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Paper Studies US Foreign-Earned Income Exclusion Reform

by Mike Godfrey,, Washington

01 November 2013

In one of its papers discussing possible United States tax reforms, the Committee for a Responsible Federal Budget (CRFB) has focused on the foreign-earned income exclusion for Americans living abroad, which was introduced as a way to compensate those living in higher cost-of-living countries.

It concluded that "the exclusion may not be the best way to reflect differences in cost of living, since it does not account for lower cost-of-living countries, and completely eliminates income tax liability for some US citizens in low-tax countries," and that Congress "will have to decide whether the exclusion is worth keeping or whether it is worth scaling back or eliminating for deficit or tax rate reduction."

The US taxes income based on American citizens' worldwide income. Americans living abroad are therefore taxed both by the country they are living in and the US, but can claim a tax credit to avoid double taxation. However, in addition to that tax credit, the foreign-earned income exclusion allows US citizens to exclude the first USD97,600 (indexed for inflation) of foreign-earned income, so that money is only taxed by the country of residence, not the US.

There is also a related exclusion for housing allowances paid by an employer (or a deduction for self-employed housing expenses), which are limited to 30 percent of the income exclusion, and federal employees, while not benefiting from the exclusions, obtain a separate set of tax benefits.

The CRFB notes that the foreign earned income exclusion "is designed to prevent a US taxpayer who moves to a high-cost country from paying more taxes than a similarly situated taxpayer in the US, since the standard deductions are not adjusted for a higher cost country."

It adds that "the exclusions do not matter to a US citizen living in a high-tax country, since they earn enough foreign tax credits not to pay any US tax. However, US citizens in low tax countries could pay little to no income tax due to these exclusions."

According to the Joint Committee on Taxation, the income and housing exclusions will cost USD6bn in 2014, or approximately USD90 billion over the next ten years – 84 percent of that cost arises from the income exclusion. It has also been estimated that repeal of the exclusions would save USD75bn between 2014 and 2023.

While those who benefit from the exclusions have much higher income on average than the overall population, the CRFB says that those in favor of keeping the foreign earned income exclusion and housing allowance argue that the provisions are necessary to align US taxation with that of other industrialized nations who do not tax their citizens who live abroad, and that the exclusions adjust for higher costs of living abroad and level the playing field for US-based multinationals that hire workers from home.

On the other hand, the CRFB points to opposing views on the exclusions as arguing that it is unfair to give Americans tax breaks for choosing to work abroad, subsidizing their lifestyle choice, and that, because many companies offer "tax equalization" packages promising employers that they will not pay any more tax overseas than they would pay in the US, the exclusions subsidize employers sending employees overseas.

The foreign-earned income exclusion has been a frequent target for repeal in tax reform bills and other plans that would repeal or limit it in some way, but the CRFB also considers the proposal to make the exclusion unlimited so that the US tax code for individuals would be transformed from the current "worldwide" system to a "territorial" system in which only people residing in the US would be taxed by the Federal Government, and a variant that would apply an exit tax on the property of individuals who take up residence abroad, after which they would be exempt entirely from US taxation.

TAGS: individuals | tax | employees | tax credits | multinationals | United States | tax breaks | tax reform | exit tax | inflation | individual income tax | Tax

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