Tax legislation enacted in 1982 and 1984 and especially in the Tax Reform Act of 1986 has eliminated many domestic tax inequities. But Congress has perpetuated a major inequity in the tax code and sacrificed a potentially significant revenue source by continuing to allow foreigners to earn tax-free portfolio income from certain investments in the United States. Some recent legislation has actually moved in the wrong direction -- the 1984 repeal of the 30 percent withholding tax on corporate interest paid on portfolio investments held by foreigners has made it even easier for foreign residents who are not U.S. citizens to escape taxation on income generated within the United States.
Tax fairness is perhaps the most important reason for changing current laws. Wealthy foreigners who invest in large certificates of deposit from American banks in order to evade taxes and to avoid financial uncertainty in their own countries pay no U.S. tax on the interest they earn. There is no reason why foreigners who use the United States as a safe haven should not be charged for the privilege, when Americans who deposit small amounts of money in the same banks pay income tax on the interest they earn.
The Latin American debt crisis has been greatly exacerbated by the several hundred billion dollars of capital flight out of the debtor countries. Much of this flight capital has been deposited in American bank accounts offered by the very banks that press for government assistance in collecting their debts. Capital flight from troubled situations is inevitable, but there is little reason for us to offer preferential treatment to those seeking to avoid taxation in Latin America, particularly when it exacerbates the growing debt crisis.
The much publicized issue of American "competitiveness" is also affected by international tax policy. Government budget deficits have put upward pressure on real interest rates, leading foreigners to demand dollar assets. This has raised the foreign exchange value of the dollar, making American goods less competitive on world markets. While the dollar has declined substantially from its peak value, the pressure of federal deficits keeps it at a level where balancing our trade account is impossible.
Given our large federal budget deficit, it is inevitable, and probably desirable in the short term (in order to prevent interest rates from rising even further), that we borrow from abroad, even though such borrowing reduces the competitiveness of American firms in international markets. But there is little reason for American tax policy to tilt the incentive to save and invest toward foreigners and away from domestic residents. Increasing taxes on foreign capital income would reduce the foreign demand for dollars and lead to a further decline in the value of the dollar. This in turn would improve our international competitiveness by making American goods cheaper relative to foreign goods.
Last year, foreigners earned more than several hundred billion dollars in interest on American assets. In addition, foreigners realized billions of dollars of capital gains in the booming stock market. Even making allowances for the fact that taxes would discourage capital inflows and for the difficulty of taxing all foreign capital income, it is reasonable to estimate that the federal government could raise an additional $5 billion to $10 billion by eliminating the provisions that exempt foreigners from taxes.
Foreigners do not vote. Why then has foreign portfolio investment received such favorable tax treatment despite the federal government's obvious need for revenue?
First, it is argued that international commitments oblige the United States to exempt from taxation income earned by the nationals of certain countries. While the recent Netherlands Antilles episode illustrates the potential disruptions caused by abrogation of treaty protection with respect to outstanding obligations, existing tax rules and treaties can be changed by Congress with respect to obligations that will be issued in the future.
A different argument against taxing foreign capital stresses the importance of the free flow of international capital. This argument confuses the interests of the financial institutions that are eager to profit from complex international transactions with our national interests. While the efficient allocation of production around the world is important in contributing to the health of the worldwide economy, international trade in paper assets is a zero-sum game -- no wealth is created by such trade. By causing exchange rate volatility that interferes with trade in goods and services, it may actually hurt overall economic performance.
Taxing foreign capital income represents a rare opportunity to make the U.S. tax system more fair by taxing those who can most easily afford to pay while simultaneously improving America's international competitiveness. Few politicians dare to acknowledge the evident need for tax increases on Americans to reduce our budget deficit. Increased taxation of foreigners would not eliminate the deficit, but it would represent a valuable start. Perhaps our leaders will be able to find the courage necessary to tax foreign investors on the same terms as American investors, even if they are unable to bring themselves to impose the general tax increases that are needed to reduce our budget and trade deficits.
Lawrence H. Summers is Nathaniel Ropes professor of political economy at Harvard University. Victoria P. Summers is a tax attorney.