The World Trade Organization (WTO) repeatedly has ruled that provisions of U.S. tax law provide an impermissible "export subsidy." The WTO also has ruled that, beginning March 1, the European Union (EU) can impose more than $4 billion of taxes on U.S. exports unless and until these provisions, known as Foreign Sales Corporation and Extraterritorial Income Exclusion (FSC/ETI), are repealed.

While lawmakers understandably are upset that the WTO is interfering with U.S. tax law, this dark cloud does have a silver lining. The FSC/ETI provisions are not good tax policy and the revenue generated by repealing those provisions can be used to finance much-needed changes in tax law. But not all tax cuts are created equal. To improve economic growth and competitiveness, policy makers should make changes that move the tax code closer to a simple, low-rate, consumption-base, territorial system.

Competing Bills

Motivated by the importance of ending the EU tariffs on American exports, Congress is examining three major options. Only two of these choices shift the tax code in the right direction.

1. Corporate tax rate reduction. Senators Don Nickles (R-OK) and John Kyl (R-AZ) have proposed to phase in a 2-percentage point reduction in the corporate income tax. This initiative is extremely attractive because it simultaneously lowers tax rates and reduces the double taxation of capital income.

International competitiveness is one of the strongest arguments for corporate rate reduction. The United States now has the second high corporate tax rate in the world, second only to Japan. America's corporate tax rate is higher than the rate in every European nation - even socialist welfare states like France and Sweden. This creates a significant competitive disadvantage for U.S.-based companies.

But even if the United States were the world's only nation, the corporate tax rate should be reduced. The CBO recently acknowledged that, "Marginal tax rates (the tax rate on another increment of income) are the rates critical to influencing growth and efficiency." Not surprisingly, CBO chose corporate rate reduction over a manufacturing tax preference, writing that, "In terms of economic efficiency, the proposed across-the-board 2 percentage- point rate cut is superior … It would not have the distortions associated with favoring exports, domestic production, or manufacturing. In addition, it would lessen all of the distortions associated with the corporate income tax."

2. International tax reform. The House Ways & Means Committee has a bill that seeks to mitigate the anti-competitive impact of America's worldwide tax system. This approach is very desirable since the current practice of imposing U.S. taxes on income earned in other nations is bad tax policy and makes it difficult for American-based companies to compete on a level playing field.

Worldwide taxation subjects U.S. companies to higher tax rates than those paid by companies based in other nations. For example, an American-based company competing in Ireland is at a disadvantage since its profits are subject to the 35 percent U.S. corporate income tax in addition to Ireland's 12.5 percent corporate tax. The U.S. company generally can claim a credit for the taxes paid to Ireland, so the overall tax rate on Irish-source income should not exceed 35 percent. But this still means that the U.S. firm pays nearly three times as much in taxes as companies based in other nations, most of which have territorial tax systems.

The Ways & Means tax bill has a number of important reforms that move the tax code toward territorial taxation. The onerous tax that is imposed when a U.S. subsidiary in one foreign country sells to a U.S. subsidiary in another foreign country would be reduced. Another positive reform is the amelioration of interest expense allocation, a policy that requires companies to pretend some interest costs are incurred overseas, thereby resulting in higher tax burdens.

3. Manufacturing tax preference. The Senate Finance Committee has produced a bill that replaces the existing FSC/ETI preference for export-oriented income with a preference for income derived from manufacturing. This idea, which also has support from a largely Democratic group of members in the House, does not move tax policy in the right direction and would make the tax code more complex.

Proponents of the manufacturing preference generally are trying to achieve something desirable - a reduction in the tax burden on U.S. production. But good intentions are not the same as good policy. The tax code already is riddled with special preference and penalties that distort economic behavior. Lawmakers should be reducing social engineering, not making the problem worse. America will be much stronger if taxpayers make decisions based on economic factors, not tax considerations.

The manufacturing preference also would create high compliance costs, as can be seen from this sentence describing the provision: "It allows a deduction from a firm's taxable income equal to 9 percent of the firm's net income from qualified domestic production multiplied by the ratio of the value added from the firm's domestic production to the total value added by the firm worldwide." While nearly indecipherable, this sentence means that U.S. companies would pay higher taxes if they successfully compete in foreign markets. Needless to say, this is precisely the wrong approach to take in today's global economy.

Why FSC/ETI should be repealed

By creating a special tax rate for a specific activity - producing for the export market - the FSC/ETI provisions artificially alter the allocation of productive investment. This is a form of industrial policy. As the Congressional Budget Office (CBO) recently noted:

If taxes are imposed on one sector and not another, however, resources will be directed to the tax-favored industries. The results will be a contraction in the ac­tivity of those industries that are not favored and an expansion of the activity of those that are. Those …unequal before-tax returns mean that the allocation of capital is inefficient.

In other words, economic growth is maximized when market incentives influence economic choices. Special tax preferences, by contrast, distort economic choices and cause a reduction in the economy's performance. The FSC/ETI provision should be repealed for a number of reasons, including the fact that it is bad tax policy and the need to put an end to the taxes that the EU has imposed on U.S. exports. But the biggest reason to repeal the FSC/ETI tax preference is that lawmakers can use the money - more than $50 billion over a 10-year period - to make much needed changes in tax law.

Guidelines for incremental tax reform

The tax code is littered with bad provisions. The good news, so to speak, is that lawmakers seeking to improve the tax system therefore have an abundance of options to pursue. As long as a particular reform satisfies one or more of the following options, it is a step in the right direction.

• Does it lower tax rates? This is important because high tax rates discourage productive behavior.
• Does it reduce the tax bias against saving and investment? This is important since capital formation is the key to long-run growth.
• Does it simplify the tax system? This is important because complexity imposes enormous compliance costs on the economy.
• Does it satisfy the common-sense principle of territorial taxation? This is important since governments should only tax income earned inside national borders.
• Does it treat all economic activities in a neutral fashion? This is important because government should not use the tax code for industrial policy.

Conclusion

Lawmakers have two attractive options for replacing FSC/ETI. Lowering the corporate income tax rate would boost economic growth and enhance U.S. competitiveness. Indeed, a 2-percentage point reduction should be viewed as just the beginning. As the CBO wrote, "The inefficiency generated by the corporate income tax is large relative to the revenue it raises, and even small changes in the corporate tax rate can reduce that inefficiency substantially."

Shifting toward a territorial tax system also would improve the U.S. economy and increase competitiveness. America's policy of worldwide taxation arguably is the worst system in the world. The former Chairman of the Council of Economic Advisers, Glenn Hubbard, noted that, "from an income tax perspective, the United States has become one of the least attractive industrial countries in which to locate the headquarters of a multinational corporation."

Creating a special tax preference for manufacturing, by contrast, is not good tax policy. Supporters of this proposal have a good motive - reducing the tax burden on U.S.-based production - but government should not be in the business of picking winners and losers through the tax system. If lawmakers want to adopt changes that are both consistent with good tax policy and disproportionately beneficial to manufacturing, there are other options. They could, for instance, replace depreciation with expensing, a reform that would significantly lower the tax burden on capital formation.

The EU should not have attacked America's FSC/ETI law, and the WTO should not have ruled in their favor. By imposing tariffs, the EU risks an escalating trade war that will hurt all nations. Fortunately, U.S. policymakers can solve this predicament by doing something - corporate rate reduction or international tax reform - that would be worth doing even in the absence of the WTO's misguided decision.

Daniel J. Mitchell is McKenna Senior Fellow in Political Economy at The Heritage Foundation.