Tax Reform Act of 1986 Hurt U.S. Competitive Position

To the extent that joint ventures provide unique opportunities, the separate 'basket' provisions of the TRA significantly weaken the competitive positions of U.S. firms in foreign markets.

Economists long have known that government policies, from anti-trust regulation to tariffs and taxes, play a role in encouraging business to favor certain competitive strategies and organizational frameworks over others. For example, the tax policies of the early 1980s encouraged business investment in plant and equipment. Similarly, the unincorporated firm remains popular in the United States because the corporate income tax must be paid by corporations. The impact of taxes on international business, however, has been more difficult to identify, presumably because so many other factors come into play in the international arena.

In "Basket" Cases: International Joint Ventures After The Tax Reform Act of 1986 (NBER Working Paper No. 5755), Mihir Desai and James Hines, Jr. find that the "organization of international business appears to be very sensitive to its tax treatment." The authors come to their conclusion by examining the impact of the Tax Reform Act of 1986 (TRA 86) on international joint ventures in which American firms have a minority (less than 50 percent) interest. Through the mid-1980s, U.S. multinationals increasingly used joint ventures to share risks with, and learn from, foreign partners in quickly growing markets. But TRA 86 overhauled the tax treatment of dividends received from international joint ventures where an American company owned 10 to 50 percent of the enterprise. The tax law placed new limits on the worldwide averaging of foreign tax credits by requiring companies to segregate income from joint ventures owned 50 percent or less by an American firm into distinct "baskets." This change in the tax law increased the cost of U.S. joint venture activity, especially for ventures in low-tax countries.

The result was that U.S. participation in such "minority" share joint ventures declined sharply after 1986. For example, joint ventures constituted 23 percent of the assets of U.S.-owned foreign affiliates in 1982, but only 19 percent in 1989 and 15 percent in 1993. The tax law revision also affected U.S. investment patterns, capital structures, and the compensation for technology transfers in joint ventures. For instance, Desai and Hines point out that even as American joint venture activity grew slowly between 1982 and 1989 in countries with low tax rates, it remained relatively robust in high-tax countries. By raising the cost of dividends received from joint ventures in low tax countries, the "basket" provisions also encouraged American firms to prefer higher debt/asset ratios in their affiliates and to substitute royalty payments for dividends from joint venture partners. "To the extent that joint ventures provide unique opportunities, the separate 'basket' provisions of the TRA significantly weaken the competitive positions of U.S. firms in foreign markets," say the authors, an outcome that was certainly not the intent of the Tax Reform Act of 1986.