A new law aims to lure money from overseas investors
On the surface, the tax bill that President Reagan signed last month is a timid, election-year effort to shrink the fearsome federal budget deficit, expected to be about $175 billion for fiscal 1984. The legislation aims to boost Government revenues by $50 billion over the next three years through such steps as raising liquor taxes and reducing business deductions for luxury cars. But buried in the fine print of the 751-page 1984 Deficit Reduction Act is a fundamental change in the way the tax code treats foreigners who invest in the U.S. The measure could attract more money from overseas, which would help finance the U.S. budget deficit, hold down interest rates and perhaps spark a boom in the stock and bond markets. Indeed, the rally seemed to have already started last week.
Up to now, foreigners who bought American bonds or other financial assets in the U.S. were subject to a 30% withholding tax on interest earned. The new legislation ends the withholding, making the investments tax-free to overseas buyers. Suddenly America has become the largest and possibly the most alluring tax haven in the world.
The U.S. is already heavily dependent on foreign money. Last year alone some $86 billion poured into American investments from abroad. By enlarging the pool of capital available for lending, the inflow from overseas has helped ease pressure on interest rates. Without the foreign investment, the prime rate that U.S. banks charge corporate customers, now at 13%, might be 1 to 3 percentage points higher.
Foreign banks and other financial institutions have been big buyers of U.S. bonds. But most individual foreign investors, seeking to avoid the U.S. withholding tax, have favored certificates of deposit offered by overseas units of American banks and bonds issued by U.S. companies in foreign financial centers where taxes are minimal. Now that the American tax has been repealed, foreigners may develop a taste for bonds sold in the U.S. The prospect of increased foreign capital flows and stable interest rates could further fuel the bull market that was gathering force last week.
The U.S. Treasury Department urged Congress to repeal the withholding tax. Treasury officials want to sell foreigners more bonds as a way of reducing the interest rates that the Government pays to finance its deficit. Part of Treasury’s motivation is political. The last thing Reagan needs in an election campaign is rising interest rates.
The tax repeal has stirred resentment abroad. One European government official accuses the U.S. of “robbing the rest of the world of capital.” To keep from losing too much money to the U.S., foreign countries may have to raise their interest rates. In West Germany the central bank and the Finance Ministry have suggested that the government should consider exempting foreigners from tax on its bonds as a way of countering the U.S. strategy.
Many Americans also take a jaundiced view of what the U.S. Treasury is doing. Says Richard Banz, a bond specialist with the London subsidiary of Chase Manhattan Bank: “Never underestimate the ingenuity of a government when it needs money.” Critics point out that the new legislation will create an unusual two-tier system in which American investors will continue to pay taxes on bond earnings while foreigners will not. For this reason, John Heimann, former U.S. Comptroller of the Currency, calls the tax repeal a “cynical decision” that invites abuses. American drug dealers and other tax dodgers could use foreign middlemen to invest their cash tax-free in U.S. bonds.
Wall Street investment houses are betting that they will benefit from the tax repeal. In the past, U.S. corporations that wanted to sell bonds to foreigners have generally set up offshore subsidiaries in tax havens like the Netherlands Antilles. Those subsidiaries issued Eurobonds, which are marketed primarily in London and other European financial capitals. Because of the tax repeal, foreigners may now be willing to buy more corporate bonds issued in the U.S. through New York investment firms. European bond houses are confident, however, that their Eurobond business will not be severely hurt. Reason: European investors who like personal service will still buy bonds from nearby sources.
In addition to making U.S. securities tax-free for foreigners, the Treasury is also considering issuing so-called bearer bonds, which can be bought anonymously. As of now, investors who buy U.S. Government securities must supply their names and addresses, and no one else can collect interest on the bond. Interest on bearer bonds, in contrast, is paid through coupons that are attached to the bond. Anyone who presents one of the coupons can receive the interest. Bearer bonds, which have traditionally been issued by many European governments and companies, are popular with investors eager to avoid the scrutiny of tax collectors.
Several members of Congress, including Republican Senator Robert Dole of Kansas, are concerned that issuing bearer bonds would mean that some Americans would evade taxes by buying the securities through foreign sources. West European governments have informally urged the U.S. not to resort to bearer bonds. Admits a Treasury official: “Going to that kind of bond might be seen abroad as an admission that we can’t finance our own deficit.”
The greatest risk from the withholding-tax repeal and the sale of bearer bonds is that the U.S. will grow even more dependent on foreign capital. For decades, America has been a creditor to the rest of the world. But the U.S. may soon owe foreigners more than they owe the U.S. Says Roger Kubarych, senior vice president of the New York Federal Reserve Bank: “By next year, the U.S. could have a net debt of $50 billion.”
If overseas investors were to lose confidence in the American economy and begin pulling out money, the result could be a surge in U.S. interest rates. The inflow of foreign capital is merely buying a little more time for the U.S. Government to take steps to close its dangerous budget deficit. —By Charles P. Alexander. Reported by Lawrence Malkln/Paris and Frederick Ungeheuer/New York
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