February 1, 2001
IRS stealth attack on economy?
by Daniel Mitchell
What's the greatest threat to our economy? Is it that interest rates or income taxes are too high? That Americans are saving too little? That federal lawmakers have a talent for
spending budget surpluses? Good guesses, all — but the answer may turn out to be the Internal Revenue Service. Why? Because the IRS has two new regulations that are going to scare away a lot of overseas investors.
And the United States benefits enormously from foreign investment.
In the last two decades, America has become a magnet for savings and investment from around the globe. In part, this is because our free-market economy rewards those who want to
create wealth. But it also is because the United States is a tax haven. Foreigners who put their money to work in our country pay very little tax, either to the IRS or to any other government.
This low-tax policy has yielded enormous benefits for our economy. Foreigners have between $7 trillion and $10 trillion invested in the United States. This translates into seed
money for small business, venture capital for high-tech start-ups, and financing for our manufacturing sector. Perhaps more importantly, this investment has boosted worker productivity, helping push wages and
salaries to all-time highs.
But this could all be severely harmed by the IRS' latest regulations, which foreign investors believe will result in a loss of financial privacy and in higher taxes. As a result,
they will likely shift money to other countries. And there will be many options. In a competitive global economy, dozens of nations are hungry for new investment and would be happy to profit from our self-inflicted
So what exactly has the IRS done? The first mistake occurred when the agency implemented "Qualified Intermediary" regulations earlier this year. Known as the QI
regulations, these rules require foreign financial institutions that are investing client money in America to reveal the identity of individual investors. The IRS claims this is necessary to prevent American
taxpayers from anonymously investing here in order to take advantage of the favorable tax treatment provided to foreign investors.
This sounds good in theory, but probably won't work well in practice. For one thing, it is highly unlikely the IRS will catch any Americans trying to avoid or evade taxes. Not
because there aren't any, but because they aren't stupid. If an American has money in an offshore account and is investing in the United States, he easily can avoid the QI regulations by shifting investments to
other countries. Our economy loses capital, and the IRS doesn't get any money — a lose-lose situation.
A bigger problem, though, is that many investors from other countries want to protect their privacy. As such, they will be leery of investing their money here if it means their
personal financial affairs will be scrutinized by tax collectors. Far better to simply shift investments to a country without such intrusive regulations.
The QI regulations also raise troubling concerns about national sovereignty, because the IRS is essentially forcing foreign financial institutions to serve as adjunct tax
collectors. But how would we feel if another country was forcing American businesses to help them collect taxes? Hopefully, we would object, but it is going to be harder to resist this kind of encroachment since
we're guilty of the same practice.
Indeed, this may already be happening. As part of the last-minute rush of regulations issued by the Clinton administration, the IRS just proposed making U.S. banks divulge the
interest they pay to foreign account-holders. This is the other half of the IRS' one-two punch against foreign investors, and there can be little doubt many will respond by pulling their money from American banks.
Oddly enough, the IRS isn't seeking this information to collect more taxes. Instead, it is trying to help other governments collect more taxes. It doesn't take an economist to
understand what will happen if this regulation goes into effect. Money will leave this country for other jurisdictions, and our economy will suffer.
Our tax laws should be based on what is best for the United States, not what is best for foreign tax collectors. Government bureaucracies should not be allowed to use regulatory
edicts to change fundamental tax policy, especially when they undermine America's competitive advantage and threaten our prosperity.
Daniel Mitchell is the McKenna senior fellow in political economy at the Heritage Foundation.