This paper examines the extent to which World Trade Organization (WTO) rules impinge on policymakers’ freedom to formulate tax policies. It provides an overview of both the economic rationale for WTO rules concerning taxation and the provisions of the main WTO agreements concerning border taxes and internal taxes (direct as well as indirect).

It also points out some tax anomalies and inconsistencies in these rules, and how the rules have evolved as a consequence of the interpretation of the WTO agreements by its Dispute Settlement Body and the latter’s rulings in connection with several disputes over taxes affecting trade.

As WTO Members will undoubtedly want to avoid having their tax policies successfully challenged in the WTO, the paper provides some guidance concerning the design of tax policy.

Introduction

Despite more than six decades of multilateral trade liberalization unleashed by the General Agreement on Tariffs and Trade (GATT) in 1947, protectionist policies persist in many international goods markets. Perhaps the greatest challenge regarding the design of multilateral trade rules is the concern that trade liberalization commitments with respect to one policy instrument, such as tariffs, may be vitiated by other protectionist instruments unconstrained by such rules. Consequently, multilateral trade and other agreements must address a wide range of potentially protective measures, including tax measures other than tariffs.

Tariffs and other indirect taxes, whether levied at the border or internally, have long been subject to the binding multilateral rules embodied in the GATT. However, in recognition of the fact that tax measures can be used as substitutes for other types of protection and government assistance or regulation, direct as well as indirect taxes have come under increased scrutiny at the World Trade Organization (WTO). This recognition is reflected in several of the agreements negotiated under the Uruguay Round, notably those concerning subsidies and trade-related investment measures (TRIMs). These agreements reflect the realization by national governments that multilateral rules need to play an increasingly important role in regulating the use of tax as well as non-tax measures, especially where these measures affect the international movement of goods, services, capital, technology and persons.

As a consequence of these agreements, the range of tax measures challenged by WTO Members has widened considerably beyond the more traditional trade taxes. Since 1995, taxation has been the cause of over 40 of the 500 disputes that have been initiated with Members’ requests for consultations submitted to the WTO’s Dispute Settlement Body (DSB), which is now arguably the world’s most prolific international dispute resolution system. Roughly half of these disputes have resulted in the establishment of panels and consequent rulings by the DSB. The DSB’s rulings against Indonesia’s National Car Programme and especially against the United States concerning the latter’s Foreign Sales Corporation (FSC) scheme, which, at the time, led to the largest retaliation award ever authorized in a dispute at the WTO, are particularly noteworthy. These rulings confirmed, if there were ever any doubt, that, generally speaking, direct as well as indirect taxes (including, of course, not only tariffs), are subject to WTO rules, notwithstanding efforts by tax authorities to secure specific exemptions for certain direct tax measures in these agreements. The FSC ruling also reconfirmed the traditional distinction under multilateral trade rules between direct and indirect taxes, especially with respect to how such taxes should be treated under the border tax adjustment and subsidy rules of the WTO. It would not be surprising if other WTO-inconsistent tax measures were identified in the future, leading to further disputes among WTO Members. WTO rules can therefore be expected to continue to be an important factor in shaping tax policies, as Members will undoubtedly want to avoid having their tax policies successfully challenged in the WTO.

This paper provides an overview of the extent to which taxation is subject to WTO rules, which embody the fundamental principles of non-discrimination, predictability and transparency. Section II provides a synopsis of the possible economic rationale for these principles (and thus the main provisions of the GATT/WTO agreements), which can be ignored by readers already familiar with the basic theory of trade policy instruments. Section III focuses attention on the basic rules of the GATT/WTO agreements as well as several other provisions that are especially relevant for tax policymakers. Section IV examines how these rules have been interpreted by the DSB in a few selected cases concerning tax measures. Section V contains some concluding remarks. The Annex provides some guidelines concerning WTO rules for tax policymakers.

Economic Rationale for WTO Rules

Before providing an overview of the extent to which GATT/WTO rules encompass taxation, this section considers the possible economic rationale for the main rules and their underlying principles, namely non-discrimination, predictability and transparency. The broad aim of these rules is to regulate, if not remove, distortions to trade. These distortions contribute to economic inefficiency, by, for example, reducing consumer choice, raising prices to consumers, including downstream processors, and disrupting global supply chains, thus impeding economic development. Attention here is focused mainly on the GATT because the fundamental principles and consequent obligations embodied in this agreement form the basis for the other WTO agreements, such as the General Agreement on Trade in Services (GATS). In some respects, however, WTO tax rules appear to be anomalous or, indeed, inconsistent with economic theory concerning trade taxation.

Notwithstanding the considerable progress made in dismantling barriers to trade as a result of multilateral negotiations under the auspices of the GATT/WTO, protectionist policy measures are still widely used by WTO Members for various reasons, compelling or not. These may include: shifting the terms-of-trade in a country’s favour; protection of specific domestic “infant” industries; correction of “market failure”; conservation of natural resources; assistance to downstream processing of such resources; food security; or as a counterbalance to domestic or other countries’ trade distortions (in accordance with the theory of Second Best). In some mainly developing countries, they are also still an important source of tax revenues. Among the various protectionist measures available concerning trade in goods are tariffs (non-discriminatory or discriminatory), quantitative restrictions (quotas), voluntary export restraints, export taxes, discriminatory tax policies, and subsidies, including tax incentives. Some of these (and other measures) may have similar or equivalent economic effects, particularly concerning their deadweight efficiency losses, while others can have very different effects. There may also be inherent similarities or differences concerning their transparency, predictability, susceptibility to rent-seeking, ease of administration, etc.

The rest of this section provides an analysis of these non-tariff measures in comparison with a tariff, irrespective of whether government intervention to restrain trade makes economic sense or not. It also highlights some well-known instances of economic equivalence as regards different measures. At the same time, it identifies protectionist tax policy measures that do the least damage. After all, damage limitation is often a major challenge for tax, if not other, policymakers. In doing so, it is shown that, by and large, WTO rules do encourage “efficient protection,” particularly as far as goods markets are concerned (Sykes, 2001). A comparison of tax measures suggests that non-discriminatory tariffs and domestic subsidies, including those in the form of tax relief, tend to involve relatively “efficient protection” and that these measures are less constrained by WTO rules. More damaging forms of protection are, to a large degree, discouraged, if not prohibited.

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This material was prepared at the request of the IMF; Mr. Daly is a member of a panel of fiscal experts advising the IMF’s Fiscal Affairs Department. The analysis and policy considerations expressed in this publication are those of a member of the author and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.