Commentary

President Bush Should Withdraw Clinton Era IRS Regulation

This article was first published in the Washington Times, Dec. 20, 2001.
Three days before Clinton left office, the Internal Revenue Service proposed a regulation that would force U.S. banks to report the deposit interest they pay to account holders from other countries. But this regulation is not designed to help the U.S. government collect taxes. Instead, the IRS wants to impose a burden on U.S. banks to help foreign governments tax this money — even though it is U.S.-source income.

That last-minute effort by the Clinton administration to help prop up Europe ‘s welfare states would be comical if the resulting outcome did not promise to damage the U.S. economy. Foreigners have about $1 trillion deposited in U.S. banks, and much of that money — and the loans it finances — will vanish if the IRS makes U.S. banks vassal tax collectors for foreign governments. But what is most surprising is the fact that the Bush administration is now in office and, in spite of a theoretical commitment to free market tax policy, has not yet withdrawn this misguided IRS regulation.

High-tax nations like France are pushing the IRS to implement this regulation. Politicians from uncompetitive nations realize that it is increasingly easy for investment funds to cross national borders, after all, and they are seeking the power to impose their taxes on income earned in America. But that’s bad economic policy. Money should flow to where it will earn the best return. One fringe benefit of these capital flows is that politicians must exercise some fiscal discipline to attract jobs, capital, and entrepreneurs instead of losing them to another country. This is known as “tax competition” and the United States is the world’s biggest beneficiary of this process.

America’s modest tax burden, combined with privacy laws for foreigners seeking to escape oppressive fiscal systems, has helped attract more that $9 trillion in foreign investment to the U.S. economy. As part of this investment, individual nonresident aliens have about $1 trillion deposited in U.S. financial institutions. That inflow of assets is a key determinant of American prosperity because that money is put to work for the nation and produces more jobs, higher standards of living, and general prosperity.

But if the IRS regulation is approved, a substantial portion of this money will flee to competing institutions in other low-tax jurisdictions like Switzerland, Hong Kong, and the Cayman Islands. At a minimum, it would drive a substantial portion of the $1 trillion of bank deposits out of the country. America will lose savings and investment, and the U.S. economy will suffer at a time when it needs this capital the most. This will soon translate into fewer jobs and lower incomes for Americans. Paradoxically, the resulting damage from this capital flight will exceed the benefits from the president’s tax cut.

Naturally, high-tax nations resent tax competition. Politicians from European welfare states get upset when their taxpayers shift their money to low-tax jurisdictions. Because they refuse to cut taxes in their country, they want to force other countries to adopt bad tax policy and help them keep their taxes high. In effect, the IRS regulation would give those high tax nations the power to impose their burdensome tax rates on income earned in America.

That initiative would also be the first step to let the EU interfere directly with U.S. tax policy. For example, we know that the EU has already asked the World Trade Organization to rule that some provisions of the U.S. tax code are impermissible because they create too much tax competition. If implemented, the new initiative would undermine the right of the United States to determine its own tax policy.

The United States should reject these hare-brained schemes, and in particular the IRS regulation that would help prop up Europe’s over-taxed economies. America does not share common interests with high tax nations like France. It makes perfect sense for uncompetitive, overtaxed nations to try to set up a tax cartel and snuff out tax competition. After all, high-tax countries suffer from tax evasion, capital flight, and brain drain along with poor economic performances.

Tax competition is good for the United States but it is also a desirable force in the world economy. Ever since the Reagan tax cuts, tax rates around the world have been falling. This has helped boost growth rates in many nations and forced politicians to be more responsible. For the sake of American taxpayers — and taxpayers in places like France — the Bush administration should immediately withdraw this IRS regulation.

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