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Why we should tax interest earned by foreigners in the United States
Howard Richman, 4/22/2010

In my last commentary, I pointed out the unintended consequence of the revenue enhancing part of the HIRE Act which would cause a greater net inflow of foreign savings to the United States which would reduce American manufacturing jobs and investment.

Instead, I advocated several alternatives that would have the opposite effects, such as Congress restoring the 35% withholding tax on foreign interest earned in the United States (a tax which was withdrawn in 1984).

My alternative proposal would tax interest income just as dividend income is already taxed, with each country taxing income earned in that country.

After foreign governments reciprocate, American tax payers would pay income tax on interest earned abroad to foreign governments but get a tax credit which they could deduct from their tax liability to the American government on those interest earnings.

My proposal is fair. It gives foreigners no advantage over Americans when lending to Americans. Moreover, it recognizes the destructive nature of most financial capital inflows.

There is a simple taxation principle here. For reasons of fairness and tax efficiency, income should be taxed where it is earned. Double-taxation is avoided when your own government rebates foreign taxes.

Although I generally hold that the FairTax would be a huge step forward over our current income tax. The current FairTax bill shares a problem with our present income tax law. In other words, there should not be any exceptions to the sensible policy of part (a) of Section 905 of the FairTax bill of 2009. Part (b) should be deleted from the bill. Section 905 currently reads:

(a) In General- All persons, in whatever capacity acting (including lessees or mortgagors or real or personal property, fiduciaries, employers, and all officers and employees of the United States) having control, receipt, custody, disposal, or payment of any income to the extent such income constitutes gross income from sources within the United States of any nonresident alien individual, foreign partnership, or foreign corporation shall deduct and withhold from that income a tax equal to 23 percent thereof.

(b) Exception- No tax shall be required to be deducted from interest on portfolio debt investments.

(c) Treaty Countries- In the case of payments to nonresident alien individuals, foreign partnerships, or foreign corporations that have a residence in (or the nationality of a country) that has entered into a tax treaty with the United States, then the rate of withholding tax prescribed by the treaty shall govern.". Apr 22 10:46 PM Reply 00What would you like to do now?

There are two alternative views of where interest income should be taxed:

1. The economists who are listened to in Washington think that borrowing money from foreigners is almost always good because it lowers American interest rates making it easier for our government to run huge budget deficits. Thus they give a huge tax break to foreigners on interest earned in order to get them to lend us their money.

2. Others, including myself, think that borrowing money from foreigners causes the dollar to strengthen which makes American producers less competitive, taking away investment opportunities in the United States, leading to slower economic growth and eventual debt crises.

It's partly the difference between those who think short-term and those who think long-term. Unfortunately, Washington is dominated by short-term thinking.

Comment by Guest, 4/24/2010:

Very few countries of the world tax interest income for individuals at anything close to 35%.  If I live in one of them, why would I invest in the US and lose 35% of my interest to tax?  My local government won't rebate the whole 35%, only the portion that equates to my local rate.  In the worst case, that could be nothing at all, Hong Kong, say.

This, by the way, will be one of the unintended consequences of the HIRE act -- a net outflow of capital from the US, since foreigners will no longer be inclined to invest with the country.  Arguing about where internationally invested income "should" be taxed is pointless while tax rates differ across nations, since entities will always invest where it is most advantageous for them.

Response to this comment by Guest, 4/24/2010:
"If I live in one of them..." should be "Unless I live in one of them...". What you propose would fundamentally subject foreigners investing in the US to harsher terms than they'd receive if investing elsewhere.  Under these circumstances, they're simply going to invest elsewhere. The FATCA provisions in the HIRE act have already begun the process.  The US is inexorably walling itself in behind a pile of bad tax policy.  

Response to this comment by Howard Richman, 4/25/2010:
I disagree with your conclusion that the HIRE act will cause a net outflow of capital out. I also disagree with your conclusion that it is good for a country to get a net inflow of foreign capital. Just how much did it benefit the United States to get the huge inflow of foreign capital from 1996-2009? The main effects upon our economy were: (1) a house price bubble, (2) a loss of millions of manufacturing jobs, (3) a shrinkage of net investment in manufacturing to near zero levels, and (4) a ballooning debt to foreign investors.

Comment by David Shipp, 4/24/2010:

Having accounts attracted from other countries woud be a good thing. Any time Banks have money to lend it improvess the US economy. Taxing those accounts would decrease the attraction of  foriegn investors.   In general, any tax more than what is needed to run the country is NOT a good thing. Fairtax puts all the Governement taxes in palin sight. Perhaps people will begin to see that the Government is over spending We the APeoples money.  Fairtax has been analyzied and demonized ad nausium Lets get it passed.

Response to this comment by Howard Richman, 4/24/2010:
David, I disagree. When financial capital flows into the United States, strengthening the dollar, it makes the U.S. economy worse not better. Although interest rates go down, investment opportunities go down for those American industries that compete in the world market place. We have scene this scenario play out since 1996. Howard

Comment by William Pitt, 4/25/2010:

I am glad there are some who recognize the folly of our present tax system and the destructive path we are going down.