The Foreign Sales Corporation (FSC) Tax Benefit for Exporting: WTO Issues and an Economic Analysis

Order Code RL30684

CRS Report for Congress

Received through the CRS Web

The Foreign Sales Corporation (FSC) Tax Benefit

for Exporting: WTO Issues and an Economic

Analysis

Updated December 11, 2000

David L. Brumbaugh

Specialist in Public Finance

Government and Finance Division

Congressional Research Service ˜ The Library of Congress

The Foreign Sales Corporation (FSC) Tax Benefit for

Exporting: WTO Issues and an Economic Analysis

Summary

The U.S. tax code’s Foreign Sales Corporation (FSC) provisions permit firms

that sell their exports through qualified sales subsidiaries (FSCs) to exempt

somewhere between 15% and 30% of their export income from federal tax. The

purpose of the provision is to stimulate U.S. exports.

Economic theory suggests that FSC probably does increase U.S. exports by a

very small amount. But beyond this, FSC’s other economic effects are probably

surprising to many non-economists. First, because of the exchange rate adjustments

that FSC triggers, it also increases U.S. imports, so that its effect on the U.S. balance

of trade – the value of exports minus the value of imports – is probably negligible.

CRS estimates based on 1996 data suggest that FSC increases the quantity of exports

by a range of 2-tenths of 1% to 4-tenths of 1%; it increases the quantity of imports

by a range of 2-tenths of 1% to 3-tenths of 1%. Based on 1996 trade flows, these

estimated changes amounted to $720 million to $1.23 billion of exports and imports

alike. Another economic effect of FSC is perhaps more important – a small transfer

of economic welfare from the United States abroad that occurs when part of the tax

benefit is passed on to foreign consumers as reduced prices for U.S. goods.

FSC is the statutory descendent of the Domestic International Sales Corporation

(DISC) provisions, enacted in 1971; DISC delivered a tax benefit of the same general

size as FSC. However, several U.S. trading partners charged that DISC was an

export subsidy in violation of the General Agreement on Tariffs and Trade (GATT).

FSC was enacted in 1984 as a replacement for DISC that was designed to be GATTlegal. Recently, however, the European Union (EU) has charged that FSC itself

contravenes GATT’s successor – the World Trade Organization (WTO) agreements

– and filed a complaint with the WTO. In October 1999, a WTO panel supported

the EU. Under WTO procedures FSC must be brought into WTO compliance by

November 2000. Absent compliance, the EU could request compensation from the

United States or ask the WTO to authorize retaliatory measures.

In November, 2000, Congress passed (and the President signed) legislation

designed to replace FSC with a WTO-compatible export tax benefit. The legislation

provides a tax benefit for exports of the same general magnitude as FSC, but its

statutory mechanics differ—qualifying exports, for example, need not be sold through

a subsidiary corporation, and a matching amount of income from foreign operations

would potentially qualify for the tax benefit. The EU has stated it does not believe the

new tax benefit to be WTO-compliant. It has asked the WTO to rule on whether the

replacement provisions are WTO-compliant, and, if they are not, to authorize

retaliatory tariffs. This report will not be updated.

Contents

How FSC Works and its Place in the U.S. Tax System . . . . . . . . . . . . . . . . . . . 1

U.S. Treatment of Export Income Without FSC . . . . . . . . . . . . . . . . . . . . . 2

The FSC Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

FSC and the World Trade Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

DISC: FSC’s Antecedent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

DISC and the General Agreement on Tariffs and Trade . . . . . . . . . . . . . . . 7

FSC and GATT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Findings of the WTO Panel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Proposed Replacements for FSC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

H.R. 4986 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Economic Effects of FSC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Size of the FSC Benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

FSC’s Impact on Trade and the Economy . . . . . . . . . . . . . . . . . . . . . . . . 14

Other Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Effects of FSC’s Possible Replacement . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Business Views . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

FSC and Value-Added Tax Rebates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Other Arguments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Data on FSC Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Marginal Effective Tax Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Impact on Exports and Imports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

List of Tables

Table 1. Marginal Effective Tax Rates for Exporters using FSC . . . . . . . . . . . . 14

Table 2. FSC’s Estimated Impact on Exports, Imports, and Economic Welfare

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Table 3. Selected Internal Revenue Service FSC Data, 1992 and 1996 . . . . . . 20

The Foreign Sales Corporation (FSC) Tax

Benefit for Exporting: WTO Issues and an

Economic Analysis

The reason for the pending legislation that would alter the current tax code’s

FSC provisions is FSC’s difficulties with the WTO. U.S. trading partners in the EU

have argued that FSC is an export subsidy in violation of the WTO agreements, and

in 1999 a WTO panel supported those claims. Clearly, an understanding of the

current legislation’s context requires a look at U.S. tax laws and how they relate to

the WTO agreements. This report’s presentation of the FSC issue begins there: with

a brief overview of the U.S. international tax system, the mechanics of FSC’s partial

tax exemption, and how FSC fits into the overall U.S. tax structure.

FSC was enacted as a replacement for the DISC tax benefit, which itself was

challenged as a prohibited export subsidy shortly after its enactment in 1971. The

current controversy thus has a long history, and the report continues by looking at

DISC’s problems with the General Agreement on Tariffs and Trade and how FSC was

designed to address challenges under GATT. The discussion then turns to the current

WTO dispute and describes H.R. 4986: the proposed replacement for FSC under

consideration in Congress.

But FSC is an instrument of economic policy and a full understanding of the

current legislative context requires economic analysis. The second part of the report

thus uses economic theory to assess FSC’s impact on exports, the balance of trade,

and U.S. economic performance. According to this analysis, FSC has at most a

negligible impact on the balance of trade, increases both exports and imports by

extremely small amounts, and – perhaps most importantly – results in a very small

transfer of economic welfare from the United States to the foreign consumers who

benefit from the reduced U.S. prices that FSC affords.

How FSC Works and its Place in the U.S. Tax System

The complaint against FSC by the EU is based on FSC’s place in the U.S. tax

system. As explained below in more detail, the WTO agreements define export

subsidies, in part, as the forgoing of taxes that are otherwise due. Thus, to understand

the FSC/WTO controversy and the forces shaping both FSC and its replacement – to

get an idea of taxes “otherwise due” – it is useful to look at the U.S. international tax

system and how FSC fits into it.

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U.S. Treatment of Export Income Without FSC

First, the overall structure: the United States generally operates a tax system

based on residence. That is, it looks to the residence of a corporation or individual

in order to determine whether it has jurisdiction to tax the entity in question. In the

case of corporations, firms that are chartered in the 50 states or the District of

Columbia are subject to U.S. tax on their worldwide income, regardless of whether

the income is earned domestically or abroad. If, however, a firm is chartered abroad,

the United States only applies its taxes to the foreign corporation’s U.S. source

income; it does not tax foreign firms on their foreign-source income.

The so-called “deferral” principle complicates this structure. Corporations are

legal, not economic entities. Thus, a U.S. firm can operate abroad through a foreignchartered subsidiary corporation that is not subject to immediate U.S. tax on its

foreign-source income. (Again, under the residence principle, foreign corporations

are subject only to U.S. tax on their U.S. income.) U.S. taxation of the subsidiary’s

income is delayed until it is remitted to the U.S. parent corporation as, for example,

dividends.

Another complication is the U.S. foreign tax credit, a provision designed to

alleviate double-taxation of foreign-source income. U.S. tax law permits firms to

credit foreign income taxes they pay against U.S. taxes they would otherwise owe.

The credit is limited, however, to those U.S. taxes that would otherwise apply to

foreign source (and not domestic) income. As a result of this limit, U.S. taxpayers

who have paid foreign taxes on foreign income at relatively high rates may well have

an “excess” of foreign tax credits that they cannot use.

With these preliminaries aside, we can now look at export income. First, it is

clear that, absent FSC, a U.S. corporation that sells its exports abroad directly is likely

to be subject to U.S. tax on its export income—U.S. corporations are generally

subject to U.S. tax on their worldwide income. Immediately, however, we note an

exception. Firms that have the excess foreign tax credits described in the preceding

paragraph can use those credits to shield export income deemed to be from foreign

sources from U.S. tax. U.S. rules for “sourcing” income, further, in some cases

permit up to half of a firm’s export income to be allocated to foreign sources.

Accordingly, U.S. corporations in these circumstances can exempt up to half their

export income from U.S. tax, even without FSC. Indeed, the magnitude of this

benefit (variously called the “export source rule,” the “inventory source rule,” and the

“sales source rule,”) is greater than that available from FSC, so that firms that have

excess foreign tax credits are likely to structure their operations to use it, instead.

However, a firm must have excess foreign tax credits to use the source rule benefit,

suggesting that it cannot be used by firms that pay few foreign taxes for one reason

or another.1

1

For information on the sales source rule, see: U.S. Library of Congress. Congressional

Research Service. Tax Benefit for Exports: The Inventory Source Rule. CRS Report 97-414

E, by David L. Brumbaugh. Washington, 1997. 6 P.

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What of firms that use neither the source rule nor FSC? Again, if the exports are

sold directly by a U.S. corporation, they are subject to full U.S. taxation because of

the residence principle. But what if the exports are marketed abroad through a

foreign subsidiary? That is, what if a U.S. corporation first manufactures the export

products, ships them to a foreign-chartered subsidiary corporation, which then sells

them to foreign consumers? As described above, the deferral principle may come into

play since foreign corporations are not subject to U.S. tax on foreign-source income.

To the extent a firm can allocate profits from its exports to its foreign subsidiary, the

profits would not be taxed by the United States until they are remitted to the U.S.

parent firm.

But in some cases deferral may be ruled out for exports, even if they are sold

through a foreign corporation. The U.S. tax code contains a set of provisions known

as Subpart F that identifies certain circumstances in which income earned by foreign

subsidiaries is subject to U.S. tax on a current basis in the hands of the subsidiaries’

U.S. shareholders. One type of income for which Subpart F potentially restricts

deferral is certain sales income from transactions between related corporations—a

type of income that could include income from export sales.2

In sum, absent FSC some U.S. export income can use an even larger tax benefit

under the source rule, but only if the exporting firm has a surfeit of foreign tax credits.

Absent either FSC or the export source rule, export income earned directly by U.S.

corporations would be subject to full U.S. taxation. Some export income earned

through foreign subsidiaries could benefit from a postponement of U.S. tax under the

deferral principle, but in some circumstances deferral would be ruled out under

Subpart F. Without FSC, in other words, some, but not all, U.S. export income

would be subject to U.S. tax. We next look at how FSC modifies this structure.

The FSC Provisions

In general, exporters use the FSC benefit by selling their products through

specially-qualified subsidiary corporations (FSCs). Eligibility for the benefit and the

size of the benefit are determined by 4 types of rules: rules for qualifying as a FSC;

rules identifying the type of FSC export income that is potentially eligible for the tax

benefit; rules dividing income between the FSC and its parent; and rules stipulating

the portion of the FSC’s eligible export income that is tax-exempt.

First, qualifying as a FSC: FSCs are required to meet certain requirements

related to their organization abroad: they must be chartered abroad or in a U.S.

possession; must have no more than 25 shareholders; must maintain an office outside

the United States where it maintains a permanent set of books; and meet certain other

organizational requirements.

Next, qualifying income: even if a firm sells its exports through a qualified FSC,

only revenue that qualifies as “foreign trading gross receipts” can generate taxfavored profits. In general, these receipts are required to be from the sale or lease of

2

The income in question is “foreign base company sales income,” as defined in section 954(d)

of the Internal Revenue Code.

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export property. The definition of export property includes most types of U.S.

products, but specifically excludes several items, including: most intangible assets

such as patents, copyrights, and trademarks; oil and gas; goods whose export is

prohibited, property that the President has determined is in short supply, and raw

timber. In addition, the tax exemption for income from exports of military property

is limited to half the exemption that would otherwise apply.

A FSC is only treated as earning foreign trading gross receipts if it conducts

certain management activities or economic processes abroad.3

Examples of

management requirements include the FSC maintaining its principal bank account

outside the United States, having a board of directors that includes at least one person

who is not a U.S. resident, and holding all shareholder meetings outside the United

States. “Foreign economic process” requirements are met if a FSC participates in

activities such as advertising, arrangement of transportation, transmittal of invoices

and receipt of payment, processing of orders, and assumption of credit risk.

Next, allocating qualified income between a FSC and its parent: a firm can use

one of three alternative rules to divide net income. The international norm for

allocating income between related entities is a method known as “arm’s length

pricing,” which divides income between firms using hypothetical prices that would be

charged if the firms were actually not related. And the FSC provisions do permit

firms to use arm’s length pricing to divide a parent and FSC’s income. But

presumably, an independent sales firm operating abroad would be able to appropriate

little of the profit from the production of exports in the United States. If it charged

market-determined prices, its profit would be based only on the value added by its

own sales and ancillary activities, contributed by its own foreign-based factors of

production. Presumably, then, little of the profit from U.S. export sales could be

attributed to a FSC using arm’s length pricing, and little benefit could be derived from

a FSC, notwithstanding the FSC’s tax exemption. The FSC rules, however, provide

two alternative “administrative” rules for allocating income.4

Under one of the administrative methods, a firm can allocate to its FSC 23% of

the combined parent-and-FSC export income. Under the second administrative

method, a firm can allocate to the FSC an amount equal to 1.83% of gross export

receipts, subject to the limit that no more than 46% of the combined taxable income

can be allocated to the FSC. Returning to the rules governing the sales corporations

themselves, the part of a FSC’s income that is tax exempt depends on the income

3

These requirements for a foreign presence were adopted in response to an understanding

approved by the General Agreement on Tariffs and Trade Council holding that a country need

not tax foreign-source income as long as arm’s length pricing is used to allocate income

among domestic firms and their foreign subsidiaries. As noted below, H.R. 4986 drops the

foreign organization and the foreign management requirements, but retains the foreign

economic process rules.

4

The Joint Tax Committee’s explanation of the original FSC legislation states that the

administrative pricing rules were “intended to approximate arm’s length pricing.” U.S.

Congress. Joint Committee on Taxation. General Explanation of the Deficit Reduction Act

of 1984. Joint Committee Print, 98th Cong., 2d sess. Washington, U.S. Govt. Print. Off.

1984. p. 1054.

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allocation method an exporter elects to use. If a firm uses arm’s length pricing, 30%

of the FSC’s income is exempt from U.S. tax. If it uses either of the two

administrative methods, 15/23 of the FSC’s income is tax exempt (16/23 if the parent

exporter is a non-corporate taxpayer). The interaction of the income allocation rules

and these exemption fractions dictate the size of the FSC benefit (see the appendix for

details): an exporting firm using FSC can exempt at least 15% of export income from

U.S. tax, but no more than 30%.

Having set forth rules for allocating income, the final part of the benefit’s

statutory mechanics is specification of the part of allocated FSC income that is

exempt. If arm’s length pricing has been used to allocate income between a parent

and its FSC, 30% of foreign trade income is exempt; if either of the two alternative

rules have been used, 15/23 of foreign trade income is tax exempt. Note the

combination of the rules for allocating income and the fractions of income specified

to be tax-exempt produce a particular arithmetic result: a U.S. exporter can use FSC

to exempt somewhere between 15% and 30% of export profit from U.S. tax.5

From the preceding section’s discussion of U.S. export taxation without FSC,

it is clear there are still several loose ends. First, even though FSCs are required to

be foreign corporations, the United States ordinarily taxes foreign corporations on

their U.S.-source income. However, the FSC provisions explicitly provide that a

FSC’s exempt income is to be treated as foreign-source income, thus placing it

beyond the U.S. tax jurisdiction.

Second, Subpart F’s restriction on deferral for certain types of sales income

would potentially subject some FSC income to current taxation in the hands of the

U.S. parent corporation; the FSC provisions exclude FSC income from Subpart F.

Finally, the U.S. tax law permits corporations to deduct at least part of dividends

received from other corporations from their taxable income.6 Dividends from foreign

corporations ordinarily do not qualify for the deduction, raising the possibility that

even exempt FSC income could be subject to U.S. tax when the FSC pays dividends

to its parent. The FSC provisions, however, provide that U.S. corporations can claim

a 100% deduction for dividends from a FSC.

5

The result occurs as follows: a firm can always choose to use the 23%-of-combined income

rule and exempt 15% of its income from tax (23% X 15/23 = 15%). Or, if a firm has a rate

of return on sales that is large, it could allocate more than 23% of income to its FSC using the

1.83%-of-gross receipts rule and exempt a percentage greater than 15%. The FSC rules

provide, however, that the amount exempted under the gross receipt rule cannot exceed twice

the amount exempted under the 23% rule. Thus, under these two rules, the exemption can

range from 15% to 30%. Conceivably a firm could also use arm’s length pricing to exempt

up to 30% of income, but is likely that the exemption under arm’s length pricing would be

smaller than 15%. Assuming that non-exempt income is subject to the top corporate tax rate

of 35%, the exemption range is the equivalent to reducing the tax rate on FSC income to a

range of 24.5% (i.e., [1-30%] X 35%) to 29.8% (i.e., [1-15%] X 35%).

6

The purpose of the deduction is to prevent multiple layers of corporate tax income tax.

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FSC and the World Trade Organization

DISC: FSC’s Antecedent

The current FSC/WTO controversy has its roots in the legislative antecedent of

FSC: the U.S. tax code’s Domestic International Sales Corporation (DISC)

provisions, first enacted in 1971. Like FSC, DISC provided a tax incentive to export,

although its design and mechanics were different in certain respects. DISC was

enacted as part of the Revenue Act of 1971 (Public Law 92-178). It was thought that

a tax incentive for exports was desirable:

!

to offset the tax code’s “deferral” benefit, which posed a tax

incentive for U.S. firms serving foreign markets to invest abroad

rather in the United States; to offset export tax incentives other

countries offered their firms; to provide a stimulus to the U.S.

economy.7

In some respects, the mechanics of the DISC provisions were a parallel of the

“deferral” tax benefit DISC was designed to offset, while applying to exports rather

than foreign-source income. Firms availed themselves of the DISC benefit by

establishing specially qualified subsidiary corporations (DISCs) that were exempt

from U.S. tax and by selling their exports through the subsidiaries. (In reality, DISCs

could be little more than paper corporations and still qualify for the tax benefit.)

Since the DISCs were tax exempt, firms obtained a tax deferral for income that was

retained by the DISC rather than distributed. The size of the benefit was partly

dependent on how much export income could be allocated to the tax-exempt DISC,

for tax purposes. Like the subsequent FSC provisions, firms could use either arm’s

length pricing or several alternative “administrative” formulas to allocate income to

the DISC, where it was protected from tax.

In contrast to FSC income, DISC income was taxed when distributed to its

parent. (Firms receive a dividends-received deduction that applies to FSC income).

However, part of the income could be retained by the DISC indefinitely, and the

parent could obtain the use of its DISC’s funds by means of “producer” loans from

the DISC to the parent. Thus, while DISC was technically a tax deferral, it had the

same economic effect as a flat exemption such as FSC’s. Further, the various

statutory parameters of the DISC provisions – the income allocation rules, and

requirements for distributions – resulted in a tax benefit of the same magnitude as that

of FSC.8

7

U.S. Congress. Joint Committee on Taxation. General Explanation of the Revenue Act of

1971. Washington, U.S. Govt. Print. Off. 1972. p. 86.

8

For a description of the DISC provisions and an economic analysis of their effects, see: U.S.

Library of Congress. Congressional Research Service. DISC: Effects, Issues, and Proposed

Replacements. CRS Report 83-69 E, by David L. Brumbaugh. Washington, 1983. 28 p.

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DISC and the General Agreement on Tariffs and Trade

If DISC was the statutory ancestor of FSC, the WTO’s institutional predecessor

was the General Agreement on Tariffs and Trade (GATT): a multilateral trade treaty

that was designed to reduce or eliminate restrictions on free trade – restrictions such

as tariffs, non-tariff barriers to trade, and subsidies. The United States and its major

trading partners were signatory to GATT, and in 1972, shortly after DISC’s

inception, several nations of the EC submitted a complaint to the GATT Council

arguing that DISC was an export subsidy and therefore contravened article XVI of

the GATT. The United States, however, filed a counter-claim, holding that the

“territorial” tax systems of 3 EEC countries – France, the Netherlands, and Belgium

– themselves conferred export subsidies. Under a territorial tax system, a nation does

not tax the income of its corporations if that income is earned by a corporate branch

located abroad. As for DISC, itself, the United States argued that because DISC

conferred a mere deferral of tax, rather than an outright exemption, it was not in

violation of GATT.9 In 1973, the GATT Council convened a panel of experts to

study the EEC’s complaint.

The GATT panel issued its reports in 1976. It found that elements of both the

territorial system and of DISC constituted prohibited export subsidies under GATT.

However, the EEC and the United States both objected to the panel’s finding, and the

debate continued to simmer until 1981. In 1981, a solution was reached (albeit, as it

turned out, a temporary one). The GATT council adopted the panel’s report together

with an Understanding. The Understanding held that countries need not tax income

from economic processes that occur outside their borders – territorial tax systems, in

other words, do not by themselves contravene GATT. The Understanding also held,

however, that arm’s length pricing must be used in applying the territorial system to

exports.10

The meaning of the Understanding itself shortly became an item of contention,

and during 1982, a debate occurred in the GATT council over how the Understanding

applied to DISC. The EEC continued to argue that DISC was an illegal export

subsidy. The United States never conceded that DISC was a subsidy, but the issue

was becoming more serious and “threatened breakdown of the dispute resolution

process.”11 The U.S. Treasury thus proposed what eventually became the 1984 FSC

provisions. The provisions were designed to achieve GATT legality by providing an

export tax benefit incorporating elements of the territorial tax system countenanced

by the 1981 Understanding.

9

McGuire, J. Michael. The GATT Panel Report on Domestic International Sales

Corporations: Illegal Subsidy Under the GATT. International Trade Law Journal. V. 3,

Summer, 1978. P. 395.

10

The key language of the understanding is quoted in the October, 1999, WTO panel report:

World Trade Organization. United States – Tax Treatment for Foreign Sales Corporations.

Report of the Panel. WT/DS108/R. October 8, 1999. P. 260.

11

U.S. Congress. Joint Committee on Taxation. General Explanation of the Deficit

Reduction Act of 1984. Washington, U.S. Govt. Print. Off. 1984. P. 1041.

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FSC and GATT

To see how FSC was meant to achieve GATT legality, we return to the 1981

Understanding and the basic FSC mechanics outlined above. The Understanding held

that a country need not tax foreign-source income. And as noted above, the United

States does not tax the foreign source income of foreign-chartered corporations; it

taxes foreign firms only on income “effectively connected” with a U.S. trade or

business. The FSC provisions require a FSC to be chartered abroad – hence

qualifying as a foreign corporation – and further provide that a portion of a FSC’s

income is foreign-source income not effectively connected with a trade or business

within the United States. As described above, FSCs are also required by the tax code

to conduct certain activities abroad. Hence, the FSC provisions seem to emulate

territorial systems by exempting “foreign” income from U.S. tax.

The countries of the EEC were still not fully satisfied of FSC’s GATT-legality.

Even before FSC was signed into law, the EEC expressed concerns about certain of

the new provision’s design features – for example, whether a country can operate a

territorial system that is confined to just exports, and whether the administrative

pricing rules can accurately allocate income.12 Still, the controversy was generally

below the surface until November, 1997, when the European Communities – a

component of the European Union (EU) – requested consultations about FSC with

the United States, thereby taking the prescribed first step in the dispute settlement

process established under the new WTO.13 The United States and the EU held

consultations without reaching a solution, and in July, 1998, the EU took the next

step in the WTO-prescribed process by requesting establishment of a panel to examine

the issue. The panel was formed and made its findings public on October 8, 1999.14

Findings of the WTO Panel

Article 3.1(a) of the WTO’s subsidies and countervailing measures (SCM)

agreement prohibits subsidies “contingent on export performance.” In turn, article 1.1

of the agreement defines a subsidy to include cases where “government revenue that

is otherwise due is foregone or not collected.” Under these provisions, the EU argued

that FSC conferred subsidies in two ways: by means of a set of tax exemptions, and

12

Caplan, Bennett, and Matthew Chametzky. Domestic International Sales Corporations

(DISCs) and Foreign Sales Corporations (FSCs): Providers of Economic Incentives for

Wholly-Owned Domestic Exporters. Brooklyn Journal of International Law. V. 12. No. 1,

1986. P. 14-5.

13

For information on the WTO’s dispute settlement process, see: U.S. Library of Congress.

Congressional Research Service. Dispute Settlement in the World Trade Organization: An

Overview. Report RS20088, by Jeanne J. Grimmett. Washington, 1999. 6 p.

If FSC and the WTO replaced DISC and the GATT in the controversy, the European

Communities and the European Union replaced the EEC. The European Communities

integrated the EEC and several other “communities” into a single organization that became

a component of the EU.

14

For a chronology of the WTO dispute process relating to FSC, see: World Trade

Organization. United States – Tax Treatment for Foreign Sales Corporations. Report of the

Panel. P. 1.

CRS-9

by permitting FSCs to use administrative rules rather than arm’s-length pricing to

allocate income.

According to the EU, there are three FSC exemptions that result in forgoing of

taxes “otherwise due.” One is FSC’s exemption from the U.S. tax code’s subpart F

provisions. As described above, subpart F denies the deferral benefit to certain types

of income earned by foreign-chartered subsidiaries of U.S. firms. Absent this

forgiveness for FSC, the requirement that FSCs be incorporated abroad and their

devotion to sales income might place many FSCs within the purview of subpart F and

negate the FSC benefit.

While the United States generally does not tax foreign corporations on foreign

income, it does apply its taxes to their income that is “effectively connected” with the

active conduct of a U.S. trade or business. The FSC provisions explicitly state that

part of FSC income is not “effectively connected;” the EC maintained that this was

a second exemption. The EC maintained that a third exemption was the availability

of the 100% dividends-received deduction applicable to FSC dividend payments;

ordinarily, dividend payments received from foreign corporations are not eligible for

the deduction.

The United States maintained in its submission to the WTO panel that FSC is not

an export subsidy. In doing so, it maintained that because the 1981 Understanding

held that a country need not tax foreign economic processes, the FSC exemptions

were countenanced by the Understanding. In addition, the United States argued that

a footnote (footnote 59) to an illustrative list of subsidies contained in Annex I to the

SCM agreement likewise established that foreign economic processes need not be

taxed.

The panel’s report generally supported the EC’s complaint, finding that FSC is

indeed an export subsidy in violation of the SCM agreement. According to the panel,

the exemptions identified by the EC indeed established forgiveness of taxes that would

be “otherwise due.” The panel, however, did not pronounce on the applicability of

each of the exemptions identified by the EC, finding instead that “Viewed as an

integrated whole, the exemptions provided by the FSC scheme represent a systematic

effort by the United States to exempt certain types of income which would be taxable

in the absence of the FSC scheme.”15

The WTO panel rejected the applicability of the 1981 Understanding to FSC,

finding that “it cannot provide guidance in understanding detailed provisions of the

SCM Agreement which did not exist at the time the understanding was adopted.”16

The panel also rejected the argument that footnote 59 countenanced FSC, finding

“nothing in footnote 59 which would lead us to conclude that a Member that decides

that it will tax income arising from foreign economic processes does not forgo

15

World Trade Organization. United States – Tax Treatment for Foreign Sales Corporations.

Report of the Panel. p. 275.

16

Ibid., p. 271.

CRS-10

revenue ‘otherwise due’ if it decides in a selective manner to exclude certain limited

categories of such income from taxation.”17

As noted above, the EC also complained that FSC violated the WTO’s

Agreement on Agriculture. More specifically, the EC maintained that FSC violated

commitments made by the United States in the agreement to limit agricultural export

subsidies. The panel also supported the EC’s complaint in this regard.18

The United States filed an appeal with the WTO’s Appellate Body, as permitted

under the dispute resolution procedures. The Body’s decision on February 24, 2000

essentially upheld the panel’s findings.

Under the WTO’s dispute procedures, the United States initially had until

October 1, 2000 to bring its system into compliance with the WTO rules. Failure to

do so might ultimately result in the WTO sanctioning retaliatory measures by the EC

against the United States.19 The United States and EU, however, agreed on an

extension of the deadline to November 1.

Proposed Replacements for FSC

On May 2, 2000, U.S. Deputy Secretary of the Treasury Stuart Eizenstat met in

London with European Trade Commissioner Pascal Lamy, and presented him with an

outline of a proposed replacement for FSC. In general, the proposal would have

replaced FSC with a tax benefit for export income of the same magnitude as FSC

along with a tax exemption for income from a matching amount of goods produced

abroad. It was on this added exemption for foreign-source income that the United

States apparently based its argument that the proposal met WTO requirements. As

noted above, the WTO panel ruled that FSC was not WTO-compliant because it

provides a tax exemption that is contingent on exporting. In making the proposal, the

United States maintained:

Specifically, as described above, by its terms, the proposed elective regime

would apply both with respect to export foreign sales (involving U.S.

manufacturing) and non-export foreign sales (involving foreign

manufacturing). Thus, the proposed elective regime would not be export

contingent in law.20

17

Ibid., p. 273.

18

Ibid., p. 293.

19

Dispute Settlement in the World Trade Organization: An Overview. P. 5.

20

BNA Daily Tax Report, May 2, 2000. P. L-10.

CRS-11

On May 29 the EU notified the United States that it would not accept the

proposal. 21 The Administration indicated that it would nonetheless work with

Congress to enact a proposed replacement by the looming deadline.22

H.R. 4986

In November, 2000, Congress approved (and the President signed) H.R. 4986,

the FSC Repeal and Extraterritorial Income Exclusion Act of 2000. The measure was

passed by a wide margin and received bipartisan support. The bill contains the

essential elements (with a few differences) of the May proposal. Like the May

proposal, the bill replaces the FSC benefit with a tax benefit of similar magnitude.

Also like the May proposal (and unlike FSC), H.R. 4986 matches its tax benefit for

exporting with a tax benefit for a like amount of income from foreign operations.23

However, unlike both the May proposal and FSC, H.R. 4986 does not require a firm

to sell its exports through a foreign-chartered corporation to qualify for the benefit.

H.R. 4986 begins by exempting “extraterritorial income” from U.S. tax, but

continues by defining “extraterritorial income” and a chain of other concepts in a way

that confines its exemption to a firm’s U.S. exports and a matching amount of income

from foreign operations. The initial link in the chain of definitions is “qualifying

foreign trade property,” which is generally products manufactured, produced, grown,

or extracted within or outside the United States. Generally, this is the full range of

U.S. exports, but the bill explicitly excludes the same items as FSC: certain

intangibles, oil and gas, raw timber, prohibited exports, and property in short supply.

Unlike FSC, however, military products would apparently qualify for the same benefit

as other exports. And unlike the parallel FSC concept of export property, qualifying

foreign trade property can be partly manufactured outside the United States.

However, not more than 50% of the value of qualified property can be added outside

the United States.

The next link in the chain is “foreign trading gross receipts,” which the bill

defines as income from the sale or lease of qualifying foreign trade property, and

which parallels the FSC concept of gross receipts. As with FSC, a firm would only

be treated as earning foreign trading gross receipts if it conducts economic processes

abroad. However, FSC’s foreign management requirements (see page 4, above)

would be dropped.

The bill next defines “foreign trade income” as taxable income attributable to

foreign trading gross receipts. The bill terms a specified part of this foreign trade

income “qualifying foreign trade income,” and grants such income a tax exemption.

The bill sets qualifying foreign trade income (and thus the exclusion) equal to either

1.2% of foreign trading gross receipts, 15% of foreign trade income, or 30% of the

21

Financial Times, May 30, 2000. P. 12.

22

BNA Daily Tax Report, May 31, 2000. P. GG-1.

23

In contrast to H.R. 4986, however, the May proposal would have only applied to income

from manufacturing. H.R. 4986 is also unlike the May proposal (and unlike FSC) in that it

does not require firms to set up subsidiary sales corporations to use its tax benefit.

CRS-12

income attributable to the foreign economic processes undertaken under the foreign

trading gross receipts requirements. (The rule exempting 30% of income is similar

in its effect to the FSC rule that applies to firms that use arm’s length pricing.) As

with FSC and the May proposal before it, the arithmetic result of these rules is that

a firm can exempt somewhere between 15% and 30% of qualified income from U.S.

tax.24

As noted above, in contrast to FSC, H.R. 4986 does not require a firm to sell its

exports through a foreign-chartered corporation to qualify for the benefit. Since a

U.S. corporation could qualify for the exemption directly, the special dividendsreceived deduction language in the FSC provisions is not necessary. The bill also

contains language that a foreign corporation that uses the benefit can elect to be taxed

like a U.S. corporation. This mechanism apparently rules out the application of

Subpart F, which applies only to income earned by firms that are foreign corporations,

for tax purposes.

The path of FSC legislation through Congress took a number of twists and turns.

After the House approved H.R. 4986, the Senate Finance Committee approved the

FSC-replacement bill on September 19. While the full Senate did not act on H.R.

4986 before the October 1 deadline, the EU agreed to an extension of the deadline to

November 1. The Senate Finance version of the FSC replacement was slightly

different than that of the House: the Senate bill denied a dividends-received deduction

in cases where the tax-favored exports were sold through a subsidiary. On October

26, the House passed a modified version of its FSC provisions containing a

compromise with the Senate version of the bill. The compromise was passed as part

of a larger bill tax cut and small business bill (H.R. 2614).

However, President Clinton stated that he might veto H.R. 2614 for reasons not

related to FSC, and the Senate did not act on H.R. 2614. Instead, on November 1 the

Senate passed the FSC-replacement provisions as a stand-alone version of H.R.

4986. The Senate’s version of H.R. 4986 was the same as the House-passed FSC

provisions in H.R. 2614. They differed, however, from those in the House version of

H.R. 4986, which contained the initial House provisions rather than the compromise

version that was subsequently passed as part of H.R. 2614. The version of H.R. 4986

passed by the Senate therefore could not be sent to the President without additional

House action. The House passed the new stand-alone bill on November 14 and the

President signed it into law (P.L. 106-519).

The EU has stated it does not believe the new tax benefit to be WTO-compliant.

It has asked the WTO to rule on whether the replacement provisions are WTOcompliant, and, if they are not, to authorize retaliatory tariffs.

24

A firm can always choose to exempt 15% of income from tax. Alternatively, if its return

on sales is sufficiently high, it could use the gross receipts method to exempt up to twice that

amount from tax. The range of exemption, in other words, is 15%-30%.

CRS-13

Economic Effects of FSC

FSC’s ultimate economic effects are probably: very small increases in both

exports and imports, little if any change in the balance of trade, and a very small

transfer of economic welfare from the United States abroad. We begin our analysis,

however, by an assessment of the size of the tax incentive that FSC provides to

exporters.

Size of the FSC Benefit

The FSC benefit produces its economic effects by reducing the rate of return

before taxes required of investment in the export sector. With FSC, export

investments can be undertaken that would otherwise have a return too low to be

profitable. FSC thus attracts added investment to the export sector, and FSC’s

impact on trade and U.S. economic welfare follow as a result.

In looking at these effects, we first gauge the size of FSC’s incentive to invest

in the export sector. Exactly how much does FSC reduce the rate of return required

of investment in the export sector? Tax economists use a particular type of effective

tax rate – termed a “marginal” effective tax rate – that measures the incentive effect

of taxes on investment. A marginal effective tax rate consists of the percentage by

which taxes change the rate of return required of new (“marginal”) investment.

Table 2, below, presents marginal effective tax rates for corporate exporters

without a tax benefit, and with the maximum and minimum FSC benefit (i.e., the 15%

and 30% exemptions). Effective rates are presented for average FSC users in general,

and for average manufacturing and non-manufacturing exporters. The effective tax

rates show that the maximum FSC benefit cuts an exporter’s tax burden by about onequarter, or 8.7 percentage points. At minimum, FSC reduces tax burdens by 4

percentage points, or about one-tenth. The tax rates also show that the magnitude of

the reduction in the tax burden on investment is relatively even across the different

industries. An explanation of how the effective tax rates were calculated is presented

in the appendix.

A second way of gauging the size of the FSC benefit is its revenue loss – its cost

to the U.S. Treasury in terms of forgone tax collections. According to the most

recent estimate by the Joint Committee on Taxation, the cost of FSC in terms of

forgone tax revenues is $2.7 billion for fiscal year 2000.25

25

U.S. Congress. Joint Committee on Taxation. Estimates of Federal Tax Expenditures for

Fiscal Years 2000-2004. Washington, U.S. Government Printing Office. 1999. P. 15.

CRS-14

Table 1. Marginal Effective Tax Rates for Exporters using FSC

No FSC Benefit

Maximum FSC

Benefit

Minimum FSC

Benefit

All Products

35.0%

27.3%

31.0%

Non-manufactured

Goods

32.0

25.3

28.4

Manufactured Goods

35.4

27.6

31.4

Product Class

Source: CRS calculations. See the appendix for methodology and assumptions.

FSC’s Impact on Trade and the Economy

Again, the FSC exemption reduces the rate of return required, before taxes, of

investment in the export sector, and thus attracts investment to exporting. As a

consequence, U.S. exports are probably higher than they would be without FSC.

How much higher depends on the extent to which export supply increases in response

to the tax benefit – that is, how much of the tax benefit U.S. suppliers pass on to

foreign consumers as lower prices – and on how responsive foreign purchasers are to

reduced prices for U.S. exports.

Beyond this effect, however, traditional economic analysis indicates that FSC

produces a set of effects that are perhaps surprising to non-economists. First, because

of theoretical exchange rate adjustments, the FSC-induced increase in exports is

diminished, and the value of U.S. imports also are increased; sales of U.S. importcompeting industries thus fall. Economic theory indicates that as a result, while FSC

increases the overall dollar value of U.S. trade, it does not change the balance of trade

– the value of imports minus the value of exports – or reduce the U.S. trade deficit.

The theoretical exchange rate adjustments work as follows: FSC increases

foreign purchases of U.S. exports, but to buy the U.S. products, foreigners require

more dollars. The increased demand for U.S. dollars drives up the price of the dollar

in foreign exchange markets, making U.S. exports more expensive. This partly offsets

the effect FSC has in increasing U.S. exports, but also makes imports to the United

States cheaper, which causes U.S. imports to increase. The net result is a higher

dollar value of both imports and exports, but no change in the overall balance of

trade.

This result is perhaps better seen by stepping back from the exchange rate

mechanisms and recognizing that when a country runs a trade deficit it is using more

goods and services than it produces. To do so, it must necessarily borrow from

abroad by importing more foreign investment than it exports. A country’s trade

deficit, in other words, is mirrored by deficit on capital account. And a country’s

trade balance changes only if the balance on capital account changes. Thus, if we

CRS-15

assume that FSC does not change the balance on capital account, it cannot change the

trade balance.26

Another effect of FSC is on U.S. economic welfare; traditional economic analysis

indicates that FSC reduces overall U.S. economic welfare. FSC does so because as

it increases U.S. exports, at least part its tax benefit is passed on to foreign consumers

in the form of lower prices. This price reduction can be viewed as a transfer of

economic welfare from U.S. taxpayers in general to foreign consumers.27

These effects, however, are probably quite small. Table 2, below, presents CRS

estimates based on FSC data for 1996 (the most recent available). According to the

estimates, the quantity of U.S. exports is between 2-tenths of one percent and 4tenths of one percent higher than they would be without the provision. (The

maximum and minimum figures in the range depend on whether it is assumed firms

received a 15% tax exemption from FSC or a 30% exemption.)28 Based on figures

for total exports in 1996, this range translates into an increase in the value of U.S.

exports ranging from $720 million to $1.23 billion. The quantity of imports are an

estimated 2-tenths of 1% to 4-tenths of 1% higher than they would be without FSC.

The transfer of economic welfare from the United States to foreign consumers is an

estimated $1.18 billion to $2.14 billion.29 A detailed explanation of the method used

in deriving these estimates is contained in the appendix.

26

As discussed for fully below (see page 16), FSC may actually reduce U.S. flows of capital

abroad. If so, FSC may have the effect of increasing the U.S. trade deficit.

27

As noted above, FSC increases both imports and exports – the overall level of trade. If FSC

were to operate in isolation, this increase in trade would reduce economic welfare in a second

way by causing the U.S. economy to inefficiently specialize in the items it exports and underproduce goods that compete with items the country imports. But in view of other trade

distortions that work in the opposite direction, it may be premature to conclude that FSC

causes an efficiency loss.

28

In its November, 1997, report on FSC, the Treasury Department estimated that in 1992,

FSC increased exports by 3-tenths of 1 percent and imports by 2-tenths of 1 percent, thus

agreeing with the estimates here in terms of the order of magnitude of FSC’s effects. See:

U.S. Department of the Treasury. The Operation and Effect of the Foreign Sales Corporation

Legislation. July 1, 1992 to June 30, 1993. Washington, 1997. P. 15..

29

At 1999 trade levels, the percentages work out to an $830 million to $1.42 billion increase

in exports as well as imports, and a $770 million to $1.15 billion transfer of welfare abroad.

CRS-16

Table 2. FSC’s Estimated Impact on Exports, Imports, and Economic

Welfare

Percent Change in the

Quantity of Exports and

Imports

Change in Dollar Amount

(Based on the volume of

1996 trade flows; in

billions)

15% Tax

Exemption

30% Tax

Exemption

15% Tax

Exemption

30% Tax

Exemption

U.S. Exports

0.24%

0.42%

U.S. Imports

0.17

0.29

$0.72

$1.23

0.08

0.13

$0.66

$1.15

Shift of Economic

Welfare from U.S.

Abroad (As percent

of exports)

Source: CRS estimates. See the appendix for details.

Other Effects

The estimates above are simplified in that they do not take into account several

other likely effects, including changes in capital flows between the United States and

abroad, and changes in economic efficiency. It is doubtful, however, that

consideration of these factors would change the qualitative results of the analysis or

appreciably alter the quantitative results.

FSC may well reduce the flow of U.S. capital abroad, for the following reason:

exports, by definition, can only be produced in the United States. It follows that a

provision such as FSC that provides a tax benefit to export investment encourages

U.S. firms to invest in the United States rather than abroad. And given that exports

serve foreign markets it is possible that, if not for FSC, many FSC-using firms would

operate abroad.

If it is the case, however, that FSC reduces the flow of capital abroad, the effect

of the change would be to reduce U.S. exports and increase imports: the reduced

demand by U.S. investors for foreign assets denominated in foreign currencies would

drive up the price of the dollar in currency markets, making U.S. exports more

expensive and imports cheaper. The magnitude of the change in investment flows,

however, is likely quite small.

Another effect is that of FSC on economic efficiency. As described above, FSC

increases the level of both U.S. imports and exports – in short, it increases the level

at which the United States trades with the rest of the world. Taken alone, this effect

would reduce the efficiency of the U.S. economy; FSC would be encouraging the

United States to “over trade” – to over specialize in the production of the goods that

CRS-17

it exports. In isolation, this effect would add to FSC’s reduction in economic welfare

that stems from the transfer of the tax benefit to foreign consumers. But FSC does

not, in fact, operate in isolation. It might be argued that FSC’s increase in the overall

level of trade mitigates a shrinkage in trade that results from what tariffs and non-tariff

barriers are in place. It also might be argued, however, that the added taxes that are

imposed to make up for FSC’s revenue loss cause economic distortions and

inefficiencies that make the net improvement in efficiency – if any – quite small.30

Effects of FSC’s Possible Replacement

As noted above, under H.R. 4986 firms could use FSC to exempt somewhere

between 15% and 30% of export income from tax. For most exports, therefore, the

benefit under the bill would be the same as under FSC. In the case of military sales,

however, the maximum benefit would increase because the proposal does not contain

FSC’s language limiting the benefit for military property to 50% of the exemption.

Perhaps a more important difference in the effect of H.R. 4986 would stem from

its extension to a certain amount of foreign-produced goods. A thorough analysis of

the provision would require a full-blown discussion of the economics of investing

abroad, and is beyond the scope of this report.

However, a few preliminary observations can still be made. First, regardless of

how low H.R. 4986 might reduce U.S. tax on foreign-source income, where high

foreign taxes apply they would at least neutralize any added U.S. incentive to invest

in high-tax foreign countries. Second, as described above in the discussion of the

U.S. tax structure (see page 2), U.S. tax on income earned by foreign-chartered

subsidiaries is generally not subject to U.S. tax until it is repatriated to the United

States parent firm as dividends; foreign-source income receives a deferral of U.S. tax

as long as it is reinvested abroad. The deferral principle thus poses an incentive for

U.S. firms to invest abroad in countries with low tax rates. In the case of investment

originating in the United States (as opposed to reinvestment of foreign-source

earnings) the magnitude of deferral’s benefit and incentive to invest abroad is greater,

the longer the income from the investment is expected to be reinvested abroad. For

investment whose stay abroad is expected to be short, H.R. 4896 may increase the tax

incentive to invest abroad beyond that posed by deferral. 31

As described above (see page 17), changes in capital flows may induce changes

in the trade balance. If H.R. 4896 does, indeed, increase U.S. investment abroad, it

may have the additional effect of reducing the U.S. trade deficit.

30

Calculations using rough estimates of the amount of capital in the export sector suggest that

even if all FSC’s efficiency changes produce welfare gains, those gains would be negligible

– substantially less than $1 billion per year.

31

Hartman has pointed out that for funds that are already abroad, the incentive to invest

abroad does not depend on taxes that apply upon repatriation, and only on the tax rate on

domestic investment versus foreign investment. The proposal would therefore apparently not

affect the incentives faced by funds originating abroad.

CRS-18

The Joint Committee on Taxation has estimated that H.R. 4986 would reduce

U.S. tax revenue by $1.5 billion over 5 years.32 This revenue loss is in addition to the

revenue that would be lost by retaining the FSC program.

Business Views

Support for FSC can be found in the business community. A possible reason for

the divergence in business views from those of economists may be perspectives:

economic analysis looks at the impact of FSC from the perspective of the economy

as a whole, taking into account its full range of effects and adjustments in all markets.

Supporters of the provision, however, are frequently businessmen whose exporting

firms would likely face declining sales, profits, and employment if FSC were to be

eliminated. For economists, there is no denying that FSC boosts employment and

increases incomes in certain sectors of the economy, and that its repeal would cause

short-term dislocation in those sectors. But FSC also results in contraction of other

parts – for example, firms that compete with imports – and transfers economic welfare

to foreign consumers.

The business community also generally supports H.R. 4986. The National

Association of Manufacturers, for example, has endorsed the bill. 33

FSC and Value-Added Tax Rebates

FSC has occasionally been defended on the grounds that it counters subsidies

provided to foreign producers by their own governments. A purported subsidy that

is sometimes cited is the practice among European (and other) countries of rebating

the value added taxes (VATs) that would otherwise apply to export sales. The

rebates work as follows: under a VAT, tax is generally applied at each stage of

production, to the value-added by that particular stage. When a firm in a VATimposing country makes an export sale, it receives a rebate of all the VAT that has

been paid with respect to the good at every level of production. At the same time,

when a VAT-imposing country imports an item, it generally applies its VAT to the full

value of the import.

Economists have long held that such “border adjustments” do not distort trade

and are in fact necessary if exported goods are to be part of the same relative price

structure as other goods in the importing country. 34 A parallel might be drawn with

sales taxes imposed by U.S. states, that apply to goods imported from other states but

not to goods exported to other states. Like the border adjustments with VATs, these

adjustments do not distort trade.

32

U.S. Congress. Joint Committee on Taxation. Estimated Revenue Effects of H.R. 4986.

JCX-88-00. Washington, July 27, 2000.

33

34

BNA Daily Tax Report, August 24, 2000. P. G-1.

Krugman, Paul, and Martin Feldstein. International Trade Effects of Value-Added

Taxation. Working Paper 3163. Cambridge, MA, 1989. National Bureau of Economic

Research. 26 p.

CRS-19

Other Arguments

In recent decades, some economists (sometimes referred to as “new trade

theorists”) have applied models of market imperfections to international trade and

have concluded that in some cases, government intervention in trade might improve

a country’s economic welfare. For example, in markets where only a few firms

compete for profits, a “strategic trade policy” such as an export subsidy might shift

profits from a foreign firm to a domestic one. Or, external economies such as

knowledge spillovers might recommend a subsidy for the industry in which the

economies occur. These policy prescriptions, however, have been met with

considerable skepticism among trade economists for a variety of reasons. First, the

theory that supports strategic trade is not robust – for it to work requires a variety of

special assumptions. Second, a more appropriate way to address external economies

that within a country’s own borders may be to apply a subsidy in the domestic

economy rather than the international one. Third, as an empirical matter, cases where

export subsidies can improve economic performance may well be quite limited. And

finally, groups that can benefit from a subsidy may co-opt a subsidy that is initially

well-targeted so that its aim ultimately fails.35 Perhaps more importantly for FSC,

even if developments in trade theory were to support export subsidies in certain

circumstances, they likely do not support a broadly available benefit such as FSC as

a structural and permanent part of the tax code.

Data on FSC Use

The most recent Internal Revenue Service FSC data are from 1992 and 1996.

(Data for the intervening years have not been published.) Table 3, below, presents a

selection of these data for FSCs and their parent firms, categorized by the principal

product class into which the firms’ exports fall. The left part of the table shows gross

export receipts of FSCs and their parents; the right part of the table shows income

exempt from tax under the FSC provisions. In each case, the numbers are averaged

for 1992 and 1996, and in each case the product classes within non-manufacturing and

manufacturing, respectively, are arranged in order of size.

It is clear from the table that most FSC exports are manufactured products:

manufactured products account for 87% of FSC-related gross export receipts and

87.5% of income exempted from tax under the FSC provisions. Within

manufacturing, use of FSC appears to be concentrated within just a few product

classes. The four largest product classes are: electrical machinery (including

electronics components, radios, and televisions), non-electrical machinery (including

engines and turbines and computers), transportation equipment (including autos and

aircraft), and chemicals (including plastics and drugs). Together, these four

categories account for about two-thirds of both FSC-related gross receipts and taxexempt FSC income.

35

For surveys of the literature on new trade theory, see: Baldwin, Robert E. Are Economists’

Traditional Trade Policy Views Still Valid? Journal of Economic Literature. V. 30. June,

1992. Pp. 804-29; Bhagwati, Jagdish. Free Trade: Old and New Challenges. The Economic

Journal. V. 104. March, 1994. Pp. 231-46; and Krugman, Paul. Does the New Trade

Theory Require a New Trade Policy? World Economy. V. 15. July, 1992. Pp. 423-41.

CRS-20

Table 3. Selected Internal Revenue Service FSC Data, 1992 and 1996

(Dollar Amounts in millions)

Average

Tax

Exempt

Income,

1992 and

1996

Percent of

Total Tax

Exempt

Income, all

Product

Classes

$6,277.3

100%

Product Class

Average

Gross

Receipts,

1992 and

1996

All Products

$219,077.8

100%

Non-Manufactured

Products

26,499.3

12.1

Non-Manufactured

Products

758.7

12.1

Non-Agricultural

Non-Manufactured

Products

13,668.5

6.2

Non-Agricultural

Products NonManufactured

553.0

8.8

Agricultural

Products

12,830.8

5.9

Agricultural

Products

205.8

3.3

Manufactured

Products

191,383.9

87.4

Manufactured

Products

5,491

87.5

Non-Electrical

Machinery

41,024.3

18.7

Electrical

Machinery

1,176.2

18.7

Transportation

Equipment

35,028.7

16.0

Non-Electrical

Machinery

1,100.4

17.5

Electrical Machinery

32,393.0

14.8

Chemicals

1,008.4

16.1

Chemicals

30,618.7

14.0

Transportation

Equipment

791.2

12.6

Manuf. Products

Not Included

Elsewhere a/

24,410.8

11.1

Manuf. Products

Not Included

Elsewhere a/

739.5

11.8

Food & Kindred

Products

11,603.8

5.3

Instruments

351.2

5.6

Instruments

10,528.0

4.8

Tobacco

269.8

4.3

Tobacco

7,171.9

3.3

Food & Kindred

Products

220.3

3.5

Paper & Allied

Products

5,903.3

2.7

Paper & Allied

Products

115.2

1.8

Fabricated Metal

3,757.8

1.7

Fabricated Metal

Products

88.4

1.4

Primary Metal

Products

2,755.4

1.3

Lumber

84.0

1.3

Lumber

2,366.4

1.1

Primary Metal

Products

51.4

1.0

Not Allocable

1,193.7

0.5

27.3

0.4

% of

Total

Receipts

of all

Product

Classes

Product Class

All Products

Not Allocable

a/ Includes: Rubber, textile mill products, stone, printing & publishing, furniture & fixtures, leather, apparel, petroleum

refining, and misc. manufacturing. Except for “misc.manufacturing,” each of these individual category accounted for less

that 1% of gross receipts. Sources for raw data: U.S. Internal Revenue Service. Statistics of Income ( SOI) Bulletin.

Summer, 1997. p. 114-31; and Statistics of Income (SOI) Bulletin. Spring, 2000. P. 87-122.

CRS-21

Appendix

Marginal Effective Tax Rates

In general, marginal effective tax rates for FSC were calculated using the wellknown Hall-Jorgenson formula for the rental cost of capital and aggregated using Jane

Gravelle’s CRS capital stock model and data on FSC use, by product class.

The starting point for the calculation is formulation of an exporter’s discount rate,

which is the rate of return its stockholders and creditors require, after corporate taxes

but before their own individual income taxes. The discount rate is a weighted average

of that for debt and equity, as follows.

(1) r = f {i (1 − a * u) − p *} + (1 − f ) E

where r is the real aftertax discount rate, f is the share of investment financed with

debt, i is the nominal interest rate, a* is the portion of export income subject to tax

(i.e., not exempted by the FSC provisions), u is the statutory corporate tax rate, p*

is the inflation rate, and E is the real return to equity. Values for the parameters were

selected based on their observed long-run values and follow those used in the CRS

capital stock model: f is set at .33, i is .11, a is either 1, .85, or .7. depending on the

portion of FSC income that is assumed to be exempt, u is .35, p is .05, and E is .07.

The following discount rates result from these parameters:

!

!

!

No FSC exemption: .0538;

FSC 15% exemption: .0558;

FSC 30% exemption: .0577.

The Hall-Jorgenson rental cost expression is modified to incorporate FSC, as

follows:

∞

(2)

q = ∫ (1 − a * u)cqe − ( r + d ) t dt + a * uzq

;

0

where q is the acquisition cost of a depreciable asset, c is the rental cost of capital, d

is the economic depreciation rate, and z is the present value of depreciation

deductions claimed over the life of the asset. The expression states that firms will

invest up to the point where the rate of return of a marginal investment is expected

to produce a stream of revenue and tax deductions over its lifetime whose present

value is equal to the asset’s acquisition cost.

The rental cost is interpreted as the rate of return required of a marginal

investment under this condition. Solving (2) for the rental cost produces:

CRS-22

(3) c =

( r + d )(1 − a * uz )

(1 − a * u )

Subtracting the economic depreciation rate from the rental cost produces the

pretax rate of return, net of depreciation, that firms require of a marginal investment.

The marginal effective tax is defined as the percentage increase taxes cause in a

marginal investment’s required rate of return, or, more precisely, the difference

between the required pretax and the discount rate, divided by the pretax return:

(4) u* =

(r * − r )

,

r*

where u* is the marginal effective tax rate and r* is the required pretax return.

The aggregate effective tax rates in table 1 of the text were calculated by first

obtaining industry-by-industry pretax returns from the CRS capital stock model, then

by weighting each industry’s pretax return by its corresponding product’s share of

FSC gross receipts, as reported in the Spring, 2000 Statistics of Income Bulletin. The

capital stock model integrates pretax returns for investment in inventory with returns

for equipment and structures.

Impact on Exports and Imports

The impact of FSC on exports and imports was calculated by specifying the

following equations:

X = X n ( p, e) + X f ( pa, e)

(5)

(6)

(7)

p( X n + X f ) −

M

= 0

e

M = M ( e)

Xn is U.S. non-FSC exports, Xf is FSC exports, p is the price of U.S. exports (in

dollars), a is the subsidy from FSC, e is the exchange rate (in dollars/foreign

currency), and M is U.S. imports. In our calculations, it was assumed that the entire

FSC tax subsidy is passed on to foreign consumers as lower prices, so that:

dp

= −1.

da

Equation (5) states that U.S. exports are a function of price and the exchange rates;

equation (6) is the balance of payments constraint that specifies that the value of

exports must equal the value of imports, and equation (7) states that U.S. imports are

a function of the exchange rate. The model’s partial derivative are assumed to have

the following signs:

CRS-23

dX

dX

dX

dM

< 0,

< 0,

> 0,

> 0.

dp

de

da

de

Supply elasticities are assumed to be infinite, so all elasticities produced by solving the

equations are interpreted as demand elasticities.

Solving the three equations simultaneously produces the following results:

(8)

dX

sM sX

Xf

(

)

=

X

1 − s X − s M X f +n

M X

M

f

(9) dM = s s X − s M ( Xf + n ) ,

M

1− s − s

X

where sM is the elasticity of demand for imports and sX is the elasticity of demand for

exports. The equations are formulas for the percentage change in exports and imports

for a 1-percent exogenous change in the price of exports. The percent change in the

value of exports (and imports) is:

d ( pX ) dX

(10) pX = X − 1 .

The change in welfare is the change in the quantity of net exports, expressed as

a percentage of exports:

(11)

dX − dM

dX

Values for the share of exports sold by FSCs were calculated on a product-byproduct basis based on unpublished IRS FSC data for 1996 in the Spring, 2000, issue

of the Statistics of Income Bulletin. Export data by industry are at the International

Trade Administration’s web site: http://www.ita.doc.gov/td/industry/otea/usfth/

aggregate/H198t26.txt. Demand elasticity values are taken from the Treasury

Department’s 1997 FSC report (p. 30).

The change in the price of exports was calculated based on the following the

formula in 1986 CRS report by Jane Gravelle.36

36

U.S. Library of Congress. Congressional Research Service. Corporate Tax Reform and

International Competitiveness. CRS Report 86-42E, by Jane G. Gravelle. Washington, 1986.

P. 18.

CRS-24

(12) dP = (c * − c)

K

VA

where P is the price of a particular export good, c* is the rental cost of capital with

FSC and c is the rental cost without it. K is the stock of capital used in production

of the good, and VA is the value added to the output by the particular industry.

Equation (12) states that the change in price induced by FSC is equal to the change

in the rental cost of capital times the ratio of capital to value-added.

The change in the rental cost under FSC was calculated on an industry-byindustry basis using the CRS capital stock model, as described above. Values were

calculated assuming first a 15% exemption under FSC, then a 30% exemption.

Figures for value added on an industry basis were taken from Bureau of

Economic Analysis (BEA) numbers published in the November, 1998 Survey of

Current Business (p. 34). Values for fixed, private, nonresidential capital by industry

were taken from figures published in the Survey of Current Business of September,

1998. The capital figures were inflated to include land and inventories based on

estimates in: Jane Gravelle, The Economic Effects of Taxing Capital Income:

Cambridge MA, MIT Press, 1994, p. 300. The figures were also each inflated by

11% to reflect an estimate of the share of intangible assets in the capital stock

published in: Don Fullerton and Andrew B. Lyon, Tax Neutrality and Intangible

Capital, in Lawrence Summers, ed., Tax Policy and the Economy, Vol. 2: Cambridge

MA, National Bureau of Economic Research, 1988, p. 73.

The price changes calculated using the formulas in (8) through (10) were applied

to the formulas in equations (4) through (6) on a product-by-product basis. They

were aggregated based on each product’s share of total U.S. exports, again using the

International Trade Administration data cited above.