November 27, 2002 | Executive Memorandum on Taxes
Clinton-Era IRS Regulation Threatens Economy and Financial Markets
Three days before President Bill
Clinton left office, the Internal Revenue Service (IRS) proposed a
regulation (No. 126100-00) that would have forced American banks to
report the interest they pay on the deposits of nonresident aliens.
The IRS openly admitted that the information collected would be
forwarded to foreign governments and that the regulation was
designed solely to help those governments tax income from accounts
in the United States.
This midnight rule generated
considerable controversy. The financial services industry said that
the proposed regulation would drive funds from U.S. banks and
undermine the industry's global competitiveness. Taxpayer
organizations opposed the rule because it would create an obstacle
to tax reform and undermine fiscal competition between nations. In
effect, the regulation would have put the enforcement of foreign
tax law ahead of America's economic interests.
Faced with strong opposition, the IRS
was forced to withdraw the rule in the summer of 2002.
Unfortunately, that was a hollow gesture. After a few cosmetic
modifications, the IRS quickly reissued the Clinton-era regulation
(with a new number, 133254-02) and now the agency is pushing to
finalize the proposed regulation.
The IRS scheme would cause serious
damage to the U.S. economy, driving away funds from the economy and
weakening financial markets. Equally troubling, the IRS is abusing
the regulatory process. In its zeal to impose an ideological
agenda, the Service is flouting the law and running roughshod over
important procedural safeguards. The proposed regulation should be
Harm to the U.S. Economy
Investment capital from overseas helps finance growth and
boost financial markets, but the proposed regulation would make
America less attractive to the world's investors. If the regulation
Capital will flee
According to privatesector estimates and government data,
nonresident aliens have deposited approximately $1 trillion in U.S.
banks. This money helps finance car loans, home mortgages, and
small business expansion for Americans. This influx of capital has
been a direct result of very favorable tax and privacy laws for
nonresident aliens, but these policies will be overturned if the
IRS regulation is approved. According to a study commissioned
by the Florida Bankers Association, it is likely that at least
one-third of affected deposits will shift to foreign banks in
places such as London and Hong Kong.
U.S. banks will become less
Bank deposits can travel around the world at the click of a
computer keyboard, as investers seek better returns and more
security. Although American banks traditionally have been
successful in this competitive environment, their ability to
attract deposits from overseas almost surely will shrink if banks
are forced to act as deputy tax collectors for foreign governments.
U.S. banks will then find it harder to meet the challenge of
Banks will suffer a paperwork
Although the IRS claims that financial institutions will
need only 500 hours to comply with this new regulation, this is an
absurdly low estimate. Banks will need to read the rule, analyze
its meaning, get appropriate legal and accounting advice, and
report on thousands of accounts.
Tax reform will be
Tax reform is based on common-sense principles, including
the premises that funds should not be double taxed and that
taxation should be limited to national borders (territorial
taxation). The IRS regulation violates both of these principles of
Fiscal competition will be
The IRS rule will make it much harder for foreigners to
take advantage of better tax laws in other nations. It will make it
much easier for high-tax governments to impose levies on income
earned outside their borders and will encourage foreign governments
to increase marginal tax rates on mobile capital.
The IRS clearly is attempting to usurp the role of the
legislative branch by replacing existing law with a regulatory
edict, and it is flouting proper procedural guidelines.
The proposed regulation would
overturn existing law.
Because they wanted to attract capital to the American
economy, legislatorschose not to tax bank deposit interest paid to
nonresident aliens and have consistently decided against requiring
that such income be reported. The proposed IRS regulation would
overturn the outcome of this democratic process.
The IRS is misusing its
The IRS is supposed to issue regulations that help
enforce U.S. tax law. Since the U.S. government does not tax bank
deposit interest paid to nonresident aliens, there is no need to
collect this information. The IRS admits that the purpose of the
proposed regulation is to help foreign governments tax U.S.-source
The IRS has not performed a
required cost/benefit analysis.
The IRS is trying to dodge the legal requirement to
review the costs and benefits of its actions. It has arbitrarily
declared that most of its regulations are either "interpretative"
under the Administrative Procedure Act or not "major" for purposes
of Executive Order 12866. For all intents and purposes, this means
that the Internal Revenue Service has effectively exempted itself
from regulatory oversight.
The IRS regulation requiring that interest on foreign bank
deposits must be reported is bad tax policy and bad regulatory
policy. It will hinder President Bush's tax reform agenda and it
will damage the U.S. economy by reducing the amount of capital that
will be available for America's workers, consumers, homeowners, and
entrepreneurs. Treasury Secretary O'Neill should immediately
withdraw this regulation.
J. Mitchell, Ph.D., is McKenna Senior Fellow in
Political Economy in the Thomas A. Roe Institute for Economic
Policy Studies at The Heritage Foundation.