Upset that local insurance companies are facing what they feel to be unfair competition, Representatives Nancy Johnson (R-CT) and Richard Neal (D-MA) have proposed legislation that would impose additional taxes on the U.S. subsidiaries of insurance companies based in low-tax jurisdictions.

The legislation, H.R. 1755, is based on the premise that it is unfair for companies from low-tax jurisdictions to compete with companies from high-tax jurisdictions. It specifies that the discriminatory tax on reinsurance premiums "shall not apply" if the reinsurer is based in a jurisdiction that has an effective income tax rate of at least 7 percent.

Yet because the United States is a low-tax jurisdiction compared with other industrialized nations, the Johnson-Neal legislation creates a dangerous precedent. If H.R. 1755 is enacted, high-tax European countries likely would use the same approach to create trade barriers and impose discriminatory taxes against U.S. companies operating overseas.

Instead of sliding into fiscal protectionism, policymakers should reform U. S. corporate income tax policy. American companies currently are subject to U.S. tax on profits they earn overseas. This "worldwide" approach makes it hard for U.S.-based companies to compete for business in low-tax environments. A foreign company may pay a tax of only 10 percent on income earned in a low-tax nation, for instance, but a U.S. multinational would have to pay 35 percent (10 percent to the host government and 25 percent to the Internal Revenue Service). A "territorial" tax system, by contrast, would eliminate this disadvantage because it is based on the common-sense notion that governments tax only income earned inside their borders.

H.R. 1755¹ is contrary to the principles of fair competition, open trade, and international comity. If enacted, it would lead to higher premium costs for insurance consumers. And since the legislation would impose a tax on the premiums that certain insurance companies pay to purchase "reinsurance," the ultimate effect would be to hinder the insurance industry's ability to spread risk.² As a result, in the event of natural disaster, there might not be sufficient assets available to pay benefits.

Fiscal Protectionism

The tax treatment of insurance company subsidiaries may not seem important, but how lawmakers deal with this issue may have enormous implications. Acting at the behest of high-tax nations, international bureaucracies such as the Organization for Economic Cooperation and Development (OECD),³ European Union (EU),⁴ and United Nations (UN)⁵ are seeking to undermine tax competition among countries. These efforts to harmonize tax systems--either directly or by using the back-door tactic of "information exchange"--would insulate governments and deny taxpayers the benefits of competition and globalization.

Tax competition is a liberalizing force in the world economy. Tax rate reductions in one country boost economic performance, and as a result, other nations are pressured to move in the same direction. The Reagan tax rate reductions in the 1980s, for instance, triggered a global revolution of lower tax rates. Tax competition also can work inside a country. States like Florida, Nevada, New Hampshire, and Texas have relatively low tax burdens, for instance, and this has helped them grow faster and create more jobs than high-tax states like New York and California. This encourages state policymakers to adopt more growth-oriented fiscal policies.

The fact that the tax system in some states or nations is more attractive than the tax system in other states or nations is not an argument for protectionist barriers at the border. And it certainly is not an argument for a high-tax jurisdiction to impose taxes on income earned in a low-tax jurisdiction or to impose special taxes on the products of companies that are based in states or nations with more attractive tax systems.

H.R. 1755, however, essentially would rewrite the rules of international taxation to impose U.S. taxes on income that foreign-based companies earn outside the United States. But, since the IRS does not have the authority to tax the foreign income of foreign taxpayers, the legislation would impose a discriminatory tax on their U.S.- based subsidiaries.

More specifically, the legislation says that the premiums insurance companies pay to purchase reinsurance from a company based in a low-tax jurisdiction would be treated as taxable income. But if the reinsurance was purchased in America or from a non-U.S. company based in a jurisdiction with an "effective rate of income tax" of at least 7 percent, the premium would be deductible and therefore not included in taxable income.

This approach is fundamentally flawed. Specifically, it represents:

• Bad tax policy. Legislation that discriminates against low-tax nations is blatantly unfair and undermines the principles of good tax policy. It seeks, albeit indirectly, to tax the foreign income of a foreign taxpayer. It forces targeted companies to pay tax on selected business expenses in addition to the tax on annual profits. Most important, it is based on the notion that low levels of taxation somehow are bad.
  
• Bad trade policy. Protectionism usually occurs when a tax, a quota, or some other limitation is placed on goods and services from another nation. The Johnson-Neal legislation actually imposes the protectionist barrier inside the United States by subjecting certain U.S.-based subsidiaries of foreign-owned insurance companies to an extra tax. This trade barrier is especially misguided since the tax is triggered when the parent company is headquartered in a low-tax jurisdiction.
  
• Bad sovereignty policy. Nations should not try to impose their laws on other countries. Nor should they feel compelled to put the laws of other countries above their own. And they certainly should not try to impose taxes on income earned outside their borders. Yet H.R. 1755, for all intents and purposes, seeks to tax the income that foreign companies earn overseas. This approach invites fiscal conflict among nations and encourages politicians to meddle in the domestic affairs of other nations.
  
• Bad insurance policy. Reinsurance allows insurance companies to spread risk and obtain the financial backing needed to pay claims. This ability is particularly important in the event of emergencies such as hurricanes, tornadoes, and floods. But this market will be hampered if politicians create protectionist barriers so that insurance companies cannot purchase the most attractive reinsurance policies. At best, consumers will have to pay higher premiums. The Risk and Insurance Management Society, which includes more than 80 percent of Fortune 500 companies, states that H.R. 1755 "would undermine and disrupt" the reinsurance market and "could prove devastating for businesses worldwide."⁶

Dangerous Precedent

Perhaps the worst feature of the Johnson-Neal legislation is that it would create a precedent that surely would undermine America's economic interests. The United States does not have the world's best tax system, but America is a fiscal Mecca compared to many of Europe's welfare states. Indeed, its relatively modest tax burden often gives U.S. companies an advantage when competing in the global economy.

Consider, though, what would happen if supporters of H.R. 1755 succeeded in imposing extra taxes on the U.S. subsidiaries of companies based in low-tax jurisdictions. Once that approach became acceptable, it would not take very long for high-tax governments in Europe to assert the right to impose additional taxes on the foreign subsidiaries of successful U.S.-based companies such as Microsoft, Boeing, and General Electric. Politicians in these countries could argue that America's relatively low tax burden creates an "unfair" advantage.

Anti-Bermuda Legislation?

While the Johnson-Neal legislation applies to any U.S. subsidiary of an insurance company based in a low-tax jurisdiction, its main target is Bermuda.⁷ Supporters of the bill say that this British territory's lack of a corporate income tax gives Bermuda-based companies an "unwarranted tax benefit." With no personal or corporate income tax, Bermuda certainly has a very attractive tax system. This market-friendly tax regime has paid big dividends, and Bermuda is now the world's third richest economy and locus of a vibrant insurance industry.⁸

But the absence of an income tax is not a form of unfair competition. An "unwarranted tax benefit" occurs when a particular industry or company receives a special exemption or preference, not when an entire economy gets to enjoy a favorable fiscal environment. Bermuda's laissez-faire tax system gives Bermuda-based companies an advantage over U.S.-based companies, but this fact should be used as an argument for lowering taxes in America, not raising taxes in Bermuda.

It also is misleading to argue that Bermuda's competitive insurance sector is a creation of the tax system. Yes, the tax system is attractive, but the island has become the world's third largest insurance center for a number of reasons, including workforce quality, lack of onerous regulation, and a more rational legal system.

The Answer: Territorial Taxation

Instead of seeking to impose bad U.S. law, policymakers should enact tax reforms that make American companies more competitive. To this end, Secretary of the Treasury Paul O'Neill has argued that the U.S. corporate income tax should be repealed.⁹ This single step would put American companies on an even footing with companies from Bermuda and other low-tax jurisdictions.

Such a radical step may not be politically feasible any time soon, but there are other options that could significantly improve the ability of American companies to compete overseas. Most important, policymakers could junk the current practice of taxing U.S. corporations on their worldwide income and instead tax companies only on the income they earn in America. This approach, known as territorial taxation, would allow U.S.-based companies to compete more effectively with businesses from low-tax nations.

Worldwide taxation of business puts U.S. companies at a disadvantage when competing in a low-tax jurisdiction because the foreign income they earn is subject to the 35 percent U.S. corporate tax rate. American companies are allowed to subtract any foreign tax liability from their U.S. tax bill, but these credits can do no more than keep the total tax burden from climbing above 35 percent. It is also true that, in some instances, U.S. tax can be delayed until the income is repatriated to America, but the tax must still be paid when that occurs.

The Negative Impact of Worldwide Taxation

As an example of the anti-competitive impact of worldwide taxation, consider the following case of a hypothetical jurisdiction, Lowtaxland, with a 10 percent corporate tax rate. Suppose that there are three companies competing in that jurisdiction: an American company, a local company, and a company from Holland--a nation with a territorial tax system.

As Table 1 indicates, the U.S. company pays a 35 percent tax on its profits, 10 percent to the host government and 25 percent to the IRS (the 35 percent U.S. rate minus a credit for the 10 percent tax imposed by the government of the country in which the income was earned). In contrast, the locally based company and the Dutch company lose only 10 percent of their profits to taxes. In other words, America's worldwide taxation of corporate income creates a disadvantage for U.S. companies.

Advantages of a Territorial Tax System

Shifting to territorial taxation creates a level playing field for U.S. companies. In effect, the U.S. company in the previous example would be treated the same as the Dutch company. But territorial taxation also has other advantages. Perhaps most important, it would result in dramatic simplification of the tax code.

Worldwide taxation requires a company to declare foreign income to the IRS. The company then has to provide all the paperwork showing taxes paid to other jurisdictions so it can claim foreign tax credits. The net result is that the IRS does not collect much money (since tax burdens in most other countries are higher than they are in America, foreign tax credits often eliminate any liability to the IRS), but the company endures significant compliance costs for the time and expense of lawyers and accountants.

Territorial taxation is good economic policy and consistent with fundamental tax reform, but there are also two other reasons why shifting to a territorial system might appeal to lawmakers.

• The World Trade Organization has ruled that America's favorable tax treatment of income generated by overseas sales is an improper export subsidy.¹⁰ There are only three realistic responses to this decision. First, U.S. lawmakers could repeal the relevant portion of the Internal Revenue Code, thereby imposing a large tax increase on America's export-oriented companies. Second, lawmakers could do nothing, a step that would allow the European Union to impose $4 billion of additional import taxes on American products. The final option--and the only one that does not harm the U.S. economy--is to junk worldwide taxation and shift to a territorial system.
  
• America's system of worldwide taxation is driving companies overseas. To remain competitive, a growing number of U.S. firms are reorganizing overseas. For example, Accenture, the management and technology consulting firm formerly known as Andersen Consulting, recently incorporated in Bermuda and maintains an operating company in Luxembourg.¹¹ Insurance companies such as Everest Re Group, Ltd., and Trenwick Group, Ltd., have moved to Bermuda, as has the Foster Wheeler Corporation, a major manufacturer.¹²

Similarly, Fruit of the Loom reorganized in the Cayman Islands a couple of years ago,¹³ and it is increasingly common for investment funds to set up headquarters outside the United States to avoid high U.S. taxes and onerous domestic regulations. America's anti-competitive worldwide tax system was also a major reason why the headquarters were located in Germany instead of Detroit when Daimler and Chrysler merged. While no single step would halt this exodus, territorial taxation would dramatically reduce the tax incentives for U.S. companies to move their headquarters to other nations.

American companies would be more effective competitors with territorial taxation. Without the millstone of worldwide taxation, U.S. firms would have little reason to move to other jurisdictions. Their costs would be lower, and their ability to focus on providing better products at better prices would be enhanced.

Other Possible Reforms

While territorial taxation would substantially improve the competitiveness of U.S. companies, other incremental reforms in the system are also possible. Instead of seeking to impose protectionist barriers, such as those contained in H.R. 1755, lawmakers should consider the following options:

• Lowering the corporate income tax rate. The U.S. corporate tax rate of 35 percent is above average for industrialized nations and even exceeds the corporate tax rate in such countries as Sweden and France. Reducing the tax rate imposed on U.S. companies would improve their ability to compete, both in America and abroad.
  
• Eliminating the double tax on dividend income. In addition to a high corporate tax rate, the income of U.S. businesses is subject to a second layer of tax when distributed to individual shareholders. Since no income should be subjected to double taxation, this tax on dividend income should be repealed. This reform would stimulate greater investment and strengthen the competitive position of U.S. companies.
  
• Replacing depreciation with expensing. The damage caused by high tax rates and double taxation is compounded by a system of depreciation accounting that forces businesses to overstate their profits. Under current tax law, businesses are not allowed to deduct most investment costs in the year they occur. As a result of this policy, some investment expenses are treated as taxable income. This system of depreciation should be replaced by immediate expensing, whereby businesses would be allowed to subtract total costs from total income when calculating taxable profit.
  
• Repealing the alternative minimum tax. Adding insult to injury, U.S. companies are also subject to a quirk in the tax code that forces them to understate their costs when income falls. This provision, known as the alternative minimum tax, is particularly damaging because it is most likely to take effect during an economic downturn. Repealing this perverse tax would also reduce compliance costs and allow companies to use human capital for productive purposes.

A number of changes in the individual income tax also would help American companies compete more effectively. These reforms include eliminating the capital gains tax and allowing unlimited expansion of IRAs. Both of these policies would encourage greater savings and investment, thereby providing U.S. businesses the capital needed to be more productive. Lower individual income tax rates would also boost the competitiveness of U.S. companies, particularly since the vast majority of American businesses are unincorporated and pay taxes using the personal income tax laws.

Why Tax Competition Should be Encouraged

The Johnson-Neal legislation is a microcosm of a much larger issue. Politicians from high-tax nations complain that it is unfair when jobs, capital, and entrepreneurial talent migrate to low-tax jurisdictions. But economists argue that tax competition helps control the size and scope of government and therefore is a liberalizing force in the world economy.

Nations that pursue market-oriented policies enjoy faster growth and more prosperity, while misguided tax policies undermine a country's competitiveness.¹⁴ Many of Europe's welfare states, for instance, suffer from high unemployment rates and anemic growth rates because of oppressive tax burdens and other policies that hinder private-sector wealth creation. The harmful impact of excessive tax rates is particularly evident in today's global economy, since it is increasingly easy for investors and entrepreneurs to shift jobs and capital to lower-tax environments.

Tax competition is very beneficial to the U.S. economy.¹⁵ America's tax burden is relatively low compared to other industrialized nations. This, combined with the fact that foreigners enjoy extremely favorable tax treatment and privacy protection when they invest money in the United States,16 explains why America attracts so much foreign capital and has one of the world's strongest economies.

More important, tax competition is very beneficial to taxpayers, as is evident from tax rate reductions that have occurred in the past two decades. President Ronald Reagan's across-the-board income tax rate reductions in the 1980s reduced the top individual rate from 70 percent to 28 percent (which was later raised to 39.6 percent and is now scheduled to fall to 35 percent). The top corporate tax rate was also dramatically reduced from 46 percent to 34 percent (since raised to 35 percent). As the accompanying charts indicate, the tax rate reductions implemented by President Reagan triggered a global tax reduction revolution.

The top individual income tax rates imposed by central governments¹⁷ in other industrialized nations have dropped by nearly 16 percentage points since 1980, according to the Organization for Economic Cooperation and Development.¹⁸ This trend is clear evidence of the positive effects of tax competition. Other nations were forced to lower tax rates, not because their politicians necessarily understood that low tax rates improve economic performance, but because they realized that jobs, capital, and entrepreneurial talent would escape to America.

Corporate income tax rates of other industrial nations have also been significantly reduced since 1980. Once again, the Reagan reductions were the driving force. As shown in Chart 2, tax competition with the United States pressured other countries to lower their corporate tax rates. Indeed, tax competition continues to impose fiscal discipline. As recently as last year, Germany announced major reductions in corporate tax rates, and many other European nations are planning similar reductions.

An Attack on Tax Competition

Not surprisingly, politicians from high-tax nations want to stop tax competition. Using international bureaucracies like the Organization for Economic Cooperation and Development, the United Nations, and the European Union, they are trying to "harmonize" taxes so that individuals and businesses will find it difficult to shift economic activity to low-tax jurisdictions. There are two ways to achieve this goal: direct and indirect tax harmonization.

• Direct tax harmonization occurs when all countries have similar tax rates. When tax rates are explicitly harmonized, investors are unable to boost after-tax income by shifting economic activity to another jurisdiction. Nations that belong to the European Union, for instance, must have a value-added tax (VAT) of at least 15 percent, and the Brussels-based bureaucracy is seeking to impose similar minimum tax requirements on corporate income and energy. As one might suspect, advocates of tax harmonization always seek to equalize tax rates at high levels rather than low levels. The EU even went so far as to condemn Ireland for its supply-side tax reduction policies.¹⁹ Countries like France, by contrast, are never criticized for their oppressive tax regimes.
  
• Indirect tax harmonization occurs when a government is able to tax its citizens and residents on the income they earn in other nations. This back-door version of tax harmonization involves a system of "information exchange" through which nations are expected to collect and share private information about any income earned inside their borders by foreigners. This process enables a high-tax country to impose its tax rates on the worldwide income of its residents. As a result, a taxpayer has little opportunity to shift economic activity to lower-tax jurisdictions. An overburdened French taxpayer, for example, would have scant incentive to shift money to a lower-tax jurisdiction if France is able to tax any resulting income at French tax rates. Information exchange almost always is a one-way street, since residents of low-tax jurisdictions rarely invest in high-tax regimes and low-tax nations usually do not try to impose their taxes on income earned outside their borders.

The Bush Administration quite properly is resisting the OECD, EU, and UN tax harmonization initiatives. That is the good news. The bad news is that the United States taxes worldwide income, both for individuals and businesses. This policy has resulted in some degree of support for information exchange--even if it means forcing low-tax nations to put the laws of other countries above their own.

This indirect form of tax harmonization should be rejected. It is bad tax policy, bad privacy policy, and bad sovereignty policy. It is also contrary to America's national interests. As the world's largest tax haven,²⁰ the United States is the principal beneficiary of tax competition.

Conclusion

Parochial protectionist legislation is the wrong way to respond to the challenge of competition. Protectionist tax legislation such as H.R. 1755 does not serve America's interests. Indeed, this shortsighted approach is particularly dangerous because of the impact it would have on other international tax issues. The Bush Administration deserves praise for giving the OECD's "harmful tax competition" initiative a chilly reception, but it is uncertain whether the White House and the Treasury Department will have the moral authority to reject misguided bureaucratic initiatives from overseas if Congress can undermine tax competition anytime a hometown company faces a challenge from overseas.

Tax competition should be celebrated rather than penalized--even in those rare cases in which the United States has a less attractive tax system. Members of Congress who are concerned that U.S. tax law is making American companies uncompetitive should seek to change the law instead of trying to broaden its reach. Short of repealing the corporate income tax, a system of territorial taxation is the best way to help U.S.-based companies compete around the world. It is an approach that would benefit taxpayers, companies, and consumers.

Daniel J. Mitchell, Ph.D., is the McKenna Senior Fellow in Political Economy at The Heritage Foundation.