Reply to Grubert

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This paper evaluates the design and the desirability of business taxes in small open economies, in light of evidence of the impact of taxation on the activities of multinational firms. The high degree of international capital mobility implies that small countries benefit by reducing their tax rates below the rates of other countries with whom they compete, possibly to the point of eliminating any taxes on inbound investment. Countries likewise have incentives not to tax the foreign incomes of resident companies. Host countries that are tempted to use their tax systems to subsidize and thereby encourage local employment, net exports, research, or other activities of foreign investors may do so effectively, but greater targeted activity of this kind typically comes at significant cost to the local economy. Particular attention is paid to the experience of low rates of Irish taxation. The increasingly global nature of American business activity implies that the future of the U.S. corporate income tax hinges on its complicated international tax provisions. Current U.S. provisions for taxing foreign income, and much of the thinking that underlies them, are based on concepts that are commonsensical, but often inconsistent with the underlying economics. The spirited comment by Grubert (2005) on Desai and Hines (2004) is a useful continuation in the ongoing debate on the appropriate taxation of foreign income. It raises numerous points on which intuition can easily go astray and, thereby, indirectly illustrates the benefits of hard and dispassionate analysis. While it is tempting to reply individually to every point raised in this comment, its length suggests that interested readers would benefit most from revisiting the original article. Accordingly, the function of this reply is to address some of the central issues in a manner that may serve to prevent further confusion. The article by Desai and Hines (2004) (hereafter, DH) makes three related points. The first point is that the U.S. tax system currently imposes a significant burden on foreign income earned by American corporations. In order to measure the magnitude of the economic burden, it is necessary to identify incentives created by the tax system, an elementary insight that is easily lost by instead applying methods used to calculate tax revenue for government budgets. The second point is that countries with worldwide tax systems, such as that used by the United States, would improve their own welfares, and world welfare, by reducing the burden of their taxation of foreign income. The reason is that ownership-based systems of worldwide taxation distort ownership patterns, and the ownership of foreign assets is critical to their productivity and tax revenue potential. Finally, DH note that these preceding points arise because the concepts and attitudes used to guide the formation of U.S. international tax policy are more than 40 years old and need to be revisited in the light of modem economic experience.


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