July 31, 1996

Comments on the

Impact of the Proposed Replacement Tax Systems on the
International Competitiveness of American Workers and Businesses

Submitted by
The Tax Reform Study Group
within the Council on Tax & Fiscal Policy
An Initiative of Joint Venture: Silicon Valley Network

These comments are submitted pursuant to the House Ways & Means announcement of June 26, 1996. They are submitted for inclusion in the printed record of the hearing held on July 18, 1996 on the impact of the proposed replacement tax systems on the international competitiveness of American workers and businesses. The Tax Reform Study Group previously submitted comments for the written record of the May 1996 hearing on the impact of tax reform on state and local governments./1/ The Tax Reform Study Group is also working on a more comprehensive comment letter to submit to the tax writing committees at a later date.

Background on the Tax Reform Study Group

The Tax Reform Study Group was formed in October 1995 and consists of individuals from business, state and local government, and academia who are interested in studying the proposals for reform of the federal and state tax systems and tax reform in general and the impact to Silicon Valley. The Group provides objective forums for people in Silicon Valley to learn about tax reform and how it affects them and their employers. The Group maintains a Web page where interested people can obtain objective information on tax reform:

http://www.jointventure.org/initiatives/tax/tax_fed.html

Joint Venture: Silicon Valley Network is a dynamic model of regional rejuvenation with a vision to build a community collaborating to compete globally. Joint Venture brings people together from business, government, education, and the community to act on regional issues affecting economic vitality and quality of life. One of its initiatives is the Council on Tax & Fiscal Policy.

Drafting: The views expressed in the comment letter represent the collective views of the Tax Reform Study Group within the Council on Tax & Fiscal Policy of Joint Venture: Silicon Valley Network, and not necessarily the views of any individual members of the Study Group, the Council or of Joint Venture. The primary draftsperson of these comments was Annette Nellen, Professor, San Jose State University; substantive contributions and review were provided by William C. Barrett, Director: Tax, Export & Customs, Applied Materials, Inc.; Dan Kostenbauder, General Tax Counsel, Hewlett-Packard Company; Larry R. Langdon, Vice President - Tax, Licensing & Customs, Hewlett-Packard Company; David W. Mitchell, Hoge, Fenton, Jones & Appel, Inc.; Jerry Nightingale, Financial Advisor, Royal Alliance; Donald J. Scott, Director: Tax Compliance, Oracle Corporation; Dean Smith, Ireland, San Filippo & Company; John Webb, Vice President - Taxes, National Semiconductor Corporation.

Global Facts Must Be Considered In Reforming the Federal Income Tax System

In reforming the federal income tax code, it must be kept in mind that it was created and, despite regular modifications, works best for an era that no longer exists. The Internal Revenue Code (IRC) is based on the industrial age where tangible goods - easy to track and measure - were the key commodities. We are now living in the information age which requires a different perspective and set of rules than the industrial age.

Today, businesses and workers must deal with a global economy. While we still hear the term "international business", such a term is outdated because all business today is involved in or influenced by the global economy in some fashion. A new business formed in the U.S. may engage in international transactions in its early years, rather than later when they get "big enough." Per the OECD, the "period between start-up and internationalization is becoming shorter - often three or four years compared to five to ten years a decade ago." The OECD also reports that about 1% of small and medium sized manufacturing businesses (about 40,000 firms) are "truly global." Such firms produce about 26% of OECD exports and about 35% of Asian exports./2/

The current global environment that must be the model in the minds of tax code reformers is shaped by many realities, including the following:

• Increasing Importance of Foreign Markets. The level of both U.S. exports and imports continues to grow./3/ In 1980, exports represented 8.5% of the U.S. economy and 12% in 1994./4/ DRI/McGraw-Hill has predicted that the current growth in exports will lead to $1 trillion by 1998./5/ Foreign markets are growing and many U.S. companies are ready to provide goods and services to them. The Computer Systems Policy Project (CSPP) predicts that by the year 2000, about 70% of the demand for information technology will come from foreign markets./6/ The importance of the global economy to the computer industry was summarized by the CSPP as follows.
  
  The ability to sell products and access technology worldwide is essential to the continued competitiveness of the U.S. computer industry and its success around the world. The industry must grow globally or die!
  ...
  Continued success of the U.S. computer industry around the world depends on its ability to bring competitive products to market quickly. To do that, it's essential that companies be able to source technology globally - wherever it can be found - to maintain the industry's competitiveness and productivity. No country can have a monopoly on technology - its flow across international boundaries is a business reality./7/
  

• Global Competition For Technology Jobs and Tax Dollars. Many foreign countries actively compete for U.S. businesses to locate operations in their countries, particularly those bringing technology based jobs. Incentives include tax holidays, low tax rates, direct funding from the government, and duty rate reductions. This reality must be considered in efforts to improve the international competitiveness of U.S. companies and workers. The OECD has undertaken efforts to deal with international business and tax competition to prevent competition that may be harmful to governments and businesses. A June 1996 economic communique of the G7 leaders noted that business and tax competition can distort trade and investment and "lead to the erosion of national tax bases."/8/
• The Services Sector Is Growing While the Manufacturing Sector Is Declining. The Department of Commerce reports that by the 21st century, telecommunications and information-based industries will represent about 20 percent of the U.S. economy./9/ In 1995, the "Fortune 500" was changed to include both industrial and service firms. The reasons for this change include the fact that a "new economy" has emerged with the line between manufacturing and service activities more blurred; "the digital revolution has made the distinction between manufacturing and services increasingly theoretical."/10/ The services sector of the economy showed job growth from 1989 to 1991 (almost 3 million jobs added), while the manufacturing and construction sectors showed job decline (about 1.5 million jobs)./11/ In 1950, services represented about 31% of GNP, while tangible goods represented about 55% of GNP. In 1990, these percentages had changed to 52% and 40%, respectively./12/
  
  The growth in the services sector is not a U.S. phenomenon. In France, job growth in financing, insurance, real estate and business services grew at double the rate of overall employment. At the same time, manufacturing jobs fell from 36% to 29% and agricultural jobs fell by about half. Similar patterns have occurred in the OECD countries./13/

• Intangible Assets - Information, Intellectual Property and Human Capital, Are Key Assets. With the decline in the manufacturing sector and the increase in the services sector, tangible assets have somewhat declined in importance relative to intangible assets and knowledge. However, financial and economic reporting is still driven by tangible capital. U.S. Department of Commerce data reports capital expenditures by industry, but not investment in workers and intangible assets./14/ Certainly, tangible assets are much easier to measure than intangible assets, but without a focus on intangible investment in intellectual property and human capital, economic perspectives will be distorted. A tax reform focus on a system to increase capital investment (in tangible/measurable items), is not by itself appropriate. Instead, consideration must also be given to what tax and fiscal policies are appropriate to a business environment where developing human capital and protecting intellectual property is key to survival and improved growth./15/
  
  Intangible assets are often difficult to fit into the taxing schemes of the current tax laws. Again, this difficulty stems from the fact that our tax rules are structured to address the industrial age, not the information age. For example, the tax law does not provide a simple answer as to whether a software developer who only transfers its software over the Internet has to deal with inventory rules, or whether software duplication and packaging is considered manufacturing. Also, the current tax law cannot clearly label a software transaction as being a sale of goods, a rental, or royalties. This failure leads to difficulties applying domestic and foreign tax rules and leads to much cost and confusion./16/
  

What is Meant by "International Competitiveness?"

The term international competitiveness has different meanings to different people. To some, it may mean a focus only on exports (trade competitiveness), and not on investment outside the U.S. (multinational competitiveness). To some, it may mean solely looking at how tax rules may encourage or discourage certain activities. However, in debating how international competitiveness is impacted by major federal tax reform, a broad perspective should be taken. This perspective should also consider how domestic policies, with respect to savings incentives and fiscal problems (such as the U.S. debt and budget deficits) impact global investment and competitiveness. It should also consider the costs that businesses face in terms of a complex tax system and uncertain tax rules and how they can hinder a firm's ability to effectively compete in the global economy. (The debate should also consider the factors described in the next section of this letter.)

A 1991 Joint Committee on Taxation report includes a detailed discussion on the competitiveness of the U.S. economy. The report looks at this concept in terms of trade competitiveness, standard-of-living competitiveness and multinational competitiveness. It also discusses different measures of competitiveness and various policies, such as government regulations, technology and investment, that can impact competitiveness./17/

Many Factors Impact International Competitiveness and Trade

While a nation's tax rules and tax infrastructure impact a company's cost of doing business and many of its decisions, many other factors are also important. These factors, many of which are briefly explained below, must be considered along with the tax rules in any reform designed to improve the international competitiveness position of U.S. companies and workers. For example, a tax rule designed to encourage exports will not help a technology company facing out-dated export controls. Similarly, the rapid technological pace at which products advance requires a legal infrastructure that can deal with this pace so that companies are not left behind in marketing their products worldwide because competitors are not subject to out-dated trade restrictions and other legal obstacles.

Briefly described below are some of the factors that must be considered in the entire debate on improving the international competitiveness position of American workers and businesses. The tax reform process should consider these factors in order to develop a cohesive set of policies that don't conflict with each other and thus defeat the overall goals of improving international competitiveness.

• Education and worker training. With the increased importance of intellectual and human capital of many businesses, relative to the importance of machinery, workers must be adequately prepared. The CSPP reported that in 1993, 74% of computer companies' revenues were derived from products that were not even in existence two years earlier./18/ Clearly, workers in such environments must be prepared for life-long learning and adaptability and have a solid technological foundation from which to grow. Development of these skills should begin in primary and secondary education; not just in college or trade schools.
• Cross-border worker mobility. We are accustomed to workers moving from state to state to find better jobs or to move when their employer expands. Such moves are relatively simple - visas and other paperwork are not required. In a global economy, attention should be given to making worker moves from one country to another a simpler proposition as well. The U.S. should work with other countries to stream-line worker transfers because such mobility is part of doing business in the global economy.
• Intellectual property protections. Clearly, protection of intellectual property of U.S. companies is an important part of being able to compete effectively in the global economy. While this is true for all types of companies with patents, copyrights, trade secrets and trademarks, it is particularly important in the software industry. Without international respect for intellectual property rights, a software company's ability to compete is greatly diminished. Software piracy must be controlled in order for U.S. software companies to be able to compete globally. Because software is one of the fastest growing industries,/19/ attention needs to be given to this difficult problem.
• Savings and investment. The U.S., its businesses and its workers could be slowed down due to impediments to savings and investment, such as:
  • a high national dissavings in the form of our $5 trillion national debt and continual annual budget deficits;
  • double taxation of corporate earnings;
  • tax depreciation rates that are slower than those of other countries and the actual obsolescence rates of some high technology equipment;
  • high tax rates on capital investment, and lacking or distorted savings incentives (current savings incentives tend to favor home ownership relative to other types of investments);
  • reduced R&D incentives/20/ and government investment in private R&D relative to other countries; and
  • anti-deferral tax provisions, such as IRC Sec. 956A* and the PFIC rule's overlap with controlled foreign corporation rules, which encourage U.S. multinational firms to invest offshore.
• Export controls. While much debate /21/ has occurred on export controls, solutions are often slow in coming. While these are difficult issues, often involving issues of national defense and security, they must be resolved in the same rapidly changing environment in which exporting businesses are trying to compete. The CSPP places the estimated cost of current export controls on cryptography at $60 billion and 200,000 potential jobs through the year 2000./22/ U.S. multinational firms should not have to suffer the consequences of politicized trade issues.
• Antitrust policies. Current antitrust policies should be reviewed and consideration given to what constitutes effective policies for U.S. companies competing in a global environment. While a company's actions are typically viewed in the context of how they affect U.S. competition, such actions should also be viewed as to how antitrust policy may impede the U.S. company from competing internationally. Again, difficult issues are involved, but they must be considered in the context of the topic of international competitiveness of American workers and businesses.
• A global information infrastructure (GII). Issues that have arisen in the U.S. regarding the national information infrastructure (NII), such as protection of intellectual property, content control and security, will also exist on the GII. The U.S. government should work with U.S. businesses and other governments to help ensure that the potential of the GII (including its business potential) is not hindered./23/
• A global legal infrastructure. U.S. businesses have been burdened by a complex domestic infrastructure involving differing regulations and rules among the 50 states and often within each state as well. As the global economy grows and the above issues are addressed, consideration should be given to standardization of some processes such as registration of intellectual property, business registration, payment procedures, settlement of tax disputes, and export and import procedures.
  

Recognize How Other Countries Tax and Spend

The U.S. is only one of two OECD countries that does not employ a federal VAT. Thus, our tax system is "out-of-sync" with most countries. Current proposals for major reform call for replacement of the federal income tax with a consumption tax. Such a step would also keep the U.S. tax system out-of-sync with other OECD countries because they employ an income tax along with consumption taxes./24/ Before taking a drastic step to completely eliminate the U.S. income tax system, careful analysis should be made as to, 1) why other countries have both income and consumption tax systems, 2) how government spending in other countries differs from the U.S. (for example, many European countries have higher social spending on unemployment benefits, education and health care) and how that impacts their taxing decisions, 3) the ability to use the income tax system to reduce the regressivity of a consumption tax, and 4) the impact to state and local governments of replacing the federal income tax with a consumption tax./25/ In addition, tax differences between the U.S. income tax system and those of other countries, such as territorial versus worldwide tax systems, sourcing rules and foreign tax credit rules, should be considered in terms of how such differences may impede the competitiveness position of U.S. firms.

Importance of Identifying Policy Goals For the New Tax Rules

Arguably, some of the complexity of today's tax laws stems from the failure to ask the following question prior to making changes to the IRC: "Does the change support the underlying revenue and competitiveness policies of the U.S. tax laws?"

For example, international tax rules do not necessarily have similar policy objectives underlying them. This can lead to distorted incentives, such as where one rule encourages domestic investment, while other rules favor foreign investment (for example, current IRC Sec. 956A* which actually encourages foreign investment in offshore plants versus the research tax credit which encourages domestic investment in R&D activities). Similarly, U.S. tax rules have not necessarily focused on the tax rules businesses face in foreign countries and how the U.S. tax rules on sourcing of expenditures, foreign tax credits, transfer pricing and labeling of transactions (such as sale of goods versus royalties) can lead to double taxation, costly controversies and non-neutrality of the tax rules (because tax implications can influence a business's investment decisions).

In reforming the tax system, time must be given to discussing what the appropriate policies should be to support the tax rules with respect to international business transactions. For example, should the rules encourage exports? be neutral as to where production occurs? follow a standard established by an international group, such as the OECD? or something else?/26/ Without first having this discussion, any replacement tax rules will lead to the same complexities and distortions that currently exist in the federal income tax rules. Similarly, any efforts made to reform our current income tax rules in the international tax area (prior to major federal tax reform) should follow these same principles of first identifying, 1) what is the policy goal of the international tax rules, 2) whether the particular proposal will be within that policy goal, and 3) whether the proposal is the simplest and most effective method of reaching that goal./27/

Finally, more efficient tax policies could stem from a better dialogue between government and industry. Government needs to listen to the experiences that companies are having in dealing with tax issues in their worldwide activities. Many of these issues can only be solved by actions on the part of Congress and the Administration to clarify or correct the U.S. tax laws, or in dealing with issues businesses face in applying both U.S. and some other country's tax laws to the same transaction.

Businesses have brought various tax rules that are not in the best interests of the U.S. economy, to the attention of Congress and the Administration. Two recent examples are, 1) the failure to clarify the IRC or regulations to enable software companies to obtain foreign sales corporation (FSC) benefits similar to that obtained by other industries, and 2) the failure to hear U.S. companies' appeal that the passive asset rule of IRC Sec. 956A* and the PFIC rule's overlap with controlled foreign corporation rules actually encourage, rather than discourage, offshore plant investment. Given the rapid technological changes companies deal with today and the various complexities of doing business globally, a more efficient system must be developed for government and business to work together to maintain a set of tax rules that best serves the interests of the U.S. fisc and does not adversely impact U.S. companies and their workers. Multi-year delays in fixing problem areas in the tax law is not acceptable in the rapid technological and business development pace of today's global economy. Reform efforts should include creation of a system for quick resolution of costly tax issues and uncertainties as to how the law applies.

Problem Areas With Current Proposals and Tax Reform In General

• Determine whether GATT-compatibility is important. Consensus does not exist as to how important it is for a tax to be GATT-compatible. Some commentators view it as unimportant under the theory that a border adjustable tax is not an effective tool in reducing the trade deficit. In a 1992 report, the Congressional Budget Office stated that border adjustments do not improve the balance of trade because of resulting changes in exchange rates./28/ However, others, including Congressman Archer, view GATT-compatibility as an important goal for tax reform./29/ The importance of GATT-compatibility, must be further analyzed and openly debated prior to instituting a tax that is not GATT-compatible, such as the Armey flat tax, or making an effort to ensure that a new tax is GATT-compatible if it makes no difference. This debate should consider, 1) the effect of GATT-compatibility under various trade balance scenarios, 2) the effect in the long-term versus the short-term, 3) the impact of transitioning to a GATT-compatible tax, 4) possible differences of impacts among industries, and 5) trading partner acceptance of the taxing system as GATT-compatible.
• Determine whether a subtraction VAT is GATT-compatible. If it is determined that GATT-compatibility is important, careful attention must be paid to the new tax to be enacted to be sure that it is truly GATT-compatible. Most of the world using a VAT uses the credit invoice VAT which is more obviously an indirect tax, relative to the subtraction VAT. As noted by former Treasury Assistant Secretary, Les Samuels, "Whether a subtraction method VAT would survive a GATT challenge is an untested issue."/30/ Also, per a 1991 Joint Committee on Taxation report: "there is considerable uncertainty as to whether a subtraction-method VAT would be legal under GATT. The distinction may be made that a subtraction-method VAT, unlike a credit-invoice VAT, is not imposed on particular transactions but directly on a business, where the tax base is equal to the business's value added. In this technical respect, a subtraction-method VAT may more closely resemble a corporate income tax than a sales tax."/31/ On the other hand, others believe that a subtraction VAT is likely to be GATT compatible./32/
  
  In the GATT-compatibility debate, it is important to note that the current proposals call for a variation on a subtraction VAT. While a pure subtraction VAT might be shown to be GATT compatible, the USA subtraction VAT is not a pure subtraction VAT because of its NOL carryforward and FICA credit provisions. These provisions may indicate that it is not an indirect tax. However, if this is true, these are fixable aspects of the proposal; the key will be to fix such problems prior to enactment, rather than upon a later GATT challenge.
  
• Expand the VAT debate to include the credit invoice VAT. Almost all countries that use a VAT use the credit invoice method VAT. However, current major tax reform proposals in the U.S. all call for some form of the subtraction method VAT. Reasons for favoring a subtraction method VAT over the credit invoice VAT include:
  • The subtraction method VAT is viewed as not tolerating any special rates or exemptions, thus it will not suffer from the same problems that the income tax has (such as having over 100 special preferences).
  • In terms of computation, the subtraction method VAT looks more like the income tax and thus, will be better accepted in the U.S.
    
    Both of the above reasons for favoring a subtraction method VAT have serious underlying problems. First, it is not politically reasonable to assume that preferences and special rates cannot be added to a subtraction VAT - someone will surely figure out a way! In fact, it has already been shown that a subtraction method VAT can tolerate exemptions as evidenced by the Danforth-Boren business activities tax (BAT), a form of subtraction VAT introduced in 1985, which calls for an exemption for businesses with gross receipts under $100,000./33/
    
    The fact that a subtraction VAT has similarities to our current income tax is both a plus and a minus. The plus is that it will rely on records businesses already have in place for state income tax and financial reporting purposes. The minus is the fact that it leads to confusion as to what is actually being taxed; it also leads to potential GATT-compatibility problems. For example, one of the common complaints voiced about a subtraction method VAT proposal, such as the USA tax, is that it is an unfair tax on labor because no deduction is allowed for labor. Such a comment likely comes about because when the tax looks so much like our income tax, we expect it to include "typical deductions," such as those for labor. However, a consumption-type VAT taxes "value-added" to goods and services acquired from another business as the goods and services move through the production and distribution chain. The key element of that "value-added" is the labor that a business applies to the goods and services as they move through the production and distribution chain (thus, there is no "deduction" for wages because it is supposed to be taxed under a value-added taxing scheme).
    
    Under the credit invoice form of a consumption type VAT, it is more clear what (and who) is being taxed and the complaint that it is an unfair tax on labor is not typically raised. Yet, where there are no exemptions or special rates, both forms of VAT raise the same amount of revenue.
    
    A subtraction VAT may lead to GATT-compatibility problems because it is proposed to look so much like a non-GATT compatible income tax (direct tax). For example, under the USA proposal, if a business has purchases greater than revenues, a net operating loss (NOL) is generated which can be carried forward for 15 years /34/ (very much like our income tax system). Under a VAT, a refund would be more appropriate when a business's purchases from other businesses exceed its sales for the year. Also, under the USA proposal, a business could transfer its NOL carryforward along with a transfer of its assets./35/ These two features make the USA business tax look more like something imposed on the business (a direct tax) rather than on the consumer (an indirect tax). Under a credit invoice VAT, these issues do not arise. A credit invoice VAT makes it clear that the ultimate consumer is paying the VAT and if purchases exceed sales for a business, the business receives a VAT refund. Also, the credit invoice VAT is known to be GATT-compatible, while the forms of subtraction VAT proposed in the current debate have not been tested under GATT (see earlier discussion).
    
    For the reasons noted above, as well as the fact that a debate as significant as replacing the federal income tax requires an honest look at all possible options, all appropriate proposals should be on the table, including the credit invoice VAT./36/ This will lead to a more effective debate, allow for consideration of how most of the rest of the world taxes and perhaps allow for a more honest perspective of what a consumption-type VAT is and how it does indeed differ from our current income tax.
    
• Renegotiation of tax treaties. Current tax treaties deal with income taxes, not consumption taxes. Thus, the treaties will need to be renegotiated if the income tax is replaced. The time frame needed for this task, as well whether other countries would be willing and interested in renegotiating treaties with the U.S., must be considered in the tax reform debate.
• Industry neutrality with respect to a destination-based tax. For a variety of reasons, certain financial factors differ among industries. For example, U.S. Department of Commerce figures for 1994 show the following for two different industries:/37/

• This information indicates that these two industries vary in the amount of shipments that are exported and the amount of total workers who are production versus non-production workers. In addition, the capital expenditures for the two industries are close in amount although total shipments in the motor vehicle industry are over twice those for the computer industry. Differing exports, capital expenditures and wage bases will exist among companies within each industry as well. These differences should be given some consideration in the design of a neutral tax system so that businesses are not unfairly and unjustifiably favored or penalized under the tax system.
  
  For example, the current design of the USA tax for businesses imposes a separate tax on the value of imports (but at the same tax rate as imposed on domestic operations). The USA tax allows businesses to reduce their tax liability by a credit equal to the FICA taxes paid. However, this credit may not be used to reduce the import tax. A capital intensive business, such as a chip manufacturer, may have zero tax liability under the business tax due to the expensing of capital equipment and the FICA credit. Such a company may likely generate NOL and FICA credit carryovers as well. At the same time, the company will owe an import tax. Thus, the tax system for such a company becomes one of zero domestic tax (with NOL and credit carryovers which may never be needed), with tax only paid in the form of an import tax. On the other hand, a company that does not rely on imports to the same degree and/or is not capital intensive, will be able to claim benefit of its FICA credit because it does have domestic business tax base. Thus, two companies could have equal domestic wage bases yet be subject to quite different tax bills. A remedy to allow for a more neutral tax would be to allow for the FICA credit to be used against any tax liability.
  
• Destination-based versus origin-based tax system. A common preference touted for a destination based tax is that it will improve the balance of trade. However, many commentators state that this is not true (see GATT discussion above). This issue is closely tied into GATT compatibility (discussed above) and should be debated with that similar issue. Included in that debate should be other factors, such as transfer pricing issues and rules, that may tend to justify one tax system over the other. For example, while transfer pricing issues would be reduced from a U.S. government perspective under a destination-based tax, transfer pricing remains an issue under an origin-based tax system. However, under a destination-based tax system, U.S. businesses may likely face heightened transfer pricing scrutiny from other countries because the pricing of U.S. exports receives no scrutiny under the U.S. tax laws, potentially making such values entering foreign countries more "suspect." State tax coordination with a federal consumption tax should also be included in this origin versus destination-based debate./38/
• More attention needs to be given to intangibles in taxing schemes. Transfers of intangible assets, such as information and software, are more difficult to tax relative to the transfer of visible tangible assets. Also, while tangible assets can be seen by customs agents when the goods cross borders, the same is not true of information, software and telecommunications. With the increasing amount of revenues generated from transfers of intangibles, realistic tax schemes must be found. Such schemes should be coordinated with the rules of other countries to avoid double taxation, and unnecessary compliance burdens. For example, under the Armey flat tax, if the licensing of U.S. technology to a foreign entity is viewed as a taxable export and the foreign country also taxes the royalty income, the U.S. taxpayer will be subject to double taxation because the Armey flat tax does not allow for a foreign tax credit. As noted by the National Commission on Economic Growth and Tax Reform ("Kemp Commission"), attention must be paid to the "proper tax treatment of foreign source license fees, royalties, and other intangibles so as not to discourage research and development in the United States."/39/
  
  The current reform proposals and the tax reform debate have ignored the tax treatment of intangible assets for the most part. For example, the USA proposal includes rules on sourcing goods and services for purposes of determining if income and expenses are considered non-taxable export income, or a taxable import. However, it does not discuss how to source royalty income and royalty payments related to intangible assets, or whether such payments are considered to be for services.
  
  The Armey flat tax does not include sourcing rules at all. Guidance would be needed, for example, on how to determine whether licensing of an intangible asset to a foreign licensee should be viewed as a taxable export, non-taxable investment income, or non-taxable foreign income. Also, where development of an intangible occurs both inside and outside the U.S. and/or it is licensed both inside and outside the U.S., guidance will be needed as to how the costs and revenues from the intangible factor into the taxpayer's U.S. tax liability.
  
• Potential problems if the U.S. becomes a tax haven. In The Flat Tax, authors Hall and Rabuska note that with a 19% tax rate and expensing of investment, "foreign investment should pour into the United States."/40/ While this may sound great for the U.S. economy, consideration must be given to whether such an assumption is realistic (investment in the U.S. is not solely dependent on tax considerations). Should this assumption be a possibility however, the U.S. must then factor in what possible "retaliatory" actions other countries may take to try to keep investment within their borders. Such competition for business and tax dollars might not be a beneficial outcome for both businesses and governments./41/

Conclusion

With respect to consideration of the impact of major federal tax reform on international competitiveness, we encourage Congress to:

• Recognize a changed business environment and the need for quick action to solve problems. Identify what the global economy of today and the tomorrow looks like and how it differs from the world that shaped our existing tax laws and policies. Businesses should not be held back by unclear rules and the slowness of the government bureaucracy to fix roadblocks that hinder a business's ability to effectively compete in the global economy. If the debate is focused on what currently exists in the IRC and why rules were written the way they were years ago, it will be a useless debate.

• Think globally, not domestically. A key statistic cited in discussing international competitiveness is the level of U.S. exports and imports. This perspective by itself is outdated and limiting because it is easy for many high technology companies to operate almost anywhere in the world, yet still provide benefits to the U.S. economy. Perhaps the focus should be on worldwide operations and whether a U.S. business is facing any legal obstacles that are impeding its worldwide growth and how the U.S. can assist in reducing such obstacles.
  
  A focus on exports and imports (the trade imbalance) may also lead to "domestic tunnel vision" which similarly might lead to policies that impede the worldwide growth of a U.S. business. A decision by a U.S. firm to locate operations outside of the U.S. should first be viewed as a reasoned economic one which likely still provides some benefits to the U.S. economy./42/ Today, application of "domestic tunnel vision" is likely to apply and lead to legislation to prevent or penalize such business decisions. Such actions should be considered in terms of whether they make sense in terms of the global economy in which businesses operate today.

• Work with businesses to better identify the appropriate policies that should underlie international tax rules. For example, should exports be encouraged? Should investment in foreign business activities be discouraged? Should taxes be a neutral factor in these decisions? Consideration must also be given to how other countries tax international transactions and how countries can work together in the global economy and collect tax revenues in an effective and cost-efficient manner.

• More than just tax rules need to be considered. Approach the task of improving international competitiveness as the broad proposition that it is. That is, consider education and worker training of today's workers who must deal with rapid technological advancement and competition from skilled workers in other countries. Also consider how to protect intellectual property of U.S. businesses in the global economy, how U.S. savings and investment actions and policies impact the ability of U.S. businesses to compete globally, as well as the impact of export controls, antitrust policies, and how the global infrastructure in which businesses must operate might be streamlined through coordinated efforts of governments working together.

• Work to preserve and further encourage this country's entrepreneurship and technological expertise. Given the rapid changes in technology and the continuing growth potential for high technology products, U.S. policies should focus on ensuring that students are provided the skills to enable them to work in and further advance high technology industries.

• Various tax impediments to competition exist. Consider the broad realm of tax impediments to competition. This includes, complexity and its related compliance costs and costs of actions not taken due to tax uncertainty, lack of government commitment to R&D incentives, depreciation rates that serve revenue needs rather than business realities, double taxation of corporate income, hindrances to capital formation such as rules that prefer debt over equity, and income tax differences between U.S. rules and those of its major trading partners.

• Start now. Realize that the international aspects of tax reform are likely the most difficult ones and the above tasks should begin now.

Footnotes

[* Note: IRC Sec. 956A was repealed in August 1996 after these comments were submitted to Congress.]

/1/ These comments can also be found at http://www.svi.org/jointventure/tax/tax_fed.html, or 96 STN 142-36 (July 23, 1996), or State Tax Notes, Vol. 11, No. 4, July 22, 1996, pg. 253.

/2/ "Helping Small Firms Adapt to the Globalised Economy," OECD Letter, Vol. 5/4, May 1996; http://www.oecdwash.org.

/3/ Department of Commerce, U.S. Foreign Trade Update, http://www.ita.doc.gov/industry/otea/usftu/usftu.html.

/4/ See Aley, "New Lift For the U.S. Export Boom," Fortune, Nov. 13, 1995, pg. 73.

/5/ Id.

/6/ CSPP, "Public Policy and the U.S. Computer Industry - Freedom To Grow - Leadership Into The 21st Century," January 1995, http://www.cspp.org/reports/. The Department of Commerce reports that for advanced technology products (ATP) a trade surplus exists of $7 billion for January to April 1996. ATP represents about 500 products where the technology is from a "recognized high technology field (e.g., biotechnology)", and which represent leading edge technology in that field. See http://www.census.gov/ftp/pub/foreign-trade/Press-Release/.

/7/ CSPP, supra.

/8/ As reported in Massey, "G7 Leaders Spur OECD's International Tax Reform Efforts, 96 TNT 132-2, July 8, 1996.

/9/ Undated memorandum from the National Telecommunications and Information Administration (NTIA) within the U.S. Department of Commerce (possible date is July 1995).

/10/ Stewart, "A New 500 For The New Economy," Fortune, May 15, 1995, pgs. 166, 174.

/11/ U.S. Bureau of the Census, "Net Job Growth/Decline in the United States by Industry Division, http://www.census.gov/ftp/pub/epcd/ssel_tabs/images/jobchan.gif. From 1980 to 1992, the number of jobs in the manufacturing industry declined by 14.2% (about 3 million jobs), while jobs in services industries grew 78.4% (about 13.5 million jobs). U.S. Bureau of the Census, Statistical Abstract of the United States 1995, 115th Ed., Table No. 858.

/12/ Snell, ed., Financing State Government in The 1990s, National Conference of State Legislatures (NCSL), December 1993, pg. 21.

/13/ Miller and Wurzburg, "Investing in Human Capital," The OECD Observer, No. 193, April/May 1995, pg. 16.

/14/ For example, International Trade Administrative Data; http://www.ita.doc.gov/industry/otea/usio/.

/15/ For more information on this topic, see "Investing in Human Capital," supra.

/16/ For example, see Erickson, "Royalty Income From Software: Is It Rental or Sales Income?," High Tech Industry, July-August 1996, pg. 46. Also see letters submitted to the Treasury Department over the past five years by Baker & McKenzie on behalf of the Software Coalition: Tax Notes Today, 95 TNT 185-61 (Sep. 21, 1995), Tax Notes Today, 92 TNT 199-75 (Oct. 1, 1992) and October 24, 1991, Tax Notes Today, 91 TNT 237-51 (Nov. 20, 1991). For an alternative perspective on revenue characterization of software transfers, see Covington & Burling letter of December 11, 1992 to the IRS on behalf of IBM; Tax Notes Today, 92 TNT 256-20 (Dec. 24, 1992). Also see September 4, 1992 letter from Compuware Corporation to the IRS supporting the IBM's comments; Tax Notes Today, 92 TNT 189-38 (Sep. 17, 1992). Also see the Covington & Burling letter to the IRS dated June 12, 1992, Tax Notes Today, 92 TNT 165-38 (Aug. 13, 1992).

/17/ Joint Committee on Taxation, Factors Affecting the International Competitiveness of the United States, (JCS-6-91), May 30, 1991, pgs. 3 to 14 [hereinafter, JCS-6-91].

/18/ CSPP, "Public Policy and the U.S. Computer Industry - Freedom To Grow - Leadership Into The 21st Century," January 1995, http://www.cspp.org/reports/.

/19/ The Business Software Alliance (BSA) describes the computer software industry as one of the fastest growing industries and one that contributed over $36 billion to the U.S. economy in 1992. BSA, "The Computer Software Industry," January 1994.

/20/ For example, the U.S. does not have a permanent research tax credit which hinders U.S. investment in R&D. Various studies have shown that an incentive and subsidy is warranted, Congress and the Administration favor a credit, yet, it is allowed to continually expire. See Cox, "Research and Experimentation Tax Credits: Who Got How Much? Evaluating Possible Changes," Congressional Research Service, June 4, 1996, for references to studies justifying some level of public support for private R&D.

/22/ For background on the encryption technology debate, see S. 1726, the Commerce Promotion Act of 1996 and S. 1587, the Encrypted Communications Privacy Act of 1996; 104th Cong., 2d Sess. Also see "U.S. Offers 'Relief" From Curbs on Exports of Encryption Products," International Trade Reporter, BNA, Vol. 13, No. 24, pg. 973, June 12, 1996.

/23/ "Foreign Encryption Products Threaten U.S. Market, Industry Warns Lawmakers," International Trade Reporter, BNA, Vol. 13, No. 25, pg. 1019, June 19, 1996.

/24/ See OECD, "Common Vision Needed for Global Information Society," OECD Letter, Vol. 5/6, July 1996, and "Global Information Infrastructure and Global Information Society (GII-GIS)," OCDE/GD(96)93, for information on OECD activities in this area. See CSPP, "Perspectives on the Global Information Infrastructure," February 1995, for suggestions from several computer companies on the role of industry and government in effective development of the GII. Also see National Telecommunications and Information Administration (NTIA), "The Global Information Infrastructure: Agenda for Cooperation," 60 FR 10359, February 24, 1995.

/25/ OECD figures show that for 1992, OECD countries as a group relied on the following sources for tax receipts: personal income taxes 29.7%, corporate income taxes 6.8%, social security 25.0%, property taxes 5.5%, general consumption taxes, 17.1% and specific goods taxes 11.5%. Joint Committee on Taxation, Selected Materials Relating to the Federal Tax System Under Present Law and Various Alternative Tax Systems, (JCS-1-96), March 14, 1996, pg. 84.

/26/ See previous submission by the Joint Venture Tax Reform Study Group on the impact of tax reform on state and local government; http://www.svi.org/jointventure/tax/tax_fed.html, or at 96 STN 142-36 (July 23, 1996) or State Tax Notes, Vol. 11, No. 4, July 22, 1996, pg. 253.

/27/ For a more detailed discussion of tax policies underlying certain foreign tax provisions of the IRC, see JCS-6-91, supra, pgs. 232 to 264.

/28/ For example, these steps should be taken with respect to recent legislative proposals: S. 1597, 104th Cong., 2d Sess. (Dorgan) and S. 1928, 104th Cong., 2d Sess. (Levin). For an alternative perspective on this type of legislation, see Merrill and Dunahoo, "'Runaway Plant' Legislation: Rhetoric and Reality," 96 TNT 131-18 (July 5, 1996).

/29/ CBO, Effects of Adopting a Value-Added Tax, February 1992, pg. 63. Also see Esenwein, Congressional Research Service, "Consumption Taxes and the Trade Balance: The Role of Border Tax Adjustments," 95-893E, Aug. 14, 1995. This report notes that the balance of trade is affected by international capital flows, not by the flow of traded goods and services and border tax adjustments. "[A]ny changes in the product prices of traded goods and services brought about by border tax adjustments would be immediately offset by exchange rate adjustments. ... That is not to say that changes in the tax structure could not influence trade patterns. Tax policy can and does affect the composition of trade. In addition, changes in tax policy which might affect the underlying macroeconomic variables that govern capital flows (for instance, by increasing either public or private savings which in turn would lower interest rates) could affect the balance of trade. But, by themselves, border tax adjustments will not change a nation's balance of trade."

/30/ Congressman Archer, "Goals of Fundamental Tax Reform," in Frontiers of Tax Reform, The Hoover Institute, 1996, pg. 5. Also, per Congressman Gibbons, a "border-adjustable tax system would promote the competitiveness of American companies and invigorate American exports." Gibbons, "A Revenue System for America's Future," outline to his subtraction method VAT proposal, March 27, 1996, pg. 3.

/30/ From June 7, 1995 record testimony (pg. 28) before the House Committee on Ways and Means by then Assistant Treasury Secretary (Tax Policy), Les Samuels.

/31/ JCS-6-91, supra, pg. 304.

/32/ For example, see Hufbauer and Gabyzon, Fundamental Tax Reform and Border Tax Adjustments, Institute For International Economics, 1996, pgs. 67 to 70. Hufbauer posits that the subtraction VAT can be attributed to individual products unlike the corporate income tax which is dependent on the business cycle and other factors. Hufbauer also suggests that the associated legislation should be drafted to indicate that the liability for the tax attaches when the goods or services are sold. The Hufbauer text contains an excellent and very complete discussion of border adjustments. Also, the sponsors of the USA proposal appear to have taken the position that it is a GATT-compatible tax.

/33/ S. 2160, 103d Cong, 2d Sess.

/34/ S. 722, 104th Cong., 1st Sess., Sec. 207(b).

/35/ S. 722, 104th Cong., 1st Sess., Sec. 207(d)(2).

/36/ Much analysis has been performed on the credit invoice VAT by two tax practitioner groups: AICPA, Design Issues in a Credit Method Value-Added Tax for the United States, May 1990, and ABA Section of Taxation, Value Added Tax - A Model Statute and Commentary, 1989.

/37/ Bureau of the Census, International Trade Administration, http://www.ita.doc.gov/industry/otea.usio/95s1481.txt, and http://www.ita.doc.gov/industry/otea.usio/95s1494.txt.

/38/ For a thorough discussion on the topic of origin based versus destination based taxes and related international tax issues presented by major federal tax reform, see Grubert and Newlon, "The International Implications of Consumption Tax Proposals," National Tax Journal, December 1995, pg. 619; Avi-Yonah, "Comment on Grubert and Newlon, "The International Implications of Consumption Tax Proposals,"" National Tax Journal, June 1996, pg. 259; Grubert and Newlon, "Reply to Avi-Yonah," National Tax Journal, June 1996, pg. 267; Avi-Yonah, "The International Implications of Tax Reform," 95 TNT 223-63, (Nov. 13, 1995); and Horowitz, "Evaluating Fundamental Tax Reform: The U.S. Multinational Perspective," 96 TNT 27-61 (Feb. 7, 1996).

/39/ Report of the National Commission on Economic Growth and Tax Reform, January 1996, pg. 18.

/40/ Hall and Rabushka, The Flat Tax, Hoover Institution Press, 1995, pg. 121.

/41/ For a perspectives on this, see Slemrod, "Some Implications for American Tax Policy of Global Competition," Tax Notes International, 3 TNI 1039, September 1991; and Holland and Owens, "Tax, Transition and Investment, The OECD Observer, No. 193, April/May 1995, pg. 29.

/42/ For example, as noted in a 1991 Joint Committee on Taxation report, outbound investment may free up U.S. debt capital and labor for new investment opportunities in the U.S. JCS-6-91, supra, pg. 235.