Designing a U.S. Exemption System For Foreign Income When the Treasury is Empty

Abstract

The U.S. government faces a well-documented long-term revenue shortage that is unlikely to be cured by government expenditure reductions. Thus, it is curious that there is currently considerable pressure for the United States to adopt some type of territorial or exemption system under which most foreign-source active business income earned by U.S. resident corporations would become substantially free of U.S. income tax.

Although we are not fans of territoriality, we recognize that a significant reform of the U.S. international tax system is necessary. In other articles, we have expressed our clear preference for strengthening the U.S. worldwide taxation system by repealing the deferral privilege and instituting a per-country foreign tax credit limitation. However, if such a reform is not politically feasible, we believe that a properly designed exemption or territorial system could be an improvement over the current U.S. international tax regime, which is badly flawed for multiple reasons. In any event, there is a significant likelihood that Congress will sooner or later be considering legislation to create a U.S territorial or exemption system. Accordingly, it is important for academics and policymakers to thoughtfully discuss the structure of such a system. We hope that this article will contribute to that conversation. Our fundamental point is that because of the U.S. fiscal situation, it is particularly important that a U.S. territorial system not forgo more revenue than is necessary to achieve the system‘s appropriate ends.

Part II illustrates why nations of the world take ameliorative action to mitigate double income taxation that could chill international trade and leave us with a poorer planet. Part III explains the customary international law solution to the double taxation conundrum. Part IV describes the current U.S. flirtation with territoriality. Part V briefly outlines the long-run U.S. fiscal challenge and argues that any U.S. territorial system should be structured to limit aggravation of the fiscal problem. Part VI describes the dividend exemption element of a properly structured territorial system, and Part VII outlines the branch exemption component of such a system. Part VIII deals with certain structural issues. Part IX discusses "competitiveness" concerns and the relevance of tax expenditure analysis. In Part X, we summarize our conclusions.