In one common usage, outsourcing simply means the use by a firm of inputs produced outside the firm, either by foreigners or unrelated domestic firms—the important fact is simply that someone else performs the function. The focus of this report, however, is the international economy; its analysis is confined to what might be termed "offshore" outsourcing. A second use of "outsourcing" has also referred to international trade, but to flows of goods rather than services. The basic analysis of taxes and trade is the same whether the trade is in services or goods; thus, it is important to look at the first two examples of outsourcing together, combining our assessment of the direct use of foreign labor with that of the importation of goods. In terms of the outsourcing debate, taxes do not affect the net amount of the first type of outsourcing identified above, the use of foreign labor services or inputs made by foreign firms. Current U.S. tax law poses a mix of incentives and disincentives towards overseas investment; its net result is uncertain. In part, this is because the focus of this report is on how taxes affect outsourcing, not how outsourcing, in turn, affects variables such as employment. Importantly, in this usage of the term "outsourcing" we rule out items produced by the U.S. firm's own foreign facilities. As applied to the outsourcing debate, theory thus indicates that taxes have little impact on the extent to which the economy as a whole engages in this type of outsourcing, at least as compared to the country's level of exports. The ETI benefit was designed to boost U.S. exports by cutting taxes on export income. Taxes will shift investment from foreign locations to the domestic economy if taxes are relatively lower on domestic investment, and taxes will have no impact on (will be "neutral" towards) the location of investment if their burden is the same in each location. The Impact of the Current System and Recent Legislation

In the preceding section we saw how taxes can have an impact on the overall level and composition of trade, though not the trade balance; they can also alter the type of outsourcing that consists of overseas production by U.S. firms. We do not provide a detailed assessment here of the impact of the current tax system on the level and composition of trade (again, the system does not have a direct impact on the balance of trade). Tax Policy and Foreign Investment

Economic theory also provides a framework for interpreting taxes' impact on foreign investment from the perspective of economic efficiency and economic welfare. Outsourcing and Domestic Employment

The preceding economic analysis concluded that taxes best promote economic efficiency and economic welfare when they neither encourage nor discourage outsourcing, whether that outsourcing consists of imports of goods or services or exports of capital investment. Summary and Conclusions

A recent focus of tax policy debate has been the impact of taxes on the extent to which firms use imported inputs rather than domestic goods and services and whether taxes encourage U.S. firms to establish operations abroad rather than in the United States. In terms of the outsourcing debate, theory holds that taxes best promote economic welfare when they do not distort the level or composition of outsourcing. With outsourcing that occurs through investment, theory similarly indicates taxes best promote world economic efficiency and economic welfare when they do not distort investment flows.
The impact of taxes on international trade and investment has been debated for decades. Most recently, a variety of bills addressing international taxation were introduced in the 110th Congress—some would have cut taxes for U.S. firms overseas, while others would have increased taxes on foreign investment. The debate over taxes and foreign outsourcing has tended to grow more heated during times of domestic economic weakness and high unemployment; questions arise over whether taxes contribute to such weakness by discouraging exports (or encouraging imports) or by encouraging U.S. firms to move abroad. The debate over international taxation has again become prominent as a part of the wider debate over "outsourcing." With taxes, the debate asks how the current system affects outsourcing, and whether policies designed to limit the phenomenon might be desirable.
The precise meaning of the term "outsourcing" varies, depending on the context. In one usage, outsourcing simply refers to the use by domestic firms of inputs produced by other firms. Other usages, however, refer exclusively to the international sector. The analysis in this report focuses on two types of such "offshore" outsourcing: the use by domestic firms of imported foreign inputs, including both the use of foreign technical services and the use of foreign-made goods; and the shifting by U.S. firms of domestic operations abroad. The analysis of the first of these types of outsourcing focuses primarily on how taxes affect trade while investment is held constant. The assessment of the second type looks at how taxes affect investment.
Taxes probably have little impact on the balance of trade (what might be termed "net" outsourcing), apart from indirect effects that may result from their impact on investment flows. In the language of the outsourcing debate, taxes likely do not change the extent to which the economy as a whole engages in the use of foreign, rather than domestic, inputs (compared to the extent the economy exports). In contrast, taxes can affect the flow of direct investment abroad—that is, the establishment of overseas production facilities by U.S. firms. Thus, if outsourcing is taken to mean the use by U.S. firms of foreign rather than domestic labor, taxes can have an impact. The current U.S. system, however, produces a variety of incentives, disincentives, and neutrality towards overseas investment, and the net impact of the system on the flow of investment is not clear. Similarly, the likely impact of recently enacted legislation is not clear.
Economic theory provides frameworks for evaluating the efficiency effect of taxes on international trade and investment, and their subsequent impact on economic welfare. According to theory, taxes best promote economic efficiency—and thus best promote economic welfare—when they do not distort the level or composition of trade or alter the allocation of investment between foreign and domestic uses. In short, taxes best promote economic efficiency and aggregate economic welfare when they do not distort the level of outsourcing, in the sense it is used in this report. With respect to employment, outsourcing may cause sector-specific and near-term job losses but likely does not have a substantial long-run impact on overall employment. This report will be updated only when major legislative developments occur.