The U.S. Tax Treatment of Foreign Source Income Earned in Developing Countries: A Policy Analysis

Abstract

The purpose of this Article is to explore whether the United States should amend its international tax rules in ways that might encourage U.S. companies to invest in developing countries. Some scholars, notably Professor Karen Brown, have argued that the current U.S. international tax regime works against the interests of developing countries and should be replaced by one that, she asserts, would benefit developing countries in general and African nations in particular.1 She has proposed that the United States replace its foreign tax credit mechanism with an exemption system for developing countries, at the least for Africa. One of the reasons for the proposal is that, as explained below, the current U.S. system prevents developing countries from offering tax incentives, such as tax holidays, to attract foreign direct investment (FDI) by U.S. multinational corporations (MNCs). Certainly, it is the case that little U.S. FDI finds its way to developing countries. At the end of 2001, total U.S.-owner assets earned abroad totaled $6.2 trillion (valued at cost). But the following shows how little of these assets were in developing countries (in $ billions):2 There is thus a real shortfall in U.S. FDI in developing countries as compared to its FDI in other developed countries. But, proposals such as the one put forward by Professor Brown raise several questions. Is FDI an unqualified good for developing countries? What are the determinants in the location of FDI? Are tax incentives offered by developing countries effective in attracting FDI, even in situations where home country tax rules do not thwart them? Can tax incentives alone attract FDI or are there necessary preconditions a developing country must satisfy before there is FDI at all? Are home country unilateral tax incentives effective in increasing FDI by its MNCs? Is it better for developed countries to assist developing countries by offering tax subsidies to its MNCs or by providing direct financial assistance to developing countries? This paper is an effort to explore these questions to see where the evidence supports clear answers and where it is inconclusive. Part I of this Article provides a broad overview of international tax systems, which countries can adopt, with particular attention to aspects of the system adopted by the United States. Part II examines how, and under what circumstances, the current U.S. system defeats the objectives of developing countries in offering tax holidays to U.S. MNCs. It then proposes a structural solution that would address the problem in the context of the ciirrent system. It is, of course, possible that the proposal would not be acceptable to the U.S. Treasury or to developing countries in general. Thus, the remainder of this Article examines Professor Brown's proposal and others that might be considered in meeting the objectives of increasing the FDI of U.S. MNCs in developing countries. Part III identifies the economic, social, and political factors and forces that adversely affect developing countries. The purpose of this discussion is to lay the groundwork for an assessment of whether particular tax changes by the United States would positively impact these forces and factors. Part III also examines recent reports by the United Nations (U.N.) and the Organization for Economic Cooperation and Development (OECD) that analyze the level and means by which developed countries can aid developing countries. Particular attention will be paid to the role of FDI in these analyses. Part IV reviews the economic evidence on the impact of tax policies on the level and location of FDI. Part V accesses several different changes in the U.S. international tax system in terms of their efficiency and simplicity effects and in terms of their effectiveness in meeting the problems identified in Part III. A concluding section sets forth my own policy conclusions. I. INTERNATIONAL TAX REGIMES: AN OVERVIEW All countries must have some system by which they apply their income tax to cross-border business and investment transitions by their own nationals. …