Taxes and International Competitiveness

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The term “international competitiveness” has long been an important part of tax policy debates
and most recently has been prominent in discussions about fundamental U.S. tax reform. For
example, in Executive Order 13369, President Bush stated that one goal of reform should be to
“strengthen the competitiveness of the United States in the global market place.” And in July
2007, the U.S. Treasury Department hosted a conference on business tax policy to explore ways
in which the U.S. tax system might be reformed to enhance competitiveness. Yet despite its
prominent use, the meaning of “competitiveness” is often vague, with its definition frequently
depending on the perspective of the user. This report looks at competitiveness from three different
perspectives: that of individual domestic firms, that of multinational corporations, and that of
domestic labor. In each case, the report then applies economic analysis to the competitiveness
concept, which adds clarity by identifying the specific ways in which taxes affect international
trade and investment. With trade, tax burdens can affect what is traded, its overall level, and who
benefits from trade, but they do not directly affect the trade balance. Further, it is the pattern of
relative U.S. taxes within the domestic economy that matters for trade, not how a firm’s taxes
compare with those of its foreign competitors. With investment, taxes can affect the extent to
which U.S. firms establish operations abroad and can affect economic efficiency and welfare as
well as the distribution of income within the domestic economy and between the United States
and foreign countries. This report was originally written by David L. Brumbaugh, Specialist in
Public Finance. It explains basic economic principles and will not be updated.

One perspective on competitiveness is that of the individual U.S. firm with exclusively domestic
operations. For such a firm, the focus of competitiveness is trade. The company and its
components—its owners, managers, employees, and perhaps even the community in which it is
situated—likely define competitiveness as the firm’s ability to compete for market share against
imports from abroad or to compete with foreign firms in overseas export markets. From this
perspective, the impact of taxes on competitiveness likely seems straightforward: taxes are an
item of cost, and so how the U.S. firm’s own taxes compare with those of its foreign competitors
likely appears to be of critical importance. And from the firm’s perspective, targeted tax relief
probably seems an obvious way to improve the firm’s competitive position. For example, foreign
governments may appear to be subsidizing the U.S. firm’s foreign competitors; consequently, a
tax benefit for exports or perhaps a tax credit or accelerated depreciation allowance may seem ¹
like useful ways to “level the playing field.”
The focus here is on trade, but although economic theory agrees that taxes can affect trade, they
do so in ways that are frequently at odds with the results that may seem intuitive at the firm level.
The reason for the diverging views is differences in perspective: economics points out that the
impact of particular tax policies reverberates throughout the economy, causing adjustments that
offset effects that may seem obvious at the firm level. As a result, to see the impact of taxes on
trade accurately, the perspective must move beyond that of the individual firm to that of the
economy as a whole.
In shifting to the economic perspective, we look first at the economy’s trade balance, perhaps
what is popularly viewed as how U.S. firms in the aggregate fare against their foreign
competitors. Here, the economic conclusion appears almost counterintuitive: taxes on export ²
income or on import-competing goods have no direct bearing on the balance of trade. The reason
is exchange-rate adjustments, which act to neutralize the impact of tax policies targeted at trade.
An example may prove helpful. Suppose a country implements a tax benefit for exporting that is
designed to offset foreign subsidies, real or perceived. Economics indicates that if foreign
consumers are to buy more of the exports, they will require more of the domestic currency (i.e.,
dollars). The increased demand will drive up the exchange rate, making dollars more expensive
for foreign buyers. The increased price of dollars will make exports more expensive for foreign
buyers and imports of foreign goods less expensive for domestic buyers. Some or all of any initial
expansion in exports will be offset by the adjustments, and imports will expand. After the
adjustments, there will have been no change in the country’s trade balance.
In short, taxes on trade do not directly affect the trade balance. Although this conclusion may
seem counter intuition, its explanation is more easily understood when we look at the nature of
the trade balance itself. An economy’s trade balance—either a deficit or a surplus—is simply the

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amount by which the goods and services a country uses differs from the amount of goods and
services it actually produces. A trade deficit is the excess of a country’s current use of goods and
services over what it produces; a trade surplus is the value of its production minus the value of
what it keeps for itself. The intuition is this: just as an individual cannot consume more than he
earns in a given period unless he borrows, a country cannot run a trade deficit unless it, in effect,
borrows by importing capital from foreign countries to finance the difference.
A country’s trade balance, in short, is mirrored by its balance on capital account. For example, a
country’s trade deficit is necessarily mirrored by the excess of its imports of investment over
investment outflows. Thus, the capital- and current-account balances move in lock-step; the trade
balance can change only if capital flows change at the same time. Under the particular
institutional framework of the current international economy, flexible exchange rates maintain the
relation between the trade balance (the “current account”) and the investment balance (the
“balance on capital account”). In short, if a tax cut does not change the balance on capital
account, the trade balance does not change.
If taxes do not affect the trade balance, what is their impact? Standard economic analysis relies on
one of the basic foundations of international trade theory: Ricardo’s theory of comparative
advantage. Without presenting a comprehensive treatment of the theory, its essence holds that
countries trade, in effect, in order to specialize in the production of those goods and services they
produce most efficiently. Thus, it is the economy’s own internal pattern of costs that matter rather
than how its overall cost of production compares with those of foreign economies.
According to the theory of comparative advantage, taxes do not alter the balance of trade, but
they can potentially alter the composition of trade. For example, if a country’s taxes apply
unevenly across its various industries, they will likely alter the particular mix of products the
country imports and exports. Building on the above illustration where a tax credit or accelerated
depreciation is targeted at an industry threatened by foreign competition, this analysis indicates
that the targeted industry may well see its exports or import-competing sales increase as the
targeted tax benefit alters the pattern of relative costs across the economy. At the same time, the
international position of that country’s less favored industries will decline as a part of the impact
of taxes on the mix of goods that are exported and imported.
Economic analysis also indicates that tax policy towards trade can alter how economic welfare is
distributed within the economy. For example, a targeted tax benefit designed to boost the
competitiveness of one sector may in the short run benefit the owners and employees of the
favored sector; at the same time, however, it will likely reduce economic welfare in sectors of the
economy that do not receive the benefit. Again, however, economics emphasizes an economy-
wide perspective. Here, it generally concludes that a tax policy that applies unevenly across
sectors of the economy distorts the allocation of resources and diverts them from their most
productive uses. Thus, although an uneven tax policy may produce “winners” in some sectors and
“losers” in others, on balance the economy registers a reduction in economic welfare because of
the reduction in economic efficiency. An uneven, distorting tax policy that is meant to improve
trade performance likely means that the economy will specialize in the production of items it is
not particularly good at making, to the detriment of overall economic welfare.
According to trade theory, each country that is a partner to trade obtains benefits from that trade;
trading partners are not competing such that one country’s gain is the other’s loss. Rather, there
are mutual gains from trade because trade allows countries to specialize in activities they do best
and trade for products they make less efficiently. Under certain conditions, tax policy can alter

how the gains from trade are shared among countries, but in ways that are, again,
counterintuitive. For example, to the extent that an export subsidy is passed on to foreign
consumers as lower prices, the subsidy shifts economic welfare from the subsidizing country to
the foreign consumers of its exports. (In economic parlance, the subsidizing country’s “terms of
trade” are worsened.) Or, if a country has market power such that the burden of taxes on some
goods is borne by foreign consumers, a judiciously applied tax policy could improve the terms of
trade. However, even setting aside the international legality of such a policy and the possibility of
retaliation, identifying the product areas where this might occur is problematic.
Another perspective on competitiveness is that of a U.S. multinational corporation—a firm that is
based in the United States but that has production facilities abroad (what economists term ³
“foreign direct investment”). Such a firm likely defines competitiveness as the ability of its
overseas operations to compete for market share with firms from foreign host countries or firms
from third countries. With respect to taxes, the firm is likely to focus on how its own taxes
compare with those of its foreign competitors. From this perspective, a policy that helps
competitiveness is one that reduces the multinationals’ taxes vis-a-vis foreign firms;
multinationals have traditionally argued that a policy that exempts foreign operations from home-
country (i.e., U.S.) tax ensures that U.S. multinationals are not at a competitive disadvantage with
foreign firms.
The focus of this view of competitiveness is investment rather than trade. As with trade, however,
economic theory’s conclusions about the impact of taxes on investment differs from that of the
firm. Economics agrees that home-country taxes can affect the attractiveness of overseas
investment, and thus alter the extent to which U.S. firms undertake foreign direct investment.
According to theory, however, the important comparison is not how foreign firms’ taxes compare
with those of the U.S. multinationals. Instead, the crucial comparison is between taxes on
overseas investment—both U.S. taxes and any foreign taxes that apply—and the U.S. tax burden
that would apply to alternative investment in the domestic economy. Where taxes on overseas
investment are lower than taxes on domestic investment, firms undertake more foreign
investment than they otherwise would; hence, this tax policy increases foreign investment. Where
taxes on foreign investment are high, foreign investment is discouraged, and where taxes are the
same in either location, tax policy does not alter the extent of foreign investment.
Theory acknowledges that a home-country exemption for foreign income may well maximize the
competitiveness of the home country’s multinationals. Again, however, economics indicates that a
broader perspective produces different results. First, theory holds that, if left to their own devices,
profit-maximizing firms will employ their investments in the most productive locations
possible—a result that maximizes the economic welfare produced by the investment. Taxes, in
turn, will not distort firms’ investment decisions if tax burdens on domestic and foreign
investment are equal. In short, although a tax exemption for foreign investment might maximize
the competitive position of the home country’s multinationals, a tax policy that equalizes tax

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burdens at home and abroad maximizes world economic welfare. In contrast, an exemption
policy—one that maximizes multinational competitiveness—would likely distort the location of
investment, resulting in more investment where foreign taxes are lower than taxes in the United
States, and lower investment when foreign taxes are higher. The economics literature has
developed labels for the different policies, as follows: “competitive neutrality,” or “capital import
neutrality,” is an exemption policy that maximizes the competitive position of a country’s firms;
“capital export neutrality” is a policy that produces equal tax burdens at home and abroad and that
(as a result) maximizes world economic welfare because investment flows to its most efficient
global location.
Economics also concludes that the perspective of multinationals’ home country may differ from
that of the foreign host countries. World economic welfare—that is, the welfare of the home and
foreign countries combined—is maximized when capital is allocated to its most productive
location. But if a country is capital-rich, as is the United States, the capital exporting country’s
economic welfare is maximized when tax policy to some extent discourages overseas investment.
In such cases, foreign labor bears part of the burden of the export-discouraging tax, and policy
increases the tax-inclusive return to the foreign investment that does occur. (Countries with less
capital lack sufficient market power to pass on the burden of their taxes.) A tax policy of this
nature, termed “national neutrality,” would apply a higher tax burden to foreign operations than to
domestic investment, thus damping the flow of capital abroad. As discussed further below,
although a policy of national neutrality maximizes the capital exporting country’s welfare, it also
alters the division of income between capital and labor, shifting income towards labor and away
from capital. Because national neutrality distorts the location of investment, it produces an
inefficient “deadweight” reduction in world economic welfare.
It is beyond the scope of this report to describe how current U.S. tax policy affects foreign
investment. Here, we simply note that U.S. policy varies widely, depending on the situation of the
investing firm and the particular country where investment occurs. Different features of the
system are consistent with different principles. For example, the ability of U.S. multinationals to
in some cases indefinitely defer U.S. tax on foreign income is consistent with competitive
neutrality. Other provisions (e.g., the foreign tax credit and Subpart F’s limit of deferral) are
consistent with capital export neutrality. The foreign tax credit itself is limited, however, a feature
consistent with national neutrality.
A third perspective on competitiveness is that of domestic labor in general.⁴ As described in the
first section’s discussion of competitiveness from the individual firm’s perspective, an individual
firm’s employees are likely to share concerns about trade with the firm’s other “stakeholders.”
Like the firm’s owners and managers, a trading firm’s employees are likely to define
competitiveness in trade as the firm’s ability to compete against foreign firms in export markets
or in markets within the United States. Labor’s policy prescriptions are likely to be in accord with
those of the firm’s owners: targeted tax relief.

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In contrast, labor’s perspective on competitiveness and international investment generally
diverges from that of a multinational firm’s owners. Rather than viewing itself as being in
competition with foreign multinationals (as U.S. multinationals often do), domestic labor
frequently views the competition as being between investment sites; labor tends to view
competitiveness as the ability of the United States to compete with foreign countries as a location
for what it views as job-creating business investment. The tax policy prescription that results is in
accordance with this view: domestic labor has tended to support tax polices that act to discourage
overseas investment, in some cases supporting tax measures explicitly designed to penalize
“runaway plants”—broadly, plants that shut down operations in the United States and shift
production abroad.
What does economic theory say about labor and international investment? Here again, theory
reaches certain conclusions that counter intuition. First, economic analysis is skeptical about the
ability of international investment flows to affect the total level of employment in economy. In
the short run, the closure of a domestic factory and its movement abroad will doubtless cause
unemployment in the closed factory’s location. In the long run, however, the economy tends to
absorb much of the labor released when a firm shuts down or simply goes out of business. The
economy as a whole, moreover, always has a certain amount of such transitional unemployment
that occurs when firms alter their operations by, for example, shutting down operations in one
location and moving to another, either at home or abroad.
The economic change behind such transitional employment is the result of a variety of factors,
ranging from technological progress, to exogenous shocks, to changes in institutional policies.
Theory suggests, however, that a permanent policy of discouraging the movement of U.S. firms
abroad would not appreciably alter the economy’s overall level of employment; economists
generally believe that monetary and fiscal policy are the most effective methods of addressing
spikes in unemployment, and that adjustment assistance is the most effective policy prescription
for short-run, local job loss.
Although investment flows do not alter aggregate employment, theory does indicate that capital
flows do affect the distribution of incomes within the domestic economy; this result was briefly
noted in the previous section’s discussion of national neutrality. The shift occurs because labor is
more productive the more capital it has to work with. As a result, wages are generally higher and
labor receives a larger share of income (and capital a smaller share) the higher is the domestic
economy’s capital/labor ratio. Thus, it is not surprising that labor views the flow of capital abroad
with distrust, notwithstanding its tendency to see its results in terms of their impact on
employment.
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