The Case Against Foreign Tax Credits

Abstract

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’’orsupport forcapital exportneutrality.While taxingforeign source income at the full domestic rate with only deductions for foreign taxes would overtaxoutboundinvestment,atleast in principal creditability is dominatedbya burdenneutral 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 the merits of (1) shifting to an exemption system,which features implicit deductibility, and (2) various proposed reforms, such as removing disincentives in subpart F for foreign tax planning by U.S. multinationals.