The Role of U.S. Tax Policy in Offshoring

U.S. corporate tax policy affects firms' choices regarding offshoring in important ways. The decision about how to provide an intermediate good or service is influenced by the tax treatment afforded different modes of provision. In addition, when firms choose to provide an intermediate good or service via in-house offshoring (foreign direct investment), their choice of country as well as their subsequent financial decisions regarding these transactions are influenced by international tax incentives.

This paper examines the role of U.S. corporate tax policy in influencing offshoring behavior. It addresses four related questions. First, how does the U.S. tax system operate? I address how the current U.S. tax system is designed and how recent legislative changes have affected that design. Second, what are the incentives provided by this system? I examine how the U.S. system of taxation affects the decision to offshore activities, the choice of foreign country for offshoring operations, and the nature of offshoring transactions. I also briefly describe the extent to which the U.S. system differs from those in other countries. Third, what should an international tax system do? I discuss four potential goals for an international tax system: enhancing efficiency, improving macroeconomic indicators, augmenting external effects associated with multinational activity, and generating government revenue. Finally, given the current U.S. system as well as these goals, what are the merits of suggested policy alternatives? I evaluate several major policy design changes with respect to these policy goals; I also consider pragmatic smaller changes that could improve the functioning of the U.S. tax system.

Background

There is substantial disagreement, in the literature and in the popular press, over the definition of offshoring. Some treat it as a synonym for outsourcing; those who distinguish between the two differ regarding the activities that fall under each heading.¹ My preferred definition of offshoring follows Cronin, Catchpowle, and Hall (2004); they generate a handy 2 x 2 matrix similar to table 1. In this formulation, both foreign direct investment (FDI) and arm's-length offshoring are classified as offshoring.

As the following sections of the paper make clear, U.S. international tax policy has two main effects on the decisions of firms in this context. First, tax incentives influence firms' decisions about the optimal method of providing a particular good or service. Second, if a firm chooses in-house offshoring or foreign direct investment, U.S. international tax policy will influence the firm's decisions regarding location choices, investment levels, and the prices and quantities of intrafirm transactions. But once a firm has decided to outsource part of its production process at arm's length, either at home or abroad, tax rules will have relatively little impact on pricing and transactions.

The U.S. International Tax System

The U.S. government taxes U.S. multinational firms on a residence basis.² Thus, U.S. multinational firms are taxed on income earned abroad as well as income earned in the United States. However, they receive a tax credit for taxes paid to foreign governments. This tax credit is limited to the firm's U.S. tax liability, although firms may (in some cases) use excess credits from income earned in high-tax countries to offset U.S. tax due on income earned in low-tax countries. Only income that is repatriated is taxed; thus, firms have an incentive to report income in low-tax countries, where it can grow tax-free before it is repatriated. Firms also typically have an incentive to avoid reporting income in high-tax countries because the tax credit received by the U.S. firm is limited to the U.S. tax liability.

As an example, consider a U.S.-based multinational firm that operates a subsidiary in Ireland. Assume that the U.S. corporate income tax rate is 35 percent and that the Irish corporate income tax rate is 12.5 percent. The Irish subsidiary earns 800 and decides to repatriate 70 of the profits to the United States. (Assume, for ease of computation only, a 1:1 exchange rate.) First, the...