So far, the discussion has ignored any foreign income taxes on Sue's surgeries. It now is time to look at this double taxation –- US income taxes plus foreign income taxes.
An obvious preliminary question is why do foreign income taxes, as compared to other costs of doing business overseas (like other foreign taxes), present a special case? The idea is that most costs are reflected in the prices at which goods and services are sold. Federal-level income taxes, however, are bone by the owners of the business. Thus, being required to pay US and foreign income taxes is double taxation. (The born-by-owners assumption is shaky, but further analysis is beyond this little post.)
So, there is double taxation, so what? The analysis here involves trade concerns more than tax policy analysis. A business' taxes should not depend upon where it does business (after adjusting for other local factors, such as malpractice liability in Sue's case), goes the analysis. This will interfere with free trade, so as to reduce world-wide well-being.
Which presents the question of which tax is the “extra” tax, the US tax or the foreign tax? The assumption underlying current international practice is that the source country (where Sue does her surgeries) gets first shot. Income is viewed as a thing that is more connected with the source than where it ends up. (As I mentioned in an earlier post, I do not view income as a thing, but what this means to this analysis I will not get to until later posts.)
Assuming that the US is to blink first, it needs a mechanism to do so. The US could just not tax foreign income that bears a foreign tax. This would unduly reward foreign income that bore only a low foreign tax. however. So, the US' mechanism is a dollar-for-dollar credit against US taxes for foreign taxes (subject to limits, which are the topic of tomorrow's post). If the foreign rate is the same as the US rate, the US gets no net tax. But, if the foreign tax is at a low rate, the US pockets the difference.
Note the US' altruism here: Historically, most multinational enterprises resided in the US. The US forbore collecting some taxes on these enterprises in the name of trade. Also, the Kennedy and Johnson Administrations embraced this regime because it discouraged tax competition between developing countries. (If the source developing country didn't impose a tax, the US would.) It was hoped that this would help such countries build needed infrastructure and institutions.
Tomorrow: more on the foreign tax credit.