Amid the search for economic leverage over Russia, Senator Ron Wyden has propose use tax law to deny tax credits to US companies that pay Russian taxes. The proposal also limits the scope of the tax treaty between the United States and Russia and could increase the pressure of financial sanctions. But Wyden’s proposal requires congressional approval – a fact that reveals how difficult it is to use fiscal policy as an economic policy tool. Congress needs to rethink tax laws so they can complement other economic tools. And Congress must act quickly, because the overuse of other tools — financial sanctions, export controls and tariffs — threatens their long-term viability.
Income tax has always been used as a foreign policy tool, primarily to direct US investment to strategically important countries. In the 1920s, there were incentives to invest in China; and during the Cold War there were incentives to invest in less developed countries. Tax treaties today perform a similar function. But there are very few rules that can be used to impose economic costs on foreign adversaries, and they mostly reflect outdated foreign policy goals. For example, American multinational corporations that earn income in countries that support terrorism, with which the United States has no diplomatic relations, or that participate in the Arab League boycott of Israel – a rule added in 1976 – lose part of their foreign tax credits and the advantages of tax deferral for their subsidiaries. Wyden’s proposal would likely add Russia to that list of countries.
These rules are obsolete. In recent research, a co-author, and I found that the rules were so neglected that there was no discussion in the legislative record of how sweeping changes to U.S. international tax rules in 2017 would affect them. In this case, the new law has probably undermined the effectiveness of these foreign policy tax rules. Next on the horizon is the recent international agreement negotiated to the Organization for Economic Co-operation and Development on a global minimum tax. It is unclear how the implementation of the agreement will affect these provisions. The United States must develop a comprehensive and forward-looking approach to the foreign policy uses of tax law rather than reacting to specific episodes as they arise.
Congress should give the executive more fiscal tools to impose costs on foreign targets when national security warrants. For example, Congress could empower the President to designate a higher tax rate on US investment income earned by foreign targets or on foreign corporations with US branches or subsidiaries. The US tax burden on income earned by US multinationals in target countries could also be increased by reducing the availability of foreign tax credit or disallowing certain deductions or simply increasing the rate on such income. There are many possibilities, but they should be considered before a crisis when they are needed. This assessment could include their potential costs and benefits as well as their legality under US international obligations.
If these tools were available to the executive branch, it could already increase pressure on Russian investors in US stocks and securities with higher withholding rates on interest and dividend payments. This action would reach a broad category of individuals – beyond the extremely wealthy individuals whom the United States already sanctions – and would nevertheless remain targeted at relatively high-income individuals who earn capital income in the United States. Although many American companies have reduced their activities in Russia, the big pharmaceutical companies Continue operate there. U.S. companies with operations in Russia could be encouraged to scale back their operations by increasing tax rates on income they earn in Russia, or Congress could reduce the availability of foreign tax credits, along the lines of Senator Wyden’s proposal. Alternatively, Congress could impose a disclosure regime that would provide US policymakers with data that could shed light on how the war is affecting companies’ relationships with the Russian government and their business partners in Russia.
Changing tax policy will be costly for American businesses and individuals. But this is always the case when the economy is used for foreign policy purposes, as the recent spike in gasoline prices demonstrated. The appeal of economic coercion is obvious: it is the main alternative to the use of force. But it’s not free. The use of tax legislation could reduce the overall domestic costs of economic coercion if it allowed the United States to reduce its reliance on sanctions, export and import controls, and tariffs.
There are several reasons why Congress should give tax policy a bigger role in foreign affairs. First, the United States could influence more targets than it currently does. US income tax jurisdiction is the most extensive in the world, reaching US citizens, residents and aliens who earn US-related income. Second, tax law also has built-in flexibility to modulate incentives. Taxes can be adjusted by degrees. Raising U.S. tax rates is unlikely to trigger a large and unexpected exodus of foreign businesses and individuals from the U.S., and because tax incentives can be modulated, it is easy to walk away if the sanctions taxes are beginning to drive foreigners out of US markets.
But perhaps more importantly, income tax acts on different leverage points than other economic tools and allows policymakers to use these other tools less aggressively. Financial sanctions affect the ability of targeted entities to use the US financial system; export controls affect access to sensitive goods; and tariffs limit access to the US market. On the other hand, the tax legislation affects all economic activities that generate US-source income. Increasing the points of leverage on which US economic coercion operates can reduce pressure on other levers of influence.
The United States uses sanctions, tariffs and other tools of economic influence more than ever. Although the trend accelerated under former President Trump, it transcends Democratic and Republican administrations. The United States’ growing reliance on economic leverage increases the risk that foreigners will divest from the U.S. financial system, the import market, and the dollar to avoid future sanctions. Adding tax legislation to the foreign policy toolbox helps reduce the use of financial sanctions, tariffs, and export controls, reducing the risk of divestment from the U.S. financial sector and the dollar as a reserve currency.
Due to the overuse and increased competition of currencies and alternative payment systems, the United States may be approaching the limits of the effectiveness of these tools. For example, the development of blockchain technology risks creating an alternative to the existing payment system. The emergence of growing middle classes in China and India is also reducing the relative importance of the US export market. And foreign currencies are becoming a larger share of global reserves. The primacy of the US dollar as a reserve currency depends on the reliability of the Federal Reserve and the US government to preserve its value. So far, US assets have benefited from any flight to safety, but that should not be taken for granted. If a divestment from the US dollar were to occur, it could be rapid and disruptive. And recent fiscal and macroeconomic trends in the United States may give foreigners additional reason to rebalance their currency portfolios. Above-average inflation in the wake of the pandemic and legislation on major infrastructure and government spending risks endangering the long-term stability of the US dollar. All of which are cause for concern about an overreliance on existing tools of economic coercion.
There are limits to the extent to which the United States can exploit the primacy of the dollar and the centrality of the American financial system to constrain foreign actors before they seek alternatives that do not expose them to the imperatives of politics. American foreigner. The United States must find other economic levers to ensure that existing levers do not break under pressure. The benefits of adding tax law to the toolkit are greater than ever, and the risks of not doing so loom.