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’)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.