U.S. Taxation of Overseas Investment

Publication Date: August 2002

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

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Abstract:

Investment abroad by U.S. individuals and firms is substantial and growing - an important aspect of the increased integration of the U.S. economy with the rest of the world. At the end of 2000, the stock of private U.S. investment abroad was a full 26.4% of the total U.S. stock of private capital; the proportion has more than doubled over the past two decades. And because investment outflows have grown, it is not surprising that U.S. taxation of overseas investment is a prominent issue before policymakers in Congress and elsewhere. First, because investment abroad is an increasingly important part of the economy, more pressure is placed on the U.S. system of taxing that aspect of the economy - the effects of taxation on foreign investment are potentially more important. Second, the increased mobility of capital has changed the environment in which taxes apply; some have suggested that the mobility of capital may call for a change in how U.S. taxes apply.

As it currently exists, U.S. tax policy towards investment abroad poses a patchwork of incentives, disincentives, and neutrality. Different features of the system, in isolation, have different effects. The foreign tax credit, for example, generally promotes tax neutrality; the credit is limited, however, and the limitation can pose either a disincentive or incentive to invest abroad. The system's deferral principle in some cases permits U.S. firms to postpone U.S. tax on foreign income indefinitely; it poses an incentive to invest overseas in countries that impose low tax rates of their own. Deferral is restricted, however, by the tax code's subpart F provisions which nudge the system back in the direction of tax neutrality.

Whether these various tax effects are beneficial depends, in part, on the perspective a policymaker takes. Traditional economic theory suggests that a tax policy that promotes neutrality between investment at home and abroad - a policy termed "capital export neutrality" - best promotes world economic welfare. Economic theory also indicates, however, that U.S. economic welfare is maximized by a policy ("national neutrality") where overseas investment is, to some extent, discouraged. Yet a third policy standard - sometimes termed "capital import neutrality" - is supported by many investors and multinational firms, who emphasize the importance of the competitive position of U.S. firms in the world market place. A complete tax exemption for overseas income - a "territorial" system of taxation - would be consistent with capital import neutrality. Clearly, the different components of the U.S. system are consistent with different ones of the three policies; which one the current U.S. system best approximates, on the average, is not clear.

Should U.S. tax policy towards investment abroad be changed? It might be argued that the increased level of foreign investment makes any flaws that might exist in the U.S. system more serious. Yet given the various policy standards that have been recommended for U.S. taxation and given the varied impact of the current system, it is not surprising that proposals for change have varied.

This report will be updated as legislative and other developments warrant.