The Case Against Foreign Tax Credits

In international tax policy debate, it is usually assumed that, if one chooses not to exempt residents’ foreign source income, the preferred system would offer foreign tax credits. This assumption is mistaken, given the bad incentives created by the credits’ marginal reimbursement rate (MRR) of 100 percent and the unpersuasiveness of common rationales for granting them, such as those based on aversion to “double taxation” or support for capital export neutrality. While taxing foreign source income at the full domestic rate with only deductions for foreign taxes would over-tax outbound investment, at least in principle creditability is dominated by a burden-neutral shift to deductions plus a reduced tax rate for such income. And even if such a shift is unfeasible or unwise, the incentive problems resulting from a 100 percent MRR for foreign taxes paid may illuminate various more practical tax issues, such as (1) the merits of shifting to an exemption system, which features implicit deductibility, and (2) the merits of various proposed reforms, such as removing disincentives in subpart F for foreign tax planning by U.S. multinationals.