Implications of Introducing U.S. Withholding Taxes on Foreigners' Interest Income

Abstract

This paper explores efficiency and equity issues related to the introduction of a withholding tax on foreigners' interest income from their investments in the U.S. Because of existing treaty obligations and tax-avoidance options, the effective tax rate of any practicable withholding tax is likely to be considerably below its statutory rate. A statutory 30 percent U.S. withholding tax on portfolio interest, if not accompanied by similar (retaliatory) tax measures introduced by foreign governments, appears to yield aggregate domestic welfare gains. The gains are attributable to U.S. financial market power stemming from the large share represented by the U.S. of world financial transactions and from the imperfect substitutability between U.S. and foreign securities in port-folios. Gains also derive from effects on domestic saving. The withholding tax leads to only a temporary improvement in the U.S. trade balance and in aggregate exports. The ultimate deterioration of the trade balance is closely related to effects of the tax on international interest flows. If foreign governments respond in kind to a U.S. withholding tax initiative, the combined effect is a decline in U.S. residents' aggregate welfare. Foreign retaliation enlarges the global efficiency losses associated with a new U.S. withholding tax. The equity arguments for the withholding tax are mixed. Restricting the application of the tax to investors from countries that already impose similar measures may have more justification on fairness grounds than applying the tax to all foreign investors. An attraction of the tax is its ability to discourage capital flight to the U.S. and related tax evasion; however, other policies with less serious efficiency costs might be equally effective in addressing tax evasion problems.