Taxes and Offshore Outsourcing
Prepared for Members and Committees of Congress
The impact of taxes on international trade and investment has been debated for decades. Most th
recently, a variety of bills addressing international taxation have been introduced in the 110
Congress—some would cut taxes for U.S. firms overseas, while others would increase taxes on
foreign investment. The debate over taxes and foreign outsourcing has tended to grow more
heated during times of domestic economic weakness and high unemployment; questions arise
over whether taxes contribute to such weakness by discouraging exports (or encouraging imports)
or by encouraging U.S. firms to move abroad. The debate over international taxation has again
become prominent as a part of the wider debate over “outsourcing.” With taxes, the debate asks
how the current system affects outsourcing, and whether policies designed to limit the
phenomenon might be desirable.
The precise meaning of the term “outsourcing” varies, depending on the context. In one usage,
outsourcing simply refers to the use by domestic firms of inputs produced by other firms. Other
usages, however, refer exclusively to the international sector, and the analysis in this report
focuses on two types of such “offshore” outsourcing: the use by domestic firms of imported
foreign inputs, including both the use of foreign technical services and the use of foreign-made
goods; and the shifting by U.S. firms of domestic operations abroad. The analysis of the first of
these types of outsourcing focuses primarily on how taxes affect trade while investment is held
constant. The assessment of the second type looks at how taxes affect investment.
Taxes probably have little impact on the balance of trade (what might be termed “net”
outsourcing), apart from indirect effects that may result from their impact on investment flows. In
the language of the outsourcing debate, taxes likely do not change the extent to which the
economy as a whole engages in the use of foreign, rather than domestic, inputs (compared to the
extent the economy exports). In contrast, taxes can affect the flow of direct investment abroad—
that is, the establishment of overseas production facilities by U.S. firms. Thus, if outsourcing is
taken to mean the use by U.S. firms of foreign rather than domestic labor, taxes can have an
impact. The current U.S. system, however, produces a variety of incentives, disincentives, and
neutrality towards overseas investment, and the net impact of the system on the flow of
investment is not clear. Similarly, the likely impact of recently enacted legislation is not clear.
Economic theory provides frameworks for evaluating the efficiency effect of taxes on
international trade and investment, and their subsequent impact on economic welfare. According
to theory, taxes best promote economic efficiency—and thus best promote economic welfare—
when they do not distort the level or composition of trade or alter the allocation of investment
between foreign and domestic uses. In short, taxes best promote economic efficiency and
aggregate economic welfare when they do not distort the level of outsourcing, in the sense it is
used in this report. With respect to employment, outsourcing may cause sector-specific and near-
term job losses but likely does not have a substantial long-run impact on overall employment.
This report will be updated only when major legislative developments occur.
What is Outsourcing?......................................................................................................................1
Taxes and Outsourcing Through Trade...........................................................................................3
Taxes and Overseas Production by U.S. Companies.......................................................................5
The Impact of the Current System and Recent Legislation.............................................................6
The Tax Increase Prevention and Reconciliation Act of 2006 (TIPRA; P.L. 109-222).............7
American Jobs Creation Act of 2004 (AJCA; P.L. 108-357)....................................................8
Deduction for Domestic Production...................................................................................8
Less Restrictive Foreign Tax Credit Rules..........................................................................8
Changes Related to Deferral...............................................................................................9
Tax Cut for Repatriated Foreign Earnings..........................................................................9
Tax Policy and Trade..........................................................................................................9
Tax Policy and Foreign Investment...................................................................................11
Outsourcing and Domestic Employment.......................................................................................13
Summary and Conclusions............................................................................................................14
Author Contact Information..........................................................................................................14
The term “outsourcing” has recently assumed a prominent place in the public debate over
economic policy. In general, the debate concerns the impact various federal policies are thought
to have on outsourcing, including the policy that is the focus of this report, taxes. But
“outsourcing” is not a formally-defined term of economic theory, and has no specific meaning in
economics. And its usage in the popular debate varies. Thus, the first step in applying economic
analysis to the outsourcing debate is to clarify the term’s meaning—to define it, using terms that 2
do have a precise meaning in economic theory.
In one common usage, outsourcing simply means the use by a firm of inputs produced outside the
firm, either by foreigners or unrelated domestic firms—the important fact is simply that someone
else performs the function. Here, a firm’s manager might speak of “outsourcing” a task, meaning
that another firm does that particular job. Similarly, outsourcing sometimes refers to the use by
government agencies of services provided by the private sector—for example, legislation has
recently been introduced in Congress that would “outsource” certain debt-collection functions of
the Internal Revenue Service. The focus of this report, however, is the international economy; its
analysis is confined to what might be termed “offshore” outsourcing.
But here, too, the term’s usage varies. For example, one focus of the recent public debate has
been the use by U.S. firms of skilled foreign technological workers who reside and work abroad,
but who provide services to customers in the United States. A prominent example of this usage is
in the 2004 Economic Report of the President, which cited “the increased use of offshore
outsourcing in which a company relocates labor-intensive service industry functions to another 3
country.” The Report, along with a subsequent statement by the President’s chief economic
advisor that such outsourcing “is just a new way of doing international trade” sparked a heated 4
debate in Congress and elsewhere. In economic terms, this particular usage of outsourcing refers
to international trade, specifically the importation of services.
A second use of “outsourcing” has also referred to international trade, but to flows of goods rather
than services. This use may have been more frequent in past years than in the current debate. For
example, a 1983 Fortune magazine article that was among the first sources to use the term
described an increasing tendency for U.S. automakers to “buy more and more parts abroad” and
further stated that “to a large extent the products to be out-sourced are low-technology items such 5
as window cranks, seat fabrics, and plastic knobs.”
Another use of the term in the current debate refers to foreign investment rather than trade. Here,
the term refers to a U.S. firm that shifts its domestic production of an item to a foreign location or
1 This report was originally written by David L. Brumbaugh, Specialist in Public Finance.
2 For its part, the Oxford English Dictionary defines “outsourcing” as follows: “to obtain (goods, etc., esp. component
parts) by contract from a source outside an organization or area; to contract (work) out.” Oxford English Dictionary
Online, at http://dictionary.oed.com/, visited Aug. 18, 2004.
3 U.S. President (Bush), Economic Report of the President Transmitted to the Congress February 2004 (Washington:
GPO, 2004), p. 229.
4 Jonathan Weisman and Paul Blustein, “Trade Deficit Hits $489 Billion; Widening Gap Triggers Further Debate on
Job Losses Overseas,” The Washington Post, Feb. 14, 2004, p. A8. The quotation is from Chairman of the President’s
Council of Economic Advisors N. Gregory Mankiw.
5 Steven Flax, “A Hard Road for Auto Parts Makers,” Fortune, vol. 107, March 7, 1983, p. 110.
to a U.S. firm that establishes a new production facility abroad rather than in the United States.
One example of this type of outsourcing that has recently been prominently featured by the media
is the closing of a Chicago plant by Radio Flyer, Inc.—maker of a popular children’s wagon—and 6
the moving of production to China. In a usage that directly applies to taxes, Presidential
candidate John Kerry called for the closing of “loopholes in international tax law that encourage
outsourcing.” (The question of whether the U.S. tax system does, in fact, encourage this type of
outsourcing is one focus of this report, and is addressed below.)
In economic terms the three popular usages of outsourcing that are mentioned here can be
described respectively as, the import of services from abroad, the import of goods from abroad,
and the use of domestic capital in foreign locations. Given this economic view of outsourcing, the
analysis in the following sections of the report looks at the impact of taxes on two key economic
variables: trade and investment. The basic analysis of taxes and trade is the same whether the
trade is in services or goods; thus, it is important to look at the first two examples of outsourcing
together, combining our assessment of the direct use of foreign labor with that of the importation
of goods. The analysis continues by assessing the impact of taxes on foreign investment, the third
type of outsourcing.
The results of the following analysis are summarized briefly in advance. First, according to
economic theory, tax policy does not alter the country’s balance of trade, as long as it does not
also produce a change in foreign investment flows. In terms of the outsourcing debate, taxes do
not affect the net amount of the first type of outsourcing identified above, the use of foreign labor
services or inputs made by foreign firms. Taxes can, however, alter both the composition and
level of trade and reduce economic efficiency and economic welfare if they distort either how
much a country trades or what it trades. Second, tax policy can affect the extent to which firms
invest abroad; in terms of outsourcing, it can affect the extent to which firms use overseas
production facilities to produce inputs for their domestic operations. Current U.S. tax law poses a
mix of incentives and disincentives towards overseas investment; its net result is uncertain.
However, in a manner similar to trade, economic theory suggests that taxes best promote world
economic efficiency when they are neutral towards investment location. In a divergence from
trade theory, investment theory suggests taxes can promote national economic welfare (though
not world welfare) if they pose a small impediment to overseas investment.
An underlying concern of the outsourcing debate is employment. The debate is sometimes
conducted in terms of the export of jobs, yet the economic analysis just summarized does not
mention employment effects of outsourcing. In part, this is because the focus of this report is on
how taxes affect outsourcing, not how outsourcing, in turn, affects variables such as 7
employment. The last section of the report does, however, briefly turn to employment questions
and summarizes how economic theory applies to outsourcing and employment. Economic theory
indicates that outsourcing does not play an important role in determining the aggregate level of
employment in the economy, although it can affect the division of income in broad terms between
labor on the one hand, and owners of investment capital, on the other.
6 Charles Murdock, “Your Jobs: A Leading U.S. Export?” Chicago Tribune, Aug. 22, 2004, p. 1.
7 These more general assessments of outsourcing are analyzed in CRS Report RL32484, Foreign Outsourcing:
Economic Implications and Policy Responses, by Craig K. Elwell. For an analysis of data on outsourcing, see CRS
Report RL32461, Outsourcing and Insourcing Jobs in the U.S. Economy: Evidence Based on Foreign Investment Data,
by James K. Jackson.
In its discussion of outsourcing through trade in services, the 2004 Economic Report of the
President used the example of a U.S. firm that might use a call-center in India to answer customer
service-related questions. For goods, an example might be a U.S. firm that uses foreign-made
components as part of an overall product made in the United States. Importantly, in this usage of
the term “outsourcing” we rule out items produced by the U.S. firm’s own foreign facilities. In
economic terms, we are thus assessing the impact of taxes on trade, while at least initially holding
investment flows constant.
In this setting, economic theory indicates that taxes have little impact on the country’s balance of
trade—the excess of imports over exports. As applied to the outsourcing debate, theory thus
indicates that taxes have little impact on the extent to which the economy as a whole engages in
this type of outsourcing, at least as compared to the country’s level of exports. (In the context of
the outsourcing debate, we might term a country’s trade balance its “net” outsourcing.) This result
is an important one, and since it may counter the reader’s intuition, it is worth examining more
First, economics points out that a country’s trade deficit is the excess of what a country uses over
what it produces. And just as an individual who spends more than he earns must necessarily
borrow to finance the difference, a country that uses more than it produces and that runs a trade
deficit must borrow from other countries to finance the deficit. In terms of the international
economy, the borrowing consists of imports or inflows of investment capital from abroad. It
follows from this fact of economic life that a country’s trade balance mirrors its balance on capital
account. Countries normally both import and export investment capital. But if a country runs a
trade deficit, it must likewise import more capital than it exports, with the difference making the
trade deficit possible.
The trade deficit (or surplus) thus moves in parallel with the balance on the capital account and
net imports can increase only if net capital inflows also increase; identically, net exports can only
increase if net capital outflows increase. In effect, if an economy does not increase its own
production, it can increase its use of goods and services only if it borrows to do so. The
mechanism by which this identity is enforced in the current international economy is exchange
rate adjustments. If there is no change in capital flows and some factor, such as taxes, changes so
as to increase imports or exports, exchange rates will eventually adjust so as to offset any impact
the factor might otherwise have on the trade balance.
An example using outsourcing is useful here; we use the case of a hypothetical domestic industry
(we’ll call it Industry A) whose firms typically employ staffs of technical support personnel who
are on call to answer customer questions. Suppose the home country implements a tax policy that
inadvertently encourages firms to shift from using domestic service employees to using foreign
ones. For example, the home country might implement more stringent depreciation rules for a
certain type of equipment the home-country technical services personnel use. Since foreign
operations of foreign firms are generally beyond the U.S. tax jurisdiction, imported services
would not be directly affected by such a change. For illustration’s purposes, we shall say that the
new depreciation rules increase the cost of using domestic personnel to such an extent that
Industry A finds it advantageous to begin importing the services it previously obtained
domestically. Industry A, in other words, increases its outsourcing, which may initially be
reflected in an increase in the home country’s trade deficit (its net outsourcing).
But this is where exchange rate adjustments occur, neutralizing any changes in the balance of
trade. In order to pay the foreign service providers, the firms in the home country’s Industry A
must increase their purchases of foreign currency. The increase in demand for foreign currency, in
turn, will normally drive up the price of the foreign currency, which, in turn, makes all the home
country’s imports more expensive while at the same time making the home country’s exports
cheaper for foreign buyers. In the aggregate, the home country’s exports increase while its
imports recede from their initial expansion, and when the adjustment is complete, the initial
increase in the trade deficit is completely offset by increases in aggregate exports and reductions
in aggregate imports induced by the exchange rate movements. Because the exchange rate
adjustments apply to all the home country’s traded goods and services, not just to Industry A’s
imports, and because we assumed that only one home-country industry was subject to increased
taxes, only part of Industry A’s initial increase in outsourcing would likely be offset by exchange
rate movements before the adjustments run their course. A part of Industry A’s initial increase in
outsourcing is, in other words, likely to remain. But the crucial point is this: if there is an increase
in outsourcing in one sector, it will be offset by reduced outsourcing, reduced imports of other
products, and increased exports in other sectors.
While taxes do not alter the trade balance, they can affect other aspects of trade, including its
composition, its level, and what economists call the “terms of trade.” First, composition: even
from the simple example here, it is clear that a tax that causes uneven changes in price across
industries can alter what is traded—the exact mix of goods and services that a country imports
and exports. In our example, we assumed that because of a tax change, a particular industry in the
home country increased its service imports but other home-country imports fell and exports
increased because of exchange rate adjustments. In general terms, the composition of trade
depends on the particular pattern of relative costs within the domestic economy; when tax
burdens within the economy are uneven, they distort relative costs and change what is traded.
Taxes can likewise alter the overall level of trade even where the balance of trade does not
change. To illustrate, in our example the increase in imports triggered by the tax change was
partly offset by exchange rate adjustments, but because part of the adjustment necessary to
maintain the trade balance was absorbed by increased exports, the overall level of imports
remained higher than before. Again in general terms, the changed tax policy did encourage a
higher reliance on imports by industry A, but to pay for the imports (again assuming no capital
flows or added borrowing) the home country also increased its exports; the overall level of trade
The “terms of trade” is an economic term denoting the price of home-country exports compared
to the price of its own imports; it measures the amount of exports a country must provide
foreigners in order to obtain a given amount of foreign products. Taxes can alter the terms of
trade by reducing the price foreigners pay for exports or by increasing the price of imports. A
prominent example in current tax policy is the impact of the U.S. extraterritorial tax exclusion
(ETI) tax benefit for exports that is at the heart of an ongoing controversy between the United
States and the European Union. The ETI benefit is designed to boost U.S. exports by cutting taxes
on export income. In order to sell more exports, however, U.S. producers necessarily pass on part
of their own tax savings to foreign consumers in the form of reduced prices, thus registering what
economists term a “worsening” of the terms of trade. (The terms of trade effect of our earlier
outsourcing examples are ambiguous, and would depend on market conditions.)
We have thus far looked at a type of outsourcing where the U.S. firm that imports its inputs does
not itself produce the imported items in an overseas production facility. Our specific examples
have consisted of trade in services, although the same general analysis applies to trade in goods.
In terms of economic variables, we have also assumed there is no outflow of capital that
accompanies the outsourcing; we have focused exclusively on trade rather than investment. But
as described at the report’s outset, a part of the outsourcing debate has concerned overseas
production by U.S. firms, and so the next section shifts the focus from trade to capital flows.
We have seen that economic theory indicates that if taxes do not alter capital flows, they have no
impact on the balance of trade, although they may affect the level and composition of trade.
Absent changes in foreign investment, in other words, taxes do not affect what might be called
net outsourcing. Theory also indicates, however, that taxes can affect investment: they can alter
the relative attractiveness of foreign and domestic locations for multinationals, leading them to
change their allocation of capital between the domestic and foreign economies. Thus, if we define
a second type of outsourcing as the use of overseas rather than domestic production facilities,
taxes can have an impact. An example of this second type of outsourcing might consist of a U.S.-
owned factory in a foreign country that produces tangible goods shipped back to the United
Taxes enter the investment equation as follows: according to economic theory, firms allocate their
investment resources between foreign and domestic locations by comparing the rate of return
investment produces in either location. In general, they invest in each location up to the point
where the rate of return on an additional increment of investment is the same at home and abroad.
Since firms are concerned with their aftertax profits, they equate the return of foreign and
domestic investment after taxes, rather than before them. The basic impact of taxes results: other
factors remaining constant, taxes will induce firms to shift more investment than they otherwise
would from the domestic economy to foreign locations if the tax burden on foreign investment is
lower than that on domestic investment. Taxes will shift investment from foreign locations to the
domestic economy if taxes are relatively lower on domestic investment, and taxes will have no
impact on (will be “neutral” towards) the location of investment if their burden is the same in
We can make this general result more concrete by constructing another example. Here, we shall
say that a domestic manufacturing industry (Industry B) uses a particular part—say, a door
handle—as a component of its final product. We will also say that the home-country government
again introduces more stringent depreciation rules, in this case for the equipment used to
manufacture the door handle, thus effectively increasing the cost of the part for Industry B. We
return below to some possible trade effects of the tax policy change, but here focus on the
investment impact. Since the new depreciation rules do not apply to investment abroad, the policy
change will have the effect of increasing the tax burden on domestic investment compared to
investment abroad. Rather than importing the door handle in this case, we will say that Industry B
establishes its own foreign operations, conducted by foreign subsidiary corporations unaffected
by the tax change. Here, then, the outsourcing consists of production overseas by U.S. firms,
using investment funds flowing from the domestic economy to foreign locations.
Before looking at how specific features of the existing U.S. tax system affect investment, we
return briefly to trade. As noted in the first section, taxes do not affect the trade balance unless
they alter capital flows, and our analysis there held capital flows constant. In the present section,
however, we have seen how taxes can, in fact, alter capital flows. Since the trade balance moves
in parallel with the balance on capital account, taxes can therefore temporarily alter the balance of
trade indirectly through their impact on capital flows. The direction of the impact is perhaps
counter to intuition; an increase in capital outflows reduces the trade deficit, since capital
outflows are, in effect, exports. In terms of the outsourcing debate, in other words, an increase of
our second type of outsourcing—the type that consists of overseas investment—actually reduces
the net amount of the first type of outsourcing—the type consisting of imports.
As before, this result occurs because of exchange rate adjustments. When U.S. firms increase
their overseas investments, they supply additional dollars as they increase their purchases of
foreign assets. The price of the dollar accordingly declines; U.S. exports become less expensive
for foreigners and U.S. imports become more expensive. Imports shrink, exports increase, and the
trade deficit—net outsourcing through trade—diminishes. While this is an attention-getting result
because of its irony (outsourcing through investment reducing outsourcing through trade), it
should not be emphasized because it is temporary: the increased flow of capital abroad lasts only 8
until U.S. firms achieve their new desired level of capital stock abroad.
A more persistent impact of tax policy on the trade balance may occur if tax policy affects the
federal budget deficit and thus alters federal borrowing requirements—a development that would
likely change net capital flows. For example, repeal of the ETI export tax subsidy would, in
isolation, increase federal tax receipts and thus reduce the budget deficit. The resulting decline in
federal borrowing requirements would (again, in isolation) reduce capital inflows, which would
reduce the trade deficit. The importance one attaches to this effect depends on whether one
assumes that a given change in tax policy is matched by another change that offsets its revenue
effect—for example, whether repeal of a provision such as ETI is matched by revenue-losing
changes occurring elsewhere. We do not offer a conclusion on this subject here. Further, it can be
argued that federal budget deficits must ultimately be offset by a surplus at some point in the
future, so this effect, too, may be temporary.
In the preceding section we saw how taxes can have an impact on the overall level and
composition of trade, though not the trade balance; they can also alter the type of outsourcing that
consists of overseas production by U.S. firms. We do not provide a detailed assessment here of
the impact of the current tax system on the level and composition of trade (again, the system does
not have a direct impact on the balance of trade). We can note, however, that the existing system
may well reduce the level of trade by virtue of its use of a “classical” system for taxing corporate
income. Under such as system, income from corporate investment is taxed twice, once at the
corporate level and once when it is received by stockholders as capital gains or dividends. In
contrast, the principal types of non-corporate investment, owner-occupied housing and non-
corporate business, are taxed only once, if at all. Given that goods and services in the “tradables”
sector consist more frequently of corporate rather than non-corporate products, the double-
8 We should also note that in the long run there may be a slight, permanent increase in the demand for domestic
currency as firms increase their repatriations of foreign earnings. This would drive up the exchange rate, reducing
exports, increasing imports, and increasing net outsourcing.
taxation of corporate investment may shift resources from tradables to non-tradables, thus
reducing the level of trade.
Other features of the federal tax system (in isolation) likely increase the level of trade from what
would otherwise occur. Specifically, the Internal Revenue Code contains two separate export tax
benefits: the extraterritorial income exclusion (ETI), and the so-called “inventory source rule,”
which permits firms, in effect, to exempt part of their export income from taxes by characterizing
part of export income as having a foreign source for purposes of the foreign tax credit rules. (As
described below, the ETI provision is the focus of legislation being actively considered in the
current Congress.) While both provisions induce U.S. firms to increase their exports, exchange
rate adjustments (in a manner similar to the adjustments described above) increase imports and do
not completely offset the expansion of exports. The provisions thus increase the overall level of
trade. We do not assess whether the two export benefits have an impact large enough to offset the
possible trade-reducing impact of the corporate income tax and the trade reducing impact that
occurs where tariffs are imposed.
We look at the impact of the existing U.S. system on investment flows in more detail. Again, the
key factor for taxes’ impact on investment is how the tax burden on foreign investment compares
with that on domestic projects. Other CRS products provide more detailed descriptions of the
U.S. international tax system and how it affects the relative tax burden on foreign and domestic 9
investment. Here, however, we note only its essential features. In general, the U.S. system
produces no single, overall impact on investment flows that is readily discernable; different parts
of the system, viewed in isolation, produce different results. The so-called “deferral” principle,
for example, permits an indefinite postponement of U.S. tax for overseas operations conducted
through foreign subsidiary corporations rather than branches of U.S. parent firms. Deferral poses
a tax incentive for investment in countries with low tax rates, resulting in more U.S. investment in
those locations than would otherwise occur. The U.S. tax system also permits its investors to
claim a foreign tax credit for foreign taxes they pay, a feature that reduces double-taxation of
overseas income; in some cases the foreign tax credit can result in even tax treatment of foreign
and domestic investment, producing tax neutrality. The foreign tax credit, however, is limited to
U.S. tax on foreign and not domestic income, a feature that poses a disincentive for investment in
countries with high tax rates, resulting in less U.S. investment in those locations than would
The principal features of TIPRA—extension of reduced rates for capital gains and minimum tax
relief—were not directly related to international taxation. Early versions of the legislation also
contained extension of a large number of temporary tax benefits (“extenders”) that expired at the
end of 2005. Most extenders were not included in the final act, but were addressed in Congress’s
December 2006 session. However, two extenders that were not excised from TIPRA were
international tax provisions. One provision extended through 2008 the exclusion of active
financing income (income from banking, insurance, and similar activities) from Subpart F’s anti-
deferral regime. A second provision excludes from Subpart F through 2008 income of a type that
9 See CRS Report RL32429, Foreign Investment and Tax Incentives: Analysis of Current Law and Legislative
Proposals, by David L. Brumbaugh.
would ordinarily be included in the regime—dividends, interest, and similar income—but that is
paid by a related foreign corporation out of active business income.
For a variety of reasons, congressional interest in tax provisions related to the types of
outsourcing outlined in this report was particularly high in 2004, and resulted in legislation much
broader in scope than that included in TIPRA. In 2004, both the House and Senate passed major
tax bills with a variety of provisions that were relevant to offshore outsourcing. In part, the bills—
H.R. 4520 and S. 1637—addressed a trade controversy between the United States and the
European Union by repealing the extraterritorial income (ETI) tax benefit the United States
provides to its exporters. Beyond this, however, the bills each contained a variety of provisions
with the potential to affect the relative tax treatment of domestic and overseas investment, and
that therefore might affect the volume of outsourcing through foreign investment. In October,
both chambers approved a conference committee version of the legislation that became P.L. 108-
357, the American Jobs Creation Act of 2004 (AJCA). As with the overall impact of the current
tax system, the likely combined impact of the act’s various provisions is uncertain. However, the
impact several of the measure’s most prominent features are likely to have, in isolation, is more 10
For domestic investment, the act contains a 9% tax deduction from income from domestic (and
not foreign) production activities. The deduction applies to corporations and non-corporate
businesses alike. To illustrate its effect, for a firm in the top corporate tax bracket of 35%, the
deduction has an effect similar to a reduction in the tax rate to 31.85% (i.e., 35% X [100% - 9%]).
Because the deduction is restricted to domestic investment, the deduction (in isolation) poses an
incentive for firms to invest in the United States rather than abroad. In this respect, the
deduction’s impact on investment is similar to the extraterritorial income (ETI) tax benefit for
exporting that was repealed by the AJCA in order to solve a trade dispute with the European
Union. Export tax benefits necessarily favor domestic over foreign investment, since export
production—by definition—requires domestic rather than foreign production. The domestic
production deduction, in fact, was partly intended to compensate for the economic impact of
ETI’s repeal. In contrast to the repealed ETI benefit, however, the incentive is not confined to
investment in the export sector.
The act makes a variety of changes in rules relating to the foreign tax credit. The general thrust of
the provisions is to relax foreign tax credit rules, principally in areas related to the credit’s
limitation. By far the most important of the changes is a change in the rules for allocating interest
expense between foreign and domestic sources—an allocation firms must make in calculating
their foreign tax credit limitation. While the act reduces taxes only for firms with foreign tax
credits and will thus be confined to firms with foreign investment, the reduction nonetheless
10 Note that the analysis does not consider the indirect effect of the proposals’ investment provisions on trade due to the
temporary nature of those effects.
applies more to multinationals’ domestic than to foreign investment.11 The provision will thus
probably reduce the tax burden on domestic investment relative to foreign investment and will
reduce net outsourcing through foreign investment. The remaining foreign tax credit provisions,
while likely smaller in impact that the interest allocation rules, will reduce the relative tax burden
on foreign investment, thus likely increasing the flow of investment abroad.
As with the foreign tax credit, the act contains several provisions related to the ability of U.S.
firms to defer U.S. tax on foreign income. The general thrust of the provisions is to expand the
scope of deferral, in most cases by restricting the applicability of subpart F’s denial of deferral.
The impact of these provisions, in isolation, will likely be to reduce the relative tax burden on
foreign investment, thus likely increasing the flow of foreign investment abroad.
An additional international provision is a temporary tax cut for earnings that repatriate from
foreign subsidiaries. As described above, the deferral of U.S. tax lasts only as long as foreign
earnings are reinvested abroad; U.S. taxes ultimately apply when the earnings are repatriated to
the United States as dividends. The act provides a temporary reduction in the U.S. tax that applies
upon repatriation; the provision will have the effect of reducing the tax rate to 5.25% (the
normally applicable corporate rate is 35%). The temporary period is one year.
While an intuitive analysis of the provision might conclude that it would persuade firms to
repatriate additional funds and would thus increase domestic investment, economic theory
suggests there is reason to be skeptical of intuition in this case. Theory indicates that firms’
investment decisions are dependent on the likely return to prospective investment rather than cash
flow, and the provision will not alter the return on domestic investment even if it were to increase
repatriations. Thus, the proposal may not alter net outsourcing through investment. Further, it
might be argued that the provision will actually increase overseas investment if firms believe that
the temporary measure will ultimately be made permanent.
Economic theory has developed frameworks for evaluating tax policy towards both international
trade and international investment in terms of economic efficiency and economic welfare. These
frameworks can be applied to tax policy towards both types of outsourcing assessed in this report.
As described above, taxes affect the trade balance (what we have termed “net outsourcing”) only
if they also alter capital flows. Thus, for example, economic theory holds that tax policies
designed to curtail imports (e.g., tariffs) or encourage exports (e.g., export subsidies) do not
change the trade balance, although they can alter the level and composition of trade. For example,
11 For an explanation, see CRS Report RL32429, Foreign Investment and Tax Incentives: Analysis of Current Law and
Legislative Proposals, by David L. Brumbaugh.
tariffs may shrink the overall level of trade or outsourcing, but because of exchange rate
adjustments, declines in imports are accompanied by reduced exports so that the trade balance is
not altered. Similarly, export subsidies cannot increase an economy’s trade surplus but do expand
the overall level of trade. Thus, economic theory indicates that taxes are powerless to alter the net
level of outsourcing that occurs through importing.
This is not necessarily a bad result: economic theory points out that imports are not inherently
“bad” and exports are not inherently “good,” and so policies that restrict imports or promote
exports may miss the point. International trade is indeed “trade” in the most literal sense—the
exchange of some items for others to enhance mutual well-being. Exports are thus not a key to the
economy’s wellbeing, but rather the goods that are given to foreigners in exchange for the
imported foreign goods the economy uses.
Classic economic theory says that such exchange occurs, and makes an economy better off,
because it enables economies to specialize in the production of goods they produce most
efficiently. For example, an economy might be able to produce wheat more efficiently than
watches. If its consumers nonetheless desire a certain amount of watches, it might behoove the
country to shift resources out of watch production into wheat, and trade wheat for watches made 12
by a foreign country that produces watches more efficiently than wheat. The important point its
that it is not the exports that make the economy better off, but the ability to specialize by trading
exports for imports.
From the point of view of the economy’s efficiency, and thus, general economic welfare, there is
an optimal level of international specialization. There is, in other words, a level of trade (imports
plus exports) at which an economy is specializing enough in what it does efficiently to improve
its welfare, but not specializing so much that it exports goods it produces inefficiently and
imports items that it could produce domestically at little resource cost. It is here that economic
theory provides an insight about the results of taxes’ impact on trade. To the extent that taxes
distort trade by either changing the mix of what an economy trades or the level at which it trades,
taxes are believed to impair economic efficiency and reduce the overall economic welfare of the
The application of this principle to tax policies designed to alter trade—policies designed to
shrink imports or expand exports—is straightforward. As previously noted, economists believe
that neither tariffs nor export subsidies alter the balance of trade, but rather can change the
composition and/or level of trade, with tariffs shrinking trade and export subsidies expanding it.
To the extent any of these tax policies shift the economy away from its optimal level of trade, 13
they make the economy’s participants as a whole worse off in terms of economic welfare.
Such arguments, however, focus on the economy as a whole and are sometimes difficult to see
when only a particular sector of the economy is the focus. The idea that a tariff probably makes
the economy as a whole worse off would likely be hard to explain to an employee who has just
been laid off because his firm has started relying on imported inputs. (The employment effects of
12 Note that the country may be better off in making this trade even if it produces both watches and wheat more
efficiently than the foreign country in an absolute sense; the key is for both countries to produce one good more
efficiently than the other good and for the margin of this efficiency to differ.
13 For a detailed economic analysis of the effect of an export subsidy on trade, efficiency, and economic welfare, see
CRS Report RL30684, The Foreign Sales Corporation (FSC) Tax Benefit for Exporting: WTO Issues and an Economic
Analysis, by David L. Brumbaugh.
outsourcing are discussed in the following section.) Trade theory does not deny that increases in
imports (or reductions in exports) can cause economic dislocation in particular sectors of the
economy. But because of the efficiency gains an economy realizes from trade, the welfare gain to
the economy as a whole are held to outweigh the sum of sector-specific losses. In principle, the
“winners” from a country’s international trade can compensate those made worse off by
providing transition relief or other transfers to those made worse off by trade. Such relief could,
in principle, be provided through the tax code, although mechanisms such as unemployment
insurance or subsidized job-training might be more effective. The message of economic theory on
the basic relation of taxes and trade, however, is clear: tax policies that distort trade make the
economy worse off. In terms of the outsourcing debate, economic theory asserts that tax policies
designed to curtail the type of outsourcing that occurs through trade probably make an economy
as a whole worse off.
Economic theory also provides a framework for interpreting taxes’ impact on foreign investment
from the perspective of economic efficiency and economic welfare. Here, the results are slightly
more ambiguous than those for trade because the framework distinguishes between policies that
promote world economic welfare and those that promote national economic welfare but that are
not optimal for world welfare.
We first ignore taxes and note that a central tenet of economics holds that as capital investment in
an economy increases, the product added by each additional increment of capital declines—in
terms of economic theory, there is a declining marginal product of capital. Given this physical
property of capital, firms will generally allocate investment between foreign and domestic
locations until the return on an additional unit of overseas investment (the marginal product of
capital employed abroad) is equal to that of an additional domestic investment—an outcome seen
above in the discussion of how taxes affect investment decisions. Here, we also note that where
capital is allocated so that the marginal product of foreign and domestic capital is equal, every
unit of capital is necessarily being used in its most productive location. Given the declining
marginal product of capital in both locations, if an increment of capital were shifted away from
this point, the shifted capital would necessarily earn a lower return in its new location than its old
one. At this point, therefore, the firm’s entire capital stock is employed in its most productive
location. More generally, again ignoring taxes, when firms equate the marginal product of
domestic and foreign capital, the world economy’s capital resources are employed in their most
productive location and world economic welfare is maximized.
But taxes can change things. Profit maximizing firms focus on the aftertax return to capital and
invest so that the aftertax return to additional investment is the same in each location. If taxes on
investment are the same in every location, this point will be no different from the allocation of
investment without taxes. But if taxes are different at home and abroad, the allocation of
investment will be distorted. Capital will therefore not be employed in its most productive 14
location and world economic welfare is not maximized. In short, theory indicates that tax policy
best promotes world economic welfare when it applies at the same rate at home and abroad, and
14 Put another way, governments use tax revenue to finance services that (in principle) enhance economic welfare.
Thus, the social benefit from capital investment consists of an investment’s pretax return: the investment’s aftertax
return plus the tax revenue it generates. Thus, economic welfare is maximized where the pretax rather than aftertax
return of marginal investment is equal.
is therefore neutral towards firms’ investment decisions. In economic parlance, such a tax policy
possesses “capital export neutrality”—it is neutral towards the export of capital.
A tax policy that maximizes world economic welfare is not necessarily that which maximizes a
nation’s own welfare. When an increment of capital is employed in the domestic economy, it is
the home country that collects and uses the tax revenue produced by the investment. Thus, the
home country’s residents benefit from the investment’s entire pre-tax return, not just the aftertax
return. In contrast, when capital is employed abroad, foreign governments normally are normally
entitled to taxes on the investment they host and the home country benefits only from the aftertax
return to the investment. Accordingly, the home country’s economic welfare is maximized when
firms equate the pretax return of marginal domestic investment with the aftertax return of foreign
investment. This outcome suggests that the home country (but not the world economy) is better
off when it allows only a deduction for foreign taxes rather than a credit. Allowing only a
deduction for foreign taxes would result in higher taxes on foreign investment than domestic 15
investment. Importantly, however, the benefit from such a policy may be offset if foreign
A third type of tax policy termed “capital import neutrality” is sometimes promoted by business
leaders and others. It recommends a policy that enables U.S. firms to compete in foreign markets
on an even footing with firms from foreign countries. This policy would consist of an exemption
for foreign investment from home-country taxes, but is not neutral in its effect on investment and
does not promote economic efficiency.
As described above, the U.S. tax system in some cases poses incentives towards overseas
investment, and in other cases is either neutral or poses a disincentive. The average impact of the
system is, however, uncertain, and so whether the system as a whole comes closest to capital
export neutrality, national neutrality, or competitive neutrality is likewise uncertain. Likewise,
whether the legislation Congress is considering in 2004 would nudge the system in the direction
of a particular standard is uncertain.
The impact of certain features of the system, considered in isolation, is, however, more clear. For
example, the foreign tax credit generally promotes capital export neutrality because it alleviates 16
double taxation. While the credit’s limitation is likely necessary to protect the U.S. tax base, it
permits the overall tax rate on investment in high-tax countries to exceed the U.S. tax rate, thus
permitting a tax disincentive towards foreign investment to exist. In a sense, then, the limitation is
consistent with national neutrality, although as a general matter, permitting firms only to deduct
rather than credit foreign taxes would closely approach national neutrality. The deferral principle
is consistent with capital import neutrality, since it can reduce the tax burden on foreign
investment to a level lower than the domestic tax rate. In contrast, the current taxation that applies
15 Trade theory suggests that, tax revenue considerations aside, a capital exporting country could benefit (at the expense
of the world economy) by taxing foreign investment more heavily than domestic investment. The situation exists where
the capital-exporting country faces a high foreign demand for its investment funds. In a manner analogous to that of a
monopolist who restricts output, the exporting country can extract economic rents by taxing investment outflows
16 Without the limitation, foreign governments could, in principle, deprive the United States of tax revenue by raising
their tax rates on U.S. firms whose investment they host to extremely high rates. Without the limitation, the foreign
governments would not need to fear that the high tax rates would drive off desirable investment because the firms could
simply credit the high foreign taxes against the firms’ U.S. tax on U.S. source income.
to branch operations or under subpart F is consistent with capital export neutrality as long as
foreign tax credits are also permitted.
The preceding economic analysis concluded that taxes best promote economic efficiency and
economic welfare when they neither encourage nor discourage outsourcing, whether that
outsourcing consists of imports of goods or services or exports of capital investment. But much of
the debate over outsourcing has concerned its perceived impact of jobs, with some participants 17
expressing fears that outsourced jobs destroy domestic jobs and reduce domestic employment.
The absence of employment from a prominent role in the preceding discussion indirectly suggests
what economic theory indicates about outsourcing and employment: outsourcing has no profound
effect on long-term aggregate employment in the domestic economy, although it can trigger short-
term sector-specific job losses. Nonetheless, given the prominence of employment considerations
in the outsourcing debate, we provide a brief summary of economic theory in this area.
First, mainstream contemporary economic theory holds that economies generally tend toward
“full employment” or are moving in that direction. The labor market is thought to ordinarily be at
equilibrium, where the supply of labor is equal to demand. Monetary policy set by the Federal
Reserve is generally set so as to keep the economy at full employment and to avoid shocks to the
system that might temporarily jar the economy from equilibrium. This is not to say there is never
unemployment—in fact, unemployment is always present due in part to transitions within the
economy (some of which may result from outsourcing). This persistent, minimum level of
unemployment is termed the “natural” rate of unemployment by economists and is viewed as an
unavoidable consequence of maintaining an efficient, flexible, and adaptable economy.
Nonetheless, given appropriate monetary policy, an economy is thought to generally absorb
displaced workers and tend towards full employment.
Against this backdrop, we return to the foregoing analysis of trade, which indicated that, absent
changes in capital flows, the balance of trade cannot change; economists believe that an
exogenous increase in imports (i.e., outsourcing) will ultimately be matched by an increase in
exports and a mitigation of the initial increase in imports. Here, the mix of what the economy
produces has indeed been changed, and an increase in unemployment in the import-competing
sector may occur. Nonetheless, with the economy tending towards full employment, new jobs will
be created in other sectors of the economy that will, in time, offset those lost in the sector where
outsourcing occurred. In short, when we view outsourcing as a trade phenomenon, its
employment effects will be confined to the near-term.
The employment analysis of outsourcing that occurs through investment—that is, where capital
outflows occur—is somewhat different. As with trade, there may be near-term and sector specific
unemployment as a result, for example, a factory that shuts down in a particular U.S. city and that
moves to a foreign location can certainly cause increased unemployment in the original U.S. 18
location. Again, however, the economy as a whole is seen as tending towards full employment
and the absorption of dislocated labor. There may also, however, be a shift in the shares of
17 For more information, see CRS Report RL32292, Offshoring (a.k.a. Offshore Outsourcing) and Job Insecurity
Among U.S. Workers, by Linda Levine.
18CRS Report RL30799, Unemployment Through Layoffs and Offshore Outsourcing, by Linda Levine.
national income accruing to labor and capital respectively. This outcome is based on the basic
economic precept that labor’s earnings depend on its productivity, which in turn depends on the
amount of capital it has to work with. The larger the economy’s stock of capital for a given supply
of labor, the higher will be labor productivity and the higher will be labor earnings. It follows,
then, that when capital shifts abroad, domestic labor earnings fall from the level they otherwise
As noted in the discussion above on efficiency, in principle those that gain from outsourcing can,
in principle, compensate those that lose and, because of the efficiency gains embedded in
outsourcing, still be better off than before. In principle, the economic harm to workers from
outsourcing can be mitigated by appropriate redistributive and retraining policies. Theory
maintains, however, that these policies are most efficiently effected as general transitional relief
than as policies designed to limit outsourcing.
A recent focus of tax policy debate has been the impact of taxes on the extent to which firms use
imported inputs rather than domestic goods and services and whether taxes encourage U.S. firms
to establish operations abroad rather than in the United States. In the current debate, the
phenomena are frequently referred to as offshore or foreign “outsourcing.” In economic terms, the
debate concerns the impact of taxes on two aspects of the international economy: trade and
Economic theory maintains that taxes can alter the composition and level of trade, but do not alter
the balance of trade (the excess of imports over exports). In contrast, taxes can alter the extent to
which firms invest abroad rather than in the United States. The current U.S. tax system produces a
patchwork of effects on investment so that its net impact, whether it encourages or discourages
overseas investment, is uncertain.
Economic theory also provides frameworks for evaluating the impact of tax policy on trade and
investment from the perspective of economic efficiency and economic welfare. Theory suggests,
in general, that tax policy best promotes efficiency and national economic welfare when it neither
encourages nor discourages imports or exports. In terms of the outsourcing debate, theory holds
that taxes best promote economic welfare when they do not distort the level or composition of
outsourcing. With outsourcing that occurs through investment, theory similarly indicates taxes
best promote world economic efficiency and economic welfare when they do not distort
investment flows. A policy that poses a small impediment to overseas investment may, in
contrast, best promote national welfare, although such a policy may make foreign economic
actors worse off and may be offset by retaliation.
Donald J. Marples
Specialist in Public Finance