Commentary

New Rule Will Hurt Foreign Investors and U.S. Jobs

While Treasury Secretary Paul O’Neill is racking up frequent flyer miles, an IRS commissioner has issued a regulation to help foreign governments tax income earned in America. This misguided initiative, which would require U.S. financial institutions to automatically report the interest paid to foreign investors is contrary to U.S economic interests. It also conflicts with the treasury secretary’s public statements. In fact, Paul O’Neill is on record saying that private financial information should only be shared with other governments in response to specific requests with proper safeguards.

The regulation in question would impose significant costs on the U.S economy, and it won’t help Europeans. In fact, it is an affront to Europeans, as it removes existing legal privacy protections European citizens now enjoy who hold deposits in American banks. The reversal will mean that Europeans simply will move their money from U.S. banks to other low-tax havens that guarantee financial privacy, meaning less loan money available for the U.S. economy — and not more revenue for European states. Since the information the IRS wants to collect is not needed to enforce U.S. tax law, it seems fair to ask whose interests the IRS and Treasury bureaucrats are serving.

The proposal is based on a scheme that was first floated three days before President Clinton left office. The original deal — like the current IRS proposition — would force U.S. banks to report the deposit interest they pay to account holders from other countries. The IRS admitted then — and admits now — that this regulation is not designed to help the U.S. government collect taxes. Instead, it is to help foreign governments tax income earned in America. Furthermore, the IRS still refuses to conduct legally required cost-benefit analyses. Why? To hide the fact that this regulation would have a terrible effect on U.S economic performance and could drive several hundred billion dollars out of the U.S. economy.

To its credit, the Bush administration initially blocked the proposal. But that turned out to be a short-term victory. With Paul O’Neill trotting around the globe giving U.S. tax dollars to corrupt-prone foreign governments, the IRS figured it could re-package the proposal. The only difference is that the original regulation required reporting on all foreign depositors, while the new proposal targets residents of 15 major European nations and a few other countries like New Zealand and Australia.

By resuscitating this initiative, the IRS demonstrates its willingness to put the interests of tax collectors above the interests of the American and European people — and jeopardize an already weak global economy.

But are U.S. bureaucrats even doing a favor to European governments? Probably not. Investors from overseas seek low taxes and financial privacy. So investors who will withdraw their money from the U.S. economy won’t bring it back to Europe’s high tax environment, but will shift their assets to other low tax jurisdictions.

There is no economic justification for this regulation. Not only is it bad policy, but it also disregards existing laws. For many years now, interest on bank deposits paid to non-residents has been tax-free unless connected with the conduct of U.S. trade or business. On several occasions, Congress debated whether or not to retain the tax exemption on bank deposit interest. Each time, it ended up making the exemption permanent. And for good reason because foreigners have invested about $5 trillion in U.S. banks and companies.

The new IRS regulation is also an attack on tax reform. The much-needed movement in the United States towards a flat tax is based on the sound economic principles that income should never be taxed more than once and that governments should only tax income earned inside national borders. The new regulation would hinder the effort to reform the tax system because now foreign governments would have the power to double-tax income earned in America.

Make no mistake, if the IRS regulation is implemented, fewer foreigners will invest money in this country. Most importantly, those who already have money in the country will shift their investments to other lower tax jurisdictions where the IRS rule would not apply, such as Switzerland, Hong Kong, or the Cayman Islands. European investors will lose historic legal protections and face double taxation. Europe’s economy will not benefit. And the giant U.S. economy that is the engine for worldwide prosperity will suffer.

If Paul O’Neill really believes in what he says, he should stop by Washington sometime, and regain control over the bureaucrats at Treasury and the IRS.

Veronique de Rugy is a fiscal policy analyst at the Cato Institute.