Taxes and Foreign Policy

The United States’ use of economic tools to pursue national security and foreign policy goals is at a high-water mark, reflecting a trend that has persisted across both Democratic and Republican presidential administrations. Familiar tools such as financial sanctions and export controls are being used more than ever before, and new instruments are being added to the toolkit. Under former President Trump, the United States imposed import restrictions on sensitive technologies, limited US investment in certain Chinese companies, and threatened to delist certain companies from US exchanges if they do not comply with information requests. President Trump also deployed import tariffs explicitly for foreign policy—rather than trade policy—reasons, representing a break from past practice.

We are concerned that placing increasing weight on these economic levers of influence could cause them to break, and in a recent article we argue that adding income tax law to the suite of tools of economic statecraft can help. Specifically, we argue that tax law can help achieve US foreign policy goals by imposing ‘tax sanctions’ on foreign targets, by increasing their tax rates or widening the tax base.

The case for tax sanctions

Our first concern about sticking with the status quo is that over-use of the existing tools—such as financial sanctions—will undermine their long-term effectiveness if foreign persons concerned about being targets divest from their US exposure. The United States derives considerable benefits—reduced borrowing costs, for example—from the fact that the US dollar is the most important global reserve currency and the fact that US financial institutions are centrally important in clearing international transactions. If the threat of being subject to US financial sanctions deters foreign states and individuals from investing in US dollar-denominated assets or using US banks, the United States will bear large domestic costs.

Using the income tax to pressure foreign targets of US foreign policy can impose costs that can only be avoided by avoiding all markets creating income subject to US tax. This would be a steep price for those targets, one that we assess many of them would be unwilling to pay. Assuming they remain exposed to US tax jurisdiction, the United States can influence their choices in a way that benefits its policy goals.

Our second concern is that the current patchwork of economic tools has incomplete coverage, targeting certain industries and certain kinds of transactions, but leaving gaps. The United States income tax reaches all US citizens and tax residents, foreign corporations with businesses (or permanent establishments, under any applicable treaty) in the United States, and foreign persons earning passive income from US sources. Adding the income tax to the tools available to US policymakers gives US economic statecraft broader coverage than it currently has.

Third, the US federal income tax provides significant flexibility in how it can be used to apply pressure. Tax sanctions can be modulated and adjusted by degrees—such as with modest increases in rates or less favorable rules for deductions—whereas import and export restrictions and financial sanctions often prohibit specified transactions entirely. This flexibility would allow the United States to apply economic pressure in degrees, learning about the consequences of that pressure before deciding whether to go further.

Past and present

There is a long history of using tax law for foreign policy goals in the United States. Throughout the 20^th century, income tax incentives were used to encourage US investment in strategically important countries—including countries throughout Latin America during the Cold War—as well as US possessions. The United States also has more than sixty income tax treaties with other countries to facilitate cross-border trade and investment.

But under current US domestic law, one mostly finds only the residue of outdated foreign policy issues and rules that are out of step with ongoing developments in international taxation. For example, US multinationals are subject to current tax on the income of their subsidiaries earned in countries that support terrorism or that participate in an Arab League boycott of Israel, which dates back to the 1970s. But when the United States significantly changed its international tax rules in 2017, it took much of the force out of these rules because almost all income of foreign subsidiaries is now subject to current US tax regardless of where it is earned. We could find no discussion in the legislative record reflecting recognition of the effects these dramatic tax law changes would have on the foreign policy provisions of US tax law, which points to general neglect of these rules by US lawmakers.

It is also unclear how these rules will be affected by implementation of the global ‘two-pillar solution’ negotiated at the Organisation for Economic Co-operation and Development (OECD), which contemplates a global minimum tax on multinational enterprises and an allocation of taxing rights to developing countries. We argue that the time is right—indeed urgent—to re-evaluate and reinvigorate the use of tax law to achieve US foreign policy goals.

Objections and replies

Using tax law for foreign policy purposes has its problems. There is the risk of lawmakers using tax law for protectionist goals under the pretext of national security. And there is the need to ensure that tax legislation—which is enacted by members of Congress—can respond nimbly to changing circumstances and accommodate the expertise of the executive branch of the US government, which has a prominent role in foreign policymaking. But we think that these risks can be managed, and that the costs are in any event worth the benefits.

The most important legal obstacle to the United States using the income tax in foreign policymaking is its World Trade Organization (WTO) obligations. We imagine, for example, that the United States might in some cases want to impose higher rates of withholding tax on interest or dividends paid to foreign persons who do business with a target whose activities adversely affect US policy. Such a rule would probably not comply with US obligations under the WTO unless there is an applicable exception. Here, the United States could invoke the national security exception under Article XXI of the General Agreement on Tariff and Trade. As scholars such as Professor Tania Voon have noted, there is significant uncertainty around the scope of that exception and the United States has adopted an interpretation that gives it a great deal of flexibility.

Using tax law as a foreign policy tool requires trading off the benefits against the risk of undermining the global liberal trade and investment regimes, just as it requires trading off those benefits against the domestic political risks of encouraging rent-seeking and protectionist impulses. These are hard choices, but we think that the benefits justify the costs.