Thank you all for the posts. Compare Jim's comments on Part III to Paul's on Part IV and you get the contours of the contemporary debate. Dan's, PGL's, and Jim's posts flesh out how complicated these issues are in the real world. (Jim, I really hope that Michael takes the blog back over before I have to talk about consumption taxes.) In the end, I do not have a view on the deduct vs. credit issue with regard to foreign taxes, because I do not understand the welfare effects of international trade adequately at this time. But, I can focus the analysis so that others can apply their views of trade.
Which gets us back to the foreign tax credit.
The discussion thus far has dealt with foreign taxes at a rate below the US rate. Sue's European taxes, however, are at 50%, which is above the US rate. For simplicity, assume that the US rate is 35%. Even if one accepts a credit for foreign taxes, giving a full credit when the foreign rate exceeds the US rate can be troubling. The US not only would be forbearing from taxing the foreign income but would be paying Sue's extra 15% foreign tax. This seems wrong, even if in the best interests of trade. Also, the extra 15% may pay for extra benefits in the foreign country, so that a deduction, not a credit, is appropriate.
The US has dealt with high foreign rates with a limit on the amount of the total credit for foreign taxes equal to total foreign income multiplied by the US tax rate.
Unfortunately, this creates a new set of problems: Sue's foreign taxes are $1 million. Her US tax credit limit is 35% (the US rate) of the $3 million of foreign income, $1,050,000. Since this exceeds her $1 million of foreign tax, so all of Sue's foreign taxes are creditable. Thus, while her foreign income generates $1,050,000 of pre-credit US tax (35% of $3 million), she is allowed a $1 million credit, and her foreign income bears only $50,000 of net US tax. In other words, her $1 million of low-tax foreign income bears only $50,000 of net US tax because of the way that the current US foreign tax credit works.
The phenomenon discussed in the preceding paragraph is referred to as the “averaging” effect. Creditable foreign taxes are limited so that the average creditable foreign rate (not any actual foreign rate) does not exceed the US rate. Consequently, the high-tax European income shelters the low-tax other foreign income. In fact, Sue may have done some surgeries in low-tax countries in order to exploit averaging.
Why is the US so dumb? One argument is simplicity: Separate limits on each item of foreign income (or even on income from each country) are unworkable, say the lobbyists. Also, business argues that averaging encourages trade. The 1986 tax act put some limits on averaging, but the pending ETI bills would soften them. Oh, well.
Tomorrow: foreign subsidiaries.