Taxes, Exports, and Investment: ETI/FSC and Domestic Investment Proposals in the 108th Congress

CRS Report for Congress
Taxes, Exports, and Investment:
ETI/FSC and Domestic Investment Proposals
in the 108 Congress
Updated November 5, 2004
David L. Brumbaugh
Specialist in Public Finance
Government and Finance Division

Congressional Research Service ˜ The Library of Congress

Taxes, Exports, and Investment:
ETI/FSC and Domestic Investment Proposals
in the 108th Congress
The 108th Congress has considered a set of alternative tax proposals that could
affect how U.S. firms compete in the world economy and how they allocate
investment between U.S. and foreign locations. A principal impetus for the bills was
a dispute between the United States and the European Union (EU) over the U.S.
extraterritorial income (ETI) tax benefit for exporting. The EU complained that the
provision is an export subsidy and thus violates the World Trade Organization
(WTO) agreements; a succession of WTO rulings supported the EU position and the
WTO authorized the EU to impose retaliatory tariffs on U.S. goods. All of the majorth
international tax proposals that were introduced in the 108 Congress addressed the
dispute by simply repealing the ETI benefit.
The bills differed in how they addressed the economic impact of ETI’s repeal.
H.R. 1769 and S. 970 (the Crane/Rangel/Hollings proposal) proposed to replace ETI
with a tax benefit for domestic production, including both export and other types of
income. Chairman Thomas of the House Ways and Means Committee proposed
H.R. 2896, containing tax cuts for investment abroad as well as benefits for domestic
investment; the bill was approved by the Ways and Means Committee in October,
2003. Also in October the Senate Finance Committee approved S. 1637, containing
an alternative mix of tax cuts for domestic and overseas investment. The full Senate
approved the measure in May, 2004. In June, Representative Thomas introduced a
modified version of his earlier bill as H.R. 4520; the full House approved the bill on
June 17. A conference committee version of the legislation was approved by both
chambers in later October; the President signed it into law as Public Law 108-357.
A focus of the debate over the proposals was their prospective impact on
domestic U.S. employment, driven in part by concern over the impact of ETI’s repeal
on U.S. jobs. Economic analysis indeed suggests that in the short run, repeal of ETI
would result in the loss of a certain amount of jobs in the U.S. export sector, although
ETI’s role in the economy is probably not large. The alternative investment
incentives provided by the bills would also likely result in the shift of labor and other
resources to sectors that qualify for the benefits, for example, domestic
manufacturing. Economic theory, however, also indicates that in the long run the
bills’ likely impact on the overall level of domestic employment would be minimal;
in the long run the economy tends towards full employment and labor released by one
sector will be absorbed by other sectors. In analyzing international taxes, traditional
economics instead focuses on how taxes affect the location of investment — on
firms’ decision of whether to invest at home or abroad — and on the efficiency and
economic welfare effects that follow. Each bill contains both provisions that favor
domestic investment and changes that favor foreign locations; each bill essentially
pulls the system in different directions at the same time. The net impact of the
respective plans is uncertain, although it is likely that none would change the basic
nature of the U.S. system in providing a patchwork of incentives and disincentives
towards location of investment and in its mix of efficiency effects. This report will
not be updated.

Basic Features of the U.S. International Tax System.......................2
The Proposals.....................................................4
H.R. 1769 and S. 970: The Crane/Rangel/Hollings Proposal............5
H.R. 2896 and H.R. 4520........................................6
S. 1637: The Senate Bill........................................8
Other Proposals...............................................9
Economic Effects.................................................10
Investment Effects............................................11
Efficiency and Welfare Effects..................................15

Taxes, Exports, and Investment: ETI/FSC
and Domestic Investment Proposals
in the 108 Congress
The focus of this report is a set of proposed tax bills in the 108th Congress that
could have potentially important effects on international income and investment.
Congressional deliberations on the legislation culminated in October, 2004, with
passage of the American Jobs Creation Act (H.R. 4520; Public Law 108-357). The
bills considered by Congress included S. 1637, a measure passed by the Senate in
May 2004, and H.R. 4520, a bill approved by the House on June 17. Other proposals
included H.R. 1769/S. 970 (the Crane/Rangel/Hollings proposal); H.R. 2896 (an
earlier version of H.R. 4520 that was approved by the Ways and Means Committee);
and a number of other bills introduced in the Senate, including S. 1475 (Senator
Hatch), S. 1688 (Senator Rockefeller), S. 1922 (Senators Smith and Breaux), and S.
1964 (Senators Stabenow and Graham). Each of the plans proposed to phase out the
U.S. extraterritorial income (ETI) tax benefit for exports that has been the center of
a dispute between the United States and the European Union (EU). Each bill also
proposed new investment tax benefits not related to exporting that differ from bill-to-
bill and that have been the subject of debate. For its part, the Administration stated
it supports both repeal of ETI and the development of alternative tax provisions that
would “increase the competitiveness of American manufacturers and other job
creating sectors of the U.S. economy.” While its FY2005 budget proposal outlined
several possible alternative tax benefits “deserving consideration,” it did not include
either repeal of ETI or include specific alternative benefits in the budget.
The issue of how U.S. federal taxes apply to the international economy has risen
to a prominent place in tax policy debates on numerous occasions since World War
II. For example, the 1960s saw Congress approve the tax code’s Subpart F
provisions, whose purpose was to restrict the ability of multinationals to avoid U.S.
taxes by shifting earnings to offshore tax havens. In the 1970s, taxation of income
from overseas investment was prominent in congressional tax policy debates, and the
Carter Administration proposed elimination of both the Domestic International Sales
Corporation (DISC) export tax benefit and the deferral tax benefit for overseas
business operations. (The proposals were later withdrawn.) And in 1986, an
important feature of the landmark Tax Reform Act was a wide ranging set of reforms
in the rules for taxing foreign source income.
But major tax legislation in the international area has, with a few exceptions, not
occurred since 1986.1 Two factors, however, may bring an end to the hiatus. One

1 Exceptions were first the enactment of a significant expansion of Subpart F with Section
956A in 1993, the subsequent repeal of Section 956A in 1996, repeal of the possessions tax

is the dispute between the United States and the EU over the ETI export benefit that
has occurred within the World Trade Organization (WTO). In response to EU
complaints, the WTO has ruled that the ETI benefit is an export subsidy and is thus
prohibited by the WTO agreements. Under WTO procedures, the United States is
required to bring its tax code into WTO compliance or face WTO-sanctioned
retaliatory tariffs. Designing an appropriate response to the ETI/WTO dilemma thus
poses a time-sensitive policy challenge for Congress. A second factor pressing
international taxation into the policy debate is the increased integration of the U.S.
economy with that of the world at large. U.S. businesses increasingly are competitors
in international as well as domestic markets; capital investment flows increasingly
freely across national boundaries. Prominent policymakers in both Congress and the
executive branch have suggested that this increased openness of the U.S. economy
calls for profound changes in how the United States taxes international transactions.
Other observers, however, have suggested that the basic economic principles
underlying the tax systems have not changed, and a fundamental reorientation of tax
policy is not required.
The most direct economic effect of the taxes that apply to international income
is on the flow of investment between the domestic U.S. economy and foreign
locations; taxes affect the attractiveness of investing overseas compared to domestic
investment and thus can directly affect the extent to which U.S. businesses operate
abroad. It is thus not surprising that the policy debate over international taxation has
tended to focus on the potential impact of various proposals on the balance between
foreign and domestic investment, and on the employment and income effects that
might follow. Each of the most prominent legislative proposals in international
taxation addresses the ETI controversy in basically the same way: each would phase
out the ETI export tax benefit without replacing it with a redesigned export subsidy.
But in line with the policy debate, the proposals differ in the tax changes they
prescribe to make up for ETI’s impact on employment, investment, and the ability
of U.S. firms to compete.
To understand the implications of the legislative proposals for the structure of
the U.S. international tax system, we look next at the basic components of the U.S.
tax system in its international context.
Basic Features of the U.S.
International Tax System
In applying its tax jurisdiction to the overseas income of its own citizens and
firms, the United States generally, with some exceptions, operates a residence-based
system rather than a territorial system. That is, the United States looks to the
nationality of the taxpayer rather than the source of income in determining its

1 (...continued)
credit in 1996 (scheduled to occur in 2006), and enactment in 2000 of the Extraterritorial
Income (ETI) export tax benefit as a response to difficulties with its Foreign Sales
Corporation (FSC) predecessor under the World Trade Organization (WTO) agreements,
as explained below.

jurisdiction to tax, taxing U.S. citizens and residents on their worldwide income and,
in the case of businesses, taxing corporations chartered or organized in the United
States on their worldwide income.
But there are exceptions to this general structure. First, the United States grants
tax credits for foreign taxes paid. While the United States taxes its residents’
worldwide income, it concedes that the country of source has the primary right to tax
that income and permits its corporate and non-corporate taxpayers to credit foreign
income taxes they pay against U.S. taxes they would otherwise owe. In so doing, the
United States, in effect, accepts the responsibility for alleviating the double-taxation
that would result when the U.S. worldwide tax jurisdiction overlaps the normal
practice of host countries in taxing income earned within their borders. Importantly,
however, to protect the U.S. tax base, the U.S. foreign tax credit is limited to
offsetting U.S. tax on foreign income; foreign taxes cannot be credited against U.S.
tax on U.S. income. The tax credit’s limitation and associated rules give rise to some
of the most complex parts of the tax code, as described further in the sections below
on the particular proposals.
Along with the foreign tax credit, another exception to U.S. worldwide taxation
is the so-called “deferral” principle. While the United States taxes foreign income
earned directly by branches of U.S. corporations — branches that are not separately
incorporated abroad — the United States does not tax foreign-chartered corporations
on their foreign-source income. Thus, if a U.S. firm conducts foreign operations
through a subsidiary firm chartered abroad, the foreign income is not subject to U.S.
tax until the income is remitted to the U.S. parent as dividends or other income (at
which point it enters the U.S. tax jurisdiction as income of a U.S.-resident
corporation). U.S. tax on the subsidiary’s income is thus tax-deferred as long as the
income is reinvested abroad.
Deferral poses a tax incentive for U.S. firms to invest abroad in countries with
relatively low tax rates and reduces U.S. tax revenues. Since 1962, however, the tax
code’s Subpart F provisions have denied deferral’s benefit to certain types of income,
generally income from passive investment and other income whose source is thought
to be easy to manipulate in order to reduce taxes.
Where do exports fit in? As noted at the report’s outset, a principal impetus for
the proposals is the dispute between the United States and the EU over the ETI
benefit. Under the United States’ residence-based tax system, U.S. taxes would
normally apply to export income in full. If a U.S. corporation were to sell exports
directly, U.S. worldwide taxation would ordinarily ensure full U.S. taxation. If a
U.S. firm were to sell exports through a related foreign subsidiary outside the U.S.
tax jurisdiction, U.S. “transfer pricing” rules (rules governing the allocation of
income among related firms) would restrict the extent to which export income could
be allocated abroad to a foreign subsidiary outside the U.S. tax jurisdiction. To the
extent flexibility in the application of transfer pricing permits the allocation of
income to foreign subsidiaries, Subpart F apparently rules out much of the potential
for deferral to apply.
Notwithstanding these rules, however, several provisions of the U.S. tax code
provide tax benefits for U.S. exports. The ETI exclusion is one of these; its

provisions permit U.S. exporters to exclude between 15% and 30% of their export
income from tax. As mentioned above, several WTO rulings and actions by the EU
have led to the possibility of retaliatory tariffs being applied by the EU to U.S.
products. 2
Tax legislation can have an impact on the flow of investment to and from the
United States by modifying any of the multiple rules that make up this structure. As
described below, however, a number of important components of the current
legislative proposals seek to boost domestic investment by providing tax benefits that
are available only in the United States, and by changing the treatment of domestic
investment rather than altering provisions for foreign-source income. It is the relative
tax treatment of domestic and overseas investment that matters, not the treatment of
foreign investment in isolation. Thus, tax provisions that apply primarily to domestic
investment can affect the flow of investment abroad. To illustrate, current law’s
modified accelerated cost recovery system (MACRS) of depreciation is available
only for domestic investment; alteration of MACRS can alter the relative treatment
of domestic and foreign investment, and thus affect investment flows. (Indeed, as
described below, H.R. 2896 would liberalize MACRS rules.) Also, changes that are
applicable to U.S. business generally, such as reductions in the corporate tax rate, can
change the relative treatment of domestic and foreign investment because only a
fraction of overseas investment is included in the U.S. tax base.
We turn now to the content of the current proposals.
The Proposals
Each of the legislative proposals was, in part, a response to the ETI controversy,
and in one sense, the response each bill proposed was the same: the phase-out and
ultimate repeal of ETI. The proposals differed, however, in the general character of
the provisions they proposed that were aimed, in part, at making up for the impact of
ETI’s repeal on U.S. employment and investment. In general, H.R. 1769 and S. 970
(Crane/Rangel/Hollings) would have implemented a tax benefit restricted to domestic
production but that would not have been limited to exports; the proposal contained
no other revenue-raisers or tax benefits for overseas investment. H.R. 4520 and S.

1637 (the initial House- and Senate-passed bills) were substantially broader,

containing a wide range of provisions; each contained a mix of benefits for overseas
investment and tax cuts applying to domestic investment, as well as revenue-raising

2 A second export tax benefit is the so-called “inventory source” or “export source” rule,
under which firms with a surfeit of foreign tax credits can use those credits to shield export
income from U.S. tax. While the benefit a firm can obtain from the export source rule is
potentially larger than that from ETI or FSC before it, because its mechanics depend on
foreign tax credits, it can only be used by firms with overseas operations that are subject to
foreign tax.
For information on the ETI controversy, see CRS Report RL31660, A History of the
Extraterritorial Income (ETI) and Foreign Sales Corporation (FSC) Export Tax-Benefit
Controversy, by David Brumbaugh.

provisions aimed at tax shelters and corporate “inversion” reorganizations.3 The
particular mix of provisions differed between the bills, although there was some
overlap. S. 1637 would have been nearly revenue neutral, while H.R. 4520 would
likely have reduced tax revenue. Elsewhere in the Senate, S. 1475 (Senator Hatch)
proposed its own mix of domestic and overseas tax cuts, while three other bills (S.
1688, S. 1922, and S. 1964) would have implemented only domestic investment
H.R. 1769 and S. 970: The Crane/Rangel/Hollings Proposal
On April 11, 2003, Representatives Crane and Rangel introduced H.R. 1769; on
May 1, Senator Hollings introduced an identical bill in the Senate as S. 970. The
proposal was intended to resolve the FSC/ETI controversy by gradually repealing ETI
while phasing in a new tax benefit restricted to domestic production. The transition
period would have been 2003-2009. According to the bill’s sponsors, the proposal
was designed to be roughly neutral with respect to tax revenue, with the revenue gain
from ETI’s repeal offsetting the revenue loss from the production benefit.
In general, the fully phased-in domestic production benefit consisted of a
deduction from a firm’s taxable income that was equal to 10% of the firm’s
“qualified production activities income” as defined by the bill. (For a firm taxed at
the maximum 35% corporate tax rate, this would have had the same effect as a 3.5
percentage point rate reduction.) The bill defined qualified production activities
income, in turn, as that portion of the firm’s taxable income generated by domestic
(and not foreign) production multiplied by what the bill defined as the firm’s
“domestic foreign fraction.” Under the bill, the numerator (top) of the domestic
foreign fraction was the value of the firm’s domestic production and the denominator
was the value of its worldwide production, with “value” being similar to the
economic concept of “value added” — that is, the amount contributed to the price of
a good by the cost of inputs at various points in the production process. In effect,
then, a firm’s deduction was smaller, dropping from 10% towards zero, the more
intensive its foreign operations. In the policy debate over the ETI bills, this provision
was sometimes referred to as a “haircut,” and was contained in several of the Senate
proposals, as described below.
The transition aspects of H.R. 1769/S. 970 consisted of a phaseout of the ETI
benefit and phase in of the domestic production benefit, both over the period 2003-
2009. The phaseout of ETI depended on the ETI benefit a firm received in a specific
“base year,” the year 2001, rather than on exports over the phase-out period. The
benefit during the transition years was a gradually declining percentage of the 2001

3 H.R. 2896 is quite similar to legislation introduced by Representative Thomas in the 107th
Congress, H.R. 5095, although with some additions and modifications. For a detailed
description of H.R. 5095, see CRS Report RL31574, International Tax Provisions of the
American Competitiveness and Corporate Accountability Act (H.R. 5095), by David L.
Brumbaugh. For a detailed description of H.R. 2896, see U.S. Congress, Joint Committee
on Taxation, Technical Explanation of H.R. 2896, the “American Jobs Creation Act of
2003,” JCX-72-03, Aug. 13, 2003, 146 pp. Available on the Committee’s website, at
[], visited Sept. 4, 2003.

benefit (although the base amount would be inflated in the last few years of the
transition period, presumably to reflect economic growth and inflation). More
specifically, for 2003 - 2005 a firm could claim the full amount of its base 2001
benefit; for 2006 and 2007 it could claim 75% of the base benefit, and for 2008 it
would receive half the benefit. The benefit would have been completely eliminated
for 2009 and beyond.
H.R. 2896 and H.R. 4520
On July 25, 2003, Chairman Thomas of the House Ways and Means Committee
introduced H.R. 2896, a bill substantially broader than H.R. 1769/S. 970. The bill
was approved by the Ways and Means Committee on October 28. In broad outline
the bill proposed to repeal ETI over a three-year transition period and enact in its
stead a mix of tax reductions for domestic as well as foreign operations. The bill also
contained several revenue-raising items apart from its repeal of the ETI benefit. With
a few differences, the international provisions and revenue-raising items of H.R.

2896 were the same as those initially proposed by Representative Thomas in the 107th

Congress, as part of H.R. 5095. H.R. 2896, however, differed from H.R. 5095 in the
addition of several substantial tax benefits for domestic rather than foreign
According to estimates by the Joint Committee on Taxation, the bill would have
reduced U.S. tax revenue by $21.1 billion over five years and by $59.8 billion over
10 years.4 The largest portion of the estimated revenue loss was attributable to the
bill’s proposed incentives for domestic investment; they accounted for $89.5 billion,
or two-thirds of the bill’s estimated $134.5 billion gross revenue loss over 10 years.
The largest of the domestic tax cuts, in turn, was a proposal to cut in the maximum
corporate tax rate applicable to domestic production to 32% from current law’s 35%.
Among its other provisions was a proposal to cut the tax rate applicable to the middle
range of corporate income, a two-year extension of an increase in the “expensing”
investment benefit for small business, and a relaxation of alternative minimum tax
(AMT) restrictions on the deduction of losses (“net operating losses,” or losses as
defined under the tax code), and more generous rules for depreciation of leasehold
The proposal’s tax cuts for foreign-source income accounted for $41.2 billion,
or about one-third of the bill’s estimated 10-year gross revenue loss. The bill’s
modifications generally provided more generous rules relating to the foreign tax
credit’s limitation and restricted the applicability of Subpart F, thereby expanding the
scope of the deferral benefit. For the foreign tax credit, the most important change
was an alteration of the rules for allocating interest expense between domestic and
foreign sources. The bill implemented a new allocation formula sometimes called
“worldwide” allocation that would generally result in a smaller portion of interest
expense being allocated to foreign sources. This is an allocation that, in turn, would

4 U.S. Congress, Joint Committee on Taxation, Estimated Revenue Effects of the Chairman’s
Amendment in the Nature of a Substitute to H.R. 2896, The “American Jobs Creation Act
of 2003,” Scheduled for Markup by the Committee on Ways and Means on October 28, 2003
JCX-95-03, Oct. 24, 2003.

increase maximum creditable foreign taxes for some firms. In addition, the bill
proposed to reduce to two the number of separate foreign tax credit limitations a firm
would be required to calculate. (Prior law required up to nine separate limitations.)
This change would increase the ability of firms to credit foreign taxes paid with
respect to one stream of foreign income against U.S. tax due on a different stream of
income. With deferral and Subpart F, the largest proposed change was a relaxation
of “foreign base company” sales and service income rules. In general terms, this is
income attributable to sales and services income generated by transactions between
related corporations that are organized in different countries, and is subject to current
taxation rather than under Subpart F. The bill treated the countries of the European
Union as a single country for purposes of Subpart F’s base company sales and service
rules, thus restricting the scope of income classified as sales and service base
company income.
Taken alone, the bill’s revenue-raising provisions would have increased
revenue by an estimated $23.5 billion over five years — an amount equal to about
51% of the bill’s gross revenue-losing items. The principal revenue-raiser was repeal
of ETI, which would have increased revenue by an estimated $11.9 billion over five
years. The remaining revenue-raising items were a set of provisions designed to
restrict the use of tax shelters, proposals designed to restrict tax avoidance through
a technique known as “earnings stripping,” and provisions designed to reduce the
corporate tax savings available from reorganizing to include a foreign parent-
corporation (“inverting”). Prominent among the tax shelter proposals were
provisions related to penalties and disclosure requirements. The earnings stripping
provisions placed restrictions on deductible interest and similar payments between
related firms. The inversion provisions stopped short of taxing foreign parent
corporations in the same manner as U.S. corporations but applied taxes to certain
gains of the inverted corporation and its officers.
The version of H.R. 2896 that was approved by the Ways and Means
Committee differed in a number of respects from the bill as it was originally
introduced. For example, the Committee bill did not include a proposal that was in
the initial version of bill that would provide a temporary 80% tax deduction for
foreign-source income firms repatriate to the United States rather than reinvesting
abroad. (As noted below, however, a similar provision was contained in the Senate
bill.) In addition, the original bill would have substantially liberalized depreciation
allowances, provided more generous net operating loss rules, and extended and
modified the research and experimentation tax credit. The Committee bill contained
none of these provisions, but instead reduced the maximum tax rate for
manufacturing income, as described above.
As described below, the Senate approved an ETI bill in May, 2004, before the
full House began consideration of the Ways and Means bill. On June 4,
Representative Thomas introduced a modified version of the 2003 Ways and Means
bill as H.R. 4520. While the new bill had the same general thrust as H.R. 2896 —
repeal of ETI with a mix of domestic and foreign tax cuts — it contained some
changes. In the domestic area, the proposal’s central provisions — the tax rate
reductions — were the same as in H.R. 2896: the bill reduced the top tax rate to 32%.
The bill also retained the temporary increase in expensing benefits, relaxation of
AMT restrictions on losses, and more generous leasehold depreciation. The new bill

added a set of provisions that would extend a list of relatively narrow temporary tax
benefits and tax-reducing provisions (often called the “extenders”) such as the
research and experimentation tax credit and the work opportunities tax credit. The
bill also contained a provision that would permit individual taxpayers to deduct state
and local sales taxes rather than income taxes.
In the foreign area, the new bill’s differences from H.R. 2896 were more
pronounced. The measure retained H.R. 2896's revised interest expense rules for the
foreign tax credit and consolidated the number of separate foreign tax credit
limitations. H.R. 4520 did not contain, however, the previous bill’s relaxation of
Subpart F base company sales rules and it added a temporary 85% tax deduction that
applied to dividends repatriated from foreign subsidiaries. The size of the
deduction’s tax reduction would have been similar to the temporary 5.25% reduced
tax rate contained in the Senate-passed bill, as described below.
The bill’s revenue-raising items also differed in certain respects from H.R.
2896. The new measure did not contain earnings-stripping provisions, but added new
restrictions on the use of leasing transactions to transfer tax benefits, and included
several fraud-related provisions in the area of energy taxation.
According to the Joint Committee on Taxation, the bill would have reduce
revenue by an estimated $32.0 billion over FY2004-FY2009 and by $35.3 billion
over FY2004-FY2014. Its expected revenue loss in the near-term was thus larger
than that of H.R. 2896 in the near term, but smaller in the long run.
S. 1637: The Senate Bill
Senators Grassley and Baucus proposed S. 1637 on September 18, 2003; the
Senate Finance Committee approved an expanded and modified version of the bill
on October 1. The full Senate began debate on the bill in March 2004 and approved
the bill on May 11. (On July 15 the Senate approved H.R. 4520, amended to include
the contents of S. 1637 rather than the provisions in the House version of the bill.)
In general terms, the bill proposed to phase out ETI over a four-year period, and —
like the House-passed bill — implement a mix of tax benefits both for domestic and
overseas investment. Like the House bill, the Senate proposal contained a set of
revenue-raisers, although they differed in their particulars. Unlike the House bill, the
Senate bill was nearly revenue “neutral,” raising slightly more revenue than it would
have lost over its first ten years. According to Joint Tax Committee estimates, the
bill as passed by the full Senate would have increased tax revenues by $2.8 billion
over ten years. (The bill would have reduced revenue by an estimated $14.6 billion
over five years.)
The bill’s principal tax benefit for domestic investment was a deduction/rate-
reduction similar in design to that of the Crane/Rangel proposal; the deduction would
have been phased in over five years. When fully phased in, it would have consisted
of a deduction equal to nine percent of income from property “manufactured,
produced, grown, or extracted” in the United States. Until 2013, the percentage was
scheduled to be reduced by an amount related to a firm’s overseas operations in a
manner similar to the “haircut” of the Crane/Rangel proposal. For a firm subject to
the maximum 35% corporate tax rate and with no foreign operations, the deduction

would have had the same effect as a rate reduction of slightly over three percentage
points. The bill also provided a more generous phase-out procedure for the Section
179 “expensing” allowance for equipment investment and an extension of the net
operating loss carryback period to three years from current law’s two. In addition,
the Senate bill provided a temporary (one-year) reduction to 5.25% in the tax rate on
dividends repatriated to U.S. parent firms from overseas subsidiaries. As noted
above, a similar provision was included in the House-passed version of H.R. 4520.
On the international side, there was substantial overlap between the House and
Senate bills (H.R. 4520 and S. 1637), but also some differences. The bills contained
similar revisions in the foreign tax credit-related rules for allocating interest expense
— perhaps the most important of the legislation’s international provisions.
Differences included the Senate bill’s carryback and carryforward provisions for the
foreign tax credit and the House bill’s consolidation of separate foreign tax credit
Prominent revenue-raising items in the bill — aside from ETI’s repeal —
included provisions aimed at tax shelters, corporate governance provisions, and more
stringent rules for both corporate and individual expatriation.
Other Proposals
Aside from the initial Crane-Rangel proposal and the two committee-passed
bills, a number of other proposals were been introduced that contained variations on
some of the same concepts. Senator Hatch introduced S. 1475, the Promote Growth
and Jobs in the USA Act, on July 29, 2003. Like the Ways and Means and Senate
bill, S. 1475 proposed to phase out the ETI export benefit over a short transition
period. And like the Committee bills, S. 1475 proposed a set of tax cuts that would
apply to foreign-source income and a set of benefits that would be restricted to
domestic investment. Many, but not all, of the foreign provisions of S. 1475 were
substantially the same as the foreign provisions of H.R. 2896; the domestic
provisions were similar, but not identical. In contrast to the Ways and Means
Committee bill, the Hatch proposal contained no earnings stripping, corporate
inversion, or tax shelter provisions. Detailed revenue estimates are not available for
the bill, but Senator Hatch indicated that the bill would likely reduce revenue by
approximately $200 billion (presumably over 10 years).5
The Hatch plan’s tax benefits for domestic investment included more generous
depreciation and expensing allowances for domestic investment in equipment. The
bill proposed a one-year extension of JGTRRA’s bonus depreciation, but would have
increased the first year allowance to 100% of an asset’s cost from 50%. S. 1475
would also have extended JGTRRA’s $100,000 expensing allowance for equipment
for one year. The bill also would have made the research and experimentation tax
credit permanent, and provided an additional alternative method of calculating the

5 See Senator Hatch’s press release that accompanied his introduction of the bill, reprinted
in BNA Daily Tax Report TaxCore, July 28, 2003.

S. 1475's foreign proposals included more generous foreign tax credit-limitation
calculations and a scaling back of Subpart F’s restrictions of the deferral benefit.
Like H.R. 2896, the Hatch plan adopted the “worldwide” method of allocating
interest and reduced the number of foreign tax credit baskets to two. With Subpart
F, the bill would have removed foreign base company sales and service income,
although it included certain restrictions related to transfer pricing. (As noted above,
the Committee-approved version of H.R. 2896 would have restricted the scope of the
base company provisions rather than repealing them altogether.)
S. 1475 would have provided a tax cut for earnings repatriated from foreign
subsidiary corporations. The tax cut would have the effect of reducing the tax rate
applicable to repatriations to 15% of the currently applicable rate — thus reducing
the tax rate to 5.25% for a firm normally subject to the top corporate rate of 35%. In
contrast to the Senate bill’s provision the Hatch proposal’s tax cut would have been
Senator Rockefeller introduced S. 1688 on September 30, 2003. Like the Senate
plan, the Rockefeller bill phased out the ETI benefit over 2003-2006, with the
transition amount equal to a declining percentage of a firm’s 2002 ETI benefit. And
like the Committee plan, the bill provided a 9% deduction for domestic production
that would have been phased in over 2003-2008. In contrast to the Committee bill,
there was no “haircut” reduction for foreign production. The bill did however,
propose a tax credit for employers who pay health insurance expenses of retired
Senators Smith and Breaux introduced S. 1922 on November 22, 2003. The bill
would have phased out ETI and phase in a 9% domestic production deduction in the
same manner and over the same period as the Senate and Rockefeller bills. Like the
Rockefeller bill, the Smith-Breaux proposal contained no haircut reduction for
foreign production. It also added a link with domestic employment: the maximum
production deduction would be limited to 50% of a firm’s wages reported on W-2
forms. S. 1964 was introduced by Senators Stabenow and Graham on November 25,
2003. It phased out ETI in the same manner as S. 1637, S. 1688, and S. 1922 and
also provided a 9% domestic production deduction. Unlike the other bills, however,
the deduction would have been effective beginning the first year after enactment —
that is, without a phase-in period. It also contained no reduction for foreign
production and limited the deduction to 50% of wages.
The Conference Agreement on H.R. 4520
On October 6, 2004, House and Senate conferees approved an agreement on
H.R. 4520. The full House approved the agreement on October 7, and the Senate on
October 11. The President signed the bill on October 22; it became P.L. 108-357.
A summary of the provisions contained in the conference agreement is provided by
CRS Report RL32652, The 2004 Corporate Tax and FSC/ETI Bill: The American
Jobs Creation Act of 2004.

Like the House and Senate bills, the conference agreement was quite broad in
scope and focused on business taxed; it contained a broad range of both tax cuts and
tax increases in areas of the tax code other than the ETI provisions. However, the
centerpiece of the agreement was a repeal of the ETI benefit on the one hand, and
provision of a tax benefit for domestic production on the other, along with a number
of tax cuts for firms with overseas production. The agreement followed the Senate’s
version of the domestic production benefit, providing a deduction rather than a tax-
rate cut for domestic production, although it omitted the “hair cut” provision
described above. After a phase-in, the deduction is scheduled to be 9% of taxable
income. As with both the House and Senate bills, the largest tax reduction for
multinational firms is an alteration of the rules for allocating interest expense in
connection with the foreign tax credit limitation.
Other prominent differences between the House and Senate bills included a
number of items included in the House bill, but not the Senate legislation. These
included a number of tax cuts, including a rate reduction for lower levels of corporate
income, an extension of the “expensing” benefit for equipment investment,
liberalized depreciation for leaseholds, and an option for individual taxpayers to
deduct state and local sales taxes rather than income taxes. Of these, the October
conference agreement did not provide the rate-reduction, but included the other three
of these items. Likewise, the Senate bill contained a number of investment tax cuts
not in the House bill, including tax incentives related to energy and an extension of
the allowable carryback period for tax losses (net operating losses, or NOLs). These
two items were not in the conference bill.
Economic Effects
Much of the public debate over the international tax proposals focused on the
impact the respective plans are likely to have on domestic U.S. employment and on
the proposals’ possible effect on the international “competitiveness” of U.S. firms.
With employment, the debate began with the premise that repeal of ETI is likely to
lose U.S. jobs and then focused on alternative ways to compensate for ETI’s
employment impact. With competitiveness, the discussion noted the growing
integration of the United States with the world economy and asked whether tax
changes are necessary to improve the ability of U.S. firms to compete.
Notwithstanding this debate, traditional economic theory evaluates international
taxes in somewhat different terms. First, while not denying that ETI’s repeal could
lead to short-term unemployment and transitional costs, theory predicts the economy
will adjust and the lost jobs would in the long run be restored in non-export sectors
of the economy. Further, this long-run adjustment would occur without provision of
alternative investment incentives.6 Second, economic theory is skeptical of the
usefulness of the concept of competitiveness in setting broad tax policy and focuses
instead on how various tax policies affect economic welfare at home and abroad.

6 The provision of new investment incentives have at least the potential of increasing rather
than reducing transitional unemployment by causing new shifts in where capital is

Rather than employment or competitiveness, economic theory begins its analysis
of international tax policy by looking at the impact of taxes on the location of
investment: how do various international tax policies affect firms’ decisions on
where to employ their investment resources and establish operations? How do those
decisions affect capital flows to and from the United States and foreign locations?
Business income taxes are, after all, taxes on the return to capital investment, and it
is logical that the most fundamental and immediate impact of those taxes will be on
how and where capital is used.
Various other effects follow from the impact of taxes on investment: shifts in
investment may affect sectoral employment in the short run, although, as noted
above, aggregate employment is not altered in the long run. Changes in investment
can also alter how income is distributed among economic actors and groups. For
example, other factors being equal, the higher the capital/labor ratio in an economy,
the larger is the share of income that accrues to labor. This is because the more
capital labor has to work with, the more productive labor is, and the higher real
wages are. On the other hand, capital income is lower, the higher is the capital/labor
ratio. These effects may help explain the traditional split between business and labor
interests over the appropriate level of taxes on foreign vis a vis domestic investment.
Although recognizing the existence of these effects, the ultimate focus of
economic analysis is on how taxes affect economic efficiency through the allocation
of investment, and on how taxes thereby affect economic welfare: the more efficient
the economy, the greater is economic welfare. We return to these concepts at the
close of this section, but first begin by assessing the plans’ most immediate impact:
how the proposals may affect the allocation of investment between foreign and
domestic locations. Due to the complexity and variety of the proposals in the bills
we do not attempt to discern the overall, net impact of each plan, and instead limit
our analysis to the likely impact of their most important components. Further, we
confine our analysis of specific proposals to the first four ETI bills introduced in the
current Congress: H.R. 1769/S. 970 (Crane-Rangel proposal); H.R. 2896 (the Ways
and Means bill); S. 1475 (the Hatch bill); and S. 1637 (the Senate plan).
Investment Effects
According to economic theory, taxes affect international business investment
by altering the relative attractiveness of domestic versus foreign investment. Other
factors being equal, if taxes on income from a foreign investment are lower than
taxes on an identical domestic project, a firm will have an incentive to undertake the
foreign investment; if taxes on domestic investment are low compared to identical
foreign investment, firms will have an incentive to undertake the domestic
investment. And if taxes are the same in either location, they have no influence —
are “neutral” towards — the location of investment. Alteration of the relative tax
burden on domestic and foreign investment can therefore alter the share of the
economy’s investment capital that is employed, respectively, at home and abroad.
The ETI benefit does not explicitly apply to foreign or domestic investment but
its repeal, the starting point for each of the bills, would nonetheless change this
calculus. An export, by definition, is the sale of a good produced in the exporter’s
home country. Thus, current law’s ETI benefit poses an incentive to employ capital

in the United States rather than abroad and, in isolation, the provision’s repeal would
encourage the shift of a certain amount of investment out of the United States to
foreign locations as well as to alternative non-export uses within the United States.
But each of the bills also proposed tax benefits targeted directly at domestic
investment.7 These measures would work in the opposite direction from ETI’s
repeal, and — in isolation — would encourage the shift of investment from foreign
locations to the United States. In this category are the deductions for income from
domestic production in the Crane/Rangel/Hollings proposal and the Finance
Committee bill and the reduced maximum tax rate in the Ways and Means bill for
domestic production. Under H.R. 1769, for example, depending on the extent of a
firm’s foreign operations, a firm could deduct from taxable income up to 10% of
qualified income, a provision that would be similar to a statutory tax rate reduction
of up to 3.5 percentage points. Further, the deduction would be larger, the less
intensive a firm’s overseas operations.
The depreciation and research and development proposals of the Hatch bill and
the expensing provision of both S. 1475 and H.R. 2896 would similarly favor
domestic over foreign investment, since each of these provisions would apply only
to domestic assets. For example, foreign research outlays do not qualify for the R&E
credit; augmentation of the credit would thus, in isolation, result in the shift of a
certain amount of investment from foreign locations to domestic research and
development. Similarly, the “bonus” depreciation provided by S. 1475 would not
apply to foreign assets nor would the extension of expensing proposed in both S.
1475 and H.R. 2896. The general effect of these provisions, then, would be to cut
taxes on a range of domestic investments compared to identical foreign investments.
In isolation, these provisions would therefore likely result in an increased share of
investment occurring in the United States rather than abroad.
Two additional provisions that would favor domestic over foreign investment
are not explicitly targeted at domestic investment: the interest allocation rules
contained H.R. 2896, S. 1475, and S. 1636; and H.R. 2896’s rate cut for intermediate
levels of corporate income. H.R. 2896’s reduced maximum tax rate would explicitly
apply only to domestic investment, but its rate cut for intermediate levels of income
— a cut not restricted to domestic production — would also favor domestic
investment but in a more indirect way. Because of deferral and the foreign tax credit,
a larger share of U.S. investment than foreign investment is subject to U.S. statutory
tax rates and a rate cut thus disproportionately benefits domestic investment. The
impact of the interest allocation rules is perhaps harder to see: the provision would
reduce taxes, after all, only for firms that have foreign operations. However, under
both the current and proposed interest allocation rules, the more foreign assets a firm
has, the more interest is allocated abroad, reducing foreign tax credits. And the thrust
of the proposed rules change is to increase the weight given to foreign assets in the
allocation calculation. Thus, the proposal will increase the tax disincentive to invest
abroad. Overall, however, a multinational’s taxes would nonetheless be reduced,

7 For an analysis of how the investment incentives would affect effective tax rates on
investment, see CRS Report RL32099, Capital Income Tax Revisions and Effective Tax
Rates, by Jane Gravelle.

implying that domestic assets would be the investments benefitting from the
Other foreign tax credit provisions of H.R. 2896 and S. 1475, however, would
unambiguously reduce the relative tax burden of foreign compared to domestic
investment. The bills’ proposed consolidation of foreign tax credit baskets would
permit firms to achieve more cross-crediting than under current law; there would
accordingly be more situations where high foreign taxes on one stream of income
could offset U.S. tax due on more lightly taxed income. As a result, there would be
more cases where lightly taxed foreign investments would be shielded from any
additional U.S. tax; there would be more situations where firms would have a tax
incentive to increase their overseas investment. In isolation, the reduction of baskets
would likely increase the level of foreign investment from what would otherwise
Most of the bills’ Subpart F provisions would likely also reduce the tax burden
on foreign compared to domestic investment. For example, the proposal to expand
the Subpart F’s look-through rules would remove a range of foreign investments
from Subpart F’s coverage, thus increasing the scope of foreign investment for which
there is a tax incentive. Similar results would likely flow from other proposals to
rescind Subpart F coverage, for example, shipping income and gain from the sale of
partnership interests.
But what of the largest Subpart F proposals — the proposals to repeal (S. 1475)
or relax (H.R. 2896) Subpart F’s foreign base company sales and service rules? At
first glance, these provisions seems likely to encourage foreign over domestic
investment: they would permit U.S. tax on income allocated to foreign sales
subsidiaries to be deferred, thus cutting taxes on investment in foreign sales activity.
But any impact in increasing foreign investment would likely be small: if it is
assumed that transfer pricing rules result in the accurate allocation of income
between domestic parents and foreign subsidiaries, the provisions would likely have
only a small effect. The value added by sales activity alone is a small portion of the
total value of a product; only a small amount of income would therefore likely be
allocated to sales subsidiaries. Further, in addition to the limited impact on foreign
investment, some of the repeal’s benefit might accrue to domestic investment. If
there were to be difficulty in accurately allocating income, firms might be able to
shift what is actually U.S. income or currently taxed foreign income to sales
subsidiaries. For example, absent workable transfer pricing rules, export income that
is actually earned by a U.S. parent corporation could be shifted to a foreign sales
subsidiary and benefit from the deferral benefit.8 Accordingly, depending on whether
the actual source of the shifted income is domestic or foreign, the base company sales

8 Although some observers have expressed concern over such developments, Treasury
officials have recently stated that advances in income allocation and transfer pricing rules
have made such a scenario “less of a concern.” See Samuel C. Thompson, Jr. “A Critical
Perspective on the Thomas Bill,” Tax Notes, July 22, 2002, pp. 581-584; and Alison Bennett
and Katherine M. Stimmel, “Extraterritorial Income” Administration Stresses International
Relief in Effort to Replace U.S. Export Tax Regime,” BNA Daily Tax Report, July 16, 2003,
p. G-9.

and service proposals could increase either foreign or domestic investment; the
outcome is thus not clear.
The final provision we assess — the temporary reduced tax rate for repatriated
dividends — is also ambiguous. The proposal is contained in the Senate bill; while
it was included in H.R. 2896 as first introduced, it was not contained in the version
of the bill approved by the Ways and Means Committee. Two alternative economic
theories of dividend behavior can be applied to the analysis. First, economists
analyzing the impact of taxes on repatriated dividends have drawn an analogy
between the repatriation decisions of foreign subsidiary corporations and the
decisions a domestic corporation makes in deciding whether to pay dividends to its
stockholders. Under this so-called “new view” or “trapped equity” theory of
dividends, a firm whose foreign operations are mature undertakes new equity-
financed investment by retaining earnings rather than sending new equity capital
from the United States abroad. In deciding whether to retain and reinvest its foreign
earnings or to repatriate them, such a firm does not factor any taxes that apply to the
act of repatriation into the calculation. The reason is this: since the earnings that fund
the investment are already abroad, repatriation taxes must inevitably be paid, whether
the repatriation occurs currently or at some point in the future. This theory therefore
predicts that a permanent reduction or elimination of taxes on repatriated dividends
will have no impact on the level of investment abroad or at home; repatriations will
not increase. The chief impact will be a windfall increase in the value of the
subsidiary’s stock in the hands of its parent, and, in turn, an increase in value of
parent’s stock in the hands of its domestic stockholders.
The reduction in repatriation taxes in the proposals at hand, however, is
temporary; the analysis therefore differs. Here, while it is still true that repatriation
taxes must be paid whether the repatriations occur sooner or later, the tax will be
reduced if they occur within the time frames specified by the proposals. Accordingly,
a firm may advance or accelerate repatriations to take advantage of the temporarily
reduced rates. This effect, however, is likely to be transitory and may even reverse
itself when the reduced rate expires. In the long-run, the aftertax attractiveness of
foreign versus domestic investment would not be changed by the proposal, and firms
might be expected to temporarily reduce repatriations after the tax cut expires so as
to restore its desired long-run level of foreign-employed capital.
Under the “new view,” the impact of eliminating the repatriation tax is different
for young, growing foreign operations than for mature subsidiaries. Young foreign
subsidiaries fund part of their foreign investment by new contributions of capital
from their U.S. parent rather than by retaining earnings. In considering the stock of
capital it desires to employ abroad, a parent considers that repatriation taxes will
ultimately have to be paid on the earnings of that capital; capital sent abroad, in other
words, will be “trapped.” Accordingly, a permanent reduction in repatriation taxes
will increase the desired stock of capital abroad and increase U.S. investment abroad.
A temporary reduction would likely have little effect.
As it applies to domestic corporations and their individual stockholders, the new
view of dividends has been criticized on a number of grounds. For example, it
assumes firms have no method of distributing earnings other than paying dividends,
which is counter-factual. Corporations, for example, can and do repurchase their

own shares. It is beyond the scope of this analysis to evaluate the applicability of
these criticisms to foreign subsidiaries. Under the more traditional view of
dividends, however, there is no distinction between young and mature firms; a
foreign subsidiary simultaneously receives new capital from its parent and repatriates
dividends, a means, perhaps, of signaling its profitability. Under this analysis, a
permanent reduction of dividend taxes might cause earnings to be repatriated, but
would also result in a new increase in U.S. firms’ overseas investment. A temporary
tax cut might likewise temporarily increase repatriations, but as under the new view,
the increase would likely be temporary and would likely not shift the long-run stock
of investment from foreign locations to the United States.9
Efficiency and Welfare Effects
Among the variety of economic effects that follow from the impact of taxes on
investment, economic theory emphasizes international taxes’ impact on economic
efficiency and economic welfare. In general, theory holds that aggregate world
economic welfare is maximized when the economies’ scarce capital and other
resources are deployed where they are most productive — that is, where they earn the
highest pre-tax return possible. In general (with a few exceptions) this occurs, again
according to theory, when taxes do not interfere with firms’ decision of where to
employ investment. Thus, taxes maximize economic welfare when they apply
equally to identical investments, regardless of their location. With respect to
international taxes, traditional economic analysis characterizes a tax system that taxes
foreign and domestic investment the same and that is therefore neutral towards
investment location as possessing “capital export neutrality” (CXN)
Economic analysis also distinguishes aggregate world economic welfare from
the economic welfare that can accrue to a capital exporting country and recognizes
that a policy that is neutral towards foreign and domestic investment may maximize
world welfare but may not be optimal from the point of view of the capital exporting
country (in this case, the United States). Rather, theory suggests that a tax policy that
to a degree discourages overseas investment by taxing it more heavily than domestic
investment maximizes the economic welfare of the capital exporting country.
According to theory, this is the case because at least part of the total, before-tax
return to investment accrues to foreign factors of production and foreign governments
when investment is undertaken abroad, but the entire return accrues to the domestic
economy when investment occurs within the United States.
A tax policy that restricts overseas investment is called “national neutrality”
(NN) in the terminology, because it is “neutral” towards the national economic
welfare of the capital exporting country. Finally, businesses frequently emphasize
the importance of their ability to compete effectively with foreign firms and
recommend a third standard for tax policy, sometimes called “competitive neutrality”
or “capital import neutrality” (CMN). Under such a policy, home country taxes (i.e.,
U.S. taxes) would not apply to foreign source income. Economic theory suggests that

9 For a more detailed analysis of proposals to reduce repatriation taxes, see CRS Report
RL32125, Tax Exemption for Repatriated Foreign Earnings: Proposals and Analysis, by
David L. Brumbaugh.

such a policy distorts the geographic allocation of capital and maximizes the welfare
of neither the world nor the United States. Thus, even though it establishes equal tax
burdens when certain comparisons are made (i.e., U.S. firms compared to foreign
firms), CMN is not a “neutral” policy in the same sense as CXN or NN.
The current United States method of taxing foreign source income conforms to
no single one of the three policies. Instead, it poses a patchwork of incentives,
disincentives, and neutrality towards foreign investment, depending on factors such
as a taxpayer’s overall foreign investment situation, the level of foreign taxes faced
by prospective foreign investment (and thus the particular country where investment
might occur), and the legal form the investment will take. Further, different facets
of the U.S. system influence the system in different directions. For example,
application of worldwide taxation to U.S. corporations combined with application of
the foreign tax credit are aspects of the U.S. system that are consistent with capital
export neutrality. In contrast, the imposition of a limitation on the foreign tax credit
is more consistent with national neutrality, although situations where cross-crediting
can occur within the limitation can produce either neutrality or pose an incentive to
invest abroad. The deferral principle generally nudges the system in the direction of
capital import neutrality, while Subpart F restrains this effect.
How, then, would the various proposals affect the system’s impact on economic
welfare? As with investment, the overall impact of each bill is not clear; each bill
contains provisions that would, in isolation, pull the system in different directions.
The bills’ repeal of ETI would, taken alone, move the system away from NN in the
direction of CXN by eliminating a provision the favors domestic over foreign
investment. Each of the bills’ various domestic incentives, however, are, taken
alone, consistent with NN since they favor domestic investment over investment
abroad. Thus, for example, H.R. 1769/S. 970’s coupling of ETI repeal with a
domestic production deduction might, on balance, either nudge the system towards
NN or towards CXN, depending on which provision is the most powerful.
The Ways and Means Committee and Hatch proposals have provisions
consistent with each of the three policy standards. As with the Crane/Rangel/
Hollings plan, they couple provisions consistent with CXN, repeal of ETI, with a set
of domestic incentives consistent with NN, for example, depreciation, expensing, and
research credit provisions that are restricted to domestic investment. Also, in a result
that is perhaps counter to intuition, the changes in the interest allocation rules are also
consistent with NN. Both the Ways and Means Committee and Hatch bills, however,
would also scale back Subpart F, a change generally consistent with CMN. The two
bills’ consolidation of foreign tax credit limitations would nudge the system away
from NN and in the direction of either CXN or CMN, depending on the particular
In short, the current U.S. tax system is a hybrid of CXN, NN, and CMN,
containing important features consistent with each of these standards. This would
likely not change under any of the bills. Like the current system, none of the bills is
consistent with any one standard. Thus, their impact on economic efficiency and
economic welfare is not certain.