CEI's Solveig Singleton Comments On The IRS's Proposed Guidance on Reporting Of Deposit Interest Paid To Nonresident A

CEI's Solveig Singleton Comments On The IRS's Proposed Guidance on Reporting Of Deposit Interest Paid To Nonresident A

November 11, 2002

Summary of Comments

Proposed IRS regulations (REG 133254-02, REG 126100-00) would require financial institutions to report interest on deposits paid to nonresident alien individuals that are residents of Australia, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, and the United Kingdom. The Competitive Enterprise Institute urges the IRS to withdraw the proposed regulations in its entirety.

The proposed rules would result in the withdrawal of foreign investment from the United States, reducing the capital available for economic growth. (This threat would be revealed by a proper regulatory assessment which, contrary to the assertion in the IRS Notice of Proposed Rulemaking, is required in this case by Executive Order 12866). The rules are not needed to enforce United States tax law, and no benefit will accrue to the United States by forcing its financial institutions to bear the costs of enforcing other jurisdictions’ tax codes. Finally, the rules represent a short-sighted approach to tax compliance policy. Tax policy, like other public policy, should be conducted from the standpoint of the public interest, rather than from the narrow point of view of tax enforcers, to minimize the distortive effect of taxes on the economy.

Part I: The Impact of Information Sharing on Foreign Investment

It is no secret that part of the reason that the United States is attractive to foreign investors is because they pay less tax here than they would in their home countries. Information sharing of the type proposed by the IRS notice would have important implications on the tax liability of foreign investors. The IRS proposal should be withdrawn, as it risks depriving U.S. businesses of capital.

Favorable tax treatment of foreign investors and confidentiality attracts capital. There is an obvious link between tax treatment of foreign investors in the United States and the foreign investors willingness to invest here. Although there are non-tax reasons to invest in the United States, the evidence shows that U.S. tax rules have a substantial impact on the foreign investment here. For example, Reagan’s tax cuts in 1981 caused increased capital inflows during the 1980s by increasing the after-tax profitability of U.S. investments.[4] U.S. businesses deployed the increased capital available to them to buy more efficient equipment, raising productivity. Workers became better off as wages and benefits rose.

Recognizing this, U.S. legislators have maintained tax policies that favor foreign investors. The United States does not withhold tax on interest paid to foreign holders of U.S. bank deposits or bonds. And dividends paid to foreign owners are taxed at low rate that varies from 5 to 30 percent—a low rate compared to the rates the foreign owners would pay in their home countries. And the U.S. Congress has rejected measures that would subject foreign investors’ interest income to tax.

In the lagging world economy, capital available as a result of foreign investment has been substantially reduced worldwide. The United Nations Conference on Trade and Development reports that foreign direct investment shrank by 59 percent overall in developed countries.[5] The United States was among the countries experiencing the sharpest declines. In this environment, it is critical to U.S. capital markets and the many businesses that rely on those markets for the U.S. to remain an attractive destination for foreign investors.

The likely consequences of information sharing with EU nations; further excessive taxation. As U.S. legislators have recognized in U.S. tax rules, the U.S. is a substantial beneficiary of capital flight from EU nations. Reporting of information about foreign investments in the United States to their home countries would make U.S. tax rules moot in many cases by subjecting the investment to taxation at an excessive foreign rate. Even if the tax laws of the EU nations would not presently subject the income to tax, the appetite of many EU nations for tax monies is apparently insatiable.

A survey of current worldwide tax trends strongly supports this. Since 1965, taxes have soared upward, though there are signs the upward trend is slowing. Reagan’s and Thatcher’s tax cuts in the 1980’s forced taxes in some other nations down (the top average personal income tax rate in major industrial OECD countries has fallen 20 percent since 1980, and average top corporate rates are down about 6 percent).[6] But where corporate taxes, income taxes or capital gains taxes are reduced, other taxes may well rise; total tax burdens are still rising.[7] Social security taxes are expected to ramp up in the future. And there have been few if any cuts in government spending. France, Germany, and Sweden made only tiny reductions in their tax burden and remained high-tax nations overall.

High-tax EU nations would find it difficult to resist the lure of taxing the income of their citizens earned in the U.S. Let us take a closer look at the fiscal state of affairs in one EU country, France. France has made a political commitment to extensive government spending. Particularly in the area of social security, its liabilities exceed income. Not surprisingly, France has high taxes, with a tax burden of about 45.5 percent of GDP (including a top personal income tax rate of 54 percent and a value-added tax of about 19 percent).[8] And capital tends to flow out of such situations. Frances’s General Directorate of Taxation estimates that in 2000 the loss of earnings to capital flight was 40 billion. In 2001 85.8 billion dollars in capital left Europe, and much of it goes to the United States.[9]

Given information-sharing arrangements of the U.S. that made more ambitious taxation possible, it is hard to see how the EU nations could resist subjecting that income to excessive taxation even if it would not be under their current law. They would perceive this as an opportunity to halt capital flight from their economy. Information-sharing with foreign nations takes away from U.S. legislators the power to shelter foreign investors’ income from excessive taxation.

Under the circumstances, the assertion in the IRS Notice that no regulatory assessment is required because the proposal is not a “significant regulatory action” under Executive Order 12866 is certainly false. The Order in question includes in its definition of “significant” action those that may “have an annual effect on the economy of $100 million or more or adversely affect in a material way the economy, a sector of the economy, productivity, competition, jobs . . . .”[10] A quick survey of data from the Bureau of Economic Affairs shows that EU nationals hold thousands of millions in U.S. debt instruments and deposits.[11] If only a small percentage of this—say, five percent, is due to capital flight, and would be withdrawn from the U.S. because of information sharing, a rather conservative estimate—the impact on U.S. GDP would be substantial.

The IRS proposed rules have consequences that go far beyond requiring U.S. institutions to bear the costs of filing some paperwork. In proposing such rules, the IRS displaces the prerogatives of the United States Congress to ensure that the United States continues to be a primary beneficiary of international tax competition.

There is no benefit to the U.S. from bearing the cost of EU tax enforcement. To put it simply, there is no reason that the IRS proposed rules are necessary to enforce U.S. tax law. Indeed, the loss of capital in the United States due to the proposed rules is likely to reduce GDP and result in a net loss of U.S. tax revenues. There is no reason to burden U.S. institutions with the cost of EU countries tax enforcement, which is overly high due to those countries own reluctance to engage in significant tax reform.

Part II: Information Sharing As a Poor Response to Tax Compliance Issues

It is perhaps understandable that IRS policymakers would feel some sympathy for their EU colleagues, who are set the difficult task of pursuing capital around the world that has fled their nations in an effort to subject it to tax.  Nevertheless it is vitally important that tax policy be good public policy, not merely that it make the enforcement tasks of tax authorities easier. As public policy, the IRS proposal does not measure up. It is a very short-sighted response to problem of the EU nations tax compliance problems—even if these problems were somehow the responsibility of U.S. institutions to resolve.

EU countries face a significant problem of tax evasion—according to the International Monetary Fund, in France and Germany, evasion amounts to about 17 percent of GDP, and it is even higher in Sweden.[12] Tax evasion is not a good thing. But some responses to it are likely to be extremely destructive of capital markets.

EU nations should reduce taxes to improve compliance. The correct first response to tax evasion for high-tax EU nations is to lower taxes. Tax compliance is highest in low-tax countries such as Switzerland, New Zealand, and Ireland.[13]  Lower taxes are likely to result in higher revenues for the high-tax EU nations due to increased growth. In 1997, Switzerland raised the same amount of tax money per capita as Sweden, even though the Swedish tax rate, at 61.5 percent, is double that of Switzerland.[14] And reducing tax rates in Ireland changed the government’s deficit, at 15 percent of GDP in 1980, to a surplus by 1998.[15]

There will be some determined criminals who will cheat on their taxes even when most people believe the rates are fair. For those individuals, information sharing on a case-by-case basis, with the full protections of due process and the possibility of appeal, should suffice, as it has historically.

Information-sharing destroys capital by forcing capital underground. Let us suppose that EU nations fail to pursue the course of tax reform, and successfully persuade other countries to held them halt capital flight by routine information-sharing and the de facto tax harmonization that results. The sad thing is, they are likely to see no net increase in revenues or an increase in available capital as a result. Their rates of taxation are simply too high.  Here are some alternate fates for that capital—other than efficient, productive U.S. capital markets:

·    The domestic underground economy, which stands at about one quarter to one third of GDP in Europe’s welfare states.

·    The pockets of emigrants leaving for other destinations (25,000 people leave France every year for tax reasons).[16]

·    Magically disappearing, as if it had never existed at all, because taxation discourages the deployment of human capital (accountants become artists; potential entrepreneurs spend 20 years in graduate school).

·    Legal tax avoidance and structuring.

The net result of information-sharing as an approach to tax compliance? Few incentives to create human capital. The removal of capital from efficient U.S. markets. More legal tax arbitrage. For these reasons, the IRS information-sharing proposal is simultaneously futile and destructive. The EU nations involved will be no better off, and the U.S. and the world economy worse off.

Why information-sharing does not improve tax neutrality—it results in taxes that are too high. A contrary view to the arguments above is that information-sharing will improve tax neutrality by reducing tax arbitrage. But view that reducing international tax arbitrage produces more neutral relies on wholly unrealistic assumptions about taxation. In reality, no tax is neutral—it moves wealth out of the efficient private sector and into the public sector. In the public sector, no new wealth is created, it can only be redistributed through rent-seeking. And much can be destroyed. In the United States, economist Bill Niskanen estimates that for every dollar of government spending, $2.43 must be collected in taxes.

There is some content to the neutrality argument. Domestically, sectoral taxes, complicated taxes, progressive taxation and tax arbitrate do cause distortions. Flatter, broader taxes are better, yes. But this is nothing compared to the level of distortion that is produced by taxes that are just plain too high. Yes, investment decisions between nations should be driven by comparative advantage. But the institutions of a country are a part of the reality there. Tax policies are a feature of the world and should compete just as different deposits of resources do—particularly because there is barely any force other than competition constraining the level of taxation. Due process and the confidentiality of foreign depositor’s accounts are a part of the United States’ comparative advantage. Long may they remain so.

Conclusion. The IRS proposed regulations are bad public policy. The regulations will drive a foreign capital from U.S. markets, and harm U.S. businesses and workers. Because billions, even trillions, of dollars in deposits are affected by this policy, the IRS proposal takes it far out on a limb, usurping the role of Congress. The EU nations own policies have caused the problems they are now experiencing with tax compliance, and it is not the responsibility of the United States to bear the cost of correcting the problem. The IRS proposed regulations should be withdrawn in their entirety.

[1] Competitive Enterprise Institute, The Future of Financial Privacy: Private Choices Versus Political Rules (2000); Stephen Entin, “New Threats To Foreign Investment: The U.S. Treasury And Information-Sharing,” Competitive Institute Policy Analysis, October 1, 2001.

[2] See Solveig Singleton, “The Tempting Of Switzerland: Financial Confidentiality And Capital Formation,” prepared for Symposium Finanzplatz Schweiz, Zurich, Switzerland, November 4, 2002; Solveig Singleton, “The Need for Financial Privacy: Human Rights in Bin Laden’s World,” Tax Competition: An Opportunity for Iceland, edited by Hannes H. Gissurarson and Tryggvi Thor Herbertsson (The University of Iceland Press, 2001).

[3] Task Force on Information Exchange and Financial Privacy, Report on Financial Privacy, Law Enforcement, and Terrorism, March 25, 2002.

[4] Mack Ott, “Foreign Investment in the United States,” The Concise Encyclopedia of Economics, 1999, available at http://www.econlib.org/library/Enc/ForeignInvestmentintheUnitedStates.html; Hans-Werner Sinn, “U.S. Tax Reform 1981 and 1986: Impact on International Capital Markets and Capital Flows,” National Tax Journal 41, No. 3, 327-40 (1988).

[5] United Nations Conference on Trade and Development, “Overview: World Investment Report 2002,” United Nations, 2002, pp. 4-6.

[6] Chris Edwards and Veronique de Rugy, “International Tax Competition: A 21st Century Restraint on Government,” Cato Institute Policy Analysis No. 431, April 21, 2002; OECD, “Tax Rates Are Falling,” OECD in Washington, March-April 2001.

[7] See generally, Edwards and de Rugy;  Paul van den Noord and Christopher Heady, “Surveillance of Tax Policies: A Synthesis of Findings in Economic Surveys,” OECD Economics Department Working Papers, No. 303.

[8] Veronique de Rugy, “European Union Tax Cartel is Bad for U.S. Economy,” Cato Institute Daily, January 10, 2002, available at http://www.cato.org/cgi-bin/scripts/printech.cgi/dailys/01-10-02.html.

[9] Veronique de Rugy, “The Power of Taxpayers’ Exit,” printed in Tax Competition, at 53.

[10] Executive Order 12866, section (3)(f)(1).

[11] See, e.g., http://www.bea.gov/international/bp_web/simple.cfm (showing trends in assets held in the United States in the form of debt instruments, deposits, and in other forms).

[12] Veronique de Rugy, “The Laetitia Casta Model (for Tax Revolts),” reprinted from The Wall Street Journal Europe, October 22, 2002, available at http://www.cato.org/cgi-bin/scripts/printtech.cgi/research/articles/derugy-011112a.html; see also de Rugy, “The Power of Taxpayers’ Exit,” (evasion is 27 percent in Italy; 25 percent in Denmark; 17 percent in Germany; 20 percent in Sweden; only 13 percent in Ireland).

[13] den Noord & Heady, at 38, 47 (noting that tax compliance is high in Switzerland despite bank secrecy).

[14] Ibid at 11.

[15] Turlough O’Sullivan, “Partnership for Prosperity: Lesson from Ireland,” printed in Tax Competition, p. 21.[16] Jack Anderson, “A Misery Index,” Forbes, February 21, 2001.