Tax Reform, Not Trade Wars, Is the Answer to China

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China's manipulation of its currency - which generates a continuing source of tension for the United States - is the impetus behind recent Senate legislation designed to pressure the country to let the Yuan rise. While "get tough" rhetoric may make for great political sound bites, retaliatory legislation against China is replete with risks.

There is a better way to, as Sen. Harry Reid (D-NV) put it, "even the playing field and help American goods compete in a global market." Congress should embark on fundamental tax reform that adopts a territorial tax system. If enacted, it would not only make America more competitive with China, but with the rest of the world as well.

America's anxiety with China is well-founded. While it continues to rise in competitiveness, our country is trending in the opposite direction. In fact, the U.S. has fallen from 1st to 5th in international competitiveness rankings over the last three years.

Part of the problem is that the U.S. tax system is not aligned with its global trading partners. America is among the few - India and France being the other exceptions - to use a worldwide taxation system, in which businesses pay the same corporate tax rate both at home and abroad. U.S. firms also pay the highest overall corporate tax rates in the industrialized world.

This antiquated tax system ultimately handicaps U.S.-based firms competing with foreign companies, while reinforcing the use of patchwork loopholes necessary to offset what would otherwise amount to double taxation (paying taxes first in other countries and then again when bringing those earnings home). Tax reform would not only put the U.S. on a level playing field with other countries, but would also level the disjointed treatment across industries. For example, the energy sector currently faces a hodge-podge of carve outs. Tax reform would put traditional energy sources and renewables like wind and solar on the same level, and let the market choose its source.

In a worldwide tax system, tax provisions such as what's called "dual capacity" are necessary to safeguard firms against being taxed twice on the same income. Unfortunately, politicians including Sen. Reid constantly target these protections for repeal, despite the fact that such a move would skew the playing field even further in China's favor.

According to the OECD, those nations which have moved from a credit (worldwide) to an exemption (territorial) system have done so "at least in part because of the competitive edge this can give to their resident multinational firms." At the very least, a full territorial system will level the playing field and reduce compliance costs, estimated at more than $40 billion annually. It will also broaden the overall tax rate, allowing the repatriating of income at a reduced rate.

Some in Congress already see the merits of this idea. Just this month, Sens. John McCain (R-AZ), and Kay Hagan (D-NC) introduced repatriation legislation to provide an opportunity for firms to bring income home without large penalty. While this is a step in the right direction, repatriation alone is not enough. A lasting shift to a territorial system of taxation would permanently even the playing field, provide reliable protection from double taxation, and enhance overall U.S.


Douglas Holtz-Eakin, former director of the Congressional Budget Office, serves as President of the American Action Forum

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