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Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21

st

Century

Office of Tax PolicyU.S. Department of the TreasuryDecember 20, 2007

Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21

st

Century

Table of Contents

Executive Summary...........................................................................................................i

Chapter I: The U.S. Business Tax System Presents Challenges to U.S.Competitiveness .............................................................................................................1

A. Introduction

...........................................................................................................1

B. Business tax reform and the economy

.................................................................3

C.

How business taxation in the United States compares with that of the UnitedStates’ major trading partners

....................................................................................6

D. Summary

..............................................................................................................16

Chapter II: Replacing Business Income Taxes with a Business Activities Tax.......19

A.

Introduction

.........................................................................................................19

B.

Description of a BAT

..........................................................................................20

C.

Economic effects of a broad-based BAT

...........................................................22

D.

Distributional issues

............................................................................................29

E.

Border tax adjustments and international trade

.............................................34

F.

Simplicity and enforceability

.............................................................................35

G.

Implications for state and local governments

...................................................36

H.

VATs in other countries

.....................................................................................37

Chapter III: Business Tax Reform with Base Broadening/Reform of the U.S.International Tax Rules..................................................................................................43

A.

Introduction

.........................................................................................................43

B.

Broadening the business tax base and either lowering the business tax rate orpermitting faster write-off of investment

..................................................................47

C.

Territorial tax systems

........................................................................................54

Chapter IV: Addressing Structural Problems with the U.S. Business Tax System.66

A.

Multiple taxation of corporate profits

...............................................................66

B.

Tax bias that favors debt financing

...................................................................81

C.

Taxation of international income

......................................................................84

D. Tax treatment of losses

.......................................................................................89

E.

Book-tax conformity

...........................................................................................96

F.

Illustrative areas to improve tax administration

...........................................101

Acknowledgements.......................................................................................................116

i

Executive Summary

The global economy has changed markedly over the past half century. Trade andinvestment flow across borders in greater volume and with greater ease. Increasingly, theability of U.S. companies to grow and prosper depends on their ability to do businessglobally.As we look to the future of the U.S. economy and U.S. workers, we must look atour competitiveness through the lens of the global marketplace. There are many factorsthat affect the ability of U.S. workers and U.S. companies to compete globally, and issuesas diverse as education, immigration, and trade policy have all been examined in thiscontext. This paper examines the role of tax policy in affecting the globalcompetitiveness of U.S. companies and U.S. workers.In the 1960s, international trade and investment flows were much less importantto the U.S. economy and the decisions of U.S. companies than they are today. Thus, theUnited States was free to make decisions about its tax system based primarily ondomestic considerations. Moreover, our trading partners generally followed the U.S. leadin tax policy.Globalization – the growing interdependence of countries resulting fromincreasing integration of trade, finance, investment, people, information, and ideas in oneglobal marketplace – has resulted in increased cross-border trade and the establishment of production facilities and distribution networks around the globe. Businesses now operatemore freely across borders, and business location and investment decisions are moresensitive to tax considerations than in the past.As barriers to cross-border movement of capital and goods have been reduced,differences in nations’ tax systems have become a greater factor in the success of globalcompanies. Recognizing this, many nations have changed their business tax systems.During the past two decades, many of our major trading partners have lowered theircorporate tax rates, some dramatically. The United States, which had a low corporate taxrate in the late 1980s as compared to other countries in the Organisation for EconomicCo-operation and Development (OECD), now has the second highest statutory corporatetax rate among OECD countries. Moreover, other OECD countries continue to reducetheir corporate income tax rates leaving the United States further behind.As other nations modernize their business tax systems to recognize the realities of the global economy, U.S. companies increasingly suffer a competitive disadvantage. TheU.S. business tax system imposes a burden on U.S. companies and U.S. workers byraising the cost of investment in the United States and burdening U.S. firms as theycompete with other firms in foreign markets.Taxing business income discourages investment by raising the cost of capital.The higher the cost of capital, the greater the disincentive to invest. The relatively highU.S. tax rate, compared to our trading partners, places a higher cost on investment.Business taxes play a particularly key role in the economy because they influence the

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