Download implications of existing tax policy for cross

National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46
IMPLICATIONS OF
EXISTING TAX POLICY
FOR CROSS-BORDER
ACTIVITY BETWEEN THE
UNITED STATES AND
MEXICO AFTER NAFTA
ROGER H. GORDON*
LEY**
& EDUARDO
During the next few years, trade and
cross-border investments are likely to increase substantially between Mexico and
the United States. This increase in activity will arise only in part from the drop
in tariff rates negotiated as part of the
North American Free Trade Agreement.
During the entire last decade, Mexico
has been undergoing a dramatic liberalization process. In 1985, Mexico reduced
its quantitative quotas and ad valorem
tariffs, while in the summer of 1986,
Mexico became a member of the GATT.
Furthermore, in 1989 Mexico considerably liberalized its 1973 Foreign Investment Law, which previously made it very
difficult for foreigners to acquire majority ownership in any firm, and which
had imposed a variety of performance
requirements on foreign investors. Rules
dealing with acquisitions and changes in
existing businesses were also substantially liberalized as part of this legislation.
While some restrictions remain, they are
minor in comparison to what they were.
In 1991 the exchange controls that had
been established in 1982 were repealed.
Many state-owned firms, including many
state banks, have recently been privatized. Not only have Canada, Mexico,
and the United States recently signed
the North American Free Trade Agreement, but they have also recently signed
an income tax treaty lowering withholding tax rates on cross-border payments.
In combination,
these policy changes
should make cross-border investments
much more attractive than they had
been previously.
This Increase in cross-border activity will
significantly increase the importance of
any existing tax distortions to the form
that this cross-border activity takes. If
the tax law and tax rates were the same
in the two countries, then there would
be no tax implications of relocating activity across borders. However, the Mexican law, while broadly similar to the
United States law, differs along several
important dimensions.
*Economics Department, University of Mlchlgan, Ann Arbor
MI 48109
l *Departamento de Economia, Unlversldad Carlos III de Ma-
The objective
drid, E-28903 Getafe, Spain
$35
of this paper is to summa-
National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46
tax basis of existing capital used in calculating depreciation
deductions is fully
indexed for inflation. When calculating
capital gains, the basis his again indexed
for inflation-when
cal~culating gains on
corporate equity, past retained earnings
(indexed for inflation) are added to the
basis. Interest income and interest deductions are measured net of the capital
loss on the principal dye to that year’s
inflation, and cross-border payments are
measured net of the exchange rate gain
or loss that year on the principal. Frnally,
the cost of materials is’deducted at the
date of purchase rather than when the
materials’ are used in production.*
rize these tax differences and explore
their implications for the nature of crossborder activity that will develop between
the United States and Mexico. In addition, we WIII assess the implications of
the recent tax treaty between the two
countries for cross-border activity. In section 1, we start by comparing the
United States and Mexican tax laws,
pointing out important similarities and
differences in their provisions. Section 2
then discusses the implications of the
differences that exist for the pattern of
business activity in the two countries.
The implications for individual portfolio
choice are then ex.plored in section 3,
and the paper concludes with a brief
summary.
SUMMARY
SIONS
OF CURRENT
TAX
The United States, in contrast, has made
no explicit clttempt to correct its definition of taxable income for the effects of
inflation,3 though some ad hoc adjustrnents have been mad to compensate
for the resulting distor t ions to the definition of taxable income.’ To begin with,
depreciation deductions are based on
the tnominal cost of assets, though in
practice the tax law hab offset the effects of Inflation on the value of depreciation deductions by accelerating the
schedule of deductions, during inflationary periods4 Deductions for the cost of
rnaterials occur when the materials are
used, and are based on the original
nominal cost of the materials. By using
LIFO accounting, and so using the price
of the most recently pqrchased item in
its inventory when calculating its materials expense, a firm caln lessen (though
not eliminate) the resul~ting bias ‘to its
definition of taxable income. However,
many finns continue to use FIFO accounting, perhaps to make their accounting income look more favorable.5
Capital gains are calculbted based on
historical cost, though fthey are taxed at
a slightly lower rate unlder the personal
(though not the corporate) tax law. Finally, interest income and interest deductions are simply taxed based on their
PROVI-
In many ways, the Mexican and United
States tax laws are very similar. Both
federal governments tax corporate income at virtually the same rate (34 percent in Mexico and 35 percent in the
United States),’ and both have a progressive personal tax with a maximum
rate of 35 percent in Mexico and 39
percent in the United States. While Mexico has a value-added tax, and the
United States has a sizable payroll tax,
these differences are not likely to have
important implications for cross-border
activities. If the definitions of taxable income were the same in the two countries, then there would be relatively minor tax implications of cross-border
activity, given the similarity in tax rates.
The definitions of taxable income do differ along a few important dimensions,
however, and these differences can lead
to important changes in the real and financial behavior of firms. The key difference is that Mexico has carefully controlled for the effects of inflation in its
definition of corporate taxable income.
To begin with, under Mexican law the
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I
SYMPOSIUM ON TAX ASPECTS OF CURRENT POLICY ISSUES
nominal value, with no attempt made to
correct for inflation.6 This lack of correction for the effects of inflation under the
United States law has a variety of implications for domestic activity, as described in Auerbach(l981).
As seen below, it has important implications as well
for cross-border activity.
National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46
owners of the firm to deduct their business losses from other income.7
In both countries, a variety of fringe
benefit payments are not taxable under
the personal income tax though remain
deductible from business income. In addition, however, Mexico requires all
firms to pay ten percent of their taxable
profits to their workers. These profitsharing payments are deductible from
business income only to the extent to
which they exceed the amounts of benefits paid to workers that are nontaxable
under the personal income tax,8 yet
these payments are fully taxable under
the personal income tax.
There are a variety of other important
differences in the tax treatment of business income in the two countries. In
particular, the Mexican tax law contains
a variety of provisions attempting to prevent firms with tax losses from transferring these losses to firms with taxable
profits. To begin with, Mexican firms
that merge cannot pool losses from one
firm with profits from the other. In addition, leases cannot be used to transfer
depreciation deductions from one firm
to another. The lessee (not the lessor) is
the owner of the asset for tax purposes,
so the lessee takes the depreciation deductions on the physical asset; the lease
is treated as a loan for tax purposes,
and implicit interest payments are calculated from the actual lease payments.
Also, all firms in Mexico (whether corporate or noncorporate)
are taxed under
the same provisions, so all face the same
restrictions on the deductibility of tax
losses.
Finally, the definition of personal taxable
income also differs in various ways between the two countries. Since there has
been no relaxation to date in the restrictions on labor mobility between the two
countries, most of these differences will
have little impact on the nature of crossborder activities, simply affecting the
labor supply and domestic savings generated in each country. Some of the differences do deserve mention, however.
To begin with, in Mexico, dividends received from domestic firms are tax exempt. In addition, Mexican shareholders
can elect to pay tax on 1.515 (= 1 /
(1 - 0.34)) times their dividend payment
and then receive a credit for corporate
taxes paid on this amount, an option
benefiting small shareholders facing a
personal tax rate below 34 percent. Only
real capital gains, net of the real value
of reinvested profits, are taxable (and at
a somewhat reduced rate) under the
Mexican personal income tax, and gains
on securities traded on the Mexican Securities Exchange are entirely exempt
from tax. In the United States, in contrast, dividends and nominal capital
gains are fully taxable, though with a
slightly lower rate applying to capital
gains income. In combination,
these provisions imply that personal income from
While United States law is no longer as
lenient in its treatment of the transfer of
losses between firms as it was in the
early 1980s during the period of “Safe
Harbor Leasing,” it is still far more lenient than the Mexican law. In particular,
firms that merge can pool income for
tax purposes, as long as the merger did
not occur solely for this reason. Leases
can be used to transfer deductions from
one firm to another, as long as the lessor bears at least some risk commensurate with its being the nominal owner of
the asset. Firms that expect to have tax
losses can choose to be noncorporate,
allowing active (though not passive)
437
National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46
equity is treated much more favorably In
Mexico than in the United States. With
respect to Interest income, in the United
States, nominal interest income is fully
taxable, whereas in Mexico, nominal interest income is subject to a flat 20 percent tax rate,’ which would norrnally be
more favorable than the United States
treatment but less favorable than havrng
real interest income taxed at ordinary
rates, particularly for those in low tax
brackets.”
IMPLICATIONS OF TAX DIFFERENCES
FOR BUSINESS ACTIVITY
What are the implications of these differences between the United States and
the Mexican tax law for firm behavior?
We first examine the implications of
these tax oifferences for business activity, assuming that the only cross-border
financial flows are loans. We then con
sider how the tax law affects the patterns of cross-border Investments by
multinationals.
Effects of the Tax Law on Industrial
Location
To begin with, consider the implications
of existing differences in the tax provisions in the two countries on the relatrve
competitiveness of different types of
firms, assuming all firms are domestically
owned. The relative pattern of effective
business tax rates across different industries varies by country, because of many
of the provisions rn the two tax laws described above. To the extent that some
industry is relatively tax-favored in one
country, and relatively tax- penalized in
the other country, then these tax differences will encourage increased exports
(or decreased imports) from the first
country to the second country. As
noted, e.g , in Gordon and Levinsohn
(1990), these tax differences have very
similar effects to tariffs on patterns of
trade.” While explicit tariffs are being
reduced, implicit distortions to trade patterns arising from differences across
countries in effective tax rates by industry remain.
These drfferences in effective tax rates
can arise from many sources. To begin
with, debt finance is cheaper in the
United States than in Mexico, since
nominal interest payments are deductible
in the Ul-rited States but only real interest payments are deductible in Mexico.
Therefore, industries th,at are in a position to borrow more easily will be encouraged by these tax differences to locate in the United States.” In contrast,
material inputs are treated more favorably for tax purposes in Mexico, so firms
with substantial inventories ( e.g., mailorder houses) may want to locate in
Mexico.13 Since one firm’s tax losses can
more easily be offset against another
firm’s tax profits in the United States
than in Mexico, firms that may end up
generating tax losses would tend to locate in the United States. Industries generating substantial capital gains (e.g., insurance companies) would do better by
locating in Mexico, given the much more
favorable tax treatment of capital gains
there. The pattern of effective deprecia.tion rates by industry will also differ
some between the United States and
Mexico, again inducing some crossborder shifting of the locations of particular industries. By distorting trade patterns, these tax differences will prevent
the two countries from taking full advantage of the potential gains from
trade.
The required profit sharing by Mexican
firms can also affect the relative attractiveness of locating in Mexico for different types of firms. In tiheory, firrns expectrng to make higher profit-sharing
payments should be able to compensate
by rnaking lower wage payments. Yf the
offset were one for one, then the only
loss to firms from this provision would
I
SYMPOSIUM ON TAX ASPECTS OF CURRENT POLICY ISSUES
be the limits on the tax deductibility of
profit-sharing
payments, but not of
wages.14 However, there are a variety of
reasons for expecting the offset to be
less than one for one. To begin with,
some workers face minimum wage restrictions, restrictions that become more
binding for firms with higher profits because of this profit-sharing
requirement.
In addition, future profit-sharing
payments are risky. Since workers are likely
to be more risk averse at the margin
than the firm’s shareholders, they would
value this risky income less than shareholders, so would not be willing to fully
compensate shareholders through reduced wage payments for these promised payments. Furthermore, information
about future profits is asymmetric, so
that workers are likely to be skeptical regarding any forecasts the firm may make
about future profit-sharing
payments.
On net, we would expect risky firms and
highly profitable firms to have an incentive to relocate to the United States.
National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46
ment. In contrast, if the Mexican firm
leases equipment to the United States
firm, neither firm depreciates the capital.
But the United States firm can deduct
the entire lease payments, whereas the
Mexican firm is taxed only on the real
interest component of the payments. If
the repayments occur sufficiently quickly,
then the United States firm can in effect
expense its capital acquisition while generattng little or no tax liability for the
Mexican lessor.
Effects of the Tax Law on Investment
by Multinationals
What further complications arise when
considering the behavior of multinationals that maintain activity in both countries? The tax treatment of the foreign
earnings of multinationals
is very similar
in the two countries. In particular, both
countries tax multinationals
based in the
home country on their world-wide
income, with credits given for taxes paid
abroad. In both countries, these credits
can offset taxes due on this foreignsource income but cannot be used to reduce taxes on domestic-source
income.
In both countries, income from subsidiaries is taxed only when repatriated,
whereas income from branches is taxed
each year. There are a variety of detailed
differences, however. For example, Mexico does not attempt to divide foreignsource income into separate “baskets”
for tax purposes.
While secured loans and leases of equipment are in substance virtually equivalent transactions, they are treated very
differently under the tax law in the
United States, though not in Mexico.
This asymmetric treatment in the United
States law creates opportunities
for firms
to construct cross-border leasing arrangements in either direction that lower
their combined tax liabilities. If a United
States firm leases equipment to a Mexican firm, by statute both firms can depreciate the capital. Offsetting this benefit, however, lease payments are fully
taxable to the United States firm, but
only the real interest payments implicit
in the pattern of lease payments are deductible for the Mexican firm. If the
principal repayments are sufficiently
postponed in time, this arrangement
saves on taxes relative to the alternative
of the United States firm lending money
to the Mexican firm to buy the equip-
In thinking through the effects of the
tax law on the behavior of a multinational, assume, to begin with, that the
multinational
has excess credits and so
owes no further corporate taxes when
profits are repatriated. Under this assumption, differences in the definitions
of taxable income continue to have important implications. The same incentives
described above to shift activities across
borders operate as well within a multinational-multinationals
should readily
439
National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46
be able to tailor the location of particuliar functions within the firm to exploit
(differences n the tax law between the
‘two countries. For example, multlnationals would have the incentive to maintain
their inventories in Mexico, and to do
their borrowing
in the IJnited States.15
‘The recent Tax Treaty, by reducing some
of the withholding
tax rates on payments made to the parent firm,‘” will
also make cross-border equity investments more attractive for frrms in an excess-credit position than had previously
been the case.
In theory, multinationals
can take advantage of any differences in statutory tax
rates between the two countries by using transfer prices to shift taxable income from the high tax to the low tax
location. Since the statutory tax rates are
virtually the same in the two countries
(ignoring United States state Income
taxes), how,ever, a multinational
will normally face Ittle incentive to make use of
transfer pricing. However, when operations in one country are subject to minrmum tax provisions then these operations face a distinctly lower marginal tax
rate on reported income--for
example,
a Mexican firm whose taxable income is
low enough that it is subject to t.he two
percent asset tax would face a zero percent marginal tax rate on reported income. In this case, a multinational
would
indeed have an inc:entrve to use transfer
prices or other means to shift taxable
profits into Mexico until all surcharges
under the assets tax have been eliminated. Conversely, if only the United
States firm were subject to the minimum
tax, then the firm would have the incentive to shift profits into the United
States. Since, as noted by Lyon and Silverstein (1994), many 1Jnited States multinationals are subject to the alternative
minimum tax, these opportunities
to
make use of transfer pricing are likely to
be common.
This analysis changes drlamatically if a
multinational
is in a deficit-credit position and so owes corporate surtaxes on
net when profits are re atriated. The
size of this surtax will v ry substantially
by industry--industries
hat face larger
surtaxes would be put t a competitive
disadvantage when inv i sting in the
other country. What ca be said about
the likely size of any su 1tax owed? Consider first the situation faced by a Mexrcan parent investing in [he United
States. Mexico does not try to recompute the taxable income of a United
States subsidiary using 4 Mexican definition Iof taxable income, lrelying instead
on the United States d finition of taxable income. Since the IJ nited States
statutory tax rate is slightly higher than
the Mexican rate, the credit received for
United States income tax liabilities would
slightly more than offse/t a firm’s tax liabilities under the Mexicbn corporate income tax. l7 As a result,~ firms with deficit
credits could be at an dvantage relative
to firms with excess credits
when invest“:
ing in the United States.
What about the case of a United States
firm investing in Mexico? Under United
States law, when profits are repatriated,
the llnited States taxable income generated equals the Mexican firm’s earnings
and Iprofits as defined
nder the United
States tax code.18 A credit is then given
for actual inlcome taxes1 that have been
paid in Mexico.‘” Since the United States
tax r,ate is sllightly high e r, the United
States income tax liabili ies would be almost offset by the credit for Mexican income tax liabilrties if th definitions of
taxable income were theI same under the
two tax laws.
U
But definitions of taxable income are not
the same across the tw, countries. A variety of differences caude taxable income
as defined under Mexiclan law to be
larger than the rneasur of foreignsource income specific f by the United
0
I
SYMPOSIUM ON TAX ASPECTS OF CURRENT POLICY ISSUES
States law.” For one, the United States
law allows a deduction for nominal
rather than real interest payments. Also
under the United States law, profitsharing payments to Mexican employees
should be entirely tax deductible,
whereas in Mexico they are only partly
deductible. In addition, under Mexican
tax law payments by the subsidiary to
the United States parent are deductible
only when they are for a specific service
that is strictly indispensable for the conduct of the business, whereas the United
States law allocates overhead expenses
between parent and subsidiary in proportion to assets.
National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46
offset taxes due on profits repatriated
from other countries.2’ As a result, a
firm in a deficit-credit
position could be
put at a competitive advantage relative
to a firm in an excess-credit position
when investing in sectors where taxable
income is larger as defined under the
Mexican law than under the United
States law.
One omitted complication in the above
discussion is that a United States parent
cannot receive a credit for any payments
made under the Mexican assets tax,
since it is not deemed to be an income
tax. This tax serves as a minimum tax,
and is due only to the extent to which
income tax liabilities in Mexico fall short
of two percent of assets. Firms with subsidiaries subject to the assets tax would
face a strong incentive to shift taxable
income from the parent to the subsidiary
in order to convert assets tax payments
into income tax payments, which are
creditable against United States tax liabilities.
There are other differences between the
two tax laws that would cause the
United States definition of taxable income to be larger. For example, the
United States provides a less generous
tax treatment of inventory holdings. In
addition, the United States law allows
only straight-line depreciation to be used
when defining foreign-source
income,
with quite conservative estimates of the
lifetimes of each type of capital. While
the Mexican law shares both of these
attributes, it differs because it allows the
basis of remaining capital to be indexed
for inflation, leading to more generous
deductions.
EFFECTS OF THE RECENT CHANGES ON
INDIVIDUAL PORTFOLIOS
Several of the recent tax changes have
important implications for individual
investors considering investing in the
other country. For one, the recent tax
treaty signed by the two countries reduced or even eliminated withholding
tax rates on payments received by residents of the other country.22 Also, the
signing of an information-sharing
agreement between the two countries will facilitate tax enforcement on income
earned by a country’s residents in the
other country. What will be the implications of these recent changes?
To the extent that taxable income for a
Mexican subsidiary is larger as defined
under the United States tax law than it
is under the Mexican law, then the
United States parent would owe additional taxes when profits are repatriated.
A United States firm that owes relatively
large surtaxes when repatriating profits
from Mexico would be put at a competitive disadvantage relative to other
United States firms that might invest in
Mexico. If the credits a firm receives
when it repatriates profits from Mexico
exceed its United States tax liabilities on
this income, however, then it can potentially make use of these excess credits to
In the past, Mexico has faced a severe
problem with capital flight-domestic
investors shifted substantial funds
abroad in part to avoid domestic tax liabilities. The threat of this flight has kept
441
National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46
I
SYMPOSIUM ON TAX ASPECTS OF CURRENT POLICY ISSUES
The recent tax changes should have less
effect on the net tax rate faced by
United States portfolio investors in Mexico. To the best of our knowledge, there
has not been a significant amount of
evasion of tax on Mexican source portfolio income by United States residents.26 As a result, the recent changes
in law should have little effect on the
net tax rate faced on direct investments
by United States residents in Mexican securities.
The above paragraphs describe the tax
treatment of funds invested directly in
the other country by individual investors.
A substantial fraction of an individual’s
financial assets are likely to be held by
pension funds, insurance companies, or
other financial intermediaries.
How will
the recent Tax Treaty affect the investment incentives faced by financial intermediaries? The change is the most dramatic for pension funds. Previously,
these funds faced no taxes on income
from domestic investments, but had to
pay sizable withholding
taxes on income
received from investments in the other
country. Now, these withholding
taxes
have been virtually eliminated, making
cross-border investments much more attractive.*’ Given the large size of pension funds, this tax change will likely
have important effects.
The investment patterns of banks and
insurance companies are likely to be less
affected by the recent tax changes. The
information-sharing
agreement will probably have little effect on the tax liabilities
of these firms, since auditing requirements for financial intermediaries
have
been quite strict. The reductions in withholding tax rates matter only for those
firms in an excess-credit position. Since
withholding
tax rates in most cases have
been lower than domestic tax rates,
both before and after the recent tax
treaty, financial intermediaries should in
most cases have been able to obtain full
National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46
credits for withholding
tax payments.
The key possible exception is the withholding taxes paid on capital gains,
which for investors in either country
used to be larger than the domestic liabilities faced on these capital gains.
Now, capital gains are exempt from
withholding
taxes, so that financial intermediaries will no longer be discouraged
from investing in assets in the other
country that generate capital gains.
Conclusions
On the whole, the United States and
Mexican tax laws are very similar, so
that shifting activity across borders between the United States and Mexico will
normally generate only small tax consequences. On the whole, therefore, the
increase in cross-border activity brought
on by the recent policy changes should
not generate much immediate pressure
to rethink domestic tax policy in either
country.
There are a few differences between the
tax laws in the two countries that can
generate immediate problems, however.
One is the differing tax treatment of
leases-in
the United States, the lessor
owns the asset for tax purposes,
whereas in Mexico the lessee does. Firms
are likely to find creative ways to exploit
these differences in provisions. The other
key difference is that Mexico has been
careful to correct its definition of taxable
income for the effects of inflation,
something the United States has not had
to do because of the much lower inflation rates, historically, in the United
States. These differences in the definitions of taxable income generate nontrivial tax incentives to shift activities across
borders. The resulting distortions to the
location of economic activity will prevent
the two countries from taking full advantage of the potential gains from
trade. Since in all of these examples, the
United States definition of taxable in-
National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46
come differs much more from eclonomic
income than does the Mexican definition, United States tax revenue is likely
to be much more affected than Mexican
tax revenue by any attempts firms make
to exploit the above differences in tax
provisions. As a result, the United States
will likely face more pressure than Mexico to rethink its domestic tax policies,
or at least to seek to coordinate tax policies with Mexico.
Ii
”
”
Note that these differences in tax provisions predate NAFTA, and were not
changed by NAFTA.28 However, the
likely increase in cross-border activity resulting from the various recent policy
changes, including NAFTA, will increase
the importance of these tax differences
for the composition of real and financial
cross-border activity between the two
countries.
”
’i
ENDNOTES
’ United States states also have their ovvn corporate taxes, wth rates as high as 12 percent; no
such supplementary
taxes exist in Mexico. In
addition, the United States has an alternative
minimum tax and Mexico has an assets tax,
each designed to impose a minimum tax liability on firms.
’ This provision is more favorable than simply indexing the cost of materials for inflation since It
accelerates the deduction for materials from
the date of use to the date of purchase.
3 Such provisions were included in the original
Treasury I proposal in 1984, but were never
submitted IO Congress.
4 For evidence on this, see Auerbach and Hines
(1988).
5 See Cummlns, Harris, and Hassett (1994) for
further disc uc;sion.
6 See Gordon and Slemrod (1988) for an assessment of the importance
of this bias for the
United Stales tax system
’ Passive owners can at least deduct losses from
one firm against profits from another firm.
’ If profit-sharing
payments exceed nontaxable
benefits, then this provision impllcitly makes
these nontaxable benefits nondeductlble
as
well under the business tax. Since the business
tax rate virtually equals the maximum personal
tax rate, benefits are as a result normally
”
treated less Favorably than other income under
the Mexican tax law.
To the degree that interest. rates exceed ten
percent, the excess is exempt from this tax.
Given that nominal intere$ rates normally exceed ten percent, actual tdx payments equal
0.02 per peso of debt. If instead real interest
were taxable, even if the @aI interest rate were
as Ihigh as 0 05 and a shareholder
were in the
top tax bracket, tax liabilities would still equal
only 0.0175 per peso of debt.
The effects of a tariff on a, particular good can
be exactly duplicated by ir$posing a domestic
consumption
tax on that good and an offsetting subsidy to domestic production
of that
good. While neither coun$ry has production
subsidies per se, granting 8n industry more favorable treatment than other industries under
the corporate tax law has many of the same effects.
By the same reasoning, firtns that expect to receive substantial interest itKome (e.g., insurance cornpalnies) would g&n by locating in
Mexico.
Another advantage of a rr)ail-order house moving to Mexico is that Unitdd States customers
of Mexican mail-order houses could then easily
evade United States state bales taxes.
Once profit-sharing
paymqnts exceed nontaxable benefits paid to workdrs, any further profitsharing payments are full9 deductible.
“’ This would IlIkely be true iril spite of provisions
In the United States code ihat restrict interest
deductions
In the United $tates by a multinational based on the fractiqn of the multinational’s assets located in the United States,.
lb The United States reduced Its withholding
tax
rate on dividends paid to B Mexican parent firm
from 30 percent to 5 percpnt-the
Mexican
rate was already zero. Under the Treaty, capital
gains ar13 made exempt from withholding
taxes
unless the parent firm’s ownership
share is
more than 25 percent, in which case they remain taxable.
Credit for wtthholding
tax, payments could then
lead to a net rebate of taNes on repatriation.
Such a rebate occurs wheh foreign-source
income from the United Staltes is pooled with
other foreigin source incoke, reduciny the
taxes due at repatriation
on this othe; income.
If only part of the profits #e repatriated,
then
tar is ovved on the fractioo of profits equal to
the ratio of dividends recdived to after-tax
earnings in Mexico (again as defined under the
United States tax law).
Mexico does not impose a withholding
tax on
dividend payments.
444
SYMPOSIUM ON TAX ASPECTS OF CURRENT POLICY ISSUES
United States law measures foreign-source
income based on the foreign firm’s earnings and
profits, so does not extend various tax benefits
such as accelerated
depreciation
to foreign
firms.
If the United States parent owns more than 50
percent of the shares in the Mexican subsidiary,
then it can pool repatriations
from Mexico with
those from other countries, allowing it to make
use of any excess credits it receives on its Mexican investments.
If the parent owns between
ten percent and 50 percent of the shares in the
Mexican subsidiary, however, then repatriations from Mexico would be treated as a separate “basket,”
in which case United States tax
liabilities on repatriated
earnings from Mexico
must be nonnegative.
Given that some restrictions still exist making it difficult for a foreign
firm to acquire a majority position in a Mexican
firm, the latter case should be not at all uncommon.
Mexico already had no withholding
taxes on
dividend payments;
the United States reduced
its rate on dividends from 30 percent to 15
percent. The United States already had no
withholding
tax on interest; the Mexican rate
had varied from 15 percent to 35 percent depending on the source of the interest. Now the
Mexican rate equals 15 percent for payments
to individual investors, 4.9 percent for payments to banks and insurance companies, and
zero percent for payments to a pension plan.
The Treaty eliminated any withholding
taxes on
capital gains. Prior to the treaty, the United
States had a 30 percent withholding
tax rate
on capital gains, while Mexico had a 20 percent tax on the gross proceeds from a sale, except for securities traded on the Mexican Stock
Exchange, which were exempt.
Investors could receive a credit for withholding
taxes paid abroad on this income.
As noted above, the domestic tax owed on corporate profits should be at least offset by the
credit received for United States tax payments
because of the slightly higher statutory tax rate
in the United States. While repatriated
dividends lead to higher profit-sharing
payments
to workers, in theory at least this should be offset by lower wage payments.
For further discussion of the relative tax treatment of portfolio versus foreign direct investment abroad, see Gordon and Jun (1993).
National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46
26 As long as Unlted States investors invest in
Mexican securities through United States financial intermediaries,
the United States government can rely on information
it obtains from
these intermediaries
to enforce the tax.
27 Income earned by United States pension funds
in Mexico is now entirely exempt from withholding taxes; only dividend income earned by
Mexican pensron funds in the United States is
still subject to withholding
taxes.
28 The main tax changes associated with NAFTA
were reductions
in some withholding
tax rates,
which will matter only for taxpayers who have
not been recetving credits for these withholding taxes against their domestic income taxes
because they were in an excess-credit
position,
were evading domestic taxes, or were exempt
from domestic taxes.
REFERENCES
Auerbach,
Alan J. “Inflation
and the Tax Treatment of Firm Behavior.” American Economic Review 77 (1981): 419-23.
Auerbach,
Alan J. and James R. Hines, Jr. “lnvestment Tax lncentrves and Frequent Tax Reforms”
American Economic Review 78 (1988):
21 l-6.
Cummins,
Jason G., Trevor Harris, and Kevin
Hassett.
Accounting
Standards, information
Flow,
and Firm investment
Behavior. Mimeo.
Gordon,
Roger H. and Joosung
Jun. “Taxes and
the Form of Ownership
of Foreign Corporate
Equity.” In Studies /r-r international
Taxation, edited
by Albert0 Giovannini,
R. Glenn Hubbard, and Joel
Slemrod. Chicago: University of Chicago Press,
1993.
Gordon,
Roger H. and James Levinsohn.
“The
Linkage Between Domestic Taxes and Border
Taxes.” In Taxation /n the Global Economy, edited
by Assaf Razin and Joel Slemrod. Chicago: University of Chicago Press, 1990.
Gordon,
Roger H. and Joel Slemrod.
Do We
Collect Any Revenue from Taxing Capital Income?
Tax Policy and the Economy 2 (1988): 89-l 30.
Lyon, Andrew
B. and Gerald Silverstein.
The
Alternative
Minimum Tax and the Behavior of
Multinational
Corporations.
Mimeo.
Price Waterhouse
Doing Business in Mexico.
New York: Price Waterhouse
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1993
National Tax Journal
Vol. 47, no. 2, (June, 1994), pp. 435-46