[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]


 
                 WTO'S EXTRATERRITORIAL INCOME DECISION

=======================================================================

                                HEARING

                               before the

                      COMMITTEE ON WAYS AND MEANS
                        HOUSE OF REPRESENTATIVES

                      ONE HUNDRED SEVENTH CONGRESS

                             SECOND SESSION

                               __________

                           FEBRUARY 27, 2002

                               __________

                           Serial No. 107-67

                               __________

         Printed for the use of the Committee on Ways and Means


79-971              U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2002
____________________________________________________________________________
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                      COMMITTEE ON WAYS AND MEANS

                   BILL THOMAS, California, Chairman

PHILIP M. CRANE, Illinois            CHARLES B. RANGEL, New York
E. CLAY SHAW, Jr., Florida           FORTNEY PETE STARK, California
NANCY L. JOHNSON, Connecticut        ROBERT T. MATSUI, California
AMO HOUGHTON, New York               WILLIAM J. COYNE, Pennsylvania
WALLY HERGER, California             SANDER M. LEVIN, Michigan
JIM McCRERY, Louisiana               BENJAMIN L. CARDIN, Maryland
DAVE CAMP, Michigan                  JIM McDERMOTT, Washington
JIM RAMSTAD, Minnesota               GERALD D. KLECZKA, Wisconsin
JIM NUSSLE, Iowa                     JOHN LEWIS, Georgia
SAM JOHNSON, Texas                   RICHARD E. NEAL, Massachusetts
JENNIFER DUNN, Washington            MICHAEL R. McNULTY, New York
MAC COLLINS, Georgia                 WILLIAM J. JEFFERSON, Louisiana
ROB PORTMAN, Ohio                    JOHN S. TANNER, Tennessee
PHIL ENGLISH, Pennsylvania           XAVIER BECERRA, California
WES WATKINS, Oklahoma                KAREN L. THURMAN, Florida
J.D. HAYWORTH, Arizona               LLOYD DOGGETT, Texas
JERRY WELLER, Illinois               EARL POMEROY, North Dakota
KENNY C. HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin

                     Allison Giles, Chief of Staff

                  Janice Mays, Minority Chief Counsel




Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.


                            C O N T E N T S

                               Page______
Advisories announcing the hearing................................  2, 3

                               WITNESSES

U.S. Department of the Treasury, Barbara Angus, International Tax 
  Counsel........................................................     7
Office of the United States Trade Representative, Peter Davidson, 
  General Counsel................................................    12

                                 ______

Institute for International Economics, Gary Hufbauer.............    45
Merrill, Peter R., Pricewaterhousecoopers LLP, and International 
  Tax Policy Forum...............................................    51
Shay, Stephen E., Ropes & Gray, and Harvard Law School...........    62

                       SUBMISSIONS FOR THE RECORD

MTI Services Limited, Princeton, NJ, and Western Growers 
  Association, Irvine, CA, joint statement.......................    87
National Foreign Trade Council, William A. Reinsch, statement....    89


                 WTO'S EXTRATERRITORIAL INCOME DECISION

                              ----------                              


                      WEDNESDAY, FEBRUARY 27, 2002

                          House of Representatives,
                               Committee on Ways and Means,
                                                    Washington, DC.

    The Committee met, pursuant to notice, at 10:45 a.m., in 
room 1100 Longworth House Office Building, Hon. Bill Thomas 
(Chairman of the Committee) presiding.
    [The advisory and revised advisory announcing the hearing 
follow:]

ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS

                                                CONTACT: (202) 225-1721
FOR IMMEDIATE RELEASE
February 19, 2002
No. FC-16

                     Thomas Announces a Hearing on

                 WTO's Extraterritorial Income Decision

    Congressman Bill Thomas (R-CA), Chairman of the Committee on Ways 
and Means, today announced that the Committee will hold a hearing on 
the World Trade Organization's (WTO's) decision that the United States' 
Extraterritorial Income Exclusion Act (ETI) is a prohibited export 
subsidy. The hearing will take place on Wednesday, February 27, 2002, 
in the main Committee hearing room, 1100 Longworth House Office 
Building, beginning at 10:00 a.m.
      
    Oral testimony at this hearing will be from invited witnesses only. 
However, any individual or organization not scheduled for an oral 
appearance may submit a written statement for consideration by the 
Committee and for inclusion in the printed record of the hearing.
      

BACKGROUND:

      
    On January 14, 2002, the WTO Appellate Panel issued its report 
finding the United States' ETI rules to be a prohibited export subsidy. 
This marks the fourth time in the past two and one-half years that the 
United States has lost this issue, twice in the Foreign Sales 
Corporation (FSC) case and now twice in the ETI case. There is no 
opportunity for the United States to appeal this latest determination.
      
    On January 29, 2002, a WTO Arbitration Panel began proceedings to 
determine the amount of retaliatory trade sanctions that the European 
Union (EU) can impose against U.S. exports to the EU. The EU has 
requested $4.043 billion in sanctions. The United States has asserted 
that the proper measure of sanctions is no more than $956 million. The 
Arbitration Panel will issue its determination by the end of April 
2002.
      
    In announcing the hearing, Chairman Thomas stated: ``Although the 
most recent decision comes as no surprise, it illustrates the need to 
fundamentally reform our tax system so that U.S. workers, farmers and 
businesses are not disadvantaged in international trade. This will be 
the first of several hearings to consider the WTO Appellate Panel 
decision and to examine ways to maintain the international 
competitiveness of the United States.''
      

FOCUS OF THE HEARING:

      
    The hearing is expected to (1) outline the history of the FSC-ETI 
dispute, (2) analyze the January 14, 2002, WTO Appellate Panel 
Decision, and (3) discuss the potential trade ramifications of the 
decision.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Please Note: Due to the change in House mail policy, any person or 
organization wishing to submit a written statement for the printed 
record of the hearing should send it electronically to 
``[email protected],'' along with a fax copy to 
(202) 225-2610 by the close of business, Wednesday, March 13, 2002. 
Those filing written statements who wish to have their statements 
distributed to the press and interested public at the hearing should 
deliver their 300 copies to the full Committee in room 1102 Longworth 
House Office Building, in an open and searchable package 48 hours 
before the hearing. The U.S. Capitol Police will refuse unopened and 
unsearchable deliveries to all House Office Buildings. Failure to do so 
may result in the witness being denied the opportunity to testify in 
person.
      

FORMATTING REQUIREMENTS:

      
    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. Due to the change in House mail policy, all statements and any 
accompanying exhibits for printing must be submitted electronically to 
[email protected], along with a fax copy to 
(202) 225-2610, in Word Perfect or MS Word format and MUST NOT exceed a 
total of 10 pages including attachments. Witnesses are advised that the 
Committee will rely on electronic submissions for printing the official 
hearing record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. Any statements must include a list of all clients, persons, or 
organizations on whose behalf the witness appears. A supplemental sheet 
must accompany each statement listing the name, company, address, 
telephone and fax numbers of each witness.

      
    Note: All Committee advisories and news releases are available on 
the World Wide Web at http://waysandmeans.house.gov

      
    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.

                                

                   * * * NOTICE--CHANGE IN TIME * * *

ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS

                                                CONTACT: (202) 225-1721
FOR IMMEDIATE RELEASE
February 26, 2002
No. FC-16 Revised

                Change in Time for Committee Hearing on

                 WTO's Extraterritorial Income Decision

    Congressman Bill Thomas (R-CA), Chairman of the Committee on Ways 
and Means, today announced that the Committee hearing on the World 
Trade Organization's decision that the United States' Extraterritorial 
Income Exclusion Act is a prohibited export subsidy, scheduled for 
Wednesday, February 27, 2002, at 10:00 a.m., in the main Committee 
hearing room, 1100 Longworth House Office Building, will now be held at 
10:30 a.m.

    All other details for the hearing remain the same. (See Committee 
Advisory No. FC-16, dated February 19, 2002.)

                                


    Chairman Thomas. If our guests will find their seats, 
please. Good morning. As the world's largest importer and the 
world's largest exporter, an orderly international trading 
system is crucial to the economic success of the United States. 
Given our global leadership, it is important that America 
complies with the established rules of engagement that the 
World Trade Organization (WTO) referees. It is in our interest 
that others follow the rules and therefore, it is imperative 
that we follow the rules as well.
    To that end, we must carefully and thoroughly address the 
problems created at the intersection of our Tax Code, and our 
international trade obligations. On January 14 of this year, 
the WTO issued an appellate ruling that the U.S. Tax Code 
provides an export subsidy. This decision marks the fourth time 
that the WTO has ruled this way, twice in the foreign sales 
corporation (FSC) case and now twice in the extraterritorial 
income (ETI) case. Four times the WTO has sent the United 
States this same clear message. Our tax system, as it is 
currently constituted, violates international trade rules. In 
the opinion of the Chairman of this Committee, the time has 
come for us to listen.
    Our corporate tax structure is in need of major 
restructuring, not another attempt at a short-term fix. More 
fundamental reform is required. In an economy struggling to 
recover, the United States cannot afford to dismiss the 
Europeans' proposed 4 billion, 3 billion, 2 billion, 1 billion, 
pick-a-number retaliation as an empty threat. Many people said 
the Europeans would never challenge us on this portion of the 
Code because they would be damaged as well. It has even been 
called a nuclear weapon. Well, it has been triggered. It is not 
an empty threat.
    U.S. Trade Representative (USTR) Robert Zoellick is 
forcefully challenging the European Union's (EUs) assessment of 
harm, but if we do nothing, trade sanctions against our country 
remain a distinct possibility. The European Union has 
graciously indicated that it will be reasonably patient and 
that it does recognize the difficulty of changing our corporate 
Tax Code. The Congress and I believe this Administration must 
also demonstrate its commitment to address the problem. It is 
not an easy task. It will require collaboration from all 
Members of this Committee, Republican and Democrat. We must 
build a consensus on a new approach that will meet our 
international obligations while maintaining the competitiveness 
of American businesses and workers in the global marketplace.
    It will be impossible to recreate a system which duplicates 
the current winners. But we must act in good faith. And we must 
begin this difficult process now. Today's hearing, where we 
will discuss the history of the foreign sales corporation 
dispute, the January 14 appellate body decision and the threat 
of retaliation, marks the beginning of this process. Yet no 
discussion of history, no attempt to justify the correctness of 
the U.S. position can be a beginning, a beginning begins with 
the realization that the previous attempts have failed.
    One chapter has been closed. We need to open a new one. 
Following the full Committee hearing, the Subcommittee on 
Select Revenue will hold a series of hearings to examine 
options in reforming America's corporate tax structure. To give 
you an idea of how difficult that will be, we have a second 
panel today in which there are some suggested options, and my 
assumption is there will be an examination of the viability of 
some of those options. This is never pleasant. It is always 
difficult. The United States believes that we should set our 
own course, but we are a partner among partners and we have to 
start with the recognition that we have to change. And with 
that, does the gentleman from New York wish to make any opening 
remarks.
    [The opening statement of Chairman Thomas follows:]

OPENING STATEMENT OF THE HON. BILL THOMAS, A REPRESENTATIVE IN CONGRESS 
FROM THE STATE OF CALIFORNIA, AND CHAIRMAN, COMMITTEE ON WAYS AND MEANS

    Good morning. As the world's largest importer and exporter, an 
orderly international trading system is crucial to the economic success 
of the United States. Given our global leadership, it is important that 
America complies with the established rules of engagement that the 
World Trade Organization (WTO) referees. It is in our interest that 
others follow the rules and therefore it is imperative that we follow 
the rules as well.
    To that end, we must carefully and thoroughly address the problems 
created at the intersection of our tax code and our international trade 
obligations.
    On January 14th of this year, the WTO issued an appellate ruling 
that the U.S. tax code prohibits an export subsidy.
    This decision marks the fourth time that the WTO has ruled this 
way, twice in the Foreign Sales Corporation (FSC) case and now twice in 
the Extraterritorial Income (ETI) case.
    Four times the WTO has sent the United States this same clear 
message--our tax system as it is currently constituted violates 
international trade rules. In the opinion of the Chairman of this 
committee, the time has come for us to listen. Our corporate tax 
structure is in need of major restructuring, not another attempt at a 
short-term fix. More fundamental reform is required.
    In an economy struggling to recover, the United States cannot 
afford to dismiss the European's proposed $4 billion, $3 billion, $2 
billion, $1 billion, pick a number--retaliation as an empty threat. 
Many people said the Europeans would never challenge us on this portion 
of the code because they would be damaged as well. It has even been 
called a nuclear weapon. Well, it's been triggered. It is not an empty 
threat. The United States Trade Representative Robert Zoellick is 
forcefully challenging the EU's assessment of harm, but if we do 
nothing trade sanctions against our country still remain a distinct 
possibility.
    The EU has graciously indicated that it will be reasonably patient 
and that it does recognize the difficulty of changing our corporate tax 
code, but Congress and, I believe, this Administration must also 
demonstrate its commitment to address the problem.
    It's not an easy task--it will require collaboration from all 
Members of this Committee, Republican and Democrat. We must build 
consensus on a new approach that will meet our international 
obligations while maintaining the competitiveness of American 
businesses and workers in the global marketplace.
    It will be impossible to recreate a system, which duplicates the 
current winners, but we must act in good faith, and we must begin this 
difficult process now.
    Today's hearing, during which we will discuss the history of the 
Foreign Sales Corporation dispute, the January 14th Appellate Body 
Decision, and the threat of retaliation, marks the beginning of this 
process. But no discussion of history, no attempt to justify the 
correctness of the U.S. position can be a beginning.
    A beginning begins with the realization that previous attempts have 
failed. One chapter has been closed and we need to open a new one. 
Following this full committee hearing, the Subcommittee on Select 
Revenue will hold a series of hearings to examine options in reforming 
America's corporate tax structure.
    To give you an idea how difficult that will be we have a second 
panel today in which there will be some suggested options. My 
assumption is there will be an examination of the viability of several 
of those options. This is never pleasant and it is always difficult. 
The United States believes we should set our own course, but we are a 
partner among partners and we have to start with the recognition that 
we have to change.
    I now recognize the ranking member from New York for his opening 
statement.

                                


    Mr. Rangel. Thank you, Mr. Chairman. This Congress, and 
more particularly this Committee, has taken a lot of pride in 
the bipartisanship in which we have handled trade and issues 
before the World Trade Organization. This dispute has gone on 
for decades, but we as a Committee have stood solidly behind 
this and previous Administrations in letting the World Trade 
Organization understand our unanimity of thought in trying to 
get a fair and flat playing field. Now it appears as though we 
may have reached an impasse. And I would hope that this 
Administration would come to this Committee with strong 
recommendations as to how we could maintain the integrity of 
our tax system, and at the same time, fulfill our international 
obligations.
    I am fearful, however, that this crisis that we face with 
the WTO may be used as a political vehicle to bring back the 
days when rhetorically we talked about pulling up the Tax Code 
by its roots and getting on buses going into communities and 
saying that we are going to simplify the system. That is a 
very, very political road, and I would hate to see our European 
friends think that our division in thought as to what the Tax 
Code should or should not be would give them an opportunity to 
go into these sanctions that they are threatening us with.
    I do hope we can continue the spirit of bipartisanship on 
this issue that historically we found ourselves. But having 
heard the Secretary of Treasury talk about proposals to repeal 
the corporate tax, knowing the rhetoric about substituting 
consumption taxes for our tax system, realizing the lack of 
progressivity on some of these things, the Chairman said it 
would be difficult. I say these are very explosive political 
issues. I don't want the crisis that we face as a nation and 
certainly the responsibilities that we have as a--as the tax 
writing Committee for the entire Congress--to allow our 
political preferences to interfere with obligations to attempt 
to resolve this problem. The Administration--the Administration 
can avoid a train wreck on this. The Administration should be 
giving us guidelines on this.
    If you let us get started on this before the election, you 
can bet your life you are going to have a political problem. 
If, on the other hand, you give us direction as to what we can 
do legislatively, well, you do the best you can diplomatically, 
I think we can maintain our tradition and move forward as a 
bipartisan Committee. Thank you, Mr. Chairman.
    [The opening statements of Mr. Crane and Mr. Ramstad 
follow:]

  OPENING STATEMENT OF THE HON. PHILLIP M. CRANE, A REPRESENTATIVE IN 
                  CONGRESS FROM THE STATE OF ILLINOIS

    Mr. Chairman, I want to thank you for holding this very important 
hearing. As you know, I have been a longtime advocate for the repeal of 
the corporate income tax. Corporations don't pay taxes, instead, they 
pass along this cost of doing business to consumers through higher 
prices. The ruling by the WTO that makes illegal the FSC/ETI is the 
perfect hook for us to finally repeal this insidious tax scheme.
    Unfortunately, there are those that will advocate for a new 
iteration of the FSC. I believe that this would be a major mistake. We 
have already made three attempts to write an export subsidy law that is 
WTO compliant and each time we have failed. Clearly, the WTO 
discriminates against our tax system, which is income based, as opposed 
to favoring those tax systems that are consumption based. It's not 
secret that the Europeans provide similar subsidies to their domestic 
corporations. Yet, there can be no successful challenge to those 
schemes because of the underlying assumption that a consumption based 
system is de facto WTO compliant.
    That leaves us in the position to advocate for either a total 
repeal of the corporate tax or, in the alternative, fundamentally 
reforming the system with a territorial or border-adjustable VAT tax. 
If we are unable to repeal the corporate tax, then I'll support a 
territorial system. But I still believe the repeal of the corporate tax 
is the best alternative. No corporate tax means that foreign 
corporations will race to set up shop in the United States. That means 
more jobs for American workers, less people on welfare, and more tax 
revenues for the Treasury. I challenge anyone to argue with those 
outcomes.

                                


OPENING STATEMENT OF THE HON. JIM RAMSTAD, A REPRESENTATIVE IN CONGRESS 
                      FROM THE STATE OF MINNESOTA

    Mr. Chairman, thank you for holding this important hearing on the 
WTO's decision that the United States' Extraterritorial Income 
Exclusion Act (ETI) rules amount to an illegal export subsidy.
    The ETI structure, and its predecessors the Foreign Sales 
Corporation (FSC) and the Domestic International Sales Corporation 
(DISC), were attempts to level the tax playing field for American 
companies doing business overseas.
    Our international competitors have territorial tax systems and many 
allow Value-Added Tax (VAT) rebates for their companies' exports. This 
structure is acceptable to the WTO, while the U.S. system of worldwide 
taxation, which taxes the income of American businesses regardless of 
where they are doing business, combined with an ETI-like structure is 
unacceptable to the WTO.
    While our U.S. trade team deals with the fallout from the WTO 
decision, we must begin to examine whether the foundations of our 
worldwide tax system are sustainable if American businesses are to 
remain competitive in our global economy. We already have too many 
examples of former U.S. companies that now are headquartered overseas 
because of our burdensome international tax system. The WTO's most 
recent decision and the resulting sanctions facing our businesses is 
another wake-up call for reform.
    I look forward to hearing from our witnesses today about possible 
short-term and long-term solutions to the massive trade challenge we 
are now facing following the WTO's ruling.
    Thank you, Mr. Chairman.

                                


    Chairman Thomas. Thank you very much, Mr. Rangel. And to 
hear the first word from the Administration on this issue, the 
two departments that are clearly focused on this issue is 
Barbara Angus, the International Tax Counsel, Office of Tax 
Policy, U.S. Department of the Treasury; and Peter Davidson, 
the General Counsel of the U.S. Trade Representative. I want to 
thank you both for appearing. Your written testimony will be 
made a part of the record and you may address us as any way you 
see fit during the time you have available. The microphones 
need to be turned on and they are very uni-directional, so you 
need to be right in front of it so we can hear you. So with 
that, Ms. Angus.

  STATEMENT OF BARBARA ANGUS, INTERNATIONAL TAX COUNSEL, U.S. 
                   DEPARTMENT OF THE TREASURY

    Ms. Angus. Mr. Chairman, Congressman Rangel and 
distinguished Members of the Committee. I appreciate the 
opportunity to appear today at this hearing on the World Trade 
Organization's recent decision regarding the extraterritorial 
income exclusion provisions of the U.S. tax law.
    On January 29, the WTO dispute settlement body adopted a 
final report finding that the ETI provisions of the U.S. tax 
law are inconsistent with U.S. obligations under the WTO. We 
are all disappointed with this outcome.
    This decision is the culmination of a challenge brought by 
the European Union in late 1997 against the FSC provisions then 
contained in the U.S. tax law. However the origins of this 
dispute go back almost 30 years, predating the WTO itself. The 
United States has consistently and vigorously pursued this 
matter and defended its laws through 3 decades because of the 
importance of the provisions and principles at stake. At its 
core, this case raises fundamental questions regarding a level 
playing field with respect to tax policy. The ETI provisions, 
like the FSC provisions that preceded them, represent an 
integral part of our larger system of international tax rules. 
These provisions were designed to help level the playing field 
for U.S.-based businesses that are subject to those 
international tax rules. As we contemplate our next steps and 
address this decision, we should not lose sight of that 
objective.
    The Congress has demonstrated its commitment to the U.S. 
businesses, both large and small, that operate in the global 
marketplace and to the U.S. workers that produce the output 
that is sold in markets around the world. The Congress took 
decisive action on a bipartisan basis under significant time 
pressure in passing legislation in November, 2000, to respond 
to the first WTO decision in this dispute by repealing the FSC 
provisions and enacting the ETI provisions. That legislation 
represented a good faith effort to bring the United States into 
compliance with its WTO obligations, while at the same time 
protecting the level playing field for U.S. businesses.
    To be facing this same issue again so soon is certainly a 
disappointment. Nevertheless, we must look forward and pursue 
all options to resolve this matter so that American workers and 
the businesses that employ them will not be disadvantaged. We 
have a serious problem, and we need to develop a serious 
solution. Mr. Chairman, the Administration looks forward to 
working closely with the Congress to find a solution that will 
protect America's interest and honor our obligations in the 
WTO. Given the focus of this hearing, our written testimony 
today focuses on the particular provisions of our tax law at 
issue, the history of the dispute in the WTO over these 
provisions and the findings and analysis of the WTO dispute 
settlement body. I would be happy to answer any questions. 
Thank you very much.
    Chairman Thomas. Thank you, Ms. Angus. Mr. Davidson.
    [The prepared statement of Ms. Angus follows:]

STATEMENT OF BARBARA ANGUS, INTERNATIONAL TAX COUNSEL, U.S. DEPARTMENT 
                            OF THE TREASURY

    Mr. Chairman, Congressman Rangel, and distinguished Members of the 
Committee, we appreciate the opportunity to appear today at this 
hearing on the World Trade Organization's recent decision regarding the 
extraterritorial income exclusion (ETI) provisions of the U.S. tax law.
    On January 29th, the WTO Dispute Settlement Body adopted a final 
report finding that the ETI provisions of the U.S. tax law are 
inconsistent with the United States' obligations under the WTO. We all 
are very disappointed with this outcome. This decision is the 
culmination of a challenge brought by the European Union in late 1997 
against the foreign sales corporation (FSC) provisions then contained 
in the U.S. tax law. However, the origins of this dispute go back 
almost 30 years, predating the WTO itself. The United States has 
vigorously pursued this matter and defended its laws because of the 
importance of the provisions and principles at stake.
    At its core, this case raises fundamental questions regarding a 
level playing field with respect to tax policy. Few things are as 
central to a country's sovereignty as the right to choose its own tax 
system. The ETI provisions, like the FSC provisions that preceded them, 
represent an integral part of our larger system of international tax 
rules. These provisions were designed to help level the playing field 
for U.S.-based businesses that are subject to those international tax 
rules. As we contemplate our next steps, we should not lose sight of 
that.
    The Congress has demonstrated its commitment to the U.S. 
businesses, both large and small, that operate in the global 
marketplace and to the U.S. workers that produce the output that is 
sold in markets around the world. The Congress took decisive action, 
under significant time pressure, in passing legislation in November 
2000 to respond to the first WTO decision in this dispute by repealing 
the FSC provisions and enacting the ETI provisions. That legislation 
represented a good faith effort to bring the United States into 
compliance with its WTO obligations while protecting the level playing 
field for U.S. businesses.
    To be facing the same issue again so soon certainly is a 
disappointment. Nevertheless, we must look forward and pursue all 
options to resolve this matter so that American workers and the 
businesses that employ them will not be disadvantaged.
    Mr. Chairman, the Administration looks forward to working closely 
with the Congress, on a bipartisan basis, to find a solution that will 
protect America's interests and honor our obligations in the WTO.
    Our testimony today will focus on the particular provisions of our 
tax law at issue, the history of the dispute in the WTO over these 
provisions, and the findings and analysis of the WTO Dispute Settlement 
Body with respect to these provisions.

The Foreign Sales Corporation Provisions
    The FSC provisions were enacted in 1984. They provided an exemption 
from U.S. tax for a portion of the income earned from export 
transactions. This partial exemption from tax was intended to provide 
U.S. exporters with tax treatment that was more comparable to the 
treatment provided to exporters under the tax systems common in other 
countries.
    A FSC that elected to be subject to these provisions generally was 
a foreign subsidiary of a U.S. manufacturer. The U.S. manufacturer sold 
its products to the FSC for resale abroad or paid the FSC a commission 
in connection with its sales of products abroad. In order to qualify 
for these provisions, the FSC was required to be managed outside the 
United States and was required to conduct certain economic processes 
outside the United States with respect to these export transactions. 
These economic processes related to the solicitation, negotiation, and 
making of contracts with respect to such transactions.
    The sales or commission income of the FSC on these transactions was 
determined under specified pricing rules. The exemption from tax 
applied to a portion of the FSC's income from sales and leases of 
export property and from related services. The FSC was subject to 
current U.S. tax on the remainder of its income from these 
transactions.
    The FSC provisions were enacted to resolve a General Agreement on 
Tariffs and Trade (GATT) dispute involving a prior U.S. tax regime--the 
domestic international sales corporation (DISC) provisions enacted in 
1971. Following a challenge to the DISC provisions brought by the 
European Union and a counter-challenge to several European tax regimes 
brought by the United States, a GATT panel in 1976 ruled against all 
the contested tax measures. This decision led to a stalemate that was 
resolved with a GATT Council Understanding adopted in 1981 (the ``1981 
Understanding''). Pursuant to this 1981 Understanding regarding the 
treatment of tax measures under the trade agreements, the United States 
repealed the DISC provisions and enacted the FSC provisions.
The WTO Decision Regarding the FSC Provisions
    The European Union formally challenged the FSC provisions in the 
WTO in November 1997, thirteen years after their enactment. 
Consultations to resolve the matter were unsuccessful, and the EU 
challenge was referred to a WTO dispute resolution panel. In October 
1999, the WTO panel issued a report finding that the FSC provisions 
constituted a violation of WTO rules. The United States appealed the 
panel report; the European Union also appealed the report. In February 
2000, the WTO Appellate Body issued its report substantially upholding 
the findings of the panel.
    Although the United States believed that the FSC provisions were 
blessed by the 1981 Understanding, the WTO panel completely dismissed 
this argument, concluding that the 1981 Understanding had no continuing 
relevance in the interpretation of current WTO rules. The panel's 
analysis focused mainly on the application of the WTO Agreement on 
Subsidies and Countervailing Measures. The panel found that the FSC 
provisions constituted a prohibited export subsidy under the Subsidies 
Agreement.
    Under the Subsidies Agreement, a subsidy exists if (1) government 
revenue otherwise due is foregone and (2) a benefit is thereby 
conferred. The Subsidies Agreement prohibits subsidies that are 
contingent, in law or in fact, on export performance. Looking first at 
the subsidy issue, the panel concluded that three specific aspects of 
the FSC provisions, taken together, resulted in an exception from 
taxation for income that otherwise would be subject to U.S. tax; the 
panel therefore concluded that the FSC provisions resulted in foregone 
government revenue through which a benefit was conferred. The panel 
then concluded that this subsidy provided by the FSC provisions was 
export-contingent, and therefore prohibited, because the tax treatment 
under the FSC provisions depended upon the exportation of U.S. goods. 
The panel further found that the FSC provisions constituted an export 
subsidy in violation of the WTO Agreement on Agriculture. The panel 
declined to rule on the European Union's additional arguments that the 
pricing rules and ``domestic content'' rules contained in the FSC 
provisions constituted separate violations of the WTO rules. The panel 
recommended that the subsidy provided by the FSC provisions be 
withdrawn with effect from October 1, 2000 (which date was later 
extended to November 1, 2000, under a procedural agreement between the 
parties).

The Extraterritorial Income Exclusion Provisions
    In response to the WTO decision against the FSC provisions, the FSC 
Repeal and Extraterritorial Income Exclusion Act was enacted on 
November 15, 2000. This legislation had been voted out of this 
Committee with a vote of 34 to 1, and was passed by the House with a 
vote of 316 to 72. The legislation repealed the FSC provisions and 
adopted in their place the ETI provisions. The legislation was intended 
to bring the United States into compliance with WTO rules by addressing 
the analysis reflected in the WTO decision. The new regime addressed 
the subsidy issue by establishing a new general rule of taxation under 
which extraterritorial income is excluded from gross income; the new 
regime addressed the export-contingency issue by applying to income 
from all foreign sales and leases of property, without regard to where 
the property is manufactured. At the same time, the legislation also 
was intended to ensure that U.S. businesses not be foreclosed from 
opportunities abroad because of differences in the U.S. tax laws as 
compared to the laws of other countries.
    The ETI provisions provide an exclusion from U.S. tax for certain 
extraterritorial income. This exclusion applies to a portion of the 
taxpayer's income from foreign sales and leases and certain related 
services. The ETI provisions apply to foreign sales and leases of 
property manufactured in the United States and also to foreign sales 
and leases of property manufactured outside the United States. In the 
case of property manufactured outside the United States, the 
manufacturer either must be subject to the taxing jurisdiction of the 
United States or must elect to subject itself to such jurisdiction. 
Thus, the income from transactions to which the ETI provisions apply is 
subject to consistent U.S. tax treatment.
    Unlike the FSC provisions, the ETI provisions do not require the 
filing of an election or the formation of a special entity to which 
sales are made or commissions are paid. Also unlike the FSC provisions, 
the ETI provisions apply to both corporations and individuals in the 
same manner.
    The exclusion provided under the ETI provisions generally is 
available only if certain economic processes are conducted outside the 
United States. As under the FSC provisions, these economic processes 
relate to the solicitation, negotiation, and making of contracts. A 
portion of the income from foreign transactions covered by the ETI 
provisions is exempt from U.S. tax. Because this exclusion is an 
alternative approach to addressing potential double taxation, foreign 
tax credits are not allowed with respect to the excluded income.

The WTO Decision Regarding the ETI Provisions
    Immediately following the enactment of the ETI Act, the European 
Union brought a challenge in the WTO. In August 2001, a WTO panel 
issued a report finding that the ETI provisions also violate WTO rules. 
The panel report contained sweeping language and conclusory statements 
that had broad implications beyond the case at hand. Because of the 
importance of the issues involved and the troubling implications of the 
panel's analysis, the United States appealed the panel report.
    The WTO Appellate Body generally affirmed the panel's findings. 
However, significantly, the Appellate Body modified and narrowed the 
panel's analysis. The Dispute Settlement Body adopted the report as 
modified by the Appellate Body on January 29, 2002.
    The Appellate Body report makes four main findings with respect to 
the ETI provisions: (1) the ETI provisions constitute a prohibited 
export subsidy under the WTO Subsidies Agreement; (2) the ETI 
provisions constitute a prohibited export subsidy under the WTO 
Agriculture Agreement; (3) the limitation on foreign content contained 
in the ETI provisions violate the national treatment provisions of 
Article III:4 of GATT; and (4) the transition rules contained in the 
ETI Act violate the WTO's prior recommendation that the FSC subsidy be 
withdrawn with effect from November 1, 2000.

Prohibited Export Subsidy Under the Subsidies Agreement
    The analysis of the prohibited export subsidy under the Subsidies 
Agreement involved three separate issues.
    First, the Appellate Body found that the ETI provisions constitute 
a subsidy under Article 1.1(a)(ii) of the Subsidies Agreement. The 
Appellate Body compared the ETI exclusion to the tax rules that 
otherwise would have applied to income from this type of transaction. 
Based on that analysis, the Appellate Body found that the ETI exclusion 
constitutes the ``foregoing of revenue which is `otherwise due','' that 
it confers a benefit, and that it is therefore a subsidy.
    Second, the Appellate Body found that the ETI provisions are export 
contingent because of the provisions' application only to income from 
transactions involving property that is sold, leased, or rented for 
direct use, consumption, or disposition outside the United States. As 
did the lower panel, the Appellate Body bifurcated the ETI provisions, 
separating the application to transactions involving property produced 
within the United States from the application to transactions involving 
property produced abroad. For property produced within the United 
States, the foreign use requirement could be met only by exporting the 
property. Based on this bifurcation, the Appellate Body found that the 
ETI provisions are export contingent with respect to domestically 
produced products. This conclusion was not affected by the fact that 
the ETI provisions apply in circumstances that are plainly not export 
contingent (i.e., with respect to property produced outside the United 
States and sold for use outside the United States).
    Third, the Appellate Body rejected the U.S. argument that the ETI 
provisions constitute a permitted measure for avoidance of double 
taxation. The United States believed that the ETI provisions fell 
within the fifth sentence of footnote 59 of the Subsidies Agreement 
which effectively permits a country to ``tak[e] measures to avoid the 
double taxation of foreign-source income,'' even if the measures 
constitute export subsidies. The Appellate Body found that footnote 59 
applies only to ``foreign-source income'' and that, to be considered 
``foreign-source income,'' the income must have sufficient links to 
another country that the income could be taxed by that other country. 
The Appellate Body further viewed the ETI provisions as potentially 
applying to income that would not fall within the reach of this rule as 
so interpreted. Therefore, the Appellate Body found that the ETI 
provisions do not constitute a measure to avoid double taxation under 
footnote 59.

Export Subsidy Under the Agriculture Agreement
    Because the Appellate Body held that the ETI provisions constitute 
a prohibited export subsidy under the Subsidies Agreement, it followed 
that the ETI provisions also violate the export subsidy provisions of 
the WTO Agriculture Agreement.

National Treatment Under GATT Article III:4
    The Appellate Body affirmed the panel's finding that the 50 percent 
limitation on foreign articles and direct labor costs contained in the 
ETI provisions violates GATT Article III:4. The Appellate Body 
dismissed the U.S. factual point that taxpayers may meet this 
requirement without using any U.S. content whatsoever. The Appellate 
Body found that this limitation in the ETI provisions represents an 
encouragement of domestic manufacturers to use domestic over imported 
components, thereby providing less favorable treatment to imported 
products than to like domestic products.
Withdrawal of FSC Benefits
    The Appellate Body also rejected the transition rules included in 
the ETI Act, finding no basis for permitting the continuance of the 
application of the FSC provisions beyond the November 1, 2000 date 
specified for withdrawal of the subsidy found to have been provided by 
the FSC provisions. The Appellate Body rejected the U.S. position that 
efficient and fair administration of the tax laws frequently requires 
tax legislation to include transition rules and binding contract relief 
for taxpayers that acted in reliance on the prior law provisions.

Current Arbitration Proceeding
    When it challenged the ETI Act in November 2000, the European Union 
simultaneously requested authority from the WTO to impose trade 
sanctions on $4.043 billion worth of U.S. exports. The United States 
responded by initiating a WTO arbitration proceeding on the grounds 
that the amount of trade sanctions requested by the European Union was 
excessive under WTO standards. This arbitration was suspended pending 
the outcome of the European Union's challenge to the WTO-consistency of 
the ETI Act, and resumed on January 29th with the Dispute Settlement 
Body's adoption of its final report. The parties are filing written 
submissions and will meet with the arbitration panel, which will issue 
its report on the appropriate level of trade sanctions on April 29th. 
Following adoption of that report, the European Union will be 
authorized to begin imposing trade sanctions on U.S. exports up to the 
level set by the arbitrators.

                                


  STATEMENT OF PETER DAVIDSON, GENERAL COUNSEL, OFFICE OF THE 
               UNITED STATES TRADE REPRESENTATIVE

    Mr. Davidson. Thank you, Mr. Chairman, Representative 
Rangel, and Members of the Committee. It is a pleasure to be 
here today. I do apologize in advance for my voice. I am 
working on a little cold here, so I will try to speak as loudly 
as I can or put it in my mouth here. But I do appreciate the 
opportunity to be here to talk about this issue, a dispute 
between the United States and the EU on the FSC and then the 
ETI case. As my detailed statement does go into somewhat more 
length on the historical record, I will try to be brief here in 
my remarks about where we are going to be going and be happy to 
answer any questions.
    Ambassador Zoellick has said on a number of occasions in 
the past year, noting the seriousness of the dispute with its 
potentially large financial implications for U.S. companies, as 
the Chairman noted last May, he likened the issue to a trade 
nuclear bomb which, if not treated with the utmost care, could 
cause enormous damage to the U.S.-EU relationship, and perhaps 
the trading system more generally.
    Mr. Chairman, I agree with you we cannot treat the threat 
of retaliation as an empty threat. Ambassador Zoellick stated 
in his joint press conference with Trade Commissioner Lamy of 
the EU last month that the United States intends to seek to 
resolve this dispute in a spirit of good faith, and that we 
intend to respect our WTO obligations.
    Mr. Chairman, as you noted, you can forcefully challenge 
the amount at issue. And the arbitration phase will also work 
cooperatively to show the progress necessary to prevent 
retaliation. I hope we can work through our differences with 
the EU in a way that will result in a true level playing field 
with respect to taxation, but it will be a difficult road and 
one that will require patience on all sides. The solution will 
be found in an appreciation of the need to move the global 
trading system forward to advance the U.S.-EU trading 
relationship overall, and at the same time, to find a solution 
to this dispute within which all parties can prosper.
    I understand that the primary purpose of today's hearing is 
to review the history of this important case, and therefore I 
hope my comments will provide the Committee with a bit of 
context, both historical and WTO procedural, to help establish 
a framework for future discussions.
    As we approach April 15, I am also reminded to provide 
another caveat that I am very far from a tax expert on any of 
these issues, and so I will defer most of those questions to 
the Treasury. But I will try to clarify some of the highlights 
if I can.
    Barbara Angus just went through the history of the dispute. 
It is a long history. As the Chairman noted, it is history. And 
so I will not go through that about each of those stages at 
this point. A detailed account is in my written testimony. But 
to summarize, essentially since 1997, the FSC, and later the 
ETI, with both twice judged by the WTO, found to be an illegal 
export subsidy under WTO rules. The latest chapter began with 
the WTO panel finding against the ETI Act in August of 2001. 
After consulting extensively with Congress and the private 
sector last November, we proceeded to appeal the latest panel 
result challenging all of the panels' ultimate findings with 
respect to the ETI Act.
    We chose to appeal even though we are not optimistic of 
achieving a reversal of all the panels' findings, we thought we 
could perhaps obtain greater clarity from the appellate body. 
The appellate bodies' report was formally adopted on January 
29. At that point, the arbitration proceeding which had been 
suspended by mutual agreement with the EU in November of 2000 
for purposes of determining the level of countermeasures to 
which the EU is entitled, resumed.
    A WTO arbitration proceeding normally takes no more than 60 
days. In this case, the arbitrators have informed us that they 
expect to take until April 29 to finish their work and issue 
their determination on the authorized maximum level of 
countermeasures. The EU and United States have, in recent days, 
submitted to the arbitrators our respective arguments on the 
appropriate maximum level for authorized countermeasures in 
this case. The EU is expected, and has argued, should be 
allowed to adopt countermeasures with a value of up to $4.043 
billion. The EU essentially claims that this amount is 
reasonable because it estimates the actual effects of the ETI 
to be far greater than this amount.
    In contrast, the United States holds that the EU should 
only be entitled to countermeasures totaling from $1 billion to 
$1.1 billion, depending on the base year chosen. This 
represents appropriately, in our view, the proportion of the 
FSC ETI subsidy that applies to the EU based on the EU's share 
of total nongoods production worldwide. If the arbitrators find 
that the EU is entitled to countermeasures in some amount, the 
EU would be in the same position to ask for WTO authority to 
impose countermeasures sometime in May.
    However, there is no deadline by which the EU must request 
this nor is there any deadline by which the EU must impose 
countermeasures once the authority is received. The European 
Commission (EC) in the fall of 2000 notified the WTO that it 
would seek authorization, when appropriate, to increase tariffs 
on U.S. exports to be selected from a very broad potential 
list. To date, we are unaware of any further-refined list of 
potential targets by the Commission.
    Throughout the WTO dispute settlement process, we have 
maintained our contacts with EU counterparts with a view toward 
managing the dispute in a manner that does not disrupt the 
general progress being made in international trade 
liberalization. Ambassador Zoellick and Commissioner Lamy have 
met numerous times and with other counterparts in the European 
Commission Member States.
    Mr. Chairman, I hope that this thumbnail sketch of our 
origin and current status of the dispute will prove useful in 
forming the Committee's future consideration of these issues. 
Given our understanding of the Committee's objectives for this 
hearing, I have refrained from going too far into thinking on 
how to move the topic forward in the coming weeks and months, 
but we look forward to working closely with Congress, the 
private sector, and in particular, this Committee, in 
developing ideas on how to respond to the WTO ruling and other 
aspects of this important issue. Thank you. And I would be 
happy to take any questions that the Committee would have.
    [The prepared statement of Mr. Davidson follows:]

  STATEMENT OF PETER DAVIDSON, GENERAL COUNSEL, OFFICE OF THE UNITED 
                      STATES TRADE REPRESENTATIVE

    Mr. Chairman, Representative Rangel, and Members of the Committee:
    I would like to thank you for the opportunity to testify before the 
Committee today on the dispute between the United States and the 
European Union (EU) in the World Trade Organization, first over the 
Foreign Sales Corporation (FSC) rules of the U.S. tax code, and most 
recently over the FSC Repeal and Extraterritorial Income Exclusion Act 
of 2000 (ETI Act).
    Ambassador Zoellick has on a number of occasions in the past year 
noted the seriousness of this dispute and its potentially large 
financial implications for U.S. companies. In Strasbourg, France, last 
May, Ambassador Zoellick likened the issue to a trade ``nuclear bomb,'' 
which, if not treated with the utmost care, could cause enormous damage 
to the U.S.-EU relationship and perhaps the trading system more 
generally. There has certainly been no lack of expressions of concern 
coming in recent months to USTR from the private sector, other 
agencies, and of course the Congress emphasizing the need to find a way 
through the dispute that avoids EU retaliation.
    As Ambassador Zoellick stated in his joint press conference with EU 
Trade Commissioner Lamy last month, the United States intends to seek 
to resolve this dispute in a spirit of good faith. He also said that we 
intend to respect our WTO obligations and seek to come into compliance 
with the WTO ruling.
    I am hopeful that we will work through our differences with the EU 
in a way that will result in a true level playing field with respect to 
taxation. But it will be a difficult road, and one that will require 
patience on all sides. The solution will be found in an appreciation of 
the need to move the global trading system forward, to advance the 
U.S.-EU trading relationship overall, and at the same time, to find a 
solution to this dispute within which all parties can prosper.
    All this being said, I understand that the primary purpose of 
today's hearing is to review the history of this important case. 
Therefore I hope my comments will provide the Committee with a bit of 
context, both historical and WTO/procedural, to help establish a 
framework for future discussions. The approach of April 15th reminds me 
that I need to underscore to you my lack of credentials as an expert on 
tax questions. However, I will do my best to make clear a rather 
complicated story.

History
    The U.S.-EU disagreement over FSC/ETI in fact has been simmering 
for a long time. Indeed, the case began with a challenge in 1972 under 
the General Agreement on Tariffs and Trade (GATT) by the then European 
Economic Community (EC) to the Domestic International Sales Corporation 
(DISC) provisions of U.S. tax law, forerunner to the FSC. The EC's 
challenge alleged that the DISC rules constituted an export subsidy 
that was prohibited under the GATT. In its defense, the United States 
contended that the DISC in essence operated no differently from methods 
of exempting foreign-source income used by the tax regimes of EC Member 
States Belgium, France and the Netherlands. In the U.S. view, the DISC 
simply ``looked different'' from European approaches because it 
operated within the U.S. worldwide (or residence-based) system of 
income taxation as opposed to European-style territorial tax systems. 
The United States proceeded to bring its own GATT disputes against the 
three EC Member States.
    In 1976, a GATT dispute settlement panel ruled against the DISC and 
the three European tax regimes, finding that each allowed exports to be 
taxed more favorably than comparable domestic transactions. In 1981, 
the panel's findings were adopted by the GATT Contracting Parties, 
together with an Understanding which essentially overturned the legal 
conclusions of the panel with respect to the European systems. In 1984, 
the United States enacted the FSC legislation, claiming in the GATT 
that the new U.S. tax rules conformed to the principles elaborated in 
the 1981 Understanding. Though the EC and Canada promptly requested 
GATT dispute settlement consultations on the new FSC, and joint 
consultations were held with these trading partners in 1985, neither 
Canada nor the EC thereafter chose to pursue the matter further in the 
GATT.
    Ten years later, in 1995, the WTO came into existence, along with a 
new Subsidies Agreement. In 1997, the EC, now the EU, requested WTO 
dispute settlement consultations with respect to the FSC. In 1998, a 
WTO dispute settlement panel was established to consider the EU's 
complaint. In developing the U.S. defense in the case, USTR worked 
closely with the Treasury Department and private sector representatives 
of FSC users. The U.S. brief covered a range of technical areas, but 
the key U.S. arguments were:

     The FSC exempted income attributable to foreign economic 
activities, as expressly permitted by the 1981 Understanding; and
     In substance, if not form, the FSC was no different from 
the territorial exemption method used by many European countries. Like 
the DISC, it simply ``looked different'' due to the different nature of 
the U.S. tax system.

    In 1999, the WTO panel issued its report, finding the FSC to be a 
prohibited export subsidy under both the WTO Subsidies and Agriculture 
Agreements. Essentially, the panel found that the FSC was an export-
specific exemption from otherwise applicable U.S. tax rules. The panel 
also found that because the 1981 Understanding did not form part of the 
WTO rules on subsidies, there was no exception for tax measures that 
exempted income attributable to foreign economic activities. As a 
result, the panel did not make findings as to whether the FSC actually 
did exempt foreign-source, as opposed to domestic-source, income. Also 
on grounds of judicial economy, the panel did not address the EU's 
challenges to the FSC administrative pricing rules, which were alleged 
to be inconsistent with the arm's length principle; and to the FSC 
definition of ``export property,'' which was alleged to violate the WTO 
prohibition against subsidies contingent upon the use of domestic over 
imported goods. The panel said that the United States should withdraw 
the FSC subsidy effective October 1, 2000.
    The United States appealed the panel decision, but in February 
2000, the WTO Appellate Body affirmed the panel's findings, although it 
modified its reasoning somewhat. Through the summer of 2000, Congress 
and the former Administration worked on replacement legislation. The 
parameters for this legislation were: (1) no significant revenue 
consequences; (2) no significant diminution of existing FSC benefits; 
and (3) WTO-consistency.
    During this time the former Administration also attempted to engage 
the EU in discussions on what could go into the replacement legislation 
that would alleviate EU WTO concerns. Former Deputy Secretary of the 
Treasury Eizenstat visited Brussels in May 2000 and met with EU Trade 
Commissioner Pascal Lamy. Unfortunately, the European Commission 
declined to enter into substantive discussions of what the new 
legislation should look like, claiming that the EU was not in a 
position to advise the United States on how to write its tax laws and 
insisting that compliance with WTO rules was the only criterion that 
mattered to the EU.
    After an intense several months of consultations between Congress, 
the Administration and the private sector, Congress in November 2000 
enacted the FSC Repeal and Extraterritorial Income Exclusion Act of 
2000 (ETI Act). The EU promptly challenged the ETI Act as an inadequate 
response to the earlier panel findings. At the same time, it requested 
authority from the WTO to withdraw WTO concessions to the United States 
(i.e., impose countermeasures) in the amount of over $4 billion, in 
line with the EU's calculation of the amount of the subsidy provided by 
the FSC rules. However, under a procedural agreement the Administration 
had negotiated with the EU in September 2000, a WTO arbitration 
proceeding to determine the amount of countermeasures to which the EU 
actually was entitled was suspended pending the outcome of the EU's 
challenge to the WTO-consistency of the ETI Act.
    In August 2001, the WTO panel issued its report, finding against 
the ETI Act. Specifically, the panel found that:

     The ETI Act's exclusion from taxation of certain 
extraterritorial income constitutes a prohibited export subsidy under 
the Subsidies Agreement.
     The tax exclusion is not protected as a measure to avoid 
double taxation of foreign-source income within the meaning of footnote 
59 to the Subsidies Agreement.
     The tax exclusion constitutes an export subsidy in 
violation of U.S. obligations under the Agreement on Agriculture.
     The ETI Act's 50 percent rule regarding certain foreign 
value violates the national treatment provisions of Article III:4 of 
GATT 1994.
     The ETI Act's transition rules resulted in a failure to 
withdraw the FSC subsidies by the recommended date.
     On grounds of judicial economy, the panel did not address 
the EU's claims that the 50 percent rule rendered the tax exclusion a 
prohibited import substitution subsidy under the Subsidies Agreement.

Where We Are Today
    After consulting extensively with the Congress and the private 
sector, on October 15, 2001, we filed a notice of appeal, challenging 
all of the panel's ultimate findings with respect to the ETI Act. We 
decided to appeal because, even though we were not optimistic about 
achieving a reversal of all of the panel's findings, we thought we 
could perhaps obtain greater clarity from the Appellate Body, which 
would be of assistance in making any further modifications to U.S. tax 
law. On November 1, we filed our appellant submission. As you will 
recall, the Appellate Body on January 14 of this year rejected our 
appeal on all counts. The Appellate Body's report was formally adopted 
on January 29, at which point the arbitration proceeding for purposes 
of determining the level of countermeasures to which the EU is 
entitled, which we had been suspended by mutual agreement with the EU 
in November of 2000, resumed. One would normally expect a WTO 
arbitration proceeding to take no more than 60 days. In this case, the 
arbitrators have informed us that they expect to take until April 29 to 
finish their work and issue their determination on the authorized 
maximum level of countermeasures.
    The EU and the United States have in recent days submitted to the 
arbitrators our respective arguments on the appropriate maximum level 
for authorized countermeasures in this case. The EU, as expected, 
argued that they should be allowed to adopt countermeasures with a 
value up to $4.043 billion. The EU essentially claims that this amount 
is reasonable because it estimates the actual effects of the ETI to be 
far greater than this amount. In contrast, the United States holds that 
the EU should only be entitled to countermeasures totaling from 1.0 
billion to 1.1 billion, depending on the base year chosen. Our 
reasoning is that WTO principles require that countermeasures be 
proportionate to the trade impact on the complaining WTO Member of a 
WTO-inconsistent measure adopted by the defending Member. To measure 
the trade impact of the ETI Act on the EU, we used the amount of the 
subsidy as a proxy for the actual trade impact, and assigned to the EU 
a portion of this amount based on the EU's share of total non-U.S. 
goods production worldwide.
    If the arbitrators find that the EU is entitled to countermeasures 
in some amount, the EU would be in position to ask for WTO authority to 
impose countermeasures sometime in May. However, there is no deadline 
by which the EU must request authority to impose countermeasures, nor 
is there any deadline by which the EU must impose countermeasures once 
the authority is received. If the European Commission decides to 
utilize whatever authority it receives from the WTO to impose 
countermeasures, we expect it would then move to seek approval from the 
EU Council of Ministers, representing the EU Member States, to impose 
increased tariffs on selected imports from the United States. How long 
such a process would take is not clear at present. The Commission in 
the fall of 2000 notified the WTO Dispute Settlement Body that it would 
intend to seek authorization, when appropriate, to increase tariffs on 
U.S. exports to be selected from a very broad potential list. To date, 
we are unaware of any further-refined lists of potential targets 
produced by the Commission.
    I should add that, throughout the WTO dispute settlement process, 
we have maintained our contacts with our EU counterparts with a view 
toward managing the dispute in a manner that does not disrupt the 
general progress being made in international trade liberalization.
Future Work
    Mr. Chairman, I hope this thumbnail sketch of the origin and 
current status of the FSC/ETI dispute will prove useful in informing 
the Committee's future consideration. Given our understanding of the 
Committee's objectives for this hearing, I have refrained from going 
into too much detail today with respect to our thinking on how to move 
this topic forward in coming weeks and months. We at USTR look forward 
to working with the Congress and the private sector to develop further 
our ideas on how to respond to the WTO ruling and other aspects of this 
important issue.
    Thank you and I will be happy to answer any questions you may have.

                                


    Chairman Thomas. Thank you very much both of you.
    As I said in my opening statement, reinforced by my 
colleague, the Ranking Member, working a solution to this will 
be difficult, one, because it is hard, and two, because anyone 
who wants to--may or may not be true--but anyone who wants to 
can twist this in terms of a partisan reason for trying to 
change the Tax Code. I guess the first question that I need to 
ask to reinforce where we ultimately need to go is, do you 
believe there is any response that will have a lasting result 
short of changing the Tax Code?
    Ms. Angus, can we do something other than changing the Tax 
Code to respond to this. It probably is a yes or no question.
    Ms. Angus. In terms of the issue of tax changes, given the 
WTO's analysis of the WTO rules, we do think that significant 
change in the system would be necessary and that legislation 
that simply replicates the FSC or ETI provisions would be 
unlikely to pass muster.
    Chairman Thomas. Or is anywhere in the ball park of 
replicating or looks anything like it? Do you agree with that?
    Ms. Angus. We need to look at this much more fundamentally 
and examine the whole range of possible ways to address the 
decision while ensuring that we continue to help maintain that 
level playingfield for U.S.-based businesses.
    Chairman Thomas. In your oral testimony, you used the term 
``disappointed'' twice--we were disappointed. Well, all of us 
were disappointed that the Europeans didn't continue to honor 
the gentleman's agreement. Were you surprised?
    Ms. Angus. I certainly was disappointed.
    Chairman Thomas. The point is that there is a legal 
argument to be made, but some of us who are not attorneys or 
legal or constitutional scholars have lived this. We were on 
the Committee when we marched through the alphabet with the 
Domestic International Sales Corp. (DISC), FSC, and up the hill 
on ETI. Has the Administration, or at least that portion of the 
Administration which this Committee has to work closely with in 
dealing with our laws, come to the conclusion, and I believe 
you said it, but I just want to underscore it, that we can't 
continue down the same similar trail and expect the Europeans 
to honor what, at one time, had been a gentleman's agreement, 
not to probe?
    Ms. Angus. Again, in light of the decision of both 
appellate bodies and their fairly compelling statements 
rejecting that gentleman's agreement, taking the position that 
it had no continuing relevance under the WTO rules, we are 
faced with a situation with the appellate body's analysis of 
those rules, that legislation that takes a similar approach is 
not likely to pass muster at all.
    Chairman Thomas. I don't need to get more out of an 
attorney than that. I would appreciate more, but I will accept 
that. Not likely. I think that is an understatement. Can we get 
away with doing nothing?
    Mr. Davidson. Mr. Chairman----
    Chairman Thomas. And what are the consequences of doing 
nothing?
    Mr. Davidson. I think doing nothing and this comes from the 
conversations that Ambassador Zoellick has had with 
Commissioner Lamy and that we have had with a number of Member 
States and other Europeans. I think the comments you made in 
your opening remarks that retaliation is not an empty threat is 
accurate. I think that the United States taking a position that 
we need to do nothing to comply with the appellate body's 
decision would invite retaliation.
    And I applaud the Committee for taking the step of having 
the hearing today and talking about the positive steps that we 
are going to make because Commissioner Lamy has made it clear, 
both in private and in public, most explicitly in the press 
conference, in meetings that he had with Ambassador Zoellick 
last month, that the EU will be looking for solid steps of 
progress in terms of what the Administration and Congress are 
going to do working together to move forward on this issue. And 
if we are doing that and it appears to the Europeans that we 
are taking our obligations seriously, that he believes it is 
possible to hold off retaliation. It is yet to be seen what 
level of retaliation will be authorized. Whatever level is 
authorized, it will be one of the largest, if not the largest 
amount in the history of the--short history of the WTO. So I 
think it is something that needs to be taken very seriously.
    Chairman Thomas. Well, if we agree that we can't stay where 
we are, which is the now and we have to go somewhere which is 
the then, between now and then, we will be looking to 
diplomatic initiatives to get people to understand that getting 
between now and then is difficult. It just so happens that I 
had a very interesting conversation with Mr. Superchi in the 
World Economic Forum up in New York and I found it ironic as he 
was talking about taking over the leadership of the WTO and 
some of the sensitive issues that they were going to have to 
face, he immediately presented to me two dates around which he 
needed to work, August and September, involving the 
parliamentary elections in France and the ministerial or the 
executive elections in Germany.
    The Europeans have been very successful in selling how 
difficult it is to make change during the season of elections. 
I think you just heard from the Ranking Member that we will 
move forward on this, but it is very difficult for us to make 
change during the season of our elections as well. So I would 
hope that the Ambassador conveys to Mr. Lamy that there are 
other elections that people should be sensitive to and they are 
in November of this year and that we will be moving forward on 
statutory changes to the Tax Code to comply with the WTO 
ruling.
    But if we are not successful by the time of the election, 
it is in great part due to the fact that we do have elections 
and that we will address this issue and we will resolve it. But 
to expect us to resolve these difficult fundamental issues in 
an election season when everyone else gets an automatic pass 
from difficult decisions, because it is an electoral decision 
is a point I think that this Administration needs to stress 
with our friends as we look at the calendar that you outlined 
in terms of potential pitfalls along the way to a resolution of 
this concern.
    We will be holding hearings on ways in which we can resolve 
this problem. But I also want to underscore what my colleague 
from New York said about the role that this Administration 
needs to play. You cannot follow and expect Congress to lead in 
this difficult issue. We have to be full working partners. And 
to a very great extent, given the brilliance and the talent and 
the expertise in both the USTR and in the Treasury, if you 
could come up with some potential resolutions that you could 
present to us, it would be a very great help in us moving 
forward. I believe we understand our responsibilities. I am not 
comfortable with the timeframe. It is going to be very 
difficult. To the degree you can buy us some time on our way to 
resolving the issue, it would be greatly appreciated, and to 
the degree you can present some potential solutions to the 
problem, that would also be greatly appreciated.
    Mr. Davidson. Mr. Chairman, could I respond to that 
briefly? I do think Commissioner Lamy and many in the EU 
understand the complexity of our system, and particularly, I 
think they understand the difficulty of dealing with tax 
legislation. Mr. Rangel referenced the complexity and 
difficulty of that issue in his statement as well.
    So I think that there is a sound understanding. At the same 
time he has been very clear that he needs to see signs of 
progress throughout that--in the near future and very quickly. 
That doesn't mean--I take that as meaning that the end of the 
process he understands is a long time, but there are a number 
of steps in the interim that progress needs to be shown.
    Your point about the elections in the EU I think is a very 
good point. This issue must also be seen in the context of the 
overall trading relationship and there are a number of 
controversial issues we have with the EU. When we have things 
that we are concerned about they make the point to us about we 
have political problems in some of our Member States, we have 
elections, this is going to be a difficult issue to resolve for 
awhile, have patience with us. I think your point is entirely 
accurate as well to be able to make the same point to them 
here. It is not a process that can be created quickly. And 
particularly when you are talking about the kinds of 
fundamental reforms that you are talking about.
    In terms of the Administration presenting alternatives and 
interaction with the Congress, we have every intention of being 
full working partners and engaging proactively in putting 
forward some ideas of what we can move forward on, but we are 
going to need some help and interaction as well so that we can 
share some of these ideas and get a feel for whether they are 
moving in the right direction.
    In that vein, I know that Secretary O'Neill, Ambassador 
Zoellick, Secretary Evans, and others are looking forward to 
creating a more formalized consultation process which I am sure 
they will be talking with you about so that we can put that 
full working partnership into effect in a way that moves 
expeditiously, at least in the interim steps toward moving 
toward some consensus solution. Thank you.
    Chairman Thomas. Thank you. Just so you clearly understand, 
the statements of my friend from New York were not taken by the 
Chairman as a threat or a promise. They were understood to be 
factual statements about the reality of the situation that we 
are in. The Congress--and Europeans are sophisticated enough to 
clearly understand our system--that clearly Congress needs to 
forward. But to the degree they don't see the cooperation and 
more importantly the understanding of the need to move forward 
from the Administration, they can rightly believe that we are 
not presenting as broad and honest an approach in trying to 
resolve the issue as we could. So it is going to take a full 
partnership. And we cannot be Alphonse and Gastone asking 
someone else to go through the door first. You don't wait for 
us, we don't wait for you. Both of us need to move forward. And 
the argument that somehow you have to have a formal invitation 
to help us address an international problem is not what I 
really want to hear.
    What I want to hear is, you folks get it, we have got to 
change, notwithstanding the difficulty of the change, we are 
beginning with this hearing and we will move forward. Now is 
behind us and then is in front of us. Between now and then, our 
diplomatic and legislative and executive efforts, all of us 
have to be part of this team pulling together. I know we will. 
And I appreciate your testimony.
    Gentleman from New York.
    Mr. Rangel. Well, I feel a little awkward in agreeing with 
almost everything the Chairman has said. And I don't really 
like the idea of foreign governments making the determination 
as to how quickly we are making progress. You see Mr. Davidson, 
your office has a very responsible diplomatic role to play. But 
it is the Secretary of the Treasury that has a real realistic 
role to play in giving us a road map as to what the 
Administration would like to see the objectives to be. It is 
never easy making dramatic changes in the Tax Code, and when 
the Chair asked the question, do we have to change the Tax 
Code, that is all we do is change the Tax Code. We change it, 
it doesn't mean we reached the results that we would want.
    So that you could be disappointed, but you had a series of 
disappointments because we never really reached a point that we 
found an international legislative resolution of this problem 
that has been hanging over our heads for decades. Now I think 
it is safe to say that the Chairman and I have not built up a 
reservoir of bipartisanship that the Administration can rely 
on. And that means that no matter how much of us have love for 
our country, that we just can't wave the flag and move forward 
and say we want to accommodate USTR and our friends in the 
European Union.
    We have to find out just what changes--how these changes 
are going to impact on American taxpayers, on American 
industry, whether they would be a flight of American industry 
if we changed the tax system so there is no corporate taxes. It 
is very complicated, but a very political decision--very 
political decisions have to be reached.
    So I think what the Chairman is saying is, you can't--you 
should not rely on us in coming up with the answers alone. We 
will do what we have done in the past and we have supported 
each Administration, Democrat and Republican, to let our 
foreign friends know that we intend to be treated fairly on 
this issue. But if you leave it up to us to come up with 
solutions that tear us apart without having your help in 
bringing us together, then whether or not progress has been 
made, it will just be a moot issue.
    So I cannot think of an issue more than the war that should 
bring us together in a bipartisan way to try to work out before 
we go public, and so I am glad that the Chairman has restricted 
the testimony this morning to the history of what got us to 
where we are.
    And I don't know what the Oversight Subcommittee is going 
to do, Mr. Chairman, but I hope that the fireworks are kept 
down to a minimum over there until we can get a handle as to 
which road we can walk down to comfortably, and then just try 
to work out the details to it. But if we are going to have a 
dramatic change in our tax law, we can just hope that the 
Administration helps us to progress quickly toward resolution 
of this long time problem we face.
    Thank you, Mr. Chairman.
    Chairman Thomas. Thank you very much. As the gentleman from 
New York can see, there are no TV cameras at the full 
Committee, and the chances of a TV camera getting to a 
Subcommittee are even less. So our purpose of moving the issues 
of resolution to a Subcommittee is clearly to pursue options 
that not only seem to be viable but acceptable. And it will be 
a difficult road.
    Mr. Rangel. If I may, I think the Administration had 
suggested, or at least Mr. Davidson, that we might have some 
informal meetings between Mr. Evans, O'Neill, and USTR and 
Members of the Committee.
    Chairman Thomas. Let me suggest that what the 
Administration has proposed, my understanding is that they are 
going to put together a working team among the Administration 
and that they will bring outsiders and academians, laypeople 
and others in looking at options that they have. My 
encouragement is that they move fairly quickly through that 
process. We can meet informally or formally. I think work 
product is the most important thing, and that if they are able 
to come up with some suggestions as the gentleman has indicated 
repeatedly, we need them as soon as possible.
    Mr. Davidson. Mr. Chairman and Mr. Rangel, if I could just 
clarify my statements, I completely agree with your assessment 
that we need to move together on this and work closely and work 
quickly. I did not mean to imply in any way that we should hold 
back on either of the fronts before one of the other front was 
moving forward. I applaud the Committee for having the hearing 
today, beginning the process of looking at where we need to go 
in the formal setting of a hearing room. I think that the 
informal process and consultation needs to move forward 
simultaneously. But I don't think we can wait on any one stage 
to move forward on all of them. And that is our position.
    Chairman Thomas. Gentleman from Illinois, the Chairman of 
the Trade Subcommittee, wish to inquire?
    Mr. Crane. Thank you, Mr. Chairman. Ms. Angus, what types 
of fiscal alternative proposals are being considered to keep 
U.S. businesses competitive in the global marketplace?
    Ms. Angus. We believe that we need to consider the full 
range of options, all possible alternatives that will address 
this issue, but as you say, ensure that we maintain the 
competitiveness of U.S. businesses and their workers. We need 
to thoroughly examine the U.S. international tax rules. Those 
rules were first developed 40 years ago when the global economy 
and the U.S. place in that global economy were very different 
than they are today. We need to look at all of those rules from 
the beginning in order to find a way to address this issue that 
doesn't disadvantage U.S. businesses.
    Mr. Crane. Well, I would hope that you would incorporate in 
your considerations a total repeal of any tax on business 
whatsoever. I pushed for that for the entire time I have been 
in Congress, but before that, when I was teaching. And the 
thing that is so disturbing about taxing business is that they 
don't pay taxes. They gather taxes. That is a cost, like, 
planned equipment and labor, and you have got to pass it 
through and get a fair return or you are out of business.
    And there are countries that are providing that kind of 
window of opportunity, and there are American businesses 
running to places like Bermuda because of it. And I would hope 
that we might consider something wholesome and healthy like 
elimination of that stupid tax all together. And I yield back 
the balance of my time.
    Chairman Thomas. Now that oil has been poured on troubled 
waters, gentleman from Michigan wish to inquire?
    Mr. Levin. I am going to try to take back some of that oil, 
Mr. Chairman.
    Chairman Thomas. As long as you don't light it.
    Mr. Levin. No. Indeed, within the bipartisan spirit the two 
of you preceded the Chairman and Ranking Member, I want to try 
to cast this in a somewhat different light, not only for those 
of us in this country, but for those in Europe and the WTO. 
First of all, we have gone over the background and I hope that 
there is not only a sense of disappointment in this country, 
but really a sense of outrage.
    This was more than a gentleman's agreement. After the 
General Agreement on Tariffs and Trade (GATT) decision in the 
early 1980s, this thing was worked out through the GATT council 
with an official understanding. And we, as a result, passed 
legislation in 1984 as we all know. That legislation was an 
effort to fulfill the understanding that we had on this issue. 
And for the next--1984.
    And for the next decade plus, that approach prevailed. It 
wasn't seriously challenged. It wasn't raised in the Uruguay 
round when the Europeans could have raised it and it was only 
after the Europeans lost a series of cases really that they 
raised this issue. And I think everybody should understand 
that--this background, so that is point one. It was more than a 
gentleman's agreement. It was a--it was a structure that was 
enacted pursuant to discussions within the GATT, and it was the 
structure that prevailed without any serious challenge until 
the Europeans lost a series of cases. Number two, I don't think 
we should act as if this is a dagger at the United States. What 
this is is a dagger at the U.S. and European economic 
relationship. I don't like the nuclear trade bomb description 
very well.
    Mr. Zoellick said trade nuclear bomb, not nuclear bomb. But 
if it is a trade nuclear bomb, that means that both sides 
better be weary about its use. And I think the same is true if 
you call it a dagger. In this respect, Mr. Davidson, I want to 
read back to you your testimony which I assume has been cleared 
by USTR and I think the Europeans should listen to this, and I 
am not saying anything that I haven't said to Mr. Zoellick and 
this is on page one. The solution will be found in an 
appreciation of the need to move the global trading system 
forward to advance the U.S.-European trading relationship 
overall, and at the same time, to find a solution to this 
dispute within which all parties can prosper.
    Now we should embrace that language and make it clear to 
the Europeans and everybody else that this dispute is a threat 
to the global trading system. And if anybody tries to grab it 
to their advantage, they are, I think threatening the global 
trading system.
    And so, we are not the only ones who should have a concern 
about this. So should the Europeans, and for them to think 
there is a major tactical advantage here I think is, for them, 
a serious mistake. And therefore, I want to make one last 
point. The Chairman talked about the difficulty of moving this 
in an election season. That is part of it, Mr. Chairman, but it 
is not only because this is an election year. These are 
exceptionally difficult issues. Mr. Crane says he has been 
advocating the change of all of his years here. That is what, 
Mr. Crane, 3 decades?
    Now maybe that says something about the substantive 
difficulties. Mr. Davidson, when you talk about signs of 
progress, let the Europeans not misunderstand that there is an 
easy solution to this in terms of American policy because there 
is not. There are deep differences and they cannot expect to 
use a temporary tactical advantage to expect that there will be 
major tax changes in this country in any foreseeable future. We 
can work on it and I am glad we are going to do it, but there 
should not be false expectations here. And I don't want to make 
it difficult by saying zero will happen because if Mr. Lamy 
wants something to point to, we should give it to him.
    But--and we will work on this issue but this is not mainly 
an election year issue. And their advantage is, I think 
something that can come back to haunt them. I told Mr. Lamy, he 
is like the dog that caught the bus, and I hope he takes it 
seriously. We didn't raise this at Doha. We didn't raise it 
before Doha, and we need to raise it now.
    And Mr. Davidson, I will finish by saying I think the words 
here about where the solution will lie is surely something that 
should be taken seriously. We will work hard on legislation but 
the Europeans should understand the ramifications of action on 
their part challenging a structure that they lived with for 
more than a decade without challenge and did not really 
challenge until they lost a series of cases in the WTO.
    Chairman Thomas. Thank the gentleman. I want to underscore 
the point that he made. I did start out in my statement by 
saying that this is going to be very hard to do. I pointed out 
the elections and I stand corrected. The French elections are 
on April 21, and Germans in September, because that is what 
they always use as an excuse. And I wanted to lay the 
groundwork that, in fact, we have a pretty darn good one as 
well. But clearly, the gentleman from Michigan's point is well 
taken. The primary reason we may not be able to resolve this in 
several months is underscored. This is going to be a hard thing 
to do. Gentlewoman from Connecticut wish to inquire?
    Mrs. Johnson of Connecticut. I thank the Chairman, and I 
too join the gentleman from Michigan in expressing my very 
strong concerns that after living with a regimen that was 
agreed to by both sides for over a decade, that they should 
have raised this. On the other hand, it is extremely important 
to us as a Nation that we have a rule based enforceable trade 
structure and that issue of abiding by decisions is just 
extremely important to America.
    If we can't enforce the intellectual property provisions of 
the World Trade agreements, we will be the ones to pay over and 
over again, and it will, in the end, have a serious effect on 
our economy. So we depend on a rules-based system. This has 
gone against us. We do have to find a way to deal with it. It 
will take time.
    But I want my colleagues on this Committee to--I want to 
just express to them and to you that I hope that we will deal 
with this issue at the same time we look at what is causing the 
American Tax Code to drive international mergers to be 
controlled by foreign entities.
    We had testimony before this Committee that DaimlerChrysler 
is DaimlerChrysler because of our Tax Code. It could have been 
Chrysler Daimler. And we see now that they are downsizing. 
Where is the power when the tough decisions are made? They are 
being made out of Germany. They are not being made out of 
America. We had testimony behind closed doors, and we had 
statements behind closed doors in some of the big international 
bank mergers that they are going to be foreign-owned, primarily 
because of our Tax Code. Last year or year before we saw 
insurance companies organizing in Bermuda.
    Now we are seeing tool makers organizing in Bermuda because 
it saves them millions and millions of dollars without laying 
anyone off or other consequences. So we do have to look at how 
our Tax Code is driving control over major actors in our 
economy offshore, and often into foreign arms. And I just think 
we need to look closely at that and maybe from looking at that, 
we will find things that also might solve this other problem or 
move us in a direction that will make us somewhat more 
harmonious with the world, because I think our tax structure is 
beginning to drive jobs abroad just like a few decades ago, 
some of our environmental regulations drove the cost of 
production so high that jobs went abroad. Now those things are 
beginning to even out at least in some parts of the world. But 
our Tax Code is now showing evidence of driving jobs abroad, 
the movie industry and all across the front. So we have our 
work cut out for us and we need you and the Secretary of the 
Treasury to begin to put a strong shoulder to the wheel. 
Thanks.
    Chairman Thomas. Gentleman from Washington, Mr. McDermott 
wish to inquire?
    Mr. McDermott. Thank you, Mr. Chairman. Seems to me like 
you walked into a lecture hall here today and hearing lectures. 
And I just would make a discussion that when you put that panel 
or working panel together, you try and make it an open one so 
that we don't have any trouble with people deciding decisions 
being made behind closed doors. But one of the things that 
strikes me as I listen to this whole thing--and I think Mr. 
Crane is the most honest man on the Committee. At least he will 
put a plan on the table. Nobody else. But I have been sitting 
here listening to this baloney for 8 years now and nobody will 
put a plan on the table. Everybody says, well, we will figure 
it out, we will go back and we will challenge them and we keep 
losing.
    We have done it a couple of times and you ought to learn 
after the second one that this isn't going to work. But I think 
you can count on this Committee for doing nothing. We are not 
going to do anything until you do something.
    I think that the record in the course of last 8 years has 
been actually we have done very little. Now, I used to 
represent one of the major exporters of this country. I still 
represent some pieces of it, but the major piece went to 
Chicago. And I don't know--I used to worry about this FSC 
thing, but I don't worry about it anymore because it looks to 
me like it is permanent employment for tax lawyers and trade 
lawyers because nobody seems very worried about this thing.
    Can you give me a cutoff date when we are really going to 
get slammed, or is this thing just going to go on forever, we 
will be looking at this when I retire in 25 years, and we will 
still be thinking we are going to deal with FSC one of these 
days? Is this just passive-aggressive on our part?
    Mr. Davidson. Mr. McDermott, I can't give you a specific 
date by which there will be retaliation and I can't tell you, 
regardless of the retaliation--that is actually given to the EU 
by the panel--what amount they may choose to proceed with. All 
I can say is that in conversations with Commissioner Lamy and 
others and Member States, that I don't think--they will not be 
hesitant to retaliate if they believe that we are going to go 
through another what you said, 8 years of doing nothing. So I 
don't know when the cutoff date is.
    It seems to us from all the indications that we have seen--
I was in Europe a couple months ago meeting with some Member 
States, and I received the same message from them. So I think 
that it is a question of looking at what--what our government 
is doing, how serious an effort they are taking toward--steps 
toward reforming the system, and I think that if we don't take 
those steps----
    Mr. McDermott. What steps did you suggest--I mean, I heard 
there was some progress. What steps did you tell the Europeans 
that we were taking toward a resolution of this? We are going 
to form a Committee? Is that what the progress was?
    Mr. Davidson. No. We didn't give a specific list of things 
that we were doing, procedures we are going to be taking, other 
than to say that we are going to be working closely with you, 
with Congress, in terms of moving forward on the issue. Now, I 
am sure their response is well, you know, we will believe it 
when we see it; the jury is out and so----
    Mr. McDermott. But there is nothing in the rules of the WTO 
that gives them a date where they can say, look, March 1, you 
either do something or here comes the penalty?
    Mr. Davidson. Once they get the--on April 29 or thereabout, 
there is a perfunctory procedure----
    Mr. McDermott. Perfunctory?
    Mr. Davidson. Well, there is one more--once they get the 
number from the panel, there is one more stage which they have 
to go through but that is perfunctory----
    Mr. McDermott. The panel has to decide how much to 
finance----
    Mr. Davidson. Find how much, and then for all practical 
purposes essentially they can retaliate to that amount in a WTO 
legal manner. They don't have to wait. There are some--
hopefully some consultations that go on, but----
    Mr. McDermott. So Boeing airplanes could go up in price, 10 
percent or 5 percent or something else, on that day.
    Mr. Davidson. That is right. That is right. And there is 
no----
    Mr. McDermott. The 29th of April, when we have just laid 
off 30,000 people.
    Mr. Davidson. But there is--there is no deadline by which 
they have to exercise that authority; so there is an 
opportunity for us to continue to work through the issue to--we 
have established quite an arsenal of weapons here, from daggers 
and nuclear bombs and things like that and----
    Mr. McDermott. I am more worried about price increases.
    Mr. Davidson. An effort to prevent that from happening I 
think is what we are here talking about; what is the process 
that prevents that from happening? And to answer your question, 
there is simply no set date. They can delay as long as they 
would like to delay before imposing retaliation, but retain the 
ability to do so.
    Mr. McDermott. Are you betting that they will just let it 
ride a while?
    Mr. Davidson. No. I think, Mr. McDermott, our belief is 
that if the EU does not see what they consider to be credible 
progress in terms of us moving forward, that we face a high 
likelihood of some type of retaliation.
    Mr. McDermott. So you think--if they see a Committee, do 
you think they would think that was credible progress?
    Mr. Davidson. Mr. McDermott, I can't speak to what they 
would see, but I think--I think what they are looking for is a 
credible process and that is--that is, you know, actually 
making some progress toward talking about the kinds of things 
that the Chairman was talking about and Mr. Rangel was talking 
about earlier.
    So I don't think--if your question is can we hold a series 
of meetings and hearings and things like that and hope to hold 
off retaliation if there is no substance there, I don't think 
that that is going to be sufficient.
    Mr. McDermott. And the substance would be a proposal on the 
table that we were considering--or what would the substance--I 
would like to know what the substance is that I need----
    Mr. Davidson. The substance would be a substantive 
discussion of options.
    Mr. McDermott. Thank you. That sounds pretty clear to me.
    Mr. Crane. If the gentleman could yield for just a moment, 
he made a reference, and I expressed appreciation for his nice 
compliment, but we lost this distinguished gentleman from 
Chicago. He moved out to Seattle, and Seattle graciously traded 
off by giving us Boeing. And what we both want to guarantee is 
that Boeing doesn't become Lufthansa-Boeing.
    Chairman Thomas. The Chair would now like to recognize the 
gentleman from New York, Mr. Houghton, if he has a question or 
two.
    Mr. Houghton. Yeah. Thanks very much. I would like to make 
a couple of statements and then have you challenge them. First 
of all, I see no way in order to help a business to solve this 
thing in a hurry, because if something else has to happen to 
our tax structure it is going to take a long time. You know how 
the process works around here. We don't even have the ideas. 
Take a long time.
    So something in the meantime, in the interim, has to come 
into play. And frankly, the only thing that I can think of, and 
challenge me on this, is that we--we say to the Europeans we 
are going to have more time on this thing. We are working on 
it, we are doing whatever we can, we are not going to be put on 
the defensive, and frankly if that is not good for you, then we 
are going to start challenging you.
    I mean, we have just been over in--Mr. English and I have 
just been over at a meeting in Germany, and they are 
complaining about some of the steel cases, the 201 situation, 
forgetting entirely that they upheld--they invested in the 
steel industry from the government. I mean, that is something 
which we can challenge.
    I don't know what happened as far as the foreign source 
income used by the tax regimes of Belgium, France and 
Netherlands, whether that was resolved or not. But they are not 
lily white clean on this thing, and frankly the only thing we 
can do--and, again, challenge me--is to say we have got to have 
time on this thing.
    Now, as far as the--as far as the taxes are concerned 
overall, I am not convinced that--that ChryslerDaimler would 
have been ChryslerDaimler if we had had a different tax 
situation. The fact is that Daimler had more of the stock, and 
that is pretty clear to me, and therefore they call the shots 
on this. There are always going to be places you can go.
    I know there was a wonderful suggestion at one time that 
the ideal situation would be for a business to own an island, 
and then have the domicile of that business on that island and 
establish its own tax rules. Well, that may happen in the 
future and they are going to be trading back and forth, and the 
question of where you can get the best price and the best cost 
structure, but those are big, big, big issues; and at the 
moment, it seems to that we must bide for time, and if we 
don't, then the people that we are trying to help are going to 
go under. Four billion dollars is not an inconsequential price 
tag. Maybe you can comment on that.
    Mr. Davidson. Mr. Houghton, I concur with you completely 
and we have made the case strongly to the Europeans that we 
need time to comply. And in fact, you know, we have been 
working with them throughout my entire tenure at USTR for the 
last year or so on pushing hard on that area, and I think they 
do understand the complexity of this area. So we have made that 
case forcefully.
    In terms of talking about if you were heading in the 
direction of filing other cases to provide leverage or 
something like that, for strategy like that to--I think there 
are some concerns about a strategy like that. You have to 
have--you actually have to have some arrows in your quiver that 
are of commensurate value, and second I think such a strategy 
runs the risk of a never-ending cycle of litigation that 
doesn't actually help you solve the underlying problem.
    I think if you look at--the bananas dispute that we have 
been working on is a good example. You know, counter cases to 
the bananas dispute I am not sure would have helped us reach a 
resolution. Instead we rolled up our sleeves, got down to work, 
and we actually worked out a resolution on that case and it 
took some time--it took some time to do it.
    I think what is going to drive the resolution of--and this 
is my own opinion, but I think what will ultimately drive the 
resolution of this will be both sides looking at it seriously, 
working hard, and looking at it in the context of the overall 
U.S.-EU relationship. We have got a lot at stake in terms of 
the positive trade liberalizing agenda and we can't allow 
disputes like this to throw those important initiatives off 
track.
    We have the launch of the new round in Doha recently. Both 
the United States and the EU were instrumental in moving that 
forward. Both sides have a real interest in moving the broader 
context forward, and so I think that is the positive incentive 
to work through this issue and come up with a result that will 
actually get us there as opposed to more negative incentives. 
That is my own personal opinion.
    Chairman Thomas. Thank you. The gentleman from 
Massachusetts----
    Mr. Neal. Mr. Chairman, could you come back to me after we 
vote?
    Chairman Thomas. Well, I think everyone would like to do 
that, and, if in fact, we are not going to be able to carry on 
the hearing, do we have just--the Chair understands it is a 
vote on the rule, and so there are other Members who wish to 
inquire, the Chair assumes. Let us then say that we will 
reconvene at 20 minutes after 12, and if you will allow us to 
do that and remain, because there are further questions by 
Members of the Committee, the Committee will stand in recess 
until 12:20.
    [Recess.]
    Chairman Thomas. The Chair wants to thank the 
representatives of the Administration. Holding hearings during 
voting clearly means we have to do two things at once 
sometimes, and we are not able. The gentleman from Louisiana 
wish to inquire?
    Mr. McCrery. Yes, Mr. Chairman. First of all I want to 
thank Chairman Thomas. I and the other Members of the Select 
Revenue Measures Subcommittee appreciate the opportunity to 
move this process forward and to seek a legislative solution to 
this matter. So we will be working on that at your direction, 
Mr. Chairman, and look forward to working with you to 
accomplish that goal.
    I would like to pose this question to either of you or both 
of you, and it concerns the question of jobs in the United 
States. Can you tell us how the FSC or ETI rules affect jobs 
here in the United States, or does it have any effect on job 
creation or job retention here in the United States?
    Ms. Angus. The ETI provisions, as a part of our 
international tax rules, help to allow U.S. companies to 
compete better in the international marketplace, and that in 
turn allows them to expand their production, investment and 
employment here in the United States. So these provisions, by 
allowing them to be more competitive in the international 
marketplace, in the markets where the customers are and where 
they need to compete, allow them to produce more here in the 
United States and employ more workers here in the United 
States.
    Mr. McCrery. That is the right answer. Mr. Davidson, I 
guess you don't have anything to add to that.
    Mr. Davidson. Yeah. Mr. McCrery, I don't really have any 
economic data to back up any different opinions, so I defer to 
Treasury on that analysis.
    Mr. McCrery. It sounds like she was well prepared for that. 
Now I would like for you to talk about this distinction between 
direct and indirect taxes and what difference that makes in 
terms of the WTO and the rules allowing indirect taxes to be 
rebated at the border. Can you give us a little background on 
that, explain that a little bit?
    Ms. Angus. The United States imposes an income tax which is 
considered a direct tax. Under the trade rules as I understand 
them, direct taxes are not border-adjustable. So under the 
trade rules the U.S. income tax isn't--isn't and cannot be--
rebatable on exports. An indirect tax is a tax on transactions, 
goods or consumption; in other words, a tax that isn't on 
income. The definition seems to be that indirect tax is 
anything that isn't a tax on income. Value added taxes and 
sales taxes are considered indirect taxes.
    As I understand the trade rules, a tax is considered a 
border-adjustable indirect tax if it is levied on the 
destination principle. Under the trade rules, a tax is not 
border-adjustable if it is levied on the origin principle. 
There are some indirect taxes that are levied on the origin 
principle. Direct taxes, like income taxes, are levied on the 
origin principle. I think on the next panel, Mr. Hufbauer in 
his testimony traces this distinction in the trade rules 
between the treatment of direct and indirect taxes all the way 
back to a 1960 GATT, General Agreement on Tariffs and Trade, 
working party.
    Mr. McCrery. And what difference does it make if indirect 
taxes are rebated at the border? What practical effect does 
that have?
    Ms. Angus. Well, I think that the real issue is one of 
consistent treatment; the treatment on the way in, and the 
treatment on the way out. This distinction under the trade 
rules on how they allow income taxes or direct taxes to be 
treated versus how the rules allow indirect taxes to be treated 
is one that has long historical roots. I think the economists 
will tell us that the distinctions in incidence between direct 
and indirect taxes really shouldn't be relevant for purposes of 
determining whether one or the other should be border-
adjustable.
    Mr. McCrery. But the practical effect of allowing indirect 
taxes to be rebated at the border, and not direct taxes as they 
are defined by the WTO, is that a product coming from, say, 
France, which has a price attached to it, part of which is the 
value-added tax, the indirect tax, when you subtract that part 
of the price, what happens to the price that we pay in the 
United States for that product? It is reduced, isn't it? 
Whereas the same product emanating from the United States, 
going to France, and the tax component is an income tax, that 
can't be rebated at the border so you don't get that reduction 
of the price, right?
    Ms. Angus. Yes. And another aspect of this difference in 
treatment between income and non-income taxes, direct and 
indirect taxes, is that should be looked at in the context of 
the fact that the United States has a tax system that is 
heavily reliant on an income tax, whereas while other countries 
do have income taxes, a larger portion of their tax is made up 
of consumption taxes for which these border adjustments are 
permitted.
    Mr. McCrery. Thank you.
    Chairman Thomas. I thank the gentleman. I guess that was a 
discussion with a lawyer about what goes on in terms of 
rebatable taxes at the border. I noticed during that discussion 
the long-time Trade Subcommittee Chair of this Committee and 
the interim Chairman of this Committee, the gentleman from 
Florida, Mr. Gibbons, came in, and I know he followed the 
lawyerly argument there; but I think probably if you will allow 
me for just a moment, a perhaps more English answer would be 
that the Europeans have a tax structure which allows them when 
they export products to rebate a tax, and when products are 
brought into the country, to impose it.
    Let me put it another way. Since we use an income tax, and 
we have taxes and some of the taxes that are the largest part 
of our tax system are social welfare costs, the Medicare and 
the Social Security Trust Fund moneys, that those costs are 
embedded in our products, whether they are in this country or 
whether they go oversees. So we have social welfare costs 
embedded in our products domestically or internationally.
    When the Germans or the Japanese or any other major 
industrial country with which we trade--as I said in my opening 
statement, we are the world's largest importer and the world's 
largest exporter. When their products remain in their country, 
it is true their social welfare costs remain, because those 
taxes have been added to their product domestically, whether it 
is Germany, Japan, or another country. But when they export 
those products, they get those taxes rebated, so the social 
welfare costs are lifted from the foreign products going into 
the United States. But when the U.S. exports into the EU, 
Japan, or any other major industrial country, those taxes are 
added. So we carry the embedded social welfare costs for the 
United States, and we carry the additional social welfare costs 
of every other country we export products into. But the 
Europeans coming to the United States have had that tax lifted. 
So they come into the U.S. market, the world's largest trading 
market, unencumbered to a very great extent by those taxes. 
They go on the shelf in direct competition with U.S. products 
that have those taxes embedded in them.
    So in one of the most fundamental ways, we are at a 
disadvantage by our unwillingness to change our Tax Code, and 
every other country with which we trade is advantaged by their 
Tax Code on social welfare costs.
    Let me put it a bit more practical way. The United States 
pays the world's social welfare costs along with ours, and we 
don't have any other country sharing the paying of our social 
welfare costs because of our tax system, and we have tried to 
modify that slightly. That is why we are here. We have to 
address the fundamentals. And it seems to me--this is an 
editorial comment. We are not supposed to look at the future at 
this hearing, but it seems to me that if we come up with a 
solution to our current dilemma and don't deal with the 
rebatable tax question, we have not really taken advantage of 
an opportunity to make a change that puts us on a level playing 
field in terms of those rebatable taxes. That does narrow our 
options. But for us to go back into the tranche of income is to 
continue to pay the world's social welfare costs, and the world 
doesn't help us with ours. And that is an undercurrent that 
will continue throughout all of the discussions as to what our 
response will be in dealing with the ETI, Foreign Sales Corp., 
DISC, or any other attempt to take away the advantage the 
Europeans have because of their tax systems.
    And I thank the Committee for allowing me to lay that out, 
because it is an issue that we are going to have to face. The 
gentleman from New York.
    Mr. Rangel. Mr. Chairman, I hope that my silence is not 
interpreted as being supportive of what you said.
    Chairman Thomas. Whether the gentleman is silent or voices 
his opinion, I have never assumed it is supportive of what I 
say.
    The gentleman from Massachusetts wish to inquire?
    Mr. Neal. Thank you, Mr. Chairman. Just one--since you 
editorialized, let me do the same for just a couple of seconds. 
Mr. Chairman, despite the talk that we heard around here, for a 
considerable period of time beginning in 1992, 1993, 1994, we 
are no closer to a flat tax today or no closer to a consumption 
tax. I mean, it sounded great in terms of campaign sloganeering 
and all those things, but a fundamental discussion of 
simplification is a good starting point for all of us, and I am 
convinced we can find some middle ground.
    But, more to the subject at hand. Ms. Angus, we have heard 
some comments today, and I expect we are going to hear a few 
more about some U.S. corporations becoming fed up with our U.S. 
tax system and leaving the country. Some have advocated 
fundamental tax reform, which will certainly take a lot of time 
to implement. But in the meantime, how might you respond if 
individuals decided that they, too, were fed up with the tax 
system and they decided to decamp to the Caribbean?
    Is the Treasury Department disturbed about this trend? Do 
you have any proposals to stop these departures, either 
corporate or individual?
    And we have also heard that some of these corporations must 
decide between layoffs and paying their share of U.S. income 
taxes. Tough decisions indeed. What if a company shuts down the 
factories and moves offshore to avoid U.S. tax, and does the 
Treasury Department have a concern about this?
    There is this great aura of patriotism that surrounds the 
country, and then there are those who in the next breath argue 
that somehow paying their share puts them at an anticompetitive 
position. We have read some disturbing news accounts. I assume 
that there are some discussions taking place within Treasury 
about what has been happening. And what is the long view of 
Treasury in this instance?
    Ms. Angus. Thank you. We need to look carefully at these 
transactions that have been reported recently to understand 
exactly what is being done from a transactional perspective and 
also from a tax treatment perspective. We need to understand 
the impact at the corporate level. We need to understand the 
impact at the shareholder level. We need to make sure that the 
transactions are properly reported and that our laws are 
complied with.
    We also need to examine why U.S. companies are entering 
into these transactions. We need to look at all the factors, 
tax and nontax, that may be encouraging a U.S. company to 
undertake this type of reorganization. An examination of the 
U.S. tax rules that affect international business certainly 
needs to be a part of that exercise.
    Many parts of our international tax rules were developed 30 
to 40 years ago. As I noted earlier, it was a time when the 
global economy looked very different and the U.S. place in that 
global economy was very different. We need to make sure that 
our international tax rules operate efficiently and 
appropriately in light of the current global environment. We 
need to make sure and address any ways in which our 
international tax rules may be impeding the ability of U.S. 
companies to compete internationally, and if there are aspects 
of our U.S. tax rules that are driving companies to consider 
this type of transaction, we need to understand that and 
understand why it is happening.
    Mr. Neal. Based upon preliminary discussions that you have 
had, would you be prepared to characterize any of what you have 
witnessed as tax avoidance?
    Ms. Angus. It is very difficult to characterize anything. 
We certainly need to look at all of these transactions 
carefully. We certainly do need to make sure that our tax laws 
are complied with and that everyone is bearing their fair share 
of tax liability, and there are a number of things that we are 
doing in that area in a whole range of areas.
    Just one particular project for which the Secretary, 
Secretary O'Neill, has made a major commitment, looking at 
internationally, is the need for us to be able to have the 
information about cross-border transactions so that we can 
enforce our tax laws.
    We do everything we can to enforce our tax laws, but there 
are sometimes situations, particularly when you are looking at 
a transaction that crosses a border, where we need information 
from another country to ensure that our tax laws have been 
properly complied with. The Secretary earlier this year made a 
commitment that he was going to expand our network of 
arrangements that would allow us to have the appropriate 
information exchange with other countries to get the 
information we need when we suspect that someone may not be 
complying with our tax laws and may be using the institutions 
of another country to avoid our tax laws.
    We think it is more important than ever not to allow the 
financial institutions of any country to be used for any 
illicit purpose, including cheating on taxes. And so we are 
very pleased that we recently signed three new information 
exchange agreements with significant financial centers, and we 
are working to continue that, all to the end of having the 
information that we need to ensure that our laws are complied 
with.
    Mr. Neal. Mr. Chairman, can I just finish for 30 seconds? 
Thank you. I think I totally agree with the second half of your 
answer. I thought it was very good. But might I point out that 
when we talk about competition, that the people that are 
visiting my office, the corporate representatives that are 
coming to my office that are upset about this, they are arguing 
that their competitive position is being compromised by this 
occurrence, and I think we have to keep light of that as well.
    Some of my best employers think this is outrageous that 
this is happening, so I am not driven here by some notion of 
wealth redistribution as much as hearing from those who do 
abide by the rules, who do pay their fair share. They are great 
employers and they feel very strongly that they are being put 
at a disadvantage by what they are witnessing.
    Thank you. Thanks, Mr. Chairman.
    Chairman Thomas. Thank the gentleman. The gentleman from 
California, Mr. Herger, wish to inquire?
    Mr. Herger. Yes. Thank you very much, Mr. Chairman. And, 
Mr. Chairman, I want to thank you for the comments that you 
just previously made. I feel that you very accurately described 
and outlined the situation that the United States is both the 
largest importer and exporter of goods of any nation in the 
world.
    My question, beginning question, one of a couple to you, 
Ms. Angus, comes from someone who has the privilege of 
representing one of the richest, most fertile, and productive 
agricultural areas in the world, the northern Sacramento Valley 
of California. We produce a major percentage of the world's 
peaches, walnuts, almonds, dried plums, all of which we in 
California and the United States cannot consume; we are 
dependent on exporting.
    And today's hearing feels a little bit like, as Yogi Berra 
used to say, ``deja vu all over again.'' This Committee and 
Congress have spent years attempting to fine-tune our tax 
system to provide American exporters a level playing field with 
their international competitors in a WTO-consistent manner.
    Unfortunately, we do not have much time given the WTO's 
most recent decision. My questions today deal with the short 
term and how we manage this issue until a final resolution can 
be worked out. And, Ms. Angus, given the impending April 
retaliation determination, what specific effort is the 
Administration making to lessen trade tensions with the EU and 
to prevent the imposition of trade sanctions against U.S. goods 
exported to the EU?
    Ms. Angus. I think, really, I ought to turn that question 
over to Peter on the trade side of things to talk about exactly 
what we are doing, as we face that deadline at the same time 
that we are looking at some of these more fundamental changes 
to our tax system and other changes, to address this in a more 
long-term way.
    Mr. Davidson. Mr. Herger, I think--to summarize some of my 
earlier comments as well, I think if I get the gist of your 
question, Commissioner Lamy has laid out some of the criteria 
that he believes will be--will allow the Europeans to put off 
retaliation, and those are efforts on behalf of the United 
States to come to terms with the appellate body decision and 
make progress in terms of what he sees as compliance.
    We had a discussion a little bit earlier with Mr. McDermott 
about precisely what steps need to be taken. I think it is more 
difficult; I think it is more art than science. But I think it 
is a question of managing the relationship between the United 
States and the EU, which gets back to the question of the close 
working relationship between the Administration and Congress.
    So, in a nutshell, clear steps, looking at satisfying our 
international obligations which are credible and move us closer 
to a final result that is acceptable to all parties, 
recognizing that this is a very complex process and a topic we 
have talked about at length; and so it is going to take some 
time. Within that amount of time, a demonstration of concrete 
steps toward the end point, I think is the best formula that I 
can articulate at this point.
    Mr. Herger. So, then, would you say that the USTR is 
working on agreement with the EU to provide Congress the time--
possibly 2 to 3 years--it may take to craft new legislation to 
keep U.S. businesses competitive in agriculture?
    Mr. Davidson. Mr. Herger, I am not sure that I would 
characterize it as an agreement as such. What I would 
characterize it as is a working understanding that, as long as 
we are making credible progress, EU will hold off retaliation. 
And again I don't know that it is possible to put down on paper 
precisely what the terms of such an agreement or working 
understanding might be, so I think it is closer to a working 
agreement or a working understanding than an agreement as such.
    Mr. Herger. Thank you. Thank you, Mr. Chairman.
    Chairman Thomas. Thank the gentleman. Gentlewoman from 
Washington wish to inquire?
    Ms. Dunn. Thank you very much, Mr. Chairman. I feel the 
same concern that everybody else on this Committee does when it 
comes to FSC or ETI. I am from the same State as Congressman 
McDermott is from, and I represent 25,000 workers in the 
company that he showed concern about.
    For me, it is an easy story. Airbus gets a rebate and 
Boeing does not, and it creates huge competitiveness problems 
with this. And yet the catch 22 is who is the sore thumb 
sticking in the air when the EU decides to retaliate? And it is 
going to be Boeing and it is going to be Mr. Herger's 
agricultural constituents. That is where it is going go, so it 
is going to hurt us over and over again unless we do something. 
So I am eager to see a solution to this problem as everybody 
else is eager to see a solution.
    I am amazed more companies have not moved their production 
out of this country. Between the burden of our tax system and 
the huge costs of labor, particularly in a State like mine, I 
don't see how shareholders are going to allow companies to 
continue to operate in this environment.
    My interest is in a trade war. I don't want to see a trade 
war. I don't want to see my companies penalized because of the 
amount of exporting they do, because it is a very simple ratio. 
The more you export, the more jobs you have. So I am wondering 
if you have garnered data over the last years on the 
relationship between the number of jobs and our use of the FSC 
provisions or the ETI provisions. Are there data out there we 
ought to be using in some way to further our case?
    Ms. Angus. I don't have data in front of me. We will 
certainly look into it and look for those studies. But it is 
absolutely clear that the ETI provisions are designed as a part 
of our current tax system to allow U.S. companies to compete 
better in the international marketplace and those marketplaces 
where it is absolutely essential that they be able to compete; 
and that ensuring their ability to compete is key to allowing 
them to continue to expand and grow their production and 
investment and employment here in the United States.
    So we see a clear link between the role of these provisions 
and the importance of a level playing field from a tax 
perspective and jobs here in the United States.
    Mr. Davidson. Ms. Dunn, can I respond quickly to your 
question, or your statement, on not wanting to see a trade war?
    I think that is also precisely where we are coming from, 
and when I was speaking earlier--before about the larger 
context of the U.S.-EU relationship, I think it is moving in a 
very positive direction overall right now. I think the launch 
of the round in Doha, other sectoral initiatives going on, 
there are some very positive directions in the relationship.
    There are a number--as there are with any trading partners 
that have a huge volume, a trillion dollars of trade volume 
that we have with the EU, there are going to be cases like this 
which are major cases and other cases as well; and we have to 
manage each of those. And so what I think I have been trying to 
say here this morning is, it is our attempt to manage this 
issue with the EU in a way that moves us forward and allows us 
to move forward on a broader context.
    But that is precisely where we are coming from, as well, 
because it would be very destructive for the EU to retaliate 
and then have this issue degenerate further.
    Ms. Dunn. I appreciate that, obviously being hurtful to 
everybody.
    As you meet with companies who come in to assist you--as we 
know, ETI was important to have the input of the companies, as 
well as tax authorities and trade authorities--are you seeing 
the development of--what I have heard you say so far is, the 
relationship is strong enough that we may be able to be allowed 
a little more time to solve the problem, and that we are 
negotiating with the EU. Are you seeing any particular 
direction that these discussions are going--what sort of a 
solution it will be, combination of tax policy and trade 
policy?
    Mr. Davidson. I can start, and then Barbara may want to 
answer that as well.
    I think it is too early to say exactly what the ultimate 
proposals will be, and I think that is precisely what we want 
to work both with the private sector and with Congress on. We 
are working closely with the private sector, and as we have 
historically, throughout this process consulting on the stages 
of the litigation.
    And I think it is going to be very important also to have 
import from the private sector in terms of where we go from 
here.
    Barbara, do you have anything else to add?
    Ms. Angus. I would just add and echo certain remarks that, 
given the importance of this matter, it is essential that we 
pursue all options and all possible routes to resolving this in 
a way that does protect American interests and, at the same 
time, honors our WTO obligations.
    Chairman Thomas. Thank you. Gentleman from Tennessee wish 
to inquire?
    Mr. Tanner. Thank you very much, Mr. Chairman.
    I appreciate you all being here today. I just returned from 
a NATO, North Atlantic Treaty Organization, trip to Brussels, 
and while there went by the Organization of Economic 
Cooperation and Development (OECD) and wound up in London. This 
is a very, very contentious and serious issue for the 
Europeans, as you know. And I was sitting here thinking as I 
was listening to your comments, perhaps this is the debate on 
the trade bill.
    Because in some ways what we are talking about goes far 
beyond the momentary disagreement we have with the Europeans 
and with WTO. Because if one looks at it in context and in 
total, it may be that our system of taxation is doing as much, 
or more, to export jobs than any sort of trade agreement we 
could possibly enter into. And so I want to premise my remarks 
by saying that in my judgment, there may be no more important 
issue coming before this Committee any time than the subject 
matter at hand.
    I heard you talking about origin-based taxes, territorial-
based taxes versus consumption taxes. And would you explain 
again to the Committee the WTO rules and the way they treat--
however one wishes to characterize it--consumption taxes versus 
territorial or direct or indirect? Could you go over that one 
more time, please.
    Ms. Angus. Certainly. And perhaps Peter has something that 
he would like to add to this.
    The WTO rules treat differently direct taxes and income--
indirect taxes. The U.S. income tax is a direct tax, and under 
the trade rules, direct taxes are not border adjustable.
    An indirect tax, a tax on transactions, goods or 
consumption, such as a value-added tax or a sales tax, is 
treated differently under the trade rules. Under the trade 
rules, an indirect tax that is levied on the destination 
principle is border adjustable. And this distinction in the 
trade rules or the history of the trade rules distinction 
between these two types of taxes dates back, all the way back 
to 1960.
    And I think, actually, Mr. Hufbauer's testimony will cover 
some of the roots of that. That was before my time.
    Mr. Tanner. Thank you very much. I wanted that again on the 
record because in looking at this issue--and I have been for 
the last 10 days--I am not sure that there is a fix as long as 
there is this difference in our system of taxation that would 
be WTO compliant and would be capable of being passed and 
signed by the President.
    And, Mr. Chairman, my observation was, given the 
distinction, I am not sure there is a legislative fix that is 
both WTO compliant and capable of being passed by this Congress 
and signed by the President, given our two extremely different 
philosophies with respect to taxation on this issue of border 
adjustability.
    Do you have any ideas as to how those two could be married, 
as it were?
    Ms. Angus. I think it is certainly a difficult issue. At 
this hearing today there has been a lot of acknowledgment about 
how difficult it will be to find a solution that addresses all 
of the needs here and something that we need to look at very 
carefully.
    We need to keep focused on some of the objectives of the 
provisions that the WTO has looked at, the provisions in our 
tax law, their objective in ensuring a level playingfield. We 
need to look at the WTO rules and their treatment of taxes. 
And, again, we think that it is very important that we look at 
all aspects of this, and that our solution looks at all options 
and takes into account all of the things that need to be done 
to address this.
    Mr. Tanner. I appreciate your time.
    Mr. Chairman, I think that this is a question for Harry 
Houdini, if you can find him, to try to match these two 
differing philosophies together. Maybe we can get him to come 
testify next time. But I want to thank you for this hearing. 
This is the trade hearing.
    Chairman Thomas. Thank the gentleman for his comments. And 
his observation is a real one, and what I would offer now, 
prior to listening to the hearings and the comments, is that if 
we cannot fundamentally change the Tax Code to allow us to have 
the same relative advantages as the Europeans, because there is 
an ideological, philosophical problem associated with it, 
perhaps an alternative way of looking at it--and I only suggest 
this now, and I don't want to enter into a debate about it--is 
that although it is true that corporations are fictitious, 
people designed them originally to create an ability to 
accumulate capital in multiple ways, if you would view 
corporations as the victims in this, we might be able to deal 
with resolving some of the problems around the victims.
    If you choose to view it as a victimless crime, then, yeah, 
we are back to the fundamentals of dealing with underlying Tax 
Code changes.
    But if the corporations are the victims in this, we might 
be able to deal with the victims and provide a solution for the 
victims. And I will simply leave it at that now.
    Gentleman from Georgia wish to inquire?
    Mr. Collins. Mr. Chairman, the gentleman from Georgia is a 
victim. You know, Yogi was brought up awhile ago, and I believe 
old Yogi also said, ``When you come to a fork in the road, take 
it.'' That is about where we are today. We are at the fork in 
the road, so we are going to take it.
    You know, the Foreign Sales Corp., as I understand it, was 
put in place for competitive purposes, is that right, to allow 
our businesses to be more competitive in a global market? Is 
that true?
    Ms. Angus. Yes, it was aimed in addressing differences 
between our tax system and other tax systems that had the 
effect of impeding the competitiveness. So the provisions in 
the context of our system were aimed at addressing exactly that 
issue.
    Mr. Collins. And that provision of Tax Codes is 
noncompliance with the WTO rules, right?
    Ms. Angus. Yes.
    Mr. Collins. Based on what I hear coming from this hearing 
and what I read about the European Union, their only solution 
is repeal of that provision, basically.
    Mr. Davidson. You are right, Mr. Collins.
    Mr. Collins. That is enough. Stop while you are ahead.
    So we have a choice, status quo or repeal. What is the 
difference cost-wise? Status quo, do we not then continue to 
allow the business to use the Foreign Sales, and we have to pay 
compensation or higher tariffs on products we export? Is that 
the choice?
    Mr. Davidson. Yes, Mr. Collins. I think the costs of status 
quo would be most likely, probably inevitably, paying the cost 
of retaliation, which means putting--basically, American 
products being exported at a higher cost overseas, harming our 
ability to export, or paying compensation back here in the 
United States, which would be lowering the cost of European 
goods.
    Mr. Collins. So it is a higher cost--reduces the advantage 
of being, or reduces the competitiveness of the world markets. 
That is the end result whether you repeal or don't repeal the 
status quo.
    Well, back then, it relates to consumers and the cost to 
consumers because if you repeal or if you don't repeal, either 
way, the cost is going to be passed on to the consumers, 
domestic or foreign.
    The only thing that I can see in the interim is the fact 
that Congress imposes a lot of cost on business. We impose cost 
through either rules, regulations, taxation. There are a 
multiple number of ways that the Congress imposes costs on 
business. That is where we hear a lot of discussion about tax 
reform.
    And then the gentleman from Tennessee made a very good 
observation of where we are with this. Reform will come from a 
mandate from the people or it will not come from this Congress 
because it is too political. That mandate is not there yet. 
Further discussion of reform may lead to such a mandate.
    But here we need some simplification, and that goes back to 
the one provision that the EU has problems with. If we were to 
repeal that or if we leave it in place, we need to look at the 
Codes themselves and see how we can change the codes that will 
lessen the cost to business for both domestic and foreign sales 
that will leave us to be in a competitive state.
    Well, that is going to disrupt somewhere the cash flow in 
this town. I mean, the focus here in this town is the cash flow 
of the Treasury, because we get our cash flow from people and 
business and such. So that is the cash flow we ought to be 
focused on. This Congress, particularly this Committee, should 
focus on substance, substance of simplification of tax law that 
we have jurisdiction over that will focus on the reduction of 
cost of goods both domestically or exported.
    As I say, there will be a disruption in cash flow. The only 
way you deal with the disruption in cash flow is one of two: 
You raise another tax to offset that disruption or you look at 
your spending habits. Folks at home tell me, look at spending 
first, because we ain't spending a lot of money in this town.
    And I see the red light is on, and I am going to close with 
this; and this is probably going to blow somebody's skirt up. I 
hear constantly that I am left out. This is just an effort on 
the part of some people that I am left out. You know, phone 
lines in my office run both ways. You can receive a call or you 
can make a call. When I walk down one of these halls, both 
ways, I meet people coming and going.
    There has to be an effort on both sides to reach 
something--an agreement that has substance to it. And that is 
what we need to do here.
    I appreciate your patience and your indulgence. Come back 
to us with something of substance, and hopefully, by the time 
you get back, we will have something of substance.
    Thank you, Mr. Chairman.
    Chairman Thomas. Thank the gentleman.
    I also would like to have heard the panel's response to you 
that since we are the world's largest importer and the world's 
largest exporter, our failure to abide by the rules is not just 
the direct loss of any financial transaction, but it is a 
fundamental erosion of the rules by which the world trades; and 
that we cannot afford any erosion of those rules because we 
will be the losers in that, not others. That is why we have 
fought so hard for another round to perfect, even beyond 
current rules, the rules of world trade.
    Mr. Collins. Well, that is true; and it could, far beyond 
just the European Union.
    Chairman Thomas. It is trying to get the world to comply 
with the trading rules.
    We are focused on America's failure to comply. The real 
problem is the world in general tries to fail to comply. Our 
job is to set the example of how we ought to operate.
    Gentleman from Pennsylvania wish to inquire?
    Mr. English. Thank you, Mr. Chairman. I think this hearing 
has explored this issue very thoroughly, and I simply want to 
say that examining the WTO decision in this area leads me to 
associate myself with those who have said today that they are 
disappointed.
    It is fairly clear the WTO decision overlooked existing 
past practices within this jurisdiction. It created a precedent 
for a massive intrusion into the design of individual States' 
tax practices. It has--by ``individual States,'' I mean 
countries. It has, I think, created the specter of future 
intrusion into legitimate tax design and tax policy decisions 
that are made by sovereign States. And I am particularly 
concerned about the long-term impact on the world trading 
system.
    I do have one question for the panel, and that is, looking 
at this decision and having analyzed it, do you see any 
jurisdictions within the European Union where their tax system 
would be equally subject to challenge, based on the principles 
that the WTO has announced?
    Mr. Davidson. Thank you, Mr. English.
    I think that one of the reasons is that we decided--and 
there was a discussion about the process of appeal. We worked 
with the private sector and worked closely with Congress. And 
one of the most important factors in terms of deciding to take 
the appeal, knowing as we did ultimately where it was likely to 
head, was obtaining some kind of clarity in the ultimate rules, 
which would both guide us in terms of our efforts to comply 
with the decision, but also give us some indication about where 
other systems might be in terms of the new appellate body 
standard.
    I think it is unclear right now as to whether there might 
be EU Member-States that would be vulnerable under the current 
criteria. It is something that we are looking at, and we will 
continue to look at that as we move through the process. We 
will inform you further if we find any provisions there that we 
think need to be acted on. But for now, I think that is an 
interesting question and something we are going to be pursuing, 
but I am not sure that is an answer to our current situation of 
where we go from here.
    Mr. English. I recognize that. And may I say, I would 
welcome correspondence with you in the future as you look at 
other tax systems. I think it is fair game for us to assess 
whether we can appropriately challenge some of our trading 
partners' tax systems if that is the path they have chosen to 
pursue.
    My final comment, Mr. Chairman, Mr. McDermott earlier, and 
I think with some justification, expressed a gloomy view of the 
likelihood of our coming up with a solution. I am not quite as 
gloomy.
    I think, as you do, Mr. Chairman, that we need to have 
fundamental reform of the business Tax Code with the objective 
of creating a system which is simpler, which accommodates our 
exports and the capital investments that are necessary for some 
of our companies to compete globally. With that in mind, I 
would encourage Mr. McDermott and others to consider the 
business side of a bill that I have reintroduced in this 
Congress, the Simplified USA Tax, which would establish a WTO 
consistent business consumption tax similar to that that was 
included in Nunn-Domenici, but which would provide for full 
expensing of capital investments.
    I believe that this approach to reform is certainly one of 
the options that needs to be considered, and I salute you, Mr. 
Chairman, for being willing to raise the banner of business tax 
reform; and I hope you receive support for that.
    And I yield back the balance of my time.
    Chairman Thomas. Thank the gentleman. The gentleman from 
Texas, Mr. Doggett, wish to inquire?
    Mr. Doggett. Thank you, Mr. Chairman. And thanks to both of 
you for your testimony this morning.
    Ms. Angus, is it correct that the law at issue before us 
today represents legislation for which, prior to your coming to 
your current job, you were a principal advocate and lobbyist on 
behalf of the FSC 2000 coalition?
    Ms. Angus. In my prior job, before I came to the U.S. 
Department of the Treasury, I did represent companies that were 
very interested in the issue of the FSC.
    Mr. Doggett. That is what I wanted to ask you about.
    This 2000 Coalition, in which you filed a disclosure form 
that you were the principal of, who are the principal 
individual members of that coalition?
    Ms. Angus. I don't think that I can give--I could recite to 
you right now----
    Mr. Doggett. Just tell me three or four that you remember.
    Ms. Angus. They were--the members of that coalition were--
there were several companies involved in that group, all very 
interested in this issue.
    Mr. Doggett. Any of the names that you recall today? You 
were lobbying for them this time last year.
    Ms. Angus. I am a little bit uncomfortable with not being 
able to give a complete list. I did give a complete list in 
disclosure forms that I filed and am certainly happy to provide 
that to you.
    Mr. Doggett. You gave a complete list of all the companies 
that were members of the FSC 2000 Coalition?
    Ms. Angus. In disclosure forms that I filed in connection 
with my current position, releasing information regarding 
companies----
    Mr. Doggett. Where did you file that?
    Ms. Angus. The financial disclosure forms.
    Mr. Doggett. Listed the names of all the individuals?
    Ms. Angus. Information regarding all companies with whom I 
worked previously.
    Mr. Doggett. If you don't want to single out some of them 
today, can you provide me that information this week, the names 
of the individual companies that comprised the FSC 2000 
Coalition?
    Chairman Thomas. If the gentleman would yield briefly.
    Mr. Doggett. As soon as I finish with her.
    Chairman Thomas. It is on this. I want to know if there is 
a legal question.
    Mr. Doggett. It is not a legal question.
    Chairman Thomas. You indicated you filed this information 
somewhere. Is that public information?
    Ms. Angus. I am not certain about that. Obviously there are 
a variety of disclosure forms that are filed. We will 
certainly----
    Mr. Doggett. I am just asking for the names of the 
companies that composed the FSC 2000 Coalition for which you 
were lobbying last year, the year before and perhaps longer 
before that.
    Ms. Angus. We will certainly look into this and get you the 
information that----
    Mr. Doggett. And that information will contain the names of 
the members of the FSC 2000 Coalition?
    Ms. Angus. We will certainly go back and look at this and 
get you----
    Mr. Doggett. What is there to look at? Can you not tell me 
the names of any member of the FSC 2000 Coalition that lobbied, 
with you as their principal, for the very bill that we have up 
for consideration today?
    Chairman Thomas. Will the gentleman yield? There is no bill 
up for consideration today.
    Mr. Doggett. It is the law we have. The bill you lobbied 
for is the one that the WTO found noncompliant. And I am asking 
the names of any of the companies that composed the FSC 2000 
Coalition for which you were working as principal.
    Chairman Thomas. I think if the witness understands the 
question, and I believe the concern is whether or not there is 
any legal concern about answering the question----
    Mr. Doggett. To identify whom she was lobbying for?
    Chairman Thomas. If the gentleman believes that is not a 
problem, then my assumption is he has resources and either 
knows the answer----
    Mr. Doggett. I am sure she is about to give it.
    Chairman Thomas. I am sure she is about to tell you that 
she will make sure that there is no legal violation to her 
answer and that she will provide it. But let us hear what her 
answer is.
    Mr. Rangel. Mr. Chairman.
    Chairman Thomas. I tell the gentleman from New York, I am 
trying to move away from what is getting very close to 
badgering the witness.
    Mr. Doggett. It is simply asking for information from a 
witness.
    Mr. Rangel. I am not saying that you are wrong in that 
pursuit, but you could be a little more sophisticated in 
planting an answer in the witness' mouth.
    Mr. Doggett. And if I may ask----
    Ms. Angus. As I indicated earlier, I would like the 
opportunity to go back and determine what is appropriate 
information to provide, and will certainly provide all of that 
information that is appropriate and required.
    [The information is being retained in the Committee files.]
    Chairman Thomas. Gentleman's time has expired.
    Mr. Doggett. Mr. Chairman, I haven't been given 5 minutes.
    Chairman Thomas. You had 5 minutes.
    Mr. Doggett. May I have just another 30 seconds?
    Chairman Thomas. Gentleman can have 30 seconds.
    Mr. Doggett. I would extend that answer to the 877 
Coalition for which you were lobbying. People that renounced 
their American citizenship, just like what Mr. Neal was asking 
about for corporations, but for individuals; and also the 
coalition of corporate taxpayers--taxpayers that were also 
involved in international tax issues.
    I want to know the names of the individual companies that 
are part of that coalition, those three together, according to 
the records that are public----
    Chairman Thomas. Gentleman's extension of time has expired.
    Mr. Doggett. Over the last 18 months, and I would like to 
know who did that.
    Chairman Thomas. Gentleman from Oklahoma wish to inquire?
    Mr. Watkins. Yes, sir. Thank you Mr. Chairman. And I have 
something that might be worthwhile. Probably a little bit of an 
editorial comment, but I hope it is helpful with the Committee, 
maybe our panel.
    First, let me say I think the gentleman from Tennessee--Mr. 
Tanner, I think you are right on the button. This is very 
crucial and very important, and I think we have to work on it. 
I don't have all the disagreement that Mr. Doggett has because 
I hope we do have some people who are knowledgeable sitting at 
this table. And I hope we do have people that have a background 
in FSC and some things that are going on, because we don't want 
people who are totally inept sitting out here trying to resolve 
our problems.
    And let me say to Ms. Angus here, the FSC provisions were 
enacted to resolve---and I would like the panel to know this, 
enacted to resolve a GATT dispute involving a prior U.S. tax 
regime that DISC enacted back in 1971. Remember that date, 
1971.
    Now, nearly a generation later, in 1998, WTO came along and 
said the dispute settlement--that this was not kosher. And the 
European Union challenged that along the way, and in 1999 a WTO 
panel was set up.
    The point I would like to make here is, FSC came into being 
because we are trying to resolve differences and it was 
accepted then. But, Mr. Chairman, 25, 30 years later, they say, 
Whoa, you've got to change that. It is not a level playing 
field.
    Well, you know, let us go back to Ground Zero. We have to 
level some other things in with them.
    Now, Mr. Davidson, let me say that I read your statement 
too, and I think we have some arrows in the quivers, so to 
speak, that we can work with because this deals also with 
agriculture; and I think you indicated, I think your testimony 
indicated, this is about a $4 billion problem.
    Mr. Davidson. The EU claims that their retaliation is a $4 
billion retaliation.
    Mr. Watkins. And I would like that to be considered, $4 
billion against business, industry as in agriculture. I don't 
know what percentage of that is agriculture. Do you know?
    Mr. Davidson. What percentage of FSC users in the United 
States are agricultural?
    Mr. Watkins. Could that be provided, a real short answer?
    Mr. Davidson. We can certainly get back to you on that.
    Mr. Watkins. If you don't mind. But agriculture is affected 
with that.
    Now, Mr. Chairman, also we do have some arrows in the 
quiver, because I would like the panel to talk about it. And 
you mentioned bananas, and I have led the fight about the beef 
industry because the EC, in an unscientific way, has blocked 
our beef from being sold in Europe. That is a blatant trade 
barrier, maybe not a big number, but maybe 250 million or more 
and sometimes larger than that.
    But the point is, we also settled in the Uruguay talks for 
a peace clause, and when you get to the peace clause, it lets 
the ECU have $7 billion worth of agricultural subsidies, I 
think we have an arrow; I think we have got a big-time one. We 
only have about 200 million export subsidies that were 
accepted. They got $7 billion, and they come to us with $4 
billion in FSC.
    We should not consider only taxation, by itself. We should 
bring the subsidies to the table at the same time. And we need 
to have someone looking at the big picture, not just simply a 
tax deal. And we are talking about--because we are being hurt, 
Mr. Rangel. We have been sold down the drain, and we should not 
let them escape this time sequence and say, Oh, now today we 
come back 30 years later and say, Let me have that, because it 
was accepted then.
    So I am very concerned. And, you know, I don't want to get 
concerned about it very much, and that is why I want you to get 
me the figures later.
    But it is not just a fly-by-night thing for me. I end up 
building a Center for International Trade in Oklahoma, trying 
to move us forward in trade, and I find all these problems.
    So an editorial comment, Mr. Chairman, I hope the comments 
of the gentleman from Tennessee and I hope something I said 
might be of help, but we need to use the arrow that we have, 
and we have $7 billion, and we need to take it to the table to 
solve this problem.
    Thank you so much. I appreciate your being here, and I am 
glad you are knowledgeable about the FSC.
    Mr. Davidson. Thank you.
    I think you know how important agriculture is in terms of 
the President's trade agenda. And Ambassador Zoellick has 
appeared here several times to make that point; I think it is 
our number one priority in terms of the new round of trade 
negotiations.
    And we want to make sure we are continuing to make 
progress, as I said before, on the broader trade agenda because 
it is so important to keep that on track to make sure that 
American agricultural products are being able to be treated 
fairly overseas. And we have a number of issues we are engaging 
people on, on the GMOs, genetically modified organisms, and 
other issues.
    Mr. Watkins. Are we putting agriculture on the table for 
discussions or leaving them off? Are we resolving that at the 
same time?
    Mr. Davidson. In terms of the round, I mean, agriculture is 
front and center in terms of the issues we want to address.
    Mr. Watkins. Thank you.
    Chairman Thomas. Mr. Ryan, wish to inquire?
    Mr. Ryan. We are in this situation because we are in this 
situation. It is important to note that this is the fourth 
time, so I think that we are in agreement here between the 
Administration and most members of this Committee that we need 
to come up with a fundamental solution.
    We can't pass something that is similar to what we just had 
struck down by the WTO. So it is going to require this 
Committee and the Administration to think fundamentally how we 
restructure corporate taxes to respond to this, and to do so in 
a way that we can continue to send our businesses overseas with 
confidence and on a level playing field so they can compete in 
the global marketplace. That means jobs here in America, and 
that is what this is all about.
    The reason I decided to comment, Ms. Angus, is there is an 
old trick in Washington, and I am a relatively new guy, but the 
oldest trick here is, if you don't want to debate somebody on 
the merits of an argument, impugn their motives. And I think 
you are seeing a little bit of that here; and it is unfortunate 
because it soils the tone of the debate we have here, which is 
a very important and time-sensitive issue.
    We need to have experienced people in government. We need 
to have people who have experience in dealing with these types 
of tax issues, who know what corporations face when they run 
into these tax regimes and who know the consequences of this 
FSC ruling. So I think it is important in our executive branch 
that we have people who know what they are talking about, who 
know how these policies affect real people in our economy and 
how they affect corporations.
    It is not an issue that we should be ashamed of in any way, 
and it is a shame that we have to go down the road of impugning 
someone's motives when we are trying to find a solution on a 
bipartisan basis to an issue that we are forced to deal with. 
Hopefully, we will rise above that in the future.
    Our next panel have some interesting ideas that we need to 
look at, and I just encourage you to work with us very quickly 
to come up with a fundamental answer to this problem. With 
that, I just yield.
    Chairman Thomas. I thank the gentleman.
    And I want to thank the panel. Obviously we will be 
pursuing more specific concerns in Subcommittee, and clearly 
the full Committee needs to revisit it. Thank you very much.
    Chair would ask the second panel to come forward. And, 
first of all, thank you for bearing with us.
    The second panel consists of Gary Hufbauer, Senior Fellow 
for the Institute for International Economics; Mr. Peter 
Merrill, who is a Partner and Director of the Economic 
International Consulting Group from PricewaterhouseCoopers; and 
Mr. Stephen Shay, who is a Tax Partner at Ropes & Gray in 
Boston, Massachusetts.
    We have written testimony from each of you and make it a 
part of the record without objection. You may address us in the 
time you have in any way you see fit to enlighten us from your 
perspective.
    And if we can start with Mr. Hufbauer and move across the 
panel. Welcome and we look forward to your testimony. And you 
are going to need to turn the microphones on and they are very 
uni-directional.

   STATEMENT OF GARY HUFBAUER, SENIOR FELLOW, INSTITUTE FOR 
                    INTERNATIONAL ECONOMICS

    Mr. Hufbauer. Thank you very much, Mr. Chairman.
    As was mentioned in the earlier panel and reinforced, this 
case seems to date back to 1971 and these core issues have been 
both negotiated and litigated for more than 30 years in the 
GATT and WTO. I subscribe to the view that the time has come 
for Congress to settle this dispute once and for all; and I 
think it should settle the dispute by eliminating the 
competitive disadvantage to the U.S. economy arising from the 
ancient practice of taxing foreign income generated when 
American firms export their goods and services to world markets 
and when they produce abroad.
    In the outline that accompanies my remarks, I traced the 
history. The most recent appellate body decision, while an 
improvement on the second panel report, contains a good deal of 
mischief. The second panel report stretched to declare the ETI 
Act was a prohibited export subsidy. The way it stretched was 
to create a new test which was not found in the first panel 
report, namely this concept of a normative benchmark for 
judging national tax systems.
    The second appellate body used a less sweeping, ``but for'' 
rule to invalidate the ETI. In terms of legal rationale, that 
counts as an improvement. In addition, the second appellate 
body actually reaffirmed most but not all of the elements of 
that 1981 Council Decision that was spoken of and what had been 
dismissed by the first appellate body. So you had kind of a 
circular process. They tossed the Decision out in the first 
round; and in the second round, at the appellate body level, 
they reinstated many of the provisions. So I guess I have to 
say that is another improvement.
    But these improvements came at a cost by comparison with 
the first panel report and first appellate body report. And 
even under the second panel report, it would have been 
relatively easy for the United States to mount an attack on 
European corporate tax systems. But the easy shots were 
foreclosed in the second appellate body report.
    There is a lot of tax detail there, and I know people don't 
really want to go into that here. I am not saying that the 
European systems are immune to attack under the second 
appellate body report, but I am saying that the area of attack 
was substantially circumscribed.
    Apart from that, there is other mischief in the second 
appellate body report. These WTO judicial mechanisms will 
become the world arbiter of what is, and what is not, foreign-
source income if they go down the path they have set. And they 
will decide what mixture of exemptions and credit systems do 
and do not create prohibited export subsidies.
    If this judicial activism is pursued by future appellate 
body judges and not curbed by WTO Members in their Doha Round 
negotiations, I think we will be traveling down the road of 
more intrusive WTO examination of national tax systems that 
differentiate between export oriented and domestically oriented 
sectors of national economies.
    I believe in the virtues of uniform taxation, but I don't 
think those virtues should be imposed from Geneva. The 
challenge for Congress is to reform the U.S. tax laws so as to 
accomplish two goals. First, eliminate the huge bargaining chip 
that the WTO Appellate body has handed the European Union. I 
think it is a far larger chip than the EU ever contemplated in 
the beginning. To paraphrase Senator Dirksen, after a billion 
dollars, who is counting, but the FSC decision is a huge chip 
for the EU and Congress has to remove the chip from the table 
or the United States will pay for it throughout the Doha Round.
    Second, I hope the Congress will remove the competitive tax 
disadvantage that U.S. firms face when they export to world 
markets and produce abroad. In his statement, Peter Merrill 
goes into some length on these disadvantages. Let me just say 
here that I totally disagree with the suggestion that Mr. Shay 
will be offering later in this panel to eliminate deferral.
    If the United States actually eliminated the practice known 
as ``deferral,'' the whole U.S. economy, including all 
exporters, would be placed at an extremely serious competitive 
disadvantage in the global marketplace, and we would see far 
more examples of inverted ownership. In fact, U.S. companies 
would become easy pickings for foreign purchasers, just based 
on tax differences, if we eliminate deferral.
    Well, a final word on the ETI case. As a supplement to 
congressional action taken in consultation with the Treasury 
Department, the Administration should renegotiate the WTO Code 
on Subsidies and Countervailing Measures, both to achieve 
greater parity in rules that are applied to direct and indirect 
taxation and to curb judicial activism in the WTO. But I want 
to emphasize those negotiations are a supplement and not a 
substitute for congressional action.
    Thank you, Mr. Chairman.
    [The prepared statement of Mr. Hufbauer follows:]

STATEMENT OF GARY HUFBAUER, SENIOR FELLOW, INSTITUTE FOR INTERNATIONAL 
                               ECONOMICS

    Chairman Thomas and members of the Committee, thank you for 
inviting me to testify on the second WTO Appellate Body decision in the 
FSC/ETI case (United States--Tax Treatment for ``Foreign Sales 
Corporations'' Recourse to Article 21.5 of the DSU by the European 
Communities. AB-2001-8, decided 14 January 2002.) In a sense, this case 
is three decades old: its antecedents date to the Domestic 
International Sales Corporation legislation enacted in 1971. The core 
issues have been repeatedly negotiated and litigated for nearly thirty 
years in the GATT and now the WTO.
    The time has come for Congress to settle the dispute once and for 
all. It should settle the dispute by eliminating the competitive 
disadvantage to the U.S. economy arising from our ancient practice of 
taxing foreign income generated when American firms export their goods 
and services to world markets, and when they produce abroad.
    In the outline that follows, I trace the history of the current FSC 
dispute back to the 1960 GATT Working Party. The most recent Appellate 
Body decision, while an improvement on the second Panel Report contains 
a good deal of mischief. The second Panel Report, stretching to declare 
the ETI Act an export subsidy, created a new test not found in the 
first Panel Report--namely the concept of a ``normative benchmark'' for 
judging national tax systems. The Appellate Body used a less sweeping 
``but for'' rule to invalidate the ETI. In terms of legal rationale, 
that counts as an improvement. Moreover, the Appellate Body, in its 
second decision, reaffirmed most (but not all) the elements of the 1981 
Council Decision--a decision that had been tossed aside (not a ``legal 
instrument'') in the first Panel Report and Appellate Body decision. 
Again, this is an improvement.
    But mischief remains. Under the second Appellate Body decision, the 
WTO's judicial mechanisms will become the world arbiter of what is, and 
what is not, foreign source income. These same mechanisms will decide 
what mixture of exemption and credit systems do and do not create 
prohibited export subsidies. This judicial activism, if pursued by 
future Appellate Body judges, and not curbed by the WTO members in 
their Doha Round negotiations, points to more intrusive WTO examination 
of domestic tax systems that differentiate between export-oriented and 
domestically-oriented sectors of national economies. Like most 
economists, I believe in the virtues of uniform taxation. But I do not 
believe these virtues should be imposed from Geneva.
    The challenge for Congress is to reform U.S. tax laws so as to 
accomplish two goals. First, eliminate the huge bargaining chip that 
the WTO Appellate Body has handed to the European Union. Second, remove 
the competitive tax disadvantage that U.S. firms face when they export 
to world markets and produce abroad.
    Supplementary to Congressional action, the Administration should 
renegotiate the WTO code on Subsidies and Countervailing Measures both 
to achieve greater parity in rules applied to ``direct'' and 
``indirect'' taxation, and to curb judicial activism in the WTO. But 
negotiations in the Doha Round should be a supplement, not a 
substitute, for Congressional action.
    Thank you.
                               __________

               THE FSC CASE: BACKGROUND AND IMPLICATIONS

A. Quick background

     A 1960 GATT Working Party codified the ancient 
distinction between permissible border adjustments for direct and 
indirect taxes: origin principle for direct (no adjustments at the 
border); destination principle for indirect (adjustments permitted at 
the border--i.e., impose the tax on imports, exempt the tax on 
exports). Hence destination principle adjustments for corporate profits 
taxes on export earnings (classified as a direct tax) are both an 
impermissible export subsidy and a violation of national treatment. But 
destination principle adjustments for VAT taxes on export and import 
sales are permitted. This distinction persists, despite the obvious 
economic point that a VAT amounts to a combination of a direct tax on 
profits, a direct tax on interest and rent paid by the corporation, and 
a direct tax on wages. In other words, by GATT alchemy, direct taxes 
can be transformed into indirect taxes and adjusted at the border. But 
without this magical transformation, direct taxes cannot be adjusted at 
the border.
     In 1962, the United States enacted Subpart F of the 
Internal Revenue Code. Subpart F eliminated deferral for ``foreign base 
company income'' earned by controlled foreign corporations in tax haven 
countries. Base company income includes profits from handling the sales 
of U.S. exports to third countries. This ``anti-abuse'' provision put 
U.S. exporters at a tax disadvantage compared to other industrial 
country exporters.
     In 1971, faced with a growing trade deficit, the U.S. 
introduced the Domestic International Sales Corporation (DISC)--tax 
deferral for the export earnings of a U.S. corporation. In tax terms, 
the DISC softened the impact of Subpart F, which subjected foreign base 
company income to U.S. tax. The United States argued that tax deferral 
under the DISC was not the same as tax exemption. The EC challenged the 
DISC in 1974. In turn, the U.S. challenged the European ``territorial 
approach'' to taxing export earnings. Specifically, the U.S. challenged 
tax exemption for the portion of export earnings attributed to a sales 
subsidiary located in a tax haven country. (None of the European 
countries then or now has an effective equivalent of Subpart F for 
current taxation of ``foreign base company income''.)
     A GATT panel decided the four ``tax cases'' in 1976: all 
defendants lost. Retaliation was held in abeyance during the Tokyo 
Round negotiations.
     The Tokyo Round Code on Subsidies & Countervailing Duties 
settled the four tax cases, based on four principles: (a) the 
distinction between direct and indirect taxes was preserved; (b) U.S. 
agreed to repeal DISC (tax deferral was conceded to be an export 
subsidy, like tax exemption); (c) however, methods of avoiding double 
taxation--both the exemption method associated with territorial systems 
of taxation and the foreign tax credit method associated with worldwide 
systems of taxation--are defined not to be subsidies; (d) the arm's 
length pricing standard is to be observed in transactions between 
parent exporting companies and their foreign sales subsidiaries.
     Following the conclusion of the Tokyo Round, in 1981 a 
GATT Council Decision disposed of the four tax cases, with a Chairman's 
note that reiterated the bargain struck in the Tokyo Round Code. In 
particular the Chairman's note stated: ``The Council adopts these 
reports on the understanding that with respect to these cases, and in 
general, economic processes (including transactions involving exported 
goods) located outside the territorial limits of the exporting country 
and should not be regarded as export activities in terms of Article 
XVI:4. It is further understood that Article XVI:4 requires that arm's-
length pricing be observed--Furthermore, Article XVI:4 does not 
prohibit the adoption of measures to avoid double taxation of foreign 
source income.''
     Based on this note, in 1984 the United States repealed 
the DISC, and enacted the Foreign Sales Corporation (FSC). The FSC 
allowed partial tax exemption for the income of a foreign corporate 
subsidiary derived from handling U.S. export sales. The amount of 
income exempted was calculated by a formula designed to approximate 
arm's length pricing (dividing export profits between domestic and 
foreign sources).

B. First Round of FSC Litigation

     In 1999, the EU challenged the FSC as a violation of the 
Uruguay Round Code on Subsidies & Countervailing Measures (SCM). This 
was a surprise to the United States, since the FSC had not been 
challenged during the course of the Uruguay Round negotiations. The EU 
motivation was to create bargaining chips to resolve other WTO disputes 
(e.g., bananas, beef hormones), potential disputes (e.g., Airbus and 
steel), and pending disputes at the expiration of the agricultural 
peace clause (December 2003).
     The first WTO FSC Panel, in its October 1999 decision, 
stated that the 1981 Council Decision was not ``a legal instrument'' of 
the GATT-1947 that had been adopted by the GATT-1994, by virtue of the 
Annex 1A of the Uruguay Round (the grandfather or savings clause). 
Surprise! The Panel then went on to hold that the FSC is a prohibited 
export subsidy because: (a) revenue is foregone; (b) exports are taxed 
more favorably than production abroad. The Panel did not rule on the EC 
claim that FSC violates the SCM because exports are taxed more 
favorably than production for the home U.S. market. However, the Panel 
did rule that the FSC is not a permissible application of the 
territorial approach--i.e., the exemption approach--to avoiding 
taxation of foreign source income because the FSC invokes the 
territorial principle for only the export segment of foreign source 
income. In February 2000, the WTO Appellate Body affirmed the Panel 
Report in all essential respects. 

C. The Extraterritorial Income Exclusion (ETI) Act

     In November 2000, the U.S. Congress passed the ETI Act in 
response to the WTO Appellate Body decision. The ETI Act excluded from 
the U.S. definition of gross income certain foreign source income--
namely a portion of export earnings, and a portion of earnings from 
production abroad--with the condition that this territorial method of 
avoiding double tax relief could only be used if the taxpayer did not 
claim foreign tax credits with respect to the same earnings. The 
benefits of the ETI Act were also conditioned on the sale of the goods 
outside the United States, and the use of less than 50% non-U.S. (i.e., 
imported) inputs. Under the ETI Act, FSC benefits are phased out.
     In the U.S. view, the ETI Act conformed to the Appellate 
Body decision because: (a) revenue was no longer foregone--ETI income 
was no longer part of gross income subject to corporate tax; (b) export 
earnings and foreign production earnings were similarly taxed under the 
ETI Act.

D. Second Round of FSC/ETI Litigation

     The EU brought a second case to the WTO, claiming: (a) 
notwithstanding the ETI Act, revenue was still foregone; (b) the export 
contingency remained, even if foreign production was, in some 
circumstances, covered; (c) the U.S. content requirements for export 
earnings under ETI violate Article III (national treatment); (d) the 
FSC phase-out does not respect the first Appellate Body deadline 
(October 2000).
     In August 2001, the WTO FSC/ETI Panel endorsed the EU 
arguments in all essential respects. In reaching its decision, the 
Panel, like its predecessor, continued to disdain any deference to 
established tax practices. Instead:

           The Panel arrogated the power to decide when a 
        mixed system of double tax relief (territorial exemption plus 
        foreign tax credits) amounts to a prohibited export subsidy. 
        The ETI exclusion flunked, according to the Panel, partly 
        because it was too broadly drawn (it could exempt income not 
        taxed by another country) and partly because it was too 
        narrowly drawn (only exports and selected foreign production 
        are covered).
           On the way to creating this power, the Panel 
        claimed the power to say that any deduction or exclusion from 
        gross income could amount to a departure from the ``normative 
        benchmark'' of the offending nation's tax system, and thus 
        could amount to a relief from tax ``otherwise due'' (SCM 
        1.1(ii)), and thus could amount to a subsidy.
           The Panel did not bother to examine actual U.S. tax 
        practice, developed since 1913, which has long allowed deferred 
        taxation of the income of controlled foreign corporations 
        (CFCs). In economic terms, deferral amounts to a partial or 
        near-total exemption. The ETI provision allows an explicit 
        exemption where prior and current law allow for its first 
        cousin, deferral.
           The Panel decided that the ETI exemption was 
        ``contingent on'' exports--in other words, that exporting is a 
        necessary condition for receiving the subsidy--even though the 
        ETI exclusion also applies to foreign production in designated 
        circumstances. This, despite footnote 4 to the SCM which 
        states: ``The mere fact that a subsidy is granted to 
        enterprises which export shall not for that reason alone be 
        considered to be an export subsidy . . .
           Not surprising, the Panel found that the U.S. 
        content rule violated Article III.
     The Appellate Body affirmed the Panel decision, but 
narrowed the rationale with two important twists. (a) The Appellate 
Body walked away from the Panel's ``normative benchmark'' concept and 
instead defined ``revenue otherwise due'' by referring to the taxation 
of ETI income when the taxpayer elects to claim a foreign tax credit 
rather than the exemption. Since the taxpayer will only elect the 
exemption method when his bottom line U.S. taxes are less under the 
credit method, it follows that the U.S. Treasury has foregone ``revenue 
otherwise due''. (b) The Appellate Body delved into ETI Act rules for 
determining the division of export income between domestic and foreign 
sources. Using simple-minded examples, the Appellate Body found 
circumstances where the rules could improperly characterize domestic 
source income as foreign source income.
     In important ways, the Appellate Body returned to the 
main outlines of the bargain struck in the 1981 GATT Council Decision. 
The Appellate Body reaffirmed the arm's length principle for 
distinguishing between domestic source and foreign source income earned 
on export sales. The Appellate Body confirmed that foreign source 
income, properly computed, could be exempt from tax and the exemption 
does not automatically amount to an export subsidy prohibited by the 
SCM.

E. Questions Raised

     First question: how big is the bargaining chip that the 
WTO has created for the WTO? Under the SCM, the Arbitral Panel decides 
the permitted level of retaliation--i.e. ``appropriate 
countermeasures'' (Article 4.11 of the SCM)--in the event that the 
subsidizing member does not ``withdraw the subsidy without delay''. The 
Arbitral Panel has said it will reach a decision at the end of April 
2002. Once decided, the Arbitral Panel's ruling cannot be appealed. 
There is little case guidance on ``appropriate countermeasures''--only 
the Brazil-Aircraft arbitration. In that case, the Arbitral Panel 
decided that ``appropriate countermeasures'' means the ``the full 
amount of the subsidy to be withdrawn''--not the level of trade 
impairment to Canada (as Brazil had argued). Following this precedent, 
the U.S. argues that the bargaining chip is $956 million, calculated 
with reference to the tax benefits on FSC/ETI exports to the EU 
directly, and to third country markets where U.S. and EU exports 
compete. The EU says the bargaining chip is $4,043 million, based on 
total FSC tax benefits on exports to the world. Both submissions avoid 
an explicit calculation of the trade impact of the FSC/ETI benefit. 
However, their implicit calculations assume that the size of trade 
impact equals the size of tax benefit (i.e., an export demand 
elasticity of--1.0). The Arbitral Panel's decision will set an 
important precedent for calculating ``appropriate countermeasures''.
     Second question: what is in the EU shopping bag? The EU 
claims that it only wants the U.S. to amend or repeal the ETI law in a 
WTO-consistent manner. This oft-repeated EU statement is only a ploy to 
force the U.S. into opening negotiations, offering ``compensation'' in 
the form of concessions on other trade issues. Plausible candidates for 
the EU shopping bag: (a) beef hormones and potential biotechnology 
claims; (b) Section 201 restrictions on steel imports (but there the EU 
can retaliate directly); (c) agricultural subsidies. The logic from 
Pascal Lamy's standpoint is to hold the bargaining chip in his pocket, 
and threaten but not invoke retaliation. Possible outcome: a standstill 
on all retaliation that lasts until the end of the Doha Work Programme 
in 2005.
     Third question: will other WTO members use the decision 
to create their own bargaining chips for negotiations and dispute 
resolution with the United States? They would have to mount new cases 
against the FSC/ETI to get permission to retaliate, but the precedent 
seems straightforward. If this scenario unfolds, how will future 
Arbitral Panels go about allocating the rights to ``appropriate 
countermeasures'' among WTO complainants?
     Fourth question: will the U.S. (and possibly other 
members) use the logic of the WTO's decision to launch their own tax 
cases against their trading partners? Export processing zones, widely 
used by developing countries, are vulnerable. So is the U.S. export 
source rule. The EU countries may have arbitrary formulas for 
calculating exempt foreign source income tucked away in their tax laws 
and regulations. The Appellate Body decision is an invitation to tax 
litigation--member A can respond to a non-tax WTO case brought against 
it by launching its own tax case against member B. This danger 
underscores the standstill option mentioned earlier.
     Fifth question: will WTO members renegotiate the SCM in 
the Doha Work Programme? Two possible objectives: (a) Stop the DSM from 
turning itself into a World Tax Court. For example, the SCM could 
instruct the DSM to defer to jurisprudence established in bilateral tax 
treaties and the OECD for defining foreign source income. (b) Eliminate 
the artificial distinction between border adjustment rules for direct 
and indirect business taxes. For example, the SCM rules could allow 
members to exempt 50% of export earnings from corporate profits tax. 
(c) As a matter of transparency, require WTO members to publish their 
schedules of border tax adjustments applied on a product basis, 
following the Harmonized Tariff System.
     Sixth question: how will the U.S. Congress change the tax 
law? Congressional action is clearly necessary, both to take away 
bargaining chips from the EU and to avert ``piling on'' by other WTO 
members. There are three broad options: (a) The ``minimal'' fix--repeal 
the ETI Act, and exclude export income from ``foreign base company'' 
income under Subpart F. (b) Abandon export tax relief--repeal the ETI 
and use the revenue for other business tax reform, for example phasing 
out the AMT. (c) Use the WTO decision as a springboard for fundamental 
reform, through a territorial system of taxing corporate profits. This 
is clearly the best answer. Politically, it may be the most difficult.

                                


    Chairman Thomas. Thank you Mr. Hufbauer.
    Mr. Merrill.

STATEMENT OF PETER R. MERRILL, PRINCIPAL AND DIRECTOR, NATIONAL 
  ECONOMIC CONSULTING GROUP, PRICEWATERHOUSECOOPERS LLP, AND 
           CONSULTANT, INTERNATIONAL TAX POLICY FORUM

    Mr. Merrill. Thank you, Mr. Chairman, Mr. Rangel, Members 
of the Committee. I am Peter Merrill, Director of the National 
Economic Consulting Group at PricewaterhouseCoopers. I am also 
a consultant to the International Tax Policy Forum (ITPF) and 
co-author of a book published recently by the National Foreign 
Trade Council on international tax policy.
    For the record, I am testifying today on my own behalf. The 
focus of my testimony is the relationship between U.S. tax 
policy and international competitiveness.
    Current rules regarding the taxation of both domestic and 
foreign income create barriers that harm the competitiveness of 
U.S. companies. These rules are also horribly complex to comply 
with and to administer. Regardless of how the ETI dispute is 
ultimately resolved, I believe it is important for this 
Committee to review the current U.S. tax rules with a view to 
reducing complexities and removing impediments to U.S. 
competitiveness.
    In a global market the competitiveness of the country 
depends on the ability of its enterprises to produce goods and 
services that are successful both at home and in foreign 
markets. Today, almost 80 percent of world income and 
purchasing power lies outside the United States. Foreign 
affiliate sales are growing three times as fast as domestic 
sales within Standard and Poor's, S&P, 500 companies.
    It is a common perception that the investment abroad by 
U.S. multinationals comes at the expense of the domestic 
economy. This is an incorrect view. According to the U.S. 
Department of Commerce, less than 11 percent of sales by U.S.-
controlled foreign corporations were made back to the United 
States.
    In 1998, U.S. multinationals were directly responsible for 
almost two-thirds of all U.S. exports. A recent study by the 
OECD found each dollar of outward foreign direct investment is 
associated with $2 of additional exports. A number of studies 
have found U.S. investment abroad generates additional 
employment at home through an increase in the domestic 
operations of U.S. multinationals. Moreover, research has shown 
that workers at domestic plants owned by U.S. multinationals 
earn higher wages than workers at domestic plants owned by 
companies with only domestic operations.
    In summary, U.S. multinationals provide significant 
contributions to the U.S. economy through sales of U.S. goods 
and services abroad and employment at above average wages at 
home.
    With the reduction of the U.S. corporate income tax rate 
from 46 to 34 percent in 1986, it is commonly thought that the 
United States is a low-tax jurisdiction for corporations. While 
this was true immediately after the 1986 tax, it is no longer 
true today. The United States increased the corporate income 
tax rate to 35 percent in 1991. Meanwhile, the average OECD 
corporate tax rate has fallen to 4.5 percentage points less 
than the U.S. rate.
    In addition to a relatively high corporate income tax rate, 
the United States is one of only three OECD Member Countries 
that does not provide some form of relief from the double 
taxation of corporate dividends. For a shareholder in the top 
individual income tax bracket, the combination of corporate and 
individual income tax is over 60 percent of distributed 
corporate income in the United States. And while the total U.S. 
tax burden as a percentage of GDP is relatively light compared 
to other OECD countries, reliance on income and profits tax is 
unusually high.
    In 1999, the U.S. relied on income and property taxes for 
almost half of all revenues, compared to slightly over a third 
in the average OECD country. Indeed, the United States is the 
only one of the 30 OECD Member Countries that does not have a 
national value-added tax.
    A study published by the European Commission last year 
found that, on average, U.S. multinationals bear a higher 
effective tax rate when investing into the European Union than 
do EU multinationals. This is a European Commission study. The 
additional tax burden ranged from 3 to 5 percentage points 
depending on the type of finance.
    There are a number of reasons why the United States has 
become an unattractive jurisdiction in which to locate the 
headquarters of a multinational company, aside from our 
relatively high corporate tax rate.
    First, unlike the United States, about half of the OECD 
countries have a dividend exemption, also called a 
``territorial'' tax system under which a parent company 
generally is not subject to tax on the active income earned by 
foreign subsidiaries.
    Second, the foreign tax credit, which is intended to 
prevent double taxation of foreign-source income, has a number 
of deficiencies that increase the complexity and prevent full 
double tax relief.
    Third, the scope of the U.S. anti-deferral rules under 
subpart F is unusually broad. While most countries tax passive 
income earned by controlled foreign subs, the United States is 
unusual in taxing a wide range of active foreign income that is 
reinvested abroad.
    In conclusion, short of adopting a territorial tax system, 
there are significant opportunities to increase the 
competitiveness and reduce the complexity of U.S. tax rules 
applicable to foreign source income.
    One opportunity that is worth special attention within the 
context of these hearings is the foreign base company sales 
rules adopted by Congress in 1962. Part of the benefit of the 
FSC regime that was rejected by the WTO was the fact that it 
created an exception to the base company rules. If the foreign 
base company rules were to be repealed, U.S. companies would be 
put in a position more comparable to their foreign competitors.
    Moreover, the original policy rationale for the base 
company rules was thrown into doubt by the Treasury 
Department's study of subpart F.
    In conclusion, U.S. rules for taxing domestic and foreign 
source income are out of step with other major industrial 
countries in a number of ways. Regardless of the ultimate 
resolution of the ETI case, Congress should consider changes to 
the U.S. system that promote economic growth and reduce the 
costs of complying with the tax system.
    Thank you.
    Chairman Thomas. Thank you, Mr. Merrill.
    Mr. Shay?
    [The prepared statement of Mr. Merrill follows:]

    STATEMENT OF PETER R. MERRILL, PRINCIPAL AND DIRECTOR, NATIONAL 
ECONOMIC CONSULTING GROUP, PRICEWATERHOUSECOOPERS LLP, AND CONSULTANT, 
                     INTERNATIONAL TAX POLICY FORUM

           U.S. TAX POLICY AND INTERNATIONAL COMPETITIVENESS

I. INTRODUCTION
    I am Peter Merrill, a Principal and Director of the National 
Economic Consulting group at PricewaterhouseCoopers LLP. I am also a 
consultant to the International Tax Policy Forum, a group of U.S.-based 
multinational companies from a broad range of industries, and co-author 
of a recent book published by the National Foreign Trade Council on 
International Tax Policy for the 21st Century. For the 
record, I am testifying today on my own behalf and not as a 
representative of any organization.
    The focus of my testimony is the relationship between U.S. tax 
policy and international competitiveness. In many instances, current 
rules regarding the taxation of both domestic and foreign income create 
barriers that harm the competitiveness of U.S. companies. These rules 
also are horribly complex both for taxpayers to comply with and for the 
Internal Revenue Service to administer.
    The existing extraterritorial income (ETI) tax regime serves in 
part to offset some of the anti-competitive features of U.S. tax 
policy. Thus, the WTO's adverse decision in the ETI case raises the 
question how Congress can strengthen the competitive position of the 
U.S. tax system. Regardless of how the ETI dispute is resolved, I 
believe it is important for this Committee to review the current U.S 
tax rules with a view to reducing complexity and removing impediments 
to U.S. competitiveness.

II. TAX POLICY AND INTERNATIONAL COMPETITIVENESS
    While there are a variety of ways to define competitiveness, in 
this testimony I focus on the standard of living of U.S. residents as 
the measure of economic performance. Achieving a high standard of 
living ultimately rests on the productivity of U.S. investments. 
Growing productivity in turn requires investment--in plant and 
equipment and in the development and dissemination of knowledge through 
research and education.
    The challenge for tax policy is to design a tax system that raises 
revenue with the least damage to the growth of productivity and 
national income. A poorly designed tax system can impose unnecessarily 
high costs to the economy--so-called dead-weight loss--by discouraging 
savings and investment, by causing investment to be allocated 
inefficiently, or by requiring excessive resources to be devoted to 
complying with and administering the tax rules.

III. U.S. MULTINATIONALS AND INTERNATIONAL COMPETITIVENESS
    In a global market, the competitiveness of a country depends on the 
ability of its enterprises to produce goods and services that are 
successful both at home and in foreign markets. Today, almost 80 
percent of world income and purchasing power lies outside of U.S. 
borders. Opportunities for U.S. companies to grow their businesses 
increasingly lie overseas. From 1986 to 1997, foreign sales of S&P 500 
companies grew 10 percent a year, compared to domestic sales growth of 
just 3 percent annually.\1\
---------------------------------------------------------------------------
    \1\ Wall Street Journal, ``U.S. Firms Global Progress is Two-
Edged,'' August 17, 1998.
---------------------------------------------------------------------------
A. U.S. Investment Abroad and Exports
    It is a common perception that investment abroad by U.S. 
multinationals comes at the expense of the domestic economy. This is an 
incorrect view. The primary motivation for U.S. multinationals to 
operate abroad is to compete better in foreign markets, not domestic 
markets. According to the Commerce Department, less than 11 percent of 
sales by U.S.-controlled foreign corporations were made to U.S. 
customers.\2\
---------------------------------------------------------------------------
    \2\ U.S. Department of Commerce, Survey of Current Business (July 
2000). Note that 40 percent of the sales back to the United States were 
from Canadian subsidiaries.
---------------------------------------------------------------------------
    Investment abroad is required to provide services that cannot be 
exported, to obtain access to natural resources, and to provide goods 
that are costly to export due to transportation costs, tariffs, and 
local content requirements. Foreign investment allows U.S. 
multinationals to compete more effectively around the world, ultimately 
increasing employment and wages of U.S. workers.
    While about one-fourth of U.S. multinational parent companies are 
in the services sector, 56 percent of all foreign affiliates are this 
sector, which includes distribution, marketing, and product support 
services.\3\ Without these sales and services subsidiaries, it would be 
impossible to sustain current export volumes.
---------------------------------------------------------------------------
    \3\ Matthew Slaughter, Global Investments, American Returns. 
Mainstay III: A Report on the Domestic Contributions of American 
Companies with Global Operations, Emergency Committee for American 
Trade (1998).
---------------------------------------------------------------------------
    According to the U.S. Commerce Department, in 1998, U.S. 
multinationals were directly responsible, through their domestic and 
foreign affiliates, for $438 billion of U.S. merchandise exports--
almost two-thirds of all merchandise exports.\4\
---------------------------------------------------------------------------
    \4\ National Foreign Trade Council, The NFTC Foreign Income 
Project: International Tax Policy for the 21st Century, chapter 6 
(1999).
---------------------------------------------------------------------------
    A recent study by the Organization for Economic Cooperation and 
Development (OECD) found that each dollar of outward foreign direct 
investment is associated with $2.00 of additional exports.\5\
---------------------------------------------------------------------------
    \5\ OECD, Open Markets Matter: The Benefits of Trade and Investment 
Liberalization, p. 50 (1998).
---------------------------------------------------------------------------
B. U.S. Employment
    Foreign investment by U.S. multinationals generates sales in 
foreign markets that generally could not be achieved by producing goods 
entirely at home and exporting them.
    A number of studies find U.S. investment abroad generates 
additional employment at home through an increase in the domestic 
operations of U.S. multinationals. As noted by Professors David Riker 
and Lael Brainard:
    ``Specialization in complementary stages of production implies that 
affiliate employees in industrialized countries need not fear the 
multinationals' search for ever-cheaper assembly sites; rather, they 
benefit from an increase in employment in developing country 
affiliates.'' \6\
---------------------------------------------------------------------------
    \6\ David Riker and Lael Brainard, U.S. Multinationals and 
Competition from Low Wage Countries, National Bureau of Economic 
Research Working Paper no. 5959 (1997) p. 19.
---------------------------------------------------------------------------
    Moreover, workers at domestic plants owned by U.S. multinational 
companies earn higher wages than workers at domestic plants owned by 
companies without foreign operations, controlling for industry, size of 
company, and state where the plant is located.\7\
---------------------------------------------------------------------------
    \7\ Mark Doms and Bradford Jensen, Comparing Wages, Skills, and 
Productivity between Domestic and Foreign-Owned Manufacturing 
Establishments in the United States, mimeo. (October 1996).
---------------------------------------------------------------------------
C. U.S. Research and Development
    Foreign direct investment allows U.S. companies to take advantage 
of their scientific expertise, increasing their return on firm-specific 
assets, including patents, skills, and technologies. Professor Robert 
Lipsey notes that the ability to make use of these firm-specific assets 
through foreign direct investment provides an incentive to increase 
investment in activities that generate this know-how, such as research 
and development.\8\
---------------------------------------------------------------------------
    \8\ Robert Lipsey, ``Outward Direct Investment and the U.S. 
Economy,'' in The Effects of Taxation on Multinational Corporations, p. 
30 (1995).
---------------------------------------------------------------------------
    Among U.S. multinationals, total research and development in 1996 
amounted to $113 billion, of which $99 billion (88 percent) was 
performed in the United States.\9\ Such research and development allows 
the United States to maintain its competitive advantage in business and 
be unrivaled as the world leader in scientific and technological know-
how.
---------------------------------------------------------------------------
    \9\ U.S. Department of Commerce, Survey of Current Business 
(September 1998).
---------------------------------------------------------------------------
D. Summary
    U.S. multinationals provide significant contributions to the U.S. 
economy through:

     Sales of U.S. goods and services abroad;
     Domestic employment at above average wages; and
     Critical domestic investments in equipment, technology, 
and research and development.

    As a result, the United States has an important interest in 
insuring that its tax rules do not hinder the competitiveness of U.S. 
multinationals.

IV. DOMESTIC TAX COMPETITIVENESS

A. Corporate Income Tax Rate
    With the reduction in the U.S. corporate income tax rate from 46 to 
34 percent, as a result of the Tax Reform Act of 1986, it is commonly 
thought that the United States is a low-tax jurisdiction for 
corporations. While true immediately after the 1986 Act, it is no 
longer true today. The United States increased the corporate income tax 
rate to 35 percent in 1991. Meanwhile, the average central government 
corporate tax rate in OECD member states has fallen since 1986 to 30.5 
percent in 2001--4.5 percentage points less than the U.S. rate (see 
Exhibit 1). This disparity in corporate tax rates would be even larger 
if corporate income taxes imposed by subnational levels of government 
were taken into account.

B. Double Taxation of Corporate Dividends
    In addition to a relatively high corporate income tax rate, the 
United States is one of only three OECD member countries that does not 
provide some form of relief from the double taxation of corporate 
dividends (see Exhibit 2). Most OECD countries relieve double taxation 
of corporate dividends at the shareholder level through some form of 
credit, exemption, or special tax rate for dividend income. For a 
shareholder in the top individual income tax bracket (38.6 percent 
\10\), the combination of corporate and individual income tax is over 
60 percent of distributed corporate income (see Exhibit 3). The 
combined income tax rate on distributed corporate income is even higher 
if state and local tax on corporate and individual income are taken 
into account.
---------------------------------------------------------------------------
    \10\ Under the Economic Growth and Tax Relief Reconciliation Act of 
2001, the top individual income tax rate is scheduled to be reduced to 
35 percent in 2006.
---------------------------------------------------------------------------
C. Reliance on Income and Profit Taxation
    While the total tax burden as a percent of Gross Domestic Product 
(GDP) is relatively light in the United States compared to other OECD 
countries, reliance on income taxes to fund spending at all levels of 
government is unusually high. In 1999, the United States relied on 
income and profits taxes for almost half of all revenues (49.1 percent) 
while the average OECD country raised slightly over one-third of 
revenues (35.3 percent) from this source (see Exhibit 4). The U.S. data 
include sales taxes imposed by state and local governments; the federal 
government is even more heavily reliant on income and profits taxes as 
there is no broad-base consumption tax at the federal level. Indeed, 
the United States is the only one of the 30 OECD member countries that 
does not have a national value-added tax.

D. Conclusion
    When compared to other OECD and EU member countries, the United 
States relies relatively heavily on income taxes to fund government 
operations, has a comparatively high corporate income tax rate, and is 
unusual in not providing a mechanism for relieving the double taxation 
of corporate income.
    From a trade standpoint, heavy reliance on income taxes relative to 
consumption taxes may be viewed as disadvantageous because the WTO 
Agreement on Subsidies and Countervailing Measures permits border tax 
adjustments for indirect taxes such as consumption taxes, but prohibits 
such adjustments for income and profits taxes. However, from the 
standpoint of U.S. economic growth, the main reason to avoid over-
reliance on income and profit taxes is that they discourage savings and 
investment, which are closely linked to growth in national income.

V. INTERNATIONAL TAX COMPETITIVENESS

A. Rising Level of International Competition
    In 1962, when the controlled foreign corporation rules in Subpart F 
were adopted, the U.S. multinationals overwhelmingly dominated global 
markets. In this environment, the consequences of adopting tax rules 
that were out-of-step with other countries were of less concern to many 
policymakers.
    Today, the increasing integration of the world economies has 
magnified the impact of U.S. tax rules on the international 
competitiveness of U.S. multinationals. Foreign markets represent an 
increasing fraction of the growth opportunities for U.S. businesses. At 
the same time, competition from multinationals headquartered outside of 
the United States is becoming greater.\11\
---------------------------------------------------------------------------
    \11\ See, National Foreign Trade Council, International Tax Policy 
for the 21st Century, vol. 1, 2001, pp 95-96.

     Of the world's 20 largest corporations, the number 
headquartered in the United States has declined from 18 in 1960 to just 
8 in 1996.
     U.S. multinational companies' share of global cross-
border investment has declined from 50 percent in 1967 to 25 percent in 
1996.
     The 21,000 foreign affiliates of U.S. multinationals 
compete with about 260,000 foreign affiliates of foreign 
multinationals.

    If U.S. rules for taxing foreign source income are more burdensome 
than those of other countries, U.S. multinationals will be less 
successful in global markets, with adverse consequences for exports and 
employment at home.

B. International Comparison of U.S. Rules for Taxing Multinational 
        Companies
    A study published by the European Commission last year found that, 
on average, U.S. multinational companies bear a higher effective tax 
rate when investing into the European Union than do EU multinationals. 
The additional tax burden borne by U.S. multinationals ranges from 3 to 
5 percentage points depending on the type of finance used (see Exhibit 
5).
    In addition to the relatively high U.S. corporate income tax rate, 
there are a number of other reasons why United States has become a 
relatively unattractive jurisdiction in which to locate the 
headquarters of a multinational corporation.
    First, about half of the OECD countries have a dividend exemption 
(``territorial'') tax system under which a parent company generally is 
not subject to tax on the active income earned by a foreign subsidiary 
(see Exhibit 6). By contrast, the United States taxes income earned 
through a foreign corporation when repatriated (or when earned if 
subject to U.S. anti-deferral rules).
    Second, the U.S. foreign tax credit, which is intended to prevent 
double taxation of foreign source income, has a number of deficiencies 
that increase complexity and prevent full double tax relief, including: 
\12\
---------------------------------------------------------------------------
    \12\ See, National Foreign Trade Council, U.S. International Tax 
Policy for the 21st Century, vol. 1, Part II, 2001

     Over allocation of U.S. interest expense against foreign 
source income due to failure to take into account foreign debt. This 
reduces the foreign tax credit limitation and can cause income that has 
been subject to foreign tax at a rate of 35 percent or more to be 
subject to additional U.S. tax;
     Asymmetric loss recapture rules that have the effect of 
restoring U.S. but not foreign income, thereby reducing the foreign tax 
credit limitation;
     The limitation on foreign tax credits to 90 percent of 
alternative minimum tax liability;
     The limited carryover period for foreign tax credits (two 
years back and five years forward); and
     The complexity associated with the numerous separate 
foreign tax credit limitations and the ``high-tax kick out'' rules that 
move certain income out of the passive basket.

    A third difference from the multinational tax rules of other 
countries is the unusually broad scope the U.S. anti-deferral rules 
under subpart F. While most countries tax passive income earned by 
controlled foreign subsidiaries, the United States is unusual in taxing 
a wide range of unrepatriated active income as a deemed dividend to the 
U.S. parent, including: \13\
---------------------------------------------------------------------------
    \13\ Ibid., vol. 1, Part I.

     Foreign base company sales income;
     Foreign base company services income; and
     Active financial services income (an exclusion of this 
income from Subpart F expired last year).

    The net effect of these tax differences is that a U.S. 
multinational frequently pays a greater share of its income in foreign 
and U.S. tax than does a competing multinational company headquartered 
outside of the United States.
    Complexity. The U.S. rules for taxing foreign source income are 
among the most complex in the Internal Revenue Code. A survey of 
Fortune 500 companies found that 43.7 percent of U.S. income tax 
compliance costs were attributable to foreign source income even though 
foreign operations represented only 26-30 percent of worldwide 
employment, assets and sales.\14\ These data show that U.S. tax 
compliance costs related to foreign source income are grossly 
disproportionate. These high compliance costs are a hidden form of 
taxation that discourages small U.S. companies from operating abroad 
and makes it more difficult for larger companies to compete 
successfully with foreign multinationals.
---------------------------------------------------------------------------
    \14\ Marsha Blumenthal and Joel Slemrod, ``The Compliance Costs of 
Taxing Foreign-Source Income: Its Magnitude, Determinants, and Policy 
Implications, International Tax and Public Finance, vol. 2, no. 1, 37-
54 (1995).
---------------------------------------------------------------------------
    The international tax recommendations in the Joint Committee on 
Taxation's simplification study are a good start to begin addressing 
the high compliance burden imposed by U.S. international tax rules.\15\ 
It should also be noted that the Treasury Department's tax 
simplification project, described in the Administrations FY 2003 
Budget, identifies the international tax rules as an area singled out 
by taxpayers as one of the biggest sources of compliance burden.\16\
---------------------------------------------------------------------------
    \15\ Joint Committee on Taxation, Study of the Overall State of the 
Federal Tax System and Recommendations for Simplification, Pursuant to 
Section 8022(3)(B) of the Internal Revenue Code of 1986, JCS-3-01 
(April 2001).
    \16\ Office of Management and Budget, Budget of the United States 
Government, Fiscal Year 2002, Analytical Perspectives, p. 79
---------------------------------------------------------------------------
C. Conclusion
    Short of adopting a territorial tax system, there are significant 
opportunities to increase the competitiveness and reduce the complexity 
of the U.S. tax rules applicable to foreign source income. Indeed, 
there are a number of reasons to think very carefully before adopting a 
territorial income tax system.
    First, foreign experience suggests that adopting a territorial 
income tax system does not guarantee a simple tax regime. OECD 
Countries with territorial income tax systems also have parallel 
foreign tax credit rules for foreign income that is not exempt. 
Moreover, many OECD countries with territorial income tax systems also 
have anti-deferral rules that tax certain income earned by foreign 
subsidiaries on a current basis.
    Second, depending on how a territorial tax system is designed, it 
could cause a substantial tax increase for companies that currently 
repatriate dividends from high-tax jurisdictions. Present law allows 
excess foreign tax credits on high-taxed foreign income to be used to 
reduce U.S. tax on low-taxed foreign income within the same limitation 
category. Under a dividend exemption system, cross crediting between 
dividends and other types of foreign income generally is not possible.
    Third, allocation of U.S. interest and other domestic expenses 
against foreign source income causes these expenses to be nondeductible 
under a territorial income tax system. Double taxation will result 
unless foreign governments allow a deduction for these allocated 
expenses.
    One opportunity for international tax reform is worth special 
mention within the context of these hearings, i.e., the foreign base 
company sales rules adopted by Congress in 1962 as part of Subpart F of 
the Internal Revenue Code. Absent these rules, U.S. companies would be 
able to set up sales companies in low-tax jurisdictions and reinvest 
their active foreign earnings without current U.S. tax. In fact, part 
of the benefits of the FSC regime were attributable to the fact that it 
created an exception to the foreign base company sales rules.\17\ 
Repeal of the foreign base company sales rules would put U.S. companies 
in a more comparable position to their foreign competitors who 
generally can use these structures with being subject to home country 
tax. Moreover, the original policy rationale for these rules was thrown 
into doubt by the Treasury Department's policy study on Subpart F, 
released in December 2000, which concluded that the economic efficiency 
effects of the base company rules were ``ambiguous.'' \18\
---------------------------------------------------------------------------
    \17\ This exception was one of the reasons that the FSC regime was 
determined by the WTO to violate the Agreement on Subsidies and 
Countervailing Measures under the ``but for'' test.]
    \18\ U.S. Department of the Treasury, Office of Tax Policy, The 
Deferral of Income Earned through U.S. Controlled Corporations: A 
Policy Study (December 2000) p. 47. The report reached similar 
conclusions regarding the other foreign-to-foreign related party rules 
of Subpart F such as the foreign base company services income rules.
---------------------------------------------------------------------------
VI. SUMMARY
    U.S. rules for taxing both domestic and foreign source income are 
out of step with other major industrial countries in a number of ways. 
Regardless of the ultimate resolution of the ETI case, Congress should 
consider changes to the U.S. system that promote economic growth and 
reduce costs of complying, with and administering the tax system.
    If the United States is an unattractive location--from a tax 
standpoint--to headquarter a multinational corporation, then U.S. 
multinationals will lose global market share. This can happen in a 
variety of ways.
    First, U.S. individual and institutional investors can choose to 
invest in foreign rather than U.S. headquartered companies. Indeed, as 
of 1999, almost two-thirds (66 percent) of all U.S. private investment 
abroad was in the form of portfolio rather than foreign direct 
investment. This allows U.S. investors to invest in multinational 
companies whose foreign operations generally are outside the scope of 
U.S. tax rules.
    Second, in a cross-border merger, the transaction may be structured 
as a foreign acquisition of a U.S. company rather than the reverse. 
Measured by deal value, over the 1998-2000 period, between 73 and 86 
percent of large cross-border transactions involving U.S. companies 
have been structured so that the merged company is headquartered 
abroad.\19\ Clearly taxes are only one of many considerations in the 
structuring of these transactions, but it is notable that in one large 
transaction, taxes were specifically identified as a significant 
factor.\20\ By choosing to be headquartered abroad, the merged entity 
can invest outside the United States without being subject to the 
complex and onerous U.S. rules that apply to the foreign source income 
of U.S.-headquartered companies.\21\
---------------------------------------------------------------------------
    \19\ Recent examples include: AEGON-Transamerica, BP-Amoco, 
Daimler-Chrysler, Deutsche Bank-Bankers Trust, and Vodafone-AirTouch.
    \20\ See, John L. Loffredo, ``Testimony before the Senate Finance 
Committee'' (March 11, 1999) regarding the Daimler-Chrysler 
transaction.
    \21\ Where business reasons dictate the form of a transaction, 
there generally is no cause for concern. The concern we are raising is 
that non-competitive U.S. tax rules may be influencing the form of 
transactions.
---------------------------------------------------------------------------
    Third, and most starkly, a growing number of U.S. companies have 
structured transactions in which their U.S. parents are acquired by 
their own foreign subsidiaries. Such ``inversion'' transactions, like 
foreign acquisitions of U.S. companies, allow new foreign investments 
to be structured as subsidiaries of a foreign parent corporation and 
thus not subject to U.S. rules relating to the taxation of foreign 
source income.
    Fourth, an increasing number of new ventures are being incorporated 
at inception as foreign corporations.
    While some have suggested that reducing the U.S. tax burden on 
foreign source income could lead to a movement of manufacturing 
operations out of the United States (``runaway plants''), an 
alternative scenario is that a noncompetitive U.S. tax system will lead 
to a migration of multinational headquarters outside the United States.
    A decline in the market share of U.S. multinationals may affect the 
well being of the U.S. economy because, as noted above, U.S. 
multinationals play an important role in promoting U.S. exports and 
creating high-wage jobs.

                       EXHIBIT 1--CENTRAL GOVERNMENT CORPORATE INCOME TAX RATES, 1986-2001
----------------------------------------------------------------------------------------------------------------
                           Country                                1986         1991         1995         2001
----------------------------------------------------------------------------------------------------------------
Australia...................................................         49.0         39.0         33.0         34.0
Austria.....................................................         30.0         30.0         34.0         34.0
Belgium.....................................................         45.0         39.0         39.0         40.2
Canada......................................................         36.0         29.0         29.0         27.0
Denmark.....................................................         50.0         38.0         34.0         30.0
Finland.....................................................         33.0         23.0         25.0         29.0
France......................................................         45.0        34/42         33.0         33.3
Germany.....................................................         56.0        50/36        45/30         25.0
Greece......................................................         49.0         46.0        35/40         37.5
Iceland.....................................................         51.0         45.0         33.0           Na
Ireland.....................................................         50.0         43.0         40.0         20.0
Italy.......................................................         36.0         36.0         36.0         36.0
Japan.......................................................         43.0         38.0         38.0         30.0
Luxembourg..................................................         40.0         33.0         33.0         30.0
Netherlands.................................................         42.0         35.0         35.0         35.0
New Zealand.................................................         45.0         33.0         33.0         33.0
Norway......................................................         28.0         27.0         19.0         28.0
Portugal....................................................        42/47         36.0         36.0         34.0
Spain.......................................................         35.0         35.0         35.0         35.0
Sweden......................................................         52.0         30.0         28.0         28.0
Switzerland.................................................         4-10         4-10         4-10          8.5
Turkey......................................................         46.0         49.0         25.0         30.0
United Kingdom..............................................         35.0         34.0         33.0         30.0
United States...............................................         46.0         34.0         35.0         35.0
Unweighted averages: \1\
EU..........................................................         42.8         35.9         34.4         31.8
OECD........................................................         41.4         35.0         32.0         30.5
----------------------------------------------------------------------------------------------------------------
1Midpoint tax rate used for countries with multiple rates.
Sources: Jeffrey Owens, Tax Reform for the 21st Century, Tax Notes International. 2001 data from American
  Council for Capital Formation, ``The Role of Federal Tax Policy and Regulatory Reform in Promoting Economic
  Recovery and Long-Term Growth,'' November 28, 2001.

                                 ______
                                 

                       EXHIBIT 2--TAXATION OF CORPORATE DIVIDENDS IN OECD COUNTRIES, 1999
----------------------------------------------------------------------------------------------------------------
                                       Method of relieving double taxation of corporate dividends
                      ------------------------------------------------------------------------------------------
No relief from double                           Shareholder level
taxation of corporate ---------------------------------------------------------------------
      dividends          Imputation system                            Special personal tax     Corporate level
                       (partial or complete)    Tax credit  method            rate
----------------------------------------------------------------------------------------------------------------
       Netherlands              Australia                       Canada          Austria            Iceland \2\
       Switzerland            Finland \5\          Rep. of Korea            Belgium \5\
     United States                 France                  Spain                       Czech Republic
                              Ireland \3\                                       Denmark
                                   Mexico                                   Germany \1\
                              New Zealand                                    Greece \5\
                                   Norway                                       Hungary
                                 Portugal                                         Italy
                           United Kingdom                                         Japan
                                                                         Luxembourg \4\
                                                                                 Poland
                                                                                 Sweden
                                                                                 Turkey
                                                                         United Kingdom
----------------------------------------------------------------------------------------------------------------
1 Germany recently has adopted a 50 percent dividend exclusion.
2 Deduction for dividends paid may offset fully the corporate and personal income tax for dividends up to 15
  percent of capital value. Dividends in excess of this limit are fully taxed at both levels.
3 Ireland eliminated its imputation credit effective April 6, 1999.
4 Luxembourg has a 50 percent dividend exclusion.
5 Information as of 1996 based on S. Cnossen.
Sources: PricewaterhouseCoopers, Individual Taxes 1999-2000: Worldwide Summaries (John Wiley & Sons, 1999) and
  Sijbren Cnossen, Reform and Harmonization of Company Tax Systems in the European Union, Research Memorandum
  9604, Erasmus University, Rotterdam (1996).

                                 ______
                                 

 EXHIBIT 3--COMBINED U.S. INDIVIDUAL AND CORPORATE STATUTORY TAX RATE IN
2002: CORPORATE INCOME DISTRIBUTED AS DIVIDEND TO INDIVIDUAL SHAREHOLDER
                             IN TOP BRACKET
 
 
------------------------------------------------------------------------
Corporate income...........................................      $100.00
  Less corporate income tax at 35% (federal)...............       $35.00
 
Net income.................................................       $65.00
 
Dividend assuming 100% distribution........................       $65.00
  Less individual income tax at 38.6% (federal)............       $25.09
Net income after federal and individual income tax.........       $39.91
 
Combined corporate and individual income tax rate..........       60.09%
------------------------------------------------------------------------

                                 ______
                                 

              EXHIBIT 4--INCOME AND PROFITS TAXATION, 1999
------------------------------------------------------------------------
               Percent of Total Taxation in OECD Countries
-------------------------------------------------------------------------
            Rank                        Country                Percent
------------------------------------------------------------------------
1                            Australia                              59%
------------------------------------------------------------------------
2                            Denmark                              58.9%
------------------------------------------------------------------------
3                            New Zealand                          57.2%
------------------------------------------------------------------------
4                            United States                        49.1%
------------------------------------------------------------------------
5                            Canada                               48.9%
------------------------------------------------------------------------
6                            Ireland                              42.2%
------------------------------------------------------------------------
7                            Sweden                               41.6%
------------------------------------------------------------------------
8                            Finland                              41.1%
------------------------------------------------------------------------
9                            United Kingdom                       39.2%
------------------------------------------------------------------------
10                           Iceland                              39.1%
------------------------------------------------------------------------
11                           Belgium                              38.6%
------------------------------------------------------------------------
12                           Luxembourg                            36.2
------------------------------------------------------------------------
13                           Switzerland                          36.2%
------------------------------------------------------------------------
14                           Norway                               35.8%
------------------------------------------------------------------------
15                           Italy                                34.0%
------------------------------------------------------------------------
16                           Japan                                31.4%
------------------------------------------------------------------------
17                           Turkey                               31.4%
------------------------------------------------------------------------
18                           Mexico                               30.0%
------------------------------------------------------------------------
19                           Germany                              29.8%
------------------------------------------------------------------------
20                           Portugal                             28.8%
------------------------------------------------------------------------
21                           Austria                               28.7
------------------------------------------------------------------------
22                           Spain                                 28.1
------------------------------------------------------------------------
23                           Greece                               26.4%
------------------------------------------------------------------------
24                           Netherlands                          25.3%
------------------------------------------------------------------------
25                           Korea                                24.8%
------------------------------------------------------------------------
26                           France                               24.0%
------------------------------------------------------------------------
27                           Slovak Republic                      24.0%
------------------------------------------------------------------------
28                           Hungary                              23/2%
------------------------------------------------------------------------
29                           Poland                               22.6%
------------------------------------------------------------------------
30                           Czech Republic                       22.3%
------------------------------------------------------------------------
Unweighted averages
 
------------------------------------------------------------------------
                             OECD                                 35.3%
------------------------------------------------------------------------
                             EU                                   34.9%
------------------------------------------------------------------------
Source: OECD, Revenue Statistics, 1965-2000 (2001)

                                 ______
                                 

                          EXHIBIT 5--EFFECTIVE AVERAGE TAX RATE FOR INVESTMENT INTO EU
----------------------------------------------------------------------------------------------------------------
                                                                      Financing of foreign subsidiary
                                                         -------------------------------------------------------
              Investment from MNC based in:                 Retained
                                                            earnings     New equity       Debt         Average
----------------------------------------------------------------------------------------------------------------
EU......................................................        30.1%         30.4%         30.2%         30.2%
US......................................................        33.2%         35.7%         34.7%         34.5%
----------------------------------------------------------------------------------------------------------------
Source: Commission of the European Communities, ``Towards an Internal Market without Obstacles,'' Com(2001)582,
  Brussels, October 23, 2001.

                                 ______
                                 

 EXHIBIT 6--TAXATION OF FOREIGN SUBSIDIARY DIVIDENDS IN OECD COUNTRIES,
                                  1999
------------------------------------------------------------------------
  Dividend exemption (territorial) system
   (Either by statute, by treaty or for       Worldwide taxation system
             listed countries)
------------------------------------------------------------------------
1. Australia                                1. Czech Republic
------------------------------------------------------------------------
2. Austria                                  2. Greece
------------------------------------------------------------------------
3. Belgium                                  3. Iceland\2\
------------------------------------------------------------------------
4. Canada                                   4. Italy
------------------------------------------------------------------------
5. Denmark                                  5. Japan
------------------------------------------------------------------------
6. Finland\2\                               6. Rep. of Korea
------------------------------------------------------------------------
7. France                                   7. Mexico
------------------------------------------------------------------------
8. Germany                                  8. New Zealand
------------------------------------------------------------------------
9. Hungary                                  9. Norway
------------------------------------------------------------------------
10. Ireland\1\                              10. Poland
------------------------------------------------------------------------
11. Luxembourg                              11. Portugal
------------------------------------------------------------------------
12. Netherlands                             12. Spain\3\
------------------------------------------------------------------------
13. Sweden                                  13. Turkey
------------------------------------------------------------------------
14. Switzerland                             14. United Kingdom
------------------------------------------------------------------------
                                            15. United States
------------------------------------------------------------------------
1 Although Ireland nominally has a worldwide tax system, under the
  Finance Act of 1988, foreign subsidiary dividends generally are exempt
  if re-invested in employment-generating activities within Ireland.
2 Information as of 1990 based on OECD.
3 Some treaties provide for the exemption method.
Sources: (1) PricewaterhouseCoopers, Individual Taxes 1999-2000:
  Worldwide Summaries (John Wiley & Sons, 1999). (2) OECD, Taxing
  Profits in a Global Economy: Domestic and International Issues (1991).

  
                                 ______
                                 
  

                               Exhibit 7

[GRAPHIC] [TIFF OMITTED] T9971A.001

                                


 STATEMENT OF STEPHEN E. SHAY, PARTNER, ROPES & GRAY, BOSTON, 
     MASSACHUSETTS, AND LECTURER IN LAW, HARVARD LAW SCHOOL

    Mr. Shay. Thank you, Mr. Chairman, Mr. Rangel and Members 
of the Committee. My name is Stephen Shay. My testimony is in 
the record along with my biography.
    I want to emphasize the views I am expressing are my 
personal views and do not represent the views of either my 
clients or my law firm. I just want to touch on four points.
    The unspoken premise of everything that has been discussed 
so far relies on a definition of competitiveness that aligns 
U.S. competitiveness with benefits to U.S. multinationals. I 
think the Committee should adopt a view of competitiveness that 
is implicit in the Chairman's statement. Does any proposal 
ultimately improve the welfare of American citizens and 
residents, that is, individual citizens, individual residents? 
That is what all of this is ultimately about.
    So when we talk about a proposal that will improve the 
profitability of a multinational, the task for it should be, 
will it meet that test, will it ultimately improve the welfare 
of the individual citizens and residents of this country?
    Second, the ETI. What the ETI does, at the bottom line, is 
reduce the effective tax rate on income from exports by roughly 
5.25 percent. So your effective rate, instead of 35 percent for 
a corporate taxpayer, is 29.75 or thereabouts.
    Who benefits from the ETI? Because of other rules, we have 
in our code, particularly something called the ``sales source 
rule,'' companies that operate abroad and have excess foreign 
tax credits normally will elect to take advantage of the sales 
source rule and not the ETI. So the ETI benefits, principally, 
two categories of taxpayers, those that export exclusively from 
the United States don't pay foreign taxes, and those that do 
operate abroad, that manage their foreign taxes to remain below 
the U.S. tax rate. That is who benefits.
    The third point I would like to make relates to adoption of 
a territorial system, the exemption of U.S. tax on foreign 
business income. Is that relevant? Is that responsive to the 
taxpayers who are affected by a repeal or demise of the ETI? I 
submit that it is not.
    If you adopt a territorial system, it generally has three 
key elements. First and most relevant, it provides that 
business income earned by a U.S. person outside the United 
States from operations outside the United States would be 
exempted from U.S. tax under a territorial system.
    Second, losses from operations outside the United States 
normally would be disallowed. In other words, you have exempt 
income, you don't get to take deductions against exempt income.
    Third, most countries--in fact, I think almost all 
countries that have adopted a territorial system--tax fully 
foreign-source interest and royalties, including royalties from 
the license of U.S. intellectual property abroad. Thus, the 
benefit of a territorial system applies where there is foreign-
located economic activity and there is a lower tax rate than 
the U.S. tax rate.
    This is not a substitute, in terms of impact, for a 
replacement of the ETI. There are other problems with a 
territorial system. First, it does create a bias if you can 
find a place to locate activity that is subject to a lower tax 
rate than the United States. If it is otherwise something you 
were doing in your business and you were indifferent at the 
margin you would place the activity where there is lower tax.
    For that reason, a territorial system needs very 
significant safeguards, more than what we have today. You need 
to be sure that expenses are not allocated to foreign income. 
You need to be sure that pricing does not shift income to the 
exempt area. You need to be sure that there are anti-abuse 
rules, so that inappropriate transfers of businesses aren't 
occurring.
    A territorial system is not a simplification panacea. So if 
this Committee chooses to look at it, you need to look at it 
very carefully with those in mind.
    As Mr. Hufbauer has suggested, I encourage the Committee to 
look at other alternatives that, frankly, go the other way, 
that would increase the taxation of foreign income to equalize 
it with what it would be on U.S. income.
    My time has expired. I would be happy to take any questions 
from the Committee.
    [The prepared statement of Mr. Shay follows:]
   Statement of Stephen E. Shay,* Tax Partner, Ropes & Gray, Boston, 
         Massachusetts, and Lecturer in Law, Harvard Law School
---------------------------------------------------------------------------
    *Mr. Shay is not appearing on behalf of any client or organization.
---------------------------------------------------------------------------
    Mr. Chairman and Members of the Committee:
    My name is Stephen Shay. I am a partner in the law firm Ropes & 
Gray in Boston and a Lecturer in Law at Harvard Law School. I 
specialize in U.S. international income taxation and was formerly an 
International Tax Counsel for the Department of the Treasury in the 
Reagan Administration. I was invited last Friday by the Committee to be 
a witness to discuss some of the potential fundamental tax reform 
alternatives that the Committee might consider in response to the WTO 
decision.\1\
---------------------------------------------------------------------------
    \1\ I have attached a copy of my biography to this testimony. The 
views I am expressing are my personal views and do not represent the 
views of either my clients or my law firm.
---------------------------------------------------------------------------
    With the Chairman's permission, I would like to submit my testimony 
for the record and summarize my principal observations in oral remarks.
Overview
    In the announcement for the Hearing, Chairman Thomas stated the 
purpose for the Hearing as follows:

          Although the most recent [WTO] decision comes as no surprise, 
        it illustrates the need to fundamentally reform our tax system 
        so that U.S. workers, farmers and businesses are not 
        disadvantaged in international trade. This will be the first of 
        several hearings to consider the WTO Appellate Panel decision 
        and to examine ways to maintain the international 
        competitiveness of the United States.

    The purpose of my testimony is to describe certain fundamental 
international tax reform alternatives and observe how they do or do not 
relate to the possible elimination of the Extraterritorial Income 
exclusion (``ETI'').
    I will first briefly review the ETI and the activity it benefits. I 
next describe a territorial tax system, how it creates an incentive to 
locate investment in lower-taxed foreign countries, and how the 
activity it benefits differs from the activity benefited by the ETI. I 
then consider other approaches to international tax reform, including 
modifying the current U.S. system of worldwide taxation (with deferral 
of tax on business income earned through foreign corporations) to 
reduce rather than increase the incentive under current law to locate 
investment outside the United States in a low-taxed foreign country.

The ETI Regime
    The ETI was enacted in November, 2000. Under the ETI, a taxpayer 
may exclude a percentage of income attributable to foreign trading 
gross receipts (``FTGR'') or net income from FTGR.\2\ The bottom line 
effect of the ETI is to reduce the tax rate on this income by 
approximately 15%. Thus, a domestic corporation subject to a 35% 
Federal corporate tax rate will pay a 29.75% rate on its net income 
subject to the ETI regime.
---------------------------------------------------------------------------
    \2\ FTGR generally are receipts from sales of qualified foreign 
trade property, leasing of qualified foreign trade property for use 
outside the United States, certain services in connection with foreign 
construction projects. Certain foreign economic processes have to be 
met in connection with earning FTGR. Qualifying foreign trade property 
is defined substantially in the same manner as ``export property'' 
under the FSC, including that no more than 50% of the property may be 
attributable to foreign content. The principal difference in 
definition, apparently thought by this Committee to be sufficient to 
satisfy the WTO rules, was that qualifying foreign trade property need 
not be manufactured in the United States.
---------------------------------------------------------------------------
    The ETI is designed, like the FSC, to prevent a taxpayer electing 
the ETI from also obtaining the full benefit of the sales source rule 
for exporters under the Internal Revenue Code. The sales source rule 
permits taxpayers that manufacture in the United States and sell 
outside the United States to treat 50% of the income from the sale as 
foreign income. In most cases, this foreign income is in the general 
foreign tax credit limitation category and, for firms that have enough 
excess foreign tax credits (i.e., have paid foreign taxes at a rate 
higher than the effective U.S. rate on the same general limitation 
category of foreign income), permits this income to be exempt from U.S. 
tax. The marginal rate of U.S. Federal tax on these export sales is 
17.50%.\3\ For taxpayers with excess foreign tax credits, the benefit 
of the sales source rule is generally larger than the ETI benefit. 
Thus, the sales source rule causes the ETI to benefit taxpayers that do 
not have excess foreign tax credits, that is, taxpayers that either 
exclusively export from the United States or, if they also conduct 
foreign operations, have managed their foreign taxes to remain below 
the effective U.S. tax rate on the same income.
---------------------------------------------------------------------------
    \3\ If the sales source rule applies to income of $100, the U.S. 
tax on $50 allocated to foreign income is $17.50 and is offset by 
foreign tax credits, the U.S. tax on the remaining 50 would be $17.50. 
Thus, the effective tax rate would be 17.50%.
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Alternatives to the ETI
    As noted in the Hearing announcement, on January 14, 2002, the WTO 
Appellate Body issued a report upholding a dispute resolution panel 
finding that the ETI is a prohibited export subsidy.\4\ The stated 
objective of the Committee's Hearing is to ``examine ways to maintain 
the international competitiveness of the United States.''
---------------------------------------------------------------------------
    \4\ The ETI was the successor to the Foreign Sales Corporation 
(``FSC''), enacted by the Congress in 1984 and found by a WTO Appellate 
Body in February, 2000, to be a prohibited export subsidy. The FSC was 
the successor to the Domestic International Sales Corporation 
(``DISC'') enacted in 1971, and found to be an export subsidy in a 
panel report adopted by the GATT Council in 1981. The 1981 GATT Council 
decision was subject to an understanding that a country need not tax 
export income attributable to economic processes outside their 
territory. This understanding was the source of the U.S. approaches in 
the FSC and the ETI to characterize the benefited income as being taxed 
in a manner comparable to the taxation under a territorial system. I do 
not discuss here the substance of the U.S. position nor its merits as a 
matter of trade law. Suffice it to say, the WTO has twice rejected the 
U.S. efforts in this regard.
---------------------------------------------------------------------------
    As an initial matter, it may be questioned whether the ETI (and its 
predecessors the FSC and DISC) did in fact improve the international 
competitiveness of the United States by comparison with alternative 
ways that the foregone revenues (or tax benefits) could have been 
spent. There appears to be support for the position that the impact of 
the ETI on net exports (the increase in exports reduced by the 
corresponding increase in demand for imports) was modest.\5\
---------------------------------------------------------------------------
    \5\ A 2000 Report on the FSC by the Congressional Research Service 
cites a 1992 Treasury Department analysis that repealing the FSC would 
have reduced net exports by 140 million. If the impact of the ETI on 
net exports was in fact less than the tax expenditure, it would be 
ironic that the United States now is faced with having to arbitrate EU 
claims for compensatory damages that are based on U.S. tax expenditure 
estimates. The CRS Report also observed that under traditional economic 
analysis the FSC by definition reduces U.S. economic welfare (as 
opposed to the welfare of the firms benefited by the subsidy and their 
shareholders) because at least some portion of the benefit is presumed 
to be passed on to foreign consumers in the form of lower prices.
---------------------------------------------------------------------------
    In the following portions of my testimony, I assume for purposes of 
discussion that the Committee will not adopt a fourth proposal along 
the lines of DISC/FSC/ETI, but instead will consider other changes to 
the U.S. international tax rules. As described in the next section, the 
alternative to the ETI most frequently discussed in recent days, a 
territorial tax system, creates an incentive to locate investment 
outside the United States and does not benefit the exporter that 
carries on its manufacturing and/or selling operations entirely from 
within the United States. A territorial system also is often heralded 
as a simplification panacea, but as discussed in the next section, its 
simplification potential generally is overstated. I urge the Committee 
to also consider fundamental tax reform alternatives that would have 
the effect of decreasing U.S. tax benefits for foreign income and 
directing those revenues toward alternative uses, such as investment in 
domestic human capital or broader reductions in the level of taxation 
on all business income.

Changing from A Worldwide Tax System with Deferral to A Territorial Tax 
        System
    The major approaches by which the tax system of a country (the 
``residence country'') accounts for income earned by its residents in a 
foreign country (``foreign-source income'') are a worldwide system and 
an exemption, or territorial, system. If the United States were to 
adopt a territorial system comparable to the systems adopted in other 
countries, the United States (i) would not tax its own residents' 
foreign-source business income that is subject to taxation in another 
country,\6\ (ii) would disallow the deduction of foreign business 
losses,\7\ and (iii) would tax currently portfolio dividends and all 
foreign source interest and royalties. In other words, only foreign-
source business income would be exempt from U.S. tax and this income 
would bear the tax only in the foreign country where the income was 
produced (the ``source country'').
---------------------------------------------------------------------------
    \6\ For this purpose, foreign business income includes foreign 
dividends or gains from substantial shareholdings.
    \7\ In some cases, foreign losses are allowed, but are recaptured 
as domestic income when the taxpayer next realizes positive foreign net 
income.
---------------------------------------------------------------------------
    The principal objection to a territorial system is that it creates 
a bias, not in favor of investment in domestic production for export, 
but in favor of investment in foreign operations. In the worst case, 
this bias causes a foreign investment to be preferred even though the 
U.S. investment has a higher before-tax rate of return and is, 
therefore, economically superior.\8\
---------------------------------------------------------------------------
    \8\ For example, assume that USCo is a U.S. corporation considering 
a new business that will produce a 10 percent return, before U.S. 
income taxation, if the business is located in the United States, and 
an 8 percent return, before U.S. income taxation, if the business is 
established in a foreign country. Assume further that the United States 
will tax USCo at a flat 35 percent rate and that the foreign country 
will impose a 10 percent rate of tax. If USCo is exempt from U.S. tax 
on profits from the foreign investment under a territorial system, USCo 
will be choosing between after-tax returns of 6.5 percent (.10 x 
[1-.35]) in the U.S. location and 7.2 percent (.08 x [1-.10]) in the 
foreign location. In this example, the pre-tax rate of return of the 
U.S. investment is 20% higher than the foreign investment, but the 
after-tax rate of return under a territorial system is 10.77% lower 
than the foreign investment. Thus, the effect of a territorial system 
is to create a strong incentive for USCo to make the economically 
inferior foreign investment.
---------------------------------------------------------------------------
    The justification for exempting U.S. multinationals' foreign-source 
business income is based principally on a competitiveness argument that 
is usually stated as follows: foreign corporations operating businesses 
in low-tax foreign countries owned by residents of countries with a 
territorial tax system, as well as local businesses in the low-tax 
foreign countries, pay only the low local income tax on their in-
country profits. Without exemption, U.S. multinationals are unduly 
disadvantaged when competing against these foreigners in low-tax 
foreign countries because in addition to the foreign tax, a U.S. 
multinational will pay a U.S. residual tax on its foreign profits, 
while the foreigners would pay only the low foreign tax. Therefore a 
U.S. multinational should be given a countervailing exemption from the 
U.S. residual tax.\9\
---------------------------------------------------------------------------
    \9\ Although a territorial system provides no direct benefit for 
foreign operations in countries with effective tax rates equal to or 
higher than the U.S. rate, it does offer greater potential for a U.S. 
multinational to reduce high foreign taxes through tax planning 
techniques that shift income from a high tax to a lower-tax foreign 
country. Although often effective today, these planning techniques 
would be frustrated by expansion of the high tax countries' CFC regimes 
which is the general trend in these countries.
---------------------------------------------------------------------------
    This argument is not a request for the United States to give U.S. 
multinationals relief from international double taxation. The foreign 
tax credit already addresses that issue. Instead, this is a request for 
tax system assistance that is not available to pure exporters or other 
earners of U.S.-source income.
    Relieving U.S. multinationals' foreign-source income from U.S. tax 
would be a poorly structured tax assistance measure because the 
assistance would not be targeted at U.S. corporations that face tax-
related competition. To be specific, a U.S. multinational facing little 
tax-related foreign competition in low-tax foreign countries, whether 
because (i) it is selling paten--or copyright-protected goods, (ii) its 
principal competitor is from a foreign country that does not have a 
territorial system, or (iii) its competitor is another U.S. 
corporation, would benefit as extensively from a territorial system as 
a U.S. multinational facing the tax-based competition.
    In the current context of the possible repeal of the ETI, 
proponents of a territorial system should be required to go further 
than making generalized competitiveness arguments, and should link the 
tax benefits of an exemption system to promotion of U.S. exports. It is 
anticipated that the proponents will argue that these benefits for 
operations in lower tax foreign countries will generate greater 
purchases of U.S. goods because U.S. multinationals will buy from their 
U.S. affiliates and suppliers. Although this is a claim that deserves 
some scrutiny, at best this is an assertion that tax assistance to the 
operations of U.S. multinationals in low-taxed foreign countries 
indirectly encourages U.S. exports. This is a remote and somewhat 
speculative support for U.S. exporters and is heavily weighted for 
businesses with foreign operations that already are advantaged by 
deferral. There is no direct relationship between adoption of a 
territorial system and benefiting domestic U.S. exporters that do not 
carry on foreign operations.
    Adoption of a territorial system also is not a simplification 
panacea. The allocation of expenses between U.S. and foreign source 
income would be critical to determining which expenses are allocable to 
exempt foreign income under a territorial system and therefore 
disallowed as deductions. Today, the allocation of expenses to foreign 
income is a potential audit issue primarily for taxpayers that have 
excess foreign tax credits. Under an exemption system, there would be 
pressure for all taxpayers that earn exempt foreign income to allocate 
expenses, such as interest and research and development costs, to 
domestic income and away from exempt foreign income. Thus, the IRS 
would have to increase its scrutiny of this difficult area.
    Similar to the transfer pricing pressures existing today, taxpayers 
with foreign operations would have an incentive to shift U.S. income to 
exempt lower taxed foreign operations. Under a territorial system, 
however, the benefit is permanent (and not a deferral of tax until 
repatriation) and transfer pricing would take on commensurately greater 
significance.
    Adoption of a territorial system would not eliminate the need for 
anti-abuse measures that are comparable in effect to our current highly 
complex anti-deferral regimes. Major developed countries that have 
territorial systems also have adopted controlled foreign corporation 
(``CFC'') regimes or other legislation to prevent tax-motivated 
offshore investment. France, for example, provides for exemption of, or 
a reduced tax on, foreign income, but has adopted expansive CFC 
legislation. Germany, which exempts foreign business income earned in 
treaty partner countries, has adopted foreign investment fund 
legislation that denies favorable tax treatment to certain diversified 
foreign investment funds that are not listed in Germany or do not have 
a tax representative in Germany. These sophisticated territorial 
countries recognize the need to protect the domestic tax base by 
reducing the incentive to shift income-producing activity abroad. 
Indeed, the need to protect the domestic tax base is more pronounced 
for a country that does not tax foreign income than for a country that 
taxes foreign income and employs a foreign tax credit system.
    The Committee should take these considerations into account if it 
considers a territorial tax system.

Reform of the Current U.S. Tax System of Worldwide Taxation with 
        Deferral
    In practice the current U.S. system of worldwide taxation with 
deferral of U.S. tax on foreign corporate business income operates in 
much the same manner as a territorial system. If U.S. multinationals 
earn income through active business operations carried on by foreign 
corporations in low-tax source countries, the U.S. multinationals 
generally pay no residual U.S. tax until they either receive dividends 
or sell their shares. This phenomenon is referred to as ``deferral.'' 
Deferral obviously decreases the present value of the U.S. residual 
tax. When this value reduction is combined with certain other features 
of the U.S. international tax regime (i.e., cross-crediting foreign 
taxes and certain source rules that overstate foreign-source income), 
well-advised U.S. multinationals can frequently reduce the U.S. 
residual tax on their repatriated foreign-source income to zero. Stated 
differently, the U.S. worldwide system, with deferral, frequently 
provides the same result as a territorial system (exemption from U.S. 
tax on foreign-source income).
    The current U.S. system therefore is subject to many of the same 
criticisms as a territorial system. An appropriate response to those 
criticisms, however, only may be achieved through a reform of the 
current worldwide tax system. Adoption of a territorial system would be 
a second best solution to a reasoned reform of the current rules.
    The original proponents of the DISC argued for the export subsidy 
in part on the grounds that exporters were disadvantaged relative to 
taxpayers that could locate their operations abroad and take advantage 
of deferral. In other words, an original rationale for the DISC 
predecessor of the ETI was to equalize for exporters the advantages 
realized by U.S. multinationals from deferral.\10\ If the ETI is 
repealed and a third DISC successor is precluded by the WTO rules, as a 
logical matter the Committee could consider decreasing the tax 
advantages to earning low-taxed foreign income through foreign 
corporations.
---------------------------------------------------------------------------
    \10\ See generally Cohen and Hankin, ``A Decade of DISC: Genesis, 
and Analysis,'' 2 Va. Tax Rev. 7 (1982).
---------------------------------------------------------------------------
    Does decreasing the tax benefits for foreign income improve 
competitiveness? An initial question is how to define competitiveness. 
It is questionable whether U.S. competitiveness should be defined in 
terms of U.S. multinationals' profitability. A more meaningful measure 
of competitiveness is whether any proposal will advance the welfare of 
individual U.S. citizens and residents.\11\ The proponents of tax 
assistance to enhance the returns of U.S. multinationals, and their 
shareholders, from foreign operations should be expected to carry the 
burden of demonstrating the value of the assistance will exceed both 
the revenue cost and the opportunity cost of alternative uses for that 
revenue. For example, would investment of a given amount of revenue in 
education grants to localities improve the living standard for 
Americans more than the same amount of tax relief for foreign income of 
U.S. multinational businesses?
---------------------------------------------------------------------------
    \11\ See Michael J. Graetz, The David Tillinghast Lecture: Taxing 
International Income: Inadequate Principles, Outdated Concepts, and 
Unsatisfactory Policies, 54 Tax Law Rev. 261, 284 (2001).
---------------------------------------------------------------------------
    I respectfully submit that the Committee should consider proposals 
that would cut back on the deferral benefit for foreign income as an 
alternative to the ETI or a territorial system. I and my co-authors, 
Professors Robert J. Peroni and J. Clifton Fleming, Jr., have outlined 
a proposal for a broad repeal of deferral.\12\ Essentially, our 
proposal would apply mandatory pass-through treatment to 10% or greater 
shareholders in foreign corporations.
---------------------------------------------------------------------------
    \12\ Robert J. Peroni, J. Clifton Fleming, Jr. & Stephen E. Shay, 
Getting Serious About Curtailing Deferral of U.S. Tax on Foreign Source 
Income, 52 SMU L. Rev. 455 (1999); J. Clifton Fleming, Jr., Robert J. 
Peroni & Stephen E. Shay, Deferral: Consider Ending It Instead of 
Expanding It, 86 Tax Notes 837 (2000).
---------------------------------------------------------------------------
    One would not have to go so far as our proposal to make substantial 
improvements in the current international tax rules without increasing 
the current incentives to locate investment outside the United States. 
There would be substantial improvements to the controlled foreign 
corporation rules if the current foreign base company sales and 
services rules applied without exception whenever the CFC's income, 
determined separately for each foreign legal entity and qualified 
business unit of the CFC, was not taxed at a effective foreign tax rate 
of some minimum amount. Under current law, a safe harbor exists for 
income taxed at 90% of the U.S. rate; the Committee could choose to 
employ a lower percentage of the U.S. rate.\13\ Although this is a 
second best approach to the mandatory pass-through approach, it would 
be a substantial improvement over today's rules.\14\
---------------------------------------------------------------------------
    \13\ The current foreign tax credit mechanism could be improved by 
repeal of the sales source rule combined with improvements to the 
interest allocation rules and allowance of foreign as well as domestic 
loss recapture. Finally, some simplification may be achieved in the 
U.S. international rules by consolidating anti-deferral rules and 
rationalizing the source rules.
    \14\ It might be argued that these changes would pressure U.S. 
companies to become foreign companies. If this is perceived as a 
significant problem, the Committee could consider a range of 
alternatives. For example, the Committee adapt existing U.S. tax 
provisions to require U.S. investors to take account at the time of 
sale whether a publicly-traded foreign corporation's earnings during 
the investor's ownership have borne a level of foreign tax equal to or 
greater than the U.S. corporate tax rate. If not, the investor could be 
taxed on the gain to make up the difference in the same manner as 
currently applies under Section 1248(b) of the Code. An alternative 
approach would be to re-examine the circumstances in which a foreign 
corporation should be taxed as a domestic corporation.
---------------------------------------------------------------------------
    The kinds of changes just described could be combined with revenue 
neutral reductions in tax for business income generally. This approach 
would assist U.S. businesses that export from the United States or 
compete against foreign imports as well as those that operate abroad. 
Alternatively, any revenue increase from these changes could pay for 
more favorable depreciation and amortization for investment in 
productive property, used to improve U.S. education or fund anti-
terrorism initiatives. Whatever the choice, I respectfully urge the 
Committee to consider international tax reform proposals that will 
improve the well-being of all U.S. citizens, workers, farmers and 
businesses and not just those in the multinational sector.
    I would be pleased to work with the Committee to analyze and 
develop alternative fundamental international tax reform proposals.

                                


    Chairman Thomas. I want to thank all of you, especially for 
your written testimony, which gives us at least a disembarking 
point on looking at some options that are inevitable as we are 
going to, as they say, round up the usual suspects. We want as 
much help as we can get in fully understanding what those 
suspects look like and clear the territorial taxes often 
offered as a potential.
    Mr. Hufbauer, let me understand your oral statement, 
because I would like to ask the question this way.
    We had a first appeal of the decision. We modified our 
position slightly, obviously, and certainly not enough; and we 
got a second decision. Are you saying by the fact that there 
was a change in the substance and manner of the second appeal 
that perhaps the United States would have been relatively 
advantaged in how many hostages we could take under the first 
appeal, that on balance we probably should not have taken the 
second appeal?
    Mr. Hufbauer. I guess it is always easy to do 
quarterbacking on these difficult legal decisions. But the 
rationale changed very dramatically between WTO reports. I know 
you did read, Mr. Chairman, and I know everybody here did read, 
that first appellate body report. What the WTO focused on in 
the first report was the difference in taxation between 
production abroad and exports. And, as you know, the ETI was an 
attempt--and I think a good-faith attempt at the time--to come 
up to the letter of the first set of decisions, because foreign 
production and export taxation was harmonized.
    The goal post moved in the second round, and in the second 
round the WTO said, well, what we have got to do is look at the 
normative benchmark. That was at the panel level, and at the 
appellate level--and really I am condensing a lot--they came to 
this ``but for'' test, but for ETI, the export income would be 
taxed with a foreign tax credit. And the only reason a company 
would choose ETI is because the tax was less. So, the WTO 
reasoned, ETI is a goner. But they moved the goal post.
    Now, I suppose with a good crystal ball you could have 
said, if the WTO doesn't like the FSC, it is going to move the 
goal post to catch ETI; with this crystal ball, you wouldn't 
have enacted the ETI, or you would have done it differently. 
But that is all rewriting history. But, I want to emphasize, 
the goal post moved. And it moved further between the panel 
report and the appellate body report in the second round.
    In the first round, the appellate body said, ``Panel, you 
are in good shape.'' In the second round, the appellate body 
said, ``This is a bombshell.'' We are going to get rid of the 
normative benchmark idea and instead we are going to go for a, 
``but for'' test. Under the normative benchmark, the United 
States could have looked at whatever the normative benchmark--
whatever that means--was for each and--every tax system, and 
then pointed out exceptions and 25 possible subsidies. And we 
could have said, ``You (Country X) are not following your own 
normative benchmark; you (Country Y) are not following yours.'' 
We could have brought a boatload of cases.
    But under the ``but for'' test, it will not be a boatload 
of potential cases. There will be some--but I don't have the 
expertise that Peter Merrill does or Steve Shay does to say how 
many. I am sure there are ``but for'' problems out there, but 
they are not as big as with the normative benchmark.
    I am sorry to be so long on that.
    Chairman Thomas. I think very few, if anyone, agrees with 
your conclusion that they moved the goal posts. But in our 
pursuit of solutions, it might be at least helpful for us to 
understand the relationship that we are now in with the 
Europeans. And then the question goes not to what the goal 
posts did, but the why.
    In your opinion, was it because we were pretty good on the 
ETI in terms of the first appellate decision, and it may have 
fit, had they remained consistent; or was it that there was too 
much collateral damage to the Europeans, based upon that first 
decision, and since we decided to try again instead of going in 
a different direction, that decision couldn't stand and that 
they needed some cover?
    Clearly, it is probably a little bit of each, but do you 
have any insight for the Committee in helping us understand the 
shifting of the goal posts?
    Mr. Hufbauer. I don't have any inside information in from 
talking to the judges or the panelists, but I think the 
direction which you are seeing is absolutely right. They 
reflected and--they saw all the comments from here and around 
the world, and those judges and panelists reflected and said, 
``Look, we are becoming a World Tax Code Court too fast, too 
soon, and we are going to create just too much of a backlash.''
    There is a big issue on the balance between the judicial 
role of the WTO and its legislative (negotiating) role, I won't 
go into that, but the judges probably saw they were really over 
the hill on this one and thought, ``Yeah, we don't like the 
FSC, we don't like the ETI, we think it is just a continuation 
of the DISC, and we are going to try to nail it more 
specifically.''
    Chairman Thomas. Mr. Merrill, in your presentation, you 
talked about making some adjustments going back to some 
decisions that were made in 1962, and certainly the world has 
changed.
    Do you have any indication of what the revenue forgone 
would be if we made some of those adjustments? Whether we look 
at it or not--as I discussed briefly with the gentleman from 
Tennessee, if we are going to look at victims here, there are 
people who are going to be looking for compensation and 
adjustments whether it merits it or not.
    Could you give us some idea of the level of dollars we are 
talking about in the disruption in the Tax Code if we make some 
of the changes you suggested?
    Mr. Merrill. I have not done revenue estimates for these 
provisions, and certainly the official scorekeepers for these 
provisions are the Joint Committee on Taxation. And I am not 
aware--I have not seen any published estimates they have done 
on any of these provisions. It may well be that some of these 
provisions would be scored as relatively expensive.
    Chairman Thomas. And I think that our Joint Tax Committee 
does an excellent job, but it seems this is very difficult to 
mark, and as they are having difficulty determining what the 
compensation is, the actual dollar values, this Committee is 
going to need as bright a light as we can get on the decisions 
that we make relative to revenue shifts and winners and losers. 
Whether we like it or not, that has to be part of the decision 
process.
    If you know of any, it would be very helpful; and we may 
rely on some of you in at least providing an alternative set of 
numbers, because in all likelihood it is going to be somewhere 
in between. No one is going to get this one right.
    Mr. Shay, you began your testimony a little bit 
defensively, because Mr. Hufbauer said he disagreed with you 
before you started; and you identified pretty much where it was 
that he may have disagreed with you without his indicating any 
particulars. So did you guys talk ahead of time about what is 
obvious about the presentation Mr. Shay, that others would 
react negatively to or at least not agree?
    Mr. Shay. Are you asking me to point out where in my 
presentation----
    Chairman Thomas. I am asking you to defend the part that 
you felt sensitive about. I think some people maybe didn't 
follow.
    Mr. Shay. Well, the thrust of my testimony, which I think 
Gary was referring to, which I did not really spend time at 
length in my oral comments on, was that much of the discussion 
has been about how to potentially reduce U.S. taxation on 
foreign income by creating an exemption from U.S. tax on 
business income earned abroad. And indeed I think this may have 
come up earlier in today's hearing.
    In fact, one of the original reasons for the DISC back in 
1971, at least as reported in an article by somebody who was 
there cited in my testimony, was to equalize the treatment of 
exporters with those companies who could earn foreign income 
through foreign corporations and not pay current U.S. tax on 
that income. And part of what I was pointing out in my 
testimony is that if you go further, as some have suggested, 
and not just defer U.S. tax on foreign income earned through 
foreign corporations, but exempt from U.S. tax all foreign 
income, whether earned through a foreign operation directly or 
through a corporation, then you further exacerbate the 
distinction between the exporter who is operating exclusively 
in the United States--perhaps in Washington, perhaps in 
Chicago--from the multinational that is conducting part of 
their operations outside the United States.
    So, as a matter of logic, there is an alternative approach 
to exempting foreign business income. It is to tax it and tax 
it equally so that that exporter in Washington or Chicago that 
may not have foreign operations is bearing the same U.S. tax 
burden as is the multinational, basically, that is performing 
aboard.
    Now, then, to answer your question, the objection is made 
that some other countries do adopt a territorial system and do 
not tax that income earned in that other country when our 
company is in that other country. And that comes back to the 
first part of my testimony, Mr. Chairman, how significant is 
that element, the taxation element in that competitive mix; 
because if that is Pepsi and Coke, it is not relevant. If that 
is a company that is operating there under the protection of 
intellectual property laws that are respected in that country, 
so that they effectively have a monopoly on that product, the 
tax is not relevant.
    So some of the solutions that are being proposed do not 
meet my criterion that I set out at the beginning of the 
testimony: Do they enhance overall U.S. competitiveness, not 
defining it in terms of the profitability of the multinational?
    I am a private, practicing tax lawyer. If you give me the 
opportunity to advise my clients to enhance their profitability 
through the rules you will pass, I guarantee you I will take 
it, and I have taken it for 25 years.
    I am here today before the Committee in a private capacity, 
not representing my clients, but representing what I perceive 
to be the best tax policy for the United States. And that is 
the standard I am asking the Committee to adopt, and for that 
reason, I am asking the Committee to include in its range of 
options that it is considering options that do not lower income 
U.S. taxation on foreign income, but increase it.
    Mr. Hufbauer has extensively criticized that position, and 
I respect his arguments and I respect his position, but it 
seems to me that is what the debate should be about.
    Chairman Thomas. And I want to underscore that the reason I 
asked you to make those comments is that this Committee is 
certainly not going to arbitrarily or artificially cut off any 
avenue of investigation.
    I do think, as you said, logic leads you to a particular 
position. We have to approach this with a somewhat scientific 
method which--more often than not, our hypotheses will be 
disproven. But in being disproven, it allows us then to move on 
to other areas.
    The thrust of a fundamental change in the Tax Code is so 
difficult that we may have to look at some of these 
alternatives, and I can assure you that while we will not 
dismiss any alternative without having gone through the process 
to the best of our ability, looking at the pros and cons, and 
especially if we are going to add several different components 
together to get a full impact of exactly who the winners and 
losers are, our goal is not to try to respond to a WTO panel's 
attempt to determine our internal taxes and wind up punishing 
ourselves even more. Our goal is, to the best of our ability, 
change our system; and to the degree we can't do it, 
fundamentally to offset some of the negatives caused by this 
decision.
    Gentleman from New York?
    Mr. Rangel. I thank all of you witnesses. You have been 
very, very helpful.
    Mr. Hufbauer, do you believe there was justification for 
the WTO's decision to reject the way we handle our exports?
    Mr. Hufbauer. Not based on their first report. If you read 
the letter of the first report, I thought that the ETI--and I 
said so at the time, and I was obviously mistaken, but I 
thought it was consistent with the first panel report and the 
first appellate body report on the theory that we are a very 
contract-driven system in the WTO, and it is not a common law 
system.
    It is becoming a common law system, and therefore, you 
could look at the letter, you could respect the letter and----
    Mr. Rangel. I was really referring to our last legislative 
response to their rejection. The last case that we lost, do you 
believe that was justification for the decision by the WTO to 
disregard what we thought was a remedial solution to our 
problem?
    Mr. Hufbauer. Mr. Rangel, I have read the decision. I see 
where they are making the arguments. I totally disagree with 
the second appellate body decision and the second panel report. 
They are the judges, not me, obviously.
    Mr. Rangel. While you disagree with their decision, you do 
believe under existing law that United States firms suffer a 
competitive disadvantage.
    Mr. Hufbauer. Yes, I do.
    Mr. Rangel. So that the WTO decision really gives us an 
opportunity to even better our position, even though their 
decision was that it put our friends at an advantage.
    Mr. Hufbauer. Absolutely. It can be changed in a way that 
we could be better off than we were before the FSC or before 
the DISC. It is up to the Congress and Treasury Department and 
people of America.
    Mr. Rangel. And are you suggesting that we should adopt a 
territorial system in terms of part of the solution to the 
problem that we face?
    Mr. Hufbauer. The word ``territorial'' is one of these 
plastic words that means different things to different people. 
And with my own nuances--and everybody would have their 
nuances--the fundamental answer is ``yes.'' And I co-authored a 
book 10 years ago, U.S. Taxation of International Income, where 
we advanced this position, and while I would certainly have 
changes to whatever I said 10 years ago on this or any other 
subject, the basic answer remains ``yes.''
    Mr. Rangel. Would you support the suggestion made by Mr. 
Shay, that would create a large incentive for U.S. companies to 
move to countries that have low corporate taxes?
    Mr. Hufbauer. Absolutely not. I fundamentally disagree with 
that. Now I have to talk about one of the nuances. I go for a 
territorial system which is territorial with respect to 
countries which have normal tax systems. And I realize, 
``normal tax system'' is a plastic term. But all these kind of 
``run away'' arguments are talking about running away from the 
United States to the Bahamas or running away from the United 
States to I don't know where. Our whole international tax 
system is focused on a handful of little countries where nobody 
is running to except maybe some insurance companies. And that 
is where I would put my nuances. But our big competitors--you 
know the countries. U.S. companies are not going to run away to 
tax havens countries, but instead to Canada, to Mexico, to 
Germany, to Japan, to China. Under a territorial system, our 
companies are in fact going to be much more competitive doing 
business here, exporting directly, and especially exporting to 
their operations abroad, which Peter Merrill emphasized. This 
is terribly important in a global economy.
    Mr. Rangel. Mr. Shay, would you care to respond to Mr. 
Hufbauer?
    Mr. Shay. I guess there are two comments. One is that there 
are very legitimate taxing countries that have chosen to adopt 
a low rate of tax. A country I have enormous admiration for is 
Ireland, and they have chosen to adopt a corporate income tax 
rate which I think is now 12 percent. That is substantially 
below 35 percent. And I could in very good conscience counsel a 
client, if we had a tax-exempt system, to say if from a 
business perspective you could ship your product to your 
customers from the United States to Ireland and the customer 
would be equally satisfied--well, I don't think anybody here 
would make a different decision as to where they would locate 
the operation.
    Second, I have been engaged in numerous planning exercises 
involving some of the countries that Mr. Hufbauer named that 
have what he calls normal tax systems, where we are able to 
bring the effective rate down not quite to 10 percent but 
substantially below 35 percent. And, in fact, I have worked 
with some at least former colleagues of people on the panel. So 
it is a complicated question.
    I think the short answer is that most businesses run their 
businesses for business objectives first. There is a point 
where they come to their tax lawyers and they say, Okay, I have 
got two choices; does tax make a difference? Sometimes they 
come to the tax lawyer earlier, but the fact is taxes at the 
margin make a difference or else we wouldn't have been having 
this discussion.
    Mr. Rangel. Mr. Merrill, you are very cautious about the 
territorial system yourself.
    Mr. Merrill. That is correct. In my written statement, I 
raise a number of practical problems. I should say that in 
April of last year, the International Tax Policy Forum and the 
Brookings Institute and had a conference on territorial income 
taxation. All the papers for that are available on the ITPF Web 
site. There were a number of papers that described how 
territorial systems worked in Canada, Netherlands, and so 
forth. And what those detailed descriptions showed is that a 
territorial system is not necessarily a simpler tax system. So 
I think that is one concern.
    There is also a concern that there could be a number of 
taxpayers that would have a substantial tax increase under a 
territorial tax system depending on how it was structured. And 
I think you would want to think carefully about redistributing 
the tax burdens in that way. And, frankly, one concern is that 
actually some exporters could face some very large tax 
increases under a territorial tax system, which again I think 
is something you would want to look at pretty carefully.
    A third issue is the allocation of expenses, which under a 
territorial system means those expenses are nondeductible if 
allocated abroad. That is an issue we face today with interest 
allocation and the foreign tax credit. It affects so-called 
excess credit taxpayers. It is a much bigger problem under a 
territorial tax system.
    So I think you have to look at it really carefully and, as 
Gary said, there are many different ways to do it and not all 
of them are particularly attractive.
    Mr. Crane. [Presiding.] I would like to throw a 
hypothetical question out at you, and it gets back to the 
proposal that I pushed for all the years that I have been here, 
and that is the total elimination of any tax whatsoever on 
business. And my argument has always been that they don't pay 
taxes in the first place, they gather taxes. And that is the 
cost of doing business just like plant and equipment and labor, 
and you got to pass it through and get a fair return or you are 
out of business.
    So, given the hypothetical, let me ask you the question, if 
we eliminated any tax on business whatsoever in this country, 
what would be your assessment as to the impact on our exports?
    Mr. Hufbauer. Let me just make a distinction, Mr. Crane, 
between eliminating a tax on business and who actually writes 
the check. It is much easier for any tax authority to collect 
taxes from, let's say, 100,000 business firms than 100 million 
households. And so you do have the issue of who writes the 
check, if I can put it that way, who has the legal liability, 
which I think is quite distinct from the tax on business the 
way you are framing it in the question.
    Now let me come to the question itself. The estimates that 
I have seen on responsiveness of investment to tax differences 
between countries, between States, between provinces, show a 
tremendous response. When I was young and going to university, 
in formal terms this responsiveness or elasticity was thought 
to be either zero or one half, 0.5. In other words, if you 
change your tax by 10 percent, at most you would get a 5 
percent change in investment. Maybe you would get zero.
    Recent studies are going to much higher numbers. The recent 
studies are more sophisticated, in their econometrics, but they 
are also capturing something that is happening in the real 
economy, which is that our firms, advised by Steve Shay and 
other bright people like Peter Merrill--are comparing taxes as 
well as everything else to a much greater extent than they once 
did, and probably the elasticity now internationally is three. 
That is to say, change your tax by 1 percentage point, and you 
get a 3 percentage change in investment, which is a big impact. 
So--Within the United States, the elasticity may be as high as 
10 between States. I think if we got rid of the corporate 
income tax as we know it today, and replaced it with something 
else on a revenue-neutral basis, there would be----
    Mr. Crane. Not replace it; eliminate it entirely, and no 
offset. Don't come up with----
    Mr. Hufbauer. Well, then cut the spending. You would have 
to cut the spending side, and I am trying to deal with the 
fiscal balance--but keeping the fiscal balance the same by 
cutting spending or replacing the tax. But I think it would be 
a tremendous stimulus to investment and the competitiveness of 
the American economy in exports worldwide.
    Mr. Crane. Let me ask you one other follow-up question. To 
what degree do you think that provides an attraction to foreign 
companies to locate here in the United States?
    Mr. Hufbauer. That would be a big part of it. If we had a 
lower tax rate on business----
    Mr. Crane. Not lower; eliminate.
    Mr. Hufbauer. If we had elimination, you know we already 
have a lot of foreign direct investment in the United States.
    Mr. Crane. I have got a small steel company in my district 
that has just moved down to Bermuda because they don't have to 
pay taxes in Bermuda. What I am thinking about is the dynamics 
of the attraction of business here and job creation. And I 
don't think anyone could even begin to speculate on what that 
might translate into as far as increased revenues here in D.C.
    Mr. Hufbauer. I agree.
    Mr. Crane. Could you other folks comment on that, Mr. 
Merrill?
    Mr. Merrill. If I understand your proposal, you would 
dramatically reduce the tax burden on capital. That would have 
the effect of lowering the costs for U.S. companies that are 
capital intensive in producing their goods. It would make their 
goods more competitive in world markets. There is no doubt 
about that.
    Your proposal, as I understand it, would make the United 
States a very attractive place to locate your operations, 
because income earned within the United States would be subject 
to only one level of tax for U.S. shareholders and that should 
attract investment into the United States.
    Mr. Crane. Mr. Shay.
    Mr. Shay. I think you would have to be careful about what 
you actually mean. If you mean by eliminating tax on business, 
as Peter just assumed, eliminating a tax on capital and only 
taxing wages that is one thing. But you suggested before that 
you didn't mean that; that what you meant was eliminating tax 
on business and reducing spending and leaving the income tax on 
individuals.
    Mr. Crane. Well, wait. I didn't say reducing spending, 
because I think the dynamics of it would not necessarily 
dictate reducing spending.
    Mr. Shay. Then I think we are getting back to where Peter 
was. You would be eliminating tax on business, and all of that 
tax revenue would be made up at the individual level, correct?
    Mr. Crane. Well, not necessarily made up. We passed a tax 
cut last year, $1.3 trillion over 10 years. And I have seen 
projections that if you eliminated any tax whatsoever on 
business it would amount, I think, like $25 to $30 billion a 
year over 10 years.
    Mr. Shay. Implicitly what you are assuming then is that, 
because what you anticipate to be the enhanced economic growth, 
there will be----
    Mr. Crane. That would be an offset that would neuter that 
revenue loss.
    Mr. Shay. Then I think you are assuming the answer to your 
question, which is there would be economic growth, which I 
think does incorporate Peter's response. I am not sure--where I 
would have difficulty with that is, I am not persuaded by the 
evidence I have seen that you are going to have that degree of 
economic growth that you make up the revenue. If you don't make 
up the revenue and your spending decreases, if it decreases in 
productivity to the United States, I am not sure where they 
come out.
    Mr. Crane. Do you agree or disagree that it would attract 
businesses here and increase jobs?
    Mr. Shay. If you define it as Peter was defining it. If you 
define it as eliminating the tax on capital and you apply only 
taxes to wages--I in fact cited an article that I co-authored, 
which agrees would have a great tendency to attracting foreign 
capital. But I think you would find it would be difficult to 
maintain another principle which is essential to our system, 
and that is taxing people on the ability to pay, because it 
would levy that tax burden on workers and they would have to 
make up for it. And the foreign investors, the reason they 
would be attracted here is because they would not be paying 
that tax.
    Mr. Crane. You are assuming you would have to have an 
offset for this.
    Mr. Shay. I am assuming that either you are going to reduce 
spending--and you are saying no to that.
    Mr. Crane. I am in favor of reducing spending, but my point 
is the projected budget surpluses--when we passed the $1.3 
trillion tax cut last year over 10 years, there was no pass-
through to put that burden on anybody in the Tax Code. The 
assumption was that we were producing surpluses because of 
record high taxes, and the taxpayers needed relief and we gave 
them relief with that tax measure.
    Mr. Shay. I think the facts are that the assumption was 
there would be economic growth that has not materialized, and 
that with the declining economic growth----
    Mr. Crane. That was historic economic growth.
    Mr. Shay. The future surpluses, which are no longer 
projected, were projected as a result of an anticipated 
economic growth that we are now scaling back. So in fact there 
would have to be a tax makeup on the current assumptions, it 
seems to me, to get to what you are driving at.
    Mr. Crane. But getting back to my question, if you 
eliminated that tax, would it not provide an incentive for 
businesses to locate here and we wouldn't have DaimlerChrysler, 
we would have ChryslerDaimler.
    Mr. Shay. I agree with the following. If you eliminated the 
tax on capital you would indeed attract capital to this 
market--and let me hasten to say, I am not an economist, but I 
agree with that proposition. I will not tell you, as Mr. 
Houghton said earlier, there are not other dynamics as to what 
was Chrysler and what was Daimler. But what you would see are 
other collateral effects that are very dramatic socially. You 
would have taxes on wages that would be bearing the burden of 
the cost of the U.S. government, including the cost of 
supporting that foreign investment which is in our market. And 
I think that is part of the equation that the Committee as a 
whole would have to take into account.
    Mr. Crane. Well, I think Mr. Greenspan was testifying 
today, and I think there are some good turnaround events, 
information that was coming in today that suggests the economy 
may be doing better. Well let me--Mr. Levin?
    Mr. Levin. Thank you. We kind of dipped our toes in the 
water--maybe more than our toes. So thank you very much.
    I won't get into the last exchange, though it was 
interesting to hear Mr. Shay's response. So let me just suggest 
that what I think your testimony shows, Mr. Hufbauer, I think 
your analysis of the WTO decisions is a cogent one and I hope 
that the Europeans and others will listen to it, that if they 
thought that tactical advantage could be gained from dipping 
into this area, it is very problematic. I don't think any more 
murkier subject could be used to try to gain a trade advantage 
in this one. And I also think they should listen to the three 
of you as you discuss and sometimes argue about what other 
solutions might be undertaken by us, because if anyone thinks 
that that can happen in a short period of time, I think they 
are being misled.
    And I think today, really, we didn't want to get into the 
substance, but you helped us do that, and it showed that we 
have a long journey ahead. So your testimony has been 
especially helpful, and I hope we will circulate it to all the 
Members who were unable to get here so that they realize that 
there is a difficult journey ahead here.
    So thank you to you all very, very much.
    Mr. Crane. Mr. McCrery.
    Mr. McCrery. Yes. Thank you, Mr. Chairman. Mr. Shay, I came 
in after your testimony and got in just on the tail end of your 
discussion with Mr. Thomas. So I heard you talking about 
raising taxes on foreign operations, I guess, of multinational 
corporations and how that would level the playingfield. And 
while that may be true vis-a-vis, say, Boeing and some other 
domestic corporation, the problem at least as I appreciate it 
is not a relative tax burden between American multinationals 
and American corporations that just do business here. The 
problem is the relative taxation of American companies, whether 
they are multinational or not, and foreign companies that are 
exporting into the United States. And that part of your--maybe 
there is much more to your solution than that, but that part of 
your solution doesn't seem to address what I perceive to be the 
principal problem here. Did I miss something here? And I 
apologize if I did.
    Mr. Shay. What I pointed out was that in arguing that tax 
differences are the key to competitive differences, when two 
companies from different countries, let's assume, are competing 
in a third market, and the U.S. company is going to pay tax at 
the U.S. rate and the other company is from a country that is 
going to let the foreign country rate apply, even if it is 
lower than their home rate, my first observation is that there 
is no competitive issue if the local country rate is higher 
than the U.S. rate, because we give a credit for that, Okay. So 
the only circumstance that we are talking about----
    Mr. McCrery. That is correct insofar as income is 
concerned.
    Mr. Shay. We will come back to indirect taxes in a moment. 
On direct taxes, the only circumstance, then, that your concern 
arises is A, the foreign country is at a lower rate than the 
U.S. rate; B, the other company is not taxed at the same rate 
as the U.S. rate back in its home country; and C, the premise 
is that the difference in taxation is the driver of a 
competitive difference. So when we talk about income tax, one 
of the problems that befuddles, I think it is fair to say, some 
economists--I am not an economist---is what is the incidence of 
that tax, who ends up bearing it? Does it reflect in price? 
Does it reflect in lower shareholder profit and so on?
    Before you give U.S. tax relief in that case, my experience 
is that there are very great advantages coming from the United 
States. We have a market that supports those companies a way 
that the other countries' own company market may not. There are 
many other factors. And so the only observation I was making 
is--and I left out a piece.
    The other piece I observed in my testimony is there may 
not, in fact, be that competitive difference as a business 
matter if the U.S. company owns intangibles or has other 
benefits that effectively preclude the competitor from selling 
the same quality product in the market. And that may come from 
our R&D, research and development in the United States. It is a 
rich and complex picture.
    So the test I was asking the Committee to apply before 
reducing the U.S. tax on all foreign income of a U.S. company, 
which is going to affect a lot of cases where we are going to 
be reducing our revenue not really for the immediate 
competitive issue addressed, we need to ask ourselves are we 
getting the bang for the buck? Is that a better use of our 
money? Because if it is going to the profitability of two U.S. 
companies competing in that market, then there may have been a 
better use for it. It may be that we could have reduced all 
corporate rates in this country, and that would not help the 
company that is not in that market but the exporter. That is 
the argument I was making.
    Mr. McCrery. So you weren't making a blanket statement. You 
are just saying in those isolated instances, we ought to look 
at that in terms of relative taxation. Any of you, Mr. Merrill 
or Mr. Hufbauer, want to comment on what Mr. Shay just said?
    Mr. Merrill. As I understand one of the options that Steve 
has put forward, it would be to eliminate deferral, which would 
tax U.S. companies operating abroad currently on their income, 
active and passive. That is something that this Committee 
considered 40 years ago and was proposed by the Kennedy 
Administration, and your Committee decided not to do that. No 
other country in the world has repealed deferral. The 
implication would be that a U.S. company doing business abroad 
would be taxed in a very different way than multinationals 
anywhere else in the world.
    The consequence of that would be that it would be extremely 
unattractive to headquarter your company in the United States 
because if you were a U.S.-headquartered company, you would pay 
U.S. tax everywhere you operated in the world, where your 
foreign competitors would only pay local country tax, in most 
cases, where they operated.
    In that sort of a world you would see an explosion of the 
phenomenon that we are already seeing, which is not only 
companies deciding to invert, which is not very common yet--
only about 28 transactions--but also acquisitions of U.S. 
companies by foreign companies, because that allows the 
acquired company to operate abroad essentially free of U.S. tax 
where they invest outside the United States. We are not talking 
about income earned in the United States. We are talking about 
income earned outside of the United States and if the United 
States imposes current tax on that, the U.S. companies will 
very logically find ways to headquarter outside the United 
States.
    We will also see increased portfolio investment. Two-thirds 
of all our investment outside the United States is not 
multinationals, it is pension funds, it is institutional 
investors, it is portfolio capital investing in foreign-
headquartered companies.
    So I think it would be pretty clear, Stephen, in your 
capacity as advisor to companies, if they had a choice to set 
up an operation in the United States or abroad and if they set 
up the operation in the United States, their entire foreign 
operations would be subject to current U.S. tax. If they set up 
abroad, only their U.S.-source income would be subject to tax; 
it is obviously what you would advise your companies to do. So 
that type of activity, setting up headquarters abroad, would 
skyrocket.
    Mr. McCrery. [Presiding.] Thank you. Very quickly, Mr. 
Hufbauer.
    Mr. Hufbauer. I obviously affiliate myself with what Peter 
Merrill has just said. And the way I see it is, without making 
a lot of complication, if you tried to make taxation of U.S. 
companies working abroad equivalent to what taxation is in the 
United States and try to achieve that parity, (``capital export 
neutrality'' in the lingo of the tax world), you have the 
competitive problem all of these other different companies used 
in different places. It is not 1950, when 80 percent of 
multinationals were U.S.-based; it is 2002, and it is down to a 
quarter or something like that.
    Anyway, you have a lot of companies based in other 
countries who can do business in those low-tax countries and 
not face this disadvantage that we are suddenly going to impose 
on U.S. companies doing business there.
    And then the point you made, Mr. McCrery, was that they 
will produce in those countries and ship back into the United 
States. So you have got the third country competition coming 
back into the United States.
    And what kind of parity do you want to achieve? If you try 
to achieve the parity that Steve is advocating, I think you are 
just putting all U.S.-based companies at a horrendous 
competitive disadvantage in a global market.
    Mr. McCrery. Thank you.
    Mr. McDermott?
    Mr. McDermott. Thank you, Mr. Chairman. I am not sure I am 
smart enough to ask any questions here, but I do have some 
anyway.
    Mr. Shay, I was reading your testimony, and in the first 
paragraph, or the bottom paragraph on the first page, it says: 
I next describe a territorial tax system, how it creates an 
incentive to locate investment in lower tax forum countries and 
how the activity it benefits differs from the activity 
benefited by the ETI.
    Unfortunately, coming from Seattle, one does think about 
Boeing. You mentioned Chicago and Washington, and I suppose you 
were talking about Boeing. They are the biggest exporter. And 
what I am trying to figure out is, I watch these companies like 
Stanley sort of go off to Bermuda, and I figure, well, I wonder 
about Boeing.
    How does this extraterritorial thing affect Boeing? Would 
they have to move their headquarters or would they have to move 
their production out of Seattle and Wichita to get the benefit?
    Or tell me how they would construct it under this new 
system or this extraterritorial system.
    Mr. Shay. Let me start with today. What has been happening, 
what you are referring to is a phenomenon where companies that 
are U.S. corporations in their parent companies are engaging in 
reorganizations, in most cases taxable, but because their stock 
prices have been down, they are willing to take that hit, 
although that is actually quite a difficult issue, for them to 
transfer the parent company to another jurisdiction.
    It does not necessarily mean at all that the group's 
headquarters leave the United States. In fact, a well-known 
example is Tyco, which took advantage of a merger a couple of 
years ago, to merge into a company that is a Bermuda company 
but the headquarters of Tyco, the executive headquarters, are 
in New Hampshire. The U.S. operations remain in the United 
States. They are in U.S. corporations.
    What is going on, though, is their other non-U.S. 
operations, by being under a foreign parent, are not being 
subjected to rules that they would be subjected to if it were a 
domestic corporation parent. It really is the phenomenon that 
Peter was accusing me of permitting to happen under my 
proposal, for which I have a response buried in the testimony 
at footnote 14; that is what has been going on.
    The ETI really has nothing to do with that at all. The 
adoption of a territorial system does not answer that in any 
sort of directly coherent way. It is a creature are of the fact 
that today we honor the identification of a legal entity called 
a corporation and treat it as a U.S. taxpayer if it is 
organized under the laws of a State or the District of 
Columbia. And if it is organized under the laws of the Cayman 
Islands, we say it is a foreign corporation and we accord 
enormous--quite substantial significance to that.
    Now that significance does not apply if they are actually 
operating in the United States; we will tax them. If that 
Cayman Islands company is actually operating in the United 
States, we will tax them. If they own a subsidiary in the 
United States, we will tax that subsidiary. But what it does 
mean is that our rules affecting the non-U.S. income are 
basically cut out.
    Part of my proposal that Peter was criticizing would be an 
effort that would make that less relevant or not relevant. Now, 
I did not describe my proposal in detail in testimony, and 
indeed in the article I refer to, we have thought about 
additional things that would have to be done basically to 
address the concern that Peter has addressed, and indeed some 
of that is in my testimony buried in the footnote.
    This is a complicated area, but I think one thing that 
should be clear about it is that you have a set of issues that 
are raised by the inversion transactions. They are susceptible 
to being dealt with by this Committee, but essentially the 
options boil down to, adopt rules that make it irrelevant, 
because basically you are not going to try to tax foreign 
income at all; or try to fix what you currently have and try to 
have more of an equalized taxation of all of your income, have 
neutral taxation of U.S. and foreign income. And these are 
difficult issues.
    The comments that Gary made and Peter made, they are 
legitimate comments, but they are not insoluble issues if there 
is the will.
    Mr. And what is the solution for Boeing, then, so that they 
could keep jobs in the United States and not be at a 
disadvantage with Airbus?
    Mr. Shay. That is a unique situation because you 
essentially have a two-competitor market. And the answer that I 
frankly--I am not at all comfortable that that is a tax-driven 
problem or that there is the problem--I don't know enough about 
how they are disadvantaged vis-a-vis Airbus, I don't know 
enough that it derives from the tax treatment of Airbus as 
opposed to government purchasing approaches, other nontax 
issues.
    I am very reluctant, and I think we all should be, to 
assume that there is a tax answer for everything. There is not. 
They have to compete head to head with Airbus. They do it by 
having the best educated workers and having good management 
that prunes away all the excess costs and all the ABCs of good 
business, and in my experience, tax comes at the end of the 
dog.
    Mr. McCrery. Before going to Mr. Watkins, that may be true, 
but at least at margin the tax burden is relevant, and I think 
that is what Mr. McDermott is getting at.
    Mr. Watkins. Mr. Chairman and Members of the Committee, I 
will say thanks for these two panels, the one earlier and 
Messrs. Hufbauer, Merrill and Shay. I think this is probably 
the most informative educational phase of this, and I 
appreciate getting some meat around the bone, because I think 
it is very good. Tax does affect that--there is no question 
about it--in many ways.
    Mr. Hufbauer, you said, in the fifties, 80 percent of the 
corporations were U.S.-based. Was this multinationals?
    Mr. Hufbauer. I am giving very loose figures, but if you 
looked at multinational, or what was called ``foreign direct 
investment,'' multinational corporations, and go back to those 
years 40, 50 years ago, it was predominantly a U.S.-driven 
phenomenon. But now, of course, a lot of other folks are in the 
game.
    Mr. Watkins. We are in a global economy, and it is not 
really that way.
    Mr. Merrill, you have an--I have read all of your 
statements. All of you have some very good--I will take it home 
and read it, and I will read it on the plane flying back and 
forth. But I noticed, Mr. Merrill stated of the world's 20 
largest corporations, the number headquartered in the United 
States has declined from 18 in 1960 to just 8. I think everyone 
who is wanting to tax corporations should look at that a little 
bit. Declined from 18 out of the top 20, from 18 to down to 
only 8. And the multinational companies' share of global cross-
border investment has declined from 50 percent in 1967; now it 
is down to only 25 percent. We were talking about an economic 
base out here, or our economic undergirding of our country; 
some of it is gradually eroding in the United States.
    I do not know about Boeing, Mr. Shay, but taxes do matter. 
But I know--my friend, Mr. McDermott, just left, but I also 
know that subsidies matter. And I also know that some of the 
environmental and labor deals matter because there are some 
variables, more than just taxes, as you say.
    But I know I speak of ``taxes'' and ``Texas,'' I have two 
colleagues here Mr. Brady and Mr. Doggett. I am from Oklahoma; 
that is just above, geographically, Texas. The fact is, Texas 
does not have a corporate tax or a personal income tax, though 
it has a franchise. I know we lose businesses and industries 
from Oklahoma to Texas because of that very reason.
    Now, they could have the same environmental base that we 
have because most of it is the United States. But it is tax 
driven.
    Let me assure you, I think what we are talking about is--
and today it is probably one of the most significant issues 
facing the future of our country and its role if we are going 
to remain the number one economic power in the world, which 
also drives where we are as far as militarily, educationally or 
anything else--we have got to have the base to do that.
    I appreciate this, Mr. Chairman. Again, I think this is a 
very, very important--to my friend from Tennessee, I hate that 
he left because I know that he is also concerned about some of 
these things we were just talking about. I will talk to him 
personally.
    I thank you so much for being here. I will probably have 
some questions I may call some of you on or ask you to give me 
more information on. Thank you.
    Mr. McCrery. Mr. Hayworth.
    Mr. Hayworth. Thank you, Mr. Chairman.
    Gentlemen, thank you for coming down and for your testimony 
today. And I listened with interest to my colleague from 
Oklahoma talking about the environment he sees at home and the 
analogy with what transpires internationally in terms of tax 
law.
    Mr. Merrill, you pointed out during your testimony, foreign 
markets in today's global economy represent an ever-increasing 
opportunity for the growth of U.S. companies. Furthermore, 
competition for these markets is at an all-time high. And 
echoes of what my friend from Oklahoma talked about, Mr. 
Merrill, in your testimony you also point out that our U.S. tax 
rules put our companies at a disadvantage when competing in 
foreign markets.
    To amplify this and get past theory and abstraction, can 
you offer an example---I don't know if you would call it 
``everyday'' or something that is so compelling and so notable 
that it certainly bears amplification in this type of setting?
    Mr. Merrill. I think one of the most graphic examples is 
the U.S.-owned foreign shipping industry. That is an area where 
Congress, in 1986, actually did what Steve recommends. It 
terminated deferral for foreign shipping income. The result is 
that the U.S.-owned foreign shipping income has been 
eliminated. There are very, very few carriers left now that 
operate a foreign flag fleet.
    And this happened because they sold or they decontrolled. 
They sold majority ownership so they would get out of these 
rules. I think that is an example where it is crystal clear the 
United States changed the law in 1986 and U.S. ownership of a 
foreign flag fleet was almost eliminated.
    Mr. Hayworth. Thank you, sir. Would anyone else care to 
elaborate?
    Mr. Shay, we do not have an equal-time provision, but do--
were there mitigating circumstances in your mind or would you 
concur with Mr. Merrill's analysis?
    Mr. Shay. Well, I can't speak to the shipping case, because 
I have not studied it, but part of my caution is that you are 
being asked by companies to reduce their tax burden.
    I served 5 years in the Treasury. I had to use the word 
``no'' more than any other word in the 5 years I was in the 
Treasury, because when you are in your position in the 
Treasury, you are always going to be asked to reduce the tax 
burden.
    The question is, is it in the overall best interest of the 
United States? And the analogy I would make to my private 
experience is, sometimes clients say, if I can just make that 
investment, I will have a bigger market share.
    That is not the only question. Will they make a profit? 
There are some investments you should not make.
    And that is the way you should analyze each of the 
questions that come before you. Because my clients do not just 
go for market share if they are not going to make a profit. And 
the analogy here is, if the United States is going to invest in 
our multinationals, which we do, we reap a huge benefit.
    Let me summarize--first, tax does matter; I have been clear 
about that in my testimony.
    Two, these are very important issues. But part of the 
importance is not only listening to the people who get the 
benefit. If you ask my clients would they like the ETI, would 
they like a territorial system, and you ask me, am I lobbying 
for them, of course, I would say yes. How can you say no?
    But that is not the issue before you. You folks have a 
difficult task. You have got to sort out what is not just in 
the best interest of the companies, but what is in the best 
interest of the country.
    And the first point I made in my oral testimony is that 
there is not a perfect identity, notwithstanding the old 
statement of Mr. Wilson from General Motors. We have limited 
resources for the government. Tax is coercion, so when we 
impose that coercion, if we are going to reduce it on the 
multinationals and we are going to keep spending the same and 
we do not have surpluses, it is going to come from somewhere 
else. And that is just the burden we are under.
    So I am not going to speak to the shipping example, but I 
just want to say that it is not automatic that tax is causing--
you have to be skeptical and shine a light on the question of 
whether in a particular case tax is creating a competitive 
disadvantage.
    I do not want to go further because it wasn't in your 
question. But there has been a lot of discussion here today 
about the advantage of countries that use indirect taxes to 
give an export an advantage to their exports. I have not heard 
any part of this discussion today getting into some of the 
economics of the difference between an indirect tax or a direct 
tax; and I encourage the Committee to find the people who can 
inform them adequately on that issue, because it is not as 
simple as today's discussion has suggested.
    Mr. McCrery. Thank you. Mr. Doggett.
    Mr. Doggett. Thank you very much, and thanks to all of you 
for staying for an informative discussion.
    Mr. Merrill, are you still lobbying for the contract 
manufacturing coalition?
    Mr. Merrill. Yes, sir. Well, as you may have read in the 
Wall Street Journal today, our legislative practice at 
PricewaterhouseCoopers has been sold to Clark/Bardes and that 
project has gone with it.
    Mr. Doggett. All right. Were you lobbying for them before 
yesterday, or the sale?
    Mr. Merrill. I was registered as a lobbyist because I did 
some economic work for the coalition.
    Mr. Doggett. And also for the FSC 2000 coalition?
    Mr. Merrill. I was registered for them. I did some economic 
work for that group.
    Mr. Doggett. Is your former client, Enron, or any of its 
subsidiaries, partnerships, or joint ventures a Member of 
either of those coalitions or any of the other coalitions that 
your firm has represented?
    Mr. Merrill. Well, I can only tell you about the 
International Tax Policy Forum. And there was a Wall Street 
Journal article--incorrect, actually---but Enron was a Member 
of the International Tax Policy Forum along with 30 other 
companies. It withdrew when it became bankrupt.
    Mr. Doggett. Do you know if it is a Member of the FSC 2000 
coalition for which you lobbied?
    Mr. Merrill. No. I would not know; my role there was to 
provide economic research for Ken Kies.
    Mr. Doggett. As to either of those coalitions, can you tell 
us who some of the other Members are?
    Mr. Merrill. I do not believe that would be appropriate for 
me to disclose more than I disclosed in the lobby disclosure 
form.
    Mr. Doggett. The lobby disclosure form, of course, 
discloses nothing, except for the name of the coalition. It 
does not identify a single company, does it?
    Mr. Merrill. As far as I know, it does not.
    Mr. Doggett. Yes, sir. Are you declining to tell me and the 
Committee today the names of any of the Members of the 
coalitions for which you have been lobbying right up to this 
past week?
    Mr. Merrill. Well, one, I certainly do not know all the 
names.
    Mr. Doggett. No, I am not asking you for all of them. I am 
asking if you can identify any of them for the Committee.
    Mr. Merrill. I think it would be unfair for me to identify 
a few and not all. And I actually want to find out about 
disclosing all by asking whether it is possible to do that with 
the clients involved, since that is not something they agreed 
to.
    Mr. Doggett. Just so the record will be clear as to the FSC 
2000 coalition, you will not identify any of the Members of 
that coalition to us today?
    Mr. Merrill. Not today. I would be happy to find out from 
the coalition whether they would be prepared----
    Mr. Doggett. The coalition is something that is set up in 
your office there at Pricewaterhouse isn't it?
    Mr. Merrill. It is not there at the moment. It is at Clark/
Bardes.
    Mr. Doggett. That was the case last week or last month?
    Mr. Merrill. Right. Right.
    Mr. Doggett. With reference to the Contract Manufacturing 
Coalition, you decline to provide any of those names, though 
that also is an entity set up there at Pricewaterhouse?
    Mr. Merrill. Right. Again, it is no longer with 
PricewaterhouseCoopers. At this point I would not be prepared 
to disclose more than I was disclosing on the lobby disclosure 
forms.
    Mr. Doggett. And the Multinational Tax Coalition, its work 
was directed at a regulation of the Treasury Department was it 
not--9835, I believe?
    Mr. Merrill. Actually, I am trying to recall. I think it 
was originally 9811 and then 9835.
    Mr. Doggett. I believe that is right. And that is where--
that coalition lobbied in an effort to try to bring change to 
9811 and 9835 Treasury IRS proposals?
    Mr. Merrill. That is correct.
    Mr. Doggett. And can you tell the Committee the names of 
any of the members of that coalition which was also formed 
there at Pricewaterhouse?
    Mr. Merrill. The same answer.
    Mr. Doggett. Am I correct--since the caution light is on--
am I correct that if Enron or one of its subsidiaries or Global 
Crossings or the ABC Corporation wants to hide its identity in 
its lobbying efforts of Treasury or any other part of this 
Congress or of our government, all they have to do is come to 
firms like the one you have worked for and form a coalition 
with them and hide their identity from the public? Is that the 
way it works?
    Mr. Merrill. I am not an expert on lobby disclosure rules. 
All I can tell you is that we disclose everything we are 
required to disclose.
    Mr. Doggett. A coalition could consist of nothing but Enron 
and itself, could it not?
    Mr. Merrill. I don't know the answer to that.
    Mr. Doggett. Thank you very much. And thank you, Mr. 
Chairman.
    Mr. McCrery. Mr. Brady.
    Mr. Brady. I am confused. Mr. Merrill, are you complying 
with all of the disclosure laws that Congress has asked you to 
comply with?
    Mr. Merrill. I certainly hope so. We have someone in our 
office whose job it is to file the lobby disclosure forms, and 
we have a regular canvassing of the entire Washington office. 
We are very conservative in our disclosure. Even though I, for 
example, haven't talked to any Member of Congress or staff 
about any of the coalitions that were just mentioned, we still 
disclose that I worked on it; and I feel that we ought to be 
conservative and disclose everything that we might conceivably 
be required to disclose. I hope that we are doing a complete 
and thorough job on that.
    Mr. Brady. I appreciate you for following the laws of the 
land and engaging in legal activity the last time I checked.
    Obviously, we have a big problem in front of us. This was a 
great panel, by the way--extremely informative.
    Sort of narrowing it back down to the end, Mr. Chairman, 
with a simple question. We ought to be trying to find a 
solution that is real and is not in your interest but in the 
interest of America.
    The question is, at this point, what would you recommend to 
Congress, if our goal is a substantial solution that creates 
American jobs or at least makes us more competitive to do so, 
what approach would you recommend that we take at this point 
for each of the panelists?
    Mr. Hufbauer. Well, I would recommend going to a modified 
territorial system. To spell out the modifications would take 
more time than anybody wants today, but I would be happy to 
talk about that later.
    I believe the foreign tax credit system is hopelessly 
complex and hard to administer. I appreciate what Stephen Shay 
has said, that a territorial system is not easy. I am not 
saying it is easy. I am saying it is an improvement over where 
we are today. Instead of chasing these wills-of-the-wisp and so 
forth. And in connection with that, I would provide for 
equivalent taxation of U.S. export earnings exactly like--well, 
not exactly, but very similar to what the Netherlands or France 
does. That would be part of this general system that I would 
urge.
    Mr. Brady. Do you mind, at some point, could we get your 
thought on the modifications?
    Mr. Hufbauer. I would be delighted, Congressman.
    Mr. Brady. Thank you, sir.
    Mr. Merrill. I will take this as an opportunity to mention 
a book done for the National Foreign Trade Council. It is 
called ``U.S. International Tax Policy for the 21st century.'' 
It represents the work of four or five different authors; I was 
one of them. And the purpose of this book is essentially a 
blueprint for how to reform the U.S. taxation of multinational 
companies. So I think that would provide a place to start.
    It does not address territorial taxation. It takes as a 
starting point our existing worldwide system and asks the 
question, how can we make our existing worldwide tax system 
simpler, more competitive, in many cases not inconsistent with 
the capital export neutrality doctrine.
    Mr. Brady. Would it address the WTO dispute?
    Mr. Merrill. It does not directly address the WTO issues 
that are at stake. It asks, how can we make our multinationals 
more competitive. That would, I think indirectly address that 
issue, because as I testified, multinationals are an extremely 
important part of U.S. exports. They account for two-thirds of 
U.S. exports. In many cases, the foreign operations of 
multinationals are the sellers, distributors, the servicers of 
U.S. exports. So I think the two go hand in hand.
    Mr. Brady. Great.
    Mr. McCrery. Mr. Brady, I am afraid I have to close this 
hearing. We have a vote. They are holding the vote for you and 
me.
    Thank you, gentlemen, very much for your testimony. The 
hearing is adjourned.
    [Whereupon, at 3 p.m., the hearing was adjourned.]
    [Submissions for the record follow:]

   STATEMENT OF MTI SERVICES LIMITED, PRINCETON, NEW JERSEY, AND THE 
            WESTERN GROWERS ASSOCIATION, IRVINE, CALIFORNIA

    MTI Services Limited (MTIS) and the Western Growers Association 
(WGA) submit the following written testimony to the Committee for its 
consideration. We appreciate this opportunity to make our views known.
History of the FSC-ETI Dispute--The Role of Decisions Made in the 1960s
    Regarding the history of the FSC-ETI dispute, the origins lie with 
the enactment of Subpart F in 1962 and the tightening of the section 
482 allocation regulations in 1968. These changes, taken together, 
tightened the tax regime too much, with the result that exporters, 
among others, were unfairly disadvantaged.\1\ At the beginning of the 
1970s, the decision was made, in effect, to loosen the rules. However, 
instead of amending Subpart F and the allocation regulations, it was 
thought better to enact a new, separate set of rules--the DISC 
provisions. These provisions and the subsequent FSC and ETI rules give 
the appearance of special exceptions for exporters, when in fact they 
are a modification in the treatment of international income.\2\ It is 
submitted that Congress should reconsider the decision made in the 
early 1970s not to amend the Subpart F and section 482 rules.
---------------------------------------------------------------------------
    \1\ We would emphasize that, in our view, the problem extends 
beyond just Subpart F.
    \2\ Cohen & Hankin, ``A Decade of DISC: Genesis and Analysis,'' 2 
VA. TAX REV. 7, 225 (1982); Bruce, Lieberman & Hickey, 934 T.M., 
Foreign Sales Corporations.
---------------------------------------------------------------------------
The WTO Appellate Body's Decision--A Misconception of the Nature of 
        U.S. Tax Rules
    The WTO Appellate Body's conclusions are based in part on the 
notion that the normal or ``benchmark'' rule is that U.S. persons are 
taxable on their foreign source income and, therefore, ETI operates as 
an exception; thus, the United States foregoes revenue that otherwise 
would be due. The U.S. tax system, however, is not this pristine. For 
example, Americans residing abroad are exempt from U.S. tax, up to the 
level of $80,000, on their foreign earned income.\3\ Moreover, the 
United States has repeatedly argued that the FSC and ETI regimes are 
not that distant from what could be achieved, albeit with a good deal 
more trouble, under existing ``regular'' international tax rules. 
Indeed, as noted below, exporters, with clarification by the Internal 
Revenue Service of existing law, could obtain the same level of 
benefits.
---------------------------------------------------------------------------
    \3\ Section 911.
---------------------------------------------------------------------------
Impact of Changes in the FSC-ETI Rules--Effects on Medium Size and 
        Smaller Taxpayers
    The FSC-ETI tax benefit, while not enormous, is significant for the 
typical medium size and smaller exporter. The impact of changes in this 
area of the tax law on these exporters is great. The changes create 
confusion. Transitioning from one regime to another is costly and time-
consuming. They cause an air of uncertainty. Many smaller exporters are 
simply falling by the wayside; how many will not be know for certain 
until the tax return information for 2002 is captured, presumably in 
late 2003 or early 2004.\4\
---------------------------------------------------------------------------
    \4\ Experience shows that it takes some time for taxpayers to 
understand a new set of rules such as the ETI rules. With FSCs, the 
``learning curve'' extended for 8-10 years. With ETI, we believe, it is 
shorter but still considerable.
---------------------------------------------------------------------------
The EU's Request for Sanctions--A Proposal for Attacking the Numbers
    The European Union's estimate of the harm caused it by the ETI 
provisions (approximately $4 billion per annum) is grossly overstated 
for the reasons stated by the United States in its submissions and the 
``fall off'' in use, especially among smaller exporters. The Treasury 
Department and taxpayers, working together, can drive down the revenue 
loss due to ETI by engineering a solution under existing ``regular'' 
U.S. international tax statutory and treaty provisions. One approach is 
for the Internal Revenue Service to issue pre-filing agreements under 
existing law, without regard to the ETI provisions, to shareholders and 
their multiple ownership entities and to take such other steps as may 
be necessary, including negotiate with treaty partners, to clarify the 
tax treatment of these taxpayers under section 245(a) and sections 951-
964. \5\ There may be other approaches. The point is a simple one: It 
is within the Treasury Department's and taxpayers' power to ``devalue'' 
the figure that underpins the EU's position on sanctions and, in so 
doing, to promote a reasonable negotiated resolution. It would be 
surprising if highly intelligent tax lawyers in the Service and 
accounting and law firms could not map out a suitable plan. Then, the 
more companies that ``buy into'' the solution, i.e., obtain an 
agreement, the more effective it is.
---------------------------------------------------------------------------
    \5\ For an explanation of how this might be achieved, see Bruce, 
``The WTO's FSC Ruling: Let's All Relax,'' 86 Tax Notes 1927 (Mar. 27, 
2000). It will be noted that this type of approach is WTO-legal. There 
are no special provisions associated with it that benefit exporters; 
therefore, there is nothing that can properly be characterized as a 
subsidy.
---------------------------------------------------------------------------
    Driving down the figure for sanctions and negotiating a resolution 
buys time for a larger solution in the form of rethinking Subpart F and 
the income allocation rules.

Multiple Ownership--Need for Continued Support
    Whatever approaches are contemplated in the future, these 
approaches should accommodate U.S. exporters that wish to band together 
in a shared entity of some sort. These provisions have always existed--
with DISCs, FSCs and the ETI regime. They should continue to exist. 
They help medium size and smaller companies that cannot afford the time 
and expense of ``going it alone.'' It is a way of ``outsourcing,'' in a 
fashion, some of the international aspects of their business. Also, 
these provisions are used by trade associations and state trade 
development offices to help their members and constituents.

                               * * * * *

    MTIS is a FSC-ETI management company that manages solo and shared 
entities, some of which are ``sponsored'' by organizations, such as the 
Delaware Economic Development Office, the Pennsylvania Office of 
International Trade and the National Association of Manufacturers. It 
is based Hamilton, Bermuda, with a subsidiary in Princeton, NJ. Over 
the last 16 years, MTIS and its subsidiary have helped approximately 
500 exporters utilize the relevant benefits. Annually its companies 
export around $500 million in total. These companies represent a broad 
spectrum of exporters from small (a couple of million dollars of gross 
receipts from exports) to medium size (approximately $50 million gross 
receipts from exports). The items of export range from automobile parts 
to fishing line, and they include agricultural and forest products.
    WGA, which is headquartered in Irvine, California, is the largest 
and most active regional fresh produce trade association in the United 
States. Its members grow, pack and ship over 90% of the fresh 
vegetables and 60% of the fresh fruit grown in California and Arizona. 
The actual items (carrots, tomatoes, broccoli, citrus, lettuce, etc.) 
number in excess of 250; and they constitute over 50% of the fresh 
produce grown in the United States. They are shipped throughout Europe 
and Asia, as well as Canada and Mexico. WGA began creating shared FSCs 
for its members in 1992. Since that time, it estimates that its members 
have shipped over $1.5 billion through its shared entities. 
Approximately 95 companies participate in the WGA export program. The 
smallest of these has exports of around $400,000.

                                


  STATEMENT OF WILLIAM A. REINSCH, PRESIDENT, NATIONAL FOREIGN TRADE 
                                COUNCIL

    The National Foreign Trade Council (NFTC), founded in 1914, is an 
association of businesses with some 400 members. It is the oldest and 
largest U.S. association of businesses devoted to international trade 
matters. Its membership consists primarily of U.S. firms engaged in all 
aspects of international business, trade, and investment. Most of the 
largest U.S. manufacturing companies are NFTC members. The NFTC's 
emphasis is to encourage policies that will expand open trade and U.S. 
exports and enhance the competitiveness of U.S. companies by 
eliminating major tax inequities and anomalies.

                              Introduction

    The NFTC applauds Chairman Thomas's decision to hold a hearing on 
the WTO Appellate Body ruling in United States--Tax Treatment for 
``Foreign Sales Corporations''--Recourse to Article 21.5 of the DSU by 
the European Communities. This statement follows the outline of the 
matters identified in the announcement of the hearing: (1) outline the 
history of the FSC-ETI dispute, (2) analyze the January 14, 2002, WTO 
Appellate Panel Decision, and (3) discuss the potential trade 
ramifications of the decision. Regarding the potential trade 
ramifications, this statement highlights the importance of developing a 
process for resolving the FSC-ETI dispute in a manner that preserves 
the competitiveness of American companies while lessening trans-
Atlantic trade tensions. The NFTC appreciates the opportunity to submit 
its views for the hearing record.
Background

    The Domestic International Sales Corporation (``DISC'') provisions 
were enacted to restore the competitiveness of U.S. exporters that were 
adversely affected by the 1962 enactment of the Subpart F rules. The 
WTO FSC-ETI case can be traced back to 1972 when the European Community 
(``EC'') objected to the 1971 enactment of the DISC legislation, and 
the United States counter-claimed that the tax exemptions for foreign-
source income provided by Belgium, France, and the Netherlands were 
export subsidies. A 1976 GATT panel issued reports finding both that 
the DISC had some characteristics of an illegal export subsidy and that 
the three European territorial tax systems provided impermissible 
export subsidies. It was not until 1981 that the parties agreed to the 
adoption of the GATT panel's reports, based on an ``Understanding'' 
adopted by the GATT Council that provided the blueprint that was used 
to develop the Foreign Sale Corporation (FSC) as a replacement for the 
DISC. In particular, the 1981 Understanding made clear that a country 
is not required to tax income from foreign economic processes.
    The FSC provided a limited tax exemption for certain U.S. export 
transactions. Income earned in these transactions from economic 
activities occurring within the United States was fully taxed. Income 
earned in FSC transactions from economic activities taking place 
outside the United States was subject to an exemption. The FSC 
replicated central aspects of territorial taxation as applied to export 
transactions. The major difference between the FSC and territorial tax 
systems was that the FSC applied specifically to exports while 
territorial systems applied to exports as well as other international 
transactions.
    The 1981 Understanding laid the issue to rest for more than 15 
years until the European Commission (``Commission'') challenged the FSC 
in late 1997. Regrettably, both a WTO Panel and Appellate Body all but 
ignored the 1981 Understanding in holding that the FSC was a prohibited 
export subsidy. Accordingly, the United States repealed the FSC regime 
and enacted a regime for ``extraterritorial income'' (``ETI'') in 
November 2000. The ETI regime represented a fundamental change in U.S. 
tax law, notably, a new, general exclusion of income earned in a broad 
range of overseas transactions. Unlike the FSC, the ETI regime did not 
require any exportation from the United States and was available to 
(essentially) all U.S. taxpayers--treating foreign and domestic 
businesses subject to U.S. taxation alike.
    Nevertheless, the Commission brought a WTO challenge immediately 
following enactment of the ETI regime. In August of last year, a WTO 
Panel agreed with the Commission, and the Appellate Body affirmed the 
Panel's decision on January 14, 2002. The matter is now before an 
arbitration panel where the Commission is seeking authorization to 
impose more than $4 billion in trade sanctions on U.S. exports. The 
arbitration process likely will be completed by the end of April 2002, 
at which time the Commission would be free to retaliate.

Brief Analysis of WTO Appellate Body Report
    The January 14, 2002, Appellate Body Report upheld each of the 
adverse ``findings'' (as opposed to the rationale) of the Panel that 
considered the validity of the ETI regime. As in the original dispute, 
the Appellate Body was required to determine whether the ETI regime 
provides a subsidy before reaching the issues of whether the subsidy 
confers a benefit and whether the subsidy is contingent on export 
performance. The Appellate Body was also required to decide whether the 
ETI is inconsistent with GATT 1994 by reason of the foreign articles/
labor limitation.
    To summarize the principal conclusions in the Appellate Body's 
report, any elective, replacement regime that departs from an otherwise 
applicable general rule would be viewed as granting a subsidy. It is 
now clear, however, that a WTO member can provide an export subsidy in 
the form of a tax exemption if it is a measure to avoid double taxation 
of foreign-source income. In this regard, the foreign economic process 
requirement under the ETI regime was viewed as sufficient to establish 
the presence of ``some'' foreign-source income, but the ETI regime as a 
whole fell short of adequately identifying ``foreign-source income'' 
(primarily because allocation rules apply fixed percentages to amounts 
that may include domestic-source income).
    The Appellate Body also upheld the Panel's finding that, by virtue 
of the fair market value rule, the ETI regime accords less favorable 
treatment to imported products than to like products of U.S. origin, 
within the meaning of Article III:4 of the GATT 1994. Similarly, the 
Appellate Body upheld the Panel's finding ``that the ETI measure 
involves export subsidies inconsistent with the United States' 
obligations under Articles 3.3, 8, and 10.1 of the Agreement on 
Agriculture. Finally, the Appellate Body made clear that the United 
States has no legal basis for providing transition rules that extend 
the time-period for fully withdrawing the prohibited FSC subsidies.

Trade Ramifications
    The dispute between the United States and the Commission over the 
ETI provisions poses a grave danger to the future stability of the 
trans-Atlantic economic relationship and, more broadly, the global 
trading system. As an organization that represents companies keenly 
interested in the future progress of both, the NFTC believes it is 
imperative that this dispute be resolved equitably.
    The European Union is one of our largest trading partners; in 2000 
the two-way volume of U.S.-EU trade totaled roughly $385 billion. In 
recent years, however, the relationship has been marred by a number of 
contentious trade disputes, many of which have been litigated before 
the WTO (hormone-fed beef, bananas, Havana Rum, and the 1916 
Antidumping Act). Other potential trade cases may follow: the systemic 
failure of the Commission to approve GMO products absent scientific 
backing and the U.S. imposition of section 201 tariffs on steel 
imports. If both parties do not pull back from the brink of this 
seemingly ceaseless trade litigation, the NFTC fears they may be 
risking long-term damage to the health of this vital economic 
partnership.
    This continued deterioration in U.S.-Commission relations will have 
consequences for the broader trading system as well. The United States 
and the Commission have traditionally played leading roles in charting 
and driving the global trade agenda, as evidenced by the successful 
creation and expansion of the GATT and then the WTO to cover an ever 
broader array of trade disciplines (i.e. services, intellectual 
property). A fractured U.S.-EU relationship will hamper the ability to 
successfully complete the Doha Round and strengthen the hand of nations 
inclined to retard progress.

The Resolution Process
    The NFTC agrees with comments made by Chairman Thomas and other 
Members of the Committee that it is important for the United States--as 
the world's leading exporter--to comply with its international trade 
obligations in a timely manner so as to set an example for other WTO 
member countries. To achieve this end, the Administration must 
demonstrate leadership by implementing a comprehensive process that 
will lead to an acceptable resolution of the FSC-ETI dispute that does 
not place U.S. businesses at a competitive disadvantage.
    The Administration must make the resolution of this dispute a high 
priority. In the end, some combination of trade and tax initiatives may 
be necessary to resolve this dispute. It seems clear, however, that a 
legislative response or a negotiated solution would take time to 
develop and implement, and that this should be accomplished without 
subjecting American businesses to a competitive disadvantage. Thus, the 
NFTC urges the chairman and members of this Committee to press the 
Administration to engage the Commission in serious, high-level 
discussions, with the aim of avoiding retaliation before an accord is 
reached. In addition to forcefully and consistently negotiating with 
the Commission on the issue of the timetable for coming into 
compliance, the Administration should seek assurances that the 
Commission would be willing to consult with our government to obtain a 
measure of certainty regarding any response that may be forthcoming.
    In any event, the Administration and the Congressional tax-writing 
committees should remain focused on leveling the playing field between 
U.S. exporters and their foreign competitors. The NFTC looks forward to 
working with the Committee and its staff in resolving this issue.

                               Conclusion

    It is imperative that the United States and the Commission agree on 
a mutually acceptable solution that ensures that U.S. businesses, 
farmers, and workers are not placed at a disadvantage in relation to 
their foreign competitors. Resolving this matter and avoiding the 
destabilizing consequences it threatens are as important as any trade 
issue currently facing our country. The NFTC stands ready to work with 
this Committee and the Administration to achieve this result.

                                
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