Tax Competition between Nations
By: Jeffrey H. Corbett & Patrick J. Kish | Click to read full article
We want you! Uncle Sam's famous slogan was posted on billboards throughout the United States during World War II. His piercing eyes were focused directly on you while a menacing finger wagged. There was no question he was looking at you as an individual to do your part. Of course, he looked at everyone the same way. The point was to make you feel guilty enough to act.
Guess what? Sixty years later, Uncle Sam is still looking at you. Well, he is actually staring at your wallet. With a stagnate economy and rising deficits, a bulls-eye has been placed on the chest of every American taxpayer. International business owners have been specifically targeted, since they often control large amounts of commerce that can be shifted or quickly transferred. At the same time, virtually every other nation in the world is eyeballing you. They are willing to court you like a college team going after a star athlete. You are in demand for both your tax dollars and equally as important, your investment capital that can stimulate markets. There is a catch. Administrations are expecting a long-term commitment. Once you make your choice, don't expect to get out without a good divorce … ah, tax attorney. You see, in the world of competition between nations for taxable dollars …the gloves are off.
In such a competitive environment you might expect government agencies to be keenly aware that there are alternatives for business and investment. Your logic may well insist that foreign capital, difficult to attract and easily moved, would receive the best red carpet treatment. You would be wrong.
The US as a Tax Haven
The Internal Revenue Service may be putting the financial markets of the United States at risk. An estimated $1trillion dollars of foreign investment has been placed in US fixed income securities. It comes to the US for security, tax-free investment and privacy. The IRS attempted to eliminate the privacy element with proposed regulations 133254-02. This caused uproar back in 2003 when these planned amendments first hit the front page. Although never enacted, it is interesting to note that the proposal is still active and has never been officially withdrawn. Instead, it sits in limbo, apparently waiting for an opportune time to be again considered. Under these planned changes, investors from fifteen different nations would have their financial information reported back to their home country. These nations are: Australia, Denmark, Finland, Germany, Greece, Ireland, Italy, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden and the United Kingdom. In addition, the IRS would be able to add countries to this list in the future.
A long-standing policy of the United States has been to attract foreign investment to its shores by not taxing interest paid to non-resident aliens. The US Government backs this even further with a strong commitment to financial privacy by not reporting to any other nation who is buying these securities. Surprisingly, this tax holiday is not well known by US citizens and yet, it has become a mainstay of their economy. Congress, recognizing its importance, has historically taken a strong stance in support of this policy.
These proposed changes in IRS regulations have been greeted with much opposition. Many organizations have expressed their dismay including the Heritage Foundation, the Center for Freedom and Prosperity, Independent Community Bankers of America and the Institute of International Bankers. In addition, numerous members of the House of Representatives and the Senate have expressed their concern. Jack Kemp, in a letter directed to the IRS, stated his position in the following manner. "The IRS claims that foreign governments will help collect US taxes if we help them collect their taxes, but this is a specious claim. It is highly unlikely that any Americans have hidden their money in the 15 nations (high-tax countries like France and Sweden) on the list. Instead, the regulation would merely serve to drive capital from America. … this is a lose-lose proposition for America."
The IRS's motivation to attempt these reporting changes becomes even more difficult to understand when examining, specifically, nonresident alien interest payments. These investments would remain tax-free. Thus, no additional tax would ever be generated and a substantial amount of cost would be placed upon US financial institutions that must comply with onerous documentation.
Their determination to take such actions and ignore very informed opposition might be easily explained. There exists, by definition, an inherit conflict of interest between two vital arms of any nation state. A delicate balancing act continues every business day between a state's tax revenue collection agency and any other department that wants to attract foreign investment. A well known mainstay of politics is that if you cut taxes and enhance privacy, private investment will follow. Of course, every tax-collecting bureaucrat worth their salt will react by taking you to the mat like an angry sumo wrestler. Thus, for every action taken by one side there is an equal and opposite reaction. Newton did not have the IRS and the Department of State in mind when he gave us his Third Law of Motion, but he could have.
We find ourselves compelled to point back at high school government studies. Government agencies and their bureaucrats cannot write legislation nor change foreign policy. Any action taken by these agencies, which potentially circumvents Congress or the Executive Branch, is illegal and shakes the foundation of the American system. A governmental department may be ready to struggle for power, and it could well be within its nature, but that does not make it right.
The United States & Its Partners
Tax shelter is a term that has seen its best days. It used to be a perfectly acceptable investment strategy. Since the turn of this century, bureaucrats and politicians have managed to tag it as something akin to a high crime. Ironically, governments compete using shelters all the time. Tax holidays and other stimulus programs are plentiful. Some are well known while others operate in obscurity. Incentive driven plans can also dramatically differ in size. A city in the northeastern US, for example, might lure specific industries with tax breaks, while much larger agreements between small clusters of nations are also common. These strategies have three primary goals: to capture investment capital, enhance influence and increase jobs.
The Caribbean Basin Initiative (CBI) is one such tool. 24 countries from Central America and the Caribbean receive trade preferences with the United States. Goods treated duty-free represent a very large carrot to developing nations. Enacted by the Caribbean Basin Economic Recovery Act in 1984, the CBI is a duel edged sword that extends US economic influence. A participating nation can loose its benefits under specified conditions. Consequently, since the US extends these benefits, they can therefore revoke them.
Another well-known agreement is the North American Free Trade Agreement (NAFTA). As you may recall, NAFTA took effect on January 1, 1994 by establishing a free-trade zone between Mexico, Canada and the United States. Tariffs on major goods were instantly lifted with a gradual reduction on most others products over the next 15 years.
Most recently, a controversial agreement has been initiated between the US and its Central American neighbors for the establishment of another free trade zone. The Central American Free Trade Agreement (CAFTA) was put in place to eliminate tariffs. CAFTA's major players are Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and of course the US. The US Senate passed this legislation 54 to 45 on June 30, 2005, with the House following in kind 217 to 215 on July 28, 2005. The votes of each branch were hardly resounding for implementation of the legislation but nevertheless represented a victory. For the Bush administration, this tax holiday was more about extending influence than creating commerce.
Conclusion
In a global economy with free markets, governments compete against each other for investment capital. It is normal and healthy. The CBI, NAFTA and finally the proposed CAFTA are trade agreements offering tax incentives worth billions of dollars. Additionally, the tax holiday offered to foreign investors who purchase US fixed income securities is worth an estimated one trillion dollars. This is big business with large stakes. It would be difficult for someone to over state the importance of such agreements.
Therefore, in conclusion, it is critical to again note that only the Executive Branch and Congress can initiate federal tax agreements and corresponding legislation. It is not the business of the IRS or any other agency, which essentially works for these two branches, to change or circumvent standing law. At least in theory, we elect the public officials entrusted with such authority. Thus, they must report back to us on Election Day every two, four or six years. It is still the US taxpayer that pays the bill and lives with the consequences.
