Annette Nellen

Groundwork for Modernizing International Tax Rules in the U.S.

The U.S. tax system is viewed by many as hindering U.S. firms from effectively participating in the global economy. How can this situation be improved?

November 13, 2008
by Annette Nellen, CPA/Esq.

In the past few years, several government groups issued reports on why international provisions of the federal tax law need to be modernized and how that might be accomplished. This article focuses on key reports that can shape the debate and the actions we’ll likely see in the next few years to modernize our system of taxing international activity. Reasons for reform and challenges to be addressed are also described.

Impediments of U.S. Federal Tax System

A common theme among proponents for modernizing U.S. tax laws is that the system should not impede the ability of U.S. businesses to compete in the global economy. Proposals are typically described as reducing economic distortions and complexity, improving fairness and promoting economic growth. Frequently cited flaws with our current tax system that harm competitiveness, include:

  • Various tax rules that affect investment and business decisions that can lead to inefficient allocation of capital. These rules include those for depreciation, treatment of debt versus equity, double taxation of corporate income and preferential rules for certain types of investment such as housing and intangibles.
  • Complexity caused by special rules, exceptions, temporary provisions and frequent change.
  • A higher statutory corporate tax rate relative to most other industrialized countries. (See Table 5.1 of Treasury’s Background Paper on Business Taxation and Global Competitiveness, 2007.)
  • Differences between how the U.S. and other countries tax domestic and international transactions that can increase the cost of competing.
  • Lack of focus in the strategy of how U.S. tax rules apply to international transactions primarily due to how these rules developed over the past several decades. A Treasury Department statement for a June 2008 hearing on international tax reform of the Senate Finance Committee noted: “The current U.S. system for taxing multinational companies has been developed in a patchwork fashion, resulting in a web of tax rules that is unlikely to promote maximum economic efficiency.”


Background Reports: In 2006, the Joint Committee on Taxation released, The Impact of International Tax Reform: Background and Selected Issues Relating to U.S. International Tax Rules and the Competitiveness of U.S Businesses (JCX-22-06 (PDF)). This report explains the current U.S. tax system for international transactions, the worldwide versus territorial approaches to international taxation, capital export and capital import theories and summaries the types of systems used in several other countries.

In 2007, Treasury released a report and held a conference entitled: Business Taxation and Global Competitiveness. The report notes several areas in our current income tax that distort business behavior, increase compliance costs and inefficiently allocate capital. Specific observations relevant to tax reform noted in the report include:

  • Removal of special provisions would allow the top corporate rate of 35 percent to be lowered to a revenue-neutral 27 percent rate.
  • Businesses spent about $40 billion in 2004 to comply with federal tax laws.

In 2007, the Organisation of Economic Co-operation Development (OECD) issued a tax policy study: Fundamental Reform of Corporate Income Tax. This report covers a range of topics relevant in redesigning a tax system including the reasons for taxing corporate income, the need to also consider other business entity forms, integration of corporate and personal income tax systems, differences between income and consumption taxes and types of reform options.

Proposal Reports: As a follow-up to its July 2007 conference, in December 2007 Treasury released a report, Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century. This report lays out three possibilities for reform: (a) a business activities tax (BAT), (b) base broadening and (c) addressing structural issues of the current system. The proposals are not new as there have been variations of each offered by policymakers in the past. Each of the proposals is summarized next.

A BAT is form of consumption tax known as a subtraction method value-added tax (VAT). A touted benefit of a consumption tax over an income tax is that the former does not tax the returns to investment and therefore should encourage investment.

In computation, a BAT looks like an income tax except there is no deduction for wages and fringe benefits because they are the value added by the business and are subject to tax. Also, the formula excludes interest income and expense. With a broad base and likely elimination of tax credits, the rate would be low. All forms of businesses would be subject to the BAT.

The Treasury report notes various design issues of a BAT including whether it should use a destination or origin approach. Under the destination basis, goods are taxed where they are consumed. In contrast, an origin approach taxes goods where they are produced.

Treasury’s second proposal would broaden the current income tax base by eliminating special deductions and credits. Treasury estimates that the corporate rate could be lowered to 28 percent as a result, or alternatively, 31 percent if accelerated depreciation is continued. Under this proposal, Treasury also suggests moving to a territorial tax system where generally, income is only taxed if earned within the tax jurisdiction’s borders.

Treasury’s third proposal would address structural problems with the current income tax. These problems include double taxation of corporate income, the “lock-in” effect that discourages sale of assets, preference for debt over equity, loss restrictions and the alternative minimum tax (AMT).

Congressman Rangel has offered a proposal similar to Treasury’s second proposal. H.R. 3970 would lower the corporate tax rate to 30.5 percent and broaden the tax base such as by eliminating the §199 manufacturing deduction. This proposal would also require corporations to defer deductions associated with income from controlled foreign corporations until the income is repatriated.

The final report of President Bush’s Advisory Panel on Federal Tax Reform included two different tax reform proposals. The Simplified Income Tax Plan (PDF) would tax active business income earned abroad on a territorial basis. International tax avoidance rules were included in this proposal such as requiring dividends paid from foreign royalties and interest to be subject to U.S. tax. Also, a business would be considered a U.S. resident if the U.S. is its place of legal residency or if the U.S. is its place of “primary management and control” (Final Report, (PDF)).

The Panel also recommended a Growth and Investment Tax Plan (PDF). This proposal is similar to a BAT except that wages are deductible. For international transactions, this plan applies the destination approach with tax rebated on exports such that all domestic consumption is taxed equally.

The Panel also evaluated a VAT, but did not recommend it although it noted that a “partial replacement VAT” would be “an option worthy of further discussion” (Final Report (PDF)).


Many challenges exist in modernizing our international tax system. Foremost is selecting an appropriate design that supports global business activities of U.S. firms, is economically efficient and not overly complex. The goals for the system must be stated upfront so that proposals can be measured as to how they achieve those goals. Finally, international tax reform must be completed in conjunction with other business tax reforms to ensure that a firm’s tax expenditure is not an impediment to participation in the global marketplace and that the overall system supports economic growth.

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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA's Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.