How U.S. Policy Affects Other Countries' Tax Rates

By Jonas Elmerraji | March 30, 2010 AAA

With a focus on domestic policy of late - thanks to a sweeping healthcare bill and student loan reforms โ€“ it's been hard to turn on the television without hearing pundits talk about how policy changes are going to affect our tax bills. But the impact of U.S. policy doesn't end at our shores; in fact, legislation and policy passed in Washington can have a significant effect on tax rates in other countries.
In today's increasingly global market environment, that fact brings with it some serious implications for your portfolio. Here's a look at how U.S. policy affects tax rates abroad.

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Foreign Aid
One of the biggest, most direct ways that the U.S. government impacts the financials, and in turn the taxes, of other countries is through direct foreign aid. With over $40 billion in foreign aid doled out to recipient countries in 2007, the U.S. is by far the biggest donor on absolute terms. As a result, the United States has a disproportionate effect on the finances of developing countries.

Foreign aid essentially works to plug budget holes in developing countries, allowing them to spend more money on public works than they would be able to sustain on tax revenues and borrowing alone. Despite the fact that foreign aid is designed to develop economies and decrease poverty, some research shows little to support the notion that sending dollars overseas actually decreases poverty.

Recipients of foreign aid tend to have political and economic systems that benefit a relatively small number of people, while underserving the rest of the population. One of the easiest ways to tell that is through the Gini coefficient, a number used by economists to show the gap between a country's rich and poor. Because countries that receive the most foreign aid also have high Gini coefficients, an uneven distribution of power often result. (Learn more in The Gini Index: Measuring Income Distribution.)

A good example of this is Pakistan, a country where American politicians (like Secretary of State Hillary Clinton) have lobbied for tax reform. Pakistan's biggest issue is an inefficient tax system that fails to generate enough revenue to operate the country without help from the West - something that Finance Minister Shaukat Tareen says would be unnecessary if the country stopped corruption and collected reasonable taxes.

According to Probe International, an independent advocacy group, foreign aid provides financially unsound countries with a crutch โ€“ and gives little incentive for reform as long as free money is flowing in from other parts of the world. But thanks to politicking from U.S. leaders who are eager to cut back on payouts to foreign nations, as well as the unpopularity of aid in general in Pakistan, the chances of an improved tax situation look very real.

Economic Sanctions
On the other end of the spectrum are the tax issues that come from economic sanctions. When the U.S. forms a policy that exerts economic pressures on another country, one of the consequences is typically lowered tax revenue. Countries that find themselves in a deficit situation because of this will often have to resort to changing their tax rates to compensate. (To learn more, check out The Power Of Economic Sanctions.)

We're All Connected
Another, less obvious, way that U.S. policy dictates foreign tax rates is through our own domestic tax rates. Today, the world's economies are more connected than ever before - and as a result, private U.S. dollars are being put to work abroad as investments. Overseas investments stimulate developing economies and ultimately (theoretically) increase the GDPs of the host country. But while our dollars are being put to use more than ever before abroad, an increasing number of investment choices has meant that countries need to be creative to compete for investment dollars.

Because tax rates affect the financial performance of companies, many countries opt to provide special tax advantages to public companies and new investors in order to elicit investments from abroad. Those policies aren't relegated to U.S.-based investors (who admittedly still have to pay U.S. taxes on capital gains and distributions) - they also apply to companies that choose to domicile themselves in a more tax-advantaged jurisdiction.

In fact, according to a 2008 study by the Government Accountability Office, more than 83 of the 100 largest publicly traded U.S. companies had subsidiaries in tax havens or financial privacy jurisdictions like the Cayman Islands and Bermuda. These tax havens exist specifically because their tax systems have been crafted to attract big businesses. (For more, see Taking A Look At Tax Havens.)

Global Tax Citizens
While we may think that U.S. policies have little effect on the taxes that others pay, the truth is that even seemingly minor changes in policy in Washington can have significant effects on citizens of other countries. Ultimately, through foreign aid, sanctions and our own tax rules, we dictate a big chunk of other nations' tax systems. (For a complete look at our tax system, check out our Investopedia Special Feature: Income Tax Guide.)

If you're still feeling uninformed, check out last week's business highlights in Water Cooler Finance: Auto Hope, Bubbling Oil and Obamanomics.

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