THE EFFECT OF THE INTEREST EQUALIZATION TAX ACT AND THE INTEREST EQUALIZATION TAX EXTENSION ACT ON PURCHASES OF LONG-TERM BONDS OF SELECTED COUNTRIES MARKETED IN THE UNITED STATES: 1959 TO MARCH 1966*

Abstract

THE DEFICIT in the United States balance of payments has persisted since 1949. An important part of the deficit, especially in recent years, has been private long-term capital flows. The Interest Equalization Tax, a key policy for the elimination of the deficit, was introduced in response to a sudden upsurge in private capital investment in foreign portfolio securities. The Act provides for the imposition of a tax on the acquisition by an American citizen of a debt obligation from a foreign obligor or of stock from a foreign issuer. The Act is applicable to purchases of both old and new issues, and is designed to bring the cost of capital raised in the American capital market by foreign persons more closely into alignment with the costs prevailing in markets in other industrial countries. The Interest Equalization Tax was designed, according to a tax schedule incorporated into the law, to raise the cost to foreigners of obtaining capital in the American capital market by an amount equal to the effect of a rise in the American long-term interest rate of approximately one percentage point, as estimated by the United States Treasury Department. It would seem, therefore, that the success of the tax in diminishing long-term capital outflows would depend to some extent upon the relationship between American purchases of foreign securities subject to the legislation and the magnitude of the long-term interest-rate differential between the United States and those countries whose securities are subject to the tax. This study explores the relationship of the Interest Equalization Tax to these variables. The analysis is limited to government-bond transactions, on the assumption that equity securities contribute to the flow of long-term capital between capital markets for reasons other than expectations engendered by differences in interest rates. The countries chosen for analysis are Belgium, Denmark, France, Germany, Italy, the Netherlands, Norway, Sweden, Switzerland, and the United Kingdom. To determine the relation between purchases of bonds of the selected European countries and long-term interest-rate differentials between Europe and America, total monthly sales of the selected countries as indicated in Treasury Bulletin data are regressed on the monthly difference between a net and gross European government-bond yield, calculated from data in International Financial Statistics, and the United States long-term government-bond yield as shown in the Federal Reserve Bulletin. The composite yields are computed by a monthly weighting, on both a gross and net basis, of each selected country's long-term government-bond yield by each selected country's percentage contribution to the total of American purchases of long-term bonds from those countries. The study concludes that the Interest Equalization Tax increased bond-purchase sensitivity to interest differentials. It seems that, from January, 1959 through March, 1966, there existed a long-term interest differential between the United States and