November 12, 2001

Europe's Vassal: IRS Reg Exposes
Foreign Investors To Tax Fleecing

By Daniel J. Mitchell

President Bush may not realize it, but his efforts to resuscitate the economy with a stimulus package of new tax cuts could well be doomed to fail. Not because it's a bad plan - in fact, it's commendable - but because of a looming economic dagger that's heading right for its heart.

The dagger in question: a draft IRS regulation that would let foreign governments tax interest income their residents earn in America. Proposed just three days before President Clinton left office, this misguided initiative could drive hundreds of billions of foreign-owned dollars (international investments) from the U.S. economy. The resulting damage almost certainly would exceed any possible benefits that flow from the president's tax cut.

We could expect foreigners with deposits in American banks to withdraw their money and move it to Switzerland or some other place with more respect for financial privacy. This would make U.S. banks less competitive. Even more important, it would leave banks with less money to lend.

This means fewer car loans to consumers, fewer mortgages to families, less capital for entrepreneurs and less credit to help businesses expand and hire new workers. Every economic theory (even Marxism) acknowledges that capital formation is the key to long-term growth and higher incomes. And because this saving and investment is so important to an economy's performance, U.S. lawmakers have long chosen not to tax the money foreigners deposit in our banks.

This has been a successful policy, one that has done much to attract the $ 1 trillion of foreign-owned capital in the U.S. economy. But if the IRS finalizes the regulation, many foreigners could be tempted to take their funds elsewhere, and American banks will suffer. Every nation has the right to decide whether to tax - and how to tax - the income earned inside its borders. Some nations, such as France, over-tax their economies and make themselves uncompetitive. Others imitate Hong Kong, which has experienced strong growth with a simple and fair flat tax. Whether these governments choose good policies or bad policies, they decide how to treat income earned inside their borders. The IRS regulation abandons this important principle and instead seeks to make U.S. banks vassal tax collectors for Europe's welfare states. The IRS regulation also undermines tax reform. Proposals such as the flat tax are based on key principles that ensure fairness and simplicity. One of these principles is that income should be taxed only once.

Yet the IRS regulation would force U.S. banks to help foreign governments double tax the money their residents save and invest in America.

Another important tax-reform principle is that countries tax only income earned inside their borders. The IRS regulation trashes this principle. It's based on the notion that American financial institutions should help foreign governments tax interest income earned in the U.S. Finally, the IRS regulation is bad regulatory policy.

Federal agencies are supposed to issue regulations that help enforce the laws approved by Congress. The IRS is betraying this obligation. Even though democratically elected officials decided that there should be no tax on the bank deposit interest paid to foreign-owned bank accounts, the IRS has decided to flout the law by unilaterally seeking to help foreign governments tax this income. This is a flagrant abuse of regulatory authority.

Only the U.S. government should have the ability to tax income earned in America. Unfortunately, the IRS seems to think other governments should have that power as well. Fortunately, the battle isn't lost yet. Government regulations must go through a "comment period" after they're proposed.

This means the Bush administration has a chance to withdraw the regulation before it is finalized (which could occur on or before Dec. 31). Bush should withdraw this risky regulation, and he should do so as soon as possible. The U.S. economy already has been weakened by terrorist attack. The last thing we need is for the IRS to add insult to injury.

Daniel J. Mitchell is the McKenna senior fellow in political economy at The Heritage Foundation, a public policy research institute.

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