A Theory of Taxing Sovereign Wealth

Abstract

Sovereign wealth funds enjoy an exemption from tax under section 892 of the tax code. This anachronistic provision offers an unconditional tax exemption when a foreign earns income from non-commercial activities in the United States. The provision, which was first enacted in 1917, reflects an expansive view of the international law doctrine of immunity that the United States (and other countries) discarded fifty years ago in other contexts. The Treasury regulations accompanying section 892 define non-commercial activity broadly, encompassing both traditional portfolio investing and more aggressive, strategic equity investments. Because section 892 was not written with wealth funds in mind, the policy rationale for this generous tax treatment has not been closely examined before. This Article provides a framework for analyzing the taxation of wealth. I start from a baseline norm of sovereign tax neutrality, which would treat the investment income of foreign sovereigns no better and no worse than private investors' income. Nor would it favor any specific nation over another. Whether we should depart from this norm depends on several factors, including the external costs and benefits created by wealth investment, whether tax or other regulatory instruments are superior methods of attracting investment or addressing harms, and which domestic political institutions are best suited to implement foreign policy. I then consider whether we should impose an excise tax that would discourage wealth fund investments in the equity of U.S. companies. If desired, the tax could be designed to complement nontax economic and foreign policy goals by discouraging investments by funds that fail to comply with best practices for transparency and accountability. The case for repealing the existing tax subsidy is strong. We should tax wealth funds as if they were private foreign corporations; there is no compelling reason to subsidize wealth. My analysis also shows that imposing a special excise tax may not be the optimal regulatory instrument for managing the special risks posed by wealth funds, although a carefully-designed tax would be more effective than the status quo.