TCS Daily

Avoid This STD!

By Daniel J. Mitchell - March 10, 2004 12:00 AM

High-tax nations like France and Germany hope fellow members of the European Union will vote this June to approve a directive governing the taxation of interest payments. This savings tax directive (STD) is designed to slow the flight of capital to low-tax jurisdictions and would require all EU nations -- and selected non-EU jurisdictions such as Switzerland and the United States -- to participate in a savings tax cartel. If the STD is implemented, nations will have two choices:

1) Collect information about interest payments made to nonresident investors from EU nations, and then provide that information to the tax authority of the investor's government so it can be taxed; or

2) Impose a withholding tax on interest payments to nonresident investors from EU nations, and then provide the lion's share of the money to the tax authority of the investor's government.

High-tax governments think that the STD will help them track down money that their citizens have deposited in places like Luxembourg and Austria, but this naively assumes that the money won't flow someplace else. In reality, financial capital is extremely mobile, and a few clicks of a computer keyboard are all that it takes for investors to shift their funds to a safer environment.

EU officials think they have solved this problem by requiring the participation of Switzerland, Monaco, Andorra, San Marino, Liechtenstein, and the United States. They even require EU nations to compel their territories to participate, thus roping "offshore" jurisdictions such as the Cayman Islands into the cartel. This sounds like good news for revenue-hungry politicians, but they shouldn't count their chickens before they hatch. They may have grandiose dreams of having more money to spend, but there are three reasons the STD probably won't work -- and one big reason why it will backfire if it does work.

The directive is riddled with loopholes. The STD is designed to tax interest payments made to "individuals" -- a term which excludes legal entities. As a result, a significant number of people seeking to protect their money will set up companies, trusts, and foundations. Others will work with the financial services industry to re-characterize their capital income so that it is no longer in the form of payments covered by the directive. The EU certainly will seek to expand the scope of the STD to cover these various strategies. Indeed, such efforts already are under way. But if there is going to be a contest between government bureaucrats and financial service providers, the private sector will probably win. This means only the least competent Germans, Greeks, or Swedes will allow themselves to get swept into the net.

Investors will move their money to nations not included in the directive. As any Economics 101 student can explain, a cartel won't work unless everyone agrees to rig the market. The EU is asking a number of nations with important financial centers to participate in the STD, but there are some very important omissions -- including Singapore, Hong Kong, Panama, and the Bahamas (plus other nations that will get into the business to take advantage of the EU's self-inflicted wound). According to the January 23, 2003, International Herald Tribune, "An agreement by European Union countries to crack down on tax cheats is likely to encourage some wealthy Europeans to park their money in tax havens in Asia and elsewhere outside the Union, tax lawyers and bankers said Wednesday." Indeed, some jurisdictions already are preparing for an influx of European money if the directive is approved. The Gulf Daily News reported last August that banks in Singapore are positioning themselves to capture a share of the $1 trillion that is expected to leave Europe if the Directive is implemented.

The United States has declined to participate in the cartel. Two senior level Bush Administration officials in 2002 announced that the American government was opposed to the Savings Tax Directive. The Chairman of the Council of Economic Advisers stated that, "We are not for the European savings initiative," and the Chairman of the National Economic Counsel remarked that, "The Administration does not support the EU Savings Directive. There is zero interest in it." Interestingly, in an effort to keep the STD from floundering, the EU has repeatedly adjusted its goals with regards to US participation. In 2001, the EU expected official negotiations with the United States, leading to a formal information-sharing arrangement, similar to the agreements it was seeking with non-EU jurisdictions in Europe. When that effort failed, the EU then said that the IRS was about to implement a regulation requiring reporting of bank deposit interest paid to foreigners, and that this would suffice as an "equivalent measure." But when it became clear that the Bush Administration was not going to approve this regulation, the EU changed its tune once again and now blithely asserts that the US already is in compliance with the directive. This willful ignorance by the EU is great news for the US economy if the STD is implemented. Capital would flow into American financial institutions and further boost US competitiveness.

These three factors suggest that the directive is a futile effort and that high-tax European nations instead should have lowered tax rates if they really wanted to encourage investors to repatriate their flight capital. But what if the previous analysis is wrong? What if the directive is successful, or, more likely, what if it is expanded and becomes an airtight system for tracking -- and taxing -- flight capital?

An old Chinese proverb states that you should be careful what you wish for, and the Europeans likewise should think twice about the supposed benefits of the STD. So-called tax havens currently provide Europeans with a tax-efficient means of investing in their home countries. A German dentist, for instance, can use a Luxembourg account to invest money in German companies. This is good for the taxpayer and good for the German economy. But if the STD is approved, our hypothetical dentist may move his money to Singapore, where investment patterns are less likely to favor Europe, or he may decide that investing is now too troublesome. Why not buy a fancy BMW and a nice house in the Black Forest? In either case, the German economy has less capital formation and long-term growth suffers.

The directive also might boomerang on Europe by creating bad incentives for politicians. The current environment pressures lawmakers to lower tax rates and implement tax reforms as part of an effort to attract investment and discourage capital flight. This process of tax competition has helped lower tax rates dramatically in the past two decades. But if taxpayers no longer have an escape hatch, governments will have much less reason to make needed fiscal reforms - and the absence of reform could have enormous negative effects, particularly in the long run.

European leaders may want to reconsider how they vote this June. Approving the savings tax directive is a lose-lose proposition. If it doesn't work, the EU loses capital and growth suffers, and if it works, the EU loses capital and growth suffers. Governments should not subject Europe to this suicide pact, especially since the other option -- tax rate reduction and tax reform -- is a proven formula for success.

Dan Mitchell recently wrote for TCS about the real threat from the east.


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