The Road to Tax Shelter Perdition

I wrote previously about Senators Levin and Coleman's bill aimed at cracking down on tax shelters abroad. Today I want to fill in some of the background. How did we arrive at the point where 50 to 100 billion dollars of tax revenue is lost every year due to the wealthy and not so wealthy sheltering their income from taxation through offshore banks?

The European Union has taken more aggressive steps than the United States to combat tax fraud. The "European Union Withholding Tax" aims to prevent citizens of E.U. member countries from hiding income by depositing it in other E.U. countries (and in a substantial number of non-EU countries). All deposits, even those in accounts protected by bank secrecy laws, are subject to a withholding tax (initially 15 percent, but 35 percent by 2011). The withheld revenue is transfered to the depositor's country of residence. For a summary of the policy see the relevant Wikipedia page.

The United States abolished all withholding of tax from foreign deposts in the U.S. in 1984. The U.S. also stopped collecting information on the deposits and interest earned by foreigners. With the exception of Canada, with which the U.S. has an agreement to share tax information, the U.S. does not inform any foreign governments about income earned in the U.S.

The beneficiaries of these policies have been U.S. banks, which are able to attract money from foreigners interested in hiding it from taxation. The policy is further protected by a curious mutant of free market conservative ideology that equates tax fraud with economic freedom. The case in point is the fight over IRS proposed regulation (REG-133254-02).

The regulation began in the waning days of the Clinton administration. In brief the regulation proposed to require that U.S. banks would report interest income earned to the IRS, which might then report this information to foreign governments.

The proposed regulation generated a firestorm of protest from conservative think tanks (e.g. the Heritage Foundation), small business organizations, and U.S. banks. In part opponents argued that the measures were unnecessary and thence illegal because the U.S. did not and does not tax interest earned by foreigners in this country. Be that as it may, some of the arguments made against reporting the interest income are worth reflection.

Argument 1. We abolished the withholding tax and protect foreigners from any realistic chance of being caught underpaying their taxes because the U.S. needs to attract foreign capital.

For instance, a quote from Andrew F. Quinlan's testimony:

House Way and Means Vice Chairman Phil Crane:"The Internal Revenue Service is supposed to enforce the tax laws approved by Congress. It is with some dismay, therefore, that I see that the Service has issued a regulation designed to overturn existing Congressional intent. On many occasions, Congress has visited this issue, and in every instance has chosen not to tax this income and not to require its reporting. The goal, clearly seen in legislative discussion, is to attract capital to the American economy where it will be used to create jobs and boost growth."

The problem with this argument is that much of the capital attracted to the U.S. economy by giving foreigners preferential tax treatment compared to American savers was used to finance consumption, including consumption of imported foreign goods. This exacerbated the trade deficit and encouraged the endebtedness that now threatens the U.S. economy. In addition, the unrealistic exchanges rates these subsized capital inflows created helped make U.S. producers less competitive internationally, which discouraged investment.

Argument 2. Reporting income would hurt the competitiveness of U.S. financial institutions.

The cheap loans financed by foreign capital did help U.S. financial institutions grow for a long time. At present it looks as if those gains were not so solid as they seemed. Ultimately, a bank is only as sound as its borrowers are credit worthy. The long era of cheap money has encouraged Americans to borrow without saving. Some banks are now reaping the whirlwind they helped create.

Argument 3. Imposing reporting requiremets would result in "double taxation" of income.

This is bogus. Because the U.S. did not and does not tax any income earned by foreigners in U.S. banks, there is no way on earth that the income could be double taxed. What reporting would do is allow the income to be taxed by someone.

Some advocate allowing individuals to avoid paying tax anywhere on interest income earned. I'm all for a shift to more emphasis on consumption taxes, but I don't think we should begin such a shift with foreigners. It should begin with U.S. citizens. Reversing the equation, and allowing foreigners to invest unlimitted amounts tax free has been a disaster. It has encouraged Americans to borrow and live beyond their means, and it his exacerbated trade deficits that have helped undermine the competitive position of the U.S. economy.

I support the effort by Senators Levin, Coleman and others to restrict the ability of American citizens to hide income earned abroad. It is worth remembering, however, that when the United States complains that data on income earned by U.S. residents in foreign banks is not forthcoming or accurate, we are the pot calling the foreign kettle black. U.S. banks play the same tax shelter game only bigger than anyone else. The game has been bad for the broader U.S. economy. It is time the game ended.