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Florida Tax Review

Abstract

The ability-to-pay fairness concept is a key factor underlying the historic U.S. policy of relying principally on the income tax to finance federal government expenditures. Indeed a major justification for this reliance, as opposed to significant dependence on consumption levies, is that the income tax is a system for spreading the costs of government in a way that advances fairness by giving substantial deference to comparative ability-to-pay.

Consequently, one would expect tax policy analysts to routinely examine the equity implications of international income tax rules by applying the fairness criterion with the same rigor as in the domestic context. But surprisingly, there has been relatively little discussion in the literature regarding the role of the ability-to-pay concept in analyzing international tax policy issues. This may be because the composition of international investment historically has been dominated by the direct foreign investments of multinational corporations, which pose perplexing issues in evaluating fairness concerns. Even if true, however, this is an inadequate reason to forego analysis of fairness considerations when scrutinizing the important international dimension of a modern income tax. In this article, we examine the role that fairness concerns, embedded in the ability-to-pay concept, play in justifying the U.S. policy of taxing U.S. residents on their worldwide incomes.

From almost the commencement of the modern income tax, the United States has taxed the worldwide income (i.e., both foreign-source and domestic-source income) of its residents and ameliorated international double taxation resulting from this approach by allowing a U.S. income tax credit for foreign tax imposed on foreign-source income. Thus, if the foreign tax is less than the U.S. tax on a resident’s foreign-source income, the United States receives a residual tax equal to the difference. Although there has been relatively little disagreement with worldwide taxation of the income of U.S. resident individuals, many in the U.S. multinational business community, and some academic commentators, argue that considerations of fairness, simplification, competitiveness and/or efficiency support abandonment of the residual U.S. tax on the foreign-source active business income of U.S. resident corporations. They would favor adopting a territorial, or exemption, system under which such foreign-source income is excluded from the gross income of corporate residents.

We have previously questioned the efficiency claims in favor of an exemption system and argued that taxation of foreign-source income at the time it is earned is necessary to avoid creating an inefficient and unjustified tax incentive for U.S. residents to invest abroad in low-tax countries. We now consider whether fairness considerations embedded in the ability-to-pay concept, as well as concerns regarding efficiency, favor worldwide taxation over an exemption system (or a deferral regime that functions as an exemption system).As we will discuss at greater length below, there are limits on our ability to apply the fairness criterion in the taxing of international (and domestic) income, such as the problems presented by our classical system of taxing corporate earnings. Nonetheless, we submit that fairness considerations are at the heart of the U.S. policy to tax the worldwide income of U.S. residents.

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