Order Code RL32587
CRS Report for Congress
Received through the CRS Web
Taxes and Offshore Outsourcing
December 15, 2004
David L. Brumbaugh
Specialist in Public Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Taxes and Offshore Outsourcing
Summary
The impact of taxes on international trade and foreign investment has had a
place in tax policy debates for decades, although its prominence has waxed and
waned. The debate has tended to grow more heated during times of domestic
economic weakness and high unemployment ; questions arise during such times over
whether taxes contribute to such weakness by discouraging exports (or encouraging
imports) or by encouraging U.S. firms to move abroad. In recent months, the debate
over international taxation again became prominent as a part of the wider debate over
“outsourcing.” With taxes, the debate asks how the current tax system likely affects
outsourcing, and whether alternative tax policies designed to limit the phenomenon
might be desirable. This report applies economic analysis to both questions.
First, what is outsourcing? The precise meaning of the term varies, depending
on the context. In one usage, outsourcing has come to refer to the use by domestic
firms of inputs produced by other domestic firms. Other usages, however, refer
exclusively to the international sector, and the analysis in this report focuses on two
types of such “offshore” outsourcing: the use by domestic firms of imported foreign
inputs, including both the use of foreign technical services and the use of foreign-
made goods; and the shifting by U.S. firms of domestic operations to foreign
locations. The analysis on the first of these types of outsourcing focuses primarily
on how taxes affect trade, and holds investment constant. The assessment of the
second type looks at how taxes affect investment.
Taxes probably have little impact on the balance of trade (what might be termed
“net” outsourcing), apart from indirect effects that may result from their impact on
investment flows. In the language of the outsourcing debate, taxes likely do not
change the extent to which the economy as a whole engages in the use of foreign,
rather than domestic inputs (compared to the extent the economy exports). In
contrast, taxes can affect the flow of direct investment abroad — that is, the
establishment of overseas production facilities by U.S. firms. Thus, if outsourcing
is taken to mean the use by U.S. firms of foreign rather than domestic labor, taxes can
have an impact. The current U.S. system, however, produces a variety of incentives,
disincentives, and neutrality towards overseas investment, and the net impact of the
system on the flow of investment is not clear. Similarly, the likely impact of recently
enacted legislation — the American Jobs Creation Act of 2004 (Public Law 108-357)
— on outsourcing is not clear.
Economic theory provides frameworks for evaluating the efficiency effect of
taxes on international trade and investment, and hence their impact on economic
welfare. According to theory, taxes best promote economic efficiency — and thus
best promote economic welfare — when they do not distort the level or composition
of trade or alter the allocation of investment between foreign and domestic uses. In
short, taxes best promote economic efficiency and aggregate economic welfare when
they do not distort the level of outsourcing, in the sense it is used in this report. With
respect to employment, outsourcing may cause sector-specific and near-term job
losses but likely does not have a substantial long-run impact on overall employment.
This report will be updated only when major legislative developments occur.

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Contents
What is Outsourcing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Taxes and Outsourcing Through Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Taxes and Overseas Production by U.S. Companies . . . . . . . . . . . . . . . . . . . . . . . 6
The Impact of the Current System and Recent Legislation . . . . . . . . . . . . . . . . . . 7
Less Restrictive Foreign Tax Credit Rules . . . . . . . . . . . . . . . . . . . . . . 9
Changes Related to Deferral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Tax Cut for Repatriated Foreign Earnings . . . . . . . . . . . . . . . . . . . . . . . 9
Policy Perspectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Tax Policy and Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Tax Policy and Foreign Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Outsourcing and Domestic Employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Summary and Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

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Taxes and Offshore Outsourcing
What is Outsourcing?
The term “outsourcing” has recently assumed a prominent place in the public
debate over economic policy. In general, the debate concerns the impact various
federal policies are thought to have on outsourcing, including the policy that is the
focus of this report, taxes. But “outsourcing” is not a formally-defined term of
economic theory, and has no specific meaning in economics. And its usage in the
popular debate varies. Thus, the first step in applying economic analysis to the
outsourcing debate is to clarify the term’s meaning — to define it, using terms that
do have a precise meaning in economic theory.1
In one common usage, outsourcing simply means the use by a firm of inputs
produced outside the firm, either by foreigners or unrelated domestic firms — the
important fact is simply that someone else performs the function. Here, a firm’s
manager might speak of “outsourcing” a task, meaning that another firm does that
particular job. Similarly, outsourcing sometimes refers to the use by government
agencies of services provided by the private sector — for example, legislation has
recently been introduced in Congress that would “outsource” certain debt-collection
functions of the Internal Revenue Service. The focus of this report, however, is the
international economy; its analysis is confined to what might be termed “offshore”
outsourcing.
But here, too, the term’s usage varies. For example, one focus of the recent
public debate has been the use by U.S. firms of skilled foreign technological workers
who reside and work abroad, but who provide services to customers in the United
States. A prominent example of this usage is in the 2004 Economic Report of the
President, which cited “the increased use of offshore outsourcing in which a
company relocates labor-intensive service industry functions to another country.”2
The Report, along with a subsequent statement by the President’s chief economic
advisor that such outsourcing “is just a new way of doing international trade” sparked
1 For its part, the Oxford English Dictionary defines “outsourcing” as follows: “to obtain
(goods, etc., esp. component parts) by contract from a source outside an organization or
area; to contract (work) out.” Oxford English Dictionary Online, at
[http://dictionary.oed.com/], visited Aug. 18, 2004.
2 U.S. President (Bush), Economic Report of the President Transmitted to the Congress
February 2004 (Washington: GPO, 2004), p. 229.

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a heated debate in Congress and elsewhere.3 In economic terms, this particular usage
of outsourcing refers to international trade, specifically the importation of services.
A second use of “outsourcing” has also referred to international trade, but to
flows of goods rather than services. This use may have been more frequent in past
years than in the current debate. For example, a 1983 Fortune magazine article that
was among the first sources to use the term described an increasing tendency for U.S.
automakers to “buy more and more parts abroad” and further stated that “to a large
extent the products to be out-sourced are low-technology items such as window
cranks, seat fabrics, and plastic knobs.”4
Another use of the term in the current debate refers to foreign investment rather
than trade. Here, the term refers to a U.S. firm that shifts its domestic production of
an item to a foreign location or to a U.S. firm that establishes a new production
facility abroad rather than in the United States. One example of this type of
outsourcing that has recently been prominently featured by the media is the closing
of a Chicago plant by Radio Flyer, Inc. — maker of a popular children’s wagon —
and the moving of production to China.5 In a usage that directly applies to taxes, the
website of Presidential candidate John Kerry has called for the closing of “loopholes
in international tax law that encourage outsourcing.”6 (The question of whether the
U.S. tax system does, in fact, encourage this type of outsourcing is one focus of this
report, and is addressed below.)
In economic terms the three popular usages of outsourcing that are mentioned
here can be described respectively as, the import of services from abroad, the import
of goods from abroad, and the use of domestic capital in foreign locations. Given this
economic view of outsourcing, the analysis in the following sections of the report
looks at the impact of taxes on two key economic variables: trade and investment.
The basic analysis of taxes and trade is the same whether the trade is in services or
goods; thus, it is important to look at the first two examples of outsourcing together,
combining our assessment of the direct use of foreign labor with that of the
importation of goods. The analysis continues by assessing the impact of taxes on
foreign investment, the third type of outsourcing.
The results of the following analysis are summarized briefly in advance. First,
according to economic theory, tax policy does not alter the country’s balance of trade,
3 Jonathan Weisman and Paul Blustein, “Trade Deficit Hits $489 Billion; Widening Gap
Triggers Further Debate on Job Losses Overseas,” The Washington Post, Feb. 14, 2004, p.
A8. The quotation is from Chairman of the President’s Council of Economic Advisors N.
Gregory Mankiw.
4 Steven Flax, “A Hard Road for Auto Parts Makers,” Fortune, vol. 107, March 7, 1983, p.
110.
5 Charles Murdock, “Your Jobs: A Leading U.S. Export?” Chicago Tribune, Aug. 22, 2004,
p. 1.
6 The website was visited August 23, 2004; the site is at [http://www.johnkerry.com/issues/
economy/jobs.html]. President Bush’s own campaign website contains links to a variety of
critiques of Senator Kerry’s outsourcing views. See [http://www.georgewbush.com/]
(visited Aug. 23, 2004).

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CRS-3
as long as it does not also produce a change in foreign investment flows. In terms of
the outsourcing debate, taxes do not affect the net amount of the first type of
outsourcing identified above, the use of foreign labor services or inputs made by
foreign firms. Taxes can, however, alter both the composition and level of trade and
reduce economic efficiency and economic welfare if they distort either how much a
country trades or what it trades. Second, tax policy can affect the extent to which
firms invest abroad; in terms of outsourcing, it can affect the extent to which firms
use overseas production facilities to produce inputs for their domestic operations.
Current U.S. tax law poses a mix of incentives and disincentives towards overseas
investment; its net result is uncertain. However, in a manner similar to trade,
economic theory suggests that taxes best promote world economic efficiency when
they are neutral towards investment location. In a divergence from trade theory,
investment theory suggests taxes can promote national economic welfare (though not
world welfare) if they pose a small impediment to overseas investment.
An underlying concern of the outsourcing debate is employment. The debate
is sometimes conducted in terms of the export of jobs, yet the economic analysis just
summarized does not mention employment effects of outsourcing. In part, this is
because the focus of this report is on how taxes affect outsourcing, not how
outsourcing, in turn, affects variables such as employment.7 The last section of the
report does, however, briefly turn to employment questions and summarizes how
economic theory applies to outsourcing and employment. Economic theory indicates
that outsourcing does not play an important role in determining the aggregate level
of employment in the economy, although it can affect the division of income in broad
terms between labor on the one hand, and owners of investment capital, on the other.
Taxes and Outsourcing Through Trade
In its discussion of outsourcing through trade in services, the 2004 Economic
Report of the President uses the example of a U.S. firm that might use a call-center
in India to answer customer service-related questions. For goods, an example might
be a U.S. firm that uses foreign-made components as part of an overall product made
in the United States. Importantly, in this usage of the term “outsourcing” we rule out
items produced by the U.S. firm’s own foreign facilities. In economic terms, we are
thus assessing the impact of taxes on trade, while at least initially holding investment
flows constant.
In this setting, economic theory indicates that taxes have little impact on the
country’s balance of trade — the excess of imports over exports. As applied to the
outsourcing debate, theory thus indicates that taxes have little impact on the extent
to which the economy as a whole engages in this type of outsourcing, at least as
compared to the country’s level of exports. (In the context of the outsourcing debate,
we might term a country’s trade balance its “net” outsourcing.) This result is an
7 These more general assessments of outsourcing are analyzed in CRS Report RL32484,
Foreign Oursourcing: Economic Implications and Policy Reponses, by Craig K. Elwell. For
an analysis of data on outsourcing, see CRS Report RL32461, Outsourcing and Insourcing
Jobs in the U.S. Economy: Evidence Based on Foreign Investment Data, by James Jackson.

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important one, and since it may counter the reader’s intuition, it is worth examining
more closely.
First, economics points out that a country’s trade deficit is the excess of what
a country uses over what it produces. And just as an individual who spends more
than he earns must necessarily borrow to finance the difference, a country that uses
more than it produces and that runs a trade deficit must borrow from other countries
to finance the deficit. In terms of the international economy, the borrowing consists
of imports or inflows of investment capital from abroad. It follows from this fact of
economic life that a country’s trade balance mirrors its balance on capital account.
Countries normally both import and export investment capital. But if a country runs
a trade deficit, it must likewise import more capital than it exports, with the
difference making the trade deficit possible.
The trade deficit (or surplus) thus moves in parallel with the balance on the
capital account and net imports can increase only if net capital inflows also increase;
identically, net exports can only increase if net capital outflows increase. In effect,
if an economy does not increase its own production, it can increase its use of goods
and services only if it borrows to do so. The mechanism by which this identity is
enforced in the current international economy is exchange rate adjustments. If there
is no change in capital flows and some factor, such as taxes, changes so as to increase
imports or exports, exchange rates will eventually adjust so as to offset any impact
the factor might otherwise have on the trade balance.
An example using outsourcing is useful here; we use the case of a hypothetical
domestic industry (we’ll call it Industry A) whose firms typically employ staffs of
technical support personnel who are on call to answer customer questions. Suppose
the home country implements a tax policy that inadvertently encourages firms to shift
from using domestic service employees to using foreign ones. For example, the
home country might implement more stringent depreciation rules for a certain type
of equipment the home-country technical services personnel use. Since foreign
operations of foreign firms are generally beyond the U.S. tax jurisdiction, imported
services would not be directly affected by such a change. For illustration’s purposes,
we shall say that the new depreciation rules increase the cost of using domestic
personnel to such an extent that Industry A finds it advantageous to begin importing
the services it previously obtained domestically. Industry A, in other words,
increases its outsourcing, which may initially be reflected in an increase in the home
country’s trade deficit (its net outsourcing).
But this is where exchange rate adjustments occur, neutralizing any changes in
the balance of trade. In order to pay the foreign service providers, the firms in the
home country’s Industry A must increase their purchases of foreign currency. The
increase in demand for foreign currency, in turn, will normally drive up the price of
the foreign currency, which, in turn, makes all the home country’s imports more
expensive while at the same time making the home country’s exports cheaper for
foreign buyers. In the aggregate, the home country’s exports increase while its
imports recede from their initial expansion, and when the adjustment is complete, the
initial increase in the trade deficit is completely offset by increases in aggregate
exports and reductions in aggregate imports induced by the exchange rate
movements. Because the exchange rate adjustments apply to all the home country’s

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traded goods and services, not just to Industry A’s imports, and because we assumed
that only one home-country industry was subject to increased taxes, only part of
Industry A’s initial increase in outsourcing would likely be offset by exchange rate
movements before the adjustments run their course. A part of Industry A’s initial
increase in outsourcing is, in other words, likely to remain. But the crucial point is
this: if there is an increase in outsourcing in one sector, it will be offset by reduced
outsourcing, reduced imports of other products, and increased exports in other
sectors.
While taxes do not alter the trade balance, they can affect other aspects of trade,
including its composition, its level, and what economists call the “terms of trade.”
First, composition: even from the simple example here, it is clear that a tax that
causes uneven changes in price across industries can alter what is traded — the exact
mix of goods and services that a country imports and exports. In our example, we
assumed that because of a tax change, a particular industry in the home country
increased its service imports but other home-country imports fell and exports
increased because of exchange rate adjustments. In general terms, the composition
of trade depends on the particular pattern of relative costs within the domestic
economy; when tax burdens within the economy are uneven, they distort relative
costs and change what is traded.
Taxes can likewise alter the overall level of trade even where the balance of
trade does not change. To illustrate, in our example the increase in imports triggered
by the tax change was partly offset by exchange rate adjustments, but because part
of the adjustment necessary to maintain the trade balance was absorbed by increased
exports, the overall level of imports remained higher than before. Again in general
terms, the changed tax policy did encourage a higher reliance on imports by industry
A, but to pay for the imports (again assuming no capital flows or added borrowing)
the home country also increased its exports; the overall level of trade increased.
The “terms of trade” is an economic term denoting the price of home-country
exports compared to the price of its own imports; it measures the amount of exports
a country must provide foreigners in order to obtain a given amount of foreign
products. Taxes can alter the terms of trade by reducing the price foreigners pay for
exports or by increasing the price of imports. A prominent example in current tax
policy is the impact of the U.S. extraterritorial tax exclusion (ETI) tax benefit for
exports that is at the heart of an ongoing controversy between the United States and
the European Union. The ETI benefit is designed to boost U.S. exports by cutting
taxes on export income. In order to sell more exports, however, U.S. producers
necessarily pass on part of their own tax savings to foreign consumers in the form of
reduced prices, thus registering what economists term a “worsening” of the terms of
trade. (The terms of trade effect of our earlier outsourcing examples are ambiguous,
and would depend on market conditions.)
We have thus far looked at a type of outsourcing where the U.S. firm that
imports its inputs does not itself produce the imported items in an overseas
production facility. Our specific examples have consisted of trade in services,
although the same general analysis applies to trade in goods. In terms of economic
variables, we have also assumed there is no outflow of capital that accompanies the
outsourcing; we have focused exclusively on trade rather than investment. But as

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described at the report’s outset, a part of the outsourcing debate has concerned
overseas production by U.S. firms, and so the next section shifts the focus from trade
to capital flows.
Taxes and Overseas Production by U.S. Companies
We have seen that economic theory indicates that if taxes do not alter capital
flows, they have no impact on the balance of trade, although they may affect the level
and composition of trade. Absent changes in foreign investment, in other words,
taxes do not affect what might be called net outsourcing. Theory also indicates,
however, that taxes can affect investment: they can alter the relative attractiveness
of foreign and domestic locations for multinationals, leading them to change their
allocation of capital between the domestic and foreign economies. Thus, if we define
a second type of outsourcing as the use of overseas rather than domestic production
facilities, taxes can have an impact. An example of this second type of outsourcing
might consist of a U.S.-owned factory in a foreign country that produces tangible
goods shipped back to the United States.
Taxes enter the investment equation as follows: according to economic theory,
firms allocate their investment resources between foreign and domestic locations by
comparing the rate of return investment produces in either location. In general, they
invest in each location up to the point where the rate of return on an additional
increment of investment is the same at home and abroad. Since firms are concerned
with their aftertax profits, they equate the return of foreign and domestic investment
after taxes, rather than before them. The basic impact of taxes results: other factors
remaining constant, taxes will induce firms to shift more investment than they
otherwise would from the domestic economy to foreign locations if the tax burden
on foreign investment is lower than that on domestic investment. Taxes will shift
investment from foreign locations to the domestic economy if taxes are relatively
lower on domestic investment, and taxes will have no impact on (will be “neutral”
towards) the location of investment if their burden is the same in each location.
We can make this general result more concrete by constructing another example.
Here, we shall say that a domestic manufacturing industry (Industry B) uses a
particular part — say, a door handle — as a component of its final product. We will
also say that the home-country government again introduces more stringent
depreciation rules, in this case for the equipment used to manufacture the door
handle, thus effectively increasing the cost of the part for Industry B. We return
below to some possible trade effects of the tax policy change, but here focus on the
investment impact. Since the new depreciation rules do not apply to investment
abroad, the policy change will have the effect of increasing the tax burden on
domestic investment compared to investment abroad. Rather than importing the door
handle in this case, we will say that Industry B establishes its own foreign operations,
conducted by foreign subsidiary corporations unaffected by the tax change. Here,
then, the outsourcing consists of production overseas by U.S. firms, using investment
funds flowing from the domestic economy to foreign locations.
Before looking at how specific features of the existing U.S. tax system affect
investment, we return briefly to trade. As noted in the first section, taxes do not

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affect the trade balance unless they alter capital flows, and our analysis there held
capital flows constant. In the present section, however, we have seen how taxes can,
in fact, alter capital flows. Since the trade balance moves in parallel with the balance
on capital account, taxes can therefore temporarily alter the balance of trade
indirectly through their impact on capital flows. The direction of the impact is
perhaps counter to intuition; an increase in capital outflows reduces the trade deficit,
since capital outflows are, in effect, exports. In terms of the outsourcing debate, in
other words, an increase of our second type of outsourcing — the type that consists
of overseas investment — actually reduces the net amount of the first type of
outsourcing — the type consisting of imports.
As before, this result occurs because of exchange rate adjustments. When U.S.
firms increase their overseas investments, they supply additional dollars as they
increase their purchases of foreign assets. The price of the dollar accordingly
declines; U.S. exports become less expensive for foreigners and U.S. imports become
more expensive. Imports shrink, exports increase, and the trade deficit — net
outsourcing through trade — diminishes. While this is an attention-getting result
because of its irony (outsourcing through investment reducing outsourcing through
trade), it should not be emphasized because it is temporary: the increased flow of
capital abroad lasts only until U.S. firms achieve their new desired level of capital
stock abroad.8
A more persistent impact of tax policy on the trade balance may occur if tax
policy affects the federal budget deficit and thus alters federal borrowing
requirements — a development that would likely change net capital flows. For
example, repeal of the ETI export tax subsidy would, in isolation, increase federal tax
receipts and thus reduce the budget deficit. The resulting decline in federal
borrowing requirements would (again, in isolation) reduce capital inflows, which
would reduce the trade deficit. The importance one attaches to this effect depends
on whether one assumes that a given change in tax policy is matched by another
change that offsets its revenue effect — for example, whether repeal of a provision
such as ETI is matched by revenue-losing changes occurring elsewhere. We do not
offer a conclusion on this subject here. Further, it can be argued that federal budget
deficits must ultimately be offset by a surplus at some point in the future, so this
effect, too, may be temporary.
The Impact of the Current System and
Recent Legislation
In the preceding section we saw how taxes can have an impact on the overall
level and composition of trade, though not the trade balance; they can also alter the
type of outsourcing that consists of overseas production by U.S. firms. We do not
provide a detailed assessment here of the impact of the current tax system on the
8 We should also note that in the long run there may be a slight, permanent increase in the
demand for domestic currency as firms increase their repatriations of foreign earnings. This
would drive up the exchange rate, reducing exports, increasing imports, and increasing net
outsourcing.

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level and composition of trade (again, the system does not have a direct impact on
the balance of trade). We can note, however, that the existing system may well
reduce the level of trade by virtue of its use of a “classical” system for taxing
corporate income. Under such as system, income from corporate investment is taxed
twice, once at the corporate level and once when it is received by stockholders as
capital gains or dividends. In contrast, the principal types of non-corporate
investment, owner-occupied housing and non-corporate business, are taxed only
once, if at all. Given that goods and services in the “tradables” sector consist more
frequently of corporate rather than non-corporate products, the double-taxation of
corporate investment may shift resources from tradables to non-tradables, thus
reducing the level of trade.
Other features of the federal tax system (in isolation) likely increase the level
of trade from what would otherwise occur. Specifically, the Internal Revenue Code
contains two separate export tax benefits: the extraterritorial income exclusion (ETI),
and the so-called “inventory source rule,” which permits firms, in effect, to exempt
part of their export income from taxes by characterizing part of export income as
having a foreign source for purposes of the foreign tax credit rules. (As described
below, the ETI provision is the focus of legislation being actively considered in the
current Congress.) While both provisions induce U.S. firms to increase their exports,
exchange rate adjustments (in a manner similar to the adjustments described above)
increase imports and do not completly offset the expansion of exports. The
provisions thus increase the overall level of trade. We do not assess whether the two
export benefits have an impact large enough to offset the possible trade-reducing
impact of the corporate income tax and the trade reducing impact that occurs where
tariffs are imposed.
We look at the impact of the existing U.S. system on investment flows in more
detail. Again, the key factor for taxes’ impact on investment is how the tax burden
on foreign investment compares with that on domestic projects. Other CRS products
provide more detailed descriptions of the U.S. international tax system and how it
affects the relative tax burden on foreign and domestic investment.9 Here, however,
we note only its essential features. In general, the U.S. system produces no single,
overall impact on investment flows that is readily discernable; different parts of the
system, viewed in isolation, produce different results. The so-called “deferral”
principle, for example, permits an indefinite postponement of U.S. tax for overseas
operations conducted through foreign subsidiary corporations rather than branches
of U.S. parent firms. Deferral poses a tax incentive for investment in countries with
low tax rates, resulting in more U.S. investment in those locations than would
otherwise occur. The U.S. tax system also permits its investors to claim a foreign tax
credit for foreign taxes they pay, a feature that reduces double-taxation of overseas
income; in some cases the foreign tax credit can result in even tax treatment of
foreign and domestic investment, producing tax neutrality. The foreign tax credit,
however, is limited to U.S. tax on foreign and not domestic income, a feature that
poses a disincentive for investment in countries with high tax rates, resulting in less
U.S. investment in those locations than would otherwise occur.
9 See CRS Report Number RL32429, Foreign Investment and Tax Incentives: Analysis of
Current Law and Legislative Proposals, by David L. Brumbaugh.

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For a variety of reasons, congressional interest in tax provisions related to the
types of outsourcing outlined in this report was high through most of 2004. In
particular, both the House and Senate in mid-2004 passed major tax bills with a
variety of provisions that are relevant to offshore outsourcing. In part, the bills —
H.R. 4520 and S. 1637 — addressed a trade controversy between the United States
and the European Union by repealing the extraterritorial income (ETI) tax benefit the
United States provides to its exporters. Beyond this, however, the bills each
contained a variety of provisions with the potential to affect the relative tax treatment
of domestic and overseas investment, and that therefore might affect the volume of
outsourcing through foreign investment. In October, both chambers approved a
conference committee version of the legislation that became law, P.L. 108-357, the
American Jobs Creation Act of 2004. As with the overall impact of the current tax
system, the likely combined impact of the act’s various provisions is uncertain.
However, the impact several of the measure’s most prominent features are likely to
have, in isolation, is more clear.10
Less Restrictive Foreign Tax Credit Rules. The act makes a variety of
changes in rules relating to the foreign tax credit. The general thrust of the
provisions is to relax foreign tax credit rules, principally in areas related to the
credit’s limitation. By far the most important of the changes is a change in the rules
for allocating interest expense between foreign and domestic sources — an allocation
firms must make in calculating their foreign tax credit limitation. While the act
reduces taxes only for firms with foreign tax credits and will thus be confined to
firms with foreign investment, the reduction nonetheless applies more to
multinationals’ domestic than to foreign investment.11 The provision will thus
probably reduce the tax burden on domestic investment relative to foreign investment
and will reduce net outsourcing through foreign investment. The remaining foreign
tax credit provisions, while likely smaller in impact that the interest allocation rules,
will reduce the relative tax burden on foreign investment, thus likely increasing the
flow of investment abroad.
Changes Related to Deferral. As with the foreign tax credit, the act
contains several provisions related to the ability of U.S. firms to defer U.S. tax on
foreign income. The general thrust of the provisions is to expand the scope of
deferral, in most cases by restricting the applicability of subpart F’s denial of deferral.
The impact of these provisions, in isolation, will likely be to reduce the relative tax
burden on foreign investment, thus likely increasing the flow of foreign investment
abroad.
Tax Cut for Repatriated Foreign Earnings. An additional international
provision is a temporary tax cut for earnings that repatriate from foreign subsidiaries.
As described above, the deferral of U.S. tax lasts only as long as foreign earnings are
reinvested abroad; U.S. taxes ultimately apply when the earnings are repatriated to
the United States as dividends. The act provides a temporary reduction in the U.S.
10 Note that the analysis does not consider the indirect effect of the proposals’ investment
provisions on trade due to the temporary nature of those effects.
11 For an explanation, see CRS Report Number RL32429, Foreign Investment and Tax
Incentives: Analysis of Current Law and Legislative Proposals, by David L. Brumbaugh.

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tax that applies upon repatriation; the provision will have the effect of reducing the
tax rate to 5.25% (the normally applicable corporate rate is 35%). The temporary
period is one year.
While an intuitive analysis of the provision might conclude that it would
persuade firms to repatriate additional funds and would thus increase domestic
investment, economic theory suggests there is reason to be skeptical of intuition in
this case. Theory indicates that firms’ investment decisions are dependent on the
likely return to prospective investment rather than cash flow, and the provision will
not alter the return on domestic investment even if it were to increase repatriations.
Thus, the proposal may not alter net outsourcing through investment. Further, it
might be argued that the provision will actually increase overseas investment if firms
believe that the temporary measure will ultimately be made permanent.
Policy Perspectives
Economic theory has developed frameworks for evaluating tax policy towards
both international trade and international investment in terms of economic efficiency
and economic welfare. These frameworks can be applied to tax policy towards both
types of outsourcing assessed in this report.
Tax Policy and Trade. As described above, taxes affect the trade balance
(what we have termed “net outsourcing”) only if they also alter capital flows. Thus,
for example, economic theory holds that tax policies designed to curtail imports (e.g.,
tariffs) or encourage exports (e.g., export subsidies) do not change the trade balance,
although they can alter the level and composition of trade. For example, tariffs may
shrink the overall level of trade or outsourcing, but because of exchange rate
adjustments, declines in imports are accompanied by reduced exports so that the trade
balance is not altered. Similarly, export subsidies cannot increase an economy’s
trade surplus but do expand the overall level of trade. Thus, economic theory
indicates that taxes are powerless to alter the net level of outsourcing that occurs
through importing.
This is not necessarily a bad result: economic theory points out that imports are
not inherently “bad” and exports are not inherently “good,” and so policies that
restrict imports or promote exports may miss the point. International trade is indeed
“trade” in the most literal sense — the exchange of some items for others to enhance
mutual well-being. Exports are thus not a key to the economy’s wellbeing, but rather
the goods that are given to foreigners in exchange for the imported foreign goods the
economy uses.
Classic economic theory says that such exchange occurs, and makes an economy
better off, because it enables economies to specialize in the production of goods they
produce most efficiently. For example, an economy might be able to produce wheat
more efficiently than watches. If its consumers nonetheless desire a certain amount
of watches, it might behoove the country to shift resources out of watch production
into wheat, and trade wheat for watches made by a foreign country that produces

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watches more efficiently than wheat.12 The important point its that it is not the
exports that make the economy better off, but the ability to specialize by trading
exports for imports.
From the point of view of the economy’s efficiency, and thus, general economic
welfare, there is an optimal level of international specialization. There is, in other
words, a level of trade (imports plus exports) at which an economy is specializing
enough in what it does efficiently to improve its welfare, but not specializing so
much that it exports goods it produces inefficiently and imports items that it could
produce domestically at little resource cost. It is here that economic theory provides
an insight about the results of taxes’ impact on trade. To the extent that taxes distort
trade by either changing the mix of what an economy trades or the level at which it
trades, taxes are believed to impair economic efficiency and reduce the overall
economic welfare of the economy’s participants.
The application of this principle to tax policies designed to alter trade —
policies designed to shrink imports or expand exports — is straightforward. As
previously noted, economists believe that neither tariffs nor export subsidies alter the
balance of trade, but rather can change the composition and/or level of trade, with
tariffs shrinking trade and export subsidies expanding it. To the extent any of these
tax policies shift the economy away from its optimal level of trade, they make the
economy’s participants as a whole worse off in terms of economic welfare.13
Such arguments, however, focus on the economy as a whole and are sometimes
difficult to see when only a particular sector of the economy is the focus. The idea
that a tariff probably makes the economy as a whole worse off would likely be hard
to explain to an employee who has just been laid off because his firm has started
relying on imported inputs. (The employment effects of outsourcing are discussed
in the following section.) Trade theory does not deny that increases in imports (or
reductions in exports) can cause economic dislocation in particular sectors of the
economy. But because of the efficiency gains an economy realizes from trade, the
welfare gain to the economy as a whole are held to outweigh the sum of sector-
specific losses. In principle, the “winners” from a country’s international trade can
compensate those made worse off by providing transition relief or other transfers to
those made worse off by trade. Such relief could, in principle, be provided through
the tax code, although mechanisms such as unemployment insurance or subsidized
job-training might be more effective. The message of economic theory on the basic
relation of taxes and trade, however, is clear: tax policies that distort trade make the
economy worse off. In terms of the outsourcing debate, economic theory asserts that
tax policies designed to curtail the type of outsourcing that occurs through trade
probably make an economy as a whole worse off.
12 Note that the country may be better off in making this trade even if it produces both
watches and wheat more efficiently than the foreign country in an absolute sense; the key
is for both countries to produce one good more efficiently than the other good and for the
margin of this efficiency to differ.
13 For a detailed economic analysis of the effect of an export subsidy on trade, efficiency,
and economic welfare, see CRS Report RL30684, The Foreign Sales Corporations (FSC)
Tax Benefit for Exporting: WTO Issues and Economic Analysis, by David L. Brumbaugh.

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Tax Policy and Foreign Investment. Economic theory also provides a
framework for interpreting taxes’ impact on foreign investment from the perspective
of economic efficiency and economic welfare. Here, the results are slightly more
ambiguous than those for trade because the framework distinguishes between policies
that promote world economic welfare and those that promote national economic
welfare but that are not optimal for world welfare.
We first ignore taxes and note that a central tenet of economics holds that as
capital investment in an economy increases, the product added by each additional
increment of capital declines — in terms of economic theory, there is a declining
marginal product of capital. Given this physical property of capital, firms will
generally allocate investment between foreign and domestic locations until the return
on an additional unit of overseas investment (the marginal product of capital
employed abroad) is equal to that of an additional domestic investment — an
outcome seen above in the discussion of how taxes affect investment decisions.
Here, we also note that where capital is allocated so that the marginal product of
foreign and domestic capital is equal, every unit of capital is necessarily being used
in its most productive location. Given the declining marginal product of capital in
both locations, if an increment of capital were shifted away from this point, the
shifted capital would necessarily earn a lower return in its new location than its old
one. At this point, therefore, the firm’s entire capital stock is employed in its most
productive location. More generally, again ignoring taxes, when firms equate the
marginal product of domestic and foreign capital, the world economy’s capital
resources are employed in their most productive location and world economic
welfare is maximized.
But taxes can change things. Profit maximizing firms focus on the aftertax
return to capital and invest so that the aftertax return to additional investment is the
same in each location. If taxes on investment are the same in every location, this
point will be no different from the allocation of investment without taxes. But if
taxes are different at home and abroad, the allocation of investment will be distorted.
Capital will therefore not be employed in its most productive location and world
economic welfare is not maximized.14 In short, theory indicates that tax policy best
promotes world economic welfare when it applies at the same rate at home and
abroad, and is therefore neutral towards firms’ investment decisions. In economic
parlance, such a tax policy possesses “capital export neutrality” — it is neutral
towards the export of capital.
A tax policy that maximizes world economic welfare is not necessarily that
which maximizes a nation’s own welfare. When an increment of capital is employed
in the domestic economy, it is the home country that collects and uses the tax revenue
produced by the investment. Thus, the home country’s residents benefit from the
investment’s entire pre-tax return, not just the aftertax return. In contrast, when
14 Put another way, governments use tax revenue to finance services that (in principle)
enhance economic welfare. Thus, the social benefit from capital investment consists of an
investment’s pretax return: the investment’s aftertax return plus the tax revenue it generates.
Thus, economic welfare is maximized where the pretax rather than aftertax return of
marginal investment is equal.

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capital is employed abroad, foreign governments normally are normally entitled to
taxes on the investment they host and the home country benefits only from the
aftertax return to the investment. Accordingly, the home country’s economic welfare
is maximized when firms equate the pretax return of marginal domestic investment
with the aftertax return of foreign investment. This outcome suggests that the home
country (but not the world economy) is better off when it allows only a deduction for
foreign taxes rather than a credit. Allowing only a deduction for foreign taxes would
result in higher taxes on foreign investment than domestic investment.15 Importantly,
however, the benefit from such a policy may be offset if foreign countries retaliate.
A third type of tax policy termed “capital import neutrality” is sometimes
promoted by business leaders and others. It recommends a policy that enables U.S.
firms to compete in foreign markets on an even footing with firms from foreign
countries. This policy would consist of an exemption for foreign investment from
home-country taxes, but is not neutral in its effect on investment and does not
promote economic efficiency.
As described above, the U.S. tax system in some cases poses incentives towards
overseas investment, and in other cases is either neutral or poses a disincentive. The
average impact of the system is, however, uncertain, and so whether the system as a
whole comes closest to capital export neutrality, national neutrality, or competitive
neutrality is likewise uncertain. Likewise, whether the legislation Congress is
considering in 2004 would nudge the system in the direction of a particular standard
is uncertain.
The impact of certain features of the system, considered in isolation, is,
however, more clear. For example, the foreign tax credit generally promotes capital
export neutrality because it alleviates double taxation. While the credit’s limitation
is likely necessary to protect the U.S. tax base,16 it permits the overall tax rate on
investment in high-tax countries to exceed the U.S. tax rate, thus permitting a tax
disincentive towards foreign investment to exist. In a sense, then, the limitation is
consistent with national neutrality, although as a general matter, permitting firms
only to deduct rather than credit foreign taxes would closely approach national
neutrality. The deferral principle is consistent with capital import neutrality, since
it can reduce the tax burden on foreign investment to a level lower than the domestic
tax rate. In contrast, the current taxation that applies to branch operations or under
15 Trade theory suggests that, tax revenue considerations aside, a capital exporting country
could benefit (at the expense of the world economy) by taxing foreign investment more
heavily than domestic investment. The situation exists where the capital-exporting country
faces a high foreign demand for its investment funds. In a manner analogous to that of a
monopolist who restricts output, the exporting country can extract economic rents by taxing
investment outflows relatively heavily.
16 Without the limitation, foreign governments could, in principle, deprive the United States
of tax revenue by raising their tax rates on U.S. firms whose investment they host to
extremely high rates. Without the limitation, the foreign governments would not need to
fear that the high tax rates would drive off desirable investment because the firms could
simply credit the high foreign taxes against the firms’ U.S. tax on U.S. source income.

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subpart F is consistent with capital export neutrality as long as foreign tax credits are
also permitted.
Outsourcing and Domestic Employment
The preceding economic analysis concluded that taxes best promote economic
efficiency and economic welfare when they neither encourage nor discourage
outsourcing, whether that outsourcing consists of imports of goods or services or
exports of capital investment. But much of the debate over outsourcing has
concerned its perceived impact of jobs, with some participants expressing fears that
outsourced jobs destroy domestic jobs and reduce domestic employment.17 The
absence of employment from a prominent role in the preceding discussion indirectly
suggests what economic theory indicates about outsourcing and employment:
outsourcing has no profound effect on long-term aggregate employment in the
domestic economy, although it can trigger short-term sector-specific job losses.
Nonetheless, given the prominence of employment considerations in the outsourcing
debate, we provide a brief summary of economic theory in this area.
First, mainstream contemporary economic theory holds that economies generally
tend toward “full employment” or are moving in that direction. The labor market is
thought to ordinarily be at equilibrium, where the supply of labor is equal to demand.
Monetary policy set by the Federal Reserve is generally set so as to keep the economy
at full employment and to avoid shocks to the system that might temporarily jar the
economy from equilibrium. This is not to say there is never unemployment — in
fact, unemployment is always present due in part to transitions within the economy
(some of which may result from outsourcing). This persistent, minimum level of
unemployment is termed the “natural” rate of unemployment by economists and is
viewed as an unavoidable consequence of maintaining an efficient, flexible, and
adaptable economy. Nonetheless, given appropriate monetary policy, an economy
is thought to generally absorb displaced workers and tend towards full employment.
Against this backdrop, we return to the foregoing analysis of trade, which
indicated that, absent changes in capital flows, the balance of trade cannot change;
economists believe that an exogenous increase in imports (i.e., outsourcing) will
ultimately be matched by an increase in exports and a mitigation of the initial
increase in imports. Here, the mix of what the economy produces has indeed been
changed, and an increase in unemployment in the import-competing sector may
occur. Nonetheless, with the economy tending towards full employment, new jobs
will be created in other sectors of the economy that will, in time, offset those lost in
the sector where outsourcing occured. In short, when we view outsourcing as a trade
phenomenon, its employment effects will be confined to the near-term.
The employment analysis of outsourcing that occurs through investment — that
is, where capital outflows occur — is somewhat different. As with trade, there may
be near-term and sector specific unemployment as a result, for example, a factory that
17 For more information, see CRS Report RL32292, Offshoring (a.k.a. Offshore
Outsourcing) and Job Insecurity Among U.S. Workers, by Linda Levine.

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shuts down in a particular U.S. city and that moves to a foreign location can certainly
cause increased unemployment in the original U.S. location.18 Again, however, the
economy as a whole is seen as tending towards full employment and the absorption
of dislocated labor. There may also, however, be a shift in the shares of national
income accruing to labor and capital respectively. This outcome is based on the basic
economic precept that labor’s earnings depend on its productivity, which in turn
depends on the amount of capital it has to work with. The larger the economy’s stock
of capital for a given supply of labor, the higher will be labor productivity and the
higher will be labor earnings. It follows, then, that when capital shifts abroad,
domestic labor earnings fall from the level they otherwise would attain.
As noted in the discussion above on efficiency, in principle those that gain from
outsourcing can, in principle, compensate those that lose and, because of the
efficiency gains embedded in outsourcing, still be better off than before. In principle,
the economic harm to workers from outsourcing can be mitigated by appropriate
redistributive and retraining policies. Theory maintains, however, that these policies
are most efficiently effected as general transitional relief than as policies designed to
limit outsourcing.
Summary and Conclusions
A recent focus of tax policy debate has been the impact of taxes on the extent
to which firms use imported inputs rather than domestic goods and services and
whether taxes encourage U.S. firms to establish operations abroad rather than in the
United States. In the current debate, the phenomena are frequently referred to as
offshore or foreign “outsourcing.” In economic terms, the debate concerns the
impact of taxes on two aspects of the international economy: trade and foreign
investment.
Economic theory maintains that taxes can alter the composition and level of
trade, but do not alter the balance of trade (the excess of imports over exports). In
contrast, taxes can alter the extent to which firms invest abroad rather than in the
United States. The current U.S. tax system produces a patchwork of effects on
investment so that its net impact, whether it encourages or discourages overseas
investment, is uncertain.
Economic theory also provides frameworks for evaluating the impact of tax
policy on trade and investment from the perspective of economic efficiency and
economic welfare. Theory suggests, in general, that tax policy best promotes
efficiency and national economic welfare when it neither encourages nor discourages
imports or exports. In terms of the outsourcing debate, theory holds that taxes best
promote economic welfare when they do not distort the level or composition of
outsourcing. With outsourcing that occurs through investment, theory similarly
indicates taxes best promote world economic efficiency and economic welfare when
they do not distort investment flows. A policy that poses a small impediment to
18 CRS Report RL30799, Unemployment Through Layoffs: What are the Underlying
Reasons?, by Linda Levine.

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overseas investment may, in contrast, best promote national welfare, although such
a policy may make foreign economic actors worse off and may be offset by
retaliation.

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