Trade policy is a complicated subject. Tax policy isn’t any easier. When the two get mixed together, they become almost impossible to resolve as Congress has proven over the last two years trying to rewrite tax laws on Foreign Sales Corporations/Extraterritorial Income (FCS/ETI) that the WTO has held are impermissible export subsidies. But the irreconcilable must be reconciled if trade agreements are to mean anything over the long term.
The issues started out rather simply. In 1960, yes 44 years ago, a GATT Working Party (General Agreement on Tariffs and Trade, the predecessor to the World Trade Organization) ruled that indirect taxes are adjustable at the border, while direct taxes were not border adjustable. The value-added taxes used by countries in the European Union are border adjustable (taxes are rebated on exports and imports are taxed), while U.S. income taxes are not border adjustable. By one estimate, today, EU export companies save as much as $100 billion a year in taxes.
In 1971 the U.S. created Domestic International Sales Corporations (DISC) that were allowed to defer taxes on export earnings. The EU (then called the EC for European Community) challenged the DISC in 1974. Tax disputes were part of the discussions in the Tokyo round of GATT negotiations. Based on that outcome, in 1984 the U.S. repealed the DISC and replaced it with the Foreign Sales Corporation (FSC) that allowed U.S. companies to establish subsidiaries off shore to avoid U.S. taxes.
Life was good until 1999 when the EU challenged the FSC under the Uruguay Round Code on Subsidies & countervailing duties. Keep in mind that the Uruguay Round resulted in the GATT becoming the WTO in 1994. In October of 1999 a WTO panel ruled that FSC is a prohibited export subsidy, and in February 2000 a WTO Appellate body concurred. In December of 2000, Congress passed and President Clinton signed the Extraterritorial Income Exclusion Act that excluded from the definition of income certain foreign source incomes.
The EU believed that the ETI also was not consistent with the WTO agreement. They took their case to the WTO, and a dispute panel ruled in August 2001 that the ETI income exclusions were impermissible. In January 2002, a WTO Appellate Body concurred that the ETI constituted a prohibited export subsidy. In August of 2002 the WTO ruled that the EU could impose $4 billion of sanctions against U.S. products.
As is true with all WTO rulings, the U.S. can either change the law or face import tariffs on items entering into the EU. After the EU delayed action, hoping that Congress would change the law, they began assessing a 5 percent tariff on selected items in March of this year. The tariff rate increases by 1 percent per month until it reaches 17 percent in March of 2005.
Congress could simply refuse to change the law and allow the tariffs to remain in place. The EU has chosen to take that approach in the beef hormone dispute that has dragged on for years. The WTO cannot force a country to change domestic policy, nor should it have that power. Each WTO country is a sovereign nation with the right to set its own domestic policies.
While each country has the right to refuse to comply with a dispute panel ruling, they also have the responsibility to abide by the WTO rules agreed to in negotiations. If countries regularly disregard the rules, then the whole relationship under the WTO will breakup. Some people who are opposed to trade or have a misunderstanding of the how the WTO works would welcome just such an outcome.
U.S. farmers and ranchers have too much at stake in trade to take lightly the potential for such an outcome. With trade already accounting for 20-50 percent of the use of many products and markets for food outside the U.S. – growing faster than markets in the U.S. – trade has become an integral part of U.S. agriculture. With the continued globalization of production and consumption of most products, no domestic policy can be considered without an eye toward international trade.
President Bush’s recent comments about possible changes in the U.S. tax system have brought calls that any new tax system recognize that tax policy cannot be separate from trade policy. Tax policy not only affects the flow of goods and services, it also affects the flow of capital.
Moving legislative changes in tax policy to bring it in compliance with the WTO ruling has been difficult for Congress. That is understandable. Given all the other issues that Representatives and Senators face in an election year, focusing on a minor piece of the tax code is hard to do.
But, ignoring it is not an option. The U.S. has as much to gain as any other country in the world through the trading rules established by the WTO. With the benefits of trade rules also comes the responsibility to abide by WTO decisions, even when those decisions appear to be unfair. The current Doha Round of negotiations is the proper place to redefine the rules on taxes so that some exporters are not disadvantaged.