The Heritage Foundation

Executive Memorandum #757 on Taxes

July 5, 2001

July 5, 2001 | Executive Memorandum on Taxes

Proposed IRS Regulation Flouts Congress and Would Harm the Economy

On January 17, 2001, the Internal Revenue Service issued a proposed regulation (REG 126100-00) that would force U.S. banks to report the bank deposit interest they pay to nonresident foreigners. According to the IRS, the purpose of the regulation is to help foreign governments collect tax on that U.S.-source income. This directive-proposed just three days before President Bill Clinton left office-is hopelessly flawed and should be withdrawn by the Treasury Department.

Discourages Investment
Under current law, America is a safe haven for international investors. Foreigners (except for Canadians) can deposit money in American banks, secure in the knowledge that their private financial information will not be divulged to tax authorities in their home countries. As the Independent Community Bankers of America wrote, in their comments opposing the IRS regulation, Foreign deposits under U.S. management are largely a function of the confidentiality, privacy, and stability of the U.S. banking system." Because of this attractive arrangement, American financial institutions have attracted about $1 trillion of deposits from nonresident aliens.

A substantial amount of this capital will be withdrawn from the U.S. economy, however, if the IRS forces financial institutions to act as informers. Simply stated, there are many jurisdictions around the world that would welcome these investors and their funds-countries and territories that respect financial privacy and understand that it is not their role to enforce the misguided tax laws of other nations.

This is why the financial services industry is united in opposition to the IRS initiative. The American Bankers Association wrote, "the unilateral imposition of these information requirements on U.S. banks will drive low-cost bank deposit funding to foreign banks." The California Bankers Association wrote that, "This is contrary to the interests of banks and could have negative ramifications on the economy." Indeed, the economic effects would be significant. Foreign deposits in U.S. banks are a source of capital that generates American jobs, promotes business expansion in the United States, and boosts America's financial markets.

Flouts Congressional Intent
Regulations are supposed to implement the laws approved by the legislative branch. Yet this proposed IRS regulation flagrantly ignores the laws Congress has enacted and clearly seeks to replace legislative intent with regulatory edicts. On several occasions, Congress has revisited the issue of how to tax-or not tax-the bank deposits of nonresident aliens. In each instance, because of the desire to attract capital to the U.S. economy, Congress has chosen not to tax the income and not to require that the income be reported to foreign governments.

Commenting against the proposed regulation, America's Community Bankers wrote, "The proposed regulations would contravene an explicit congressional policy of encouraging foreigners to deposit funds in U.S. banks, which is expressed in the exemption of deposit interest payments from [a] 30% withholding [tax] and information reporting."

Not only does the regulation seek to overturn existing law, it also ignores the law governing how regulations are to be issued by failing to provide the required cost-benefit analysis. As the Credit Union National Association noted, "We also question the IRS's Special Analyses accompanying the proposal regarding whether the rule is a significant regulatory action, the applicability of the Administrative Procedure Act and the applicability of the Regulatory Flexibility Act." The firm of Miller & Chevalier was more direct, commenting, "This type of regulation is exactly the sort that the Congressional Review Act and the Executive Order [12866] sought to subject to closer study."

Bad Tax Policy
Perhaps most important, the proposed regulation is bad tax policy. It is based upon a worldwide theory of taxation, which assumes governments should be able to tax the income their citizens earn in other nations. Yet this approach is anti-competitive since it makes it very difficult for taxpayers to shift their activities to a lower-tax environment. It also is an infringement of privacy, since it requires the collection and sharing of private financial information between governments. The preferable approach is a territorial tax system. Territorial taxation is based on the common-sense notion that governments only tax income earned inside their borders. Within that constraint, a government is allowed to adopt any type of tax or impose any level of tax, but it does not have the right to impose its tax laws on income earned in other jurisdictions.

The IRS regulation violates this principle of good tax policy by seeking to make it easier for foreign governments to tax income earned in the United States. Yet the only government that should have the right to tax bank deposit interest earned in the United States is the United States. Other governments, of course, can enact laws designed to tax their citizens on income they earn in the United States, but the U.S. government has no obligation to help enforce the tax laws of other nations.

The proposed regulation also is bad tax policy in that it assumes it is appropriate to impose a harsher tax penalty on income that is saved and invested than on income that is consumed. This is particularly foolish since every economic theory-even Marxism-agrees that capital formation is the key to long-term growth and rising living standards. The easiest way to remove the anti-savings bias in the tax code is to give IRA treatment to all income (i.e., income would be taxed the year it is earned but there would be no second layer of tax on earnings if a taxpayer saved and invested any after-tax income). This explains why bank deposit interest should not be taxed, regardless of whether the recipient is a U.S. resident or non-U.S. resident.

The proposed IRS regulation flouts congressional intent and seeks to overturn existing law. It is bad economic policy, bad tax policy, and bad regulatory policy. The Treasury Department should withdraw this misguided regulation.

Daniel J. Mitchell, Ph.D., is the McKenna Senior Fellow in Political Economy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy

Related Issues: Taxes