It is the taxation of U.S. business operations that has been the recent focus of policymakers, and that has raised the question of basic tax reform in the international sector: Is the current U.S. system for taxing U.S. international business appropriate in this age of globalized business operations, or is reform needed? The current U.S. system is a hybrid construct, embodying a mix of opposing jurisdictional principles. Not surprisingly, the mixed system—in conjunction with foreign host-country taxes—poses a patchwork of incentive effects for U.S. firms and their global operations, in some cases taxing foreign operations favorably and creating an incentive to invest abroad, and in other cases imposing high tax burdens and posing a disincentive to overseas investment. Prescriptions for a "good" tax system vary, and the hybrid system satisfies none of them fully. Along with deferral, another basic feature of the U.S. system is the foreign tax credit. Where U.S. taxes apply, foreign tax credits alleviate double taxation but are limited to offsetting U.S. tax on foreign income. Capital Ownership Neutrality

A new concept of neutrality has appeared in recent years. First, firms are assumed not to substitute operations in one location for those in another—capital is completely immobile across locations. These assets could be leased by the firm with the intangible asset. When the foreign country's tax is higher, the home country would have to refund the excess so that, again, the tax on the foreign investment would be the same as the tax on domestic investment. This feature of the tax system introduces elements of a territorial or source-based taxation into the system, and it also introduces a distortion in firms' decisions of whether to return profits to the United States or reinvest them abroad. Where current taxation applies—for example, to branch income—there is a disincentive to invest in high-tax countries and either an incentive or neutrality toward investment in low-tax countries, depending on whether the investing firm can use cross-crediting of foreign taxes. Some have argued, however, that although territorial taxation may not be the most efficient system in a perfect world, it is nonetheless superior to the hybrid, patchwork system that is the current U.S. system—a second-best argument. Grubert and Mutti described their proposal as a "dividend exemption" system, thus focusing on the chief modification their plan would make to the current regime: it would exempt from U.S. taxes dividends repatriated to U.S. parents from foreign subsidiary corporations, thus moving from current law's deferral for foreign income to a permanent exemption. First, the plan would not permit foreign tax credits to be claimed for foreign taxes paid with respect to repatriated earnings. A Residence-Based System in Practice

The capital export neutrality standard recommends a system that would be based on residence—that is, a system that taxes the income of home-country firms, regardless of where it is earned. They further note that their plan's reduction of tax rates at the corporate level would shift more of the overall U.S. tax burden on corporations from the corporate to the shareholder level—a virtue in the modern world in which capital is increasingly mobile because shareholder-level taxes are generally imposed on a residence basis and thus achieve allocative efficiency. The Administration earlier presented a framework for tax reform that mentioned five elements: the allocation of interest for deferred income, a tax on excess intangibles, a minimum tax on foreign-source income in low-tax countries, disallowing a deduction for the cost of moving abroad, and providing a 20% credit for costs of moving an operation from abroad to the United States. The plan moves to a territorial tax system but also introduces a destination-based cash flow tax for corporations and unincorporated business. These changes largely eliminate the corporate tax and replace it with a consumption tax.
A striking feature of the modern U.S. economy is its growing openness—its increased integration with the rest of the world. The attention of tax policymakers has recently been focused on the growing participation of U.S. firms in the international economy and the increased pressure that engagement places on the U.S. system for taxing overseas business. Is the current U.S. system for taxing U.S. international business the appropriate one for the modern era of globalized business operations, or should its basic structure be reformed?
The current U.S. system for taxing international business is a hybrid. In part, the system is based on a residence principle, applying U.S. taxes on a worldwide basis to U.S. firms while granting foreign tax credits to alleviate double taxation. The system, however, also permits U.S. firms to defer foreign-source income indefinitely—a feature that approaches a territorial tax jurisdiction. In keeping with its mixed structure, the system produces a patchwork of economic effects that depend on the location of foreign investment and the circumstances of the firm. Broadly, the system poses a tax incentive to invest in countries with low tax rates of their own and a disincentive to invest in high-tax countries. In theory, U.S. investment should be skewed toward low-tax countries and away from high-tax locations.
Evaluations of the current tax system vary, and so do prescriptions for reform. According to traditional economic analysis, world economic welfare is maximized by a system that applies the same tax burden to prospective (marginal) foreign and domestic investment so that taxes do not distort investment decisions. Such a system possesses capital export neutrality, and could be accomplished by worldwide taxation applied to all foreign operations along with an unlimited foreign tax credit. In contrast, a system that maximizes national welfare—a system possessing national neutrality—would impose a higher tax burden on foreign investment, thus permitting an overall disincentive for foreign investment. Such a system would impose worldwide taxation but would permit only a deduction, and not a credit, for foreign taxes.
A tax system based on territorial taxation would exempt overseas business investment from U.S. tax. In recent years, several proponents of territorial taxation have argued that changes in the world economy have rendered traditional prescriptions for international taxation obsolete and instead prescribe territorial taxation as a means of maximizing both world and national economic welfare. For such a system to be neutral, however, capital would have to be completely immobile across locations. A case might be made that such a system is less distorting than the current hybrid system, but it is not clear that it is more likely to achieve policy goals than other reforms, including not only a movement toward worldwide taxation by ending deferral but also proposals to provide a minimum tax and restrict deductions for costs associated with deferred income or restrict deferral and foreign tax credits for tax havens.
A House tax proposal, called the "Better Way" tax plan, would not only move to a territorial tax but convert the income tax into a consumption tax. In this case, equity capital would likely be attracted to the United States from foreign countries because of the elimination, in most respects, of a tax on capital income of firms in the United States.