The international effects of the adoption of a consumption tax in the United States.

AuthorMcMahan, Matthew

ABSTRACT

This Note concludes that through the adoption of a consumption tax the United States will benefit from both short- and long-term gains. This Note presents the advantages of consumption taxes and where relevant, discusses a specific consumption tax proposal--the Fairtax Plan. The Author responds to several critiques of consumption taxation, including whether consumption taxes are disproportionately placed on labor, the existence of efficiency gains, the international effects, increased black market activity, and cross-border tax arbitrage.

TABLE OF CONTENTS I. INTRODUCTION II. OVERVIEW OF SOME PERTINENT INTERNATIONAL TAX ISSUES A. Relevant Background B. WTO Rules III. INEFFICIENT MARKETS IV. NEEDED CHANGE? A CONSUMPTION ALTERNATIVE V. CRITICISMS OF CONSUMPTION TAXES AT THE INTERNATIONAL LEVEL A. Consumption Taxation may be Unfairly Biased Toward Immobile Sources B. Are Efficiency Gains a Myth? C. World Reaction 1. Foreign Response: Potential Effect on Tax Treaties 2. Foreign Response: Foreign Changes at the Domestic Level D. Avoidance 1. Black Market VI. CONCLUSION I. INTRODUCTION

Historically, national governments structured their tax systems without accounting for international investment levels. Until recently, tax regimes were, by and large, a purely domestic issue, but as increased globalization dissolved barriers to free capital flows, the concerns of tax policy changed. (1) Modern advances in areas such as transportation and communication have helped free capital, an important part of any government's tax base, from its geographical roots. For instance, between 1973 and 1995, global capital transfers increased by a multiple of eighty. (2) The increasingly vast resources involved in the global market required a new understanding of tax policy.

As the prior century progressed, new technologies spurred policy changes worldwide, increasing the opportunities to invest abroad. (3) The Industrial Revolution led to advances in transportation technology, such as the railroad, spurring economic growth and increasing "incentives for capital formation, industrial concentration, international specialization, and for labor and capital migration." (4) Beginning in the 1970s, developed countries instituted policies that led to the drastic reduction of limitations on the international flow of capital. (5) Developing countries have changed their policies even more drastically; once suspicious of foreign investment, most developing nations currently view foreign investment as beneficial. (6) Changes in legislation continue to show an emphatic favoring of foreign investment: 93% of legislation in 2001 affecting international investment created more favorable conditions for investing. (7)

Increasingly mobile capital has raised concerns with some critics over the continued ability of governments to use traditional means of taxation. (8) Economic studies confirm that the combination of globalization, domestic economic stress, and budgetary imperatives have led to reductions in worldwide tax rates on capital. (9) For example, as of April 2005, nine countries in Eastern Europe made themselves more attractive to global investment by lowering the rate of taxation on capital as part of a transition to a flat tax. (10) Lower tax rates on capital concern critics, such as Avi-Yonah, who worry that decreasing tax rates will lower government revenues, thereby constraining social expenditures that they deem beneficial. (11) Taxes on capital, however, create inefficiencies in capital accumulation and raise the relative price, and thereby reduce demand. Thus, this Note rejects the Avi-Yonah type concerns over tax competition and contends instead that the need for economic efficiency outweighs concerns about the ability of governments to maintain high levels of expenditures. (12)

The lowering of taxes on capital is a form of global tax competition, an issue which ties into a longstanding debate in the United States over whether the federal government should continue to use an income tax or adopt any of a variety of consumption tax proposals. (13) Under most consumption tax proposals seriously considered by Congress, capital is either lightly taxed or not taxed at all. (14) Compared to the current tax code--which taxes corporate capital returns at 35%--exempting such income, as this Note proposes, would be significant. (15) No major economy completely exempts investment from taxation, (16) and the adoption of such a policy by an economy the size of the United States has the potential to dramatically raise the level of tax competition.

With the advent of the global economy and increased tax competition, corporations and other investors use geographically fungible capital to lower their tax liabilities by moving their investments to low tax areas. (17) The potential for capital flight imposes constraints on the level of taxation, which, in turn, imposes fiscal discipline on governments. (18) Several normative economic studies have shown that the optimal tax rate on capital is zero, whereas the optimal tax rate on labor is positive, suggesting that the identifiable reduction of taxes on capital, through by tax competition, would provide worldwide benefits. (19) Discipline also may lead to reduced inefficiencies by forcing governments to streamline their tax systems. (20) Furthermore, in a more efficient market, investment will be allocated more productively, leading to worldwide welfare benefits in the long run. (21)

The thesis of this Note is that, should the United States replace its current tax system with a consumption tax, global benefits would outweigh global costs. Although the tax reform literature is thick, by concentrating on the international effects of a consumption tax, this Note takes a less traveled path. This Note makes an additional contribution by focusing on House Resolution 2525, nicknamed the "Fairtax Plan" by its supporters. The Fairtax Plan is a national sales tax proposal. It is an economically neutral non-cascading sales tax, under which only new goods and services are taxed. (22) The tax literature has not fully examined the Fairtax Plan, and this Note is an attempt to give a more complete analysis of the costs and benefits. This Note concludes that the adoption of a national sales tax will result in drastic change in international tax regimes and the global economy by lessening distortions and facilitating the efficient flow of international savings and investment.

Although this Note offers a solution to inefficiencies created by the current international system for taxing international flows of savings and investment, it recognizes that adoption of a consumption tax has tradeoffs, including a failure to remove cross-border arbitrage, thereby creating potential incentives to international organized crime. Furthermore, this Note recognizes that valid non-economic domestic concerns exist and, while not addressed in this Note, should be considered along with the potential adoption of a consumption tax.

Part II of this Note provides an overview of the international taxation of investment. This Part investigates basic concepts in international taxation and further develops the discussion of international tax competition. Part III describes the current international system and highlights the mass of inefficiencies and the need for radical reform. Part IV describes the benefits of consumption taxes, introducing the two dominant consumption tax systems and the relevant advantages of the Fairtax Plan. Because the Fairtax Plan has many of the general attributes of consumption taxation, this Note first addresses the attributes that the Fairtax Plan has in common with consumption tax plans. Finally, Part V addresses the critiques of consumption taxes and answers these critiques through the lens of the Fairtax Plan. This Part demonstrates how the criticisms of consumption taxes have been overstated

  1. OVERVIEW OF SOME PERTINENT INTERNATIONAL TAX ISSUES

    1. Relevant Background

      World taxation systems can be separated into two generic groupings: territorial systems and worldwide residence systems. (23) Under a territorial system, income produced outside a country is not taxed. (24) Tax systems like the U.S. tax regime are based on worldwide residence. Thus, income earned by tax citizens, permanent residents, and corporations is taxed regardless of where it is earned. (25) Potential double taxation is addressed by either allowing a deduction or credit based on the amount of foreign taxes paid. (26) The United States gives domestic investors the option to choose to take either a tax credit or a deduction on foreign taxes paid. (27) Deductions and credits are limited. (28) If no limitations were in place, foreign nations could charge high taxes with the expectation that the U.S. government would reimburse U.S. corporations. (29)

      Processes to relieve double taxation of international investment create incentives to manipulate the tax system, minimizing taxable income. Corporations, within limits, can decrease their tax liability by misclassifying income earned domestically as income produced by foreign sources. (30) For example, the limit of foreign tax credits can be increased by reclassifying income earned from the domestic production of export goods as foreign-source income. (31) Also, by transferring income to lower tax countries, total tax liability can be reduced. (32) For example, evidence indicates that corporations use transfer pricing to take advantage of Ireland's low tax rates, which provides significant tax savings. (33) Tax liability can also be reduced by manipulating interest-expense deductions. (34) Manipulation occurs when money is borrowed for a foreign business investment in foreign jurisdictions that do not allow the deduction of loan interest. (35) Because the United States allows the deduction of business loans, investors are incentivized to minimize their tax liability by shifting the loan...

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