The Committee on Ways and Means recently approved a bill that repeals the preferential tax rate for export-related corporate income: the Extraterritorial Income Act (ETI), formerly Foreign Sales Corporation (FSC). This legislation is a step in the right direction towards making the U.S. tax code more competitive among our major trading partners.

EU Threatens Sanctions

House and Senate tax-writing committees have been wrangling with how best to make changes to the tax treatment of exports and foreign-source income. This effort is due to the fact that the European Union (EU) is threatening to impose sanctions on American exports if lawmakers do not repeal a provision of the tax code -- FSC/ETI -- that has been declared an impermissible export subsidy by the World Trade Organization (WTO).

Retaliatory sanctions could reach $4 billion a year and would be targeted towards products ranging from agriculture to jewelry. The EU is expected to begin retaliations early next year.

The WTO's decision is very troubling since the Geneva-based bureaucracy traditionally has focused on removing trade barriers. This attempt to interfere with national tax laws creates a troubling precedent since Europe's welfare states might begin to argue that America's less onerous tax laws somehow represent an "unfair" trade subsidy. On the positive side, however, the EU's attack on US fiscal sovereignty has created an opportunity to make much needed tax reforms that will both boost growth and improve the competitiveness of US-based companies. Congressman Bill Thomas, Chairman of the House Ways & Means Committee, has been the strongest advocate of these reforms, and his bill, H.R. 2896, contains a number of important changes.

Turning Lemonade into Lemons

American policy makers generally believe that the WTO relied on faulty reasoning, but nonetheless intend to comply with the WTO ruling and repeal the FSC-ETI law. The real question is what lawmakers will do with the money - roughly $50 billion over 10 years - that is generated by repealing the existing tax preference. There is a widespread consensus to use the money for business tax relief.

But not all tax cuts are created equal. Some tax provisions - such as the ETI/FSC preferences - have mixed economic effects. They do lower the effective tax rates on some forms of income, which is good, but they also are a form of industrial policy that distorts the efficient allocation of resources, which is bad. To provide unambiguous economic benefits, tax cuts should be designed to lower marginal tax rates on all income - especially types of income that currently are penalized by multiple layers of taxation. Lawmakers also should not tax income that is earned - and already subject to tax - in other nations (the misguided policy known as worldwide taxation) since that prevents US-based companies from competing on a level playing field with companies based in nations with territorial tax systems (the common sense notion of taxing only income earned inside national borders). The current U.S. tax code often double taxes such foreign-source income.

The Committee on Ways and Means' bill that repeals FSC-ETI, is a step in the right direction towards making the U.S. tax code more competitive among our major trading partners (the Chairman's original bill was far better, but that bill had to be watered-down to overcome objections). Key provisions include:

1. A 32 percent corporate tax rate for companies under $20 million of taxable income. The United States currently has the second highest corporate tax rate in the developed world, so ideally this lower rate would apply to all corporate income. But a lower rate for small and mid-sized corporations - or companies with modest profits - is a step in the right direction.
2. More competitive taxation of companies competing in multiple foreign markets. Current law imposes worldwide taxation when the subsidiary of a US-based company in one nation earns income by providing goods or services to a subsidiary in another nation. The Committee bill ameliorates this destructive policy by treating the EU as one nation for purposes of foreign sales and services income.
3. Less onerous allocation of interest expense. U.S. companies that operate globally are required to pretend that some of their domestic interest costs are incurred overseas. This complex provision exacerbates the negative effect of worldwide taxation by making it harder for companies to claim tax credits for taxes paid to foreign governments leading often to increased double taxation of such income.
4. Fewer baskets for foreign tax credits. Currently, U.S. companies are forced to segregate their foreign-source income into nine separate "baskets," and foreign taxes paid on income in one basket cannot be credited against U.S. taxes on foreign-source income in another basket. This policy means the effective tax rate on foreign-source income can be higher than the statutory tax rate in either the United States or the country where the income is earned. The Committee bill reduces the number of baskets to two.
5. Extension of Section 179 expensing. In general, the tax code forces businesses to treat a portion of their investment expenses as if they were taxable income. Section 179 ameliorates this destructive policy by allowing small businesses to immediately deduct - or "expense" - their investment costs when calculating taxable income. This provision was greatly enhanced in the most recent tax cut but is currently scheduled to expire.
6. Corporate AMT reform. The corporate alternative minimum tax is a perverse law that forces companies to recalculate their taxes and pay even more if they are "guilty" of using too many "preferences." Unfortunately, the tax code relies on a grossly inaccurate definition of preferences. The Committee bill mitigates the adverse effect of international tax provisions and Net Operating Losses (NOLs) on the corporate AMT. Furthermore, under an additional provision in the bill, no firm with less than $20 million in gross receipts will be required to even calculate their potential corporate AMT. 97 percent of all firms will be automatically exempt for this tax.
7. Better treatment of "S" corporations. Unlike "C" corporation, "S" corporations are not subject to double taxation. That's the good news. The bad news is that there are restrictions on the number of investors that can be shareholders in a single "S" corporation. The Committee bill eases these senseless restrictions and also reduces the burden of the death tax on owners of "S" corporations.

All of these provisions move tax policy in the right direction. To be sure, not all of the provisions in the bill are desirable - especially when compared to the Chairman's original bill, which provided more pro-growth tax relief and contained more long-term reform. The Committee legislation creates a special 32 percent tax rate for income from manufacturing. This is better than the current ETI/FSC tax preference - which applies only to export-oriented income, but it is inferior to a broader-based rate reduction for all corporate income.

Ultimately, the House and Senate will each pass legislation to comply with the WTO ruling. Ideally, lawmakers should maximize the amount of pro-growth reform when the time comes to reconcile differences between the two pieces of legislation during a conference committee.