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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 In 1991 the exchange controls that had been established in 1982 were repealed.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 430 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 Information Series, 1993 National Tax Journal Vol. 47, no. 2, (June, 1994), pp. 435-46