New Threats To Foreign Investment: The U.S. Treasury And Information-Sharing

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The United States Treasury is considering actions to shore up enforcement of the income tax. But two proposals brought forward so far threaten to do more economic harm than good, and distract policymakers from the real need for fundamental tax reform. They also threaten the right to financial privacy.

One new set of Treasury rules, the Qualified Intermediary Regulations (QI), requires banks to collect information on all accounts maintained by foreign investment institutions, even accounts held by tax-exempt foreign investors. But real foreign investors may fear the IRS will pass the information to their home-country tax authorities. This loss of privacy could trigger the withdrawal of foreign savings from the United States and reduce investment, productivity, wages, employment and incomes in the United States.

Meanwhile, the Organization for Economic Cooperation and Development (OECD) has proposed a crackdown on tax havens. First, the OECD has called for international “tax harmonization,” pressuring low-tax nations into raising their tax rates through economic sanctions; but the sanctions cannot work unless the United States signs on. Second, the OECD proposes that forty-one small nations considered tax “havens” be required to repeal their financial privacy laws and share information about the capital earnings of foreign investors with OECD nations’ tax authorities. U.S. Treasury Secretary Paul O’Neill made remarks suggesting that he views the first plan as a threat to sovereignty; he is more open to the second plan, although historically the United States has supported a much less invasive vision of information-sharing than the OECD’s.

The unintended economic consequences of the new QI rules could be considerable. If, for example, $400 billion in foreign investment were driven out of the U.S. by the QI rules, this analysis shows that U.S. GDP might be reduced by $80 billion annually. Adoption of the OECD proposals would do further harm. Both OECD initiatives would protect the high tax rates of its European members and the large government sectors they support from international competition.

The best solution to these international tax enforcement problems is for countries to scrap their income taxes, which impose multiple layers of tax on income used for saving and investment, in favor of unbiased consumption-based taxes. Such taxes should be imposed on a territorial basis, that is, on the taxable activity carried out within each nation’s own borders. These steps would improve economic performance and eliminate the need for one nation to gather tax information from another.