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Commentary: This Tax Break Could Trigger A Trade War


Commentary: This Tax Break Could Trigger a Trade War

Alarmed by a $1.4 billion trade deficit in 1971, the Nixon Administration concocted a special income-tax break for U.S. exporters. The corporate deduction, now known as the foreign sales corporation (FSC), produced some hefty tax savings for big U.S. exporters, but it never actually did much to narrow the trade deficit, which hit a record $339 billion last year. Now, this 30-year-old business boondoggle is about to spark the biggest transatlantic tax dispute since the Boston Tea Party.

Last year, after Europeans protested that the U.S. tax loophole violates international trade laws prohibiting export subsidies, the World Trade Organization agreed and gave the U.S. until Oct. 1 to comply. Otherwise, the WTO's guidelines would allow Europe to slap 100% tariffs on $4 billion worth of U.S. exports, potentially the largest court-ordered trade retaliation in history.

The ruling against the hideously complex tax scheme took the Clinton Administration, congressional Republicans, and business by surprise. The prospect of a huge trade sanction sent Treasury officials, tax lawyers on the House Ways & Means Committee, and business lobbyists into a frenzy to fashion an FSC fix. The business lobby's challenge: how to preserve the lucrative tax break while at least appearing to address the substance of Europe's complaint. After all, real money is involved. Boeing Co., the biggest user of the FSC, saved $130 million in U.S. taxes in 1998, 12% of its earnings that year.

After laboring mightily in strict secrecy, the lawyers and lobbyists unveiled their legislative fix on July 27 before a House panel. The proposed law change does get rid of the hundreds of FSCs that exist for the sole purpose of generating paper transactions and sheltering up to 30% of export income from U.S. taxes. But the bill actually expands the tax break, adding $1.5 billion to the projected $25 billion, five-year cost of the tax write-off to the U.S. treasury.

U.S. exporters would be relieved of the burden of opening an office in a Caribbean tax haven under the proposed law change, but they would still get the deduction. Without a single hearing and practically no debate, the panel rubber-stamped the bill on a 34-1 vote. The ostensible reason for retaining the tax break, say its defenders, is to compensate for the European practice of rebating value-added taxes on European exports.

Not surprisingly, the Europeans aren't buying it. "If a company receives preferential income-tax treatment for export sales as compared to domestic sales, it's not acceptable," says John B. Richardson, deputy head of the European Union's office in Washington.

In this case, the Europeans are right. Trade rules allow rebates on such consumption taxes as the European VAT and on U.S. excise taxes and state sales taxes--but specifically not on income taxes. Furthermore, Europeans don't generally exempt their corporations from income taxes on export revenue. And their corporate income taxes are comparable to America's, while the overall business tax burden in Europe is considerably higher overall. Says one European diplomat: "The U.S. is always lecturing us that we have too high a business tax burden in Europe; suddenly it's too low?"

The U.S. also argues that it had an "unwritten gentlemen's agreement" in 1981 that neither the U.S. nor Europe would attack each other's tax systems in the trade courts. But in fact, Europe has been making formal complaints about the FSC and its predecessor export tax break to international trade bodies--and winning--since 1976. Countries have been free traditionally to establish their own tax laws without challenge, note U.S. officials. But Europeans grouse that the U.S. has been challenging Europe lately in the WTO on other policies usually considered internal matters, such as food safety and environmental regulations. So why should tax laws be any different?WASTEFUL. U.S. lawmakers aren't all agreed on the Ways & Means bill. Representative Peter A. DeFazio (D-Ore.) has introduced a bill to repeal the current FSC tax break entirely rather than expand its reach. "But once a tax break or a corporate subsidy is in the code, it takes a Herculean effort to remove it," he says ruefully. Representative Lloyd Doggett (D-Tex.) objects that the tax break on exports extends to U.S. tobacco companies, despite an Administration policy not to push for tobacco exports. And at the insistence of Ways & Means Chairman William Archer (R-Tex.), the tax break for weapons exporters was doubled over objections from some Democrats.

The great danger now is a tit-for-tat trade war. Not only does the dispute threaten to escalate the use of retaliatory trade tariffs but it could even encourage a new barrage of subsidies at the expense of ordinary taxpayers. Just listen to Deputy Treasury Secretary Stuart E. Eizenstat, ordinarily one of the Administration's most thoughtful negotiators and a former ambassador to the European Union: "If the EU wants to drive the relationship off the cliff, that is their position. We are not going to sit back and be defenseless. We have a number of cases that we are now ready to bring--some in the tax area and perhaps others." Eizenstat refuses to say what. But one possibility: arguing that European commercial airplane maker Airbus Industrie is receiving illegal subsidies.

Besides the need to comply with the WTO court's ruling, there are other reasons to dump the FSC. It's both wasteful and inefficient. Although the FSC was intended to help reduce the trade deficit, "the long-run impact on the trade balance is probably nil," according to a June, 2000, report of the Congressional Research Service. Even worse, the FSC creates winners and losers in the U.S. economy--aiding exporters but hurting import-sensitive U.S. companies. "Investment and employment in import-competing industries in the U.S. declined about as much as they increased in the export industries," said the Congressional Budget Office in an April, 1999, report. And, of course, the FSC requires U.S. taxpayers and consumers to subsidize lower prices for consumers abroad.PRODUCER BOON. The larger problem with subsidies is that they invite counter-subsidies and so accomplish little besides transferring money from consumers and taxpayers to politically powerful producers. That is the case with farm exports--half of all farm income in Europe derives from subsidies. Agriculture subsidies alone cost consumers and taxpayers in the developed world $361 billion in 1999, according to the Paris-based Organization for Economic Cooperation & Development.

It's time to call a halt to such waste by both sides. Getting rid of income-tax subsidies for exports would be a good place to start. The Clinton Administration should drop its plans to expand the FSC, get back to the negotiating table, and start proposing some real solutions, such as eliminating all export subsidies.

And the Europeans, who thus far have been unwilling to propose any solutions of their own for the FSC subsidy, need to start talking. "The best progress on settling these disputes gets made when the two sides sit down and work out a cooperative agreement," notes Peter Morici, an economist with the Economic Strategy Institute. When subsidies are the weapon, it is consumers and taxpayers who lose.By Paul Magnusson; Magnusson Covers International Trade and Economics from Washington.Return to top

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