no change in capital flows and some factor, such as taxes, changes so as to increase imports or exports, exchange rates will eventually adjust so as to offset any impact the factor might otherwise have on the trade balance. An example using outsourcing is useful here; we use the case of a hypothetical domestic industry (we'll call it Industry A) whose firms typically employ staffs of technical support personnel who are on call to answer customer questions. Suppose the home country implements a tax policy that inadvertently encourages firms to shift from using domestic service employees to using foreign ones. For example, the home country might implement more stringent depreciation rules for a certain type of equipment the home-country technical services personnel use. Since foreign operations of foreign firms are generally beyond the U.S. tax jurisdiction, imported services would not be directly affected by such a change. For illustration's purposes, we shall say that the new depreciation rules increase the cost of using domestic personnel to such an extent that Industry A finds it advantageous to begin importing the services it previously obtained domestically. Industry A, in other words, increases its outsourcing, which may initially be reflected in an increase in the home country's trade deficit (its net outsourcing). But this is where exchange rate adjustments occur, neutralizing any changes in the balance of trade.