The Foreign Sales Corporation (FSC) Tax Benefit for Exporting: WTO Issues and Economic Analysis
CRS Report for Congress
for Exporting: WTO Issues and an Economic
Updated December 11, 2000
David L. Brumbaugh
Specialist in Public Finance
Government and Finance Division
Congressional Research Service The Library of Congress
The Foreign Sales Corporation (FSC) Tax Benefit for
Exporting: WTO Issues and an Economic Analysis
The U.S. tax code’s Foreign Sales Corporation (FSC) provisions permit firms
that sell their exports through qualified sales subsidiaries (FSCs) to exempt
somewhere between 15% and 30% of their export income from federal tax. The
purpose of the provision is to stimulate U.S. exports.
Economic theory suggests that FSC probably does increase U.S. exports by a
very small amount. But beyond this, FSC’s other economic effects are probably
surprising to many non-economists. First, because of the exchange rate adjustments
that FSC triggers, it also increases U.S. imports, so that its effect on the U.S. balance
of trade – the value of exports minus the value of imports – is probably negligible.
CRS estimates based on 1996 data suggest that FSC increases the quantity of exports
by a range of 2-tenths of 1% to 4-tenths of 1%; it increases the quantity of imports
by a range of 2-tenths of 1% to 3-tenths of 1%. Based on 1996 trade flows, these
estimated changes amounted to $720 million to $1.23 billion of exports and imports
alike. Another economic effect of FSC is perhaps more important – a small transfer
of economic welfare from the United States abroad that occurs when part of the tax
benefit is passed on to foreign consumers as reduced prices for U.S. goods.
FSC is the statutory descendent of the Domestic International Sales Corporation
(DISC) provisions, enacted in 1971; DISC delivered a tax benefit of the same general
size as FSC. However, several U.S. trading partners charged that DISC was an
export subsidy in violation of the General Agreement on Tariffs and Trade (GATT).
FSC was enacted in 1984 as a replacement for DISC that was designed to be GATT-
legal. Recently, however, the European Union (EU) has charged that FSC itself
contravenes GATT’s successor – the World Trade Organization (WTO) agreements
– and filed a complaint with the WTO. In October 1999, a WTO panel supported
the EU. Under WTO procedures FSC must be brought into WTO compliance by
November 2000. Absent compliance, the EU could request compensation from the
United States or ask the WTO to authorize retaliatory measures.
In November, 2000, Congress passed (and the President signed) legislation
designed to replace FSC with a WTO-compatible export tax benefit. The legislation
provides a tax benefit for exports of the same general magnitude as FSC, but its
statutory mechanics differ—qualifying exports, for example, need not be sold through
a subsidiary corporation, and a matching amount of income from foreign operations
would potentially qualify for the tax benefit. The EU has stated it does not believe the
new tax benefit to be WTO-compliant. It has asked the WTO to rule on whether the
replacement provisions are WTO-compliant, and, if they are not, to authorize
retaliatory tariffs. This report will not be updated.
How FSC Works and its Place in the U.S. Tax System...................1
U.S. Treatment of Export Income Without FSC.....................2
The FSC Provisions..........................................3
FSC and the World Trade Organization...............................6
DISC: FSC’s Antecedent......................................6
DISC and the General Agreement on Tariffs and Trade...............7
FSC and GATT.............................................8
Findings of the WTO Panel....................................8
Proposed Replacements for FSC...............................10
Economic Effects of FSC.........................................13
Size of the FSC Benefit......................................13
FSC’s Impact on Trade and the Economy........................14
Effects of FSC’s Possible Replacement..........................17
FSC and Value-Added Tax Rebates.............................18
Data on FSC Use...........................................19
Appendix ..................................................... 21
Marginal Effective Tax Rates..................................21
Impact on Exports and Imports................................22
List of Tables
Table 1. Marginal Effective Tax Rates for Exporters using FSC............14
Table 2. FSC’s Estimated Impact on Exports, Imports, and Economic Welfare
Table 3. Selected Internal Revenue Service FSC Data, 1992 and 1996......20
The Foreign Sales Corporation (FSC) Tax
Benefit for Exporting: WTO Issues and an
The reason for the pending legislation that would alter the current tax code’s
FSC provisions is FSC’s difficulties with the WTO. U.S. trading partners in the EU
have argued that FSC is an export subsidy in violation of the WTO agreements, and
in 1999 a WTO panel supported those claims. Clearly, an understanding of the
current legislation’s context requires a look at U.S. tax laws and how they relate to
the WTO agreements. This report’s presentation of the FSC issue begins there: with
a brief overview of the U.S. international tax system, the mechanics of FSC’s partial
tax exemption, and how FSC fits into the overall U.S. tax structure.
FSC was enacted as a replacement for the DISC tax benefit, which itself was
challenged as a prohibited export subsidy shortly after its enactment in 1971. The
current controversy thus has a long history, and the report continues by looking at
DISC’s problems with the General Agreement on Tariffs and Trade and how FSC was
designed to address challenges under GATT. The discussion then turns to the current
WTO dispute and describes H.R. 4986: the proposed replacement for FSC under
consideration in Congress.
But FSC is an instrument of economic policy and a full understanding of the
current legislative context requires economic analysis. The second part of the report
thus uses economic theory to assess FSC’s impact on exports, the balance of trade,
and U.S. economic performance. According to this analysis, FSC has at most a
negligible impact on the balance of trade, increases both exports and imports by
extremely small amounts, and – perhaps most importantly – results in a very small
transfer of economic welfare from the United States to the foreign consumers who
benefit from the reduced U.S. prices that FSC affords.
How FSC Works and its Place in the U.S. Tax System
The complaint against FSC by the EU is based on FSC’s place in the U.S. tax
system. As explained below in more detail, the WTO agreements define export
subsidies, in part, as the forgoing of taxes that are otherwise due. Thus, to understand
the FSC/WTO controversy and the forces shaping both FSC and its replacement – to
get an idea of taxes “otherwise due” – it is useful to look at the U.S. international tax
system and how FSC fits into it.
U.S. Treatment of Export Income Without FSC
First, the overall structure: the United States generally operates a tax system
based on residence. That is, it looks to the residence of a corporation or individual
in order to determine whether it has jurisdiction to tax the entity in question. In the
case of corporations, firms that are chartered in the 50 states or the District of
Columbia are subject to U.S. tax on their worldwide income, regardless of whether
the income is earned domestically or abroad. If, however, a firm is chartered abroad,
the United States only applies its taxes to the foreign corporation’s U.S. source
income; it does not tax foreign firms on their foreign-source income.
The so-called “deferral” principle complicates this structure. Corporations are
legal, not economic entities. Thus, a U.S. firm can operate abroad through a foreign-
chartered subsidiary corporation that is not subject to immediate U.S. tax on its
foreign-source income. (Again, under the residence principle, foreign corporations
are subject only to U.S. tax on their U.S. income.) U.S. taxation of the subsidiary’s
income is delayed until it is remitted to the U.S. parent corporation as, for example,
Another complication is the U.S. foreign tax credit, a provision designed to
alleviate double-taxation of foreign-source income. U.S. tax law permits firms to
credit foreign income taxes they pay against U.S. taxes they would otherwise owe.
The credit is limited, however, to those U.S. taxes that would otherwise apply to
foreign source (and not domestic) income. As a result of this limit, U.S. taxpayers
who have paid foreign taxes on foreign income at relatively high rates may well have
an “excess” of foreign tax credits that they cannot use.
With these preliminaries aside, we can now look at export income. First, it is
clear that, absent FSC, a U.S. corporation that sells its exports abroad directly is likely
to be subject to U.S. tax on its export income—U.S. corporations are generally
subject to U.S. tax on their worldwide income. Immediately, however, we note an
exception. Firms that have the excess foreign tax credits described in the preceding
paragraph can use those credits to shield export income deemed to be from foreign
sources from U.S. tax. U.S. rules for “sourcing” income, further, in some cases
permit up to half of a firm’s export income to be allocated to foreign sources.
Accordingly, U.S. corporations in these circumstances can exempt up to half their
export income from U.S. tax, even without FSC. Indeed, the magnitude of this
benefit (variously called the “export source rule,” the “inventory source rule,” and the
“sales source rule,”) is greater than that available from FSC, so that firms that have
excess foreign tax credits are likely to structure their operations to use it, instead.
However, a firm must have excess foreign tax credits to use the source rule benefit,
suggesting that it cannot be used by firms that pay few foreign taxes for one reason1
1 For information on the sales source rule, see: U.S. Library of Congress. Congressional
Research Service. Tax Benefit for Exports: The Inventory Source Rule. CRS Report 97-414
E, by David L. Brumbaugh. Washington, 1997. 6 P.
What of firms that use neither the source rule nor FSC? Again, if the exports are
sold directly by a U.S. corporation, they are subject to full U.S. taxation because of
the residence principle. But what if the exports are marketed abroad through a
foreign subsidiary? That is, what if a U.S. corporation first manufactures the export
products, ships them to a foreign-chartered subsidiary corporation, which then sells
them to foreign consumers? As described above, the deferral principle may come into
play since foreign corporations are not subject to U.S. tax on foreign-source income.
To the extent a firm can allocate profits from its exports to its foreign subsidiary, the
profits would not be taxed by the United States until they are remitted to the U.S.
But in some cases deferral may be ruled out for exports, even if they are sold
through a foreign corporation. The U.S. tax code contains a set of provisions known
as Subpart F that identifies certain circumstances in which income earned by foreign
subsidiaries is subject to U.S. tax on a current basis in the hands of the subsidiaries’
U.S. shareholders. One type of income for which Subpart F potentially restricts
deferral is certain sales income from transactions between related corporations—a
type of income that could include income from export sales.2
In sum, absent FSC some U.S. export income can use an even larger tax benefit
under the source rule, but only if the exporting firm has a surfeit of foreign tax credits.
Absent either FSC or the export source rule, export income earned directly by U.S.
corporations would be subject to full U.S. taxation. Some export income earned
through foreign subsidiaries could benefit from a postponement of U.S. tax under the
deferral principle, but in some circumstances deferral would be ruled out under
Subpart F. Without FSC, in other words, some, but not all, U.S. export income
would be subject to U.S. tax. We next look at how FSC modifies this structure.
The FSC Provisions
In general, exporters use the FSC benefit by selling their products through
specially-qualified subsidiary corporations (FSCs). Eligibility for the benefit and the
size of the benefit are determined by 4 types of rules: rules for qualifying as a FSC;
rules identifying the type of FSC export income that is potentially eligible for the tax
benefit; rules dividing income between the FSC and its parent; and rules stipulating
the portion of the FSC’s eligible export income that is tax-exempt.
First, qualifying as a FSC: FSCs are required to meet certain requirements
related to their organization abroad: they must be chartered abroad or in a U.S.
possession; must have no more than 25 shareholders; must maintain an office outside
the United States where it maintains a permanent set of books; and meet certain other
Next, qualifying income: even if a firm sells its exports through a qualified FSC,
only revenue that qualifies as “foreign trading gross receipts” can generate tax-
favored profits. In general, these receipts are required to be from the sale or lease of
2 The income in question is “foreign base company sales income,” as defined in section 954(d)
of the Internal Revenue Code.
export property. The definition of export property includes most types of U.S.
products, but specifically excludes several items, including: most intangible assets
such as patents, copyrights, and trademarks; oil and gas; goods whose export is
prohibited, property that the President has determined is in short supply, and raw
timber. In addition, the tax exemption for income from exports of military property
is limited to half the exemption that would otherwise apply.
A FSC is only treated as earning foreign trading gross receipts if it conducts
certain management activities or economic processes abroad.3 Examples of
management requirements include the FSC maintaining its principal bank account
outside the United States, having a board of directors that includes at least one person
who is not a U.S. resident, and holding all shareholder meetings outside the United
States. “Foreign economic process” requirements are met if a FSC participates in
activities such as advertising, arrangement of transportation, transmittal of invoices
and receipt of payment, processing of orders, and assumption of credit risk.
Next, allocating qualified income between a FSC and its parent: a firm can use
one of three alternative rules to divide net income. The international norm for
allocating income between related entities is a method known as “arm’s length
pricing,” which divides income between firms using hypothetical prices that would be
charged if the firms were actually not related. And the FSC provisions do permit
firms to use arm’s length pricing to divide a parent and FSC’s income. But
presumably, an independent sales firm operating abroad would be able to appropriate
little of the profit from the production of exports in the United States. If it charged
market-determined prices, its profit would be based only on the value added by its
own sales and ancillary activities, contributed by its own foreign-based factors of
production. Presumably, then, little of the profit from U.S. export sales could be
attributed to a FSC using arm’s length pricing, and little benefit could be derived from
a FSC, notwithstanding the FSC’s tax exemption. The FSC rules, however, provide
two alternative “administrative” rules for allocating income.4
Under one of the administrative methods, a firm can allocate to its FSC 23% of
the combined parent-and-FSC export income. Under the second administrative
method, a firm can allocate to the FSC an amount equal to 1.83% of gross export
receipts, subject to the limit that no more than 46% of the combined taxable income
can be allocated to the FSC. Returning to the rules governing the sales corporations
themselves, the part of a FSC’s income that is tax exempt depends on the income
3 These requirements for a foreign presence were adopted in response to an understanding
approved by the General Agreement on Tariffs and Trade Council holding that a country need
not tax foreign-source income as long as arm’s length pricing is used to allocate income
among domestic firms and their foreign subsidiaries. As noted below, H.R. 4986 drops the
foreign organization and the foreign management requirements, but retains the foreign
economic process rules.
4 The Joint Tax Committee’s explanation of the original FSC legislation states that the
administrative pricing rules were “intended to approximate arm’s length pricing.” U.S.
Congress. Joint Committee on Taxation. General Explanation of the Deficit Reduction Actth
of 1984. Joint Committee Print, 98 Cong., 2d sess. Washington, U.S. Govt. Print. Off.
allocation method an exporter elects to use. If a firm uses arm’s length pricing, 30%
of the FSC’s income is exempt from U.S. tax. If it uses either of the two
administrative methods, 15/23 of the FSC’s income is tax exempt (16/23 if the parent
exporter is a non-corporate taxpayer). The interaction of the income allocation rules
and these exemption fractions dictate the size of the FSC benefit (see the appendix for
details): an exporting firm using FSC can exempt at least 15% of export income from
U.S. tax, but no more than 30%.
Having set forth rules for allocating income, the final part of the benefit’s
statutory mechanics is specification of the part of allocated FSC income that is
exempt. If arm’s length pricing has been used to allocate income between a parent
and its FSC, 30% of foreign trade income is exempt; if either of the two alternative
rules have been used, 15/23 of foreign trade income is tax exempt. Note the
combination of the rules for allocating income and the fractions of income specified
to be tax-exempt produce a particular arithmetic result: a U.S. exporter can use FSC5
to exempt somewhere between 15% and 30% of export profit from U.S. tax.
From the preceding section’s discussion of U.S. export taxation without FSC,
it is clear there are still several loose ends. First, even though FSCs are required to
be foreign corporations, the United States ordinarily taxes foreign corporations on
their U.S.-source income. However, the FSC provisions explicitly provide that a
FSC’s exempt income is to be treated as foreign-source income, thus placing it
beyond the U.S. tax jurisdiction.
Second, Subpart F’s restriction on deferral for certain types of sales income
would potentially subject some FSC income to current taxation in the hands of the
U.S. parent corporation; the FSC provisions exclude FSC income from Subpart F.
Finally, the U.S. tax law permits corporations to deduct at least part of dividends
received from other corporations from their taxable income.6 Dividends from foreign
corporations ordinarily do not qualify for the deduction, raising the possibility that
even exempt FSC income could be subject to U.S. tax when the FSC pays dividends
to its parent. The FSC provisions, however, provide that U.S. corporations can claim
a 100% deduction for dividends from a FSC.
5 The result occurs as follows: a firm can always choose to use the 23%-of-combined income
rule and exempt 15% of its income from tax (23% X 15/23 = 15%). Or, if a firm has a rate
of return on sales that is large, it could allocate more than 23% of income to its FSC using the
1.83%-of-gross receipts rule and exempt a percentage greater than 15%. The FSC rules
provide, however, that the amount exempted under the gross receipt rule cannot exceed twice
the amount exempted under the 23% rule. Thus, under these two rules, the exemption can
range from 15% to 30%. Conceivably a firm could also use arm’s length pricing to exempt
up to 30% of income, but is likely that the exemption under arm’s length pricing would be
smaller than 15%. Assuming that non-exempt income is subject to the top corporate tax rate
of 35%, the exemption range is the equivalent to reducing the tax rate on FSC income to a
range of 24.5% (i.e., [1-30%] X 35%) to 29.8% (i.e., [1-15%] X 35%).
6 The purpose of the deduction is to prevent multiple layers of corporate tax income tax.
FSC and the World Trade Organization
DISC: FSC’s Antecedent
The current FSC/WTO controversy has its roots in the legislative antecedent of
FSC: the U.S. tax code’s Domestic International Sales Corporation (DISC)
provisions, first enacted in 1971. Like FSC, DISC provided a tax incentive to export,
although its design and mechanics were different in certain respects. DISC was
enacted as part of the Revenue Act of 1971 (Public Law 92-178). It was thought that
a tax incentive for exports was desirable:
!to offset the tax code’s “deferral” benefit, which posed a tax
incentive for U.S. firms serving foreign markets to invest abroad
rather in the United States; to offset export tax incentives other
countries offered their firms; to provide a stimulus to the U.S.
In some respects, the mechanics of the DISC provisions were a parallel of the
“deferral” tax benefit DISC was designed to offset, while applying to exports rather
than foreign-source income. Firms availed themselves of the DISC benefit by
establishing specially qualified subsidiary corporations (DISCs) that were exempt
from U.S. tax and by selling their exports through the subsidiaries. (In reality, DISCs
could be little more than paper corporations and still qualify for the tax benefit.)
Since the DISCs were tax exempt, firms obtained a tax deferral for income that was
retained by the DISC rather than distributed. The size of the benefit was partly
dependent on how much export income could be allocated to the tax-exempt DISC,
for tax purposes. Like the subsequent FSC provisions, firms could use either arm’s
length pricing or several alternative “administrative” formulas to allocate income to
the DISC, where it was protected from tax.
In contrast to FSC income, DISC income was taxed when distributed to its
parent. (Firms receive a dividends-received deduction that applies to FSC income).
However, part of the income could be retained by the DISC indefinitely, and the
parent could obtain the use of its DISC’s funds by means of “producer” loans from
the DISC to the parent. Thus, while DISC was technically a tax deferral, it had the
same economic effect as a flat exemption such as FSC’s. Further, the various
statutory parameters of the DISC provisions – the income allocation rules, and
requirements for distributions – resulted in a tax benefit of the same magnitude as that8
7 U.S. Congress. Joint Committee on Taxation. General Explanation of the Revenue Act of
8 For a description of the DISC provisions and an economic analysis of their effects, see: U.S.
Library of Congress. Congressional Research Service. DISC: Effects, Issues, and Proposed
Replacements. CRS Report 83-69 E, by David L. Brumbaugh. Washington, 1983. 28 p.
DISC and the General Agreement on Tariffs and Trade
If DISC was the statutory ancestor of FSC, the WTO’s institutional predecessor
was the General Agreement on Tariffs and Trade (GATT): a multilateral trade treaty
that was designed to reduce or eliminate restrictions on free trade – restrictions such
as tariffs, non-tariff barriers to trade, and subsidies. The United States and its major
trading partners were signatory to GATT, and in 1972, shortly after DISC’s
inception, several nations of the EC submitted a complaint to the GATT Council
arguing that DISC was an export subsidy and therefore contravened article XVI of
the GATT. The United States, however, filed a counter-claim, holding that the
“territorial” tax systems of 3 EEC countries – France, the Netherlands, and Belgium
– themselves conferred export subsidies. Under a territorial tax system, a nation does
not tax the income of its corporations if that income is earned by a corporate branch
located abroad. As for DISC, itself, the United States argued that because DISC
conferred a mere deferral of tax, rather than an outright exemption, it was not in
violation of GATT.9 In 1973, the GATT Council convened a panel of experts to
study the EEC’s complaint.
The GATT panel issued its reports in 1976. It found that elements of both the
territorial system and of DISC constituted prohibited export subsidies under GATT.
However, the EEC and the United States both objected to the panel’s finding, and the
debate continued to simmer until 1981. In 1981, a solution was reached (albeit, as it
turned out, a temporary one). The GATT council adopted the panel’s report together
with an Understanding. The Understanding held that countries need not tax income
from economic processes that occur outside their borders – territorial tax systems, in
other words, do not by themselves contravene GATT. The Understanding also held,
however, that arm’s length pricing must be used in applying the territorial system to
The meaning of the Understanding itself shortly became an item of contention,
and during 1982, a debate occurred in the GATT council over how the Understanding
applied to DISC. The EEC continued to argue that DISC was an illegal export
subsidy. The United States never conceded that DISC was a subsidy, but the issue
was becoming more serious and “threatened breakdown of the dispute resolution11
process.” The U.S. Treasury thus proposed what eventually became the 1984 FSC
provisions. The provisions were designed to achieve GATT legality by providing an
export tax benefit incorporating elements of the territorial tax system countenanced
by the 1981 Understanding.
9 McGuire, J. Michael. The GATT Panel Report on Domestic International Sales
Corporations: Illegal Subsidy Under the GATT. International Trade Law Journal. V. 3,
Summer, 1978. P. 395.
10 The key language of the understanding is quoted in the October, 1999, WTO panel report:
World Trade Organization. United States – Tax Treatment for Foreign Sales Corporations.
Report of the Panel. WT/DS108/R. October 8, 1999. P. 260.
11 U.S. Congress. Joint Committee on Taxation. General Explanation of the Deficit
Reduction Act of 1984. Washington, U.S. Govt. Print. Off. 1984. P. 1041.
FSC and GATT
To see how FSC was meant to achieve GATT legality, we return to the 1981
Understanding and the basic FSC mechanics outlined above. The Understanding held
that a country need not tax foreign-source income. And as noted above, the United
States does not tax the foreign source income of foreign-chartered corporations; it
taxes foreign firms only on income “effectively connected” with a U.S. trade or
business. The FSC provisions require a FSC to be chartered abroad – hence
qualifying as a foreign corporation – and further provide that a portion of a FSC’s
income is foreign-source income not effectively connected with a trade or business
within the United States. As described above, FSCs are also required by the tax code
to conduct certain activities abroad. Hence, the FSC provisions seem to emulate
territorial systems by exempting “foreign” income from U.S. tax.
The countries of the EEC were still not fully satisfied of FSC’s GATT-legality.
Even before FSC was signed into law, the EEC expressed concerns about certain of
the new provision’s design features – for example, whether a country can operate a
territorial system that is confined to just exports, and whether the administrative12
pricing rules can accurately allocate income. Still, the controversy was generally
below the surface until November, 1997, when the European Communities – a
component of the European Union (EU) – requested consultations about FSC with
the United States, thereby taking the prescribed first step in the dispute settlement13
process established under the new WTO. The United States and the EU held
consultations without reaching a solution, and in July, 1998, the EU took the next
step in the WTO-prescribed process by requesting establishment of a panel to examine
the issue. The panel was formed and made its findings public on October 8, 1999.14
Findings of the WTO Panel
Article 3.1(a) of the WTO’s subsidies and countervailing measures (SCM)
agreement prohibits subsidies “contingent on export performance.” In turn, article 1.1
of the agreement defines a subsidy to include cases where “government revenue that
is otherwise due is foregone or not collected.” Under these provisions, the EU argued
that FSC conferred subsidies in two ways: by means of a set of tax exemptions, and
12 Caplan, Bennett, and Matthew Chametzky. Domestic International Sales Corporations
(DISCs) and Foreign Sales Corporations (FSCs): Providers of Economic Incentives for
Wholly-Owned Domestic Exporters. Brooklyn Journal of International Law. V. 12. No. 1,
13 For information on the WTO’s dispute settlement process, see: U.S. Library of Congress.
Congressional Research Service. Dispute Settlement in the World Trade Organization: An
Overview. Report RS20088, by Jeanne J. Grimmett. Washington, 1999. 6 p.
If FSC and the WTO replaced DISC and the GATT in the controversy, the European
Communities and the European Union replaced the EEC. The European Communities
integrated the EEC and several other “communities” into a single organization that became
a component of the EU.
14 For a chronology of the WTO dispute process relating to FSC, see: World Trade
Organization. United States – Tax Treatment for Foreign Sales Corporations. Report of the
Panel. P. 1.
by permitting FSCs to use administrative rules rather than arm’s-length pricing to
According to the EU, there are three FSC exemptions that result in forgoing of
taxes “otherwise due.” One is FSC’s exemption from the U.S. tax code’s subpart F
provisions. As described above, subpart F denies the deferral benefit to certain types
of income earned by foreign-chartered subsidiaries of U.S. firms. Absent this
forgiveness for FSC, the requirement that FSCs be incorporated abroad and their
devotion to sales income might place many FSCs within the purview of subpart F and
negate the FSC benefit.
While the United States generally does not tax foreign corporations on foreign
income, it does apply its taxes to their income that is “effectively connected” with the
active conduct of a U.S. trade or business. The FSC provisions explicitly state that
part of FSC income is not “effectively connected;” the EC maintained that this was
a second exemption. The EC maintained that a third exemption was the availability
of the 100% dividends-received deduction applicable to FSC dividend payments;
ordinarily, dividend payments received from foreign corporations are not eligible for
The United States maintained in its submission to the WTO panel that FSC is not
an export subsidy. In doing so, it maintained that because the 1981 Understanding
held that a country need not tax foreign economic processes, the FSC exemptions
were countenanced by the Understanding. In addition, the United States argued that
a footnote (footnote 59) to an illustrative list of subsidies contained in Annex I to the
SCM agreement likewise established that foreign economic processes need not be
The panel’s report generally supported the EC’s complaint, finding that FSC is
indeed an export subsidy in violation of the SCM agreement. According to the panel,
the exemptions identified by the EC indeed established forgiveness of taxes that would
be “otherwise due.” The panel, however, did not pronounce on the applicability of
each of the exemptions identified by the EC, finding instead that “Viewed as an
integrated whole, the exemptions provided by the FSC scheme represent a systematic
effort by the United States to exempt certain types of income which would be taxable15
in the absence of the FSC scheme.”
The WTO panel rejected the applicability of the 1981 Understanding to FSC,
finding that “it cannot provide guidance in understanding detailed provisions of the16
SCM Agreement which did not exist at the time the understanding was adopted.”
The panel also rejected the argument that footnote 59 countenanced FSC, finding
“nothing in footnote 59 which would lead us to conclude that a Member that decides
that it will tax income arising from foreign economic processes does not forgo
15 World Trade Organization. United States – Tax Treatment for Foreign Sales Corporations.
Report of the Panel. p. 275.
16 Ibid., p. 271.
revenue ‘otherwise due’ if it decides in a selective manner to exclude certain limited
categories of such income from taxation.”17
As noted above, the EC also complained that FSC violated the WTO’s
Agreement on Agriculture. More specifically, the EC maintained that FSC violated
commitments made by the United States in the agreement to limit agricultural export
subsidies. The panel also supported the EC’s complaint in this regard.18
The United States filed an appeal with the WTO’s Appellate Body, as permitted
under the dispute resolution procedures. The Body’s decision on February 24, 2000
essentially upheld the panel’s findings.
Under the WTO’s dispute procedures, the United States initially had until
October 1, 2000 to bring its system into compliance with the WTO rules. Failure to
do so might ultimately result in the WTO sanctioning retaliatory measures by the EC19
against the United States. The United States and EU, however, agreed on an
extension of the deadline to November 1.
Proposed Replacements for FSC
On May 2, 2000, U.S. Deputy Secretary of the Treasury Stuart Eizenstat met in
London with European Trade Commissioner Pascal Lamy, and presented him with an
outline of a proposed replacement for FSC. In general, the proposal would have
replaced FSC with a tax benefit for export income of the same magnitude as FSC
along with a tax exemption for income from a matching amount of goods produced
abroad. It was on this added exemption for foreign-source income that the United
States apparently based its argument that the proposal met WTO requirements. As
noted above, the WTO panel ruled that FSC was not WTO-compliant because it
provides a tax exemption that is contingent on exporting. In making the proposal, the
United States maintained:
Specifically, as described above, by its terms, the proposed elective regime
would apply both with respect to export foreign sales (involving U.S.
manufacturing) and non-export foreign sales (involving foreign
manufacturing). Thus, the proposed elective regime would not be export
contingent in law.20
17 Ibid., p. 273.
18 Ibid., p. 293.
19 Dispute Settlement in the World Trade Organization: An Overview. P. 5.
20 BNA Daily Tax Report, May 2, 2000. P. L-10.
On May 29 the EU notified the United States that it would not accept the
proposal.21 The Administration indicated that it would nonetheless work with
Congress to enact a proposed replacement by the looming deadline.22
In November, 2000, Congress approved (and the President signed) H.R. 4986,
the FSC Repeal and Extraterritorial Income Exclusion Act of 2000. The measure was
passed by a wide margin and received bipartisan support. The bill contains the
essential elements (with a few differences) of the May proposal. Like the May
proposal, the bill replaces the FSC benefit with a tax benefit of similar magnitude.
Also like the May proposal (and unlike FSC), H.R. 4986 matches its tax benefit for
exporting with a tax benefit for a like amount of income from foreign operations.23
However, unlike both the May proposal and FSC, H.R. 4986 does not require a firm
to sell its exports through a foreign-chartered corporation to qualify for the benefit.
H.R. 4986 begins by exempting “extraterritorial income” from U.S. tax, but
continues by defining “extraterritorial income” and a chain of other concepts in a way
that confines its exemption to a firm’s U.S. exports and a matching amount of income
from foreign operations. The initial link in the chain of definitions is “qualifying
foreign trade property,” which is generally products manufactured, produced, grown,
or extracted within or outside the United States. Generally, this is the full range of
U.S. exports, but the bill explicitly excludes the same items as FSC: certain
intangibles, oil and gas, raw timber, prohibited exports, and property in short supply.
Unlike FSC, however, military products would apparently qualify for the same benefit
as other exports. And unlike the parallel FSC concept of export property, qualifying
foreign trade property can be partly manufactured outside the United States.
However, not more than 50% of the value of qualified property can be added outside
the United States.
The next link in the chain is “foreign trading gross receipts,” which the bill
defines as income from the sale or lease of qualifying foreign trade property, and
which parallels the FSC concept of gross receipts. As with FSC, a firm would only
be treated as earning foreign trading gross receipts if it conducts economic processes
abroad. However, FSC’s foreign management requirements (see page 4, above)
would be dropped.
The bill next defines “foreign trade income” as taxable income attributable to
foreign trading gross receipts. The bill terms a specified part of this foreign trade
income “qualifying foreign trade income,” and grants such income a tax exemption.
The bill sets qualifying foreign trade income (and thus the exclusion) equal to either
21 Financial Times, May 30, 2000. P. 12.
22 BNA Daily Tax Report, May 31, 2000. P. GG-1.
23 In contrast to H.R. 4986, however, the May proposal would have only applied to income
from manufacturing. H.R. 4986 is also unlike the May proposal (and unlike FSC) in that it
does not require firms to set up subsidiary sales corporations to use its tax benefit.
income attributable to the foreign economic processes undertaken under the foreign
trading gross receipts requirements. (The rule exempting 30% of income is similar
in its effect to the FSC rule that applies to firms that use arm’s length pricing.) As
with FSC and the May proposal before it, the arithmetic result of these rules is that
a firm can exempt somewhere between 15% and 30% of qualified income from U.S.
As noted above, in contrast to FSC, H.R. 4986 does not require a firm to sell its
exports through a foreign-chartered corporation to qualify for the benefit. Since a
U.S. corporation could qualify for the exemption directly, the special dividends-
received deduction language in the FSC provisions is not necessary. The bill also
contains language that a foreign corporation that uses the benefit can elect to be taxed
like a U.S. corporation. This mechanism apparently rules out the application of
Subpart F, which applies only to income earned by firms that are foreign corporations,
for tax purposes.
The path of FSC legislation through Congress took a number of twists and turns.
After the House approved H.R. 4986, the Senate Finance Committee approved the
FSC-replacement bill on September 19. While the full Senate did not act on H.R.
4986 before the October 1 deadline, the EU agreed to an extension of the deadline to
November 1. The Senate Finance version of the FSC replacement was slightly
different than that of the House: the Senate bill denied a dividends-received deduction
in cases where the tax-favored exports were sold through a subsidiary. On October
26, the House passed a modified version of its FSC provisions containing a
compromise with the Senate version of the bill. The compromise was passed as part
of a larger bill tax cut and small business bill (H.R. 2614).
However, President Clinton stated that he might veto H.R. 2614 for reasons not
related to FSC, and the Senate did not act on H.R. 2614. Instead, on November 1 the
Senate passed the FSC-replacement provisions as a stand-alone version of H.R.
4986. The Senate’s version of H.R. 4986 was the same as the House-passed FSC
provisions in H.R. 2614. They differed, however, from those in the House version of
H.R. 4986, which contained the initial House provisions rather than the compromise
version that was subsequently passed as part of H.R. 2614. The version of H.R. 4986
passed by the Senate therefore could not be sent to the President without additional
House action. The House passed the new stand-alone bill on November 14 and the
President signed it into law (P.L. 106-519).
The EU has stated it does not believe the new tax benefit to be WTO-compliant.
It has asked the WTO to rule on whether the replacement provisions are WTO-
compliant, and, if they are not, to authorize retaliatory tariffs.
24 A firm can always choose to exempt 15% of income from tax. Alternatively, if its return
on sales is sufficiently high, it could use the gross receipts method to exempt up to twice that
amount from tax. The range of exemption, in other words, is 15%-30%.
Economic Effects of FSC
FSC’s ultimate economic effects are probably: very small increases in both
exports and imports, little if any change in the balance of trade, and a very small
transfer of economic welfare from the United States abroad. We begin our analysis,
however, by an assessment of the size of the tax incentive that FSC provides to
Size of the FSC Benefit
The FSC benefit produces its economic effects by reducing the rate of return
before taxes required of investment in the export sector. With FSC, export
investments can be undertaken that would otherwise have a return too low to be
profitable. FSC thus attracts added investment to the export sector, and FSC’s
impact on trade and U.S. economic welfare follow as a result.
In looking at these effects, we first gauge the size of FSC’s incentive to invest
in the export sector. Exactly how much does FSC reduce the rate of return required
of investment in the export sector? Tax economists use a particular type of effective
tax rate – termed a “marginal” effective tax rate – that measures the incentive effect
of taxes on investment. A marginal effective tax rate consists of the percentage by
which taxes change the rate of return required of new (“marginal”) investment.
Table 2, below, presents marginal effective tax rates for corporate exporters
without a tax benefit, and with the maximum and minimum FSC benefit (i.e., the 15%
and 30% exemptions). Effective rates are presented for average FSC users in general,
and for average manufacturing and non-manufacturing exporters. The effective tax
rates show that the maximum FSC benefit cuts an exporter’s tax burden by about one-
quarter, or 8.7 percentage points. At minimum, FSC reduces tax burdens by 4
percentage points, or about one-tenth. The tax rates also show that the magnitude of
the reduction in the tax burden on investment is relatively even across the different
industries. An explanation of how the effective tax rates were calculated is presented
in the appendix.
A second way of gauging the size of the FSC benefit is its revenue loss – its cost
to the U.S. Treasury in terms of forgone tax collections. According to the most
recent estimate by the Joint Committee on Taxation, the cost of FSC in terms of
forgone tax revenues is $2.7 billion for fiscal year 2000.25
25 U.S. Congress. Joint Committee on Taxation. Estimates of Federal Tax Expenditures for
Fiscal Years 2000-2004. Washington, U.S. Government Printing Office. 1999. P. 15.
Table 1. Marginal Effective Tax Rates for Exporters using FSC
Maximum FSCMinimum FSC
Product ClassNo FSC BenefitBenefitBenefit
Non-manufactured 32.0 25.3 28.4
Source: CRS calculations. See the appendix for methodology and assumptions.
FSC’s Impact on Trade and the Economy
Again, the FSC exemption reduces the rate of return required, before taxes, of
investment in the export sector, and thus attracts investment to exporting. As a
consequence, U.S. exports are probably higher than they would be without FSC.
How much higher depends on the extent to which export supply increases in response
to the tax benefit – that is, how much of the tax benefit U.S. suppliers pass on to
foreign consumers as lower prices – and on how responsive foreign purchasers are to
reduced prices for U.S. exports.
Beyond this effect, however, traditional economic analysis indicates that FSC
produces a set of effects that are perhaps surprising to non-economists. First, because
of theoretical exchange rate adjustments, the FSC-induced increase in exports is
diminished, and the value of U.S. imports also are increased; sales of U.S. import-
competing industries thus fall. Economic theory indicates that as a result, while FSC
increases the overall dollar value of U.S. trade, it does not change the balance of trade
– the value of imports minus the value of exports – or reduce the U.S. trade deficit.
The theoretical exchange rate adjustments work as follows: FSC increases
foreign purchases of U.S. exports, but to buy the U.S. products, foreigners require
more dollars. The increased demand for U.S. dollars drives up the price of the dollar
in foreign exchange markets, making U.S. exports more expensive. This partly offsets
the effect FSC has in increasing U.S. exports, but also makes imports to the United
States cheaper, which causes U.S. imports to increase. The net result is a higher
dollar value of both imports and exports, but no change in the overall balance of
This result is perhaps better seen by stepping back from the exchange rate
mechanisms and recognizing that when a country runs a trade deficit it is using more
goods and services than it produces. To do so, it must necessarily borrow from
abroad by importing more foreign investment than it exports. A country’s trade
deficit, in other words, is mirrored by deficit on capital account. And a country’s
trade balance changes only if the balance on capital account changes. Thus, if we
assume that FSC does not change the balance on capital account, it cannot change the
Another effect of FSC is on U.S. economic welfare; traditional economic analysis
indicates that FSC reduces overall U.S. economic welfare. FSC does so because as
it increases U.S. exports, at least part its tax benefit is passed on to foreign consumers
in the form of lower prices. This price reduction can be viewed as a transfer of27
economic welfare from U.S. taxpayers in general to foreign consumers.
These effects, however, are probably quite small. Table 2, below, presents CRS
estimates based on FSC data for 1996 (the most recent available). According to the
estimates, the quantity of U.S. exports is between 2-tenths of one percent and 4-
tenths of one percent higher than they would be without the provision. (The
maximum and minimum figures in the range depend on whether it is assumed firms
received a 15% tax exemption from FSC or a 30% exemption.)28 Based on figures
for total exports in 1996, this range translates into an increase in the value of U.S.
exports ranging from $720 million to $1.23 billion. The quantity of imports are an
estimated 2-tenths of 1% to 4-tenths of 1% higher than they would be without FSC.
The transfer of economic welfare from the United States to foreign consumers is an29
estimated $1.18 billion to $2.14 billion. A detailed explanation of the method used
in deriving these estimates is contained in the appendix.
26 As discussed for fully below (see page 16), FSC may actually reduce U.S. flows of capital
abroad. If so, FSC may have the effect of increasing the U.S. trade deficit.
27 As noted above, FSC increases both imports and exports – the overall level of trade. If FSC
were to operate in isolation, this increase in trade would reduce economic welfare in a second
way by causing the U.S. economy to inefficiently specialize in the items it exports and under-
produce goods that compete with items the country imports. But in view of other trade
distortions that work in the opposite direction, it may be premature to conclude that FSC
causes an efficiency loss.
28 In its November, 1997, report on FSC, the Treasury Department estimated that in 1992,
FSC increased exports by 3-tenths of 1 percent and imports by 2-tenths of 1 percent, thus
agreeing with the estimates here in terms of the order of magnitude of FSC’s effects. See:
U.S. Department of the Treasury. The Operation and Effect of the Foreign Sales Corporation
Legislation. July 1, 1992 to June 30, 1993. Washington, 1997. P. 15..
29 At 1999 trade levels, the percentages work out to an $830 million to $1.42 billion increase
in exports as well as imports, and a $770 million to $1.15 billion transfer of welfare abroad.
Table 2. FSC’s Estimated Impact on Exports, Imports, and Economic
Change in Dollar Amount
Percent Change in the(Based on the volume of
Quantity of Exports and1996 trade flows; in
15% Tax30% Tax15% Tax 30% Tax
Exemption Exemption Exemption Exemption
Shift of Economic
Welfare from U.S.0.080.13$0.66$1.15
Abroad (As percent
Source: CRS estimates. See the appendix for details.
The estimates above are simplified in that they do not take into account several
other likely effects, including changes in capital flows between the United States and
abroad, and changes in economic efficiency. It is doubtful, however, that
consideration of these factors would change the qualitative results of the analysis or
appreciably alter the quantitative results.
FSC may well reduce the flow of U.S. capital abroad, for the following reason:
exports, by definition, can only be produced in the United States. It follows that a
provision such as FSC that provides a tax benefit to export investment encourages
U.S. firms to invest in the United States rather than abroad. And given that exports
serve foreign markets it is possible that, if not for FSC, many FSC-using firms would
If it is the case, however, that FSC reduces the flow of capital abroad, the effect
of the change would be to reduce U.S. exports and increase imports: the reduced
demand by U.S. investors for foreign assets denominated in foreign currencies would
drive up the price of the dollar in currency markets, making U.S. exports more
expensive and imports cheaper. The magnitude of the change in investment flows,
however, is likely quite small.
Another effect is that of FSC on economic efficiency. As described above, FSC
increases the level of both U.S. imports and exports – in short, it increases the level
at which the United States trades with the rest of the world. Taken alone, this effect
would reduce the efficiency of the U.S. economy; FSC would be encouraging the
United States to “over trade” – to over specialize in the production of the goods that
it exports. In isolation, this effect would add to FSC’s reduction in economic welfare
that stems from the transfer of the tax benefit to foreign consumers. But FSC does
not, in fact, operate in isolation. It might be argued that FSC’s increase in the overall
level of trade mitigates a shrinkage in trade that results from what tariffs and non-tariff
barriers are in place. It also might be argued, however, that the added taxes that are
imposed to make up for FSC’s revenue loss cause economic distortions and
inefficiencies that make the net improvement in efficiency – if any – quite small.30
Effects of FSC’s Possible Replacement
As noted above, under H.R. 4986 firms could use FSC to exempt somewhere
between 15% and 30% of export income from tax. For most exports, therefore, the
benefit under the bill would be the same as under FSC. In the case of military sales,
however, the maximum benefit would increase because the proposal does not contain
FSC’s language limiting the benefit for military property to 50% of the exemption.
Perhaps a more important difference in the effect of H.R. 4986 would stem from
its extension to a certain amount of foreign-produced goods. A thorough analysis of
the provision would require a full-blown discussion of the economics of investing
abroad, and is beyond the scope of this report.
However, a few preliminary observations can still be made. First, regardless of
how low H.R. 4986 might reduce U.S. tax on foreign-source income, where high
foreign taxes apply they would at least neutralize any added U.S. incentive to invest
in high-tax foreign countries. Second, as described above in the discussion of the
U.S. tax structure (see page 2), U.S. tax on income earned by foreign-chartered
subsidiaries is generally not subject to U.S. tax until it is repatriated to the United
States parent firm as dividends; foreign-source income receives a deferral of U.S. tax
as long as it is reinvested abroad. The deferral principle thus poses an incentive for
U.S. firms to invest abroad in countries with low tax rates. In the case of investment
originating in the United States (as opposed to reinvestment of foreign-source
earnings) the magnitude of deferral’s benefit and incentive to invest abroad is greater,
the longer the income from the investment is expected to be reinvested abroad. For
investment whose stay abroad is expected to be short, H.R. 4896 may increase the tax31
incentive to invest abroad beyond that posed by deferral.
As described above (see page 17), changes in capital flows may induce changes
in the trade balance. If H.R. 4896 does, indeed, increase U.S. investment abroad, it
may have the additional effect of reducing the U.S. trade deficit.
30 Calculations using rough estimates of the amount of capital in the export sector suggest that
even if all FSC’s efficiency changes produce welfare gains, those gains would be negligible
– substantially less than $1 billion per year.
31 Hartman has pointed out that for funds that are already abroad, the incentive to invest
abroad does not depend on taxes that apply upon repatriation, and only on the tax rate on
domestic investment versus foreign investment. The proposal would therefore apparently not
affect the incentives faced by funds originating abroad.
The Joint Committee on Taxation has estimated that H.R. 4986 would reduce
U.S. tax revenue by $1.5 billion over 5 years.32 This revenue loss is in addition to the
revenue that would be lost by retaining the FSC program.
Support for FSC can be found in the business community. A possible reason for
the divergence in business views from those of economists may be perspectives:
economic analysis looks at the impact of FSC from the perspective of the economy
as a whole, taking into account its full range of effects and adjustments in all markets.
Supporters of the provision, however, are frequently businessmen whose exporting
firms would likely face declining sales, profits, and employment if FSC were to be
eliminated. For economists, there is no denying that FSC boosts employment and
increases incomes in certain sectors of the economy, and that its repeal would cause
short-term dislocation in those sectors. But FSC also results in contraction of other
parts – for example, firms that compete with imports – and transfers economic welfare
to foreign consumers.
The business community also generally supports H.R. 4986. The National
Association of Manufacturers, for example, has endorsed the bill.33
FSC and Value-Added Tax Rebates
FSC has occasionally been defended on the grounds that it counters subsidies
provided to foreign producers by their own governments. A purported subsidy that
is sometimes cited is the practice among European (and other) countries of rebating
the value added taxes (VATs) that would otherwise apply to export sales. The
rebates work as follows: under a VAT, tax is generally applied at each stage of
production, to the value-added by that particular stage. When a firm in a VAT-
imposing country makes an export sale, it receives a rebate of all the VAT that has
been paid with respect to the good at every level of production. At the same time,
when a VAT-imposing country imports an item, it generally applies its VAT to the full
value of the import.
Economists have long held that such “border adjustments” do not distort trade
and are in fact necessary if exported goods are to be part of the same relative price
structure as other goods in the importing country.34 A parallel might be drawn with
sales taxes imposed by U.S. states, that apply to goods imported from other states but
not to goods exported to other states. Like the border adjustments with VATs, these
adjustments do not distort trade.
32 U.S. Congress. Joint Committee on Taxation. Estimated Revenue Effects of H.R. 4986.
JCX-88-00. Washington, July 27, 2000.
33 BNA Daily Tax Report, August 24, 2000. P. G-1.
34 Krugman, Paul, and Martin Feldstein. International Trade Effects of Value-Added
Taxation. Working Paper 3163. Cambridge, MA, 1989. National Bureau of Economic
Research. 26 p.
In recent decades, some economists (sometimes referred to as “new trade
theorists”) have applied models of market imperfections to international trade and
have concluded that in some cases, government intervention in trade might improve
a country’s economic welfare. For example, in markets where only a few firms
compete for profits, a “strategic trade policy” such as an export subsidy might shift
profits from a foreign firm to a domestic one. Or, external economies such as
knowledge spillovers might recommend a subsidy for the industry in which the
economies occur. These policy prescriptions, however, have been met with
considerable skepticism among trade economists for a variety of reasons. First, the
theory that supports strategic trade is not robust – for it to work requires a variety of
special assumptions. Second, a more appropriate way to address external economies
that within a country’s own borders may be to apply a subsidy in the domestic
economy rather than the international one. Third, as an empirical matter, cases where
export subsidies can improve economic performance may well be quite limited. And
finally, groups that can benefit from a subsidy may co-opt a subsidy that is initially
well-targeted so that its aim ultimately fails.35 Perhaps more importantly for FSC,
even if developments in trade theory were to support export subsidies in certain
circumstances, they likely do not support a broadly available benefit such as FSC as
a structural and permanent part of the tax code.
Data on FSC Use
The most recent Internal Revenue Service FSC data are from 1992 and 1996.
(Data for the intervening years have not been published.) Table 3, below, presents a
selection of these data for FSCs and their parent firms, categorized by the principal
product class into which the firms’ exports fall. The left part of the table shows gross
export receipts of FSCs and their parents; the right part of the table shows income
exempt from tax under the FSC provisions. In each case, the numbers are averaged
for 1992 and 1996, and in each case the product classes within non-manufacturing and
manufacturing, respectively, are arranged in order of size.
It is clear from the table that most FSC exports are manufactured products:
manufactured products account for 87% of FSC-related gross export receipts and
87.5% of income exempted from tax under the FSC provisions. Within
manufacturing, use of FSC appears to be concentrated within just a few product
classes. The four largest product classes are: electrical machinery (including
electronics components, radios, and televisions), non-electrical machinery (including
engines and turbines and computers), transportation equipment (including autos and
aircraft), and chemicals (including plastics and drugs). Together, these four
categories account for about two-thirds of both FSC-related gross receipts and tax-
exempt FSC income.
35 For surveys of the literature on new trade theory, see: Baldwin, Robert E. Are Economists’
Traditional Trade Policy Views Still Valid? Journal of Economic Literature. V. 30. June,
1992. Pp. 804-29; Bhagwati, Jagdish. Free Trade: Old and New Challenges. The Economic
Journal. V. 104. March, 1994. Pp. 231-46; and Krugman, Paul. Does the New Trade
Theory Require a New Trade Policy? World Economy. V. 15. July, 1992. Pp. 423-41.
Table 3. Selected Internal Revenue Service FSC Data, 1992 and 1996
(Dollar Amounts in millions)
Average% ofTaxTotal Tax
Gross Total Exempt Exempt
Product ClassReceipts,ReceiptsProduct ClassIncome,Income, all
1992 andof all1992 andProduct
1996 Product 1996 Classes
All Products$219,077.8100%All Products$6,277.3100%
Non-Manufactured 26,499.3 12.1 Non-Manufactured 758.7 12.1
Non-Agricultural 13,668.5 6.2 Non-Agricultural 553.0 8.8
Agricultural 12,830.8 5.9 Agricultural 205.8 3.3
Manufactured 191,383.9 87.4 Manufactured 5,491 87.5
Non-Electrical 41,024.3 18.7 Electrical 1,176.2 18.7
Transportation 35,028.7 16.0 Non-Electrical 1,100.4 17.5
Chemicals 30,618.7 14.0 Transportation 791.2 12.6
Manuf. Products24,410.811.1 Manuf. Products739.511.8
Not Includeda/Not Includeda/
Food & Kindred11,603.85.3Instruments351.25.6
Instruments 10,528.0 4.8 Tobacco 269.8 4.3
Tobacco7,171.93.3Food & Kindred220.33.5
Paper & Allied5,903.32.7Paper & Allied115.21.8
Fabricated Metal3,757.81.7Fabricated Metal88.41.4
Not Allocable1,193.70.5Not Allocable27.30.4
a/ Includes: Rubber, textile mill products, stone, printing & publishing, furniture & fixtures, leather, apparel, petroleumrefining, and misc. manufacturing. Except for “misc.manufacturing,” each of these individual category accounted for less
that 1% of gross receipts. Sources for raw data: U.S. Internal Revenue Service. Statistics of Income ( SOI) Bulletin. Summer, 1997. p. 114-31; and Statistics of Income (SOI) Bulletin. Spring, 2000. P. 87-122.
Marginal Effective Tax Rates
In general, marginal effective tax rates for FSC were calculated using the well-
known Hall-Jorgenson formula for the rental cost of capital and aggregated using Jane
Gravelle’s CRS capital stock model and data on FSC use, by product class.
The starting point for the calculation is formulation of an exporter’s discount rate,
which is the rate of return its stockholders and creditors require, after corporate taxes
but before their own individual income taxes. The discount rate is a weighted average
of that for debt and equity, as follows.
where r is the real aftertax discount rate, f is the share of investment financed with
debt, i is the nominal interest rate, a* is the portion of export income subject to tax
(i.e., not exempted by the FSC provisions), u is the statutory corporate tax rate, p*
is the inflation rate, and E is the real return to equity. Values for the parameters were
selected based on their observed long-run values and follow those used in the CRS
capital stock model: f is set at .33, i is .11, a is either 1, .85, or .7. depending on the
portion of FSC income that is assumed to be exempt, u is .35, p is .05, and E is .07.
The following discount rates result from these parameters:
!No FSC exemption: .0538;
!FSC 15% exemption: .0558;
!FSC 30% exemption: .0577.
The Hall-Jorgenson rental cost expression is modified to incorporate FSC, as
(2) ;q a u cqe dt a uzqr d t= − +− +∫ ( * ) *( )1
where q is the acquisition cost of a depreciable asset, c is the rental cost of capital, d
is the economic depreciation rate, and z is the present value of depreciation
deductions claimed over the life of the asset. The expression states that firms will
invest up to the point where the rate of return of a marginal investment is expected
to produce a stream of revenue and tax deductions over its lifetime whose present
value is equal to the asset’s acquisition cost.
The rental cost is interpreted as the rate of return required of a marginal
investment under this condition. Solving (2) for the rental cost produces:
r d a uz+ −( )( * )1
Subtracting the economic depreciation rate from the rental cost produces the
pretax rate of return, net of depreciation, that firms require of a marginal investment.
The marginal effective tax is defined as the percentage increase taxes cause in a
marginal investment’s required rate of return, or, more precisely, the difference
between the required pretax and the discount rate, divided by the pretax return:
where u* is the marginal effective tax rate and r* is the required pretax return.
The aggregate effective tax rates in table 1 of the text were calculated by first
obtaining industry-by-industry pretax returns from the CRS capital stock model, then
by weighting each industry’s pretax return by its corresponding product’s share of
FSC gross receipts, as reported in the Spring, 2000 Statistics of Income Bulletin. The
capital stock model integrates pretax returns for investment in inventory with returns
for equipment and structures.
Impact on Exports and Imports
The impact of FSC on exports and imports was calculated by specifying the
Mn f( )+ − = 0
Xn is U.S. non-FSC exports, Xf is FSC exports, p is the price of U.S. exports (in
dollars), a is the subsidy from FSC, e is the exchange rate (in dollars/foreign
currency), and M is U.S. imports. In our calculations, it was assumed that the entire
FSC tax subsidy is passed on to foreign consumers as lower prices, so that:
Equation (5) states that U.S. exports are a function of price and the exchange rates;
equation (6) is the balance of payments constraint that specifies that the value of
exports must equal the value of imports, and equation (7) states that U.S. imports are
a function of the exchange rate. The model’s partial derivative are assumed to have
the following signs:
< < > >0 0 0 0, , , .
Supply elasticities are assumed to be infinite, so all elasticities produced by solving the
equations are interpreted as demand elasticities.
Solving the three equations simultaneously produces the following results:
M X f
X s s X− −1
M X M f−
M s s X− −1
where sM is the elasticity of demand for imports and sX is the elasticity of demand for
exports. The equations are formulas for the percentage change in exports and imports
for a 1-percent exogenous change in the price of exports. The percent change in the
value of exports (and imports) is:
(10) .pX X= − 1
The change in welfare is the change in the quantity of net exports, expressed as
a percentage of exports:
Values for the share of exports sold by FSCs were calculated on a product-by-
product basis based on unpublished IRS FSC data for 1996 in the Spring, 2000, issue
of the Statistics of Income Bulletin. Export data by industry are at the International
Trade Administration’s web site: http://www.ita.doc.gov/td/industry/otea/usfth/
aggregate/H198t26.txt. Demand elasticity values are taken from the Treasury
Department’s 1997 FSC report (p. 30).
The change in the price of exports was calculated based on the following the
formula in 1986 CRS report by Jane Gravelle.36
36 U.S. Library of Congress. Congressional Research Service. Corporate Tax Reform and
International Competitiveness. CRS Report 86-42E, by Jane G. Gravelle. Washington, 1986.
where P is the price of a particular export good, c* is the rental cost of capital with
FSC and c is the rental cost without it. K is the stock of capital used in production
of the good, and VA is the value added to the output by the particular industry.
Equation (12) states that the change in price induced by FSC is equal to the change
in the rental cost of capital times the ratio of capital to value-added.
The change in the rental cost under FSC was calculated on an industry-by-
industry basis using the CRS capital stock model, as described above. Values were
calculated assuming first a 15% exemption under FSC, then a 30% exemption.
Figures for value added on an industry basis were taken from Bureau of
Economic Analysis (BEA) numbers published in the November, 1998 Survey of
Current Business (p. 34). Values for fixed, private, nonresidential capital by industry
were taken from figures published in the Survey of Current Business of September,
1998. The capital figures were inflated to include land and inventories based on
estimates in: Jane Gravelle, The Economic Effects of Taxing Capital Income:
Cambridge MA, MIT Press, 1994, p. 300. The figures were also each inflated by
11% to reflect an estimate of the share of intangible assets in the capital stock
published in: Don Fullerton and Andrew B. Lyon, Tax Neutrality and Intangible
Capital, in Lawrence Summers, ed., Tax Policy and the Economy, Vol. 2: Cambridge
MA, National Bureau of Economic Research, 1988, p. 73.
The price changes calculated using the formulas in (8) through (10) were applied
to the formulas in equations (4) through (6) on a product-by-product basis. They
were aggregated based on each product’s share of total U.S. exports, again using the
International Trade Administration data cited above.