|
Article Excerpt
INTRODUCTION
Income tax systems, such as that used by the United States, permit taxpayers to claim deductions for expenses incurred in the course of earning income. Thus, a taxpayer who spends $100 on labor and materials to produce output subsequently sold for $140 will be taxed on income of only $40, since the $100 expense is deductible for tax purposes. Any sensible income tax must permit expense deductions, since otherwise it becomes a form of turnover tax, taxing gross rather than net income, overstating the incomes of some taxpayers, and reducing the efficiency of the economy by prompting excessive vertical integration and discouraging other activities that add economic value.
In an open economy, a taxpayer may incur expenses in one jurisdiction that contribute to producing income in other jurisdictions. What is the appropriate tax treatment of such expenses?
It is natural to match expense deductions against revenue attributable to the expenses. As a practical matter, however, considerable challenges arise in matching deductions against income for certain types of expenses, such as interest expense or general and administrative expense, that are general to a firm and difficult to attribute to particular activities. If a large multinational firm headquartered in the United States and with operations in 20 other countries spends $80 million on headquarters activities in the United States, the foreign countries typically do not permit the firm to take local tax deductions for any portion of the $80 million headquarters expense. What then should be the policy of the home country--should the firm be permitted to deduct the $80 million against its U.S. income or should that deduction be limited by apportioning some fraction of the $80 million against its income in other countries?
The common answer to this question is that it depends on the nature of the home country tax regime. So this reasoning goes, the firm should be permitted to claim home country deductions only for that part of an expense that produces income taxed by the home country. Hence, if a firm is resident in a country that taxes domestic but not foreign income, it follows that the portion of domestic expenses incurred to produce foreign income should not be deductible in the home country.
The analysis in this paper takes issue with this answer, instead concluding that the only policy consistent with efficiency, given the refusal of foreign governments to allow taxpayers to take deductions for general expenses incurred outside their countries, is to permit full domestic deductibility of expenses incurred in the home country. Full domestic deductibility is a feature of any efficient tax regime, including residence based worldwide tax systems with and without provision of foreign tax credits, and a system in which the home country exempts active foreign business income from taxation. All that is necessary is that the home country tax regime be tailored to promote home country welfare efficiently, and if it is, then full domestic deductibility is an efficient policy.
The claim that full domestic deductibility of home country expenses promotes efficiency is perhaps unintuitive and is certainly inconsistent with current U.S. policy and most prior analysis of this subject. In order to appreciate why full domestic deductibility is efficient, it is necessary to understand why countries have the international tax systems they do. This is particularly important in the cases of countries that exempt foreign income from taxation. Such tax systems appear inefficient from the standpoint of single investment decisions in isolation, since from this perspective they seem to give excessive incentives to invest in low-tax foreign countries. Hence, if an exemption system is efficient, it must be that its efficiency stems from considerations omitted by considering just one investment at a time. Since new investments trigger reactions by investors and their competitors, it is important to incorporate these reactions in evaluating the welfare properties of exempting foreign income from home country taxation. It is from the standpoint of all of the induced reactions that permitting full domestic expense deductibility makes considerable sense, since the failure to permit deductibility would distort asset ownership patterns and thereby reduce the productivity of domestic business operations.
It should not be surprising that a fully efficient tax system permits complete deductibility of domestic expenses. It is an efficient, and virtually universal, practice to permit full deductibility of domestic expenses incurred by firms that earn only domestic income, since efficient taxation preserves incentives to spend $1 to create more than $1 of pretax economic return. But a tax system that maximizes the welfare of the residence country also taxes foreign income in a way that makes the residence country indifferent between a marginal dollar of activity undertaken by one of its firms at home or abroad. If this were not so--if, for example, the home government would prefer that its firms concentrate more of their activity at home at the expense of activities abroad--then the tax treatment of foreign income must not be optimal in the first place. Hence, with optimal tax systems the value of foreign activity at the margin is the same as the value of domestic activity, so if an expense is properly deductible when producing domestic income, efficiency requires that it also be deductible when producing foreign income.
The second section of the paper describes international practice in permitting expense deductions and reviews evidence of the impact of the U.S. system of allocating domestic expenses against foreign income. The third section of the paper summarizes the efficiency rationales underlying competing systems of taxing foreign income. The fourth section analyzes the deductibility of domestic expenses with worldwide and territorial (exemption) tax systems, finding in every case that the efficient treatment corresponds to full domestic deductibility. The fifth section is the conclusion.
DOMESTIC EXPENSE DEDUCTIONS IN PRACTICE
The tax treatment of domestic expenses incurred by multinational businesses varies between countries and over time within the same country. Most of the world exempts active foreign business income from taxation and also effectively permits taxpayers full domestic tax deductions for general domestic business expenses, such as interest expense and general and administrative expenses. The details of these policies differ among countries; some permit blanket domestic expense deductibility, whereas others use tracing rules that require taxpayers to identify the income streams that deductible expenses are incurred to produce. (1) As a practical matter, tracing rules are largely equivalent to blanket domestic deductibility (Shaviro, 2001), since the unwillingness of foreign governments to grant tax deductions for domestic expenses gives taxpayers incentives to arrange their tracing to maximize domestic deductions. Most countries limit the deductibility of domestic interest expenses with "thin capitalization" rules of one form or another (Buettner, Overesch, Schreiber, and Wamser 2008), and while these typically apply even to purely domestic firms, there may be additional restrictions on interest deductions taken by foreign-owned firms and firms whose foreign affiliates have capital structures that differ greatly from those of their parent companies. In addition, there are countries that exempt slightly less than 100 percent of active foreign business income (France exempts only 95 percent, for example) to compensate, in some very rough sense, for permitting full domestic deductibility of home...
|
