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CF&P Strategic Memo, June 26, 2002

Center for Freedom and Prosperity Strategic Memorandum

Date:  Wednesday, June 26, 2002

To:      Supporters of tax competition and fiscal sovereignty

From:  Dan Mitchell, Heritage Foundation Senior Fellow

Re:      Who is in Charge: President Bush or IRS Bureaucrats?

 The European Union issued a communiqué last week claiming that the United States supports the "savings tax directive," a tax harmonization proposal that would require American financial institutions to act as vassal tax collectors for Europe's welfare states. Specifically, the EU claimed, "Contacts at political and technical level have been held with the United States, Monaco, Andorra, San Marino and Liechtenstein. These States have expressed their willingness to cooperate with the European Union." [Emphasis added]

 If true, this would be an enormous betrayal by the White House. President Bush was elected to lower taxes and reduce the burden of government. Capitulating to Europe's welfare states would be a victory for the career bureaucrats at Treasury and the IRS and a stunning defeat for the President's economic team.

Déjà vu?

 There is a growing concern that President Bush might be repeating his Father's mistakes. The first President Bush was elected to be an heir to Ronald Reagan, but he spent the next four years presiding over higher tax rates, record spending increases, and numerous regulatory impositions. The result, not surprisingly, was economic stagnation and the election of Bill Clinton.

The current President Bush started out on the right foot, pushing through a modest tax cut, but things have gone downhill ever since. Budget-busting farm bills and protectionist steel tariffs are symbolic of a dangerous drift. Little wonder U.S. financial markets have been sluggish. One can only imagine what would happen if the Savings Tax Directive was implemented and foreigners withdrew more than $1 trillion from the U.S. economy.

Good News, But it Depends on Who is Lying to Whom

 The White House and the Treasury Department both deny that the Bush Administration has endorsed the EU's proposed tax cartel. Various Administration officials vigorously insist that the EU communiqué is a grotesque misinterpretation of the President's position. They state that the Administration has engaged in staff-level discussions with EU officials, but those meetings have been designed solely to learn more about what the Brussels-based bureaucracy is proposing.

 So is the Bush Administration lying to its pro-tax competition supporters? Or is the EU lying to the world in order to create a false sense of momentum for a proposal that is on the brink of self-destruction?

In all likelihood, this confusion may be the result of struggles inside the Administration. The career bureaucrats at Treasury and the IRS are ideological zealots and they fully support the EU "Savings Tax Directive." These people, many of whom worked on tax harmonization issues for the Clinton Administration, are the ones that would have attended the lower-level and mid-level meetings with their EU counterparts. Needless to say, it is quite likely that these bureaucrats would have expressed support for the EU scheme.

 Similarly, it is not surprising that the President's political appointees and economic advisers vehemently deny that the U.S. is supporting the EU's proposed cartel. These men and women generally support competitive markets. They also understand that countries benefiting from international capital flows have nothing to gain from tax harmonization schemes. Perhaps more importantly, they also are people who want President Bush to serve a second term. And as the first President Bush demonstrated, initiatives that expand the size and cost of government are bad economics and bad politics.

  Since the President and his senior staff will make the final decision, this logically should mean that the "Savings Tax Directive" is dead. But this would be an unwise assumption. The Administration knew that the farm bill was a mistake, but the President signed the bill. The Administration knows that steel protectionism is counter-productive, but the President imposed the tariffs. The Administration knows that new entitlement programs are irresponsible, but the President has endorsed a mental health coverage mandate.

 Because of the Administration's less-than-stellar record, supporters of tax competition must work even harder to make sure that America's economic interests are not sacrificed on an altar of political expediency. To be sure, it is difficult to imagine that the White House might conclude that there is a political reason to support the "Savings Tax Directive" (after all, French tax collectors – unlike U.S. farmers and steelworkers – cannot vote in America). Nonetheless, advocates of competitive tax policy must pressure the Administration lest the President and his team get snookered by zealous IRS bureaucrats and self-serving EU politicians.

The Savings Tax Directive: A Threat to America

 Fortunately, there are many strong arguments against the "savings tax directive." This scheme would require financial institutions in low-tax nations to comply with the tax laws of high tax nations. Specifically, it would require those institutions to ignore their fiduciary responsibility and report to government the savings and investment activities of nonresident clients. In addition to the 15 EU nations, six non-EU nations are being asked to participate – including the United States and Switzerland. Indeed, the proposal does not take effect unless all 21 nations agree to participate in the cartel. The EU would like to obtain agreement from all targeted countries by the end of 2002.

The Savings Tax Directive would undermine sovereignty, tax competition, and tax reform. It is bad sovereignty policy since it assumes that nations with good tax policy can be forced to change their laws to prop up the bad tax laws of other countries. It is bad tax competition policy since it is a form of indirect tax harmonization that would prevent an individual taxpayer from benefiting from lower tax rates in other nations. And it is bad tax reform policy since it violates two important principles – first, that income should never be taxed more than one time, and second, that governments should only tax economic activity inside national borders.

But this is not just a matter of principle. The "savings tax directive" is a threat to America's competitive advantage in the world economy. The U.S. is a capital-inflow nation, and it has attracted more than $5 trillion of passive investment from overseas because of appealing tax and privacy laws for foreign investors. This is money deposited in American banks and money invested in American companies. If the IRS requires American financial institutions to enforce foreign tax laws by reporting the income and assets of foreign clients, a substantial share of that money will flee the U.S. economy.

Responding to the Critics

Supporters of the "savings tax directive," particularly career bureaucrats at Treasury and the IRS, argue that the U.S. government will collect more tax revenue if the proposal is implemented because there are some Americans with unreported (and therefore untaxed) investments in other low-tax jurisdictions. This certainly is true, but even greatly exaggerated estimates of foregone tax revenue ($20 billion per year) provide scant evidence that the "savings tax directive" is in America's interests. The putative benefit (more money for politicians to spend) is greatly exceeded by the loss of hundreds of $billions – probably well in excess of $1 trillion – of job-creating private sector capital.

Another argument for the proposal is that the destruction of financial privacy somehow will help track down terrorist funds. There is zero evidence for this proposition. The United States certainly had the ability to track the terrorist accounts at SunTrust in Florida, but such tracking ability is only valuable if accompanied by effective intelligence so law enforcement knows whom to investigate. The EU "savings tax directive" would create a giant haystack of financial data, which would make it harder – not easier – for law enforcement to find the needles. In any event, mutual legal assistance treaties and other bilateral initiatives are a far better way to investigate and prosecute universally recognized crimes like drug-running and terrorism.

Another Reason to Defeat the EU

While there are many reasons to reject the EU "Savings Tax Directive," high on the list is the collateral damage that would be imposed on the OECD. The Paris-based bureaucracy was the instigator of the infamous "harmful tax competition" project. This effort largely failed because persecuted "tax haven" jurisdictions wisely stated that they would not impose bad tax law on their economies unless all OECD member nations agreed to abide by the same misguided policies.

Yet if the EU "Savings Tax Directive" is implemented, this presumably would oblige OECD tax havens (such as Switzerland, the United States, Luxembourg, and the United Kingdom) to abolish their appealing tax laws for nonresident investors. As a result, the jurisdictions that sent meaningless "commitment letters" to the OECD suddenly would find themselves in a difficult position.


If the Administration supports the "savings tax directive," there will be an adverse reaction from the President's core supporters. The White House should not take that risk. In addition, approval of the "savings tax directive" would damage American financial markets. Money would be withdrawn from the U.S. economy, the dollar would be weakened, and the recovery – which already is rather anemic – would be jeopardized. Most important of all, the President should reject the "Savings Tax Directive" because it is inconsistent with American values.

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