WTO and tax subsidies

The WTO pro­hibits the use of tax laws to dis­tort mar­kets for goods, ser­vices and invest­ment. For more than 30 years, these rules have been the occa­sion for fierce trans-Atlantic bat­tles and some debat­able dis­putes deci­sions. In the past 5 years, com­pli­ance action by WTO on the use of direct tax exemp­tions has led to the biggest penal­ties ever approved in a trade dis­pute ‘retal­i­a­tion’ action and laid the ground work for the biggest dis­putes ever brought to WTO. These rules deserve close exam­i­na­tion by trade advo­cates because their appli­ca­tion remains uncer­tain in many respects and their impact will cer­tain­ly grow as they are applied to the terms of com­pe­ti­tion from giant emerg­ing economies like Chi­na and India. First some ter­mi­nol­o­gy: direct tax­es are levied on firms that import and export; indi­rect tax­es tar­get the prod­ucts or ser­vices that they import or export. Direct tax­es include income tax­es, tax­es on cap­i­tal gain, tax­es on pay­roll and the like. Exam­ples of indi­rect tax­es are val­ue-added or con­sump­tion tax­es, or excise duties that apply to the prod­uct or ser­vice sold. The glob­al trade regime makes a debat­able dis­tinc­tion between direct and indi­rect tax­es, each of which is capa­ble of affect­ing the terms of com­pe­ti­tion in trade. In brief (more below) it allows gov­ern­ments to can­cel-out indi­rect tax­es at the bor­der to ‘adjust’ their export impact but pro­hibits such adjust­ments for direct tax­es. There is an appar­ent dif­fer­ence in the dis­tri­b­u­tion of the bur­den of the two forms of tax that seems to jus­ti­fy dif­fer­ent treat­ment under the trade rules. Indi­rect taxes—although levied on the seller—are passed for­ward to the con­sumer in the form of an impost on the price of the good or ser­vice at the point of sale. In fact, the indi­rect tax oblig­a­tion may first be cre­at­ed at the time the raw mate­r­i­al is pro­duced and sold to the proces­sor and passed for­ward all the way along the pro­duc­tion chain until it reach­es the con­sumer of the final tax. But firms can’t always pass the bur­den of indi­rect tax­es on to cus­tomers; it depends on a host of mar­ket fac­tors whether they may absorb some of the costs. Gary Huf­bauer “argues”:http://www.iie.com/publications/papers/paper.cfm?ResearchID=451 that a val­ue-added (indi­rect) tax is sim­ply “… 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.” Econ­o­mists debate whether direct tax­es are passed for­ward in this way to cus­tomers, work­ers and the own­ers of land: at best it’s a grey area and may depend on the cir­cum­stances of each firm. In the short-term, it seems not. But firms with “mar­ket pow­er” (Boe­ing? Air­bus? Microsoft? Intel? Google?) prob­a­bly find it eas­i­er to pass for­ward the impact of the tax­es on their cap­i­tal and most firms may be able to do so in the long-run. The WTO rules, like those of the GATT before them, take the unsur­pris­ing view that if a gov­ern­ment fore­goes or for­gives a tax on con­di­tion that a prod­uct or ser­vice is export­ed, that tax-oblig­a­tion-fore­gone is an export sub­sidy. This rule was spelled out in the ‘illus­tra­tive list’ of export sub­si­dies first attached to the Tokyo Round (mid-1970s) Code on export sub­si­dies, and was sub­se­quent­ly embod­ied in the WTO Agree­ment on Sub­si­dies and Coun­ter­vail­ing Mea­sures (SCM) in 1994. The cru­cial aspect of this rule, as con­firmed by a num­ber of dis­putes deci­sions, is not the actu­al inci­dence of tax that a gov­ern­ment might apply in the case of export activ­i­ties, but any vari­a­tion of the gen­er­al tax pro­vi­sions that cre­ates some ben­e­fit con­se­quent on exports. It’s not dif­fi­cult to see why such a carve-out of export activ­i­ties from the nor­mal tax pro­vi­sions should be con­sid­ered a ben­e­fit to the firm as a con­se­quence of gov­ern­ment action (this is the def­i­n­i­tion of a sub­sidy in gen­er­al terms). So there’s no real con­tro­ver­sy about the rule itself. The con­tro­ver­sy that led to a dis­tinc­tion in the WTO treat­ment of indi­rect and direct tax­es begins twen­ty-five years ago with an his­tor­i­cal ‘under­stand­ing’ reached in the GATT Coun­cil to resolve a brace of dis­putes between the Unit­ed States and a num­ber of Euro­pean coun­tries (France, Nether­lands and Bel­gium) who main­tained ‘ter­ri­to­r­i­al’ tax­a­tion sys­tems and offered tax remis­sions to ensure that no firm paid direct tax twice-over in dif­fer­ent ter­ri­to­ries. The USA, unlike the Euro­pean coun­tries (and unlike most oth­er WTO mem­bers), levies its income tax­es on a world-wide basis, not a ter­ri­to­r­i­al basis. Firms liable for U.S. income tax­es are tax­able on their world-wide income not just their income gen­er­at­ed in or repa­tri­at­ed to the ter­ri­to­ry of the Unit­ed States. How­ev­er, a Unit­ed States law (that has had many forms; it was at first known by the acronym DISC and, in its most recent form has been known as FSC) deferred tax­es on income from, and even­tu­al­ly exempt­ed alto­geth­er, cer­tain export activ­i­ties of for­eign sub­sidiaries of U.S. firms from this world-wide tax lia­bil­i­ty. The Euro­pean coun­tries alleged DISC was an export sub­sidy, and the USA coun­ter­charged that their use of ‘ter­ri­to­r­i­al’ tax­es also sub­si­dized exports, per­mit­ting firms to min­imise tax bur­dens on exports by means of trans­fer pric­ing. The Pan­el reports gave some sup­port to both argu­ments. In the 1981 GATT under­stand­ing that seemed to resolve this legal impasse, the USA and the EC agreed that an export­ing Mem­ber (of GATT at that time) was under no oblig­a­tion to col­lect a tax on an eco­nom­ic process that takes place out­side its ter­ri­to­ry; that GATT did not pro­hib­it mea­sures to alle­vi­ate dou­ble-tax­a­tion and that arms-length pric­ing prin­ci­ples should be fol­lowed when allo­cat­ing income among dif­fer­ent parts of relat­ed firms. This under­stand­ing con­firmed the con­for­mi­ty of ter­ri­to­r­i­al tax sys­tems with GATT and per­mit­ted Euro­pean gov­ern­ments to remit (via a bor­der ‘adjustment&#8217)indi­rect tax­es on export­ed goods because the sales trans­ac­tion in an export takes place out­side its ter­ri­to­ry. By the same log­ic they were able to apply the VAT to imports. For the next fif­teen years, the USA believed that the under­stand­ing sanc­tioned DISC (lat­er FISC/FSC) tax exemp­tions and defer­rals that it said were mere­ly repli­cat­ing the effects of a ter­ri­to­r­i­al tax sys­tem. But the USA was unable to sus­tain this argu­ment against the EC’s insis­tence that the rules pro­hib­it­ed tax ‘carve outs’. In 1997 the EC brought a com­plaint under the new WTO dis­putes mech­a­nisms alleg­ing that the FSC offered mas­sive export sub­si­dies. It won the case twice in the fol­low­ing three years lead­ing to two attempts to revise U.S. law that have result­ed in the with­draw­al of the U.S. tax exemptions—in return for $138 bil­lion in tax relief for U.S. man­u­fac­tur­ing. The fail­ure of the first U.S. attempt to com­ply with the WTO rul­ing led to the autho­riza­tion of a mas­sive $4 bil­lion sanc­tion against U.S. exports to Europe (that was not, how­ev­er, levied). This was the largest ‘retal­i­a­tion’ mea­sure ever approved by the WTO, cal­cu­lat­ed to equal the lev­el of the subsidy’s impact on Europe. The his­to­ry of these strug­gles over the impact of WTO tax-relat­ed rules is buried in volu­mi­nous deci­sions of GATT and WTO Pan­els and the Appel­late Body of WTO. But a recent ‘dis­cus­sion paper’ by Pro­fes­sor Michael Lang on the WTO web­site gives an excel­lent overview from a neu­tral per­spec­tive. Dr Gary Huf­bauer, who was an author of the tax com­pro­mise writ­ten into the 1979 Tokyo Round sub­si­dies code has writ­ten a com­pressed, but “com­pre­hen­sive note”:http://www.iie.com/publications/papers/paper.cfm?ResearchID=451 on the his­to­ry of the dis­pute seen from the U.S. side that is well worth read­ing. For even more detail, see his “paper”:http://www.iie.com/publications/papers/paper.cfm?ResearchID=373 propos­ing that the recent WTO Appel­late body rul­ings be used as a basis for fun­da­men­tal reform of the U.S. approach to tax­a­tion of exporters. The sec­ond (2004) attempt by the U.S. Con­gress to change the U.S. law con­tained, how­ev­er, some ‘grand­fa­ther­ing’ pro­vi­sions that allow U.S. ben­e­fi­cia­ries such as Boe­ing, Microsoft, Intel, Cater­pil­lar etc. to con­tin­ue to receive some ben­e­fits for a peri­od of time. The EC is again chal­leng­ing the U.S. on this point, prob­a­bly with an eye to it’s impact on the par­al­lel dual over Boeing/Airbus sub­si­dies. The Air­bus sub­si­dies dis­pute brought by the USA in Octo­ber, 2004 is still larg­er than the FSC dis­pute. It alleges that Air­bus received more than $15 bil­lion in sub­si­dies since 1967, most­ly in the form of gov­ern­ment grants, soft loans and equi­ty injec­tions. The EC coun­ter­charges, how­ev­er, that Boe­ing has received $23 bil­lion since 1992, part­ly in the form of direct tax sub­si­dies from FSC (con­tin­ued under then grand­fa­ther­ing pro­vi­sions, above). Although the his­to­ry of these dis­putes sug­gests that they are lim­it­ed to tit-for-tat actions across the Atlantic, there is every rea­son to believe that these mas­sive dis­putes will soon involve devel­op­ing coun­tries as well. Many devel­op­ing coun­tries, notably includ­ing Chi­na and India, pro­vide direct tax relief for income from exports or to firms under­tak­ing export activ­i­ties. So-called “for­eign-invest­ed enterprises”:http://us.tom.com/english/435.htm in Chi­na, for exam­ple, that export at least 70 per­cent of their out­put ben­e­fit from a 50 per­cent reduc­tion in their income tax lia­bil­i­ty and more if locat­ed in an export-pro­cess­ing zone.

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