Congress will put together a tax reform bill with the goal of eliminating tax loopholes, simplifying the tax system and reducing tax rates.  One loophole that they should eliminate is the most self-destructive tax loophole ever enacted, the Foreign Investors Tax Loophole [Sections §871(h,i,k) and §881(c,d,e) of the Internal Revenue Service code]. Enacted in 1984, it lets foreigners earn interest in the U.S. tax free, so long as they don’t reside in the United States.

Negative Effects upon Economy

Previous to this loophole, foreigners paid 30% withholding tax on interest income earned in the United States. After the loophole, they paid zip, zero, nada. Even worse, the bill directly harmed the U.S. economy in four ways:

1. Hurt U.S. Manufacturing. It drove up the dollar in foreign exchange markets which made American products less competitive in world markets, thereby decreasing American income.
2. Discouraged American Savings. It gave foreign savers a tax advantage over American savers, thereby lowering interest rates and decreasing American savings and wealth accumulation.
3. Encouraged Tax Cheating.  Foreign governments reciprocated with the same loophole. This encouraged the rich to hide their savings in foreign banks so that their savings could grow with interest, tax free.
4. Hid Foreign Government Assets from Freezing by U.S. Government. It helped the Chinese government, and others, hide their U.S. investments. All they needed to do was use foreign banks as intermediaries that would invest their dollars in the U.S. tax free.

Some economists mistakenly thought that the lower interest rates caused by foreign savings inflows would result in increased business investment, but they were wrong. Although direct foreign investment is beneficial, such as when foreign companies build new factories in the United States, the inflow of foreign savings into existing securities contributes nothing to the American economy.

In fact, the inflow of foreign savings slows long-term economic growth, because it raises exchange rates. Economist Robert Blecker found that from 1995 to 2004, the rising exchange rate of the dollar drove down manufacturing investment, even though falling long-term interest rates reduced the costs of business borrowing. Similarly, economists Prasad, Rajan and Subramanian found that the more foreign savings a nonindustrial country received, the slower it grew.

In short, the inflow of foreign savings, subsidized by this tax loophole, reduces American private savings and manufacturing investment. The lower interest rates can increase consumption on credit within an economy, but the effects upon fixed investment, wealth creation, and long-term economic growth are all negative.

Goal was to Help Wall Street

This loophole was enacted in 1984 in order to benefit Wall Street. Tax treaties between the United States and some European countries had let European banks invest in the United States free of tax on interest, creating the so-called “EuroDollar Market.” The banks in Britain and the Netherlands Antilles were the worst offenders. Some of the Wall Street banks wanted a share of the loot.

At the House Ways and Means Committee hearings on May 24, 1984, the only question was how much this loophole would strengthen the dollar, and thereby hurt U.S. manufacturing. At the hearing, Roberto C. Mendoza of Morgan Guaranty Trust put it succinctly:

Among all the evidence that we have heard today, no one has disputed the fact that [this proposal] would strengthen the dollar. The only question is by how much.

The effects of the loophole were so catastrophic that economist Giuseppe Ammendola called his 1994 book about the loophole: From Creditor to Debtor: The U.S. Pursuit of Foreign Capital – The Case of the Repeal of the Withholding Tax.

Instead, of helping Wall Street at the expense of Main Street, the U.S. should have closed the EuroDollar market by renegotiating its tax treaties with the European countries so as to eliminate interest tax exemption. The tax treaties all include provisions which allow them to be easily renegotiated.

The Coming Move to a Territorial Tax System

This tax loophole runs completely counter to the “territorial” tax system which Republicans hope to enact as part of the upcoming tax reform. Under the current U.S. income tax system, Americans owe taxes on income earned abroad whenever the foreign tax rate is lower than the U.S. tax rate.

But, under a territorial tax system, each country taxes income that is earned locally, and income earned abroad is exempt from local taxation. The 1984 tax loophole does just the opposite. It exempts foreign interest income from being taxed at its source.

Once the United States moves to a territorial tax system, President Trump should direct his Treasury Secretary to renegotiate all of our tax treaties. Income earned by foreigners (including foreign governments) in the United States should always be taxed at the same tax rate that rich Americans would pay on that income.

Conclusion

No longer should the U.S. tax code discourage manufacturing investment. No longer should it punish savings and wealth creation. No longer should it encourage tax cheating. No longer should it favor foreigners over Americans.

In 1984, Congress enacted a tax loophole which had all of those bad effects. The House Ways and Means Committee wanted to benefit Wall Street, even though it knew that it would be hurting Main Street. It’s time that Congress started putting Main Street first.

The Richmans co-authored the 2014 book Balanced Trade published by Lexington Books, and the 2008 book Trading Away Our Future published by Ideal Taxes Association.