The European Union has won its case against the United States in one of the longest running trade disputes in international trade law. On Jan. 15, the WTO ruled that the Extraterritorial Income Exclusion Act (ETI), a tax break for U.S. exporters, amounted to an illegal trade subsidy.
The U.S. has been told get rid of ETI, which saves over 6,000 companies more than $3.5 billion a year, or the WTO will render punishment. And as soon as April, the EU may begin retaliation. The options are staggering: sanctions as high as $4 billion, or tariffs of 100 percent on goods ranging from textiles to aircraft.
European reaction was not restrained. "We have been given a gun, and now the WTO must decide how many bullets we have to put in it," was how one EU official chose to characterize the win in the French press. It's a nearly apt metaphor. As Brussels contemplates knee-capping the U.S. (and its own consumers), it may want to consider that retaliation may ricochet.
The U.S. has several options. It can toss the ETI and watch its multinationals relocate to countries with lower corporate taxes, like Ireland. Dan Mitchell of the Heritage Foundation notes that several companies have chosen this option in recent years: Accenture, Ingersoll-Rand, Tyco and Fruit-of-the-Loom. He says that "in every case protecting shareholders from worldwide taxation was a major reason for the move."
On the other hand, the U.S. could choose to ignore the EU and continue allowing multinationals to report their overseas income in tax havens. The ETI is not negligible to its biggest beneficiaries: Boeing, Microsoft and General Electric. Boeing stands to lose $685 million per year if the ETI is scrapped.
But there is a better option open to the U.S. that would be beyond EU and WTO reproach. Reform the corporate tax code. Make it a territorial system, just like most of Europe's.
The existence of the ETI is due to a decision made in 1918 by the U.S. government to tax the income of its residents on a worldwide basis. The U.S. remains one of the only countries that taxes its citizens on their foreign income. "The worldwide tax approach was born in a different era as an administrative convenience," writes Gary Hufbauer, economist at the Institute for International Economics, and an expert on ETI, "but it is defended today by emotion, not logic. Every U.S. corporation should pay U.S. tax, whether it operates in Indiana or India, New Mexico or old Mexico. Carried to the extreme the general rule would render U.S. firms totally non-competitive in a global economy, both as exporters and producers."
Modifications to the archaic code began in 1971. In order to balance the trade deficit and promote U.S. exports, the Nixon Administration created the Domestic International Sales Corp. allowing companies with significant exports to report their income in an offshore financial center, exempting it from tax.
The WTO's predecessor, the General Atlantic Trade Treaty, decided it didn't like the exception and pushed for the U.S. to drop it. In 1984 a compromise was reached, and the DISC became the Foreign Sales Corporation (FSC).
Ten years later, Brussels had become increasingly unhappy with the U.S. favoring South American bananas over African, and trying to sell hormone-laced beef to organically conscious Europeans. The "beef-banana" dispute created bad feelings, stoked by then EU trade commissioner, Sir Leon Brittan.
The petitioning of the WTO began in the mid-1990s and the U.S. was forced to modify the FSC once more in November 2000, creating the ETI. That was not enough for the EU, which wanted the U.S. to stop giving its exporters any tax break, in order to "level the playing field." Of course, Europe's cry for "fair play" blithely ignores a few difficult facts.
Most European countries have territorial tax systems. Its citizens and companies are not taxed on their foreign income. Then there is the Value Added Tax, or VAT, which permits European countries to exempt tax on exports. Without the ETI, it is the United States that will no longer be on a level playing field with its European competitors.
For now, the EU is relishing its upper hand. However, the U.S. can quickly disarm its trigger-happy trading partner. There is a simple solution that would give Europe the level playing field it so desires. Mimic the European corporate tax system (not the rates). The voices supporting a move to a territorial system have grown. Rep. Bill Thomas, R-Calif., chairman of the House Ways and Means Committee, has been drumming up support for the notion in the House. President Bush has spoken favorably of a territorial system, and the idea has great support among the U.S. multinationals who must struggle to remain competitive with the byzantine worldwide code.
There were cooler heads in Geneva when the WTO handed down its decision. Negotiators on both sides realize that sanction or tariffs on such a scale will cripple trade, and economic recovery, on both sides of the Atlantic. Said another EU official, "Compliance is what we are after, compliance, compliance and compliance." And compliance is exactly what they will have if the U.S. takes the high road and reforms the code.
Eileen Ciesla is Warren Brookes Fellow at the Competitive Enterprise Institute in Washington, D.C.