This transcript has been edited for clarity.
David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: just like haven.
Tax havens and financial secrecy are regular topics of discussion in the tax world. We've previously looked at tax havens from an international perspective, and you can find those episodes in the show notes. But today, we're turning the lens around and considering if the United States is a tax haven.
Here to talk more about this are two authors who have recently considered this topic in-depth in the pages of Tax Notes. Kenneth Austin is a retired Treasury economist, and an adjunct professor at American University's International School of Service, and Hillel Nadler is an assistant professor at Wayne State University School of Law.
Hillel, Ken. Welcome to the podcast.
Hillel Nadler: Great to be here.
Kenneth Austin: Thanks for having us.
David D. Stewart: Let's start off with the big question of why should we look at the United States as being a tax haven?
Hillel Nadler: Well, there are really two aspects to this. One is that, on the U.S. side, in terms of the U.S. tax burden on financial inflows, foreign investors can hold U.S. financial assets while paying minimal U.S. tax on the profits from those assets, so that's one aspect of it. The second aspect of America being a tax haven in this sense is that the U.S. has a unique financial secrecy position, which means that foreign investors can not only avoid paying tax to the U.S., or pay minimal tax to the U.S., but they can avoid paying tax in their home countries on their profits from U.S. financial assets.
David D. Stewart: In your article about this subject, you talked about this affecting the trade deficit. Could you explain that?
Kenneth Austin: Yeah. Basically, the way it works in today's world, and particularly for the U.S., our trade deficit is equal to how much money we borrow net from the rest of the world. When I say borrow, it's not exactly like we go down to the People's Bank of China and fill out a loan application. It's just that any foreigner, or I guess in the tax code, nonresident alien, can simply buy U.S. assets on, say, the bond market, stock market, deposit it in a bank.
That's lending internationally. It may not be to a particular individual, and the money may already have been borrowed. Say the U.S. Treasury sells a bond, and that bond is sold to an American, but that American sells it to a nonresident alien, then we are borrowing internationally. That will affect the exchange rates. And as we borrow, the exchange rate appreciates, which causes the U.S. trade deficit to grow.
David D. Stewart: How did we start going down this road?
Hillel Nadler: These provisions have accumulated over time. These provisions that offer favorable tax treatment to foreign investment, many of them made sense in a different exchange rate situation, when the United States' financial situation was different.
If you start by addressing each provision, one provision that's favorable to foreign investors in the United States is that capital gains from the sale of most U.S. investment assets, including stock buybacks by U.S. corporations, aren't taxed at all to foreign investors. They pay no U.S. tax on those. Then in the early 1930s, all the way back then, the U.S. Treasury actually tried to collect tax on capital gains of foreign investors. If you looked at the code then, there was no specific exemption. But doing that was difficult because, if the foreign investor didn't actually file a tax return, Treasury had no way of knowing what they had earned. And Treasury was also concerned about discouraging foreign investment.
Eventually, Congress responded by introducing what we currently have now, which is an exemption for capital gains for foreign investors. I think this historical episode, the following historical episode illustrates our point nicely, which was that the exemption was actually broadened in the 1960s, by adding what's known as the securities trading safe harbor, which says that capital gains of foreign investors would be exempt even if they're present in the United States, they're trading in the United States, or acting through a U.S. agent.
Previously, doing so would have been considered engaging in a trade or business in the U.S. and would have subjected the foreign investor to U.S. tax. But this change was made explicitly to encourage foreign investment in the U.S.
The context was this was in response to the then balance of payments crisis. At the time, the U.S. was trying to prop up the Bretton Woods system of fixed exchange rates and wanted to encourage foreign investment inflows into the United States. They wanted to encourage investors to turn U.S. dollars into longer-term investments. That's just one example, but a lot of these provisions were specifically designed to attract foreign investment into the United States.
Kenneth Austin: May I interject one thing? I know this may sound rather picayune. But in English, the word "investment" has more than one meaning. And words have multiple definitions, eventually they lose meaning. Because I say one thing, you hear another. You can talk about a foreigner buying a share of GM, and we'll call that an investment in the stock market. What congressmen tend to hear is creating some form of productive capacity, like plant and equipment, and something especially with an employee parking lot. When really, what they've done is made a bank deposit in the U.S. and then used that bank deposit to buy a stock. No real productive capacity was created.
As long as you say the word "investment," I think a lot of people, and particularly politicians, will hear, "We're going to have bigger employee parking lots." That's just not necessarily true. Most of the money that's come into the U.S. in the last 30 years has not built productive capacity. Yeah, we have some Honda factories, and BMW factories, etc. But overwhelmingly, the money has just gone into the banking system. It's bank deposits. A lot of it winds up just financing dodgy consumer debt.
David D. Stewart: Now, is the U.S. unique in the way that it treats these foreign inflows? You're mentioning this nontaxation of capital gains.
Hillel Nadler: The U.S. isn't unique in the way it treats foreign financial inflows. At least, not now. But in some ways, the U.S. has been a leader on this.
If you go back to the 1980s, the U.S. introduces this exemption for interest income on portfolio debt. If you're a foreign investor, you hold a U.S. issued bond, then the interest on that bond is going to be, in most cases, going to be exempt from tax in the U.S. At the time when this exemption was introduced, the U.S. was alone, but other countries wanted to follow suit with the U.S., and other major economies, and they were worried about losing capital flows to the U.S., so they followed suit and also abolished their taxes on interest paid to foreign investors.
David D. Stewart: Now you mentioned this Bretton Woods, the fixed exchange rates. Since the collapse of that, what have been the results of the U.S. treatment of foreign investments since then?
Kenneth Austin: Well, I would say that there's really two periods. When the Bretton Woods system first collapsed, most of the Western countries, the advanced countries, whatever we want to call them — Europe, the U.S., Japan — just gave up on trying to control their exchange rates. The Japanese backtracked on that and it became a problem. But we backed up on that. We just let currencies move against each other. The Europeans didn't like that, and that started a movement towards the European Union.
A lot of other countries continued to control their exchange rate. The way you do that is you buy and sell foreign currency. Particularly, the U.S. dollar was very valued because we had big financial markets. You can move your money in and out quickly. If you wanted to make your own currency more valuable, you would buy it and pay for it in dollars, but you needed dollars to do that. Or if you want to depreciate your currency so you could run a larger trade surplus or smaller deficit, then you bought foreign currency. The price of foreign currency would go up, and that would encourage your exporters to earn more of the more valuable foreign currency, and discourage imports. If the price of foreign currency went down, it had the opposite effect. It was less valuable to you as an exporter, and it was cheaper to buy foreign goods.
That was a way to control your trade balance. For a long time, that mostly worked. I don't want to go in too much detail here, but things started to change when we had the oil crises of the '70s, because a lot of countries in the Middle East that had not previously had a lot of money to invest, they just started buying U.S. dollars. We allowed that. We actually encouraged that. Then the Reagan administration came along, did a lot of huge tax cuts, tried to cut the budget expenditures, but we still had a huge deficit. We were issuing a lot of U.S. government bonds, and that attracted more. Our interest rates went very high. A lot of people bought dollars around the world. Then that gradually tapered off.
By the late 1990s, America actually had a small fiscal surplus. But then, something new started to happen. There was what was called the global savings glut. A lot of countries, particularly in Asia, were growing very rapidly, and they were saving more than they were investing, actually finding uses for those savings. When the Asian financial crisis came, a lot of money came to the U.S. It also came from Europe, which was trying to reduce its budget deficits. So it all came here. The U.S. current account deficit, which is the trade deficit with some extras thrown in, basically tripled within about two, three years. Now all this money flowing into U.S. financial markets blew up the dot-com bubble, and we had a recession in 2000, two, three years after the Asian financial crisis.
Normally, that would have caused the trade deficits to shrink. It just shrank for a little bit. And then it started growing, because the rest of the world needed a place to put their money and it came to the U.S. That financed a larger and larger trade deficit. Because there are basically two ways you can get foreign currency. You can earn it by exporting; you can borrow it. Whether you want to borrow it or not, if you borrowed it, it causes your currency to become more expensive on world markets. That encourages trade deficit, because more is coming in than is going out.
Actually, what'll happen almost immediately is that the amount that you're borrowing and your trade deficit will be equal. It's actually to the penny because the balance of payments is a double-entry bookkeeping system, and that's the way it has to work.
David D. Stewart: What is the negative to the U.S. economy of having a lot of this money coming in?
Kenneth Austin: Well, one thing is our financial system can't always handle it. We just had a huge amount of money came in in the first decade of the 21st century. All of a sudden, you're watching all these TV ads, "Don't have to fill out paperwork, get our mortgage." A lot of these mortgages were bad. All sorts of ridiculous things happened in U.S. financial markets because interest rates started to go really low. People became desperate to find something they could actually put their money in. That led to a lot of the abuses that caused the great financial crisis.
At the same time, all this money was raising the price of the U.S. dollar. It was just not profitable to invest in U.S. production facilities anymore, because things could always be made cheaper elsewhere, particularly in China, and this was the China shock. There's some economic work that actually said this China shock, all these people who got thrown out of work in what are now the swing states — Wisconsin, Pennsylvania, Michigan, all across the Midwest, the old Rust Belt — a lot of these people, the children and grandchildren of New Deal Democrats, they voted Trump because somebody had to help. And if you look at the areas where that trade impact was the biggest, where the most jobs were lost, not only in the factories but in the surrounding towns that depended on the factories for the money that would be spent there, they were terribly harmed by this. It's very tangible, particularly to the people who lost their job.
David D. Stewart: Turning back to the tax policy underlying this, you mentioned the treatment of capital gains. Are there other things that the U.S. government is doing that are allowing inflowing dollars to escape taxation?
Hillel Nadler: Yeah. The basic structure of the U.S. tax code, especially as it relates to inbound investment, or inbound financial flows if you don't like to use the word "investment," is that it's very favorable towards passive investment by foreign taxpayers.
Your listeners are probably familiar — there are basically two different tax regimes that apply to foreign taxpayers: one that applies to passive investment income, and another that applies to active business profits from an active business in the United States. Very broadly, foreign taxpayers, if there's income that's derived from a U.S. trade or business, or in the lingo of the tax code, effectively connected with a U.S. trade or business, then on that income, they're going to be subject to the same graduated tax rates that apply to U.S. taxpayers. When it comes to passive investment income, nominally, that type of income is subject to tax at a flat rate of 30 percent on the gross amount of U.S.-sourced passive investment income.
But when it comes to that passive investment income, there are large gaps in that flat rate tax. For one, as we mentioned, capital gains from the sale of most U.S. investment assets, other than real estate, aren't taxed at all because they're not considered U.S.-source income. Also, interest from U.S. bank deposits, and most importantly, from U.S. portfolio debt, bonds, most other debt instruments, are also going to be exempt from U.S. taxation. And these two categories, capital gains and portfolio interest, account for the majority of passive income earned by foreign investors in the United States, and they're exempt from U.S. tax.
Kenneth Austin: Yeah. This is a bit I'm going to tread here on the tax part. But you can think of, if I own a Treasury bond, at the end of the year, I'm going to have some interest and a 1099 form. If I sell that bond to a German resident, then they get the interest on that bond, but it's disappeared from the U.S. tax base. And they pay nothing. And the U.S. isn't necessarily going to share the information with the German government that your resident or citizen earned this income on a U.S. bond. It's very hard for them to get it, and we made that system deliberate. Your choice is, "OK, I could buy a German bond, but I'm going to pay interest on it. If I buy an American bond, I won't." I could voluntarily pay some German taxes, but I may not.
If you look at, for example, a lot of Europe, you can find 40, 50, 60 percent marginal interest rates there. In the U.S., the worst you could do is pay the 30 percent withholding, but you don't have to. It's a much better deal from the tax point of view to put your money in the U.S. That is a result of U.S. policies designed to bring that money in. I think you can discuss what the politics is, but a lot of congressmen really believe that that money coming in is investment, in the sense it creates jobs and employee parking lots, when really it's just a bank deposit. What happens to that money after it gets here is anybody's guess, particularly the bankers.
Hillel Nadler: Just to add another wrinkle there, it's not just the statutory provisions of the code that offer favorable treatment, U.S. tax treatment, to foreign investment. The U.S. also has a network of bilateral tax treaties, which also exempt a lot of passive foreign investment from U.S. tax. But if you look at where financial inflows are coming, it's not just from those treaty countries. It's also from jurisdictions with which the U.S. doesn't have those bilateral tax treaties.
And that's because the other leg of the U.S. status as a tax haven, which is that the U.S., or U.S. financial institutions, can offer financial secrecy to their clients in a way that other jurisdictions can't, or other major economies and financial centers can't because other major economies signed up for the common reporting standard, which is reciprocal and provides for the automatic exchange of information between different jurisdictions and different tax authorities.
The U.S. has FATCA, which it adopted unilaterally, which provides the U.S. with a lot of information about U.S. taxpayers, but doesn't provide the same information to other jurisdictions and to other tax authorities. The U.S. financial institutions aren't required to collect and the U.S. isn't required to share information with other countries, for example, about the identity of controlling persons or beneficial owners of certain entities that are used to hold passive investments. Foreign investors can avoid tax reporting to their own tax authorities by holding U.S. accounts through U.S. entities, like LLCs or trusts, and things like that.
Kenneth Austin: If you'd spoke to the lobbyists behind a lot of these provisions, they'd say, "We're just trying to prevent double taxation." Double taxation isn't the issue. It's zero taxation.
If all the foreign financiers who bought these Treasury bonds paid tax somewhere, the full amount, particularly to their home government maybe in Denmark, or Switzerland, or Germany, they'd keep more of it at home, they'd be less inclined to bring it to the U.S. But the U.S. says, "Bring it here, and there won't be double taxation. There won't any taxation."
In some ways, double taxation might be unfortunate. But remember, nobody is forced to put their money somewhere else. They could always just keep it at home and pay their own taxes. They made a choice. Now I think one country collecting the tax makes sense. But to exempt these interest or other portfolio income from all taxes is a bit ridiculous. Since it's not symmetrical, it attracts more of that money here, which triggers a higher U.S. trade deficit.
David D. Stewart: It sounds like the policy of trying to get more money in was very effective. Maybe too effective. How would we go about unwinding that and making the U.S. less of a tax haven?
Kenneth Austin: We could theoretically eliminate the trade deficit overnight, but that would be a terrible idea. We want the economy to adjust. We don't want to shock it. We would have to rebuild an awful lot of factories and companies that were destroyed in the last 30 years. That would take time. Maybe four years, maybe 10 years. It's a guess now; we haven't started that project. We would want to do this gradually. Just gradually unwind this. We don't know how fast it would go, but as we get a little bit of experience, we should be able to do that. As long as we are, as I say, we want to do this carefully. It's not something we do overnight.
But during that period, we're going to be rebuilding all of these companies, all of these factories, and that will create a lot of jobs. That transition period will be a period of prosperity.
I'll let Hillel talk about how he would wind it down.
Hillel Nadler: Sure. I think, for starters, reversing some of these exemptions, the current exemptions for portfolio interest, for example, would be a first step towards making U.S. financial assets and foreign financial inflows less attractive. Providing reciprocal exchange of information so that, even if these foreign investors aren't paying tax in the U.S., we can at least help ensure that they're paying tax to their home governments.
But I do want to caution, our argument isn't that the only reason investors are holding U.S. financial assets is because of favorable tax treatment. There are a lot of reasons why someone outside the U.S. might want to hold a U.S. asset. This goes into the status of the U.S. dollar as a reserve currency, and all sorts of other reasons why people might want to hold U.S. financial assets. We just think the tax treatment is part of the picture. If we're trying to reduce foreign financial inflows, part of the solution is to start thinking about reversing some of the favorable tax treatment that foreign investors get.
Kenneth Austin: There are other things we could do. A few years ago, I think it was 2018, there was a bill introduced into the U.S. Senate, the Baldwin-Hawley Bill. That would have introduced, I think, the market access charge — I think Hillel calls it a transactions tax — which was a small payment every time you converted another currency into the dollar. Unfortunately, the bill went nowhere, but it was the right approach.
The thing is, you can't reduce the trade deficit by imposing tariffs. It doesn't work. It just results in same trade deficit, just at a more appreciated dollar. What you have to do is attenuate the financial inflows. I think ideally, we might want to bring those to zero. Now lots of people would still own dollars abroad, but they just on net wouldn't be buying more. If you got to that point, U.S. current account deficit, which is, as I said, a larger definition of the trade deficit, would go to zero.
David D. Stewart: The issue of extra money coming into this country doesn't seem to be something that is talked about as a negative. Why is it that you're viewing this as a negative, but we don't generally hear that from other people discussing the issue of trade imbalances?
Kenneth Austin: That's a very good question I ask myself. I say, "Why am I one of the few economists that wants to do this?" I am a retired Treasury economist, and nobody wanted to talk about it.
But I think part of it is, among mainstream economists, there seems to be an ideological taboo against this. One reason is mainstream economists hate the idea of what used to be called capital controls. It's still actually called capital controls, although once again, it's not little factories flowing across the world. It's just bank deposits.
They keep saying, "Oh, well this is investment." And actually, some pretty good economists confuse this flow of bank deposits with, they say, "Real, productive capacity." New factories, new electrical generation facilities, ships, transport, all this stuff. It's not. It's bank deposit. But by this verbal ambiguity, they convince themselves of it.
But they do know that this is really a question of financial flow. In 2016 Alan Blinder, who I think is probably almost the definition of mainstream esteemed economists, wrote an op-ed piece in The Wall Street Journal on five important facts about trade. He said, "A trade deficit isn't so bad because we're getting real goods and services, and the rest of the world is just getting our IOUs" of bonds, stocks, corporate bonds, treasury bonds. "It's just paper. It's just paper. Is that so bad?"
Well, that is ridiculous in the sense that it's something worthy of ridicule. And for an economist of his stature to say that, I don't even know if it's plausible he believes it. It's an astonishing thing to say. But I can give you other examples of economists just twisting themselves in knots, not to acknowledge that the U.S., if we stop borrowing — the one exception that I find is when the other party holds the White House, then everybody comes really worried about the budget deficit, and blames all the borrowing and the budget deficit for the trade deficit. But that's not necessarily true.
When these large trade deficits began in the late '90s, the U.S. actually had a small fiscal surplus. But the rest of the world had the global savings glut. They just had a lot of money that they couldn't use at home. So it came here.
David D. Stewart: Well, this has been fascinating. Ken, Hillel, thank you so much for being here.
Hillel Nadler: Thank you very much for having us.
David D. Stewart: And now, coming attractions. Each week we highlight new and interesting commentary in our magazines. Joining me now is Acquisitions and Engagement Editor in Chief Paige Jones. Paige, what will you have for us?
Paige Jones: Thanks, Dave. We are excited to announce that our Editors' Wish List for fall 2024 is now live. Twice a year, our editors share a list of subject areas that they hope to see covered in the coming months. Follow the link in our show notes to check out the topics sought by our commentary editors to inspire your next submission to Tax Notes.
This week in Tax Notes Federal, Joe Skarbek examines the exclusion for qualified small business stock. David Kamin argues that 2025 looks like an appropriate year for fiscal consolidation, given the macroeconomic context for the TCJA's expiring provisions.
In Tax Notes State, Xiaoli Ortega examines the complex relationship between Utah's income tax cuts, school funding, economic growth, and rapidly rising property taxes. Billy Hamilton examines water shortages, focusing on California.
In Tax Notes International, Julien Tremblay-Gravel argues that a unified tax regime could serve to address the collective action problem of climate change. Jeffrey Kadet responds to a recent article on reforms to the subpart F and GILTI regimes.
And finally, in featured analysis, Joe Thorndike examines recent proposals by Vice President Kamala Harris and former President Donald Trump to exclude tipped wages from taxation.
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