EXEMPTING FOREIGNSOURCE DIVIDENDS
FROM U.S. TAXATION
Presentation to the President’s
Advisory Panel on Federal Tax Reform
James R. Hines Jr.
May 12, 2005
The current U.S. tax regime.

The United States taxes the worldwide incomes of
American individuals and corporations.

Hence dividends received from foreign subsidiaries
of American corporations are subject to U.S. tax.

Taxpayers may claim foreign tax credits for foreign
income tax payments.

U.S. tax obligations are generally deferred until
dividends are repatriated.

A special 85% dividend exclusion applies to 2005.
Why tax foreign income this way?
 The Capital Export Neutrality concept: income is
taxed at the same total (foreign plus domestic)
rate wherever earned.
 As a result, market considerations, rather than
taxes, determine investment.
 A common claim: that such taxation by the U.S.
promotes global efficiency.
 Note that the same logic implies that U.S.
national interests would be best served by taxing
foreign income, permitting only a deduction (not
a credit) for foreign taxes paid.
The hybrid U.S. system.
 The current U.S. tax system does not correspond to
Capital Export Neutrality in two key respects:
 Foreign tax credits are limited.
 U.S. taxation of unrepatriated foreign income is deferred.
 As a result of foreign tax credit limitations and taxation
of income upon repatriation, the system distorts:
 Ownership of business assets in the U.S. and abroad.
 Investment in plant and equipment.
 The financing of investment in the U.S. and abroad.
 R&D spending.
 Repatriation of dividends from foreign subsidiaries.
 Transfers of intangible assets within firms.
 International trade.
 The magnitude of the associated economic distortion
can greatly exceed the amount of revenue collected
from foreign investment.
Would it be better for the U.S. system to
correspond to capital export neutrality?
 In a word, no.
 Taxing U.S. investors at the same total rate
regardless of investment location promotes
neither global efficiency nor national welfare.
Matters would be even worse if foreign taxes
were merely deductible and not creditable.
 Why? Because investors from other countries
are not subject to such a tax regime.
Consequently, the U.S. tax system distorts
capital ownership.
Downsides of worldwide taxation.
 The logic behind worldwide taxation presumes
the United States is the only country in the
world. This is simply inaccurate.
 American firms are subject to higher total tax
burdens on their foreign operations than are
firms from many other countries. Tax differences
cause them to be outbid in some foreign
acquisitions, and encourage American firms to
outbid foreign competitors in other acquisitions.
 Taxation on the basis of ownership, rather than
production, has the predictable effect of
distorting capital ownership. The problem is that
ownership is critical to productivity.
Realities of FDI.
 Foreign direct investment consists primarily of
firms in rich countries acquiring, and then
operating, firms in other rich countries.
 In 2001, more than 96% of foreign direct
investment in the United States represented
acquisitions of existing American firms.
 Foreign investment by American firms is heavily
concentrated other G-7 countries, which, in
1999, together accounted for 57% of their total
foreign gross product.
 International investment is largely about who
owns and manages capital, rather than being
about movements of plant and equipment.
Would exempting foreign income from taxation
reduce U.S. prosperity?
 No, current policies reduce U.S. prosperity by subjecting
foreign income to taxation that is burdensome and
distortionary.
 As a consequence, the tax system indirectly reduces the
productivity of businesses located in the United States,
which thereby reduces the return to labor in the U.S.
 Exempting foreign income from taxation would not cause
plant and equipment to flee from the U.S., but would
instead rationalize ownership and thereby increase
productivity.
 Domestic productivity is enhanced by treating foreign
taxes as costs of doing business, but not imposing
added home-country tax burdens merely because a
foreign operation is owned by a U.S. business.
Equity considerations.
 Consider two American businesses, one that earns $100
in the U.S., and one that earns $100 in a country that
does not tax business profits.
 Is it fair to exempt the second business from U.S.
taxation on the $100 profit? After all, the first business
must pay taxes on the $100, whereas the second
business would then not pay taxes to anyone.
 The point to keep in mind is that earning pre-tax $100 in
a country without taxes is more difficult than earning
$100 in a country with a 35% tax rate, since international
competition is more keen in the zero-tax place.
Investors from countries that exempt foreign income
from taxation drive down local pre-tax rates of return.
 Hence it is misleading to consider only pre-tax returns.
Methods of exempting foreignsource income from tax.
 Exempt foreign-source dividends by
statute. Many countries do this.
 Exempt foreign-source dividends as
provisions of U.S. treaties. A number of
other countries go this route.
 Alternatively, the U.S. could impose border
cash-flow taxation: permit a deduction for
funds invested abroad, and include
repatriations as taxable U.S. income.
Reform considerations.
 Exempting foreign income increases the importance of
correctly allocating income and expenses between
foreign and domestic sources, since it increases the tax
consequence of the distinction.
 An example: if foreign dividends are statutorily exempt
from domestic taxation, then royalties received from
foreign source are properly taxed as domestic income.
Expenses incurred in producing intangible property
should then be fully deductible against domestic income.
 Transition rules need to account for changes in regime.
This is not as difficult as it appears. For example, a
transition to border cash-flow taxation could be
accompanied by granting American firms deductions for
accumulated unrepatriated foreign earnings and profits.